THE
LEGG MASON INCOME TRUST, INC.
Legg Mason Investment Grade Income Portfolio
Legg Mason U. S. Government Money Market Portfolio
STATEMENT OF ADDITIONAL INFORMATION
Legg Mason Income Trust, Inc. ("Corporation") is an open-end,
diversified management investment company which currently has four
separate investment portfolios. This Statement of Additional Information
relates to two of those portfolios ("Portfolios").
Legg Mason Investment Grade Income Portfolio ("Investment Grade
Portfolio") seeks to provide investors with a high level of current income
through investment in a diversified portfolio of debt securities. In
attempting to achieve the Investment Grade Portfolio's objective, its
investment adviser, Western Asset Management Company ("Adviser"), invests
primarily in debt securities which it considers to be investment grade.
The Investment Grade Portfolio expects to maintain an average dollar-
weighted maturity of between five and twenty years. The Portfolio's
current yield is expected to be higher than the current yields of mutual
funds that own debt securities with shorter average maturities.
Legg Mason U. S. Government Money Market Portfolio ("Government
Money Market Portfolio") seeks to obtain high current income consistent
with liquidity and conservation of principal. In attempting to achieve
this objective, the Adviser will invest only in debt obligations
guaranteed as to principal and interest by the U.S. Government, its
agencies or instrumentalities, and in repurchase agreements collateralized
by such instruments. The Adviser attempts to maintain a stable net asset
value per share of $1.00, although there can be no assurance that it will
always be able to do so.
Separate Statements of Additional Information each dated May 1,
1995 are available for the Legg Mason High Yield Portfolio, and the Legg
Mason U.S. Government Intermediate-Term Portfolio, the other portfolios of
the Corporation.
This Statement of Additional Information is not a prospectus and
should be read in conjunction with the Prospectus for the Investment Grade
Portfolio or the Government Money Market Portfolio, each dated May 1,
1995, and each of which has been filed with the Securities and Exchange
Commission ("SEC"). A copy of each Portfolio's prospectus is available
without charge from the Corporation's distributor, Legg Mason Wood Walker,
Incorporated ("Legg Mason") (address and telephone numbers listed below).
Dated: May 1, 1995
LEGG MASON WOOD WALKER, INCORPORATED
111 South Calvert Street
Baltimore, Maryland 21202
(410) 539-0000
(800) 822-5544
<PAGE>
This Statement of Additional Information is not an offer of
sale of the securities of either Portfolio. An offer can be made only
by means of a Prospectus.
Table of Contents
Page
----
Additional Information About Investment
Limitations and Policies 2
Additional Tax Information 13
Additional Purchase and Redemption
Information 15
Performance Information 19
Valuation of Shares 24
Tax-Deferred Retirement Plans 26
The Corporation's Directors and Officers 27
Management Agreements 32
Investment Advisory Agreements 33
Portfolio Transactions and Brokerage 34
The Portfolios' Distributor 36
The Portfolios' Custodian and Transfer
and Dividend-Disbursing Agent 37
The Corporation's Legal Counsel 37
The Corporation's Independent Accountants 37
Financial Statements 38
Appendix A: Ratings of Securities A-1
No person has been authorized to give any information or
to make any representations not contained in the Prospectuses
or this Statement of Additional Information in connection with
the offerings made by the Prospectuses and, if given or made,
such information or representations must not be relied upon as
having been authorized by either Portfolio or its distributor.
The Prospectuses and the Statement of Additional Information do
not constitute offerings by either Portfolio or by the
distributor in any jurisdiction in which such offerings may not
lawfully be made.
<PAGE>
ADDITIONAL INFORMATION ABOUT INVESTMENT LIMITATIONS AND POLICIES
The following information supplements the information concerning each
Portfolio's investment objectives, policies and limitations found in the
relevant Prospectus.
Investment Grade Portfolio The Investment Grade Portfolio has
adopted certain fundamental investment limitations that cannot be changed
except by vote of a majority of its outstanding voting securities. The
Investment Grade Portfolio may not:
1. Borrow money, except for temporary purposes in an aggregate amount
not to exceed 5% of the value of its total assets at the time of
borrowing. (Although not a fundamental policy subject to shareholder
approval, the Investment Grade Portfolio intends to repay any money
borrowed before any additional portfolio securities are purchased.);
2. Invest more than 5% of its total assets (taken at market value) in
securities of any one issuer, other than the U.S. Government, its agencies
and instrumentalities, or buy more than 10% of the voting securities or
more than 10% of all the securities of any issuer;
3. Mortgage, pledge or hypothecate any of its assets, except to
collateralize permitted borrowings up to 5% of the value of its total
assets at the time of borrowing; provided, that the deposit in escrow of
underlying securities in connection with the writing of call options is
not deemed to be a pledge; and provided further, that deposit of initial
margin or the payment of variation margin in connection with the purchase
or sale of futures contracts or of options on futures contracts shall not
be deemed to constitute pledging assets;
4. Purchase securities on "margin," except that the Investment Grade
Portfolio may make margin deposits in connection with its use of options,
interest rate futures contracts and options on interest rate futures
contracts;
5. Make short sales of securities unless at all times while a short
position is open the Investment Grade Portfolio maintains a long position
in the same security in an amount at least equal thereto; provided,
however, that the Investment Grade Portfolio may purchase or sell futures
contracts, and may make initial and variation margin payments in
connection with purchases or sales of futures contracts or of options on
futures contracts;
6. Invest more than 25% of its total assets (taken at market value) in
any one industry;
7. Invest in securities issued by other investment companies, except
in connection with a merger, consolidation, acquisition or reorganization
or by purchase in the open market of securities of closed-end investment
companies where no underwriter or dealer commission or profit, other than
a customary brokerage commission, is involved and only if immediately
2
<PAGE>
thereafter not more than 10% of the Investment Grade Portfolio's total
assets (taken at market value) would be invested in such securities;
8. Purchase or sell commodities and commodity contracts, except that
the Investment Grade Portfolio may purchase or sell options, interest rate
futures contracts and options on interest rate futures contracts;
9. Underwrite the securities of other issuers, except to the extent
that in connection with the disposition of restricted securities or the
purchase of securities either directly from the issuer or from an
underwriter for an issuer, the Investment Grade Portfolio may be deemed to
be an underwriter;
10. Make loans, except loans of portfolio securities and except to the
extent the purchase of a portion of an issue of publicly distributed
notes, bonds or other evidences of indebtedness or deposits with banks and
other financial institutions may be considered loans;
11. Purchase or sell real estate, except that the Investment Grade
Portfolio may invest in securities collateralized by real estate or
interests therein or in securities issued by companies that invest in real
estate or interests therein; or
12. Purchase or sell interests in oil and gas or other mineral
exploration or development programs.
Government Money Market Portfolio The Government Money Market
Portfolio has adopted certain fundamental investment limitations that
cannot be changed except by vote of a majority of its outstanding voting
securities. The Government Money Market Portfolio may not:
1. Borrow money, except for temporary purposes in an aggregate amount
not to exceed 5% of the value of its total assets at the time of
borrowing. (Although not a fundamental policy subject to shareholder
approval, the Fund intends to repay any money borrowed before any
additional portfolio securities are purchased);
2. Mortgage, pledge or hypothecate any of its assets, except to
collateralize permitted borrowings up to 5% of the value of its total
assets at the time of borrowing;
3. Purchase securities on "margin" except that the Fund may obtain
such credits as may be necessary for clearing the purchases and sales of
securities;
4. Make short sales of securities unless at all times while a short
position is open the Fund maintains a long position in the same security
in an amount at least equal thereto;
5. Purchase or sell commodities and commodity contracts;
3
<PAGE>
6. Underwrite the securities of other issuers, except to the extent
that in connection with the disposition of restricted securities or the
purchase of securities either directly from the issuer or from an
underwriter for an issuer, the Fund may be deemed to be an underwriter;
7. Make loans, except loans of portfolio securities and except to the
extent the purchase of a portion of an issue of publicly distributed
notes, bonds or other evidences of indebtedness, entry into repurchase
agreements or deposits with banks and other financial institutions may be
considered loans;
8. Purchase or hold real estate, except that the Fund may invest in
securities collateralized by real estate or interests therein; and
9. Purchase or sell interests in oil and gas or other mineral
exploration or development programs.
As noted above, the fundamental investment limitations of each
Portfolio, along with its investment objective, may not be changed without
the vote of a majority of the Portfolio's outstanding voting securities.
Under the Investment Company Act of 1940, as amended ("1940 Act"), a "vote
of a majority of the outstanding voting securities" of a Portfolio means
the affirmative vote of the lesser of (1) more than 50% of the outstanding
shares of the Portfolio or (2) 67% or more of the shares present at a
shareholders' meeting if more than 50% of the outstanding shares are
represented at the meeting in person or by proxy. If a percentage
restriction described above is complied with at the time an investment is
made, a later increase in percentage resulting from changing values of
portfolio securities or in the amount of assets of the Portfolio will not
be considered a violation of any of those restrictions. Except as
otherwise noted, the investment policies and limitations described in this
Statement of Additional Information are non-fundamental and may be changed
without a shareholder vote.
Yield Factors and Ratings Standard & Poor's Ratings Group ("S&P")
and Moody's Investors Service, Inc. ("Moody's") are private services that
provide ratings of the credit quality of obligations. Investment grade
bonds are generally considered to be those bonds rated at the time of
purchase within one of the four highest grades assigned by S&P or Moody's.
A description of the range of ratings assigned to obligations by Moody's
and S&P is included in Appendix A to this Statement of Additional
Information. A Portfolio may use these ratings in determining whether to
purchase, sell or hold a security. These ratings represent Moody's and
S&P's opinions as to the quality of the obligations which they undertake
to rate. It should be emphasized, however, that ratings are general and
are not absolute standards of quality. Consequently, obligations with the
same maturity, interest rate and rating may have different market prices.
Subsequent to its purchase by either Portfolio, an issue of obligations
may cease to be rated or its rating may be reduced below the minimum
rating required for purchase by that Portfolio. The Adviser will consider
such an event in determining whether the Portfolio should continue to hold
the obligation, but is not required to dispose of it.
4
<PAGE>
In addition to ratings assigned to individual bond issues, the Adviser
will analyze interest rate trends and developments that may affect
individual issuers, including factors such as liquidity, profitability and
asset quality. The yields on bonds and other debt securities in which the
Portfolios invest are dependent on a variety of factors, including general
money market conditions, general conditions in the bond market, the
financial conditions of the issuer, the size of the offering, the maturity
of the obligation and its rating. There is a wide variation in the
quality of bonds, both within a particular classification and between
classifications. An issuer's obligations under its bonds are subject to
the provisions of bankruptcy, insolvency and other laws affecting the
rights and remedies of bond holders or other creditors of an issuer;
litigation or other conditions may also adversely affect the power or
ability of issuers to meet their obligations for the payment of interest
and principal on their bonds.
FUTURES AND OPTIONS
-------------------
The following information about futures and options applies to the
Investment Grade Portfolio:
Interest Rate Futures Contracts Interest rate futures contracts,
which are traded on commodity futures exchanges, provide for the sale by
one party and the purchase by another party of a specified type and amount
of financial instruments (or an index of financial instruments) at a
specified future date. Interest rate futures contracts currently exist
covering such financial instruments as U.S. Treasury bonds, notes and
bills, Government National Mortgage Association certificates, bank
certificates of deposit and 90-day commercial paper. An interest rate
futures contract may be held until the underlying instrument is delivered
and paid for on the delivery date, but most contracts are closed out
before then by taking an offsetting position on a futures exchange.
The Portfolio may purchase an interest rate futures contract (that is,
enter into a futures contract to purchase an underlying financial
instrument) when it intends to purchase fixed-income securities but has
not yet done so. This strategy is sometimes called an anticipatory hedge.
This strategy is intended to minimize the effects of an increase in the
price of the securities the Portfolio intends to purchase (but may also
reduce the effects of a decrease in price), because the value of the
futures contract would be expected to rise and fall in the same direction
as the price of the securities the Portfolio intends to purchase. The
Portfolio could purchase the intended securities either by holding the
contract until delivery and receiving the financial instrument underlying
the futures contract, or by purchasing the securities directly and closing
out the futures contract position. If the Portfolio no longer wished to
purchase the securities, it would close out the futures contract before
delivery.
The Portfolio may sell a futures contract (that is, enter into a
futures contract to sell an underlying financial instrument) to offset
price changes of securities it already owns. This strategy is intended to
5
<PAGE>
minimize any price changes in the securities the Portfolio owns (whether
increases or decreases) caused by interest rate changes, because the value
of the futures contract would be expected to move in the opposite
direction from the value of the securities owned by the Portfolio. The
Portfolio does not expect ordinarily to hold futures contracts it has sold
until delivery or to use securities it owns to satisfy delivery
requirements. Instead, the Portfolio expects to close out such contracts
before the delivery date.
The prices of interest rate futures contracts depend primarily on the
value of the instruments on which they are based, the price changes of
which, in turn, primarily reflect changes in current interest rates.
Because there are a limited number of types of interest rate futures
contracts, it is likely that the standardized futures contracts available
to the Portfolio will not exactly match the securities the Portfolio
wishes to hedge or intends to purchase, and consequently will not provide
a perfect hedge against all price fluctuation. Because fixed-income
instruments all respond similarly to changes in interest rates, however, a
futures contract the underlying instrument of which differs from the
securities the Portfolio wishes to hedge or intends to purchase may still
provide protection against changes in interest rate levels. To compensate
for differences in historical volatility between positions the Portfolio
wishes to hedge and the standardized futures contracts available to it,
the Portfolio may purchase or sell futures contracts with a greater or
lesser value than the securities it wishes to hedge or intends to
purchase.
Futures Trading If the Portfolio does not wish to hold a futures
contract position until the underlying instrument is delivered and paid
for on the delivery date, it may attempt to close out the contract by
entering into an offsetting position on a futures exchange that provides a
secondary market for the contract. A futures contract is closed out by
entering into an opposite position in an identical futures contract (for
example, by purchasing a contract on the same instrument and with the same
delivery date as a contract the Portfolio had sold) at the current price
as determined on the futures exchange. The Portfolio's gain or loss on
closing out a futures contract depends on the difference between the price
at which the Portfolio entered into the contract and the price at which
the contract is closed out. Transaction costs in opening and closing
futures contracts must also be taken into account. There can be no
assurance that the Portfolio will be able to offset a futures position at
the time it wishes to, or at a price that is advantageous. If the
Portfolio were unable to enter into an offsetting position in a futures
contract, it might have to continue to hold the contract until the
delivery date, in which case it would continue to bear the risk of price
fluctuation in the contract until the underlying instrument was delivered
and paid for.
At the time the Portfolio enters into an interest rate futures
contract, it is required to deposit with its custodian, in the name of the
futures broker (known as a futures commission merchant, or "FCM"), a
percentage of the contract's value. This amount, which is known as
6
<PAGE>
initial margin, generally equals 5% or less of the value of the futures
contract. Initial margin is in the nature of a good faith deposit or
performance bond, and is returned to the Portfolio when the futures
position is terminated, after all contractual obligations have been
satisfied. Futures margin does not represent a borrowing by the
Portfolio, unlike margin extended by a securities broker, and depositing
initial margin in connection with futures positions does not constitute
purchasing securities on margin for the purposes of the Portfolio's
investment limitations. Initial margin may be maintained either in cash
or in liquid, high-quality debt securities such as U.S. government
securities.
As the contract's value fluctuates, payments known as variation margin
or maintenance margin are made to or received from the FCM. If the
contract's value moves against the Portfolio (i.e., the Portfolio's
futures position declines in value), the Portfolio may be required to make
payments to the FCM, and, conversely, the Portfolio may be entitled to
receive payments from the FCM if the value of its futures position
increases. This process is known as "marking-to-market" and takes place
on a daily basis.
In addition to initial margin deposits, the Portfolio will instruct
its custodian to segregate additional cash and liquid debt securities to
cover its obligations under futures contracts it has purchased and to
ensure that the contracts are unleveraged. The value of the assets held
in the segregated account will be equal to the daily market value of all
outstanding futures contracts purchased by the Portfolio, less the amount
deposited as initial margin. Where the Portfolio enters into positions
that substantially offset one another, it may segregate assets equal to
only one side of the transaction, consistent with SEC staff interpretive
positions. When the Portfolio has sold futures contracts to hedge
securities it owns, it will not sell those securities (or lend them to
another party) while the contracts are outstanding, unless it substitutes
other similar securities for the securities sold or lent. The Portfolio
will not sell futures contracts with a value exceeding the value of
securities it owns, except that the Portfolio may do so to the extent
necessary to adjust for differences in historical volatility between the
securities owned and the contracts used as a hedge.
Risks of Interest Rate Futures Contracts By purchasing an interest
rate futures contract, the Portfolio in effect becomes exposed to price
fluctuations resulting from changes in interest rates, and by selling a
futures contract the Portfolio neutralizes those fluctuations. If
interest rates fall, the Portfolio would expect to profit from an increase
in the value of the instrument underlying a futures contract it had
purchased, and if interest rates rise, the Portfolio would expect to
offset the resulting decline in the value of the securities it owns by
profits in a futures contract it has sold. If interest rates move in the
direction opposite that which was contemplated at the time of purchase,
however, the Portfolio's positions in futures contracts could have a
negative effect on the Portfolio's net asset value. If interest rates
rise when the Portfolio has purchased futures contracts, the Portfolio
7
<PAGE>
could suffer a loss in its futures positions. Similarly, if interest
rates fall, losses in a futures contract the Portfolio has sold could
negate gains on securities the Portfolio owns, or could result in a net
loss to the Portfolio. In this sense, successful use of interest rate
futures contracts by the Portfolio will depend on the Adviser's ability to
hedge the Portfolio in an advantageous way at the appropriate time.
Other than the risk that interest rates will not move as expected, the
primary risk in employing interest rate futures contracts is that the
market value of the futures contracts may not move in concert with the
value of the securities the Portfolio wishes to hedge or intends to
purchase. This may result from differences between the instrument
underlying the futures contracts and the securities the Portfolio wishes
to hedge or intends to purchase, as would be the case, for example, if the
Portfolio hedged U.S. Treasury bonds by selling futures contracts on U.S.
Treasury notes.
Even if the securities which are the objects of a hedge are identical
to those underlying the futures contract, there may not be perfect price
correlation between the two. Although the value of interest rate futures
contracts is primarily determined by the price of the underlying financial
instruments, the value of interest rate futures contracts is also affected
by other factors, such as current and anticipated short-term and long-term
interest rates, the time remaining until expiration of the futures
contract, and conditions in the futures markets, which may not affect the
current market price of the underlying financial instruments in the same
way. In addition, futures exchanges establish daily price limits for
interest rate futures contracts, and may halt trading in the contracts if
their prices move up or down more than a specified daily limit on a given
day. This could distort the relationship between the price of the
underlying instrument and the futures contract, and could prevent prompt
liquidation of unfavorable futures positions. The value of a futures
contract may also move differently from the price of the underlying
financial instrument because of inherent differences between the futures
and securities markets, including variations in speculative demand for
futures contracts and for debt securities, the differing margin
requirements for futures contracts and debt securities, and possible
differences in liquidity between the two markets.
Put Options on Interest Rate Futures Contracts Purchasing a put
option on an interest rate futures contract gives a Portfolio the right to
assume a seller's position in the contract at a specified exercise price
at any time up to the option's expiration date. In return for this right,
the Portfolio pays the current market price for the option (known as the
option premium), as determined on the commodity futures exchange where the
option is traded.
The Portfolio may purchase put options on interest rate futures
contracts to hedge against a decline in the market value of securities the
Portfolio owns. Because a put option is based on a contract to sell a
financial instrument at a certain price, its value will tend to move in
the opposite direction from the price of the financial instrument
8
<PAGE>
underlying the futures contract; that is, the put option's value will tend
to rise when prices fall, and fall when prices rise. By purchasing a put
option on an interest rate futures contract, the Portfolio would attempt
to offset potential depreciation of securities it owns by appreciation of
the put option. This strategy is similar to selling the underlying
futures contract directly.
The Portfolio's position in a put option on an interest rate futures
contract may be terminated either by exercising the option (and assuming a
seller's position in the underlying futures contract at the option's
exercise price) or by closing out the option at the current price as
determined on the futures exchange. If the put option is not exercised or
closed out before its expiration date, the entire premium paid will be
lost by the Portfolio. The Portfolio could profit from exercising a put
option if the current market value of the underlying futures contract were
less than the sum of the exercise price of the put option and the premium
paid for the option (because the Portfolio would, in effect, be selling
the futures contract at a price higher than the current market price).
The Portfolio could also profit from closing out a put option if the
current market price of the option is greater than the premium the
Portfolio paid for the option. Transaction costs must also be taken into
account in these calculations. The Portfolio may close out an option it
has purchased by selling an identical option (that is, an option on the
same futures contract, with the same exercise price and expiration date)
in a closing transaction on a futures exchange that provides a secondary
market for the option. The Portfolio is not required to make futures
margin payments when it purchases an option on an interest rate futures
contract.
Compared to the purchase or sale of an interest rate futures contract,
the purchase of a put option on an interest rate futures contract involves
a smaller potential risk to the Portfolio, because the maximum amount at
risk is the premium paid for the option (plus related transaction costs).
If prices of debt securities remain stable, however, purchasing a put
option may involve a greater probability of loss than selling a futures
contract, even though the amount of the potential loss is limited. The
Adviser will consider the different risk and reward characteristics of
options and futures contracts when selecting hedging instruments.
Risks of Transactions in Options on Interest Rate Futures Contracts
Options on interest rate futures contracts are subject to risks similar to
those described above with respect to interest rate futures contracts.
These risks include the risk that the Adviser may not hedge the Portfolio
in an advantageous way at the appropriate time, the risk of imperfect
price correlation between the option and the securities being hedged, and
the risk that there may not be an active secondary market for the option.
There is also a risk of imperfect price correlation between the option and
the underlying futures contract.
Although the Adviser will purchase and write only those options for
which there appears to be a liquid secondary market, there can be no
assurance that such a market will exist for any particular option at any
9
<PAGE>
particular time. If there were no liquid secondary market for a
particular option, the Portfolio might have to exercise an option it had
purchased in order to realize any profit, and might continue to be
obligated under an option it had written until the option expired or was
exercised.
Options Writing on Debt Securities The Portfolio may from time to
time write (sell) covered call options and covered put options on certain
of its portfolio securities. When it writes a covered call option, the
Portfolio obligates itself to sell the underlying security to the
purchaser of the option at a fixed price if the purchaser exercises the
option during the option period. A call is "covered" if the Portfolio
owns the optioned securities or, in the case of options on certain U.S.
government securities, the Portfolio maintains with its custodian in a
segregated account cash, U.S. government securities or other high-grade
liquid debt securities with a value sufficient to meet its obligations
under the call. When the Portfolio writes a call option, it receives a
premium from the purchaser. During the option period, the Portfolio
forgoes the opportunity to profit from any increase in the market price of
the security above the exercise price of the option, but retains the risk
that the price of the security may decline.
The Portfolio may also write covered put options. When the Portfolio
writes a put option, it receives a premium and gives the purchaser of the
put the right to sell the underlying security to the Portfolio at the
exercise price at any time during the option period. A put is "covered"
if the Portfolio maintains cash, U.S. government securities or other high-
grade liquid debt securities with a value equal to the exercise price in a
segregated account. The risk in writing puts is that the market price of
the underlying security may decline below the exercise price (less the
premiums received).
The Portfolio may seek to terminate its obligations as a writer of a
put or call option prior to its expiration by entering into a "closing
purchase transaction." A closing purchase transaction is the purchase of
an option covering the same underlying security and having the same
exercise price and expiration date as an option previously written by the
Portfolio on which it wishes to terminate its obligation.
Although not a fundamental policy subject to shareholder vote, the
Portfolio does not presently intend to write options on portfolio
securities exceeding 25% of its total assets. Normally, options will be
written on those portfolio securities which the Adviser does not expect to
have significant short-term capital appreciation.
Risks of Writing Options on Debt Securities When the Portfolio
writes an option, it assumes the risk of fluctuations in the value of the
underlying security in return for a fixed premium and must be prepared to
satisfy exercise of the option at any time until the expiration date. The
writing of options could also result in an increase in the Portfolio's
turnover rate, particularly in periods of appreciation in the market price
of the underlying securities. In addition, writing options on portfolio
10
<PAGE>
securities involves a number of other risks, including the risk that the
Adviser may not correctly predict interest rate movement and the risk that
there may not be a liquid secondary market for the option, as a result of
which the Portfolio might be unable to effect a closing transaction.
If the Portfolio is unable to close out an option it has written, it
must continue to bear the risks associated with the option, and must
continue to hold cash or securities to cover the option until the option
is exercised or expires. The Portfolio may engage in options on
securities which are not traded on national exchanges ("unlisted
options"). Because unlisted options may be closed out only with the other
party to the option transaction, it may be more difficult to close out
unlisted options than listed options.
Regulatory Notification of Futures and Options Strategies The
Corporation has filed on behalf of the Portfolio a notice of eligibility
for exclusion from the definition of the term "commodity pool operator"
with the Commodity Futures Trading Commission ("CFTC") and the National
Futures Association, which regulate trading in the futures markets. Under
Section 4.5 of the regulations under the Commodity Exchange Act, the
notice of eligibility must include representations that the Portfolio will
use futures contracts and related options solely for bona fide hedging
purposes within the meaning of the CFTC regulations, provided that the
Portfolio may hold futures contracts and related options that do not fall
within the definition of bona fide hedging transactions if, with respect
to such non-hedging transactions, the sum of initial margin deposits on
futures contracts and related options and premiums paid for related
options after taking into account unrealized profits and losses on such
contracts, do not exceed 5% of the Portfolio's net assets; and provided
further that the Portfolio may exclude the amount by which an option is
"in the money" in computing such 5%. The Portfolio will not purchase
futures contracts or related options if as a result more than 33 1/3% of
the Portfolio's total assets would be so invested. Where the Portfolio
enters into two positions that substantially offset each other, it
determines compliance with the foregoing limitation by considering its net
exposure to changes in the underlying instrument or market. These limits
on the Portfolio's investments in futures contracts are not fundamental
and may be changed by the Board of Directors as regulatory agencies
permit. The Portfolio will not modify these limits to increase its
permissible futures and related options activities without supplying
additional information in a supplement to a current Prospectus or
Statement of Additional Information that has been distributed or made
available to the Portfolio's shareholders.
OTHER INVESTMENT POLICIES
-------------------------
Private Placements The Investment Grade Portfolio may acquire
restricted securities in private placement transactions, directly from the
issuer or from security holders, frequently at higher yields than
comparable publicly traded securities. Restricted securities will not be
purchased if as a result more than 5% of the Portfolio's assets would
consist of restricted securities. Privately placed securities can be sold
11
<PAGE>
by the Portfolio only (1) pursuant to SEC Rule 144A or other exemption;
(2) in privately negotiated transactions to a limited number of
purchasers; or (3) in public offerings made pursuant to an effective
registration statement under the Securities Act of 1933. Private or
public sales of such securities by the Portfolio may involve significant
delays and expense. Private sales require negotiations with one or more
purchasers and generally produce less favorable prices than the sale of
comparable unrestricted securities. Public sales generally involve the
time and expense of preparing and processing a registration statement
under the Securities Act of 1933 and may involve the payment of
underwriting commissions; accordingly, the proceeds may be less than the
proceeds from the sale of securities of the same class which are freely
marketable.
Securities Lending A Portfolio may lend portfolio securities to
brokers or dealers in corporate (with respect to the Investment Grade
Portfolio only) or U.S. government securities, banks or other recognized
institutional borrowers of securities, provided that the borrower
maintains cash or equivalent collateral, equal to at least 100% of the
market value of the securities loaned with the Portfolios' custodian.
During the time portfolio securities are on loan, the borrower will pay
the Portfolio an amount equivalent to any dividends or interest paid on
such securities, and the Portfolio may invest the cash collateral and earn
income, or it may receive an agreed upon amount of interest income from
the borrower who has delivered equivalent collateral. These loans are
subject to termination at the option of the Portfolio or the borrower. A
Portfolio may pay reasonable administrative and custodial fees in
connection with a loan and may pay a negotiated portion of the interest
earned on the cash or equivalent collateral to the borrower or placing
broker. In the event of the bankruptcy of the other party to a securities
loan, the Portfolio could experience delays in recovering the securities
lent. To the extent that, in the meantime, the value of the securities
purchased had decreased or the securities lent increased, the Portfolio
could experience a loss. The Portfolio will enter into securities loan
transactions only with financial institutions which the Adviser believes
to present minimal risk of default during the term of the loan. A
Portfolio does not have the right to vote securities on loan, but would
terminate the loan and regain the right to vote if that were considered
important with respect to the investment. The Portfolios presently do not
intend to loan more than 5% of their respective portfolio securities at
any given time.
Repurchase Agreements Repurchase agreements are usually for periods
of one week or less, but may be for longer periods. The securities are
held for the Portfolios by State Street Bank and Trust Company ("State
Street"), the Portfolios' custodian, as collateral until resold and are
supplemented by additional collateral if necessary to maintain a total
value equal to or in excess of the value of the repurchase agreement. A
Portfolio bears a risk of loss in the event that the other party to a
repurchase agreement defaults on its obligations and the Portfolio is
delayed or prevented from exercising its rights to dispose of the
collateral securities. The Portfolios enter into repurchase agreements
12
<PAGE>
only with financial institutions which the Adviser believes to present
minimal risk of default during the term of the agreement based on
guidelines established by the Board of Directors. Each of the Portfolios
currently intends to invest in repurchase agreements when cash is
temporarily available or for temporary defensive purposes.
Reverse Repurchase Agreements A reverse repurchase agreement is a
portfolio management technique in which a Portfolio temporarily transfers
possession of a portfolio instrument to another person, such as a
financial institution or broker-dealer, in return for cash. At the same
time, the Portfolio agrees to repurchase the instrument at an agreed upon
time (normally within seven days) and price, including interest payment.
A Portfolio may engage in reverse repurchase agreements as a means of
raising cash to satisfy redemption requests or for other temporary or
emergency purposes without the necessity of selling portfolio instruments.
When a Portfolio reinvests the proceeds of a reverse repurchase
agreement in other securities, any fluctuations in the market value of
either the securities transferred to another party or the securities in
which the proceeds are invested would affect the market value of the
Portfolio's assets. As a result, such transactions could increase
fluctuation in the Portfolio's net asset value. If a Portfolio reinvests
the proceeds of the agreement at a rate lower than the cost of the
agreement, engaging in the agreement will lower the Portfolio's yield.
While engaging in reverse repurchase agreements, each Portfolio will
maintain cash, U.S. government securities or other high-grade, liquid debt
securities in a segregated account at its custodian bank with a value at
least equal to the Portfolio's obligation under the agreements.
The ability of each Portfolio to engage in reverse repurchase
agreements is subject to each Portfolio's fundamental investment
limitation concerning borrowing, i.e., that borrowing may be for temporary
purposes only and in an amount not to exceed 5% of the Portfolio's total
assets.
For the Investment Grade Portfolio:
-----------------------------------
Warrants Although not a fundamental policy subject to shareholder
vote, so long as the Portfolio's shares continue to be registered in
certain states, the Portfolio may not invest more than 5% of the value of
its net assets, taken at the lower of cost or market value, in warrants or
invest more than 2% of the value of such net assets in warrants not listed
on the New York or American Stock Exchanges.
Mortgage-Related Securities Mortgage-related securities represent an
ownership interest in a pool of residential mortgage loans. These
securities are designed to provide monthly payments of interest, and in
most instances, principal to the investor. The mortgagor's monthly
payments to his/her lending institution are "passed-through" to investors
such as the Portfolio. Most issuers or poolers provide guarantees of
payments, regardless of whether or not the mortgagor actually makes the
13
<PAGE>
payment. The guarantees made by issuers or poolers are backed by various
forms of credit, insurance and collateral.
Pools consist of whole mortgage loans or participations in loans. The
majority of these loans are made to purchasers of one- to four-family
homes. The terms and characteristics of the mortgage instruments are
generally uniform within a pool but may vary among pools. For example, in
addition to fixed-rate, fixed-term mortgages, the Portfolio may purchase
pools of variable-rate mortgages, growing-equity mortgages, graduated-
payment mortgages and other types.
All poolers apply standards for qualification to lending institutions
which originate mortgages for the pools. Poolers also establish credit
standards and underwriting criteria for individual mortgages included in
the pools. In addition, many mortgages included in pools are insured
through private mortgage insurance companies.
The majority of mortgage-related securities currently available are
issued by governmental or government-related organizations formed to
increase the availability of mortgage credit. The largest government-
sponsored issuer of mortgage-related securities is the Government National
Mortgage Association ("GNMA"). GNMA certificates are interests in pools
of loans insured by the Federal Housing Administration or by the Farmer's
Home Administration ("FHA"), or guaranteed by the Veterans Administration
("VA"). The Federal National Mortgage Association ("FNMA") and the
Federal Home Loan Mortgage Corporation ("FHLMC") each issue pass-through
securities which are guaranteed as to principal and interest by FNMA and
FHLMC, respectively.
The average life of mortgage-related securities varies with the
maturities and the nature of the underlying mortgage instruments. For
example, GNMAs tend to have a longer average life than FHLMC participation
certificates ("PCs") because there is a tendency for the conventional and
privately-insured mortgages underlying FHLMC PCs to repay at faster rates
than the FHA and VA loans underlying GNMAs. In addition, the term of a
security may be shortened by unscheduled or early payments of principal
and interest on the underlying mortgages. The occurrence of mortgage pre-
payments is affected by various factors, including the level of interest
rates, general economic conditions, the location and age of the mortgaged
property and other social and demographic conditions.
In determining the dollar-weighted average maturity of the Portfolio's
portfolio, the Adviser will follow industry practice in assigning an
average life to the mortgage-related securities of the Portfolio unless
the interest rate on the mortgages underlying such securities is such that
a different prepayment rate is likely. For example, where a GNMA has a
high interest rate relative to the market, that GNMA is likely to have a
shorter overall maturity than a GNMA with a market rate coupon. Moreover,
the Adviser may deem it appropriate to change the projected average life
for the Portfolio's mortgage-related security as a result of fluctuations
in market interest rates and other factors.
14
<PAGE>
Quoted yields on mortgage-related securities are typically based on
the maturity of the underlying instruments and the associated average life
assumption. Actual prepayment experience may cause the yield to differ
from the average life yield. Reinvestment of the prepayments may occur at
higher or lower interest rates than the original investment, thus
affecting the yield of the Portfolio. The compounding effect from the
reinvestments of monthly payments received by the Portfolio will increase
the yield to shareholders compared to bonds that pay interest semi-
annually.
Like other debt securities, the value of mortgage-related securities
will tend to rise when interest rates fall, and fall when rates rise. The
value of mortgage-related securities may also change because of changes in
the market's perception of the creditworthiness of the organization that
issued or guaranteed them. In addition, the mortgage securities market in
general may be adversely affected by changes in governmental regulation or
tax policies.
ADDITIONAL TAX INFORMATION
The following is a general summary of certain federal tax
considerations affecting each Portfolio and their shareholders. Investors
are urged to consult their own tax advisers for more detailed information
regarding any federal, state or local taxes that may be applicable to
them.
General For federal tax purposes, each Portfolio is treated as a
separate corporation. In order to continue to qualify for treatment as a
regulated investment company ("RIC") under the Internal Revenue Code of
1986, as amended ("Code"), a Portfolio must distribute annually to its
shareholders at least 90% of its investment company taxable income
(generally, net investment income plus any net short-term capital gain)
("Distribution Requirement") and must meet several additional
requirements. For each Portfolio, these requirements include the
following: (1) each Portfolio 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
contracts) derived with respect to its business of investing in securities
("Income Requirement"); (2) the Portfolio must derive less than 30% of its
gross income each taxable year from the sale or other disposition of
securities, options or futures contracts held for less than three months
("Short-Short Limitation"); (3) at the close of each quarter of the
Portfolio'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, with those other securities
limited, in respect of any one issuer, to an amount that does not exceed
5% of the value of the Portfolio's total assets; and (4) at the close of
each quarter of the Portfolio'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.
15
<PAGE>
A Portfolio will be subject to a nondeductible 4% excise tax ("Excise
Tax") to the extent it fails to distribute by the end of any calendar year
substantially all of its ordinary income for that year and capital gain
net income for the one-year period ending on October 31 of that year, plus
certain other amounts. For this and other purposes, dividends and other
distributions declared by a Portfolio in December of any year and payable
to shareholders of record on a date in that month will be deemed to have
been paid by the Portfolio and received by the shareholders on December 31
if the distributions are paid by the Portfolio during the following
January. Accordingly, such distributions will be taxed to the
shareholders for the year in which that December 31 falls.
