<PAGE>
LEGG MASON
INCOME TRUST, INC.:
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LEGG MASON U.S. GOVERNMENT
INTERMEDIATE-TERM PORTFOLIO
LEGG MASON INVESTMENT GRADE INCOME
PORTFOLIO
LEGG MASON HIGH YIELD PORTFOLIO
LEGG MASON U.S. GOVERNMENT MONEY
MARKET PORTFOLIO
PRIMARY SHARES PROSPECTUS May 3, 1999
[LEGG MASON GRAPHIC GOES HERE]
HOW TO INVEST(SM)
As with all mutual funds, the Securities and Exchange Commission
has not passed upon the adequacy of this prospectus, nor has it
approved or disapproved these securities. It is a criminal offense
to state otherwise.
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TABLE OF CONTENTS
About the funds:
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<TABLE>
<S> <C>
1 Investment objectives
5 Principal risks
8 Performance
12 Fees and expenses of the funds
14 Management
</TABLE>
About your investment:
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<TABLE>
<S> <C>
16 How to invest
18 How to sell your shares
19 Account policies
20 Services for investors
21 Dividends and taxes
22 Financial highlights
</TABLE>
<PAGE>
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LEGG MASON INCOME TRUST, INC.
[GRAPHIC]
INVESTMENT OBJECTIVES
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The Legg Mason Income Trust, Inc. offers four series: Legg Mason U.S.
Government Intermediate-Term Portfolio, Legg Mason Investment Grade
Income Portfolio, Legg Mason High Yield Portfolio and Legg Mason U.S.
Government Money Market Portfolio.
Western Asset's approach in managing these four funds revolves around
an investment outlook developed by its Investment Strategy Group, a
team of senior professionals that meets at least twice a week to
review developments in the economy and the markets. Based on their
consensus view of the economic outlook for the following six months,
this group arrives at a recommended portfolio structure, including
targets for duration, yield curve exposure, and sector allocation.
Western's Portfolio Management Group implements the strategy in a
manner consistent with the investment policies of each fund, using
information on the relative credit strength, liquidity, issue
structure, event risk, covenant protection and market valuation of
available securities developed by the Research Group. Each fund is
managed in accordance with the investment objective and policies
described below.
U.S. Government Intermediate-Term Portfolio
Investment objective: high current income consistent with prudent
investment risk and liquidity needs
Principal investment strategies:
The fund, under normal circumstances, invests at least 75% of its
total assets in obligations issued or guaranteed by the U.S.
Government, its agencies or instrumentalities, or repurchase
agreements secured by such securities. Investments in mortgage-related
securities issued by governmental or government-related entities will
be included in the 75% limitation.
The balance of the fund, up to 25% of its total assets, may be
invested in commercial paper and investment grade debt securities
rated within one of the four highest grades assigned by Standard &
Poor's or Moody's Investors Service, Inc., securities comparably rated
by another nationally recognized statistical rating organization, or
unrated securities judged by the adviser to be of comparable quality.
Although the fund can invest in securities of any maturity, it expects
to maintain a dollar-weighted average maturity of between three and
ten years.
The fund may hold cash or money market instruments without limit for
temporary defensive purposes or pending investment. As a result, the
fund may not achieve its investment objective when so invested.
Legg Mason Income Trust
1
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Investment Grade Income Portfolio
Investment objective: high level of current income through investment
in a diversified portfolio of debt securities
Principal investment strategies:
The fund invests primarily in fixed-income securities which the
adviser considers to be investment grade. Although the fund can invest
in securities of any maturity, it expects to maintain a
dollar-weighted average maturity of between five and twenty years.
The fund invests, under normal circumstances, at least 75% of its
total assets in the following types of investment grade fixed-income
securities:
o debt securities which are rated at the time of purchase within the
four highest grades assigned by Moody's or S&P, or, if unrated by
Moody's or S&P, judged by the adviser to be of comparable quality;
o securities of, or guaranteed by, the U.S. Government, it agencies
or instrumentalities;
o commercial paper and other money market instruments which are rated
A-1 or A-2 by S&P or Prime-1 or Prime-2 by Moody's at the date of
investment, or if unrated by Moody's or S&P, judged by the adviser
to have investment quality comparable to securities which may be
purchased under the first item above; bank certificates of deposit;
and bankers' acceptances; and
o preferred stocks (including step down preferred securities) rated no
lower than Baa by Moody's or, if unrated by Moody's, judged by the
adviser to be of comparable quality.
The remainder of the fund's assets, not in excess of 25% of its total
assets, may be invested in:
o debt securities of issuers which are rated at the time of purchase
below Moody's and S&P's four highest grades, but rated B or better
by Moody's or S&P, or if unrated by Moody's or S&P, judged by the
adviser to be of comparable quality; and
o securities which may be convertible into or exchangeable for, or
carry warrants to purchase, common stock or other equity interests.