For the Investment Grade Portfolio:
If shares of the Investment Grade Portfolio are sold at a loss after
being held for six months or less, the loss will be treated as a long-
term, instead of a short-term, loss to the extent of any capital gain
distributions received on those shares. Investors also should be aware
that if shares of the Portfolio are purchased shortly before the record
date for any dividend or other distribution, the investor will pay full
price for the shares and receive some portion of the price back as a
taxable distribution.
Hedging Instruments The use of hedging instruments, such as options
and futures contracts, involves complex rules that will determine for
income tax purposes the character and timing of recognition of the gains
and losses the Portfolio realizes in connection therewith.
Regulated futures contracts and options that are subject to Section
1256 of the Code (collectively, "Section 1256 contracts") and are held by
the Portfolio at the end of each taxable year will be required to be
"marked-to-market" for federal income tax purposes (that is, treated as
having been sold at that time at market value). Any unrealized gain or
loss recognized under this mark-to-market rule will be added to any
realized gains and losses on Section 1256 contracts actually sold by the
Portfolio during the year, and the resulting gain or loss will be treated
(without regard to the holding period) as 60% long-term capital gain or
loss and 40% short-term capital gain or loss. These rules may operate to
increase the amount of dividends, which will be taxable to shareholders,
that must be distributed to meet the Distribution Requirement and avoid
imposition of the Excise Tax, without providing the cash with which to
make the distributions. The Portfolio may elect to exclude certain
transactions from Section 1256, although doing so may have the effect of
increasing the relative proportion of short-term capital gain (taxable as
ordinary income when distributed to the Portfolio's shareholders).
Generally, the hedging transactions undertaken by the Portfolio may
result in "straddles" for federal income tax purposes. Because
application of the straddle rules may affect the character of gains or
losses, defer the recognition of losses and/or accelerate the recognition
of gains from the affected straddle positions, and may require the
capitalization of interest expense associated therewith, the amount that
16
<PAGE>
must be distributed to shareholders (and the character of the distribution
as ordinary income or long-term capital gain) may be increased or
decreased substantially as compared to a fund that did not engage in such
hedging transactions.
Income from transactions in options and futures contracts derived by
the Portfolio with respect to its business of investing in securities will
qualify as permissible income under the Income Requirement. However,
income from the disposition of options and futures contracts will be
subject to the Short-Short Limitation if they are held for less than three
months. Furthermore, if the Portfolio satisfies certain requirements, any
increase in value of a position that is part of a "designated hedge" will
be offset by any decrease in value (whether realized or not) of the
offsetting hedging position during the period of the hedge for purposes of
determining whether the Portfolio satisfies the Short-Short Limitation.
Thus, only the net gain (if any) from the designated hedge will be
included in gross income for purposes of this limitation. The Portfolio
intends that, when it engages in hedging transactions, it will qualify for
this treatment, but at the present time it is not clear whether this
treatment will be available for, or that the Portfolio will elect to have
this treatment apply to, all hedging transactions it undertakes. To the
extent this treatment is not available, the Portfolio may be forced to
defer the closing out of certain options and futures contracts beyond the
time when it otherwise would be advantageous to do so, in order for the
Portfolio to continue to qualify as a RIC.
Original Issue Discount The Portfolio may acquire zero coupon
bonds or other debt securities issued with original issue discount. As a
holder of those securities, the Portfolio must include in its income the
original issue discount that accrues on the securities during the taxable
year, even if it receives no corresponding payment on the securities
during the year. Because the Portfolio annually must distribute
substantially all of its investment company taxable income, including any
earned original issue discount, to satisfy the Distribution Requirement
and avoid imposition of the Excise Tax, it may be required in a particular
year to distribute as a dividend an amount that is greater than the total
amount of cash it actually receives. Those distributions will be made
from the Portfolio's cash assets or from the proceeds of sales of
portfolio securities, if necessary. The Portfolio may realize capital
gains or losses from those sales, which would increase or decrease its
investment company taxable income and/or net capital gain (the excess of
net long-term capital gain over net short-term capital loss). In
addition, any such gains may be realized on the disposition of securities
held for less than three months. Because of the Short-Short Limitation,
any such gains would reduce the Portfolio's ability to sell other
securities, or options or futures contracts, held for less than three
months that it might wish to sell in the ordinary course of its portfolio
management.
17
<PAGE>
ADDITIONAL PURCHASE AND REDEMPTION INFORMATION
Future First Systematic Investment Plan and Transfer of Funds from
Financial Institutions The Prospectus for each Portfolio explains that
you may buy additional shares of the Portfolio through the Portfolio's
Future First Systematic Investment Plan. Under this plan you may arrange
for automatic monthly investments in a Portfolio of $50 or more by
authorizing Boston Financial Data Services ("BFDS"), the Portfolios'
transfer agent, to prepare a check each month drawn on your checking
account. Each month the transfer agent will send a check to your bank for
collection, and the proceeds of the check will be used to buy shares of
the Portfolio at the per share net asset value determined on the day the
check is sent to your bank. You will receive a cumulative quarterly
confirmation for the purchase of additional shares through your checking
account. You may terminate the Future First Systematic Investment Plan at
any time without charge or penalty. Forms to enroll in the Future First
Systematic Investment Plan are available from any Legg Mason or
affilitated office.
You may also buy additional shares of the Portfolios through a plan
permitting transfers of funds from a financial institution. Certain
financial institutions may allow you, on a pre-authorized basis, to have
$50 or more automatically transferred monthly for investment in shares of
the Portfolios to:
Legg Mason Wood Walker, Incorporated
Funds Processing
P.O. Box 1476
Baltimore, MD 21203-1476
If your check is not honored by the institution it is drawn on, you
may be subject to extra charges in order to cover collection costs. These
charges may be deducted from your shareholder account.
Systematic Withdrawal Plan You may also elect to make systematic
withdrawals from your Portfolio account of a minimum of $50 on a monthly
basis if you own shares with a net asset value of $5,000 or more. The
amounts paid to you each month are obtained by redeeming sufficient shares
from your account to provide the withdrawal amount that you have
specified. The Systematic Withdrawal Plan is not currently available for
shares held in an Individual Retirement Account ("IRA"), Self-Employed
Individual Retirement Plan ("Keogh Plan"), Simplified Employee Pension
Plan ("SEP") or other qualified retirement plan. You may change the
monthly amount to be paid to you without charge not more than once a year
by notifying Legg Mason or the affiliate with which you have an account.
Redemptions will be made at the net asset value determined as of the close
of business on the New York Stock Exchange, Inc. ("Exchange") on the first
day of each month. If the Exchange is not open for business on that day,
the shares will be redeemed at the net asset value as determined as of the
close of regular trading of the Exchange on the preceding business day.
The check for the withdrawal payment will usually be mailed to you on the
next business day following redemption. If you elect to participate in
18
<PAGE>
the Systematic Withdrawal Plan, dividends and distributions on all shares
in your Portfolio account must automatically be reinvested in shares of
that Portfolio. You may terminate the Systematic Withdrawal Plan at any
time without charge or penalty. Each Portfolio, its transfer agent, Legg
Mason and its affiliates also reserve the right to modify or terminate the
Systematic Withdrawal Plan at any time.
Withdrawal payments are treated as a sale of shares rather than as a
dividend or capital gain distribution. To the extent periodic withdrawals
exceed reinvested dividends and distributions, the amount of your original
investment will be correspondingly reduced.
Ordinarily, you should not purchase additional shares of a Portfolio
if you maintain a Systematic Withdrawal Plan because you may incur tax
liabilities in connection with such purchases and withdrawals. The
Portfolios will not knowingly accept purchase orders from you for
additional shares if you maintain a Systematic Withdrawal Plan unless your
purchase is equal to at least one year's scheduled withdrawals. In
addition, if you maintain a Systematic Withdrawal Plan, you may not make
periodic investments under the Future First Systematic Investment Plan.
For Government Money Market Portfolio:
--------------------------------------
Conversion to Federal Funds A cash deposit made after the daily
cashiering deadline of the Legg Mason office in which the deposit is made
will be credited to your Legg Mason brokerage account ("Brokerage
Account") on the next business day following the day of deposit, and the
resulting free credit balance will be invested on the second business day
following the day of receipt.
Legg Mason Premier Asset Management Account/VISA Account
Shareholders of the Government Money Market Portfolio who have cash or
negotiable securities (including Government Money Market Portfolio shares)
valued at $20,000 or more in accounts with Legg Mason may subscribe to
Legg Mason's Premier Asset Management Account ("Premier"). This program
provides a direct link between a shareholder's Government Money Market
Portfolio account and his or her Brokerage Account. Premier provides
shareholders with a convenient method to invest in the Government Money
Market Portfolio through their Brokerage Account, which includes automatic
daily investment of free credit balances of $100 or more and automatic
weekly investment of free credit balances of less than $100.
Premier is a comprehensive financial service which combines a
shareholder's Government Money Market Portfolio account, a preferred
customer VISA Gold debit card, a Legg Mason Brokerage Account and
unlimited checks with no minimum check amount. Premier is offered as an
exclusive preferred customer service for shareholders of certain Legg
Mason funds.
The VISA Gold debit card may be used to purchase merchandise or
services from merchants honoring VISA or to obtain cash advances (which a
19
<PAGE>
bank may limit to $5,000 or less, per account per day) from any bank
honoring VISA.
Checks, VISA charges and cash advances are posted to the shareholder's
margin account and create automatic same day redemptions if shares are
available in the Government Money Market Portfolio. If Portfolio shares
have been exhausted, the debits will remain in the margin account,
reducing the cash available. The shareholder will receive one
consolidated monthly statement which details all Portfolio transactions,
securities activity, check writing activity and VISA Gold purchases and
cash advances.
BancOne Columbus ("BancOne"), 757 Carolyn Avenue, Columbus, Ohio
43271, is the Government Money Market Portfolio's agent for processing
payment of VISA Gold debit card charges and clearance of checks written on
the Premier Account. Shareholders are subject to BancOne's rules and
regulations governing VISA accounts, including the right of BancOne not to
honor VISA drafts in amounts exceeding the authorization limit of the
shareholder's account at the time the VISA draft is presented for payment.
The authorization limit is determined daily by taking the shareholder's
Government Money Market Portfolio account balance and subtracting (1) all
shares purchased by other than federal funds wired within 15 days; (2) all
shares for which certificates have been issued; and (3) any previously
authorized VISA transaction.
Preferred Customer Card Services Unlike some other investment
programs which offer the VISA card privilege, Premier also includes
travel/accident insurance at no added cost when shareholders purchase
travel tickets with their Premier VISA Gold debit card. Coverage is
provided through VISA and extends up to $250,000.
If a VISA Gold debit card is lost or stolen, the shareholder should
report the loss immediately by contacting Legg Mason directly between the
hours of 8:30 a.m. and 5:00 p.m., or BancOne collect after hours at 1-614-
248-4242. Those shareholders who subscribe to the Premier VISA account
privilege may be liable for the unauthorized use of their VISA Gold debit
card in amounts up to $50.
Legg Mason is responsible for all Premier VISA Gold debit card
inquiries as well as billing and account resolutions. Simply call Legg
Mason Premier Client Services directly between 8:30 a.m. and 5:00 p.m.,
Eastern time, at 1-800-253-0454 or 1-410-528-2066 with your account
inquiries.
Automatic Purchases of Fund Shares For shareholders participating in
the Premier program who sell shares held in their Brokerage Account, any
free credit balances of $100 or more resulting from any such sale will
automatically be invested in shares of the Government Money Market
Portfolio on the same business day the proceeds of sale are credited to
the Brokerage Account. Free credit balances of less than $100 will be
invested in Portfolio shares weekly.
20
<PAGE>
Free credit balances arising from sales of Brokerage Account shares
for cash (i.e., same day settlement), redemption of debt securities,
dividend and interest payments and cash deposits will be invested
automatically in Portfolio shares on the next business day following the
day the transaction is credited to the Brokerage Account.
Portfolio shares will receive the next dividend declared following
purchase (normally 12:00 noon, Eastern time, on the following business
day). A purchase order will not become effective until cash in the form
of federal funds is received by the Portfolio.
How to Open a Premier Account To subscribe to Premier services,
clients must contact Legg Mason to execute both a Premier Agreement with
Legg Mason and a VISA Account Application and Agreement with BancOne.
Legg Mason charges a fee for the Premier service, which is currently $85
per year for individuals and $100 per year for businesses and
corporations. Legg Mason reserves the right to alter or waive the
conditions upon which a Premier Account may be opened. Both Legg Mason
and BancOne reserve the right to terminate or modify any shareholder's
Premier services at their discretion.
You may request Premier Account status by filling out the Premier
Asset Management Account Agreement and Check Application which can be
obtained from your investment executive. You will receive your VISA Gold
debit card (if applicable) from BancOne. The Premier VISA Gold debit card
may be used at over 8 million locations, including 23,000 ATMs, in 24
countries around the world. Premier checks will be sent to you directly.
There is no limit to the number of checks you may write against your
Premier account.
Shareholders should be aware that the various features of the Premier
program are intended to provide easy access to assets in their accounts
and that the Premier Account is not a bank account. Additional
information about the Premier program is available by calling your Legg
Mason or affiliated investment executive or Legg Mason's Premier Client
Services.
Other Information Regarding Redemption The Government Money
Market Portfolio reserves the right to modify or terminate the check,
wire, telephone or VISA Gold card redemption services described in the
Prospectus and this Statement of Additional Information at any time.
You may request the Government Money Market Portfolio's checkwriting
service by sending a written request to Legg Mason. State Street will
supply you with checks which can be drawn on an account of the Government
Money Market Portfolio maintained with State Street. When honoring a
check presented for payment, the Government Money Market Portfolio will
cause State Street to redeem exactly enough full and fractional shares
from your account to cover the amount of the check. Cancelled checks will
be returned to you.
21
<PAGE>
Check redemption is subject to State Street's rules and regulations
governing checking accounts. Checks should not be used to close a
Government Money Market Portfolio account because when the check is
written you will not know the exact value of the account, including
accrued dividends, on the day the check clears. Persons obtaining
certificates for their shares may not use the checkwriting service.
For Both Portfolios:
--------------------
Each Portfolio reserves the right to modify or terminate the wire or
telephone redemption services described in their Prospectus at any time.
The date of payment for a redemption may not be postponed for more
than seven days, and the right of redemption may be suspended except (1)
for any period during which the Exchange is closed (other than for
customary weekend or holiday closings), (2) when trading in markets a
Portfolio normally utilizes is restricted, or an emergency, as defined by
rules and regulations of the SEC, exists, making disposal of a Portfolio's
investments or determination of its net asset value not reasonably
practicable, or (3) for such other periods as the SEC by regulation or
order may permit for protection of a Portfolio's shareholders. In the
case of any such suspension, you may either withdraw your request for
redemption or receive payment based upon the net asset value next
determined after the suspension is lifted.
Each Portfolio reserves the right, under certain conditions, to honor
any request or combination of requests for redemption from the same
shareholder in any 90-day period, totalling $250,000 or 1% of the net
assets of the Portfolio, whichever is less, by making payment in whole or
in part by securities valued in the same way as they would be valued for
purposes of computing each Portfolio's net asset value per share. If
payment is made in securities, a shareholder should expect to incur
brokerage expenses in converting those securities into cash and will be
subject to fluctuation in the market price of those securities until they
are sold. The Portfolios do not redeem "in kind" under normal
circumstances, but would do so where the Adviser determines that it would
be in the best interests of the shareholders as a whole.
Although a Portfolio may elect to redeem any shareholder account with
a current value of less than $500, a Portfolio will not redeem accounts
that fall below $500 solely as a result of a reduction in net asset value
per share.
PERFORMANCE INFORMATION
For the Investment Grade Portfolio:
----------------------------------
Total Return Calculations Average annual total return quotes used
in the Portfolio's advertising and other promotional materials
("Performance Advertisements") are calculated according to the following
formula:
22
<PAGE>
n
P(1+T) = ERV
where P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a
hypothetical $1,000 payment made at the
beginning of that period.
Under the foregoing formula, the time periods used in Performance
Advertisements will be based on rolling calendar quarters, updated to the
last day of the most recent quarter prior to submission of the Performance
Advertisements 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 redeeming
value all dividends and other distributions by the Portfolio are assumed
to have been reinvested at net asset value on the reinvestment dates
during the period.
Yield Yields used in the Portfolio's Performance Advertisements
are calculated by dividing the Portfolio's net investment income for a 30-
day period ("Period"), by the average number of shares 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 at the end of the Period. Yield quotations are calculated
according to the following formula:
6
Yield = 2 [ (a-b +1) - 1 ]
cd
where: a = interest earned during the Period
b = expenses accrued for the Period
(net of reimbursements)
c = the average daily number of shares
outstanding during the period that were
entitled to receive dividends
d = the maximum offering price per share on
the last day of the Period.
Except as noted below, in determining net investment income earned
during the Period (variable "a" in the above formula), the Portfolio
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). Once
interest earned is calculated in this fashion for each debt obligation
held by the Portfolio, interest earned during the Period is then
determined by totalling the interest earned on all debt obligations. For
23
<PAGE>
the purposes of these calculations, the maturity of an obligation with one
or more call provisions is assumed to be the next on which the obligation
reasonably can be expected to be called or, if none, the maturity date.
With respect to the treatment of discount and premium on mortgage-
backed and other asset-backed obligations that are expected to be subject
to monthly payments of principal and interest ("paydowns"): (1) the
Portfolio accounts for gain or loss attributable to actual paydowns as an
increase or decrease to interest income during the period and (2) the
Portfolio accrues the discount and amortizes the premium on the remaining
obligation, based on the cost of the obligation, to the weighted average
maturity date or, if average weighted average maturity information is not
available, to the remaining term of the obligation. The yield of the
Investment Grade Portfolio for the 30-day period ended December 31, 1994
was 8.50%. The yield would have been lower if the Manager had not
reimbursed the Portfolio for a portion of its expenses.
For the Government Money Market Portfolio:
------------------------------------------
Yield The current annualized yield for the Government Money
Market Portfolio is based upon a seven-day period and is computed by
determining the net change in the value of a hypothetical account in the
Portfolio. The net change in the value of the account includes the value
of dividends and of additional shares purchased with dividends, but does
not include gains and losses or unrealized appreciation and depreciation.
In addition, the Portfolio may use a compound effective annualized yield
quotation which is calculated as prescribed by SEC regulations, by adding
one to the base period return (calculated as described above), raising the
sum to a power equal to 365 divided by 7, and subtracting one.
The Government Money Market Portfolio's yield may fluctuate daily
depending upon such factors as the average maturity of its securities,
changes in investments, changes in interest rates and variations in
operating expenses. Therefore, current yield does not provide a basis for
determining future yields. The fact that the Portfolio's current yield
will fluctuate and that shareholders' principal is not guaranteed or
insured should be considered in comparing the Portfolio's yield with
yields on fixed-income investments, such as insured savings certificates.
In comparing the yield of the Portfolio to other investment vehicles,
consideration should be given to the investment policies of each,
including the types of investments owned, lengths of maturities of the
portfolio, the method used to compute the yield and whether there are any
special charges that may reduce the yield.
Other Information In Performance Advertisements each Portfolio may
compare its total return (or taxable yield with respect to the Government
Money Market Portfolio) with data published by Lipper Analytical Services,
Inc. ("Lipper") for U. S. government funds, corporate bond (BBB) funds
(Investment Grade Portfolio) and for money funds (Government Money Market
Portfolio), CDA Investment Technologies, Inc. ("CDA"), Wiesenberger
Investment Companies Service ("Wiesenberger"), or Morningstar Mutual Funds
("Morningstar"), or with the performance of U.S. Treasury securities of
24
<PAGE>
various maturities, recognized stock, bond and other indexes, including
(but not limited to) the Salomon Brothers Bond Index, Shearson Lehman Bond
Index, Shearson Lehman Government/Corporate Bond Index, the Standard &
Poor's 500 Composite Stock Price Index ("S & P 500"), the Dow Jones
Industrial Average, and changes in the Consumer Price Index as published
by the U.S. Department of Commerce. Each Portfolio also may refer in such
materials to mutual fund performance rankings and other data, such as
comparative asset, expense and fee levels, published by Lipper, CDA,
Wiesenberger or Morningstar. Performance Advertisements also may refer to
discussions of a Portfolio and comparative mutual fund data and ratings
reported in independent periodicals, including (but not limited to) THE
WALL STREET JOURNAL, MONEY Magazine, FORBES, BUSINESS WEEK, FINANCIAL
WORLD, BARRONS, FORTUNE and THE NEW YORK TIMES.
The Portfolios invest primarily in the fixed-income securities
described in their Prospectuses, and do not invest in the equity
securities that make up the S&P 500 or the Dow Jones indices. Comparison
with such indices is intended to show how an investment in a Portfolio
behaved as compared to indices that are often taken as a measure of
performance of the equity market as a whole. The indices, like the
Portfolios' total returns, assume reinvestment of all dividends and other
distributions. They do not take account of the costs or the tax
consequences of investing.
Each Portfolio may include discussions or illustrations of the effects
of compounding in performance advertisements. "Compounding" refers to the
fact that, if dividends or other distributions on an investment in a
Portfolio are reinvested in additional Portfolio shares, any future income
or capital appreciation of the Portfolio would increase the value, not
only of the original Portfolio investment, but also of the additional
Portfolio shares received through reinvestment. As a result, the value of
the Portfolio investment would increase more quickly than if dividends or
other distributions had been paid in cash.
Each Portfolio may also compare its performance with the performance
of bank certificates of deposit (CDs) as measured by the CDA Investment
Technologies, Inc. Certificate of Deposit Index and the Bank Rate Monitor
National Index. In comparing the Portfolio's performance to CD
performance, investors should keep in mind that bank CDs are insured in
whole or in part by an agency of the U.S. Government and offer fixed
principal and fixed or variable rates of interest, and that bank CD yields
may vary. Portfolio shares are not insured or guaranteed by the U.S.
Government and returns and net asset value will fluctuate. The securities
held by a Portfolio generally have longer maturities than most CDs and may
reflect interest rate fluctuations for longer-term securities.
Portfolio advertisements may reference the history of the distributor
and its affiliates, and the education and experience of the portfolio
manager. Advertisements may also describe techniques the Adviser employs
in selecting among the sectors of the fixed-income market and may focus on
the technique of "value investing." With value investing, the Adviser
invests in those securities it believes to be undervalued in relation to
25
<PAGE>
the long-term earning power or asset value of their issuers. Securities
may be undervalued because of many factors, including market decline, poor
economic conditions, tax-loss selling, or actual or anticipated
unfavorable developments affecting the issuer of the security.
In advertising, the Portfolios may illustrate hypothetical investment
plans designed to help investors meet long-term financial goals, such as
saving for a child's college education or for retirement. Sources such as
the Internal Revenue Service, the Social Security Administration, the
Consumer Price Index and Chase Global Data and Research may supply data
concerning interest rates, college tuitions, the rate of inflation, Social
Security benefits, mortality statistics and other relevant information.
The Portfolios may use other recognized sources as they become available.
The Portfolios may use data prepared by Ibbotson Associates of
Chicago, Illinois ("Ibbotson") to compare the returns of various capital
markets and to show the value of a hypothetical investment in a capital
market. Ibbotson relies on different indices to calculate the performance
of common stocks, corporate and government bonds and Treasury bills.
The Portfolios may illustrate and compare the historical volatility of
different portfolio compositions where the performance of stocks is
represented by the performance of an appropriate market index, such as the
S&P 500 and the performance of bonds is represented by a nationally
recognized bond index, such as the Lehman Brothers Long-Term Government
Bond Index.
The Portfolios may also include in advertising biographical
information on key investment and managerial personnel.
The Portfolios may advertise examples of the potential benefits of
periodic investment plans, such as dollar cost averaging, a long-term
investment technique designed to lower average cost per share. Under such
a plan, an investor invests in a mutual fund at regular intervals a fixed
dollar amount thereby purchasing more shares when prices are low and fewer
shares when prices are high. Although such a plan does not guarantee
profit or guard against loss in declining markets, the average cost per
share could be lower than if a fixed number of shares were purchased at
the same intervals. Investors should consider their ability to purchase
shares through low price levels.
The Portfolios may discuss Legg Mason's tradition of service. Since
1899, Legg Mason and its affiliated companies have helped investors meet
their specific investment goals and have provided a full spectrum of
financial services. Legg Mason affiliates serve as investment advisors
for private accounts and mutual funds with assets of more than $17 billion
as of December 31, 1994.
In advertising, the Portfolios may discuss the advantages of saving
through tax-deferred retirement plans or accounts, including the
advantages and disadvantages of "rolling over" a distribution from a
retirement plan into an IRA, factors to consider in determining whether
26
<PAGE>
you qualify for such a rollover, and the other options available. These
discussions may include graphs or other illustrations that compare the
growth of a hypothetical tax-deferred investment to the after-tax growth
of a taxable investment.
The following table shows the value, as of the end of each fiscal
year, of hypothetical investments of $10,000 made in the Investment Grade
Portfolio at the commencement of operations on August 7, 1987. The table
assumes that all dividends and other distributions are reinvested in the
Portfolio. It includes the effect of all charges and fees the Portfolio
has paid. (There are no fees for investing or reinvesting in the
Portfolio, and there are no redemption fees.) It does not include the
effect of any income taxes that an investor would have to pay on
distributions.
27
<PAGE>
Investment Grade Portfolio
Value of Original
Shares Plus Shares Value of Shares
Obtained Through Acquired Through
Reinvestment of Reinvestment of Total
Fiscal Capital Gain Income Dividends Value
Year Distributions
1987* $9,940 $320 $10,260
1988 9,908 1,137 11,045
1989 10,319 2,158 12,477
1990 10,046 3,154 13,200
1991 10,835 4,476 15,311
1992 10,893 5,456 16,349
1993 11,940 6,244 18,184
1994 10,717 6,590 17,307
*August 7, 1987 (commencement of operations) to December 31, 1987.
If the investor had not reinvested dividends and other distributions,
the total value of the hypothetical investment as of December 31, 1994
would have been $9,270, and the investor would have received a total of
$6,415 in distributions. Returns would have been lower if the Adviser had
not waived/reimbursed certain Fund expenses during the fiscal years 1987
through 1994.
VALUATION OF SHARES
For the Investment Grade Portfolio:
-----------------------------------
Net asset value of the shares of the Portfolio is determined daily as
of the close of the Exchange (normally 4:00 p.m., eastern time), on every
day that the Exchange is open, by subtracting the Portfolio's liabilities
from its total assets and dividing the result by the Portfolio's number of
shares outstanding. Pricing will not be done on days when the Exchange is
closed. The Exchange currently observes the following holidays: New
Year's Day, President's Day, Good Friday, Memorial Day, Independence Day,
Labor Day, Thanksgiving and Christmas. When market quotations for
institutional size positions are readily available, portfolio securities
are valued based upon market quotations. Where such market quotations are
not readily available, securities are valued based upon appraisals
received from a pricing service using a computerized matrix system or
based upon appraisals derived from information concerning the security or
28
<PAGE>
similar securities received from recognized dealers in those securities.
The methods used by the pricing service and the quality of the valuations
so established are reviewed by the Adviser under the general supervision
of the Corporation's Board of Directors. The amortized cost method of
valuation is used with respect to obligations with 60 days or less
remaining to maturity unless the Adviser determines that this does not
represent fair value. All other assets are valued at fair value as
determined in good faith, by or under the direction of the Corporation's
Board of Directors. Premiums received on the sale of put and call options
are included in the Portfolio's net asset value, and the current market
value of options sold by the Portfolio will be subtracted from its net
assets.
For the Government Money Market Portfolio:
------------------------------------------
The Government Money Market Portfolio attempts to stabilize the value
of a share at $1.00. Net asset value will not be calculated on days when
the Exchange is closed.
Use of the Amortized Cost Method The directors have determined that
the interests of shareholders are best served by using the amortized cost
method for determining the value of portfolio instruments. Under this
method, portfolio instruments are valued at the acquisition cost as
adjusted for amortization of premium or accumulation of discount rather
than at current market value. The Board of Directors continually assesses
the appropriateness of this method of valuation.
The Portfolio's use of the amortized cost method of valuing portfolio
instruments depends on its compliance with Rule 2a-7 under the 1940 Act.
Under that Rule, the directors must establish procedures reasonably
designed to stabilize the net asset value per share, as computed for
purposes of distribution and redemption, at $1.00 per share, taking into
account current market conditions and the Portfolio's investment
objective.
Monitoring Procedures The Portfolio's procedures include monitoring
the relationship between the amortized cost value per share and the net
asset value per share based upon available indications of market value.
If there is a difference of more than 0.5% between the two, the directors
will take any steps they consider appropriate (such as shortening the
dollar-weighted average portfolio maturity) to minimize any material
dilution or other unfair results arising from differences between the two
methods of determining net asset value.
Investment Restrictions Rule 2a-7 requires the Portfolio, if it
wishes to value its assets at amortized cost, to limit its investments to
instruments that, (i)in the opinion of the Adviser, present minimal credit
risk and (ii) (a) are rated in the two highest rating categories by at
least two nationally recognized statistical rating organizations
("NRSROs") (or one, if only one rating services has rated the security)
or, (b) if unrated, determined to be of comparable quality by the Adviser,
all pursuant to procedures determined by the Board of Directors ("Eligible
29
<PAGE>
Securities"). The Portfolio may invest no more than 5% of its total
assets in securities that are Eligible Securities but have not been rated
in the highest short-term ratings category by at least two NRSROs (or by
one NRSRO, if only one NRSRO has assigned the obligation a short-term
rating) or, if the obligations are unrated, determined by the Adviser to
be of comparable quality ("Second Tier Securities"). In addition, the
Portfolio will not invest more than 1% of its total assets or $1 million
(whichever is greater) in the Second Tier Securities of a single issuer.
The Rule requires the Portfolio to maintain a dollar-weighted average
portfolio maturity appropriate to the objective of maintaining a stable
net asset value of $1.00 per share and in any event not more than 90 days.
In addition, under the Rule, no instrument with a remaining maturity (as
defined in the Rule) of more than 397 days, as defined, can be purchased
by the Portfolio; except that the Portfolio may hold securities with
remaining maturities greater than 397 days as collateral for repurchase
agreements and other collateralized transactions of short duration.
Should the disposition of a portfolio security result in a
dollar-weighted average portfolio maturity of more than 90 days, the
Portfolio will invest its available cash to reduce the average maturity to
90 days or less as soon as possible.
It is the Portfolio's usual practice to hold portfolio securities to
maturity and realize par, unless the Adviser determines that sale or other
disposition is appropriate in light of the Portfolio's investment
objective. Under the amortized cost method of valuation, neither the
amount of daily income nor the net asset value is affected by any
unrealized appreciation or depreciation of the portfolio.
In periods of declining interest rates, the indicated daily yield on
shares of the Portfolio, computed by dividing the annualized daily income
on the Portfolio's investment portfolio by the net asset value computed as
above, may tend to be higher than a similar computation made by using a
method of valuation based upon market prices and estimates.
In periods of rising interest rates, the indicated daily yield on
shares of the Portfolio computed the same way may tend to be lower than a
similar computation made by using a method of calculation based upon
market prices and estimates.
TAX-DEFERRED RETIREMENT PLANS
As noted in the Prospectus for each Portfolio, an investment in
Portfolio shares may be appropriate for IRAs, Keogh Plans, SEPs and other
qualified retirement plans. In general, income earned through the
investment of assets of those accounts and plans is not taxed to their
beneficiaries until the income is distributed to them. Investors who are
considering establishing such an account or plan should consult their
attorneys or tax advisers with respect to individual tax questions. The
option of investing in these accounts or plans through regular payroll
deductions may be arranged with a Legg Mason or affiliated investment
30
<PAGE>
executive and your employer. Additional information with respect to these
accounts and plans is available upon request from any Legg Mason or
affiliated investment executive.
Individual Retirement Account - IRA
-----------------------------------
Certain investors may obtain tax advantages by establishing IRAs.
Specifically, if neither you nor your spouse is an active participant in a
qualified employer or government retirement plan, or if either you or your
spouse is an active participant and your adjusted gross income does not
exceed a certain level, then you may deduct cash contributions made to an
IRA in an amount for each taxable year not exceeding the lesser of 100% of
your earned income or $2,000. In addition, if your spouse is not employed
and you file a joint return, you may establish a separate IRA for your
spouse and contribute up to a total of $2,250 to the two IRAs, provided
that the contribution to either does not exceed $2,000. If you and your
spouse are both employed and neither of you is an active participant in a
qualified employer or government retirement plan and you establish
separate IRAs, you each may contribute all of your earned income, up to
$2,000 each, and thus may together receive tax deductions of up to $4,000
for contributions to your IRAs. If your employer's plan qualifies as a
SEP, permits voluntary contributions and meets certain other requirements,
you may make voluntary contributions to that plan that are treated as
deductible IRA contributions.
Even if you are not in one of the categories described in the
preceding paragraph, you may find it advantageous to invest in shares of a
Portfolio through nondeductible IRA contributions, up to certain limits,
because all dividends and capital gain distributions on your Portfolio
shares are then not immediately taxable to you or the IRA; they become
taxable only when distributed to you. To avoid penalties, your interest
in an IRA must be distributed, or start to be distributed, to you not
later than the end of the taxable year in which you attain age 70 1/2.
Distributions made before age 59 1/2, in addition to being taxable,
generally are subject to a penalty equal to 10% of the distribution,
except in the case of death or disability, where the distribution is
rolled over into another qualified plan or certain other situations.
Self-Employed Individual Retirement Plan - Keogh Plan
------------------------------------------------------
Legg Mason makes available to self-employed individuals a Plan and
Trustee Agreement for a Keogh Plan through which shares of the Portfolios
may be purchased. You have the right to use a bank of your own choice to
provide these services at your own cost. There are penalties for
distributions from a Keogh Plan prior to age 59 1/2, except in the case of
death or disability.
Simplified Employee Pension Plan - SEP
--------------------------------------
Legg Mason also makes available to corporate and other employers a SEP
Plan for investment in shares of the Portfolios.
31
<PAGE>
Withholding at the rate of 20% is required for federal income tax
purposes on certain distributions (excluding, for example, certain
periodic payments) from the foregoing retirement plans (except IRAs and
SEPs), unless the recipient transfers the distribution directly to an
"eligible retirement plan" (including IRAs and other qualified plans) that
accepts those distributions. Other distributions generally are subject to
regular wage withholding or withholding at the rate of 10% (depending on
the type and amount of the distribution), unless the recipient elects not
to have any withholding apply. Please consult your plan administrator or
tax adviser for further information.
THE CORPORATION'S DIRECTORS AND OFFICERS
The Corporation's officers are responsible for the operation of the
Corporation under the direction of the Board of Directors. The officers
and directors of the Corporation and their principal occupations during
the past five years are set forth below. An asterisk (*) indicates those
officers and/or directors who are interested persons of the Corporation as
defined by the 1940 Act. The business address of each officer and
director is 111 South Calvert Street, Baltimore, Maryland 21202, unless
otherwise indicated.
JOHN F. CURLEY, JR.*, [55] Chairman of the Board and Director; Vice
Chairman and Director of Legg Mason Wood Walker, Inc. and Legg Mason,
Inc.; Director of Legg Mason Fund Adviser, Inc. and Western Asset
Management Company; Officer and/or Director of various other affiliates of
Legg Mason, Inc.; Chairman of the Board and Director of three Legg Mason
funds; President and Director of three Legg Mason funds; Chairman of the
Board, President and Trustee of one Legg Mason fund and Chairman of the
Board and Trustee of one Legg Mason fund.
EDMUND J. CASHMAN, JR.*, [58] Vice Chairman and Director; Senior
Executive Vice President and Director of Legg Mason, Inc.; Officer and/or
Director of various other affiliates of Legg Mason, Inc.; President and
Director of one Legg Mason fund; President and Trustee of one Legg Mason
fund; Director of Worldwide Value Fund, Inc.
EDWARD A. TABER, III*, [51] President and Director; Executive Vice
President of Legg Mason, Inc. and Legg Mason Wood Walker, Inc.; Vice
Chairman and Director of Legg Mason Fund Adviser, Inc.; Director of three
Legg Mason funds; President and Director of two Legg Mason funds; Trustee
of one Legg Mason fund; Vice President of Worldwide Value Fund, Inc.
Formerly: Executive Vice President of T. Rowe Price-Fleming
International, Inc. (1986-1992) and Director of the Taxable Fixed Income
Division at T. Rowe Price Associates, Inc. (1973-1992).
RICHARD G. GILMORE, [67] Director; 5534 Chanteclaire, Sarasota,
Florida. Independent Consultant. Director of CSS Industries, Inc.
(diversified holding company whose subsidiaries are engaged in manufacture
and sale of decorative paper products, business forms, and specialty metal
packaging); Director of PECO Energy Company (formerly Philadelphia
Electric Company); Director of six Legg Mason funds; and Trustee of one
32
<PAGE>
Legg Mason fund. Formerly: Senior Vice President and Chief Financial
Officer of Philadelphia Electric Company (now PECO Energy Company);
Executive Vice President and Treasurer, Girard Bank, and Vice President of
its parent holding company, the Girard Company; and Director of Finance,
City of Philadelphia.
CHARLES F. HAUGH, [69] Director; 14201 Laurel Park Drive, Suite 104,
Laurel, Maryland. Real Estate Developer and Investor; President and
Director of Resource Enterprises, Inc. (real estate brokerage); Chairman
of Resource Realty LLC (management of retail and office space); Partner in
Greater Laurel Health Park Ltd. Partnership (real estate investment and
development); Director of six Legg Mason funds; and Trustee of two Legg
Mason funds.
ARNOLD L. LEHMAN, [51] Director; The Baltimore Museum of Art, Art
Museum Drive, Baltimore, Maryland. Director of the Baltimore Museum of
Art; Director of six Legg Mason funds; Trustee of two Legg Mason funds.
JILL E. McGOVERN, [50] Director; 1500 Wilson Boulevard, Arlington,
Virginia. Chief Executive Officer of the Marrow Foundation. Director of
six Legg Mason funds; Trustee of two Legg Mason funds. Formerly: Executive
Director of the Baltimore International Festival January 1991 - March
1993; and Senior Assistant to the President of The Johns Hopkins
University (1986-1991).
T. A. RODGERS, [60] Director; 2901 Boston Street, Baltimore, Maryland.
Principal, T.A. Rodgers & Associates (management consulting); Director of
six Legg Mason funds; Trustee of one Legg Mason fund. Formerly: Director
and Vice President of Corporate Development, Polk Audio, Inc.
(manufacturer of audio components) .
The executive officers of the Corporation, other than those who also
serve as directors, are:
MARIE K. KARPINSKI*, [46] Vice President and Treasurer; Treasurer of
Legg Mason Fund Adviser, Inc.; Vice President and Treasurer of eight Legg
Mason funds; and Secretary/Treasurer of Worldwide Value Fund, Inc.; Vice
President of Legg Mason.
STEFANIE L. WONG*, [27] Secretary; Secretary of one Legg Mason fund;
Employee of Legg Mason.
BLANCHE P. ROCHE*, [46] Assistant Secretary and Assistant Vice
President; Assistant Secretary and Assistant Vice President of seven Legg
Mason funds; employee of Legg Mason since 1991. Formerly: Manager of
Consumer financial services, Primerica Corporation (1989-1991).
Officers and directors of the Corporation who are "interested persons"
of the Corporation, as defined in the 1940 Act, receive no salary or fees
from the Corporation. Independent directors of the Corporation receive a
fee of $400 annually for serving as a director, and a fee of $400 for each
meeting of the Board of Directors attended by him or her. For the fiscal
33
<PAGE>
year ended December 31, 1994, the present independent directors as a group
received a total of $7,500 from each Portfolio of the Corporation.
The Nominating Committee of the Board of Directors is responsible for
the selection and nomination of disinterested directors. The Committee is
composed of Messrs. Haugh, Gilmore, Lehman and Dr. McGovern, each of whom
is a disinterested director as that term is defined in the 1940 Act.
At February 28, 1995, the directors and officers of the Corporation
beneficially owned, in the aggregate, less than 1% of the Corporation's
outstanding shares.
The following table provides certain information relating to the
compensation of the Corporation's directors for the fiscal year ended
December 31, 1994.
34
<PAGE>
<TABLE>
<CAPTION>
COMPENSATION TABLE
------------------
<S> <C> <C> <C> <C>
Pension or Retirement Total Compensation
Aggregate Benefits Accrued as Estimated Annual From Corporation and
Name of Person and Position Compensation From Part of Corporation's Benefits Upon Fund Complex Paid to
Corporation* Expenses Retirement Directors**
John F. Curley, Jr. -
Chairman of the Board and
Director None N/A N/A None
Edward A. Taber, III -
President and Director None N/A N/A None
Edmund J. Cashman, Jr.
Vice Chairman and Director
None N/A N/A None
Marie K. Karpinski -
Vice President and Treasurer
None N/A N/A None
Richard G. Gilmore -
Director $7,500 N/A N/A $21,600
Charles F. Haugh -
Director $7,500 N/A N/A $23,600
Arnold L. Lehman -
Director $7,500 N/A N/A $23,600
Jill E. McGovern -
Director $7,500 N/A N/A $23,600
T. A. Rodgers -
Director $7,500 N/A N/A $21,600
</TABLE>
* Represents fees paid to each director during the fiscal year
ended December 31, 1994.
** Represents aggregate compensation paid to each director during
the calendar year ended December 31, 1994.
35
<PAGE>
MANAGEMENT AGREEMENTS
Legg Mason Fund Adviser, Inc. ("Manager"), 111 South Calvert Street,
Baltimore, MD 21202, is a wholly owned subsidiary of Legg Mason, Inc.,
which is also the parent of Legg Mason Wood Walker, Incorporated. The
Manager serves as the manager for each Portfolio under separate Management
Agreements dated June 19, 1987 for the Investment Grade Portfolio and
November 1, 1988 for the Government Money Market Portfolio ("Management
Agreements"), which were approved by the Corporation's Board of Directors,
including a majority of the directors who are not "interested persons" (as
defined in the 1940 Act) of the Corporation, the Manager or the Adviser,
on May 8, 1987, and was approved by the shareholders of the Investment
Grade Portfolio on April 22, 1988. Continuation of the Management
Agreements was most recently approved by the Board of Directors on October
21, 1994. Each Management Agreement provides that, subject to overall
direction by the Board of Directors, the Manager will manage the
investment and other affairs of the Portfolio. Under each Management
Agreement, the Manager is responsible for managing the Portfolio's
securities and for making purchases and sales of securities consistent
with the investment objectives and policies described in the Portfolio's
Prospectus and this Statement of Additional Information. The Manager is
obligated to furnish each Portfolio with office space and certain
administrative services as well as executive and other personnel necessary
for the operation of the Portfolio. The Manager and its affiliates also
are responsible for the compensation of directors and officers of the
Corporation who are employees of the Manager and/or its affiliates. The
Manager has delegated the portfolio management functions for each
Portfolio to the Adviser, Western Asset Management Company.
As explained in each Portfolio's Prospectus, the Manager receives for
its services to the Investment Grade Portfolio, a management fee,
calculated daily and payable monthly, at an annual rate equal to 0.60% of
the Investment Grade Portfolio's average daily net assets and for its
services to the Government Money Market Portfolio, a management fee,
calculated daily and payable monthly, at an annual rate equal to 0.50% of
the Government Money Market Portfolio's average daily net assets. The
management fee paid by a Portfolio may be reduced under regulations in
various states where shares of the Portfolio are qualified for sale that
impose limitations on the annual expense ratio of the Portfolio. The most
restrictive annual expense limitation currently requires that the Manager
reimburse a Portfolio for certain expenses, including the management fees
received by it (but excluding interest, taxes, brokerage fees and
commissions, distribution fees and certain extraordinary charges), in any
fiscal year in which the Portfolio's expenses exceed 2.5% of the first $30
million, 2.0% of the next $70 million, and 0.5% of the balance over $100
million in net assets. No reimbursements have been made nor have any been
required to be made pursuant to this undertaking. In addition, the
Manager has agreed to waive its fees and reimburse each Portfolio if and
to the extent its expenses (exclusive of taxes, interest, brokerage and
extraordinary expenses) exceed during any month annual rates of each
Portfolio's average daily net assets for such month, or certain asset
levels, whichever occurs first, in accordance with the following schedule:
36
<PAGE>
For the Investment Grade Portfolio:
----------------------------------
Rate Expiration Date Asset Level
---- --------------- ----------
0.90% October 31, 1995 $100 million
0.85% April 30, 1995 $100 million
0.85% October 31, 1994 $100 million
0.85% August 31, 1993 $75 million
0.85% October 31, 1992 $75 million
For the years ended December 31, 1994 and 1993, the Manager
waived management fees of $370,000 and $361,000, respectively, and for the
year ended December 31, 1992, the Manager waived all management fees for
the Investment Grade Portfolio. During the fiscal years ended December 31,
1994, 1993 and 1992, the Government Money Market Portfolio paid fees of
$1,006,789, $898,826, and $886,904, respectively, to the Manager, net of
waivers and reimbursements.
Under each Management Agreement, the Manager will not be liable
for any error of judgment or mistake of law or for any loss suffered by a
Portfolio in connection with the performance of the Management Agreements,
except a loss resulting from a breach of fiduciary duty with respect to
the receipt of compensation for services or losses resulting from willful
misfeasance, bad faith or gross negligence in the performance of its
duties or from reckless disregard of its obligations or duties thereunder.
Each Management Agreement terminates automatically upon
assignment and is terminable at any time without penalty by vote of the
Corporation's Board of Directors, by vote of a majority of the outstanding
voting securities of the applicable Portfolio or by the Manager, on not
less than 60 days' written notice to the other party, and may be
terminated immediately upon the mutual written consent of the Manager and
the Portfolio.
Each Portfolio pays all of its expenses which are not expressly
assumed by the Manager. These expenses include, among others, interest
expense, taxes, brokerage fees and commissions, expenses of preparing and
printing prospectuses, statements of additional information, proxy
statements and reports and of distributing them to existing shareholders,
custodian charges, transfer agency fees, organizational expenses,
distribution fees to the Portfolio's distributor, compensation of the
independent directors, legal, accounting and audit expenses, insurance
expenses, expenses of registering and qualifying shares of the Portfolios
for sale under federal and state law, governmental fees and expenses
incurred in connection with membership in investment company
organizations. Each Portfolio also is liable for such nonrecurring
expenses as may arise, including litigation to which the Portfolio may be
a party. Each Portfolio may also have an obligation to indemnify the
directors and officers of the Corporation with respect to any such
litigation.
37
<PAGE>
Under each Management Agreement, the Portfolio has the non-
exclusive right to use the name "Legg Mason" until that Agreement is
terminated, or until the right is withdrawn in writing by the Manager.
INVESTMENT ADVISORY AGREEMENTS
The Adviser, Western Asset Management Company, 117 East Colorado
Boulevard, Pasadena, CA 91105, an affiliate of Legg Mason, serves as
investment adviser to each Portfolio under a separate Investment Advisory
Agreement with respect to the Investment Grade Portfolio, dated June 19,
1987, and November 1, 1988 with respect to the Government Money Market
Portfolio, between the Adviser and the Manager ("Advisory Agreements").
Each Advisory Agreement was approved by the Board of Directors, including
a majority of the directors who are not "interested persons" of the
Corporation, the Adviser or the Manager, on May 8, 1987, and was approved
by the shareholders of the Investment Grade Portfolio on April 22, 1988.
Continuation of the Agreements was most recently approved by the Board of
Directors on October 21, 1994.
Under each Advisory Agreement, the Adviser is responsible,
subject to the general supervision of the Manager and the Corporation's
Board of Directors, for the actual management of the Portfolio's assets,
including the responsibility for making decisions and placing orders to
buy, sell or hold a particular security. For the Adviser's services to
the Investment Grade Portfolio, the Manager (not the Portfolio) pays the
Adviser a fee, computed daily and payable monthly, at an annual rate equal
to 40% of the fee received by the Manager. During the years ended
December 31, 1994, 1993, and 1992, the Manager paid $14,593, $560, and $0,
respectively, to the Adviser on behalf of the Investment Grade Portfolio.
For the Adviser's services to the Government Money Market Portfolio, the
Manager (not the Portfolio) pays the Adviser a fee, computed daily and
payable monthly, at an annual rate equal to 30% of the fee received by the
Manager. During the years ended December 31, 1994, 1993 and 1992, the
Manager paid the Adviser fees of $302,037, $269,648, and $266,071,
respectively, on behalf of the Government Money Market Portfolio.
Under each Advisory Agreement, the Adviser will not be liable for
any error of judgment or mistake of law or for any loss suffered by the
Manager or by the Portfolio in connection with the performance of the
Advisory Agreement, except a loss resulting from a breach of fiduciary
duty with respect to the receipt of compensation for services or a loss
resulting from willful misfeasance, bad faith or gross negligence on its
part in the performance of its duties or from reckless disregard by it of
its obligations or duties thereunder.
Each Advisory Agreement terminates automatically upon assignment
and is terminable at any time without penalty by vote of the Corporation's
Board of Directors, by vote of a majority of the applicable Portfolio's
outstanding voting securities, by the Manager or by the Adviser, on not
less than 60 days' notice to the Portfolio and/or the other party(ies).
Each Advisory Agreement terminates immediately upon any termination of the
Management Agreement or upon the mutual written consent of the Adviser,
the Manager and the applicable Portfolio.
38
<PAGE>
To mitigate the possibility that the Fund will be affected by
personal trading of employees, the Corporation, the Manager and the
Adviser have adopted policies that restrict securities trading in the
personal accounts of portfolio managers and others who normally come into
advance possession of information on portfolio transactions. These
policies comply, in all material respects, with the recommendations of the
Investment Company Institute.
PORTFOLIO TRANSACTIONS AND BROKERAGE
The portfolio turnover rate is computed by dividing the lesser of
purchases or sales of securities for the period by the average value of
portfolio securities for that period. Short-term securities are excluded
from the calculation. For the years ended December 31, 1994 and 1993, the
Investment Grade Portfolio's portfolio turnover rates were 200.1% and
348.2%, respectively.
Under each Advisory Agreement, the Adviser is responsible for the
execution of portfolio transactions. Corporate and government debt
securities are generally traded on the over-the-counter market on a "net"
basis without a stated commission, through dealers acting for their own
account and not as brokers. Prices paid to a dealer in debt securities
will generally include a "spread", which is the difference between the
price at which the dealer is willing to purchase and sell the specific
security at the time, and includes the dealer's normal profit. Some
portfolio transactions may be executed through brokers acting as agent.
In selecting brokers or dealers, the Adviser must seek the most favorable
price (including the applicable dealer spread) and execution for such
transactions, subject to the possible payment as described below of higher
brokerage commissions for agency transactions or spreads to broker-dealers
who provide research and analysis. The Portfolios may not always pay the
lowest commission or spread available. Rather, in placing orders on
behalf of a Portfolio, the Adviser also takes into account such factors as
size of the order, difficulty of execution, efficiency of the executing
broker's facilities (including the services described below) and any risk
assumed by the executing broker.
Consistent with the policy of most favorable price and execution,
the Adviser may give consideration to research, statistical and other
services furnished by brokers or dealers to the Adviser for its use, may
place orders with broker-dealers who provide supplemental investment and
market research and securities and economic analysis, and may, for agency
transactions, pay to these broker-dealers a higher brokerage commission
than may be charged by other broker-dealers. Such research and analysis
may be useful to the Adviser in connection with services to clients other
than the Portfolios. The Adviser's fee is not reduced by reason of its
receiving such brokerage and research services. For the years ended
December 31, 1994, 1993, and 1992, the Investment Grade Portfolio paid
commissions of $112,930, $152,260 and $47,750, respectively, to broker-
dealers who acted as agents in executing options and futures trades. The
Government Money Market Portfolio paid no brokerage commissions, nor did
39
<PAGE>
it allocate any transactions to dealers for research, analysis, advice or
similar services during any of its last three fiscal years.
From time to time, the Investment Grade Portfolio may use Legg
Mason as its broker for agency transactions in listed securities at
commission rates and under circumstances consistent with the policy of
best execution. Commissions paid to Legg Mason will not exceed "usual and
customary" brokerage commissions. Rule 17e-1 under the 1940 Act defines
"usual and customary" commissions to include amounts which are "reasonable
and fair compared to the commission, fee or other remuneration received or
to be received by other brokers in connection with comparable transactions
involving similar securities being purchased or sold on a securities
exchange during a comparable period of time." In the over-the-counter
market, the Investment Grade Portfolio generally will deal with
responsible primary market makers unless a more favorable execution can
otherwise be obtained.
The Portfolios may not buy securities from, or sell securities
to, Legg Mason or its affiliated persons as principal. However, the
Corporation's Board of Directors has adopted procedures in conformity with
Rule 10f-3 under the 1940 Act whereby each Portfolio may purchase
securities that are offered in underwritings in which Legg Mason or any of
its affiliated persons is a participant.
Investment decisions for each Portfolio are made independently
from those of other funds and accounts advised by the Adviser. However,
the same security may be held in the portfolios of more than one fund or
account. When two or more accounts simultaneously engage in the purchase
or sale of the same security, the prices and amounts will be equitably
allocated to each account. In some cases, this procedure may adversely
affect the price or quantity of the security available to a particular
account. In other cases, however, an account's ability to participate in
large-volume transactions may produce better executions and prices.
THE PORTFOLIOS' DISTRIBUTOR
Legg Mason acts as distributor of the Portfolios' shares pursuant
to an Underwriting Agreement with the Corporation. The Underwriting
Agreement obligates Legg Mason to pay certain expenses in connection with
the offering of the Portfolios' shares, including compensation to its
investment executives. Legg Mason also pays for the printing and
distribution of prospectuses and periodic reports used in connection with
the offering to prospective investors, after the prospectuses and reports
have been prepared, set in type and mailed to shareholders at the
Portfolios' expense, and for supplementary sales literature and
advertising costs.
For the year ended December 31, 1994, Legg Mason incurred the
following expenses:
40
<PAGE>
Investment Grade
Portfolio
---------------
Compensation to sales personnel $241,000
Printing and mailing of prospectuses
to prospective shareholders 32,000
Advertising 61,000
Other 225,000
--------
Total expenses $559,000
========
The Corporation has adopted a Distribution and Shareholder
Services Plan ("Plan") which, among other things, permits it to pay Legg
Mason a distribution fee out of the net assets of each Portfolio. The
Plan was adopted, as required by Rule 12b-1 under the 1940 Act, by a vote
of the Board of Directors on May 8, 1987 (for the Investment Grade
Portfolio), and October 27, 1988 (for the Government Money Market
Portfolio), including a majority of the directors who are not "interested
persons" of the Corporation and who have no direct or indirect financial
interest in the operation of the Plan or the Underwriting Agreement ("12b-
1 directors"). Continuation of the Plan was most recently approved by the
Board of Directors on October 21, 1994, including a majority of the 12b-1
directors. In approving the continuance of the Plan, in accordance with
the requirements of Rule 12b-1, the directors considered various factors,
including the amount of the distribution fee. The directors determined
that there is a reasonable likelihood that the Plan will continue to
benefit the Portfolios and their present and future shareholders. The
Plan was also approved by the vote of a majority of the Investment Grade
Portfolio's outstanding shares on April 22, 1988.
The Plan continues in effect only so long as it is approved at
least annually by the vote of a majority of the Board of Directors,
including a majority of the 12b-1 directors, cast in person at a meeting
called for the purpose of voting on the Plan. The Plan may be terminated
with respect to either Portfolio by vote of a majority of the 12b-1
directors, or by vote of a majority of the outstanding voting securities
of such Portfolio. Any change in the Plan that would materially increase
the distribution cost to the Portfolios requires shareholder approval.
Otherwise, the Plan may be amended by the directors, including a majority
of the 12b-1 directors, as previously described.
Rule 12b-1 requires that any person authorized to direct the
disposition of monies paid or payable by the Portfolios, pursuant to the
Plan or any related agreement, shall provide to the Corporation's Board of
Directors, and the directors shall review, at least quarterly, a written
report of the amounts so expended and the purposes for which the
expenditures were made. Rule 12b-1 also provides that the Portfolios may
rely on that Rule only if, while the Plan is in effect, the nomination and
selection of the Corporation's independent directors is committed to the
discretion of such independent directors.
41
<PAGE>
As compensation for its services and expenses, Legg Mason
receives from the Corporation with respect to the Investment Grade
Portfolio, annual distribution and service fees each equivalent to 0.25%
of that Portfolio's average daily net assets in accordance with the Plan.
The distribution and service fees are computed daily and paid monthly.
For the years ended December 31, 1994, 1993 and 1992, the Investment Grade
Portfolio paid distribution and service fees of $339,151, $302,213, and
$198,544, respectively, to Legg Mason, pursuant to the Underwriting
Agreement. Pursuant to the Plan, the Government Money Market Portfolio is
authorized to pay Legg Mason distribution and service fees for its
distribution and shareholder services not to exceed an annual rate of
0.20% of the Portfolio's average daily net assets. Legg Mason has no
present intention of requesting such a fee, but may do so in the future.
THE PORTFOLIOS' CUSTODIAN AND TRANSFER AND DIVIDEND-DISBURSING AGENT
State Street Bank and Trust Company, P.O. Box 1713, Boston,
Massachusetts 02105 serves as custodian of the Portfolios' assets. Boston
Financial Data Services, Inc., P.O. Box 953, Boston, Massachusetts 02103,
serves as transfer and dividend-disbursing agent, and administrator of
various shareholder services. BFDS has contracted with Legg Mason for the
latter to assist it with certain of its duties as transfer agent, for
which BFDS compensates Legg Mason. For the year ended December 31, 1994,
Legg Mason received $19,980 and $62,115 with respect to the Investment
Grade Portfolio and the Government Money Market Portfolio, respectively,
for such services. Shareholders who request an historical transcript of
their account will be charged a fee based upon the number of years
researched. The Portfolios reserve the right, upon 60 days' written
notice, to make other charges to investors to cover administrative costs.
THE CORPORATION'S LEGAL COUNSEL
Kirkpatrick & Lockhart LLP, 1800 M Street, N.W., Washington, D.C.
20036, serves as counsel to the Corporation.
THE CORPORATION'S INDEPENDENT ACCOUNTANTS
Coopers & Lybrand L.L.P., 217 East Redwood Street, Baltimore, MD
21202, has been selected by the Directors to serve as the Corporation's
independent accountants.
FINANCIAL STATEMENTS
The Statement of Net Assets as of December 31, 1994 (for the
Government Money Market Portfolio); the Portfolio of Investments as of
December 31, 1994 (for the Investment Grade Portfolio); the Statement of
Assets and Liabilities as of December 31, 1994 (for the Investment Grade
Portfolio); for each Portfolio, the Statement of Operations for the year
ended December 31, 1994; the Statement of Changes in Net Assets for the
years ended December 31, 1994 and 1993; the Financial Highlights for the
periods presented; the Notes to Financial Statements and the Report of the
42
<PAGE>
Independent Accountants, all of which are included in each respective
Portfolio's Annual Report to Shareholders for the year ended December 31,
1994, are hereby incorporated by reference in this Statement of Additional
Information for the Investment Grade Portfolio and the Government Money
Market Portfolio.
43
<PAGE>
APPENDIX A
For the Investment Grade Portfolio:
-----------------------------------
RATINGS OF SECURITIES
Description of Moody's Investors Service, Inc. ("Moody's") corporate bond
ratings:
Aaa-Bonds which are rated Aaa are judged to be of the best
quality. They carry the smallest degree of investment risk and are
generally referred to as "gilt edge". Interest payments are protected by
a large or 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
risks appear somewhat larger than the Aaa securities.
A-Bonds which are rated A possess many favorable investment
attributes and are to be considered upper-medium-grade obligations.
Factors giving security to principal and interest are considered adequate,
but elements may be present which suggest a susceptibility to impairment
some time in the future.
Baa-Bonds which are rated Baa are considered medium-grade
obligations, (i.e., they are neither highly protected nor poorly secured).
Interest payments and principal security appear adequate for the present
but certain protective elements may be lacking or may be
characteristically unreliable over any great length of time. Such bonds
lack outstanding investment characteristics and in fact have speculative
characteristics as well.
Ba-Bonds which are rated Ba are judged to have speculative
elements; their future cannot be considered 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
maintenance of other terms of the contract over any long period of time
may be small.
<PAGE>
Description of Standard & Poor's Ratings Group corporate bond ratings:
AAA-This is the highest rating assigned by Standard & Poor's to
an obligation. Capacity to pay interest and repay principal is extremely
strong.
AA-Bonds rated AA have a very strong capacity to pay interest and
repay principal and differ from the higher rated issues only in small
degree.
A-Bonds rated A have a strong capacity to pay interest and
repay principal , although they are somewhat more susceptible to the
adverse effects of changes in circumstances and economic conditions then
debt in higher categories.
BBB-Bonds rated BBB are regarded as having an adequate capacity
to pay principal and interest. Whereas they normally exhibit adequate
protection parameters, adverse economic conditions or changing
circumstances are more likely to lead to a weakened capacity to pay
interest and repay principal for bonds in this category than for bonds in
higher rated categories.
BB, B, CCC, CC-Bonds rated BB, B, CCC and CC are regarded, on
balance, as predominately speculative with respect to the issuer's
capacity to pay interest and repay principal in accordance with the terms
of the obligation. BB indicates the lowest degree of speculation and C
the highest degree of speculation. While such bonds will likely have some
quality and protective characteristics, these are outweighed by large
uncertainties or major risk exposures to adverse conditions.
Description of Moody's preferred stock ratings:
aaa-An issue which is rated "aaa" is considered to be a top-
quality preferred stock. This rating indicates good asset protection and
the least risk of dividend impairment within the universe of preferred
stocks.
aa-An issue which is rated "aa" is considered a high-grade
preferred stock. This rating indicates that there is a reasonable
assurance that earnings and asset protection will remain relatively well-
maintained in the foreseeable future.
a-An issue which is rated "a" is considered to be an upper-medium
grade preferred stock. While risks are judged to be somewhat greater than
in the "aaa" and "aa" classification, earnings and asset protection are,
nevertheless, expected to be maintained at adequate levels.
baa-An issue which is rated "baa" is considered to be a medium-
grade preferred stock, neither highly protected nor poorly secured.
Earnings and asset protection appear adequate at present but may be
questionable over any great length of time.
ba-An issue which is rated "ba" is considered to have speculative
elements and its future cannot be considered well assured. Earnings and
asset protection may be very moderate and not well safeguarded during
adverse periods. Uncertainty of position characterizes preferred stocks
in this class.
A-45
<PAGE>
THE LEGG MASON INCOME TRUST, INC.:
U.S. GOVERNMENT INTERMEDIATE-TERM PORTFOLIO
PRIMARY SHARES
NAVIGATOR SHARES
STATEMENT OF ADDITIONAL INFORMATION
U.S. Government Intermediate-Term Portfolio ("Government
Intermediate Portfolio" or "Fund"), is a separate series of Legg Mason
Income Trust, Inc. ("Corporation"), an open-end, diversified management
investment company. The Fund seeks to provide investors with high current
income consistent with prudent investment risk and liquidity needs. In
attempting to achieve this objective, the Fund's investment adviser,
Western Asset Management Company ("Adviser"), under normal circumstances,
invests at least 75% of the Government Intermediate Portfolio's assets in
obligations issued or guaranteed by the U.S. Government, its agencies or
instrumentalities. The Government Intermediate Portfolio expects to
maintain an average dollar-weighted maturity of between three and ten
years. The Fund seeks to provide income higher than that of money market
funds and greater price stability than funds with longer average
maturities.
Shares of Navigator U.S. Government Intermediate-Term Portfolio
("Navigator Shares"), described in this Statement of Additional
Information, represent interests in the Fund that are currently offered
for sale only to institutional clients of the Fairfield Group, Inc.
("Fairfield") for investment of their own funds and funds for which they
act in a fiduciary capacity, to clients of Legg Mason Trust Company
("Trust Company") for which the Trust Company exercises discretionary
investment management responsibility (such institutional investors are
referred to collectively as "Institutional Clients" and accounts of such
Clients are referred to collectively as "Customer Accounts"), to qualified
retirement plans managed on a discretionary basis and having net assets of
at least $200 million, and to The Legg Mason Profit Sharing Plan and
Trust. The Navigator Class of Shares may not be purchased by individuals
directly, but Institutional Clients may purchase shares for Customer
Accounts maintained for individuals.
The Primary Class of shares of U.S. Government Intermediate-Term
Portfolio ("Primary Shares") are offered for sale to all other investors
and may be purchased directly by individuals.
Navigator and Primary Shares are sold and redeemed without any
purchase or redemption charge imposed by the Fund, although Institutional
Clients may charge their Customer Accounts for services provided in
connection with the purchase or redemption of shares. The Fund will pay
management fees to Legg Mason Fund Adviser, Inc. Primary Shares pay a
12b-1 distribution fee, but Navigator Shares pay no distribution fees.
See "The Fund's Distributor."
MUTUAL FUND SHARES ARE NOT DEPOSITS OR OBLIGATIONS OF, OR
GUARANTEED OR ENDORSED BY, ANY BANK OR OTHER DEPOSITORY INSTITUTION.
SHARES ARE NOT INSURED BY THE FDIC, THE FEDERAL RESERVE BOARD OR ANY OTHER
<PAGE>
AGENCY, AND ARE SUBJECT TO INVESTMENT RISK, INCLUDING THE POSSIBLE LOSS OF
THE PRINCIPAL AMOUNT INVESTED.
This Statement of Additional Information is not a prospectus and
should be read in conjunction with the Prospectuses for Primary Shares and
for Navigator Shares, both dated May 1, 1995, which have been filed with
the Securities and Exchange Commission ("SEC"). Copies of the
Prospectuses are available without charge from the Corporation's
distributor, Legg Mason Wood Walker, Incorporated ("Legg Mason") (address
and telephone numbers listed below).
Dated: May 1, 1995
LEGG MASON WOOD WALKER,
INCORPORATED
--------------------------------------------------------------------------
111 South Calvert Street
Baltimore, Maryland 21202
(410) 539-0000 (800) 822-5544
<PAGE>
Table of Contents
Page
Additional Information About Investment
Limitations and Policies 2
Additional Tax Information 12
Additional Purchase and Redemption Information 14
Performance Information 16
Valuation of Fund Shares 20
Tax-Deferred Retirement Plans 20
The Corporation's Directors and Officers 21
Management Agreement 26
Investment Advisory Agreement 27
Portfolio Transactions and Brokerage 28
The Fund's Distributor 29
The Fund's Custodian and Transfer
and Dividend-Disbursing Agent 30
The Corporation's Legal Counsel 31
The Corporation's Independent Accountants 31
Financial Statements 31
Appendix A: Ratings of Securities A-1
No person has been authorized to give any information or to
make any representations not contained in the Prospectuses or
this Statement of Additional Information in connection with the
offerings made by the Prospectuses and, if given or made, such
information or representations must not be relied upon as having
been authorized by the Fund or its distributor. The
Prospectuses and this Statement of Additional Information do not
constitute an offering by the Fund or by the distributor in any
jurisdiction in which such offering may not lawfully be made.
<PAGE>
ADDITIONAL INFORMATION ABOUT INVESTMENT LIMITATIONS AND
POLICIES
The following information supplements the information concerning
the Fund's investment objective, policies and limitations found in the
Prospectuses.
The Fund has adopted certain fundamental investment limitations
that cannot be changed except by vote of a majority of the Fund's
outstanding voting securities. The Fund may not:
1. Borrow money, except for temporary purposes in an aggregate
amount not to exceed 5% of the value of its total assets at the time of
borrowing. (Although not a fundamental policy subject to shareholder
approval, the Government Intermediate Portfolio intends to repay any money
borrowed before any additional portfolio securities are purchased.);
2. Invest more than 5% of its total assets (taken at market
value) in securities of any one issuer, other than the U.S. Government,
its agencies and instrumentalities, or buy more than 10% of the voting
securities or more than 10% of all the securities of any issuer;
3. Mortgage, pledge or hypothecate any of its assets, except to
collateralize permitted borrowings up to 5% of the value of its total
assets at the time of borrowing; provided, that the deposit in escrow of
underlying securities in connection with the writing of call options is
not deemed to be a pledge; and provided further, that deposit of initial
margin or the payment of variation margin in connection with the purchase
or sale of futures contracts or of options on futures contracts shall not
be deemed to constitute pledging assets;
4. Purchase securities on "margin," except that the Government
Intermediate Portfolio may make margin deposits in connection with its use
of options, interest rate futures contracts and options on interest rate
futures contracts;
5. Make short sales of securities unless at all times while a
short position is open the Government Intermediate Portfolio maintains a
long position in the same security in an amount at least equal thereto;
provided, however, that the Government Intermediate Portfolio may purchase
or sell futures contracts, and may make initial and variation margin
payments in connection with purchases or sales of futures contracts or of
options on futures contracts;
6. Invest more than 25% of its total assets (taken at market
value) in any one industry;
7. Invest in securities issued by other investment companies,
except in connection with a merger, consolidation, acquisition or
reorganization or by purchase in the open market of securities of closed-
end investment companies where no underwriter or dealer commission or
2
<PAGE>
profit, other than a customary brokerage commission, is involved and only
if immediately thereafter not more than 10% of the Government Intermediate
Portfolio's total assets (taken at market value) would be invested in such
securities;
8. Purchase or sell commodities and commodity contracts, except
that the Government Intermediate Portfolio may purchase or sell options,
interest rate futures contracts and options on interest rate futures
contracts;
9. Underwrite the securities of other issuers, except to the
extent that in connection with the disposition of restricted securities or
the purchase of securities either directly from the issuer or from an
underwriter for an issuer, the Government Intermediate Portfolio may be
deemed to be an underwriter;
10. Make loans, except loans of portfolio securities and except
to the extent the purchase of a portion of an issue of publicly
distributed notes, bonds or other evidences of indebtedness or deposits
with banks and other financial institutions may be considered loans;
11. Purchase or sell real estate, except that the Government
Intermediate Portfolio may invest in securities collateralized by real
estate or interests therein or in securities issued by companies that
invest in real estate or interests therein; or
12. Purchase or sell interests in oil and gas or other mineral
exploration or development programs.
Yield Factors and Ratings Standard & Poor's Ratings Group
("S&P") and Moody's Investors Service, Inc. ("Moody's") are private
services that provide ratings of the credit quality of obligations.
Investment grade bonds are generally considered to be those bonds rated at
the time of purchase within one of the four highest grades assigned by S&P
or Moody's. A description of the range of ratings assigned to obligations
by Moody's and S&P is included in Appendix A to this Statement of
Additional Information. The Fund may use these ratings in determining
whether to purchase, sell or hold a security. These ratings represent
Moody's and S&P's opinions as to the quality of the obligations which they
undertake to rate. It should be emphasized, however, that ratings are
general and are not absolute standards of quality. Consequently,
obligations with the same maturity, interest rate and rating may have
different market prices. Subsequent to its purchase by the Fund, an issue
of obligations may cease to be rated or its rating may be reduced below
the minimum rating required for purchase by the Fund. The Adviser will
consider such an event in determining whether the Fund should continue to
hold the obligation, but is not required to dispose of it.
In addition to ratings assigned to individual bond issues, the
Adviser will analyze interest rate trends and developments that may affect
individual issuers, including factors such as liquidity, profitability and
asset quality. The yields on bonds and other debt securities in which the
3
<PAGE>
Fund invests are dependent on a variety of factors, including general
money market conditions, general conditions in the bond market, the
financial conditions of the issuer, the size of the offering, the maturity
of the obligation and its rating. There is a wide variation in the
quality of bonds, both within a particular classification and between
classifications. An issuer's obligations under its bonds are subject to
the provisions of bankruptcy, insolvency and other laws affecting the
rights and remedies of bond holders or other creditors of an issuer;
litigation or other conditions may also adversely affect the power or
ability of issuers to meet their obligations for the payment of interest
and principal on their bonds.
Interest Rate Futures Contracts Interest rate futures contracts,
which are traded on commodity futures exchanges, provide for the sale by
one party and the purchase by another party of a specified type and amount
of financial instruments (or an index of financial instruments) at a
specified future date. Interest rate futures contracts currently exist
covering such financial instruments as U.S. Treasury bonds, notes and
bills, Government National Mortgage Association certificates, bank
certificates of deposit and 90-day commercial paper. An interest rate
futures contract may be held until the underlying instrument is delivered
and paid for on the delivery date, but most contracts are closed out
before then by taking an offsetting position on a futures exchange.
The Fund may purchase an interest rate futures contract (that is,
enter into a futures contract to purchase an underlying financial
instrument) when it intends to purchase fixed-income securities but has
not yet done so. This strategy is sometimes called an anticipatory hedge.