Securities purchased by the fund may be privately placed. The fund may
hold cash or money market instruments without limit for temporary
defensive purposes or pending investment. As a result, the fund may
not achieve its investment objective when so invested.
2
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High Yield Portfolio
Investment objectives: high current income and, secondarily, capital
appreciation
Principal investment strategies:
The fund's adviser, under normal circumstances, invests at least 65%
of the fund's total assets in high yield, fixed-income securities,
including those commonly known as "junk bonds". Such securities
include, but are not limited to: foreign and domestic corporate debt
securities and debt securities of other issuers, preferred stocks,
convertible securities, zero coupon securities, deferred interest
securities, mortgage-backed securities, asset-backed securities,
commercial paper and obligations issued or guaranteed by foreign
governments or any of their respective political subdivisions,
agencies or instrumentalities, including repurchase agreements secured
by such instruments. Most fixed-income securities in which the fund
invests are rated BBB/Baa or lower, or are unrated but deemed by the
adviser to be of equivalent quality.
The fund's remaining assets may be held in cash or money market
instruments, or invested in common stocks and other equity securities
when these types of investments are consistent with the objectives of
the fund or are acquired as part of a unit consisting of a combination
of fixed-income securities and equity investments. Such remaining
assets may also be invested in fixed-income securities rated above BBB
by S&P or Baa by Moody's, securities comparably rated by another
nationally recognized statistical rating organization, or unrated
securities deemed by the adviser to be of equivalent quality.
The fund may invest up to 25% of its total assets in private
placements and securities which, though not registered at the time of
their initial sale, are issued with registration rights. This
limitation does not apply to securities purchased pursuant to Rule
144A.
The fund may invest up to 25% of its total assets in securities
denominated in foreign currencies, including securities of issuers
based in emerging markets.
The fund may hold cash or money market instruments without limit for
temporary defensive purposes or pending investment. As a result, the
fund may not achieve its investment objective when so invested.
Legg Mason Income Trust
3
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U.S. Government Money Market Portfolio
Investment objective: high current income consistent with liquidity
and conservation of principal
Principal investment strategies:
The fund is a money market fund that seeks to maintain a net asset
value of $1.00 per share. To achieve its objective, the fund adheres
to the following practices:
o it invests only in U.S. Government obligations, repurchase
agreements secured by such instruments, and securities issued or
guaranteed by multi-national development banks of which the U.S. is
a member, such as the World Bank.
o it invests at least 65% of its total assets in securities issued or
guaranteed by the U.S. Government, its agencies or instrumentalities
and in repurchase agreements secured by such securities.
o it buys money market securities maturing in 397 days or less. (It
can also buy certain variable and floating rate securities the
adviser believes will act as though they have maturities of 397 days
or less.)
o it maintains a dollar-weighted average portfolio maturity of 90 days
or less.
o it buys only high-quality money market securities which the adviser
determines to present minimal credit risk.
4
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[GRAPHIC]
PRINCIPAL RISKS
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In general -
As with all mutual funds, an investment in any of these funds is not
insured or guaranteed by the Federal Deposit Insurance Corporation or
any other government agency; investors can lose money by investing in
the funds. Although Government Money Market seeks to maintain a net
asset value of $1.00 per share, there can be no assurance that the
fund will always be able to do so. There is no guarantee that any fund
will achieve its objective.
Interest rate risk -
Each fund is subject to interest rate risk, which is the possibility
that the market prices of the funds' investments may decline due to an
increase in market interest rates. Generally, the longer the maturity
of a fixed-income security, the greater is the effect on its value
when rates increase.
Certain securities pay interest at variable or floating rates.
Variable rate securities reset at specified intervals, while floating
rate securities reset whenever there is a change in a specified index
rate. In most cases, these reset provisions reduce the effect of
market interest rates on the value of the security. However, some
securities do not track the underlying index directly, but reset based
on formulas that can produce an effect similar to leveraging; others
may provide for interest payments that vary inversely with market
rates. The market prices of these securities may fluctuate
significantly when interest rates change.
Credit risk -
Each fund is also subject to credit risk, i.e., the risk that an
issuer of securities will be unable to pay principal and interest when
due, or that the value of the security will suffer because investors
believe the issuer is less able to pay. This is broadly gauged by the
credit ratings of the securities in which each fund invests. However,
ratings are only the opinions of the agencies issuing them and are not
absolute guarantees as to quality.