This strategy is intended to minimize the effects of an increase in the
price of the securities the Fund intends to purchase (but may also reduce
the effects of a decrease in price), because the value of the futures
contract would be expected to rise and fall in the same direction as the
price of the securities the Fund intends to purchase. The Fund could
purchase the intended securities either by holding the contract until
delivery and receiving the financial instrument underlying the futures
contract, or by purchasing the securities directly and closing out the
futures contract position. If the Fund no longer wished to purchase the
securities, the Fund would close out the futures contract before delivery.
The Fund may sell a futures contract (that is, enter into a
futures contract to sell an underlying financial instrument) to offset
price changes of securities it already owns. This strategy is intended to
minimize any price changes in the securities the Fund owns (whether
increases or decreases) caused by interest rate changes, because the value
of the futures contract would be expected to move in the opposite
direction from the value of the securities owned by the Fund. The Fund
does not expect ordinarily to hold futures contracts it has sold until
delivery or to use securities it owns to satisfy delivery requirements.
Instead, the Fund expects to close out such contracts before the delivery
date.
4
<PAGE>
The prices of interest rate futures contracts depend primarily on
the value of the instruments on which they are based, the price changes of
which, in turn, primarily reflect changes in current interest rates.
Because there are a limited number of types of interest rate futures
contracts, it is likely that the standardized futures contracts available
to the Fund will not exactly match the securities the Fund wishes to hedge
or intends to purchase, and consequently will not provide a perfect hedge
against all price fluctuation. Because fixed-income instruments all
respond similarly to changes in interest rates, however, a futures
contract the underlying instrument of which differs from the securities
the Fund wishes to hedge or intends to purchase may still provide
protection against changes in interest rate levels. To compensate for
differences in historical volatility between positions the Fund wishes to
hedge and the standardized futures contracts available to it, the Fund may
purchase or sell futures contracts with a greater or lesser value than the
securities it wishes to hedge or intends to purchase.
Futures Trading If the Fund does not wish to hold a futures
contract position until the underlying instrument is delivered and paid
for on the delivery date, it may attempt to close out the contract by
entering into an offsetting position on a futures exchange that provides a
secondary market for the contract. A futures contract is closed out by
entering into an opposite position in an identical futures contract (for
example, by purchasing a contract on the same instrument and with the same
delivery date as a contract the Fund had sold) at the current price as
determined on the futures exchange. The Fund's gain or loss on closing
out a futures contract depends on the difference between the price at
which the Fund entered into the contract and the price at which the
contract is closed out. Transaction costs in opening and closing futures
contracts must also be taken into account. There can be no assurance that
the Fund will be able to offset a futures position at the time it wishes
to, or at a price that is advantageous. If the Fund were unable to enter
into an offsetting position in a futures contract, it might have to
continue to hold the contract until the delivery date, in which case it
would continue to bear the risk of price fluctuation in the contract until
the underlying instrument was delivered and paid for.
At the time the Fund enters into an interest rate futures
contract, it is required to deposit with its custodian, in the name of the
futures broker (known as a futures commission merchant, or "FCM"), a
percentage of the contract's value. This amount, which is known as
initial margin, generally equals 5% or less of the value of the futures
contract. Initial margin is in the nature of a good faith deposit or
performance bond, and is returned to the Fund when the futures position is
terminated, after all contractual obligations have been satisfied.
Futures margin does not represent a borrowing by the Fund, unlike margin
extended by a securities broker, and depositing initial margin in
connection with futures positions does not constitute purchasing
securities on margin for the purposes of the Fund's investment
limitations. Initial margin may be maintained either in cash or in
liquid, high-quality debt securities such as U.S. government securities.
5
<PAGE>
As the contract's value fluctuates, payments known as variation
margin or maintenance margin are made to or received from the FCM. If the
contract's value moves against the Fund (i.e., the Fund's futures position
declines in value), the Fund may be required to make payments to the FCM,
and, conversely, the Fund may be entitled to receive payments from the FCM
if the value of its futures position increases. This process is known as
"marking to market" and takes place on a daily basis.
In addition to initial margin deposits, the Fund will instruct
its custodian to segregate additional cash and liquid debt securities to
cover its obligations under futures contracts it has purchased and to
ensure that the contracts are unleveraged. The value of the assets held
in the segregated account will be equal to the daily market value of all
outstanding futures contracts purchased by the Fund, less the amount
deposited as initial margin. Where the Fund enters into positions that
substantially offset one another, it may segregate assets equal to only
one side of the transaction, consistent with SEC staff interpretive
positions. When the Fund has sold futures contracts to hedge securities
it owns, it will not sell those securities (or lend them to another party)
while the contracts are outstanding, unless it substitutes other similar
securities for the securities sold or lent. The Fund will not sell
futures contracts with a value exceeding the value of securities it owns,
except that the Fund may do so to the extent necessary to adjust for
differences in historical volatility between the securities owned and the
contracts used as a hedge.
Risks of Interest Rate Futures Contracts By purchasing an
interest rate futures contract, the Fund in effect becomes exposed to
price fluctuations resulting from changes in interest rates, and by
selling a futures contract the Fund neutralizes those fluctuations. If
interest rates fall, the Fund would expect to profit from an increase in
the value of the instrument underlying a futures contract it had
purchased, and if interest rates rise, the Fund would expect to offset the
resulting decline in the value of the securities it owns by profits in a
futures contract it has sold. If interest rates move in the direction
opposite that which was contemplated at the time of purchase, however, the
Fund's positions in futures contracts could have a negative effect on the
Fund's net asset value. If interest rates rise when the Fund has
purchased futures contracts, the Fund could suffer a loss in its futures
positions. Similarly, if interest rates fall, losses in a futures
contract the Fund has sold could negate gains on securities the Fund owns,
or could result in a net loss to the Fund. In this sense, successful use
of interest rate futures contracts by the Fund will depend on the
Adviser's ability to hedge the Fund in an advantageous way at the
appropriate time.
Other than the risk that interest rates will not move as
expected, the primary risk in employing interest rate futures contracts is
that the market value of the futures contracts may not move in concert
with the value of the securities the Fund wishes to hedge or intends to
purchase. This may result from differences between the instrument
underlying the futures contracts and the securities the Fund wishes to
6
<PAGE>
hedge or intends to purchase, as would be the case, for example, if the
Fund hedged U.S. Treasury bonds by selling futures contracts on U.S.
Treasury notes.
Even if the securities which are the objects of a hedge are
identical to those underlying the futures contract, there may not be
perfect price correlation between the two. Although the value of interest
rate futures contracts is primarily determined by the price of the
underlying financial instruments, the value of interest rate futures
contracts is also affected by other factors, such as current and
anticipated short-term and long-term interest rates, the time remaining
until expiration of the futures contract, and conditions in the futures
markets, which may not affect the current market price of the underlying
financial instruments in the same way. In addition, futures exchanges
establish daily price limits for interest rate futures contracts, and may
halt trading in the contracts if their prices move up or down more than a
specified daily limit on a given day. This could distort the relationship
between the price of the underlying instrument and the futures contract,
and could prevent prompt liquidation of unfavorable futures positions.
The value of a futures contract may also move differently from the price
of the underlying financial instrument because of inherent differences
between the futures and securities markets, including variations in
speculative demand for futures contracts and for debt securities, the
differing margin requirements for futures contracts and debt securities,
and possible differences in liquidity between the two markets.
Put Options on Interest Rate Futures Contracts Purchasing a put
option on an interest rate futures contract gives the Fund the right to
assume a seller's position in the contract at a specified exercise price
at any time up to the option's expiration date. In return for this right,
the Fund pays the current market price for the option (known as the option
premium), as determined on the commodity futures exchange where the option
is traded.
The Fund may purchase put options on interest rate futures
contracts to hedge against a decline in the market value of securities the
Fund owns. Because a put option is based on a contract to sell a
financial instrument at a certain price, its value will tend to move in
the opposite direction from the price of the financial instrument
underlying the futures contract; that is, the put option's value will tend
to rise when prices fall, and fall when prices rise. By purchasing a put
option on an interest rate futures contract, the Fund would attempt to
offset potential depreciation of securities it owns by appreciation of the
put option. This strategy is similar to selling the underlying futures
contract directly.
The Fund's position in a put option on an interest rate futures
contract may be terminated either by exercising the option (and assuming a
seller's position in the underlying futures contract at the option's
exercise price) or by closing out the option at the current price as
determined on the futures exchange. If the put option is not exercised or
closed out before its expiration date, the entire premium paid will be
7
<PAGE>
lost by the Fund. The Fund could profit from exercising a put option if
the current market value of the underlying futures contract were less than
the sum of the exercise price of the put option and the premium paid for
the option (because the Fund would, in effect, be selling the futures
contract at a price higher than the current market price). The Fund could
also profit from closing out a put option if the current market price of
the option is greater than the premium the Fund paid for the option.
Transaction costs must also be taken into account in these calculations.
The Fund may close out an option it has purchased by selling an identical
option (that is, an option on the same futures contract, with the same
exercise price and expiration date) in a closing transaction on a futures
exchange that provides a secondary market for the option. The Fund is not
required to make futures margin payments when it purchases an option on an
interest rate futures contract.
Compared to the purchase or sale of an interest rate futures
contract, the purchase of a put option on an interest rate futures
contract involves a smaller potential risk to the Fund, because the
maximum amount at risk is the premium paid for the option (plus related
transaction costs). If prices of debt securities remain stable, however,
purchasing a put option may involve a greater probability of loss than
selling a futures contract, even though the amount of the potential loss
is limited. The Adviser will consider the different risk and reward
characteristics of options and futures contracts when selecting hedging
instruments.
Risks of Transactions in Options on Interest Rate Futures
Contracts Options on interest rate futures contracts are subject to
risks similar to those described above with respect to interest rate
futures contracts. These risks include the risk that the Adviser may not
hedge the Fund in an advantageous way at the appropriate time, the risk of
imperfect price correlation between the option and the securities being
hedged, and the risk that there may not be an active secondary market for
the option. There is also a risk of imperfect price correlation between
the option and the underlying futures contract.
Although the Adviser will purchase and write only those options
for which there appears to be a liquid secondary market, there can be no
assurance that such a market will exist for any particular option at any
particular time. If there were no liquid secondary market for a
particular option, the Fund might have to exercise an option it had
purchased in order to realize any profit, and might continue to be
obligated under an option it had written until the option expired or was
exercised.
Options Writing on Debt Securities The Fund may from time to
time write (sell) covered call options and covered put options on certain
of its portfolio securities. When it writes a covered call option, the
Fund obligates itself to sell the underlying security to the purchaser of
the option at a fixed price if the purchaser exercises the option during
the option period. A call is "covered" if the Fund owns the optioned
securities or, in the case of options on certain U.S. government
8
<PAGE>
securities, the Fund maintains with its custodian in a segregated account
cash, U.S. government securities or other high-grade, liquid debt
securities with a value sufficient to meet its obligations under the call.
When the Fund writes a call option, it receives a premium from the
purchaser. During the option period, the Fund forgoes the opportunity to
profit from any increase in the market price of the security above the
exercise price of the option, but retains the risk that the price of the
security may decline.
The Fund may also write covered put options. When the Fund
writes a put option, it receives a premium and gives the purchaser of the
put the right to sell the underlying security to the Fund at the exercise
price at any time during the option period. A put is "covered" if the
Fund maintains cash, U.S. government securities or other high-grade,
liquid debt securities with a value equal to the exercise price in a
segregated account. The risk in writing puts is that the market price of
the underlying security may decline below the exercise price (less the
premiums received).
The Fund may seek to terminate its obligations as a writer of a
put or call option prior to its expiration by entering into a "closing
purchase transaction." A closing purchase transaction is the purchase of
an option covering the same underlying security and having the same
exercise price and expiration date as an option previously written by the
Fund on which it wishes to terminate its obligation.
Although not a fundamental policy subject to shareholder vote,
the Fund presently does not intend to write options on portfolio
securities exceeding 25% of its total assets. Normally, options will be
written on those portfolio securities which the Adviser does not expect to
have significant short-term capital appreciation.
Risks of Writing Options on Debt Securities When the Fund
writes an option, it assumes the risk of fluctuations in the value of the
underlying security in return for a fixed premium and must be prepared to
satisfy exercise of the option at any time until the expiration date. The
writing of options could also result in an increase in the Fund's turnover
rate, particularly in periods of appreciation in the market price of the
underlying securities. In addition, writing options on portfolio
securities involves a number of other risks, including the risk that the
Adviser may not correctly predict interest rate movement and the risk
that there may not be a liquid secondary market for the option, as a
result of which the Fund might be unable to effect a closing transaction.
If the Fund is unable to close out an option it has written, it
must continue to bear the risks associated with the option, and must
continue to hold cash or securities to cover the option until the option
is exercised or expires. The Fund may engage in options on securities
which are not traded on national exchanges ("unlisted options"). Because
unlisted options may be closed out only with the other party to the option
transaction, it may be more difficult to close out unlisted options than
listed options.
9
<PAGE>
Regulatory Notification of Futures and Options Strategies The
Corporation has filed on behalf of the Fund a notice of eligibility for
exclusion from the definition of the term "commodity pool operator" with
the Commodity Futures Trading Commission ("CFTC") and the National Futures
Association, which regulate trading in the futures markets. Under Section
4.5 of the regulations under the Commodity Exchange Act, the notice of
eligibility must include representations that the Fund will use futures
contracts and related options solely for bona fide hedging purposes within
the meaning of the CFTC regulations, provided that the Fund may hold
futures contracts and related options that do not fall within the
definition of bona fide hedging transactions if, with respect to such non-
hedging transactions, the sum of initial margin deposits on futures
contracts and related options and premiums paid for related options, after
taking into account unrealized profits and losses on such contracts, do
not exceed 5% of the Fund's net assets; and provided further that the Fund
may exclude the amount by which an option is "in the money" in computing
such 5%. The Fund will not purchase futures contracts or related options
if as a result more than 33 1/3% of the Fund's total assets would be so
invested. Where the Fund enters into two positions that substantially
offset each other, it determines compliance with the foregoing limitation
by considering its net exposure to changes in the underlying instrument or
market. These limits on the Fund's investments in futures contracts are
not fundamental and may be changed by the Board of Directors as regulatory
agencies permit. The Fund will not modify these limits to increase its
permissible futures and related options activities without supplying
additional information in a supplement to a current Prospectus or
Statement of Additional Information that has been distributed or made
available to the Fund's shareholders.
Private Placements The Fund may acquire restricted
securities in private placement transactions, directly from the issuer or
from security holders, frequently at higher yields than comparable
publicly traded securities. Restricted securities will not be purchased
if as a result more than 5% of the Fund's assets would consist of
restricted securities. Privately placed securities can be sold by the
Fund only (1) pursuant to SEC Rule 144A or other exemption; (2) in
privately negotiated transactions to a limited number of purchasers; or
(3) in public offerings made pursuant to an effective registration
statement under the Securities Act of 1933. Private or public sales of
such securities by the Fund may involve significant delays and expense.
Private sales require negotiations with one or more purchasers and
generally produce less favorable prices than the sale of comparable
unrestricted securities. Public sales generally involve the time and
expense of preparing and processing a registration statement under the
Securities Act of 1933 and may involve the payment of underwriting
commissions; accordingly, the proceeds may be less than the proceeds from
the sale of securities of the same class which are freely marketable.
Securities Lending The Fund may lend portfolio securities to
brokers or dealers in corporate or U.S. government securities, banks or
other recognized institutional borrowers of securities, provided that the
borrower maintains cash or equivalent collateral, equal to at least 100%
10
<PAGE>
of the market value of the securities loaned with the Fund's custodian.
During the time portfolio securities are on loan, the borrower will pay
the Fund an amount equivalent to any dividends or interest paid on such
securities, and the Fund may invest the cash collateral and earn income,
or it may receive an agreed upon amount of interest income from the
borrower who has delivered equivalent collateral. These loans are subject
to termination at the option of the Fund or the borrower. The Fund may
pay reasonable administrative and custodial fees in connection with a loan
and may pay a negotiated portion of the interest earned on the cash or
equivalent collateral to the borrower or placing broker. In the event of
the bankruptcy of the other party to a securities loan, the Fund could
experience delays in recovering the securities lent. To the extent that,
in the meantime, the value of the securities purchased had decreased or
the securities lent increased, the Fund could experience a loss. The Fund
will enter into securities loan transactions only with financial
institutions which the Adviser believes to present minimal risk of default
during the term of the loan. The Fund does not have the right to vote
securities on loan, but would terminate the loan and regain the right to
vote if that were considered important with respect to the investment.
The Fund presently does not intend to loan more than 5% of its portfolio
securities at any given time.
Repurchase Agreements Repurchase agreements are usually for
periods of one week or less, but may be for longer periods. The
securities are held for the Fund by State Street Bank and Trust Company
("State Street"), the Fund's custodian, as collateral until resold and are
supplemented by additional collateral if necessary to maintain a total
value equal to or in excess of the value of the repurchase agreement. The
Fund bears a risk of loss in the event that the other party to a
repurchase agreement defaults on its obligations and the Fund is delayed
or prevented from exercising its rights to dispose of the collateral
securities. The Fund enters into repurchase agreements only with
financial institutions which the Adviser believes to present minimal risk
of default during the term of the agreement based on guidelines
established by the Corporation's Board of Directors. The Fund currently
intends to invest in repurchase agreements when cash is temporarily
available or for temporary defensive purposes.
Reverse Repurchase Agreements A reverse repurchase agreement is
a portfolio management technique in which the Fund temporarily transfers
possession of a portfolio instrument to another person, such as a
financial institution or broker-dealer, in return for cash. At the same
time, the Fund agrees to repurchase the instrument at an agreed upon time
(normally within seven days) and price, including interest payment. The
Fund may engage in reverse repurchase agreements as a means of raising
cash to satisfy redemption requests or for other temporary or emergency
purposes without the necessity of selling portfolio instruments.
When the Fund reinvests the proceeds of a reverse repurchase
agreement in other securities, any fluctuations in the market value of
either the securities transferred to another party or the securities in
which the proceeds are invested would affect the market value of the
11
<PAGE>
Fund's assets. As a result, such transactions could increase fluctuation
in the Fund's net asset value. If the Fund reinvests the proceeds of the
agreement at a rate lower than the cost of the agreement, engaging in the
agreement will lower the Fund's yield. While engaging in reverse
repurchase agreements, the Fund will maintain cash, U.S. government
securities or other high-grade, liquid debt securities in a segregated
account at its custodian bank with a value at least equal to the Fund's
obligation under the agreements.
The ability of the Fund to engage in reverse repurchase
agreements is subject to the Fund's fundamental investment limitation
concerning borrowing, i.e., that borrowing may be for temporary purposes
only and in an amount not to exceed 5% of the Fund's total assets.
Warrants Although not a fundamental policy subject to
shareholder vote, as long as the Fund's Shares continue to be registered
in certain states, the Fund may not invest more than 5% of the value of
its net assets, taken at the lower of cost or market value, in warrants or
invest more than 2% of the value of such net assets in warrants not listed
on the New York or American Stock Exchanges.
Mortgage-Related Securities Mortgage-related securities
represent an ownership interest in a pool of residential mortgage loans.
These securities are designed to provide monthly payments of interest, and
in most instances, principal to the investor. The mortgagor's monthly
payments to his/her lending institution are "passed-through" to investors
such as the Fund. Most issuers or poolers provide guarantees of payments,
regardless of whether or not the mortgagor actually makes the payment.
The guarantees made by issuers or poolers are backed by various forms of
credit, insurance and collateral.
Pools consist of whole mortgage loans or participations in loans.
The majority of these loans are made to purchasers of one- to four-family
homes. The terms and characteristics of the mortgage instruments are
generally uniform within a pool but may vary among pools. For example, in
addition to fixed-rate, fixed-term mortgages, the Fund may purchase pools
of variable-rate mortgages, growing-equity mortgages, graduated-payment
mortgages and other types.
All poolers apply standards for qualification to lending
institutions which originate mortgages for the pools. Poolers also
establish credit standards and underwriting criteria for individual
mortgages included in the pools. In addition, many mortgages included in
pools are insured through private mortgage insurance companies.
The majority of mortgage-related securities currently available
are issued by governmental or government-related organizations formed to
increase the availability of mortgage credit. The largest government-
sponsored issuer of mortgage-related securities is the Government National
Mortgage Association ("GNMA"). GNMA certificates are interests in pools
of loans insured by the Federal Housing Administration or by the Farmer's
Home Administration ("FHA"), or guaranteed by the Veterans Administration
12
<PAGE>
("VA"). The Federal National Mortgage Association ("FNMA") and the
Federal Home Loan Mortgage Corporation ("FHLMC") each issue pass-through
securities which are guaranteed as to principal and interest by FNMA and
FHLMC, respectively.
The average life of mortgage-related securities varies with the
maturities and the nature of the underlying mortgage instruments. For
example, GNMAs tend to have a longer average life than FHLMC participation
certificates ("PCs") because there is a tendency for the conventional and
privately-insured mortgages underlying FHLMC PCs to repay at faster rates
than the FHA and VA loans underlying GNMAs. In addition, the term of a
security may be shortened by unscheduled or early payments of principal
and interest on the underlying mortgages. The occurrence of mortgage pre-
payments is affected by various factors, including the level of interest
rates, general economic conditions, the location and age of the mortgaged
property and other social and demographic conditions.
In determining the dollar-weighted average maturity of the Fund's
portfolio, the Adviser will follow industry practice in assigning an
average life to the mortgage-related securities of the Fund unless the
interest rate on the mortgages underlying such securities is such that a
different prepayment rate is likely. For example, where a GNMA has a high
interest rate relative to the market, that GNMA is likely to have a
shorter overall maturity than a GNMA with a market rate coupon. Moreover,
the Adviser may deem it appropriate to change the projected average life
for the Fund's mortgage-related security as a result of fluctuations in
market interest rates and other factors.
Quoted yields on mortgage-related securities are typically based
on the maturity of the underlying instruments and the associated average
life assumption. Actual prepayment experience may cause the yield to
differ from the average life yield. Reinvestment of the prepayments may
occur at higher or lower interest rates than the original investment, thus
affecting the yield of the Fund. The compounding effect from the
reinvestments of monthly payments received by the Fund will increase the
yield to shareholders compared to bonds that pay interest semi-annually.
Like other debt securities, the value of mortgage-related
securities will tend to rise when interest rates fall, and fall when rates
rise. The value of mortgage-related securities may also change because of
changes in the market's perception of the creditworthiness of the
organization that issued or guaranteed them. In addition, the mortgage
securities market in general may be adversely affected by changes in
governmental regulation or tax policies.
ADDITIONAL TAX INFORMATION
The following is a general summary of certain federal tax
considerations affecting the Fund and its shareholders. Investors are
urged to consult their own tax advisers for more detailed information
13
<PAGE>
regarding any federal, state or local taxes that may be applicable to
them.
General For federal tax purposes, the Fund is treated as a
separate corporation. In order to continue to qualify for treatment as a
regulated investment company ("RIC") under the Internal Revenue Code of
1986, as amended ("Code"), the Fund must distribute annually to its
shareholders at least 90% of its investment company taxable income
(generally, net investment income plus any net short-term capital gain)
("Distribution Requirement") and must meet several additional
requirements. These requirements include the following: (1) at least 90%
of the Fund's gross income each taxable year must be derived 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 contracts) derived with respect
to its business of investing in securities ("Income Requirement"); (2) the
Fund must derive less than 30% of its gross income each taxable year from
the sale or other disposition of securities, options or futures contracts
held for less than three months ("Short-Short Limitation"); (3) at the
close of each quarter of the Fund's taxable year, at least 50% of the
value of its total assets must be represented by cash and cash items, U.S.
government securities, securities of other RICs and other securities, with
those other securities limited, in respect of any one issuer, to an amount
that does not exceed 5% of the value of the Fund's total assets; and (4)
at the close of each quarter of the Fund's taxable year, not more than 25%
of the value of its total assets may be invested in securities (other than
U.S. government securities or the securities of other RICs) of any one
issuer.
If Fund shares are sold at a loss after being held for six months
or less, the loss will be treated as a long-term, instead of a short-term,
loss to the extent of any capital gain distributions received on those
shares. Investors also should be aware that if shares are purchased
shortly before the record date for any dividend or other distribution, the
investor will pay full price for the shares and receive some portion of
the price back as a taxable distribution.
The Fund will be subject to a nondeductible 4% excise tax
("Excise Tax") to the extent it fails to distribute by the end of any
calendar year substantially all of its ordinary income for that year and
capital gain net income for the one-year period ending on October 31 of
that year, plus certain other amounts. For this and other purposes,
dividends and other distributions declared by the Fund in December of any
year and payable to shareholders of record on a date in that month will be
deemed to have been paid by the Fund and received by the shareholders on
December 31 if the distributions are paid by the Fund during the following
January. Accordingly, those dividends and other distributions will be
taxed to the shareholders for the year in which that December 31 falls.
Hedging Instruments The use of hedging instruments, such as
options and futures contracts, involves complex rules that will determine
14
<PAGE>
for income tax purposes the character and timing of recognition of the
gains and losses the Fund realizes in connection therewith.
Regulated futures contracts and options that are subject to
Section 1256 of the Code (collectively, "Section 1256 contracts") and are
held by the Fund at the end of its taxable year will be required to be
"marked-to market" for federal income tax purposes (that is, treated as
having been sold at that time at market value). Any unrealized gain or
loss recognized under this mark-to-market rule will be added to any
realized gains and losses on Section 1256 contracts actually sold by the
Fund during the year, and the resulting gain or loss will be treated
(without regard to the holding period) as 60% long-term capital gain or
loss and 40% short-term capital gain or loss. These rules may operate to
increase the amount of dividends, which will be taxable to shareholders,
that must be distributed to meet the Distribution Requirement and avoid
imposition of the Excise Tax, without providing the cash with which to
make the distributions. The Fund may elect to exclude certain
transactions from Section 1256, although doing so may have the effect of
increasing the relative proportion of short-term capital gain (taxable as
ordinary income when distributed to the Fund's shareholders).
Generally, the hedging transactions undertaken by the Fund may
result in "straddles" for federal income tax purposes. Because
application of the straddle rules may affect the character of gains or
losses, defer the recognition of losses and/or accelerate the recognition
of gains from the affected straddle positions, and may require the
capitalization of interest expense associated therewith, the amount that
must be distributed to shareholders (and the character of the distribution
as ordinary income or long-term capital gain) may be increased or
decreased substantially as compared to a fund that did not engage in such
hedging transactions.
Income from transactions in options and futures contracts derived
by the Fund with respect to its business of investing in securities will
qualify as permissible income under the Income Requirement. However,
income from the disposition of options and futures contracts will be
subject to the Short-Short Limitation if they are held for less than three
months. Furthermore, if the Fund satisfies certain requirements, any
increase in value of a position that is part of a "designated hedge" will
be offset by any decrease in value (whether realized or not) of the
offsetting hedging position during the period of the hedge for purposes of
determining whether the Fund satisfies the Short-Short Limitation. Thus,
only the net gain (if any) from the designated hedge will be included in
gross income for purposes of this limitation. The Fund intends that, when
it engages in hedging transactions, it will qualify for this treatment,
but at the present time it is not clear whether this treatment will be
available for, or that the Fund will elect to have this treatment apply
to, all hedging transactions undertaken by the Fund. To the extent this
treatment is not available, the Fund may be forced to defer the closing
out of certain options and futures contracts beyond the time when it
otherwise would be advantageous to do so, in order for the Fund to
continue to qualify as a RIC.
15
<PAGE>
Original Issue Discount The Fund may acquire zero coupon
securities or other debt securities issued with original issue discount.
As a holder of those securities, the Fund must include in its income the
original issue discount that accrues on the securities during the taxable
year, even if the Fund receives no corresponding payment on the securities
during the year. Because the Fund annually must distribute substantially
all of its investment company taxable income, including any earned
original issue discount, to satisfy the Distribution Requirement and avoid
imposition of the Excise Tax, it may be required in a particular year to
distribute as a dividend an amount that is greater than the total amount
of cash it actually receives. Those distributions will be made from the
Fund's cash assets or from the proceeds of sales of portfolio securities,
if necessary. The Fund may realize capital gains or losses from those
sales, which would increase or decrease its investment company taxable
income and/or net capital gain (the excess of net long-term capital gain
over net short-term capital loss). In addition, any such gains may be
realized on the disposition of securities held for less than three months.
Because of the Short-Short Limitation, any such gains would reduce the
Fund's ability to sell other securities, or options or futures contracts,
held for less than three months that it might wish to sell in the ordinary
course of its portfolio management.
ADDITIONAL PURCHASE AND REDEMPTION INFORMATION
The Fund offers two classes of shares, known as Primary Shares
and Navigator Shares. Primary Shares are available from Legg Mason and
certain of its affiliates. Navigator Shares are currently offered for
sale only to Institutional Clients, to clients of Trust Company for which
the Trust Company exercises discretionary investment management
responsibility, to qualified retirement plans managed on a discretionary
basis and having net assets of at least $200 million, and to The Legg
Mason Profit Sharing Plan and Trust. Navigator Shares may not be
purchased by individuals directly, but Institutional Clients may purchase
shares for Customer Accounts maintained for individuals. Primary Shares
are available to all other investors.
Future First Systematic Investment Plan and Transfer of Funds from
Financial Institutions
If you invest in Primary Shares, the Prospectus for those shares
explains that you may buy additional Primary Shares through the Future
First Systematic Investment Plan. Under this plan you may arrange for
automatic monthly investments in Primary Shares of $50 or more by
authorizing Boston Financial Data Services ("BFDS"), the Fund's transfer
agent, to prepare a check each month drawn on your checking account. Each
month the transfer agent will send a check to your bank for collection,
and the proceeds of the check will be used to buy Primary Shares at the
per share net asset value determined on the day the check is sent to your
bank. You will receive a quarterly cumulative account statement. You
may terminate the Future First Systematic Investment Plan at any time
without charge or penalty. Forms to enroll in the Future First Systematic
Investment Plan are available from any Legg Mason or affiliated office.
16
<PAGE>
Investors in Primary Shares may also buy additional Primary
Shares through a plan permitting transfers of funds from a financial
institution. Certain financial institutions may allow the investor, on a
pre-authorized basis, to have $50 or more automatically transferred
monthly for investment in shares of the Fund to:
Legg Mason Wood Walker, Incorporated
Funds Processing
P.O. Box 1476
Baltimore, Maryland 21203-1476
If the investor's check is not honored by the institution it is
drawn on, the investor may be subject to extra charges in order to cover
collection costs. These charges may be deducted from the investor's
shareholder account.
Systematic Withdrawal Plan
If you invest in Primary Shares, you may also elect to make
systematic withdrawals from your Fund account of a minimum of $50 on a
monthly basis if you own Primary Shares with a net asset value of $5,000
or more. The amounts paid to you each month are obtained by redeeming
sufficient Primary Shares from your account to provide the withdrawal
amount that you have specified. The Systematic Withdrawal Plan is not
currently available for shares held in an Individual Retirement Account
("IRA"), Self-Employed Individual Retirement Plan ("Keogh Plan"),
Simplified Employee Pension Plan ("SEP") or other qualified retirement
plan. You may change the monthly amount to be paid to you without charge
not more than once a year by notifying Legg Mason or the affiliate with
which you have an account. Redemptions will be made at the Primary
Shares' net asset value per share determined as of the close of regular
trading on the New York Stock Exchange, Inc. ("Exchange") on the first day
of each month. If the Exchange is not open for business on that day, the
shares will be redeemed at the per share net asset value determined as of
the close of regular trading on the Exchange on the preceding business
day. The check for the withdrawal payment will usually be mailed to you
on the next business day following redemption. If you elect to
participate in the Systematic Withdrawal Plan, dividends and other
distributions on all Primary Shares in your account must be automatically
reinvested in Primary Shares. You may terminate the Systematic Withdrawal
Plan at any time without charge or penalty. The Fund, its transfer agent,
and Legg Mason also reserve the right to modify or terminate the
Systematic Withdrawal Plan at any time.
Withdrawal payments are treated as a sale of shares rather than
as a dividend or a capital gain distribution. These payments are taxable
to the extent that the total amount of the payments exceeds the tax basis
of the shares sold. If the periodic withdrawals exceed reinvested
dividends and other distributions, the amount of your original investment
may be correspondingly reduced.
17
<PAGE>
Ordinarily, you should not purchase additional shares of the Fund
if you maintain a Systematic Withdrawal Plan because you may incur tax
liabilities in connection with such purchases and withdrawals. The Fund
will not knowingly accept purchase orders from you for additional shares
if you maintain a Systematic Withdrawal Plan unless your purchase is equal
to at least one year's scheduled withdrawals. In addition, if you
maintain a Systematic Withdrawal Plan you may not make periodic
investments under the Future First Systematic Investment Plan.
Other Information Regarding Redemption
The date of payment for a redemption may not be postponed for
more than seven days, and the right of redemption may not be suspended,
except (i) for any period during which the Exchange is closed (other than
for customary weekend and holiday closings), (ii) when trading in markets
the Fund normally utilizes is restricted, or an emergency, as defined by
rules and regulations of the SEC, exists, making disposal of the Fund's
investments or determination of its net asset value not reasonably
practicable, or (iii) for such other periods as the SEC by regulation or
order may permit for protection of the Fund's shareholders. In the case
of any such suspension, you may either withdraw your request for
redemption or receive payment based upon the net asset value next
determined after the suspension is lifted.
The Fund reserves the right, under certain conditions, to honor
any request or combination of requests for redemption from the same
shareholder in any 90-day period, totalling $250,000 or 1% of the net
assets of the Fund, whichever is less, by making payment in whole or in
part by securities valued in the same way as they would be valued for
purposes of computing the Fund's net asset value per share. If payment is
made in securities, a shareholder should expect to incur brokerage
expenses in converting those securities into cash and will be subject to
fluctuation in the market price of those securities until they are sold.
The Fund does not redeem "in kind" under normal circumstances, but would
do so where the Adviser determines that it would be in the best interests
of the shareholders as a whole.
PERFORMANCE INFORMATION
Total Return Calculations Average annual total return quotes
used in the Fund's advertising and other promotional materials
("performance advertisements") are calculated separately for each Class
according to the following formula:
18
<PAGE>
n
P(1+T) = ERV
where P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1,000
payment made at the beginning of that period.
Under the foregoing formula, the time periods used in performance
advertisements will be based on rolling calendar quarters, updated to the
last day of the most recent quarter prior to submission of the performance
advertisements 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 redeeming
value all dividends and other distributions by the Fund are assumed to
have been reinvested at net asset value on the reinvestment dates during
the period.
Yield Yields used in the Fund's performance advertisements for
each Class of Shares are calculated by dividing the Fund's net investment
income for a 30-day period ("Period") attributable to that Class, by the
average number of Shares in that 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
at the end of the Period. Yield quotations are calculated according to
the following formula:
6
Yield = 2 [(a-b +1) - 1]
cd
where: a = interest earned during the Period
b = expenses accrued for the Period (net of
reimbursements)
c = the average daily number of shares
outstanding during the period that were
entitled to receive dividends
d = the maximum offering price per share on
the last day of the Period.
Except as noted below, in determining net investment income earned
during the Period (variable "a" in the above formula), the 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). Once
interest earned is calculated in this fashion for each debt obligation
19
<PAGE>
held by the Fund, interest earned during the Period is then determined by
totalling the interest earned on all debt obligations. For the purposes
of these calculations, the maturity of an obligation with one or more call
provisions is assumed to be the next on which the obligation reasonably
can be expected to be called or, if none, the maturity date.
With respect to the treatment of discount and premium on mortgage-
backed and other asset-backed obligations that are expected to be subject
to monthly payments of principal and interest ("paydowns"): (1) the Fund
accounts for gain or loss attributable to actual paydowns as an increase
or decrease to interest income during the period and (2) the Fund accrues
the discount and amortizes the premium on the remaining obligation, based
on the cost of the obligation, to the weighted average maturity date or,
if weighted average maturity information is not available, to the
remaining term of the obligation. The yield for Primary Shares for the
30-day period ended December 31, 1994 was 5.43%. The 30-day yield for
Navigator Shares for the same period was 5.97%. Yields would have been
lower if the Manager had not waived a portion of the Fund's expenses.
Other Information In performance advertisements the Fund may compare
the total return of a class of shares with data published by Lipper
Analytical Services, Inc. ("Lipper"), CDA Investment Technologies, Inc.
("CDA"), Wiesenberger Investment Companies Service ("Wiesenberger"), or
Morningstar Mutual Funds ("Morningstar"), or with the performance of U.S.
Treasury securities of various maturities, recognized stock, bond and
other indexes, including (but not limited to) the Salomon Brothers Bond
Index, Shearson Lehman Bond Index, Shearson Lehman Government/Corporate
Bond Index, the Standard & Poor's 500 Composite Stock Price Index ("S & P
500"), the Dow Jones Industrial Average ("Dow Jones"), and changes in the
Consumer Price Index as published by the U.S. Department of Commerce. The
Fund also may refer in such materials to mutual fund performance rankings
and other data, such as comparative asset, expense and fee levels,
published by Lipper, CDA, Wiesenberger or Morningstar. Performance
Advertisements also may refer to discussions of a Class of the Fund and
comparative mutual fund data and ratings reported in independent
periodicals, including THE WALL STREET JOURNAL, MONEY Magazine, FORBES,
BUSINESS WEEK, FINANCIAL WORLD, BARRON'S, FORTUNE and THE NEW YORK TIMES.
The Fund invests primarily in the fixed-income securities described in
its Prospectus, and does not invest in the equity securities that make up
the S&P 500 or the Dow Jones indices. Comparison with such indices is
intended to show how an investment in a class of shares behaved as
compared to indices that are often taken as a measure of performance of
the equity market as a whole. The indices, like the total return of a
class of shares, assume reinvestment of all dividends and other
distributions. They do not take account of the costs or the tax
consequences of investing.
The Fund may include discussions or illustrations of the effects of
compounding in performance advertisements. "Compounding" refers to the
fact that, if dividends or other distributions on an investment in the
Fund are reinvested in additional shares, any future income or capital
20
<PAGE>
appreciation of the Fund would increase the value, not only of the
original Fund investment, but also of the additional shares received
through reinvestment. As a result, the value of the Fund investment would
increase more quickly than if dividends or other distributions had been
paid in cash.
The Fund may also compare the performance of a Class of Shares with
the performance of bank certificates of deposit (CDs) as measured by the
CDA Investment Technologies, Inc. Certificate of Deposit Index and the
Bank Rate Monitor National Index. In comparing the performance of a Class
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. Fund Shares are not insured or guaranteed by the U.S.
Government and returns and net asset value will fluctuate. The securities
held by the Fund generally have longer maturities than most CDs and may
reflect interest rate fluctuations for longer-term securities.
Fund advertisements may reference the history of the distributor and
its affiliates, and the education and experience of the portfolio manager.
Advertisements may also describe techniques the Adviser employs in
selecting among the sectors of the fixed-income market and may focus on
the technique of "value investing." With value investing, the Adviser
invests in those securities it believes to be undervalued in relation to
the long-term earning power or asset value of their issuers. Securities
may be undervalued because of many factors, including market decline, poor
economic conditions, tax-loss selling or actual or anticipated unfavorable
developments affecting the issuer of the security.
In advertising, the Fund may illustrate hypothetical investment plans
designed to help investors meet long-term financial goals, such as saving
for a child's college education or for retirement. Sources such as the
Internal Revenue Service, the Social Security Administration, the Consumer
Price Index and Chase Global Data and Research may supply data concerning
interest rates, college tuitions, the rate of inflation, Social Security
benefits, mortality statistics and other relevant information. The Fund
may use other recognized sources as they become available.
The Fund may use data prepared by Ibbotson Associates of Chicago,
Illinois ("Ibbotson") to compare the returns of various capital markets
and to show the value of a hypothetical investment in a capital market.
Ibbotson relies on different indices to calculate the performance of
common stocks, corporate and government bonds and Treasury bills.
The Fund may illustrate and compare the historical volatility of
different portfolio compositions where the performance of stocks is
represented by the performance of an appropriate market index, such as the
S&P 500 and the performance of bonds is represented by a nationally
recognized bond index, such as the Lehman Brothers Long-Term Government
Bond Index.
21
<PAGE>
The Fund may also include in advertising biographical information on
key investment and managerial personnel.
The Fund may advertise examples of the potential benefits of periodic
investment plans, such as dollar cost averaging, a long-term investment
technique designed to lower average cost per share. Under such a plan, an
investor invests in a mutual fund at regular intervals a fixed dollar
amount thereby purchasing more shares when prices are low and fewer shares
when prices are high. Although such a plan does not guarantee profit or
guard against loss in declining markets, the average cost per share could
be lower than if a fixed number of shares were purchased at the same
intervals. Investors should consider their ability to purchase shares
through low price levels.
The Fund may discuss Legg Mason's tradition of service. Since 1899,
Legg Mason and its affiliated companies have helped investors meet their
specific investment goals and have provided a full spectrum of financial
services. Legg Mason affiliates serve as investment advisors for private
accounts and mutual funds with assets of more than $17 billion as of
December 31, 1994.
In advertising, the Fund may discuss the advantages of saving through
tax-deferred retirement plans or accounts, including the advantages and
disadvantages of "rolling over" a distribution from a retirement plan into
an IRA, factors to consider in determining whether you qualify for such a
rollover, and the other options available. These discussions may include
graphs or other illustrations that compare the growth of a hypothetical
tax-deferred investment to the after-tax growth of a taxable investment.
The following tables show the value, as of the end of each fiscal
year, of a hypothetical investment of $10,000 made in the Fund at
commencement of operations of each class of Fund shares. The tables
assume that all dividends and other distributions are reinvested in the
Fund. They include the effect of all charges and fees applicable to the
respective class of shares the Fund has paid. (There are no fees for
investing or reinvesting in the Fund, and there are no redemption fees.)
They do not include the effect of any income taxes that an investor would
have to pay on distributions.
22
<PAGE>
<TABLE>
<CAPTION>
Primary Shares
Value of Original Shares Plus Value of Shares Acquired
Shares Obtained Through Through Reinvestment of Income
Fiscal Year Reinvestment of Capital Gain Dividends Total
Distributions Value
<S> <C> <C> <C>
1987* $9,920 $302 $10,222
1988 9,990 1,080 10,880
1989 10,210 2,062 12,272
1990 10,301 3,081 13,382
1991 11,087 4,217 15,304
1992 11,180 5,081 16,261
1993 11,607 5,735 17,342
1994 10,829 6,179 17,008
*August 7, 1987 (commencement of operations) to December 31 1987.
</TABLE>
<TABLE>
<CAPTION>
Navigator Shares
Value of Original Shares Plus
Shares Obtained Through Value of Shares Acquired
Fiscal Year Reinvestment of Capital Gain Through Reinvestment of Income Total
Distributions Dividends Value
<S> <C> <C> <C>
1994* $9,720 $49 $9,769
</TABLE>
*December 1, 1994 (commencement of operations) to December 31 1994.
With respect to Primary Shares, if the investor had not reinvested
dividends and other distributions, the total value of the hypothetical
investment as of December 31, 1994 would have been $9,720, and the
investor would have received a total of $5,774 in distributions. With
23
<PAGE>
respect to Navigator Shares, if the investor had not reinvested dividends
and other distributions, the total value of the hypothetical investment as
of December 31, 1994 would have been $9,720, and the investor would have
received a total of $49 in distributions. Returns would have been lower
if the Manager had not waived/reimbursed certain Fund expenses during the
fiscal years 1987 through 1994.
VALUATION OF FUND SHARES
Net asset value of a Fund share is determined daily for each Class as
of the close of the Exchange (normally 4:00 p.m., eastern time), on every
day that the Exchange is open, by subtracting liabilities attributable to
that Class, from total assets attributable to that Class, and dividing the
result by the number of shares of that Class, outstanding. Pricing will
not be done on days when the Exchange is closed. The Exchange currently
observes the following holidays: New Year's Day, President's Day, Good
Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving and
Christmas. When market quotations for institutional size positions are
readily available portfolio securities are valued based upon market
quotations. Where such market quotations are not readily available,
securities are valued based upon appraisals received from a pricing
service using a computerized matrix system or based upon appraisals
derived from information concerning the security or similar securities
received from recognized dealers in those securities. The methods used by
the pricing service and the quality of the valuations so established are
reviewed by the Adviser under the general supervision of the Corporation's
Board of Directors. The amortized cost method of valuation is used with
respect to obligations with 60 days or less remaining to maturity unless
the Adviser determines that this does not represent fair value. All
other assets are valued at fair value as determined in good faith, by or
under the direction of the Corporation's Board of Directors. Premiums
received on the sale of put and call options are included in net asset
value of each class, and the current market value of options sold by the
Fund will be subtracted from net assets of each class.
TAX-DEFERRED RETIREMENT PLANS
As noted in the Prospectus for Primary Shares, an investment in those
shares may be appropriate for IRAs, Keogh Plans, SEPs and other qualified
retirement plans. In general, income earned through the investment of
assets of qualified retirement plans is not taxed to the beneficiaries of
such plans until the income is distributed to them. Primary Share
investors who are considering establishing such a plan should consult
their attorneys or other tax advisers with respect to individual tax
questions. The option of investing in these plans with respect to Primary
Shares through regular payroll deductions may be arranged with a Legg
Mason or affiliated investment executive and your employer. Additional
information with respect to these plans is available upon request from any
Legg Mason or affiliated investment executive.
24
<PAGE>
Individual Retirement Account -- IRA
Certain Primary Share investors may obtain tax advantages by
establishing IRAs. Specifically, if neither you nor your spouse is an
active participant in a qualified employer or government retirement plan,
or if either you or your spouse is an active participant and your adjusted
gross income does not exceed a certain level, you may deduct cash
contributions made to an IRA in an amount for each taxable year not
exceeding the lesser of 100% of your earned income or $2,000. In
addition, if your spouse is not employed and you file a joint return, you
may establish a separate IRA for your spouse and contribute up to a total
of $2,250 to the two IRAs, provided that the contribution to either does
not exceed $2,000. If you and your spouse are both employed and neither
of you is an active participant in a qualified employer or government
retirement plan and you establish separate IRAs, you each may contribute
all of your earned income, up to $2,000 each, and thus may together
receive tax deductions of up to $4,000 for contributions to your IRAs. If
your employer's plan qualifies as a SEP, permits voluntary contributions
and meets certain requirements, you may make voluntary contributions to
that plan that are treated as deductible IRA contributions.
Even if you are not in one of the categories described in the
preceding paragraph, you may find it advantageous to invest in Primary
Shares through IRA contributions, up to certain limits, because all
dividends and capital gain distributions on your Primary Shares are then
not immediately taxable to you or the IRA; they become taxable only when
distributed to you. To avoid penalties, your interest in an IRA must be
distributed, or start to be distributed, to you not later than the end of
the taxable year in which you attain age 70-1/2. Distributions made
before age 59-1/2, in addition to being taxable, generally are subject to
a penalty equal to 10% of the distribution, except in the case of death or
disability or where the distribution is rolled over into another qualified
plan or certain other situations.
Self-Employed Individual Retirement Plan -- Keogh Plan
Legg Mason makes available to self-employed individuals a Plan and
Trustee Agreement for a Keogh Plan through which Primary Shares may be
purchased. Primary Share investors have the right to use a bank of their
own choice to provide these services at their own cost. There are
penalties for distributions from a Keogh Plan prior to age 59-1/2, except
in the case of death or disability.
Simplified Employee Pension Plan -- SEP
Legg Mason makes available to corporate and other employers a SEP for
investment in Primary Shares.
Withholding at the rate of 20% is required for federal income tax
purposes on certain distributions (excluding, for example, certain
periodic payments) from the foregoing retirement plans (except IRAs and
SEPs), unless the recipient transfers the distribution directly to an
25
<PAGE>
"eligible retirement plan" (including IRAs and other qualified plans) that
accepts those distributions. Other distributions generally are subject to
regular wage withholding at the rate of 10% (depending on the type and
amount of the distribution), unless the recipient elects not to have any
withholding apply. Primary Share investors should consult their plan
administrator or tax adviser for further information.
THE CORPORATION'S DIRECTORS AND OFFICERS
The Corporation's officers are responsible for the operation of the
Corporation under the direction of the Board of Directors. The officers
and directors of the Corporation and their principal occupations during
the past five years are set forth below. An asterisk (*) indicates those
officers and/or directors who are interested persons of the Corporation as
defined by the Investment Company Act of 1940, as amended ("1940 Act").
The business address of each officer and director is 111 South Calvert
Street, Baltimore, Maryland 21202, unless otherwise indicated.
JOHN F. CURLEY, JR.*, [55] Chairman of the Board and
Director; Vice Chairman and Director of Legg Mason Wood Walker, Inc. and
Legg Mason, Inc.; Director of Legg Mason Fund Adviser, Inc. and Western
Asset Management Company; Officer and/or Director of various other
affiliates of Legg Mason, Inc.; Chairman of the Board and Director of
three Legg Mason funds; President and Director of three Legg Mason funds;
Chairman of the Board, President and Trustee of one Legg Mason fund and
Chairman of the Board and Trustee of one Legg Mason fund.
EDMUND J. CASHMAN, JR.*, [58] Vice Chairman and Director; Senior
Executive Vice President and Director of Legg Mason, Inc.; Officer and/or
Director of various other affiliates of Legg Mason, Inc.; President and
Director of one Legg Mason fund; President and Trustee of one Legg Mason
fund; Director of Worldwide Value Fund, Inc.
EDWARD A. TABER, III*, [51] President and Director; Executive Vice
President of Legg Mason, Inc. and Legg Mason Wood Walker, Inc.; Vice
Chairman and Director of Legg Mason Fund Adviser, Inc.; Director of three
Legg Mason funds; President and Director of two Legg Mason funds; Trustee
of one Legg Mason fund; Vice President of Worldwide Value Fund, Inc.
Formerly: Executive Vice President of T. Rowe Price-Fleming
International, Inc. (1986-1992) and Director of the Taxable Fixed Income
Division at T. Rowe Price Associates, Inc. (1973-1992).
RICHARD G. GILMORE, [67] Director; 5534 Chanteclaire, Sarasota,
Florida. Independent Consultant. Director of CSS Industries, Inc.
(diversified holding company whose subsidiaries are engaged in manufacture
and sale of decorative paper products, business forms, and specialty metal
packaging); Director of PECO Energy Company (formerly Philadelphia
Electric Company); Director of six Legg Mason funds; and Trustee of one
Legg Mason fund. Formerly: Senior Vice President and Chief Financial
Officer of Philadelphia Electric Company (now PECO Energy Company);
Executive Vice President and Treasurer, Girard Bank, and Vice President of
26
<PAGE>
its parent holding company, the Girard Company; and Director of Finance,
City of Philadelphia.
CHARLES F. HAUGH, [69] Director; 14201 Laurel Park Drive, Suite 104,
Laurel, Maryland. Real Estate Developer and Investor; President and
Director of Resource Enterprises, Inc. (real estate brokerage); Chairman
of Resource Realty LLC (management of retail and office space); Partner in
Greater Laurel Health Park Ltd. Partnership (real estate investment and
development); Director of six Legg Mason funds; and Trustee of two Legg
Mason funds.
ARNOLD L. LEHMAN, [51] Director; The Baltimore Museum of Art, Art
Museum Drive, Baltimore, Maryland. Director of the Baltimore Museum of
Art; Director of six Legg Mason funds; Trustee of two Legg Mason funds.
JILL E. McGOVERN, [50] Director; 1500 Wilson Boulevard, Arlington,
Virginia. Chief Executive Officer of the Marrow Foundation. Director of
six Legg Mason funds; Trustee of two Legg Mason funds. Formerly: Executive
Director of the Baltimore International Festival January 1991 - March
1993; and Senior Assistant to the President of The Johns Hopkins
University (1986-1991).
T. A. RODGERS, [60] Director; 2901 Boston Street, Baltimore, Maryland.
Principal, T.A. Rodgers & Associates (management consulting); Director of
six Legg Mason funds; Trustee of one Legg Mason fund. Formerly: Director
and Vice President of Corporate Development, Polk Audio, Inc.
(manufacturer of audio components) .
The executive officers of the Corporation, other than those who also
serve as directors, are:
MARIE K. KARPINSKI*, [46] Vice President and Treasurer; Treasurer of
Legg Mason Fund Adviser, Inc.; Vice President and Treasurer of eight Legg
Mason funds; and Secretary/Treasurer of Worldwide Value Fund, Inc.; Vice
President of Legg Mason.
STEFANIE L. WONG*, [27] Secretary; Secretary of one Legg Mason fund;
employee of Legg Mason.
BLANCHE P. ROCHE*, [46] Assistant Secretary and Assistant Vice
President; Assistant Secretary and Assistant Vice President of seven Legg
Mason funds; employee of Legg Mason since 1991. Formerly: Manager of
Consumer financial services, Primerica Corporation (1989-1991).
Officers and directors of the Corporation who are "interested persons"
of the Corporation, as defined in the 1940 Act, receive no salary or fees
from the Corporation. Independent directors of the Corporation receive a
fee of $400 annually for serving as a director, and a fee of $400 for each
meeting of the Board of Directors attended by him or her. For the fiscal
year ended December 31, 1994, the present independent directors as a group
received a total of $7,500 from each Portfolio of the Corporation.
27
<PAGE>
The Nominating Committee of the Board of Directors is responsible for
the selection and nomination of disinterested directors. The Committee is
composed of Messrs. Haugh, Gilmore, Lehman and Dr. McGovern, each of whom
is a disinterested director as that term is defined in the 1940 Act.
At February 28, 1995 the directors and officers of the Corporation
beneficially owned, in the aggregate, less than 1% of the Fund's
outstanding Shares.
The following table provides certain information relating to the
compensation of the Corporation's directors for the fiscal year ended
December 31, 1994.
28
<PAGE>
<TABLE>
<CAPTION>
COMPENSATION TABLE
Pension or Retirement Total Compensation
Aggregate Compensation Benefits Accrued as Part Estimated Annual From Corporation and
Name of Person and Position From Corporation* of Corporation's Expenses Benefits Upon Fund Complex Paid to
Retirement Directors**
<S> <C> <C> <C> <C>
John F. Curley, Jr. -
Chairman of the Board and
Director None N/A N/A None
Edward A. Taber, III -
President and Director None N/A N/A None
Edmund J. Cashman, Jr.
Vice Chairman and Director
None N/A N/A None
Marie K. Karpinski -
Vice President and
Treasurer None N/A N/A None
Richard G. Gilmore -
Director $6,000 N/A N/A $21,600
Charles F. Haugh -
Director $6,000 N/A N/A $23,600
Arnold L. Lehman -
Director $6,000 N/A N/A $23,600
Jill E. McGovern -
Director $6,000 N/A N/A $23,600
T. A. Rodgers -
Director $6,000 N/A N/A $21,600
</TABLE>
* Represents fees paid to each director during the fiscal year
ended December 31, 1994.
** Represents aggregate compensation paid to each director during
the calendar year ended December 31, 1994.
29
<PAGE>
MANAGEMENT AGREEMENT
Legg Mason Fund Adviser, Inc. ("Manager"), 111 South Calvert Street,
Baltimore, Md. 21202, is a wholly owned subsidiary of Legg Mason, Inc.,
which is also the parent of Legg Mason Wood Walker, Incorporated. The
Manager serves as the manager for the Fund under a Management Agreement
dated June 19, 1987 ("Management Agreement"), which was approved by the
Corporation's Board of Directors, including a majority of the directors
who are not "interested persons" (as defined in the 1940 Act) of the
Corporation, the Manager or the Adviser, on May 8, 1987, and was approved
by the shareholders of the Fund on April 22, 1988. Continuation of the
Management Agreement was most recently approved by the Board of Directors
on October 21, 1994. The Management Agreement provides that, subject to
overall direction by the Board of Directors, the Manager will manage the
investment and other affairs of the Fund. Under the Management Agreement,
the Manager is responsible for managing the Fund's securities and for
making purchases and sales of securities consistent with the investment
objectives and policies described in the Fund's Prospectus and this
Statement of Additional Information. The Manager is obligated to furnish
the Fund with office space and certain administrative services as well as
executive and other personnel necessary for the operation of the Fund.
The Manager and its affiliates also are responsible for the compensation
of directors and officers of the Corporation who are employees of the
Manager and/or its affiliates. The Manager has delegated the portfolio
management functions for the Fund to the Adviser, Western Asset Management
Company.
As explained in the Fund's Prospectus, the Manager receives for its
services a management fee, calculated daily and payable monthly, at an
annual rate equal to 0.55% of the Fund's average daily net assets. The
management fee paid by the Fund may be reduced under regulations in
various states where shares of the Fund are qualified for sale that impose
limitations on the annual expense ratio of the Fund. The most restrictive
annual expense limitation currently requires that the Manager reimburse
the Fund for certain expenses, including the management fees received by
it (but excluding interest, taxes, brokerage fees and commissions,
distribution fees and certain extraordinary charges), in any fiscal year
in which the Fund's expenses exceed 2.5% of the first $30 million, 2.0% of
the next $70 million, and 0.5% of the balance over $100 million in net
assets. No reimbursements have been made nor have any been required to be
made pursuant to this undertaking. In addition, the Manager has agreed to
waive its fees and reimburse the Fund if and to the extent the expenses
(exclusive of taxes, interest, brokerage and extraordinary expenses)
exceed during any month annual rates of the Fund's average daily net
assets for such month, or certain asset levels are achieved, whichever
occurs first, in accordance with the following schedule:
30
<PAGE>
Primary Shares:
<TABLE>
<CAPTION>
<S> <C> <C>
Rate Expiration Date Asset Level
0.95% October 31, 1995 $400 million
0.90% October 31, 1994 $400 million
0.90% August 31, 1993 $400 million
0.85% October 31, 1992 $300 million
Navigator Shares:
Rate Expiration Date Asset Level
0.45% October 31, 1995 $400 million
0.40% April 30, 1995 $400 million
</TABLE>
For the years ended December 31, 1994, 1993 and 1992, the Manager
waived management fees of $788,260, $860,000, and $1,003,000,
respectively, for the Fund.
Under the Management Agreement, the Manager will not be liable
for any error of judgment or mistake of law or for any loss suffered by
the Fund in connection with the performance of the Management Agreement,
except a loss resulting from a breach of fiduciary duty with respect to
the receipt of compensation for services or losses resulting from willful
misfeasance, bad faith or gross negligence in the performance of its
duties or from reckless disregard of its obligations or duties thereunder.
The Management Agreement terminates automatically upon assignment
and is terminable at any time without penalty by vote of the Corporation's
Board of Directors, by vote of a majority of the outstanding voting
securities of the Fund or by the Manager, on not less than 60 days'
written notice to the other party, and may be terminated immediately upon
the mutual written consent of the Manager and the Fund.
The Fund pays all of its expenses which are not expressly assumed
by the Manager. These expenses include, among others, interest expense,
taxes, brokerage fees and commissions, expenses of preparing and printing
prospectuses, statements of additional information, proxy statements and
reports and of distributing them to existing shareholders, custodian
charges, transfer agency fees, organizational expenses, distribution fees
to the Fund's distributor, compensation of the independent directors,
legal, accounting and audit expenses, insurance expenses, expenses of
registering and qualifying shares of the Fund for sale under federal and
state law, governmental fees and expenses incurred in connection with
membership in investment company organizations. The Fund also is liable
for such nonrecurring expenses as may arise, including litigation to which
the Fund may be a party. The Fund may also have an obligation to
indemnify the directors and officers of the Corporation with respect to
any such litigation.
31
<PAGE>
Under the Management Agreement, the Fund has the non-exclusive
right to use the name "Legg Mason" until that Agreement is terminated, or
until the right is withdrawn in writing by the Manager.
INVESTMENT ADVISORY AGREEMENT
The Adviser, Western Asset Management Company, 117 East Colorado
Boulevard, Pasadena, CA 91105, an affiliate of Legg Mason, serves as
investment adviser to the Fund under an Investment Advisory Agreement,
dated June 19, 1987, between the Adviser and the Manager ("Advisory
Agreements"). The Advisory Agreement was approved by the Board of
Directors, including a majority of the directors who are not "interested
persons" of the Corporation, the Adviser or the Manager, on May 8, 1987,
and was approved by the shareholders of the Fund on April 22, 1988.
Continuation of the Agreement was most recently approved by the Board of
Directors on October 21, 1994.
Under the Advisory Agreement, the Adviser is responsible, subject
to the general supervision of the Manager and the Corporation's Board of
Directors, for the actual management of the Fund's assets, including
the responsibility for making decisions and placing orders to buy, sell
or hold a particular security. For the Adviser's services to the Fund,
the Manager (not the Fund) pays the Adviser a fee, computed daily and
payable monthly, at an annual rate equal to 40% of the fee received by the
Manager. During the years ended December 31, 1994, 1993 and 1992, the
Manager paid $598,693, $336,400 and $477,347, respectively, to the Adviser
on behalf of the Fund.
Under the Advisory Agreement, the Adviser will not be liable for
any error of judgment or mistake of law or for any loss suffered by the
Manager or by the Fund in connection with the performance of the Advisory
Agreement, except a loss resulting from a breach of fiduciary duty with
respect to the receipt of compensation for services or a loss resulting
from willful misfeasance, bad faith or gross negligence on its part in the
performance of its duties or from reckless disregard by it of its
obligations or duties thereunder.
The Advisory Agreement terminates automatically upon assignment
and is terminable at any time without penalty by vote of the Corporation's
Board of Directors, by vote of a majority of the Fund's outstanding voting
securities, by the Manager or by the Adviser, on not less than 60 days'
notice to the Fund and/or the other party(ies). The Advisory Agreement
terminates immediately upon any termination of the Management Agreement or
upon the mutual written consent of the Adviser, the Manager and the Fund.
To mitigate the possibility that the Fund will be affected by
personal trading of employees, the Corporation, the Manager and the
Adviser have adopted policies that restrict securities trading in the
personal accounts of portfolio managers and others who normally come into
advance possession of information on portfolio transactions. These
policies comply, in all material respects, with the recommendations of the
Investment Company Institute.
32
<PAGE>
PORTFOLIO TRANSACTIONS AND BROKERAGE
The portfolio turnover rate is computed by dividing the lesser of
purchases or sales of securities for the period by the average value of
portfolio securities for that period. Short-term securities are excluded
from the calculation. For the years ended December 31, 1994 and 1993, the
Fund's portfolio turnover rates were 315.7% and 490.2%, respectively.
Under the Advisory Agreement, the Adviser is responsible for the
execution of portfolio transactions. Corporate and government debt
securities are generally traded on the over-the-counter market on a "net"
basis without a stated commission, through dealers acting for their own
account and not as brokers. Prices paid to a dealer in debt securities
will generally include a "spread", which is the difference between the
price at which the dealer is willing to purchase and sell the specific
security at the time, and includes the dealer's normal profit. Some
portfolio transactions may be executed through brokers acting as agent.
In selecting brokers or dealers, the Adviser must seek the most favorable
price (including the applicable dealer spread) and execution for such
transactions, subject to the possible payment as described below of higher
brokerage commissions for agency transactions or spreads to broker-dealers
who provide research and analysis. The Fund may not always pay the lowest
commission or spread available. Rather, in placing orders on behalf of
the Fund, the Adviser also takes into account such factors as size of the
order, difficulty of execution, efficiency of the executing broker's
facilities (including the services described below) and any risk assumed
by the executing broker.
Consistent with the policy of most favorable price and
execution, the Adviser may give consideration to research, statistical
and other services furnished by brokers or dealers to the Adviser for its
use, may place orders with broker-dealers who provide supplemental
investment and market research and securities and economic analysis, and
may, for agency transactions, pay to these broker-dealers a higher
brokerage commission than may be charged by other broker-dealers. Such
research and analysis may be useful to the Adviser in connection with
services to clients other than the Fund. The Adviser's fee is not reduced
by reason of its receiving such brokerage and research services. For the
years ended December 31, 1994, 1993 and 1992, the Fund paid commissions of
$381,650, $526,090 and $400,030, respectively, to broker-dealers who acted
as agents in executing options and futures trades.
The Fund may not buy securities from, or sell securities to, Legg
Mason or its affiliated persons as principal. However, the Corporation's
Board of Directors has adopted procedures in conformity with Rule 10f-3
under the 1940 Act whereby the Fund may purchase securities that are
offered in underwritings in which Legg Mason or any of its affiliated
persons is a participant.
Investment decisions for the Fund are made independently from
those of other funds and accounts advised by the Adviser. However, the
same security may be held in the portfolios of more than one fund or
33
<PAGE>
account. When two or more accounts simultaneously engage in the purchase
or sale of the same security, the prices and amounts will be equitably
allocated to each account. In some cases, this procedure may adversely
affect the price or quantity of the security available to a particular
account. In other cases, however, an account's ability to participate in
large-volume transactions may produce better executions and prices.
THE FUND'S DISTRIBUTOR
Legg Mason acts as distributor of the Fund's shares pursuant to
an Underwriting Agreement with the Corporation. The Underwriting
Agreement obligates Legg Mason to pay certain expenses in connection with
the offering of the Fund's shares, including compensation to its
investment executives. Legg Mason also pays for the printing and
distribution of prospectuses and periodic reports used in connection
with the offering to prospective investors, after the prospectuses and
reports have been prepared, set in type and mailed to shareholders at the
Fund's expense, and for supplementary sales literature and advertising
costs.
For the year ended December 31, 1994, Legg Mason incurred the
following expenses with respect to Primary Shares:
Compensation to sales personnel $ 962,000
Printing and mailing of prospectuses
to prospective shareholders 42,000
Advertising 60,000
Other 438,000
---------------
Total expenses $ 1,502,000
===============
The foregoing are estimated and do not include all expenses fairly
allocable to Legg Mason's or its affiliates' efforts to distribute Shares.
Fairfield Group, Inc., a wholly owned subsidiary of Legg Mason, Inc.,
with principal offices at 200 Gibraltar Road, Horsham, Pennsylvania, acts
as a dealer for Navigator Shares pursuant to a Dealer Agreement with Legg
Mason. Neither Legg Mason nor Fairfield receives any compensation from
the Fund for its activities in selling Navigator Shares.
The Corporation has adopted a Distribution and Shareholder Services
Plan ("Plan") which, among other things, permits it to pay Legg Mason fees
for its services related to sales and distribution of Primary Shares and
for the provision of ongoing services to Primary Class shareholders.
Payments are made only from assets attributable to Primary Shares. The
Plan was adopted, as required by Rule 12b-1 under the 1940 Act, by a vote
of the Board of Directors on May 8, 1987, including a majority of the
directors who are not "interested persons" of the Corporation as that term
is defined in the 1940 Act and who have no direct or indirect financial
34
<PAGE>
interest in the operation of the Plan or the Underwriting Agreement
("12b-1 directors"). Continuation of the Plan was most recently approved
by the Board of Directors on October 21, 1994, including a majority of the
12b-1 directors. In approving the continuance of the Plan, in accordance
with the requirements of Rule 12b-1, the directors considered various
factors, including the amount of the distribution fee. The directors
determined that there is a reasonable likelihood that the Plan will
continue to benefit the Fund and its present and future Primary Class
shareholders. The Plan was also approved by the vote of a majority of the
Fund's outstanding Primary Shares on April 22, 1988.
The Plan continues in effect only so long as it is approved at least
annually by the vote of a majority of the Board of Directors, including a
majority of the 12b-1 directors, cast in person at a meeting called for
the purpose of voting on the Plan. The Plan may be terminated with respect
to the Fund by vote of a majority of the 12b-1 directors, or by vote of a
majority of the outstanding voting Primary Class securities of the Fund.
Any change in the Plan that would materially increase the distribution
cost to the Fund requires Primary Class shareholder approval. Otherwise,
the Plan may be amended by the directors, including a majority of the 12b-
1 directors, as previously described.
Rule 12b-1 requires that any person authorized to direct the
disposition of monies paid or payable by the Fund, pursuant to the Plan or
any related agreement, shall provide to the Corporation's Board of
Directors, and the directors shall review, at least quarterly, a written
report of the amounts so expended and the purposes for which the
expenditures were made. Rule 12b-1 also provides that the Fund may rely
on that Rule only if, while the Plan is in effect, the nomination and
selection of the Corporation's independent directors is committed to the
discretion of such independent directors.
As compensation for its services and expenses, Legg Mason receives
from the Corporation annual distribution and service fees equivalent to
0.25% of the Fund's average daily net assets attributable to Primary
Shares in accordance with the Plan. The distribution and service fees are
computed daily and paid monthly. For the years ended December 31, 1994,
1993 and 1992, the Fund paid distribution and service fees of $1,344,353,
$1,533,030 and $1,333,705, respectively, to Legg Mason, pursuant to the
Underwriting Agreement from assets attributable to Primary Shares.
THE FUND'S CUSTODIAN AND TRANSFER AND DIVIDEND-DISBURSING AGENT
State Street Bank and Trust Company, P.O. Box 1713, Boston, Massachusetts
02105, serves as custodian of the Fund's assets. Boston Financial Data
Services P.O. Box 953, Boston, Massachusetts 02103, serves as transfer
and dividend-disbursing agent, and administrator of various shareholder
services. BFDS has contracted with Legg Mason for the latter to assist it
with certain of its duties as transfer agent, for which BFDS compensates
Legg Mason. For the year ended December 31, 1994, Legg Mason received
$57,597 for such services. Shareholders who request an historical
transcript of their account will be charged a fee based upon the number of
35
<PAGE>
years researched. The Fund reserves the right, upon 60 days' written
notice, to make other charges to investors to cover administrative costs.
THE CORPORATION'S LEGAL COUNSEL
Kirkpatrick & Lockhart LLP, 1800 M Street, N.W., Washington, D.C.
20036, serves as counsel to the Corporation.
THE CORPORATION'S INDEPENDENT ACCOUNTANTS
Coopers & Lybrand L.L.P., 217 East Redwood Street, Baltimore, MD
21202, have been selected by the Directors to serve as the Corporation's
independent accountants.
FINANCIAL STATEMENTS
The Portfolio of Investments as of December 31, 1994; the Statement of
Assets and Liabilities as of December 31, 1994; the Statement of
Operations for the year ended December 31, 1994; the Statement of Changes
in Net Assets for the years ended December 31, 1994 and 1993; the
Financial Highlights for the periods presented; the Notes to Financial
Statements and the Report of the Independent Accountants, all of which are
included in the Fund's Annual Report to Shareholders for the year ended
December 31, 1994, are hereby incorporated by reference in this Statement
of Additional Information.
36
<PAGE>
APPENDIX A
For the Government Intermediate Portfolio:
RATINGS OF SECURITIES
Description of Moody's Investors Service, Inc. ("Moody's") corporate bond
ratings:
Aaa-Bonds which are rated Aaa are judged to be of the best quality.
They carry the smallest degree of investment risk and are generally
referred to as "gilt edge." Interest payments are protected by a large or
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 risks appear
somewhat larger than the Aaa securities.
A-Bonds which are rated A possess many favorable investment attributes
and are to be considered upper-medium-grade obligations. Factors giving
security to principal and interest are considered adequate, but elements
may be present which suggest a susceptibility to impairment some time in
the future.
Baa-Bonds which are rated Baa are considered medium-grade obligations,
(i.e., they are neither highly protected nor poorly secured). Interest
payments and principal security appear adequate for the present but
certain protective elements may be lacking or may be characteristically
unreliable over any great length of time. Such bonds lack outstanding
investment characteristics and in fact have speculative characteristics as
well.
Ba-Bonds which are rated Ba are judged to have speculative elements;
their future cannot be considered 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
maintenance of other terms of the contract over any long period of time
may be small.
Description of Standard & Poor's Ratings Group corporate bond ratings:
A-1
<PAGE>
AAA-This is the highest rating assigned by Standard & Poor's to an
obligation. Capacity to pay interest and repay principal is extremely
strong.
AA-Bonds rated AA have a very strong capacity to pay interest and
repay principal and differ from the higher rated issues only in small
degree.
A-Bonds rated A have a strong capacity to pay interest and repay
principal, although they are somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than debt in
higher categories.
BBB-Bonds rated BBB are regarded as having an adequate capacity to pay
principal and interest. Whereas they normally exhibit adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal
for bonds in this category than for bonds in higher rated categories.
BB, B, CCC, CC-Bonds rated BB, B, CCC and CC are regarded, on balance,
as predominately speculative with respect to the issuer's capacity to pay
interest and repay principal in accordance with the terms of the
obligation. BB indicates the lowest degree of speculation and C the
highest degree of speculation. While such bonds will likely have some
quality and protective characteristics, these are outweighed by large
uncertainties or major risk exposures to adverse conditions. Description
of Moody's preferred stock ratings:
Description of Moody's preferred stock ratings:
aaa-An issue which is rated "aaa" is considered to be a top-quality
preferred stock. This rating indicates good asset protection and the
least risk of dividend impairment within the universe of preferred stocks.
aa-An issue which is rated "aa" is considered a high-grade preferred
stock. This rating indicates that there is a reasonable assurance that
earnings and asset protection will remain relatively well-maintained in
the foreseeable future.
a-An issue which is rated "a" is considered to be an upper-medium
grade preferred stock. While risks are judged to be somewhat greater than
in the "aaa" and "aa" classification, earnings and asset protection
are, nevertheless, expected to be maintained at adequate levels.
baa-An issue which is rated "baa" is considered to be a medium-grade
preferred stock, neither highly protected nor poorly secured. Earnings
and asset protection appear adequate at present but may be questionable
over any great length of time.
ba-An issue which is rated "ba" is considered to have speculative
elements and its future cannot be considered well assured. Earnings and
asset protection may be very moderate and not well safeguarded during
A-2
<PAGE>
adverse periods. Uncertainty of position characterizes preferred stocks
in this class.