Moody's considers debt securities rated Baa to have speculative
characteristics. Debt securities rated below Baa/BBB are deemed by the
ratings agencies to be speculative and may involve major risk of
exposure to adverse conditions. High Yield may invest in securities
rated as low as C by Moody's or D by S&P. These ratings indicate that
the securities are highly speculative and may be in default or in
danger of default as to principal and interest. Therefore, High Yield
is subject to credit risk to a greater extent than the other funds.
Legg Mason Income Trust
5
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Not all government securities are backed by the full faith and credit
of the United States. Some are backed only by the credit of the
issuing agency or instrumentality. Accordingly, there is at least a
chance of default on these securities.
Call risk -
Many fixed-income securities, especially those issued at high interest
rates, provide that the issuer may repay them early. Issuers often
exercise this right when interest rates are low. Accordingly, holders
of callable securities may not benefit fully from the increase in
value that other fixed-income securities experience when rates
decline. Furthermore, the fund reinvests the proceeds of the payoff at
current yields, which are lower than those paid by the security that
was paid off.
Special risks of high yield securities -
Securities rated below Baa/BBB are subject to greater fluctuations in
value and risk of loss of income and principal due to default by the
issuer, than are higher rated securities. These securities may be less
liquid than higher-rated securities, which means the fund may have
difficulty selling them at times, and may have to apply a greater
degree of judgment in establishing a price. These securities
constitute the primary focus of the High Yield Portfolio. Investment
Grade Portfolio can invest in them to a limited extent.
Special risks of mortgage-backed securities -
Mortgage-backed securities represent an interest in a pool of
mortgages. When market interest rates decline, many mortgages are
refinanced, and mortgage-backed securities are paid off earlier than
expected. The effect on the fund's return is similar to that discussed
above for call risk.
When market interest rates increase, the market values of
mortgage-backed securities decline. At the same time, however,
mortgage refinancing slows, which lengthens the effective maturities
of these securities. As a result, the negative effect of the rate
increase on the market value of mortgage securities is usually more
pronounced than it is for other types of fixed-income securities.
Other risks -
The use of certain derivatives to hedge interest rate or other risks
could affect fund performance if the derivatives do not perform as
expected.
The values of foreign securities are subject to economic and political
developments in the countries and regions where the companies operate,
such as changes in economic or monetary policies, and to changes in
exchange rates. In general, less information is publicly available
about foreign companies than
6
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about U.S. companies. Some foreign governments have defaulted on
principal and interest payments.
The investment strategies employed by the funds (except Government
Money Market) often involve high turnover rates. This results in
higher trading costs and could cause a fund to realize higher levels
of taxable gains.
Compliance with the percentage investment policies and limitations
described in this prospectus is measured as of the time an investment
is made. A fund is not required to sell a security if changing market
prices or changes in the level of fund assets cause a percentage
limitation to be exceeded. Accordingly, a fund's composition at any
given time may not be within the stated limitations.
Year 2000 -
Like other mutual funds (and most organizations around the world), the
funds could be adversely affected by computer problems related to the
year 2000. These could interfere with operations of the funds, their
manager, distributor or adviser, or could impact companies in which
the funds invest. The year 2000 poses an even greater risk for foreign
securities.
While no one knows if these problems will have any impact on the funds
or on financial markets in general, the manager and its affiliates are
taking steps to protect fund investors. These include efforts to
determine that the problem will not directly affect the systems used
by major service providers.
Whether these steps will be effective can only be known for certain in
the year 2000.
Legg Mason Income Trust
7
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[GRAPHIC]
PERFORMANCE
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The information below provides an indication of the risks of investing in a fund
by showing changes in each fund's performance from year to year. Annual returns
assume reinvestment of dividends and distributions. Historical performance of a
fund does not necessarily indicate what will happen in the future. A fund's
yield is its net income over a recent 30-day (or 7-day with respect to a money
market fund) period, expressed as an annualized rate of return. For a fund's
current yield, call toll-free 1-800-822-5544.
U.S. Government Intermediate-Term Portfolio -- Primary Shares
Year by year total return as of December 31 of each year (%):
[CHARTS APPEARS HERE]
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
12.80 9.10 14.40 6.28 6.64 -1.93 13.88 4.47 6.85 6.56
During the past ten years:
<TABLE>
<S> <C> <C>
Quarter Ended Total Return
- --------------------- ------------------- --------------------
Best quarter: June 30, 1989 +6.98%
Worst quarter: March 31, 1994 -1.45%
</TABLE>
In the following table, average annual total returns as of December
31, 1998 are compared with the Salomon Brothers Medium-Term
Treasury/Government-Sponsored Index.