A-3
<PAGE>
LEGG MASON INCOME TRUST, INC.
Legg Mason High Yield Portfolio
STATEMENT OF ADDITIONAL INFORMATION
Legg Mason High Yield Portfolio ("Fund"), a diversified,
professionally managed portfolio, is a separate series of Legg Mason
Income Trust, Inc. ("Corporation"), an open-end investment company. The
Fund seeks to provide investors with a high level of current income. As a
secondary objective, the Fund seeks capital appreciation. The Fund
normally will seek to achieve its investment objectives by investing not
less than 65% of its total assets in high-yield, fixed-income securities
(including those commonly known as "junk bonds"); that is, income-
producing debt securities and preferred stocks of all types, including
(but not limited to) corporate debt securities and preferred stock,
convertible securities, zero coupon securities, deferred interest
securities, mortgage-backed securities and asset-backed securities. In
addition to other risks, these bonds are subject to greater fluctuations
in value and risk of loss of income and principal due to default by the
issuer than are lower-yielding, higher-rated bonds; therefore, these
investments may not be suitable for all investors.
This Statement of Additional Information is not a prospectus and
should be read in conjunction with the Prospectus for the Fund, dated May
1, 1995, which has been filed with the Securities and Exchange Commission
("SEC"). Copies of the Fund's Prospectus are available without charge
from the Corporation's distributor, Legg Mason Wood Walker, Incorporated
("Legg Mason") (address and telephone numbers listed below).
Dated: May 1, 1995
Legg Mason Wood Walker, Incorporated
--------------------------------------------
111 South Calvert Street
Baltimore, Maryland 21202
(410) 539-0000
Outside Maryland (800) 822-5544
<PAGE>
Table of Contents
Page
----
Additional Information About Investment Limitations and Policies 1
Additional Purchase and Redemption Information 21
Additional Tax Information 23
Tax-Deferred Retirement Plans 27
Performance Information 28
Valuation of Fund Shares 32
The Corporation's Directors and Officers 32
The Fund's Manager 37
Investment Advisory Agreement 38
The Fund's Distributor 39
Portfolio Transactions and Brokerage 40
The Fund's Custodian and Transfer and
Dividend-Disbursing Agent 41
The Corporation's Legal Counsel 42
The Corporation's Independent Accountants 42
Financial Statements 42
No person has been authorized to give any information or to make
any representations not contained in the Prospectus or this Statement of
Additional Information in connection with the offerings made by the
Prospectus and, if given or made, such information or representations
must not be relied upon as having been authorized by the Fund or its
distributor. The Prospectus and this Statement of Additional Information
do not constitute an offering by the Fund or by the distributor in any
jurisdiction in which such offering may not lawfully be made.
- 2 -
<PAGE>
ADDITIONAL INFORMATION ABOUT INVESTMENT LIMITATIONS AND POLICIES
In addition to the investment objectives described in the
Prospectus, the Fund has adopted the following fundamental investment
limitations that cannot be changed except by vote of the holders of a
majority of the outstanding voting securities of the Fund. The Fund may
not:
1. Borrow money, except from banks or through reverse repurchase
agreements or dollar rolls for temporary purposes in an aggregate amount
not to exceed 5% of the value of its total assets at the time of
borrowing. (Although not a fundamental policy subject to shareholder
approval, the Fund will repay any money borrowed before any portfolio
securities are purchased);
2. Issue senior securities, except as permitted under the Investment
Company Act of 1940, as amended ("1940 Act");
3. Engage in the business of underwriting the securities of other issuers
except insofar as the Fund may be deemed an underwriter under the
Securities Act of 1933, as amended ("1933 Act"), in disposing of a
portfolio security;
4. Buy or hold any real estate; provided, however, that instruments
secured by real estate or interests therein are not subject to this
limitation;
5. With respect to 75% of its total assets, invest more than 5% of its
total assets (taken at market value) in securities of any one issuer,
other than the U.S. Government, its agencies and instrumentalities, or
purchase more than 10% of the voting securities of any one issuer;
6. Purchase or sell any commodities or commodities contracts, except that
the Fund may purchase or sell currencies, interest rate and currency
futures contracts, options on currencies, securities, and securities
indexes and options on interest rate and currency futures contracts, and
may enter into swap agreements;
7. Make loans, except loans of portfolio securities and except to the
extent the purchase of notes, bonds or other evidences of indebtedness,
the entry into repurchase agreements, or deposits with banks and other
financial institutions may be considered loans;
8. Purchase any security if, as a result thereof, 25% or more of its
total assets would be invested in the securities of issuers having their
principal business activities in the same industry. This limitation does
not apply to securities issued or guaranteed by the U.S. Government, its
agencies or instrumentalities and repurchase agreements with respect
thereto.
The foregoing investment limitations cannot be changed without
the affirmative vote of the lesser of (1) more than 50% of the outstanding
- 1 -
<PAGE>
shares of the Fund or (2) 67% or more of the shares of the Fund present at
a shareholders' meeting if more than 50% of the outstanding shares of the
Fund are represented at the meeting in person or by proxy.
Except as otherwise specified, the investment limitations and
policies which follow, and those set forth throughout this Statement of
Additional Information, may be changed by the Corporation's Board of
Directors without shareholder approval. The following are some of the
non-fundamental limitations which the Fund currently observes. The Fund
may not:
1. Purchase or sell any oil, gas or mineral exploration or development
programs, including leases;
2. Buy securities on "margin," except for short-term credits necessary
for clearance of portfolio transactions and except that the Fund may make
margin deposits in connection with the use of permitted currency futures
contracts and options on currency futures contracts;
3. Make short sales of securities or maintain a short position, except
that the Fund may (a) make short sales and maintain short positions in
connection with its use of options, futures contracts and options on
futures contracts and (b) sell short "against the box" (the Fund does not
intend to make short sales against the box in excess of 5% of its net
assets during the coming year);
4. Purchase or retain the securities of an issuer if, to the knowledge
of the Fund's management, those officers and directors of the Fund, of
Legg Mason Fund Adviser, Inc. and of Western Asset Management Company who
individually own beneficially more than 0.5% of the outstanding securities
of that issuer own in the aggregate more than 5% of the securities of that
issuer;
5. Purchase any security if, as a result, more than 5% of the Fund's
total assets would be invested in securities of companies that together
with any predecessors have been in continuous operation for less than
three years;
6. Make investments in warrants if such investments, valued at the lower
of cost or market, exceed 5% of the value of its net assets, which amount
may include warrants that are not listed on the New York or American Stock
Exchanges, provided that such unlisted warrants, valued at the lower of
cost or market, do not exceed 2% of the Fund's net assets, and further
provided that this restriction does not apply to warrants attached to, or
sold as a unit with, other securities. For purposes of this restriction,
the term "warrants" does not include options on securities, stock or bond
indices, foreign currencies or futures contracts.
7. Acquire securities of other open-end investment companies, except in
connection with a merger, consolidation, reorganization or acquisition.
- 2 -
<PAGE>
8. Hold more than 10% of the outstanding voting securities of any one
issuer.
The Fund interprets fundamental investment limitation (4) to
prohibit investment in real estate limited partnerships.
If a percentage limitation is complied with at the time an
investment is made, a later increase or decrease in percentage resulting
from a change in value of portfolio securities, in the net asset value of
the Fund, or in the number of securities an issuer has outstanding will
not be considered a violation of any limitation.
Repurchase Agreements
---------------------
When the Fund enters into a repurchase agreement, it will obtain
from the other party securities equal in value to 102% of the amount of
the repurchase agreement (or 100%, if the securities obtained are U.S.
Treasury bills, notes and bonds). Such securities will be held by the
Fund's custodian or an approved securities depository or book-entry
system.
Illiquid Securities
-------------------
SEC regulations permit the sale of certain restricted securities
to qualified institutional buyers. Western Asset Management Company
("Adviser"), the Fund's investment adviser, acting pursuant to guidelines
established by the Board of Directors, may determine that certain
restricted securities qualified for trading on this newly developing
market are liquid. If the market does not develop as anticipated, it may
adversely affect the Fund's liquidity.
Private Placements
------------------
The Fund may acquire restricted securities in private placement
transactions, directly from the issuer or from security holders,
frequently at higher yields than comparable publicly-traded securities.
Privately-placed securities can be sold by the Fund only (1) pursuant to
SEC Rule 144A or other exemption; (2) in privately-negotiated transactions
to a limited number of purchasers; or (3) in public offerings made
pursuant to an effective registration statement under the 1933 Act.
Private or public sales of such securities by the Fund may involve
significant delays and expense. Private sales require negotiations with
one or more purchasers and generally produce less favorable prices than
the sale of comparable unrestricted securities. Public sales generally
involve the time and expense of preparing and processing a registration
statement under the Securities Act of 1933 and may involve the payment of
underwriting commissions; accordingly, the proceeds may be less than the
proceeds from the sale of securities of the same class which are freely
marketable.
- 3 -
<PAGE>
Foreign Securities
------------------
Since the Fund may invest in securities denominated in currencies
other than the U.S. dollar, the Fund may be affected favorably or
unfavorably by exchange control regulations or changes in the exchange
rates between such currencies and the U.S. dollar. Changes in the
currency exchange rates may influence the value of the Fund's shares, and
also may affect the value of dividends and interest earned by the Fund and
gains and losses realized by the Fund. Exchange rates are determined by
the forces of supply and demand in the foreign exchange markets. These
forces are affected by the international balance of payments and other
economic and financial conditions, government intervention, speculation
and other factors.
Foreign securities transactions could be subject to settlement procedures
different from those followed in the United States, where delivery is made
versus payment. The settlement procedures in some foreign markets expose
investors to the creditworthiness of an intermediary, such as a bank or
brokerage firm, for a period of time during settlement.
Securities Lending
------------------
The Fund may lend portfolio securities to brokers or dealers in
corporate or government securities, banks or other recognized
institutional borrowers of securities provided that cash or equivalent
collateral equal to at least 100% of the market value of the securities
loaned, is continuously maintained by the borrower with the Fund. During
the time portfolio securities are on loan, the borrower pays the Fund an
amount equivalent to any dividends or interest paid on such securities,
and the Fund may invest the cash collateral and earn income, or it may
receive an agreed upon amount of interest income from the borrower who has
delivered equivalent collateral. These loans are subject to termination
at the option of the Fund or the borrower. The Fund may pay reasonable
administrative and custodial fees in connection with a loan and may pay a
negotiated portion of the interest earned on the cash or equivalent
collateral to the borrower or placing broker. The Fund does not have the
right to vote securities on loan, but would terminate the loan and retain
the right to vote if that were considered important with respect to the
investment. The risks of securities lending are similar to those of
repurchase agreements, described in the Prospectus. The Fund presently
does not intend to loan more than 5% of its portfolio securities at any
given time during the foreseeable future.
Options and Futures
-------------------
The Fund may purchase call options on securities that the Adviser
intends to include in the Fund's investment portfolio in order to fix the
cost of a future purchase. Purchased options also may be used as a means
of participating in an anticipated price increase of a security on a more
limited risk basis than would be possible if the security itself were
purchased. In the event of a decline in the price of the underlying
security, use of this strategy would serve to limit the Fund's potential
- 4 -
<PAGE>
loss to the option premium paid; conversely, if the market price of the
underlying security increases above the exercise price and the Fund either
sells or exercises the option, any profit realized will be reduced by the
premium.
The Fund may purchase put options in order to hedge against a
decline in the market value of securities held in its portfolio or to
enhance income. The put option enables the Fund to sell the underlying
security at the predetermined exercise price; thus the potential for loss
to the Fund below the exercise price is limited to the option premium
paid. If the market price of the underlying security is higher than the
exercise price of the put option, any profit the Fund realizes on the sale
of the security would be reduced by the premium paid for the put option
less any amount for which the put option may be sold.
The Fund may write covered call options on securities in which it
is authorized to invest. Because it can be expected that a call option
will be exercised if the market value of the underlying security increases
to a level greater than the exercise price, the Fund might write covered
call options on securities generally when its Adviser believes that the
premium received by the Fund will exceed the extent to which the market
price of the underlying security will exceed the exercise price. The
strategy may be used to provide limited protection against a decrease in
the market price of the security, in an amount equal to the premium
received for writing the call option less any transaction costs. Thus, in
the event that the market price of the underlying security held by the
Fund declines, the amount of such decline will be offset wholly or in part
by the amount of the premium received by the Fund. If, however, there is
an increase in the market price of the underlying security and the option
is exercised, the Fund would be obligated to sell the security at less
than its market value. The Fund would give up the ability to sell the
portfolio securities used to cover the call option while the call option
was outstanding. Such securities would also be considered illiquid in the
case of over-the-counter ("OTC") options written by the Fund, and
therefore subject to the Fund's limitation on investing no more than 15%
of its total assets in illiquid securities. In addition, the Fund could
lose the ability to participate in an increase in the value of such
securities above the exercise price of the call option because such an
increase would likely be offset by an increase in the cost of closing out
the call option (or could be negated if the buyer chose to exercise the
call option at an exercise price below the securities' current market
value).
The sale of a put option on a security by the Fund also serves to
partially offset the cost of a security that the Fund anticipates
purchasing. If the price of the security rises, the increased cost to the
Fund of purchasing the security will be offset, in whole or in part, by
the premium received. In the event, however, that the price of the
security falls below the exercise price of the option and the option is
exercised, the Fund will be required to purchase the security from the
holder of the option at a price in excess of the current market price of
the security. The Fund's loss on this transaction will be offset, in
- 5 -
<PAGE>
whole or in part, to the extent of the premium received by the Fund for
writing the option.
The Fund may purchase put and call options and write put and
covered call options on bond indices in much the same manner as securities
options, except that bond index options may serve as a hedge against
overall fluctuations in the debt securities markets (or a market sector)
rather than anticipated increases or decreases in the value of a
particular security. A bond index assigns a value to the securities
included in the index and fluctuates with changes in such values.
Settlements of bond index options are effected with cash payments and do
not involve the delivery of securities. Thus, upon settlement of a bond
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 bond index. The effectiveness of hedging techniques using
bond index options will depend on the extent to which price movements in
the bond index selected correlate with price movements of the securities
in which the Fund invests.
The Fund may purchase and write covered straddles on securities,
currencies or bond indices. A long straddle is a combination of a call
and a put option purchased on the same security, index or currency where
the exercise price of the put is less than or equal to the exercise price
of the call. The Fund would enter into a long straddle when the Adviser
believes that it is likely that interest rates or currency exchange rates
will be more volatile during the term of the options than the option
pricing implies. A short straddle is a combination of a call and a put
written on the same security, index or currency where the exercise price
of the put is less than or equal to the exercise price of the call. In a
covered short straddle, the same issue of security or currency is
considered cover for both the put and the call that the Fund has written.
The Fund would enter into a short straddle when the Adviser believes that
it is unlikely that interest rates or currency exchange rates will be as
volatile during the term of the options as the option pricing implies. In
such case, the Fund will set aside cash and/or liquid, high grade debt
securities in a segregated account with its custodian equivalent in value
to the amount, if any, by which the put is in-the-money, that is, the
amount by which the exercise price of the put exceeds the current market
value of the underlying security.
Foreign Currency Options and Related Risks
------------------------------------------
The Fund may purchase and write (sell) options on foreign
currencies in order to hedge against the risk of foreign exchange rate
fluctuation on foreign securities the Fund holds or which it intends to
purchase. For example, if the Fund enters into a contract to purchase
securities denominated in a foreign currency, it could effectively fix the
maximum U.S. dollar cost of the securities by purchasing call options on
that foreign currency. Similarly, if the Fund held securities denominated
in a foreign currency and anticipated a decline in the value of that
currency against the U.S. dollar, it could hedge against such a decline by
purchasing a put option on the currency involved. The purchase of an
- 6 -
<PAGE>
option on foreign currency may be used to hedge against fluctuations in
exchange rates although, in the event of exchange rate movements adverse
to the Fund's options position, it may forfeit the entire amount of the
premium plus related transaction costs. In addition, the Fund may
purchase call options on foreign currency to enhance income when its
Adviser anticipates that the currency will appreciate in value, but the
securities denominated in that currency do not present attractive
investment opportunities.
If the Fund writes an option on foreign currency, it will
constitute only a partial hedge, up to the amount of the premium received,
and the Fund could be required to purchase or sell foreign currencies at
disadvantageous exchange rates, thereby incurring losses. The Fund may
use options on currency to cross-hedge, which involves writing or
purchasing options on one currency to hedge against changes in exchange
rates of a different, but related, currency.
The Fund's ability to establish and close out positions on such
options is subject to the maintenance of a liquid secondary market.
Although many options on foreign currencies are exchange traded, the
majority are traded on the OTC market. The Fund will not purchase or
write such options unless, in the opinion of the Adviser, the market for
them has developed sufficiently. There can be no assurance that a liquid
secondary market will exist for a particular option at any specific time.
In addition, options on foreign currencies are affected by all of those
factors that influence foreign exchange rates and investments generally.
These OTC options also involve credit risks that may not be present in the
case of exchange-traded currency options.
Futures Contracts and Options on Futures Contracts
--------------------------------------------------
The Fund will limit its use of futures contracts and options on
futures contracts to hedging transactions or other circumstances permitted
by regulatory authorities. For example, the Fund might use futures
contracts to attempt to hedge against anticipated changes in interest
rates that might adversely affect either the value of the Fund's
securities or the price of the securities that the Fund intends to
purchase. The Fund's hedging may include sales of futures contracts as an
offset against the effect of expected increases in interest rates, and
purchases of futures contracts as an offset against the effect of expected
declines in interest rates. Although other techniques could be used to
reduce exposure to interest rate fluctuations, the Fund may be able to
hedge its exposure more effectively and perhaps at a lower cost by using
futures contracts and options on futures contracts.
The Fund may also purchase call or put options on foreign
currency futures contracts to obtain a fixed foreign exchange rate at
limited risk. The Fund may purchase a call option on a foreign currency
futures contract to hedge against a rise in the foreign exchange rate
while intending to invest in a foreign security of the same currency. The
Fund may purchase put options on foreign currency futures contracts as a
hedge against a decline in the foreign exchange rates or the value of its
- 7 -
<PAGE>
foreign portfolio securities. The Fund may write a call option on a
foreign currency futures contract as a partial hedge against the effects
of declining foreign exchange rates on the value of foreign securities.
The Fund may sell a put option on a foreign currency to partially offset
the cost of a security denominated in that currency that the Fund
anticipates purchasing; however, the cost will only be offset to the
extent of the premium received by the Fund for writing the option.
The Fund also may use futures contracts on fixed income
instruments and options thereon to hedge its investment portfolio against
changes in the general level of interest rates. A futures contract on a
fixed income instrument is a bilateral agreement pursuant to which one
party agrees to make, and the other party agrees to accept, delivery of
the specified type of fixed income security called for in the contract at
a specified future time and at a specified price. The Fund may purchase a
futures contract on a fixed income security when it intends to purchase
fixed income securities but has not yet done so. This strategy may
minimize the effect of all or part of an increase in the market price of
the fixed income security that the Fund intends to purchase in the future.
A rise in the price of the fixed income security prior to its purchase may
be either offset by an increase in the value of the futures contract
purchased by the Fund or avoided by taking delivery of the fixed income
securities under the futures contract. Conversely, a fall in the market
price of the underlying fixed income security may result in a
corresponding decrease in the value of the futures position. The Fund may
sell a futures contract on a fixed income security in order to continue to
receive the income from a fixed income security, while endeavoring to
avoid part or all of the decline in the market value of that security that
would accompany an increase in interest rates.
The Fund may purchase a call option on a futures contract to
hedge against a market advance in debt securities that the Fund plans to
acquire at a future date. The purchase of a call option on a futures
contract is analogous to the purchase of a call option on an individual
fixed income security that can be used as a temporary substitute for a
position in the security itself. The Fund also may write covered call
options on futures contracts as a partial hedge against a decline in the
price of fixed income securities held in the Fund's investment portfolio,
or purchase put options on futures contracts in order to hedge against a
decline in the value of fixed income securities held in the Fund's
investment portfolio. The Fund may write a put option on a security that
the Fund anticipates purchasing to partially offset the cost of purchasing
that security; however, the cost will only be offset to the extent of the
premium the Fund receives for writing the option.
The Fund may sell securities index futures contracts in
anticipation of a general market or market sector decline that could
adversely affect the market value of its investments. To the extent that
a portion of the Fund's investments correlate with a given index, the sale
of futures contracts on that index could reduce the risks associated with
a market decline and thus provide an alternative to the liquidation of
securities positions. For example, if the Fund correctly anticipates a
- 8 -
<PAGE>
general market decline and sells securities index futures to hedge against
this risk, the gain in the futures position should offset some or all of
the decline in the value of the portfolio. The Fund may purchase
securities index futures contracts if a significant market or market
sector advance is anticipated. Such a purchase of a futures contract
would serve as a temporary substitute for the purchase of individual
securities, which securities may then be purchased in an orderly fashion.
This strategy may minimize the effect of all or part of an increase in the
market price of securities that the Fund intends to purchase. A rise in
the price of the securities should be partly or wholly offset by gains in
the futures position.
As in the case of a purchase of a securities index futures
contract, the Fund may purchase a call option on a securities index
futures contract to hedge against a market advance in securities that the
Fund plans to acquire at a future date. The Fund may write put options
on securities index futures as a partial anticipatory hedge and may write
covered call options on securities index futures as a partial hedge
against a decline in the prices of bonds held in its portfolio. This is
analogous to writing covered call options on securities. The Fund also
may purchase put options on securities index futures contracts. The
purchase of put options on securities index futures contracts is analogous
to the purchase of protective put options on individual securities where a
level of protection is sought below which no additional economic loss
would be incurred by the Fund.
The Fund may also purchase and sell futures contracts on a
foreign currency. The Fund may sell a foreign currency futures contract
to hedge against possible variations in the exchange rate of the foreign
currency in relation to the U.S. dollar. In addition, the Fund may sell a
foreign currency futures contract when the Adviser anticipates a general
weakening of the foreign currency exchange rate that could adversely
affect the market values of the Fund's foreign securities holdings. In
this case, the sale of futures contracts on the underlying currency may
reduce the risk to the Fund caused by foreign currency variations and, by
so doing, provide an alternative to the liquidation of securities
positions in the Fund and resulting transaction costs. When the Adviser
anticipates a significant foreign exchange rate increase while intending
to invest in a security denominated in a foreign currency, the Fund may
purchase a foreign currency futures contract to hedge against a rise in
foreign exchange rates pending completion of the anticipated transaction.
Such a purchase would serve as a temporary measure to protect the Fund
against any rise in the foreign exchange rate that may add additional
costs to acquiring the foreign security position.
The Fund may also purchase call or put options on foreign
currency futures contracts to obtain a fixed foreign exchange rate at
limited risk. The Fund may purchase a call option or write a put option
on a foreign currency futures contract to hedge against a rise in the
foreign exchange rate while intending to invest in a foreign security of
the same currency. The Fund may purchase put options on foreign currency
futures contracts as a partial hedge against a decline in the foreign
- 9 -
<PAGE>
exchange rates or the value of its foreign portfolio securities. It may
also write a call option on a foreign currency futures contract as a
partial hedge against the effects of declining foreign exchange rates on
the value of foreign securities.
The Fund may also write put options on interest rate, securities
index or foreign currency futures contracts while, at the same time,
purchasing call options on the same interest rate, securities index or
foreign currency futures contract in order synthetically to create a long
interest rate, securities index or foreign currency futures contract
position. The options will have the same strike prices and expiration
dates. The Fund will engage in this strategy only when its Adviser
believes it is more advantageous to the Fund to do so as compared to
purchasing the futures contract.
The Fund may also purchase and write covered straddles on
interest rate, foreign currency or securities index futures contracts. A
long straddle is a combination of a call and a put purchased on the same
futures contract where the exercise price of the put option is less than
the exercise price of the call option. The Fund would enter into a long
straddle when it believes that it is likely that interest rates or foreign
currency exchange rates will be more volatile during the term of the
options than the option pricing implies. A short straddle is a
combination of a call and put written on the same futures contract where
the exercise price of the put option is less than the exercise price of
the call option. In a covered short straddle, the same futures contract
is considered "cover" for both the put and the call that the Fund has
written. The Fund would enter into a short straddle when it believes that
it is unlikely that interest rates or foreign currency exchange rates will
be as volatile during the term of the options as the option pricing
implies. In such case, the Fund will set aside cash and/or liquid, high
grade debt securities in a segregated account with its custodian equal in
value to the amount, if any, by which the put is "in-the-money", that is,
the amount by which the exercise price of the put exceeds the current
market value of the underlying futures contract.
When a purchase or sale of a futures contract is made by the
Fund, the Fund is required to deposit with its custodian (or a broker, if
legally permitted) a specified amount of cash or U.S. Government
securities ("initial margin"). The margin required for a futures contract
is set by the exchange on which the contract is traded and may be modified
during the term of the contract. The initial margin is in the nature of a
performance bond or good faith deposit on the futures contract, which is
returned to the Fund upon termination of the contract assuming all
contractual obligations have been satisfied. Under certain circumstances,
such as periods of high volatility, the Fund may be required by an
exchange to increase the level of its initial margin payment.
Additionally, initial margin requirements may be increased generally in
the future by regulatory action. The Fund expects to earn interest income
on its initial margin deposits. A futures contract held by the Fund is
valued daily at the official settlement price of the exchange on which it
is traded. Each day the Fund pays or receives cash, called "variation
- 10 -
<PAGE>
margin," equal to the daily change in value of the futures contract. This
process is known as "marking-to-market." Variation margin does not
represent a borrowing or loan by the Fund but is instead settlement
between the Fund and the broker of the amount one would owe the other if
the futures contract had expired on that date. In computing daily net
asset value, the Fund will mark-to-market its open futures positions.
The Fund is also required to deposit and maintain margin with
respect to put and call options on futures contracts and on certain
foreign currencies written by it. Such margin deposits will vary
depending on the nature of the underlying futures contract or currency
(and the related initial margin requirements), the current market value of
the option and other options and futures positions held by the Fund.
Although some futures contracts call for making or taking
delivery of the underlying securities, generally futures contracts are
closed out prior to delivery by offsetting purchases or sales of matching
futures contracts (involving the same currency, index or underlying
security and delivery month). If an offsetting purchase price is less
than the original sale price, the Fund realizes a gain, or if it is more,
the Fund realizes a loss. If an offsetting sale price is more than the
original purchase price, the Fund realizes a gain, or if it is less, the
Fund realizes a loss. The Fund will also bear transaction costs for each
contract, which must be considered in these calculations.
The Fund will not enter into futures contracts or commodities
option positions if, immediately thereafter, the initial margin deposits
plus premiums paid by it, less the amount by which any such options
positions are "in-the-money" at the time of purchase, would exceed 5% of
the fair market value of the Fund's total assets. A call option is "in-
the-money" if the value of the futures contract that is the subject of the
option exceeds the exercise price. A put option is "in-the-money" if the
exercise price exceeds the value of the futures contract that is the
subject of the option. Foreign currency options traded on a commodities
exchange are considered commodity options for this purpose.
Risks Associated with Futures and Options
-----------------------------------------
In considering the Fund's use of futures contracts and options,
particular note should be taken of the following:
(1) Positions in futures contracts may be closed out only on
an exchange or board of trade that provides a secondary market for such
futures contracts. Futures exchanges may limit the amount of fluctuation
permitted in certain futures contract prices during a single trading day.
The daily limit establishes the maximum amount that the price of a futures
contract may vary either up or down from the previous day's settlement
price at the end of the current trading session. Once the daily limit has
been reached in a futures contract subject to the limit, no more trades
may be made on that day at a price beyond that limit. The daily limit
governs only price movements during a particular trading day and therefore
does not limit potential losses because the limit may work to prevent the
- 11 -
<PAGE>
liquidation of unfavorable positions. For example, futures prices have
occasionally moved to the daily limit for several consecutive trading days
with little or no trading, thereby preventing prompt liquidation of
positions and subjecting some holders of futures contracts to substantial
losses.
(2) The ability to establish and close out positions in
either futures contracts or exchange-listed options is also subject to the
maintenance of a liquid secondary market. Consequently, it may not be
possible for the Fund to close a position and, in the event of adverse
price movements, the Fund would have to make daily cash payments of
variation margin (except in the case of purchased options). However, in
the event futures contracts or options have been used to hedge portfolio
securities, such securities will not be sold until the contracts can be
terminated. In such circumstances, an increase in the price of the
securities, if any, may partially or completely offset losses on the
futures contract. However, there is no guarantee that the price of the
securities will, in fact, correlate with the price movements in the
contracts and thus provide an offset to losses on the contracts.
(3) Successful use by the Fund of futures contracts and
options will depend upon the Adviser's ability to predict movements in the
direction of the overall securities, currency and interest rate markets,
which may require different skills and techniques than predicting changes
in the prices of individual securities. Moreover, futures contracts
relate not to the current level of the underlying instrument but to the
anticipated levels at some point in the future. There is, in addition,
the risk that the movements in the price of the futures contract will not
correlate with the movements in prices of the securities or currencies
being hedged. For example if the price of the futures contract moves less
than the price of the securities or currencies that are subject to the
hedge, the hedge will not be fully effective; however, if the price of
securities or currencies being hedged has moved in an unfavorable
direction, the Fund would be in a better position than if it had not
hedged at all. If the price of the securities or currencies being hedged
has moved in a favorable direction, this advantage may be partially offset
by losses in the futures position. In addition, if the Fund has
insufficient cash, it may have to sell assets from its investment
portfolio to meet daily variation margin requirements. Any such sale of
assets may or may not be made at prices that reflect the rising market;
consequently, the Fund may need to sell assets at a time when such sales
are disadvantageous to the Fund. If the price of the futures contract
moves more than the price of the underlying securities or currencies, the
Fund will experience either a loss or a gain on the futures contract that
may or may not be completely offset by movements in the price of the
securities or currencies that are the subject of the hedge.
(4) The value of an option position will reflect, among other
things, the current market price of the underlying security, futures
contract or currency, the time remaining until expiration, the
relationship of the exercise price to the market price, the historical
price volatility of the underlying security, index, futures contract or
- 12 -
<PAGE>
currency and general market conditions. For this reason, the successful
use of options as a hedging strategy depends upon the Adviser's ability to
forecast the direction of price fluctuations in the underlying market or
market sector.
(5) In addition to the possibility that there may be an
imperfect correlation, or no correlation at all, between price movements
in the futures position and the securities or currencies being hedged,
movements in the prices of futures contracts may not correlate perfectly
with movements in the prices of the hedged securities or currencies due to
price distortions in the futures market. There may be several reasons
unrelated to the value of the underlying securities or currencies that
cause this situation to occur. First, as noted above, all participants in
the futures market are subject to initial and variation margin
requirements. If, to avoid meeting additional margin deposit requirements
or for other reasons, investors choose to close a significant number of
futures contracts through offsetting transactions, distortions in the
normal price relationship between the securities or currencies and the
futures markets may occur. Second, because the margin deposit
requirements in the futures market are less onerous than margin
requirements in the securities market, there may be increased
participation by speculators in the futures market; such speculative
activity in the futures market also may cause temporary price distortions.
Third, participants could make or take delivery of the underlying
securities or currencies instead of closing out their contracts. As a
result, a correct forecast of general market trends may not result in
successful hedging through the use of futures contracts over the short
term. In addition, activities of large traders in both the futures and
securities markets involving arbitrage and other investment strategies may
result in temporary price distortions.
(6) Options normally have expiration dates of up to three
years. The exercise price of the options may be below, equal to or above
the current market value of the underlying security, index, futures
contract or currency. Purchased options that expire unexercised have no
value, and the Fund will realize a loss in the amount paid plus any
transaction costs.
(7) Like options on securities and currencies, options on
futures contracts have a limited life. The ability to establish and close
out options on futures will be subject to the development and maintenance
of liquid secondary markets on the relevant exchanges or boards of trade.
There can be no certainty that liquid secondary markets for all options on
futures contracts will develop.
(8) Purchasers of options on futures contracts pay a premium
in cash at the time of purchase. This amount and the transaction costs
are all that is at risk. Sellers of options on futures contracts,
however, must post an initial margin and are subject to additional margin
calls that could be substantial in the event of adverse price movements.
In addition, although the maximum amount at risk when the Fund purchases
an option is the premium paid for the option and the transaction costs,
- 13 -
<PAGE>
there may be circumstances when the purchase of an option on a futures
contract would result in a loss to the Fund when the use of a futures
contract would not, such as when there is no movement in the value of the
securities or currencies being hedged.
(9) The Fund's activities in the futures and options markets
may result in a higher portfolio turnover rate and additional transaction
costs in the form of added brokerage commissions; however, the Fund also
may save on commissions by using such contracts as a hedge rather than
buying or selling individual securities or currencies in anticipation or
as a result of market movements.
(10) The Fund may purchase and write both exchange-traded
options and OTC options. The ability to establish and close out positions
on the exchanges is subject to the maintenance of a liquid secondary
market. Although the Fund intends to purchase or write only those
exchange-traded options for which there appears to be an active secondary
market, there is no assurance that a liquid secondary market will exist
for any particular option at any specific time. Closing transactions may
be effected with respect to options traded in the OTC markets (currently
the primary markets for options on debt securities and foreign currencies)
only by negotiating directly with the other party to the option contract,
or in a secondary market for the option if such market exists. Although
the Fund will enter into OTC options only with dealers that agree to enter
into, and that are expected to be capable of entering into, closing
transactions with the Fund, there can be no assurance that the Fund will
be able to liquidate an OTC option at a favorable price at any time prior
to expiration. In the event of insolvency of the contra-party, the Fund
may be unable to liquidate an OTC option. Accordingly, it may not be
possible to effect closing transactions with respect to certain options,
with the result that the Fund would have to exercise those options that it
has purchased in order to realize any profit. With respect to options
written by the Fund, the inability to enter into a closing transaction may
result in material losses to the Fund. For example, because the Fund must
maintain a covered position with respect to any call option it writes on a
security, futures contract or currency, the Fund may not sell the
underlying security, futures contract or currency or invest any cash, U.S.
Government securities or liquid high quality debt securities used as cover
during the period it is obligated under such option. This requirement may
impair the Fund's ability to sell a portfolio security or make an
investment at a time when such a sale or investment might be advantageous.
(11) Securities index options are settled exclusively in cash.
If the Fund purchases a put or call option on an index, the Fund will not
know in advance the difference, if any, between the closing value of the
index on the exercise date and the exercise price of the option itself.
Thus, if the Fund exercises a securities index option before the closing
index value for that day is available, the Fund runs the risk that the
level of the underlying index may subsequently change.
Special Risks Related to Foreign Currency Futures Contracts and Options on
Such Contracts and Options on Foreign Currencies
- 14 -
<PAGE>
--------------------------------------------------------------------------
Buyers and sellers of foreign currency futures contracts are
subject to the same risks that apply to the use of futures generally. In
addition, there are risks associated with foreign currency futures
contracts and their use as a hedging device similar to those associated
with options on foreign currencies described below. Further, settlement
of a foreign currency futures contract must occur within the country
issuing the underlying currency. Thus, the Fund must accept or make
delivery of the underlying foreign currency in accordance with any U.S. or
foreign restrictions or regulations regarding the maintenance of foreign
banking arrangements by U.S. residents and may be required to pay any
fees, taxes or charges associated with such delivery that are assessed in
the issuing country.
Options on foreign currency futures contracts may involve certain
additional risks. The ability to establish and close out positions on such
options is subject to the maintenance of a liquid secondary market. To
reduce this risk, the Fund will not purchase or write options on foreign
currency futures contracts unless and until, in the opinion of the
Adviser, the market for such options has developed sufficiently that the
risks in connection with such options are not greater than the risks in
connection with transactions in the underlying foreign currency futures
contracts. Compared to the purchase or sale of foreign currency futures
contracts, the purchase of call or put options on futures contracts
involves less potential risk to the Fund because the maximum amount at
risk is the premium paid for the option (plus transaction costs).
However, there may be circumstances when the purchase of a call or put
option on a foreign currency futures contract would result in a loss, such
as when there is no movement in the price of the underlying currency or
futures contract, when the purchase of the underlying futures contract
would not result in a loss.
The value of a foreign currency option depends upon the value of
the underlying currency relative to the U.S. dollar. As a result, the
price of the option position may vary with changes in the value of either
or both currencies and may have no relationship to the investment merits
of a foreign security. Because foreign currency transactions occurring in
the interbank market involve substantially larger amounts than those that
may be involved in the use of foreign currency options, investors may be
disadvantaged by having to deal in an odd lot market (generally consisting
of transactions of less than $1 million) for the underlying foreign
currencies at prices that are less favorable than for round lots.
There is no systematic reporting of last sale information for
foreign currencies or any regulatory requirement that quotations available
through dealers or other market sources be firm or revised on a timely
basis. Quotation information available is generally representative of
very large transactions in the interbank market and thus may not reflect
relatively smaller transactions (i.e., less than $1 million) where rates
may be less favorable. The interbank market in foreign currencies is a
global, around-the-clock market. To the extent that the U.S. options
markets are closed while the markets for the underlying currencies remain
- 15 -
<PAGE>
open, significant price and rate movements may take place in the
underlying markets that cannot be reflected in the options markets until
they reopen.
Additional Risks of Options on Securities, Futures Contracts, Options on
Futures and Forward Currency Exchange Contracts and Options Thereon Traded
on Foreign Exchanges
--------------------------------------------------------------------------
Options on securities, futures contracts, options on futures
contracts, currencies and options on currencies may be traded on foreign
exchanges. Such transactions may not be regulated as effectively as
similar transactions in the United States, may not involve a clearing
mechanism and related guarantees and are subject to the risk of
governmental actions affecting trading in, or the price of, foreign
securities. The value of such positions also could be adversely affected
by (1) other complex foreign political, legal and economic factors, (2)
lesser availability than in the United States of data on which to make
trading decisions, (3) delays in the Fund's ability to act upon economic
events occurring in foreign markets during non-business hours in the
United States, (4) the imposition of different exercise and settlement
terms and procedures and margin requirements than in the United States and
(5) lesser trading volume.
Forward Contracts
-----------------
The Fund may use forward currency exchange contracts ("forward
contracts") to hedge against uncertainty in the level of future exchange
rates.
The Fund may enter into forward contracts with respect to
specific transactions. For example, when the Fund anticipates purchasing
or selling a security denominated in a foreign currency, or when it
anticipates the receipt in a foreign currency of dividend or interest
payments on a security that it holds, the Fund may desire to "lock in" the
U.S. dollar price of the security or the U.S. dollar equivalent of such
payment, as the case may be, by entering into a forward contract for the
purchase or sale, for a fixed amount of U.S. dollars or foreign currency,
of the amount of foreign currency involved in the underlying transaction.
The Fund will thereby attempt to protect itself against a possible loss
resulting from an adverse change in the relationship between the currency
exchange rates during the period between the date on which the security is
purchased or sold, or on which the payment is declared, and the date on
which such payments are made or received.
The Fund also may use forward contracts to "lock in" the U.S.
dollar value of its portfolio positions, to increase the Fund's exposure
to foreign currencies that the Adviser believes may rise in value relative
to the U.S. dollar or to shift the Fund's exposure to foreign currency
fluctuations from one country to another. For example, when the Adviser
believes that the currency of a particular foreign country may suffer a
substantial decline relative to the U.S. dollar or another currency, it
may enter into a forward contract to sell the amount of the former foreign
- 16 -
<PAGE>
currency approximating the value of some or all of the Fund's securities
denominated in such foreign currency. These investment practices
generally are referred to as "cross-currency hedging" when two foreign
currencies are involved.
At or before the maturity date of a forward contract requiring
the Fund to sell a currency, the Fund may either sell a portfolio security
and use the sale proceeds to make delivery of the currency or retain the
security and offset its contractual obligation to deliver the currency by
purchasing a second contract pursuant to which the Fund will obtain, on
the same maturity date, the same amount of the currency that it is
obligated to deliver. Similarly, the Fund may close out a forward
contract requiring it to purchase a specified currency by entering into a
second contract entitling it to sell the same amount of the same currency
on the maturity date of the first contract. The Fund would realize a gain
or loss as a result of entering into such an offsetting forward contract
under either circumstance to the extent the exchange rate or rates between
the currencies involved moved between the execution dates of the first
contract and the offsetting contract.
The precise matching of the forward contract amount and the value
of the securities involved will not generally be possible because the
future value of such securities in foreign currencies will change as a
consequence of market movements in the value of those securities between
the date the forward contract is entered into and the date it matures.
Accordingly, it may be necessary for the Fund to purchase additional
foreign currency on the spot (i.e., cash) market (and bear the expense of
such purchase) if the market value of the security is less than the amount
of foreign currency the Fund is obligated to deliver and if a decision is
made to sell the security and make delivery of the foreign currency.
Conversely, it may be necessary to sell on the spot market some of the
foreign currency received upon the sale of the portfolio security if its
market value exceeds the amount of foreign currency the Fund is obligated
to deliver.
The projection of short-term currency market movements is
extremely difficult, and the successful execution of a short-term hedging
strategy is highly uncertain. Forward contracts involve the risk that
anticipated currency movements will not be accurately predicted, causing
the Fund to sustain losses on these contracts and transaction costs. The
Fund may enter into forward contracts or maintain a net exposure to such
contracts only if (1) the consummation of the contracts would not obligate
the Fund to deliver an amount of foreign currency in excess of the value
of the Fund's portfolio securities or other assets denominated in that
currency or (2) the Fund maintains cash, U.S. Government securities or
other liquid, high-grade debt securities in a segregated account with the
Fund's custodian, marked-to-market daily, in an amount not less than the
value of the Fund's total assets committed to the consummation of the
contract. Under normal circumstances, consideration of the prospect for
currency parities will be incorporated into the longer-term investment
decisions made with regard to overall diversification strategies.
However, the Adviser believes that it is important to have the flexibility
- 17 -
<PAGE>
to enter into such forward contracts when it determines that the best
interests of the Fund will be served.
The cost to the Fund of engaging in forward contracts varies with
factors such as the currencies involved, the length of the contract period
and the market conditions then prevailing. Because forward contracts are
usually entered into on a principal basis, no fees or commissions are
involved. The use of forward contracts does not eliminate fluctuations in
the prices of the underlying securities the Fund owns or intends to
acquire, but it does fix a rate of exchange in advance. In addition,
although forward contracts limit the risk of loss due to a decline in the
value of the hedged currencies, at the same time they limit any potential
gain that might result should the value of the currencies increase.
Although the Fund values its assets daily in terms of U.S.
dollars, it does not intend to convert its holdings of foreign currencies
into U.S. dollars on a daily basis. The Fund may convert foreign currency
from time to time, and investors should be aware of the costs of currency
conversion. Although foreign exchange dealers do not charge a fee for
conversion, they do realize a profit based on the difference between the
prices at which they are buying and selling various currencies. Thus, a
dealer may offer to sell a foreign currency to the Fund at one rate, while
offering a lesser rate of exchange should the Fund desire to resell that
currency to the dealer.
Foreign Currency Exchange-Related Securities and Foreign Currency Warrants
-------------------------------------------------------------------------
Foreign currency warrants entitle the holder to receive from
their issuer an amount of cash (generally, for warrants issued in the
United States, in U.S. dollars) that is calculated pursuant to a
predetermined formula and based on the exchange rate between a specified
foreign currency and the U.S. dollar as of the exercise date of the
warrant. Foreign currency warrants generally are exercisable upon their
issuance and expire as of a specified date and time. Foreign currency
warrants have been issued in connection with U.S. dollar-denominated debt
offerings by major corporate issuers in an attempt to reduce the foreign
currency exchange risk that is inherent in the international fixed
income/debt marketplace. The formula used to determine the amount payable
upon exercise of a foreign currency warrant may make the warrant worthless
unless the applicable foreign currency exchange rate moves in a particular
direction.
Foreign currency warrants are severable from the debt obligations
with which they may be offered and may be listed on exchanges. Foreign
currency warrants may be exercisable only in certain minimum amounts, and
an investor wishing to exercise warrants who possesses less than the
minimum number required for exercise may be required either to sell the
warrants or to purchase additional warrants, thereby incurring additional
transaction costs. In the case of any exercise of warrants, there may be
a time delay between the time a holder of warrants gives instructions to
exercise and the time the exchange rate relating to exercise is
determined, during which time the exchange rate could change
- 18 -
<PAGE>
significantly, thereby affecting both the market and cash settlement
values of the warrants being exercised.
The expiration date of the warrants may be accelerated if the
warrants are delisted from an exchange or if their trading is suspended
permanently, which would result in the loss of any remaining "time value"
of the warrants (i.e., the difference between the current market value and
the exercise value of the warrants) and, in the case where the warrants
were "out-of-the-money," in a total loss of the purchase price of the
warrants. Warrants are generally unsecured obligations of their issuers
and are not standardized foreign currency options issued by the Options
Clearing Corporation ("OCC"). Unlike foreign currency options issued by
OCC, the terms of foreign currency warrants generally will not be amended
in the event of governmental or regulatory actions affecting exchange
rates or in the event of the imposition of other regulatory controls
affecting the international currency markets. The initial public offering
price of foreign currency warrants is generally considerably in excess of
the price that a commercial user of foreign currencies might pay in the
interbank market for a comparable option involving significantly larger
amounts of foreign currencies. Foreign currency warrants are subject to
significant foreign exchange risk, including risks arising from complex
political and economic factors.
The requirements for qualification as a regulated investment
company also may limit the extent to which the Fund may engage in
transactions in options, futures, options on futures or forward contracts.
See "Additional Tax Information."
Cover for Strategies Involving Options, Futures and Forward Contracts
---------------------------------------------------------------------
The Fund will not use leverage in its options, futures and
forward contract strategies. The Fund will not enter into an options,
futures or forward currency strategy that exposes it to an obligation to
another party unless it owns either (1) an offsetting ("covering")
position in securities, currencies or other options, futures or forward
contracts or (2) cash, receivables and liquid high quality debt securities
with a value sufficient to cover its potential obligations. The Fund will
comply with guidelines established by the SEC with respect to coverage of
these strategies by mutual funds, and, if the guidelines so require, will
set aside cash and/or liquid, high-grade debt securities in a segregated
account with its custodian in the amount prescribed, as marked to market
daily. Securities, currencies or other options or futures positions used
for cover and securities held in a segregated account cannot be sold or
closed out while the strategy is outstanding, unless they are replaced
with similar assets. As a result, there is a possibility that the use of
cover or segregation involving a large percentage of the Fund's assets
could impede portfolio management or the Fund's ability to meet redemption
requests or other current obligations.
- 19 -
<PAGE>
When-Issued Securities
----------------------
The Fund may enter into commitments to purchase securities on a
when-issued basis. To meet its payment obligation under a when-issued
commitment, the Fund will establish a segregated account with its
custodian and maintain cash or liquid high-quality debt obligations, in an
amount at least equal in value to the Fund's commitments to purchase when-
issued securities. The Fund may sell the securities underlying a when-
issued purchase, which may result in a capital gain or loss.
Reverse Repurchase Agreements and Other Borrowing
-------------------------------------------------
A reverse repurchase agreement is a portfolio management
technique in which the Fund temporarily transfers possession of a
portfolio instrument to another person, such as a financial institution or
broker-dealer, in return for cash. At the same time, the Fund agrees to
repurchase the instrument at an agreed upon time (normally within seven
days) and price, including interest payment. The Fund may also enter into
dollar rolls, in which the Fund sells a fixed income security for delivery
in the current month and simultaneously contracts to repurchase a
substantially similar security (same type, coupon and maturity) on a
specified future date. During the roll period, the Fund would forgo
principal and interest paid on such securities. The Fund would be
compensated by the difference between the current sales price and the
forward price for the future purchase, as well as by any interest earned
on the proceeds of the initial sale.
The Fund may engage in reverse repurchase agreements and dollar
rolls as a means of raising cash to satisfy redemption requests or for
other temporary or emergency purposes without the necessity of selling
portfolio instruments. While engaging in reverse repurchase agreements
and dollar rolls, the Fund will maintain cash, U.S. Government securities
or other high-grade, liquid debt securities in a segregated account at its
custodian bank with a value at least equal to the Fund's obligation under
the agreements.
The ability of the Fund to engage in reverse repurchase
agreements and dollar rolls is subject to the Fund's fundamental
investment limitation concerning borrowing, i.e., that borrowing may be
for temporary purposes only and in an amount not to exceed 5% of the
Fund's total assets.
Mortgage-Related Securities
---------------------------
Mortgage-related securities represent an ownership interest in a
pool of residential mortgage loans. These securities are designed to
provide monthly payments of interest, and in most instances, principal to
the investor. The mortgagor's monthly payments to his/her lending
institution are "passed-through" to investors such as the Fund. Most
issuers or poolers provide guarantees of payments, regardless of whether
or not the mortgagor actually makes the payment. The guarantees made by
- 20 -
<PAGE>
issuers or poolers are backed by various forms of credit, insurance and
collateral. They may not extend to the full amount of the pool.
Pools consist of whole mortgage loans or participations in loans.
The majority of these loans are made to purchasers of one- to four-family
homes. The terms and characteristics of the mortgage instruments are
generally uniform within a pool but may vary among pools. For example, in
addition to fixed-rate, fixed-term mortgages, the Fund may purchase pools
of variable-rate mortgages, growing-equity mortgages, graduated-payment
mortgages and other types.
All poolers apply standards for qualification to lending
institutions which originate mortgages for the pools. Poolers also
establish credit standards and underwriting criteria for individual
mortgages included in the pools. In addition, many mortgages included in
pools are insured through private mortgage insurance companies.
The majority of mortgage-related securities currently available
are issued by governmental or government-related organizations formed to
increase the availability of mortgage credit. The largest government-
sponsored issuer of mortgage-related securities is the Government National
Mortgage Association ("GNMA"). GNMA certificates ("GNMAs") are interests
in pools of loans insured by the Federal Housing Administration or by the
Farmer's Home Administration ("FHA"), or guaranteed by the Veterans
Administration ("VA"). The Federal National Mortgage Association ("FNMA")
and the Federal Home Loan Mortgage Corporation ("FHLMC") each issue pass-
through securities which are guaranteed as to principal and interest by
FNMA and FHLMC, respectively.
The average life of mortgage-related securities varies with the
maturities and the nature of the underlying mortgage instruments. For
example, GNMAs tend to have a longer average life than FHLMC participation
certificates ("PCs") because there is a tendency for the conventional and
privately-insured mortgages underlying FHLMC PCs to repay at faster rates
than the FHA and VA loans underlying GNMAs. In addition, the term of a
security may be shortened by unscheduled or early payments of principal
and interest on the underlying mortgages. The occurrence of mortgage pre-
payments is affected by various factors, including the level of interest
rates, general economic conditions, the location and age of the mortgaged
property and other social and demographic conditions.
In determining the dollar-weighted average maturity of the Fund's
portfolio, the Adviser will follow industry practice in assigning an
average life to the mortgage-related securities of the Fund unless the
interest rate on the mortgages underlying such securities is such that a
different prepayment rate is likely. For example, where a GNMA has a high
interest rate relative to the market, that GNMA is likely to have a
shorter overall maturity than a GNMA with a market rate coupon. Moreover,
the Adviser may deem it appropriate to change the projected average life
for the Fund's mortgage-related security as a result of fluctuations in
market interest rates and other factors.
- 21 -
<PAGE>
Quoted yields on mortgage-related securities are typically based
on the maturity of the underlying instruments and the associated average
life assumption. Actual prepayment experience may cause the yield to
differ from the average life yield. Reinvestment of the prepayments may
occur at higher or lower interest rates than the original investment, thus
affecting the yield of the Fund. The compounding effect from the
reinvestment of monthly payments received by the Fund will increase the
yield to shareholders compared to bonds that pay interest semi-annually.
Like other debt securities, the value of mortgage-related
securities will tend to rise when interest rates fall, and fall when rates
rise. The value of mortgage-related securities may also change because of
changes in the market's perception of the creditworthiness of the
organization that issued or guaranteed them. In addition, the mortgage
securities market in general may be adversely affected by changes in
governmental regulation or tax policies.
Private Mortgage-Related Securities
-----------------------------------
The private mortgage-related securities in which the Fund may
invest include foreign mortgage pass-through securities ("Foreign Pass-
Throughs"), which are structurally similar to the pass-through instruments
described above. Such securities are issued by originators of and
investors in mortgage loans, including savings and loan associations,
mortgage bankers, commercial banks, investment bankers, specialized
financial institutions and special purpose subsidiaries of the foregoing.
Foreign Pass-Throughs usually are backed by a pool of fixed rate or
adjustable-rate mortgage loans. The Foreign Pass-Throughs in which the
Fund may invest are not guaranteed by an entity having the credit status
of the GNMA, but generally utilize various types of credit enhancement.
Certain mortgage pools are organized in such a way that the SEC staff
considers them to be closed-end investment companies. The Fund's
investment in such pools is constrained by a federal statute that
restricts investments in the shares of other investment companies.
Asset-Backed Securities
-----------------------
Asset-backed securities are structurally similar to mortgage-
backed securities, but are secured by interest in a different type of
receivable. Asset-backed securities therefore present certain risks that
are not presented by mortgage-related debt securities or other securities
in which the Fund may invest. Primarily, these securities do not have the
benefit of the same security interest in the related collateral. Credit
card receivables are generally unsecured and the debtors are entitled to
the protection of a number of state and federal consumer credit laws, many
of which give such debtors the right to set off certain amounts owed on
the credit cards, thereby reducing the balance due. Most issuers of
automobile receivables permit the servicers to retain possession of the
underlying obligations. If the servicer were to sell these obligations to
another party, there is a risk that the purchaser would acquire an
interest superior to that of the holders of the automobile receivables.
In addition, because of the large number of vehicles involved in a typical
- 22 -
<PAGE>
issuance and technical requirements under state laws, the trustee for the
holders of the automobile receivables may not have proper security
interest in all of the obligations backing such receivables. Therefore,
there is the possibility that recoveries on repossessed collateral may
not, in some cases, be available to support payments on these securities.
Because asset-backed securities are relatively new, the market experience
in these securities is limited and the market's ability to sustain
liquidity through all phases of the market cycle has not been tested.
Ratings of Debt Obligations
---------------------------
Moody's Investors Service, Inc. ("Moody's"), Standard & Poor's
Ratings Group ("S&P") and other nationally recognized statistical rating
organizations ("NRSROs") are private organizations that provide ratings of
the credit quality of debt obligations. A description of the ratings
assigned to corporate debt obligations by Moody's and S&P is included in
Appendix A to the Prospectus. The Fund may consider these ratings in
determining whether to purchase, sell or hold a security.
Ratings are not absolute assurances of quality. Consequently,
securities with the same maturity, interest rate and rating may have
different market prices. Credit rating agencies attempt to evaluate the
safety of principal and interest payments and do not evaluate the risks of
fluctuations in market value. Also, rating agencies may fail to make
timely changes in credit ratings in response to subsequent events, so that
an issuer's current financial condition may be better or worse than the
rating indicates.
Swaps, Caps, Floors and Collars
-------------------------------
The Fund may enter into interest rate swaps, and may purchase and
sell caps, floors, and collars for hedging purposes or in an effort to
increase overall return. An interest rate swap is an exchange of interest
payment streams of differing character between counterparties with respect
to a "notional amount" of principal. Index swaps link one of the payments
to the total return of a market portfolio. A cap enables an investor, in
return for a fee, to receive payments if a predetermined interest rate,
currency rate or index value exceeds a particular level. A floor entitles
the investor to receive payments if the interest rate, currency rate or
index value falls below a predetermined level. A collar is a combination
of a cap and a floor and protects a return within a range of values.
The Fund does not intend to purchase swaps, caps, collars, or
floors if, as a result, more than 5% of the Fund's net assets would
thereby be placed at risk. Swaps, caps, collars and floors can be highly
volatile instruments. The value of these agreements is dependent on the
ability of the counterparty to perform and is therefore linked to the
counterparty's creditworthiness. The Fund may also suffer a loss if it is
unable to terminate an outstanding swap agreement.
The Fund will enter into swaps, caps, collars and floors only
with parties deemed by the Adviser to present a minimal risk of default
- 23 -
<PAGE>
during the period of agreement. When the Fund enters into a swap, cap,
collar or floor, it will maintain a segregated account containing cash and
high-quality liquid debt securities equal to the payment, if any, due to
the other party; where contracts are on a net basis, only the net payment
will be segregated. The Fund regards caps, collars and floors as
illiquid, and therefore subject to the Fund's 15% limit on illiquid
securities. There can be no assurance that the Fund will be able to
terminate a swap at the appropriate time. The Fund will sell caps,
collars and floors only to close out its positions in such instruments.
As with options and futures transactions, successful use of swap
agreements depends on the Adviser's ability to predict movements in the
direction of overall interest rate markets. There might be imperfect
correlations between the value of a swap, cap, collar or floor agreement
and movements in the underlying interest rate markets. While swap
agreements can offset the potential for loss on a position, they can also
limit the opportunity for gain by offsetting favorable price movements.
The swap market has grown substantially in recent years with a
large number of banks and investment banking firms acting both as
principals and as agents utilizing standardized swap documentation. Caps,
collars and floors are more recent innovations for which documentation is
less standardized, and accordingly, they are less liquid than swaps. The
market for all of these instruments is largely unregulated. Swaps, caps,
collars and floors are generally considered "derivatives."
Loan Participations and Assignments
-----------------------------------
The Fund may purchase an interest in loans originated by banks
and other financial institutions. Policies of the Fund limit the
percentage of the Fund's assets that can be invested in the securities of
any one issuer, or in issuers primarily involved in one industry. Legal
interpretations by the SEC staff may require the Fund, in some instances,
to treat both the lending bank and the borrower as "issuers" of a loan
participation by the Fund. In combination, the Fund's policies and the
SEC staff's interpretations may limit the amount the Fund can invest in
loan participations.
Although some of the loans in which the Fund invests may be
secured, there is no assurance that the collateral can be liquidated in
particular cases, or that its liquidation value will be equal to the value
of the debt. Borrowers that are in bankruptcy may pay only a small
portion of the amount owed, if they are able to pay at all. Where the
Fund purchases a loan through an assignment, there is a possibility that
the Fund will, in the event the borrower is unable to pay the loan, become
the owner of the collateral. This involves certain risks to the Fund as a
property owner.
Loans are often administered by a lead bank, which acts as agent
for the lenders in dealing with the borrower. In asserting rights against
the borrower, the Fund may be dependent on the willingness of the lead
bank to assert these rights, or upon a vote of all the lenders to
- 24 -
<PAGE>
authorize the action. Assets held by the lead bank for the benefit of the
Fund may be subject to claims of the lead bank's creditors.
ADDITIONAL PURCHASE AND REDEMPTION INFORMATION
The Prospectus explains that the basic minimum initial investment
is $1,000 and subsequent investments must be at least $100. Purchases made
through the Future First Systematic Investment Plan, payroll deduction
plans and plans involving automatic payment of funds from financial
institutions or automatic investment of dividends from certain unit
investment trusts are subject to an initial minimum and a minimum monthly
investment of only $50.
Future First Systematic Investment Plan
---------------------------------------
When you purchase shares through the Future First Systematic
Investment Plan, Boston Financial Data Services ("BFDS"), the Fund's
transfer agent, will send a check each month to your bank for collection,
and the proceeds of the check will be used to buy shares of the Fund. The
check will also be reflected on your regular checking account statement.
You will receive a cumulative statement of your purchases quarterly. You
may terminate the Future First Systematic Investment Plan at any time
without charge or penalty. Forms to enroll in the Future First Systematic
Investment Plan are available from any Legg Mason Wood Walker, Inc. ("Legg
Mason") or affiliated office.
Purchases by Check
------------------
In making purchases of Fund shares by check, you should be aware
that checks drawn on a member bank of the Federal Reserve System will
normally be converted to federal funds and used to purchase shares of the
Fund within two business days of receipt by Legg Mason. Legg Mason is
closed on the same days as the New York Stock Exchange, Inc. ("Exchange")
is closed, which are listed under "Valuation of Fund Shares" on page 36.
Checks drawn on banks that are not members of the Federal Reserve System
may take up to nine business days to be converted.
Systematic Withdrawal Plan
--------------------------
You may also elect to make systematic withdrawals from your Fund
account of a minimum of $50 on a monthly basis if you own shares with a
net asset value of $5,000 or more. The amounts paid to you each month are
obtained by redeeming sufficient shares from your account to provide the
withdrawal amount that you have specified. The Systematic Withdrawal Plan
is not currently available for shares held in an Individual Retirement
Account ("IRA"), Self-Employed Individual Retirement Plan ("Keogh Plan"),
Simplified Employee Pension Plan ("SEP") or other qualified retirement
plan. You may change the monthly amount to be paid to you without charge
not more than once a year by notifying Legg Mason or the affiliate with
which you have an account. Redemptions will be made at the net asset
value determined as of the close of regular trading of the Exchange on the
first day of each month. If the Exchange is not open for business on that
- 25 -
<PAGE>
day, the shares will be redeemed at the net asset value determined as of
the close of regular trading of the Exchange on the preceding business
day. The check for the withdrawal payment will usually be mailed to you
on the next business day following redemption. If you elect to
participate in the Systematic Withdrawal Plan, dividends and distributions
on all shares in your account must automatically be reinvested. You may
terminate the Systematic Withdrawal Plan at any time without charge or
penalty. The Fund, its transfer agent, and Legg Mason also reserve the
right to modify or terminate the Systematic Withdrawal Plan at any time.
Withdrawal payments are treated as a sale of shares rather than
as a dividend or a capital gain distribution. To the extent periodic
withdrawals exceed reinvested dividends and other distributions, the
amount of your original investment may be correspondingly reduced.
Ordinarily, you should not purchase additional shares of the Fund
if you maintain a Systematic Withdrawal Plan because you may incur tax
liabilities in connection with such purchases and withdrawals. The Fund
will not knowingly accept purchase orders from you for additional shares
if you maintain a Systematic Withdrawal Plan unless your purchase is equal
to at least one year's scheduled withdrawals. In addition, if you
maintain a Systematic Withdrawal Plan, you may not make periodic
investments under the Future First Systematic Investment Plan.
Redemption Services
-------------------
The Fund reserves the right to modify or terminate the telephone
redemption services described in the Prospectus at any time.
The date of payment may not be postponed for more than seven
days, and the right of redemption may not be suspended except (a) for any
periods during which the Exchange is closed (other than for customary
weekend and holiday closings), (b) when trading in markets the Fund
normally utilizes is restricted or an emergency, as defined by rules and
regulations of the SEC, exists, making disposal of the Fund's investments
or determination of its net asset value not reasonably practicable, or (c)
for such other periods as the SEC, by order, may permit for protection of
the Fund's shareholders. In the case of any such suspension, you may
either withdraw your request for redemption or receive payment based upon
the net asset value next determined after the suspension is lifted.
The Fund reserves the right, under certain conditions, to honor
any request or combination of requests for redemption from the same
shareholder in any 90-day period, totalling $250,000 or 1% of the net
assets of the Fund, whichever is less, by making payment in whole or in
part by securities valued in the same way as they would be valued for
purposes of computing the Fund's net asset value per share. If payment is
made in securities, a shareholder should expect to incur brokerage
expenses in converting those securities into cash and will be subject to
fluctuation in the market price of those securities until they are sold.
The Fund does not redeem in kind under normal circumstances, but would do
- 26 -
<PAGE>
so where the Adviser determines that it would be in the best interests of
the shareholders as a whole.
- 27 -
<PAGE>
ADDITIONAL TAX INFORMATION
The following is a general summary of certain federal tax
considerations affecting the Fund and its shareholders. Investors are
urged to consult their own tax advisers for more detailed information
regarding any federal, state, local or foreign taxes that may be
applicable to them.
General
-------
For federal tax purposes, the Fund is treated as a separate
corporation. In order to continue to qualify for treatment as a regulated
investment company ("RIC") under the Internal Revenue Code of 1986, as
amended ("Code"), the Fund must distribute annually to its shareholders at
least 90% of its investment company taxable income (generally, net
investment income, any net short-term capital gain and any net gains from
certain foreign currency transactions) ("Distribution Requirement") and
must meet several additional requirements. 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
foreign currencies, or other income (including gains from options, futures
or forward contracts) derived with respect to its business of investing in
securities or those currencies ("Income Requirement"); (2) the Fund must
derive less than 30% of its gross income each taxable year from the sale
or other disposition of securities, or any of the following, held for less
than three months -- options, futures or forward contracts (other than
those on foreign currencies), or foreign currencies (or options, futures
or forward contracts thereon) that are not directly related to the Fund's
principal business of investing in securities (or options and futures with
respect thereto) ("Short-Short Limitation"); (3) at the close of each
quarter of the Fund's taxable year, at least 50% of the value of its total
assets must be represented by cash and cash items, U.S. government
securities, securities of other RICs and other securities, with those
other securities 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 that does
not represent more than 10% of the issuer's outstanding voting securities;
and (4) at the close of each quarter of the Fund's taxable year, not more
than 25% of the value of its total assets may be invested in the
securities (other than U.S. government securities or the securities of
other RICs) of any one issuer.
If Fund shares are sold at a loss after being held for six months
or less, the loss will be treated as a long-term, instead of a short-term,
loss to the extent of any capital gain distributions received on those
shares. Investors also should be aware that if shares are purchased
shortly before the record date for any dividend or other distribution, the
investor will pay full price for the shares and receive some portion of
the price back as a taxable distribution.
The Fund will be subject to a nondeductible 4% excise tax
("Excise Tax") to the extent that it fails to distribute by the end of any
- 28 -
<PAGE>
calendar year substantially all of its ordinary income for that year and
capital gain net income for the one-year period ending on October 31 of
that year, plus certain other amounts. For this and other purposes,
dividends and other distributions declared by the Fund in December of any
year and payable to shareholders of record on a date in that month will be
deemed to have been paid by the Fund and received by the shareholders on
December 31 if the distributions are paid by the Fund during the following
January. Accordingly, those dividends and other distributions will be
taxed to shareholders for the year in which that December 31 falls.
Interest received by the Fund may be subject to income,
withholding or other taxes imposed by foreign countries and U.S.
possessions that would reduce the yield on the Fund's securities. Tax
conventions between certain countries and the United States may reduce or
eliminate these foreign taxes, however, and many foreign countries do not
impose taxes on capital gains in respect of investments by foreign
investors.
Options, Futures, Forward Contracts and Foreign Currencies
----------------------------------------------------------
The use of hedging instruments, such as writing (selling) and
purchasing options and futures contracts and entering into forward
contracts, involves complex rules that will determine for income tax
purposes the character and timing of recognition of the gains and losses
the Fund realizes in connection therewith.
Regulated futures contracts and options that are subject to
Section 1256 of the Code (collectively, "Section 1256 contracts") and are
held by the Fund at the end of each taxable year will be required to be
"marked-to-market" for federal income tax purposes (that is, treated as
having been sold at that time at market value). Any unrealized gain or
loss recognized under this mark-to-market rule will be added to any
realized gains and losses on Section 1256 contracts actually sold by the
Fund during the year, and the resulting gain or loss will be treated
(without regard to the holding period) as 60% long-term capital gain or
loss and 40% short-term capital gain or loss. These rules may operate to
increase the amount of dividends, which will be taxable to shareholders,
that must be distributed to meet the Distribution Requirement and avoid
imposition of the Excise Tax, without providing the cash with which to
make the distributions. The Fund may elect to exclude certain
transactions from Section 1256, although doing so may have the effect of
increasing the relative proportion of short-term capital gain (taxable as
ordinary income when distributed to the Fund's shareholders).
Generally, the hedging transactions undertaken by the Fund may
result in "straddles" for federal income tax purposes. Because
application of the straddle rules may affect the character of gains or
losses, defer the recognition of losses and/or accelerate the recognition
of gains from the affected straddle positions, and may require the
capitalization of interest expense associated therewith, the amount that
must be distributed to shareholders (and the character of the distribution
as ordinary income or long-term capital gain) may be increased or
- 29 -
<PAGE>
decreased substantially as compared to a fund that did not engage in such
hedging transactions.
Income from foreign currencies (except certain gains therefrom
that may be excluded by future regulations), and income from transactions
in options, futures and forward contracts derived by the Fund with respect
to its business of investing in securities or foreign currencies, will
qualify as permissible income under the Income Requirement. However,
income from the disposition of options and futures contracts (other than
those on foreign currencies) will be subject to the Short-Short Limitation
if they are held for less than three months. Income from the disposition
of foreign currencies, and options, futures and forward contracts thereon,
that are not directly related to the Fund's principal business of
investing in securities (or options and futures with respect thereto),
also will be subject to the Short-Short Limitation if they are held for
less than three months.
If the Fund satisfies certain requirements, any increase in value
of a position that is part of a "designated hedge" will be offset by any
decrease in value (whether realized or not) of the offsetting hedging
position during the period of the hedge for purposes of determining
whether the Fund satisfies the Short-Short Limitation. Thus, only the net
gain (if any) from the designated hedge will be included in gross income
for purposes of this limitation. The Fund anticipates engaging in hedging
transactions, if any, that are intended to qualify for this treatment, but
at the present time it is not clear whether this treatment will be
available for, or that the Fund will elect to have this treatment apply
to, all hedging transactions it undertakes. To the extent this treatment
is not available, the Fund may be forced to defer the closing out of
certain options, futures and forward contracts beyond the time when it
otherwise would be advantageous to do so, in order for the Fund to
continue to qualify as a RIC.
Zero Coupon and Pay-in-Kind Securities
--------------------------------------
The Fund may acquire zero coupon securities or other securities
issued with original issue discount. As a holder of those securities, the
Fund must include in its income the original issue discount that accrues
on the securities during the taxable year, even if it receives no
corresponding payment on the securities during the year. Similarly, the
Fund must include in its gross income securities it receives as "interest"
on pay-in-kind securities. Because the Fund annually must distribute
substantially all of its investment company taxable income, including any
earned original issue discount and other non-cash income, to satisfy the
Distribution Requirement and avoid imposition of the Excise Tax, it may be
required in a particular year to distribute as a dividend an amount that
is greater than the total amount of cash it actually receives. Those
distributions will be made from the Fund's cash assets or from the
proceeds of sales of portfolio securities, if necessary. The Fund may
realize capital gains or losses from those sales, which would increase or
decrease its investment company taxable income and/or net capital gain
(the excess of net long-term capital gain over net short-term capital
- 30 -
<PAGE>
loss). In addition, any such gains may be realized on the disposition of
securities held for less than three months. Because of the Short-Short
Limitation, any such gains would reduce the Fund's ability to sell other
securities (or certain options, futures, forward contracts or foreign
currencies), held for less than three months that it might wish to sell in
the ordinary course of its portfolio management.
Passive Foreign Investment Companies
------------------------------------
The Fund may invest in the stock of "passive foreign investment
companies" ("PFICs"). A PFIC is a foreign corporation that, in general,
meets either of the following tests: (1) at least 75% of its gross income
is passive or (2) an average of at least 50% of its assets produce, or are
held for the production of, passive income. Under certain circumstances,
the Fund will be subject to federal income tax on a portion of any "excess
distribution" received on the stock of a PFIC or of any gain on disposi-
tion of that stock (collectively "PFIC income"), plus interest thereon,
even if the Fund distributes the PFIC income as a taxable dividend to its
shareholders. The balance of the PFIC income will be included in the
Fund's investment company taxable income and, accordingly, will not be
taxable to it to the extent that income is distributed to its
shareholders.
If the Fund invests in a PFIC and elects to treat the PFIC as a
"qualified electing fund," then in lieu of the foregoing tax and interest
obligation, the Fund will be required to include in income each year its
pro rata share of the qualified electing fund's annual ordinary earnings
and net capital gain, which most likely would have to be distributed to
satisfy the Distribution Requirement and avoid imposition of the Excise
Tax, even if those earnings and gain are not received by the Fund. In
most instances it will be very difficult, if not impossible, to make this
election because of certain requirements thereof.
The "Tax Simplification and Technical Corrections Bill of 1993,"
passed in May 1994 by the House of Representatives, would substantially
modify the taxation of U.S. shareholders of foreign corporations,
including eliminating the provisions described above dealing with PFICS
and replacing them (and other provisions) with a regulatory scheme
involving entities called "passive foreign corporations." Three similar
bills were passed by Congress in 1991 and 1992 and were vetoed. It is
unclear at this time whether, and in what form, the proposed modifications
may be enacted into law.
Pursuant to proposed regulations, open-end RICs, such as the
Fund, would be entitled to elect to "mark-to-market" their stock in
certain PFICs. "Marking-to-market," in this context, means recognizing as
gain for each taxable year the excess, as of the end of that year, of the
fair market value of each such PFIC's stock over the adjusted basis in
that stock (including mark-to-market gain for each prior year for which an
election was in effect).
- 31 -
<PAGE>
Foreign Currencies
------------------
Gains or losses attributable to fluctuations in exchange rates
that occur between the time the Fund accrues dividends, interest or other
receivables or accrues expenses or other liabilities denominated in a
foreign currency and the time the Fund actually collects the receivables
or pays the liabilities generally are treated as ordinary income or
ordinary loss. Similarly, on disposition of a debt security denominated
in a foreign currency or of a forward contract on a foreign currency,
gains or losses attributable to fluctuations in the value of the foreign
currency between the date of acquisition of the security or contract and
the date of disposition also are treated as ordinary gain or loss. These
gains or losses, referred to under the Code as "Section 988" gains or
losses, may increase or decrease the amount of the Fund's investment
company taxable income to be distributed to its shareholders.
Miscellaneous
-------------
If the Fund invests in shares of common stock or preferred stock
or otherwise holds dividend-paying securities as a result of exercising a
conversion privilege, a portion of the dividends from its investment
company taxable income (whether paid in cash or reinvested in additional
Fund shares) may be eligible for the dividends-received deduction allowed
to corporations. The eligible portion may not exceed the aggregate
dividends received by the Fund from U.S. corporations. However, dividends
received by a corporate shareholder and deducted by it pursuant to the
dividends-received deduction are subject indirectly to the alternative
minimum tax.
TAX-DEFERRED RETIREMENT PLANS
As noted in the Fund's Prospectus, an investment in Fund shares
may be appropriate for IRAs, Keogh Plans, SEPs and other qualified
retirement plans. In general, income earned through the investment of
assets of those accounts and plans is not taxed to their beneficiaries
until the income is distributed to them. Investors who are considering
establishing such an account or plan should consult their tax advisers
with respect to individual tax questions. The option of investing in
these accounts or plans through regular payroll deductions may be arranged
with a Legg Mason or affiliated investment executive and your employer.
Additional information with respect to these accounts and plans is
available upon request from any Legg Mason or affiliated investment
executive.
Individual Retirement Account - IRA
-----------------------------------
Certain investors may obtain tax advantages by establishing IRAs.
Specifically, if neither you nor your spouse is an active participant in a
qualified employer or government retirement plan, or if either you or your
spouse is an active participant and your adjusted gross income does not
exceed a certain level, you may deduct cash contributions made to an IRA
in an amount for each taxable year not exceeding the lesser of 100% of
- 32 -
<PAGE>
your earned income or $2,000. In addition, if your spouse is not employed
and you file a joint return, you may establish a separate IRA for your
spouse and contribute up to a total of $2,250 to the two IRAs, provided
that the contribution to either does not exceed $2,000. If you and your
spouse are both employed and neither of you is an active participant in a
qualified employer or government retirement plan and you establish
separate IRAs, you each may contribute all of your earned income, up to
$2,000 each, and thus may together receive tax deductions of up to $4,000
for contributions to your IRAs. If your employer's plan qualifies as a
SEP, permits voluntary contributions and meets certain requirements, you
may make voluntary contributions to that plan that are treated as
deductible IRA contributions.
Even if you are not in one of the categories described in the
preceding paragraph, you may find it advantageous to invest in shares of
the Fund through nondeductible IRA contributions, up to certain limits,
because all dividends and other distributions on your Fund shares are then
not immediately taxable to you or the IRA; they become taxable only when
distributed to you. To avoid penalties, your interest in an IRA must be
distributed, or start to be distributed, to you not later than the end of
the taxable year in which you attain age 70-1/2. Distributions made
before age 59-1/2, in addition to being taxable, generally are subject to
a penalty equal to 10% of the distribution, except in the case of death or
disability or where the distribution is rolled over into another qualified
plan or certain other situations.
Self-Employed Individual Retirement Plan-Keogh Plan
---------------------------------------------------
Legg Mason makes available to self-employed individuals a Plan
and Trustee Agreement for a Keogh Plan through which Fund shares may be
purchased. You have the right to use a bank of your own choice to
provide these services at your own cost. There are penalties for
distributions from a Keogh Plan prior to age 59-1/2, except in the case of
death or disability.
Simplified Employee Pension Plan-SEP
------------------------------------
Legg Mason makes available to corporate and other employers a SEP
for investment in Fund shares.
Withholding at the rate of 20% is required for federal income tax
purposes on distributions eligible for rollover from the foregoing
retirement plans (except IRAs and SEPs), unless the recipient transfers
the distribution directly to an "eligible retirement plan" (including IRAs
and other qualified plans) that accepts those distributions. Other
distributions generally are subject to regular wage withholding or
withholding at the rate of 10% (depending on the type and amount of the
distribution), unless the recipient elects not to have any withholding
apply. Please consult your plan administrator or tax adviser for further
information.
- 33 -
<PAGE>
PERFORMANCE INFORMATION
Total Return Calculations Average annual total return quotes used
in the Fund's advertising and other promotional materials ("Performance
Advertisements") are calculated according to the following formula:
n
P(1+T) = ERV
where: P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1,000
payment made at the beginning of that period.
Under the foregoing formula, the time periods used in Performance
Advertisements will be based on rolling calendar quarters, updated at
least to the last day of the most recent quarter prior to submission of
the Performance Advertisements 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 all dividends and other distributions by the Fund
are assumed to have been reinvested at net asset value on the reinvestment
dates during the period.
YIELD Yields used in the Fund's Performance Advertisements are
calculated by dividing the Fund's net investment income for a 30-day
period ("Period"), by the average number of shares 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 at the end of the Period. Yield quotations are calculated
according to the following formula:
6
Yield = 2 [(a-b +1) - 1]
---
cd
where: a = interest earned during the Period
b = expenses accrued for the Period (net of
reimbursements)
c = the average daily number of shares outstanding
during the period that were entitled to receive
dividends
d = the maximum offering price per share on the last
day of the Period.
Except as noted below, in determining net investment income
earned during the Period (variable "a" in the above formula), the 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
- 34 -
<PAGE>
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). 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
totalling the interest earned on all debt obligations. For the 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.
The Fund's yield for the thirty-day period ended December 31, 1994 was
9.42%.
With respect to the treatment of discount and premium on
mortgage-backed and other asset-backed obligations that are expected to be
subject to monthly payments of principal and interest ("paydowns"): (1)
the Fund accounts for gain or loss attributable to actual paydowns as an
increase or decrease to interest income during the period and (2) the Fund
accrues the discount and amortizes the premium on the remaining
obligation, based on the cost of the obligation, to the weighted average
maturity date or, if weighted average maturity information is not
available, to the remaining term of the obligation.
OTHER INFORMATION In Performance Advertisements the Fund may compare its
total return with data published by Lipper Analytical Services, Inc.
("Lipper") for U.S. government funds, corporate bond (BBB) funds, CDA
Investment Technologies, Inc. ("CDA"), Wiesenberger Investment Companies
Service ("Wiesenberger"), or Morningstar Mutual Funds ("Morningstar"), or
with the performance of U.S. Treasury securities of various maturities,
recognized stock, bond and other indexes, including (but not limited to)
the Salomon Brothers Bond Index, Shearson Lehman Bond Index, Shearson
Lehman Government/Corporate Bond Index, the Standard & Poor's 500
Composite Stock Price Index (S&P 500"), the Dow Jones Industrial Average
("Dow Jones"), and changes in the Consumer Price Index as published by the
U.S. Department of Commerce. The Fund also may refer in such materials to
mutual fund performance rankings and other data, such as comparative
asset, expense and fee levels, published by Lipper, CDA, Wiesenberger or
Morningstar. Performance Advertisements also may refer to discussions of
the Fund and comparative mutual fund data and ratings reported in
independent periodicals, including (but not limited to) THE WALL STREET
JOURNAL, MONEY Magazine, FORBES, BUSINESS WEEK, FINANCIAL WORLD, BARRONS,
FORTUNE and THE NEW YORK TIMES.
The Fund invests primarily in the fixed-income securities
described in its Prospectus, and does not invest in the equity securities
that make up the S&P 500 or the Dow Jones indices. Comparison with such
indices is intended to show how an investment in the Fund behaved as
compared to indices that are often taken as a measure of performance of
the equity market as a whole. The indices, like the Fund's total return,
assume reinvestment of all dividends and other distributions. They do not
take into account the costs or the tax consequences of investing.
- 35 -
<PAGE>
The Fund may include discussions or illustrations of the effects
of compounding in performance advertisements. "Compounding" refers to the
fact that, if dividends or other distributions on an investment in the
Fund are reinvested in additional Fund shares, any future income or
capital appreciation of the Fund would increase the value, not only of the
original Fund investment, but also of the additional Fund shares received
through reinvestment. As a result, the value of the Fund investment would
increase more quickly than if dividends or other distributions had been
paid in cash.
The Fund may also compare its performance with the performance of
bank certificates of deposit (CDs) as measured by the CDA Investment
Technologies, Inc. Certificate of Deposit Index and the Bank Rate Monitor
National Index. In comparing the Fund's performance to CD performance,
investors should keep in mind that bank CDs are insured in whole or in
part by an agency of the U.S. government and offer fixed principal and
fixed or variable rates of interest, and that bank CD yields may vary.
Fund shares are not insured or guaranteed by the U.S. Government and
returns and net asset value will fluctuate. The securities held by the
Fund generally have longer maturities than most CDs and may reflect
interest rate fluctuations for longer-term securities.
Fund advertisements may reference the history of the distributor
and its affiliates, and the education and experience of the portfolio
manager. Advertisements may also describe techniques the Adviser employs
in selecting among the sectors of the fixed-income market and adjusting
average portfolio maturity. In particular, the advertisements may focus on
the techniques of "value investing". With value investing, the Adviser
invests in those securities it believes to be undervalued in relation to
the long-term earning power or asset value of their issuers. Securities
may be undervalued because of many factors, including market decline, poor
economic conditions, tax-loss selling, or actual or anticipated
unfavorable developments affecting the issuer of the security.
In advertising, the Fund may illustrate hypothetical investment
plans designed to help investors meet long-term financial goals, such as
saving for a child's college education or for retirement. Sources such as
the Internal Revenue Service, the Social Security Administration, the
Consumer Price Index and Chase Global Data and Research may supply data
concerning interest rates, college tuitions, the rate of inflation, Social
Security benefits, mortality statistics and other relevant information.
The Fund may use other recognized sources as they become available.
The Fund may use data prepared by Ibbotson Associates of Chicago,
Illinois ("Ibbotson") to compare the returns of various capital markets
and to show the value of a hypothetical investment in a capital market.
Ibbotson relies on different indices to calculate the performance of
common stocks, corporate and government bonds and Treasury bills.
The Fund may illustrate and compare the historical volatility of
different portfolio compositions where the performance of stocks is
represented by the performance of an appropriate market index, such as the
- 36 -
<PAGE>
S&P 500 and the performance of bonds is represented by a nationally
recognized bond index, such as the Lehman Brothers Long-Term Government
Bond Index.
The Fund may also include in advertising biographical information
on key investment and managerial personnel.
The Fund may advertise examples of the potential benefits of
periodic investment plans, such as dollar cost averaging, a long-term
investment technique designed to lower average cost per share. Under such
a plan, an investor invests in a mutual fund at regular intervals a fixed
dollar amount thereby purchasing more shares when prices are low and fewer
shares when prices are high. Although such a plan does not guarantee
profit or guard against loss in declining markets, the average cost per
share could be lower than if a fixed number of shares were purchased at
the same intervals. Investors should consider their ability to purchase
shares through low price levels.
The Fund may discuss Legg Mason's tradition of service. Since
1899, Legg Mason and its affiliated companies have helped investors meet
their specific investment goals and have provided a full spectrum of
financial services. Legg Mason affiliates serve as investment advisors
for private accounts and mutual funds with assets of more than $17 billion
as of December 31, 1994.
In advertising, the Fund may discuss the advantages of saving
through tax-deferred retirement plans or accounts, including the
advantages and disadvantages of "rolling over" a distribution from a
retirement plan into an IRA, factors to consider in determining whether
you qualify for such a rollover, and the other options available. These
discussions may include graphs or other illustrations that compare the
growth of a hypothetical tax-deferred investment to the after-tax growth
of a taxable investment.
The following table shows the value, as of the end of each fiscal
year, of a hypothetical investment of $15,000 made in the Fund at the
Fund's commencement of operations on February 1, 1994. The table assumes
that all dividends and other distributions are reinvested in the Fund. It
includes the effect of all charges and fees applicable to shares the Fund
has paid. (There are no fees for investing or reinvesting in the Fund,
and there are no redemption fees.) It does not include the effect of any
income taxes that an investor would have to pay on distributions.
- 37 -
<PAGE>
Value of Original
Shares Plus Shares
Obtained Through Value of Shares
Reinvestment of Acquired Through
Fiscal Capital Gain Reinvestment of Total
Year Distributions Income Dividends Value
------ --------------------- ------------------- ---------------
1994* $13,560 $1,006 $14,566
*February 1, 1994 (commencement of operations) to December 31 1994.
If the investor had not reinvested dividends and other
distributions, the total value of the hypothetical investment as of
December 31, 1994 would have been $13,560, and the investor would have
received a total of $1,012 in distributions.
VALUATION OF FUND SHARES
Net asset value of a Fund share is determined daily as of the
close of the Exchange, on every day that the Exchange is open, by dividing
the value of the total assets of the Fund, less liabilities, by the number
of shares outstanding. Pricing will not be done on days when the Exchange
is closed. The Exchange currently observes the following holidays: New
Year's Day, Presidents' Day, Good Friday, Memorial Day, Independence Day,
Labor Day, Thanksgiving and Christmas. When market quotations for
institutional size positions are readily available, portfolio securities
are valued based upon market quotations. Where such market quotations are
not readily available, securities are valued based upon appraisals
received from a pricing service using a computerized matrix system or
based upon appraisals derived from information concerning the security or
similar securities received from recognized dealers in those securities.
The methods used by the pricing service and the quality of the valuations
so established are reviewed by the Adviser under the general supervision
of the Corporation's Board of Directors. The amortized cost method of
valuation is used with respect to obligations with 60 days or less
remaining to maturity unless the Adviser determines that this does not
represent fair value. Foreign securities denominated in foreign currency
generally are valued at the U.S. dollar equivalents at the spot currency
value as reported by a major New York bank. All other securities are
valued at fair value as determined by or under the direction of the Fund's
Board of Directors. Premiums received on the sale of call options are
included in the Fund's net asset value, and the current market value of
options sold by the Fund will be subtracted from net assets.
- 38 -
<PAGE>
THE CORPORATION'S DIRECTORS AND OFFICERS
The Corporation's officers are responsible for the operation of
the Fund under the supervision of the Board of Directors. The officers
and directors of the Corporation and their principal occupations during
the past five years are set forth below. An asterisk (*) indicates those
officers and/or directors who are "interested persons" of the Corporation
as defined by the 1940 Act. The business address of each officer and
director is 111 South Calvert Street, Baltimore, Maryland 21202, unless
otherwise indicated.
JOHN F. CURLEY, JR.*, [55] Chairman of the Board and Director;
Vice Chairman and Director of Legg Mason Wood Walker, Inc. and Legg Mason,
Inc.; Director of Legg Mason Fund Adviser, Inc. and Western Asset
Management Company; Officer and/or Director of various other affiliates of
Legg Mason, Inc.; President and Director of three Legg Mason funds;
Chairman of the Board, President and Trustee of one Legg Mason fund;
Chairman of the Board and Director of three Legg Mason funds; and Chairman
of the Board and Trustee of one Legg Mason fund.
EDWARD A. TABER, III,* [51] President and Director; Executive Vice-
President of Legg Mason, Inc. and Legg Mason Wood Walker, Inc.; Vice-
Chairman and Director of Legg Mason Fund Adviser, Inc.; Director of three
Legg Mason funds; President and Director of two other Legg Mason funds;
Trustee of one Legg Mason fund; and Vice President of Worldwide Value
Fund, Inc. Formerly: Executive Vice President of T. Rowe Price-Fleming
International, Inc. (1986-1992) and Director of the Taxable Fixed Income
Division at T. Rowe Price Associates, Inc. (1973-1992).
EDMUND J. CASHMAN, JR.*, [58] Vice Chairman and Director; Senior
Executive Vice President and Director of Legg Mason, Inc.; Officer and/or
Director of various other affiliates of Legg Mason, Inc.; President and
Director of one Legg Mason fund; President and Trustee of one Legg Mason
fund; and Director of Worldwide Value Fund, Inc.
RICHARD G. GILMORE, [67] Director; 5534 Chanteclaire, Sarasota,
Florida. Independent Consultant; Director of CSS Industries, Inc.
(diversified holding company engaged in manufacture and sale of decorative
paper products, business forms, and specialty metal packaging); Director
of PECO Energy Company (formerly Philadelphia Electric Company); Director
of six Legg Mason funds; Trustee of one Legg Mason fund. Formerly: Senior
Vice President and Chief Financial Officer of Philadelphia Electric
Company (electric and gas utility) (now PECO Energy Company); Executive
Vice President and Treasurer, Girard Bank, and Vice President of its
parent holding company, the Girard Company (bank holding company); and
Director of Finance, City of Philadelphia.
CHARLES F. HAUGH, [69] Director; 14201 Laurel Park Drive, Laurel,
Maryland. Real Estate Developer and Investor; President and Director of
Resource Enterprises, Inc. (real estate brokerage); Chairman of Resource
Realty LLC (management of retail and office space); Partner in Greater
Laurel Health Park Ltd. Partnership (real estate investment and
- 39 -
<PAGE>
development); Director of six Legg Mason funds; Trustee of two Legg Mason
funds.
ARNOLD L. LEHMAN, [51] Director; The Baltimore Museum of Art, Art
Museum Drive, Baltimore, Maryland. Director of the Baltimore Museum of
Art; Director of six Legg Mason funds; Trustee of two Legg Mason funds.
JILL E. McGOVERN, [50] Director; 1500 Wilson Boulevard,
Arlington, Virginia. Chief Executive Officer of the Marrow Foundation.
Director of six Legg Mason funds; Trustee of two Legg Mason funds.
Formerly: Executive Director of the Baltimore International Festival,
January 1991-March 31, 1993; Senior Assistant to the President of the
Johns Hopkins University (1986-1991).
T. A. RODGERS, [60] Director; 2901 Boston Street, Baltimore,
Maryland. Principal, T. A. Rodgers & Associates (management consulting);
Director of six Legg Mason funds; Trustee of one Legg Mason fund.
Formerly: Partner, Bufka & Rodgers (investment counsellors), June 1987-
April 1990; Director and Vice President of Corporate Development, Polk
Audio, Inc. (manufacturer of audio components).
The executive officers of the Fund, other than those who also
serve as directors, are:
MARIE K. KARPINSKI*, [46] Vice President and Treasurer; Vice
President and Treasurer of the Adviser; Vice President and Treasurer of
eight Legg Mason funds; Vice President, Secretary and Treasurer of
Worldwide Value Fund, Inc.; Vice President of Legg Mason Wood Walker,
Inc.
STEFANIE L. WONG*, [27] Secretary; Secretary of Legg Mason
Investors Trust, Inc.; employee of Legg Mason since 1990. Prior to 1990,
full-time student.
BLANCHE P. ROCHE*, [46] Assistant Secretary and Assistant Vice
President; Assistant Secretary and Assistant Vice President of seven Legg
Mason funds; employee of Legg Mason since 1991. Formerly: Manager of
Consumer financial services, Primerica Corporation (1989-1991).
Officers and directors of the Corporation who are interested
persons of the Corporation receive no salary or fees from the Fund.
Independent Directors of the Corporation receive a fee of $1,500 annually
for serving as a director, . For the fiscal year ended December 31, 1994,
the present independent directors as a group received a total of $7,500
from the Fund.
On February 28, 1995, the directors and officers of the Fund
beneficially owned in the aggregate less than 1% of the Fund's outstanding
shares.
- 40 -
<PAGE>
The following table provides certain information relating to the
compensation of the Corporation's directors for the fiscal year ended
December 31, 1994.
<TABLE>
<CAPTION>
COMPENSATION TABLE
-------------------
<S> <C> <C> <C> <C>
Pension or
Retirement Total
Benefits Estimated Compensation
Aggregate Accrued as Annual From Corporation
Compensation Part of Benefits and Fund Complex
Name of Person and From Corporation's Upon Paid to
Position Corporation* Expenses Retirement Directors**
---------------------------------- ------------- ----------- ----------------
John F. Curley, Jr. -
Chairman of the Board
and Director None N/A N/A None
Edward A. Taber, III -
President and DirectorNone N/A N/A None
Marie K. Karpinski -
Vice President and
Treasurer None N/A N/A None
Edmund J. Cashman -
Vice Chairman and
Director None N/A N/A None
Richard G. Gilmore -
Director $6,000 N/A N/A $21,600
Charles F. Haugh -
Director $6,000 N/A N/A $23,600
Arnold L. Lehman -
Director $6,000 N/A N/A $23,600
Jill E. McGovern -
Director $6,000 N/A N/A $23,600
T. A. Rodgers -
Director $6,000 N/A N/A $21,600
</TABLE >
- 41 -
<PAGE>
* Represents fees paid to each director during the fiscal year
ended December 31, 1994.
** Represents aggregate compensation paid to each director during
the calendar year ended December 31, 1994.
The Nominating Committee of the Board of Directors is responsible
for the selection and nomination of disinterested directors. The
Committee is composed of Messrs. Haugh, Gilmore, Lehman, Rodgers and Dr.
McGovern.
THE FUND'S MANAGER
The Manager, Legg Mason Fund Adviser, Inc., 111 South Calvert
Street, Baltimore, Maryland 21202, is a wholly owned subsidiary of Legg
Mason, Inc., which also is the parent of Legg Mason Wood Walker,
Incorporated. The Manager serves as the Fund's manager under an
Investment Management Agreement ("Management Agreement") dated January 24,
1994, which was approved by the Corporation's Board of Directors,
including a majority of the directors who are not "interested persons" of
the Corporation, the Manager or the Adviser on October 22, 1993. The
Management Agreement provides that, subject to overall direction by the
Board of Directors, the Manager manages the investment and other affairs
of the Fund. The Manager is responsible for managing the Fund's
securities and for making purchases and sales of securities consistent
with the Fund's investment objectives and policies described in its
Prospectus and this Statement of Additional Information. The Manager is
obligated to furnish the Fund with office space and executive and other
personnel necessary for the operations of the Fund. The Manager and its
affiliates are also responsible for the compensation of directors and
officers of the Corporation who are employees of the Manager and/or its
affiliates. In accordance with the Management Agreement, the Manager has
delegated the portfolio management functions for the Fund to the Adviser,
Western Asset Management Company.
As explained in the Fund's Prospectus, the Manager receives for
its services to the Fund, a management fee, calculated daily and payable
monthly, at an annual rate equal to 0.65% of the Fund's average daily net
assets. The management fee paid by the Fund may be reduced under state
regulations that impose limitations on the annual expense ratio of the
Fund. The most restrictive state limitation currently requires that the
Manager reimburse the Fund for certain expenses, including the management
fees received by it (but excluding interest, taxes, brokerage fees and
commissions, distribution fees and certain extraordinary charges), in any
fiscal year in which the Fund's expenses exceed 2.5% of the first $30
million of the Fund's average net assets, 2.0% of the next $70 million of
average net assets, and 1.5% of average net assets in excess of $100
million. No reimbursements have been made nor have any been required to
be made pursuant to this undertaking. For the period February 1, 1994
(commencement of operations) to December 31, 1994, the Fund paid fees of
$253,100 to the Manager.
- 42 -
<PAGE>
Under the Management Agreement, the Manager will not be liable
for any error of judgment or mistake of law or for any loss suffered by
the Fund in connection with the performance of the Management Agreement,
except a loss resulting from a breach of fiduciary duty with respect to
the receipt of compensation for services or a loss resulting from willful
misfeasance, bad faith or gross negligence on its part in the performance
of its duties or from reckless disregard by it of its obligations or
duties thereunder.
The Management Agreement terminates automatically upon assignment
and is terminable at any time without penalty by vote of the Corporation's
Board of Directors, by vote of a majority of the Fund's outstanding voting
securities, or by the Manager, on not less than 60 days' written notice to
the Fund, and may be terminated immediately upon the mutual written
consent of the Manager and the Fund.
The Fund pays all of its expenses which are not expressly assumed
by the Manager. These expenses include, among others, interest expense,
taxes, brokerage fees and commissions, expenses of preparing and printing
prospectuses, statements of additional information, proxy statements and
reports and of distributing them to existing shareholders, custodian
charges, transfer agency fees, organizational expenses, distribution fees
to the Fund's distributor, compensation of the independent directors,
legal, accounting and audit expenses, insurance expenses, expenses of
registering and qualifying shares of the Fund for sale under federal and
state law, governmental fees and expenses incurred in connection with
membership in investment company organizations. The Fund also is liable
for such nonrecurring expenses as may arise, including litigation to which
the Fund may be a party. The Fund may also have an obligation to
indemnify the directors and officers of the Corporation with respect to
any such litigation.
Under the Management Agreement, the Fund has the non-exclusive
right to use the name "Legg Mason" until that Agreement is terminated or
until the right is withdrawn in writing by the Manager.
INVESTMENT ADVISORY AGREEMENT
The Adviser, Western Asset Management Company, 117 East Colorado
Boulevard, Pasadena, CA 91105, an affiliate of Legg Mason, serves as
investment adviser to the Fund under an Investment Advisory Agreement
dated January 24, 1994, between the Adviser and the Manager ("Advisory
Agreement"). The Advisory Agreement was approved by the Board of
Directors, including a majority of the directors who are not "interested
persons" (as that term is defined in the 1940 Act) of the Corporation,
the Adviser or the Manager, on October 22, 1993.
Under the Advisory Agreement, the Adviser is responsible, subject
to the general supervision of the Manager and the Corporation's Board of
Directors, for the actual management of the Fund's assets, including the
responsibility for making decisions and placing orders to buy, sell or
hold a particular security. For the Adviser's services to the Fund, the
- 43 -
<PAGE>
Manager (not the Fund) pays the Adviser a fee, computed daily and payable
monthly, at an annual rate equal to 77% of the fee received by the Manager
from the Fund. For the period February 1, 1994 (commencement of
operations) to December 31, 1994, the Manager paid the Adviser fees of
$194,887.
Under the Advisory Agreement, the Adviser will not be liable for
any error of judgment or mistake of law or for any loss suffered by the
Manager or by the Fund in connection with the performance of the Advisory
Agreement, except a loss resulting from a breach of fiduciary duty with
respect to the receipt of compensation for services or a loss resulting
from willful misfeasance, bad faith or gross negligence on its part in the
performance of its duties or from reckless disregard by it of its
obligations or duties thereunder.
The Advisory Agreement terminates automatically upon assignment
and is terminable at any time without penalty by vote of the Corporation's
Board of Directors, by vote of a majority of the Fund's outstanding voting
securities, by the Manager or by the Adviser, on not less than 60 days'
written notice to the Fund and/or the other party(ies). The Advisory
Agreement terminates immediately upon any termination of the Management
Agreement or upon the mutual written consent of the Adviser, the Manager
and the Fund.
To mitigate the possibility that the Fund will be affected by
personal trading of employees, the Corporation, the Manager and the
Adviser have adopted policies that restrict securities trading in the
personal accounts of portfolio managers and others who normally come into
advance possession of information on portfolio transactions. These
policies comply, in all material respects, with the recommendations of the
Investment Company Institute.
THE FUND'S DISTRIBUTOR
Legg Mason acts as distributor of the Fund's shares pursuant to
an Underwriting Agreement with the Corporation. The Underwriting
Agreement obligates Legg Mason to pay certain expenses in connection with
the offering of the Fund's shares, including compensation to its
investment executives. Legg Mason also pays for the printing and
distribution of prospectuses and periodic reports used in connection with
the offering to prospective investors (after the prospectuses and reports
have been prepared, set in type and mailed to existing shareholders at the
Fund's expense) and for supplementary sales literature and advertising
costs.
For the period February 1, 1994 (commencement of operations) to
December 31, 1994, Legg Mason incurred the following expenses:
- 44 -
<PAGE>
Compensation to sales personnel $ 122,000
Printing and mailing of prospectuses
to prospective shareholders 39,000
Advertising 86,000
Other 678,000
--------
Total expenses $925,000
========
The Corporation has adopted a Distribution and Shareholder
Services Plan ("Plan") which, among other things, permits the Fund to pay
Legg Mason fees for its services related to sales and distribution of Fund
shares and the provision of ongoing services to shareholders. The Plan
was adopted, as required by Rule 12b-1 under the 1940 Act, by a vote of
the Board of Directors on October 22, 1993, including a majority of the
directors who are not "interested persons" of the Corporation as that term
is defined in the 1940 Act and who have no direct or indirect financial
interest in the operation of the Plan or the Underwriting Agreement ("12b-
1 directors"). The Plan was approved by Legg Mason Fund Adviser, Inc., as
sole shareholder of the Fund, on December 29, 1993. Continuation of the
Plan was most recently approved by the Board of Directors on October 21,
1994, including a majority of the 12b-1 directors. In approving the
continuance of the Plan, in accordance with the requirements of Rule 12b-
1, the directors considered various factors, including the amount of the
distribution fee. The directors determined that there is a reasonable
likelihood that the Plan will continue to benefit the Fund and its present
and future shareholders.
The Plan continues in effect only so long as it is approved at
least annually by the vote of a majority of the Board of Directors,
including a majority of the 12b-1 directors, cast in person at a meeting
called for the purpose of voting on the Plan. The Plan may be terminated
with respect to the Fund by a vote of a majority of the 12b-1 directors or
by vote of a majority of the outstanding voting securities of the Fund.
Any change in the Plan that would materially increase the distribution
costs to the Fund requires shareholder approval; otherwise, the Plan may
be amended by the directors, including a majority of the 12b-1 directors.
Rule 12b-1 requires that any person authorized to direct the
disposition of monies paid or payable by the Fund, pursuant to the Plan or
any related agreement, shall provide to the Corporation's Board of
Directors, and the directors shall review, at least quarterly, a written
report of any amounts expended pursuant to the Plan and the purposes for
which such expenditures were made. In addition, as long as the Plan is in
effect, the selection and nomination of the directors who are not
interested persons of the Corporation will be committed to the discretion
of such non-interested directors.
As compensation for its services and expenses, Legg Mason
receives from the Fund, annual distribution and service fees each
equivalent to 0.25% of the Fund's average daily net assets in accordance
with the Plan. The distribution and service fees are computed daily and
- 45 -
<PAGE>
paid monthly. For the period February 1, 1994 (commencement of
operations) to December 31, 1994, the Fund paid distribution and service
fees of $194,692 to Legg Mason pursuant to the Underwriting Agreement.
PORTFOLIO TRANSACTIONS AND BROKERAGE
The portfolio turnover rate is computed by dividing the lesser of
purchases or sales of securities for the period by the average value of
portfolio securities for that period. Short-term securities are excluded
from the calculation. For the period February 1, 1994 (commencement of
operations) to December 31, 1994, the Fund's annualized portfolio turnover
rate was 67.39%.
Under the Advisory Agreement, the Adviser is responsible for the
execution of the Fund's portfolio transactions and must seek the most
favorable price and execution for such transactions, subject to the
possible payment (as described below) of higher brokerage commissions or
spreads to brokers who provide research and analysis. The Fund may not
always pay the lowest commission or spread available. Rather, the
Adviser also will take into account such factors as size of the order,
difficulty of execution, efficiency of the executing broker's facilities
(including the services described below), and any risk assumed by the
executing broker.
Consistent with the policy of most favorable price and execution,
the Adviser may give consideration to research, statistical and other
services furnished by brokers or dealers to the Adviser for its use, may
place orders with broker-dealers who provide supplemental investment and
market research and securities and economic analysis, and may, for agency
transactions, pay to those broker-dealers a higher brokerage commission
than may be charged by other brokers. Such services include, without
limitation, advice as to the value of securities; the advisability of
investing in, purchasing, or selling securities; advice as to the
availability of securities or of purchasers or sellers of securities; and
furnishing analyses and reports concerning issuers, industries,
securities, economic factors and trends, portfolio strategy and the
performance of accounts. Such research and analysis may be useful to the
Adviser in connection with services to clients other than the Fund. The
Adviser's fee is not reduced by reason of its receiving such brokerage and
research services. For the period February 1, 1994 (commencement of
operations) to December 31, 1994, the Fund paid no brokerage commissions.
From time to time, the Fund may use Legg Mason as broker for
agency transactions in listed and over-the-counter securities at
commission rates and under circumstances consistent with the policy of
best execution. Commissions paid to Legg Mason will not exceed "usual and
customary brokerage commissions." Rule 17e-1 under the 1940 Act defines
"usual and customary" commissions to include amounts which are "reasonable
and fair compared to the commission, fee or other remuneration received or
to be received by other brokers in connection with comparable transactions
involving similar securities being purchased or sold on a securities
exchange during a comparable period of time." The Adviser also selects
- 46 -
<PAGE>
other brokers to execute portfolio transactions. In the over-the-counter
market, the Fund generally deals with responsible primary market-makers
unless the Adviser believes a more favorable execution can otherwise be
obtained.
The Fund may not buy securities from, or sell securities to, Legg
Mason or its affiliated persons as principal. However, the Corporation's
Board of Directors has adopted procedures in conformity with Rule 10f-3
under the 1940 Act whereby the Fund may purchase securities that are
offered in certain underwritings in which Legg Mason or any of its
affiliated persons is a participant. These procedures, among other
things, limit the Fund's investment in the amount of securities of any
class of securities offered in an underwriting in which Legg Mason or any
of its affiliated persons is a participant so that: (i) the Fund together
with all other registered investment companies advised by the Adviser, may
not purchase more than 4% of the principal amount of the offering of such
class or $500,000 in principal amount, whichever is greater, but in no
event greater than 10% of the principal amount of the offering; and (ii)
the consideration to be paid by the Fund in purchasing the securities
being offered may not exceed 3% of the total assets of the Fund. In
addition, the Fund may not purchase securities during the existence of an
underwriting if Legg Mason is the sole underwriter of those securities.
Investment decisions for the Fund are made independently from
those of other accounts advised by the Adviser. However, the same
security may be held in the portfolios of more than one fund or account.
When two or more accounts simultaneously engage in the purchase or sale of
the same security, the prices and amounts will be equitably allocated to
each account. In some cases, this procedure may adversely affect the
price or quantity of the security available to a particular account. In
other cases, however, an account's ability to participate in large-volume
transactions may produce better executions and prices.
THE FUND'S CUSTODIAN AND
TRANSFER AND DIVIDEND-DISBURSING AGENT
State Street Bank and Trust Company ("State Street"), P.O. Box
1790, Boston, Massachusetts 02105, serves as custodian of the Fund's
assets. Boston Financial Data Services, P.O. Box 953, Boston,
Massachusetts 02103, serves as transfer and dividend-disbursing agent,
and administrator of various shareholder services. Legg Mason also
assists BFDS with certain of its duties as transfer agent for which BFDS
pays Legg Mason a fee. For the period February 1, 1994 (commencement of
operations) to December 31, 1994, Legg Mason received $9,327 for such
services in connection with this Fund. Shareholders who request an
historical transcript of their account will be charged a fee based on the
number of years researched. The Fund reserves the right, upon 60 days'
written notice, to make other charges to investors to cover administrative
costs.
- 47 -
<PAGE>
THE CORPORATION'S LEGAL COUNSEL
Kirkpatrick & Lockhart LLP, 1800 M Street, N.W., Washington, D.C.
20036, serves as counsel to the Fund.
THE CORPORATION'S INDEPENDENT ACCOUNTANTS
Coopers & Lybrand L.L.P., 217 E. Redwood Street, Baltimore, MD.
21202, have been selected by the Fund to serve as the Fund's independent
accountants.
FINANCIAL STATEMENTS
The Statement of Net Assets as of December 31, 1994; the
Statement of Operations for the period February 1, 1994 (commencement of
operations) to December 31, 1994; the Statement of Changes in Net Assets
for the period February 1, 1994 (commencement of operations) to December
31, 1994; the Financial Highlights for the period February 1, 1994
(commencement of operations) to December 31, 1994; the Notes to Financial
Statements and the Report of the Independent Accountants, all of which are
included in the Fund's annual report for the period ended December 31,
1994, are hereby incorporated by reference in this Statement of Additional
Information.
- 48 -
<PAGE>
</TABLE>