<TABLE>
<S> <C> <C> <C>
1 Year 5 Years 10 Years
- ---------------------------------------- ----------- ----------- ------------
U.S Government Intermediate-Term
Portfolio +6.56% +5.87% +7.80%
Salomon Brothers Medium-Term
Treasury/Government-Sponsored
Index +8.51% +6.47% +8.36%
</TABLE>
These figures include changes in principal value, reinvested dividends
and capital gain distributions, if any.
8
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Investment Grade Income Portfolio -- Primary Shares
Year by year total return as of December 31 of each year (%):
[CHART APPEARS HERE]
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
13.00 5.60 16.00 6.77 11.22 -4.82 20.14 4.31 10.31 8.89
During the past ten years:
<TABLE>
<S> <C> <C>
Quarter Ended Total Return
- --------------------- ------------------- --------------------
Best quarter: June 30, 1989 +7.26%
Worst quarter: March 31, 1994 -2.91%
</TABLE>
In the following table, average annual total returns as of December
31, 1998 are compared with the Salomon Brothers Broad Investment-Grade
Bond Index.
<TABLE>
<S> <C> <C> <C>
1 Year 5 Years 10 Years
- ------------------------------------------ ----------- ----------- ------------
Investment Grade Income Portfolio +6.99% +7.08% +8.77%
Salomon Brothers Broad
Investment-Grade Bond Index +8.71% +7.30% +9.31%
</TABLE>
These figures include changes in principal value, reinvested dividends
and capital gain distributions, if any.
Legg Mason Income Trust
9
<PAGE>
High Yield Portfolio -- Primary Shares
Year by year total return as of December 31 of each year (%):
[CHART APPEARS HERE]
1995 1996 1997 1998
---- ---- ---- ----
18.01 14.91 15.86 -1.79
During the last four years:
<TABLE>
<S> <C> <C>
Quarter Ended Total Return
- --------------------- ----------------------- --------------------
Best quarter: June 30, 1995 +5.48%
Worst quarter: September 30, 1998 -9.52%
</TABLE>
In the following table, average annual total returns as of December
31, 1998 are compared with the Lehman High Yield Index.
<TABLE>
<S> <C> <C>
1 Year Life of Class
- -------------------------------- ------------ ---------------------
High Yield Portfolio -1.79% +8.57%(a)
Lehman High Yield Index +1.87% +8.44%(b)
</TABLE>
These figures include changes in principal value, reinvested dividends
and capital gain distributions, if any.
(a) February 1, 1994 (commencement of operations) to December 31,
1998.
(b) For the period February 28, 1994 to December 31, 1998.
10
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U.S. Government Money Market Portfolio
Year by year total return as of December 31 of each year (%):
[CHART APPEARS HERE]
1990 1991 1992 1993 1994 1995 1996 1997 1998
---- ---- ---- ---- ---- ---- ---- ---- ----
7.58 5.87 3.49 2.80 3.86 5.31 4.81 4.86 4.63
During the last nine years:
<TABLE>
<S> <C> <C>
Quarter Ended Total Return
- --------------------- ----------------------- --------------------
Best quarter: June 30, 1990 +1.86%
Worst quarter: September 30, 1993 +0.68%
</TABLE>
In the following table, average annual total returns as of December
31, 1998 are compared with the Donoghue Government/Agency Index.
<TABLE>
<S> <C> <C> <C>
1 Year 5 Years Life of Fund(a)
- ----------------------------------------- ----------- ----------- --------------------
U.S Government Money Market
Portfolio +4.83% +4.69% +5.14%
Donoghue Government/Agency Index +5.59% +5.38% +5.71%
</TABLE>
These figures include changes in principal value, if any, and
reinvested dividends.
(a) January 31, 1989 (commencement of operations) to December 31,
1998.
Legg Mason Income Trust
11
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[GRAPHIC]
FEES AND EXPENSES OF THE FUNDS
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The table below describes the fees and expenses you will incur
directly or indirectly as an investor in a fund. Each fund pays
operating expenses directly out of its assets so they lower that
fund's share price and dividends. Other expenses include transfer
agency, custody, professional and registration fees. The funds have no
sales charge but are subject to a 12b-1 fee. The funds charge no
redemption fees.
The fees shown are current fees, and the expenses shown are based on
expenses for the fiscal year ended December 31, 1998. The fees and
expenses are calculated as a percentage of average net assets.
<TABLE>
<S> <C> <C> <C> <C>
Annual Fund Operating Expenses
(expenses that are deducted from fund assets)
- -------------------------------------------------------------------------------------------------
Government
Government Investment High Money
Intermediate Grade Yield Market
Management fees 0.55%(a) 0.60%(a) 0.65% 0.50%
Distribution and/or
Service (12b-1) fees 0.50% 0.50% 0.50% 0.20%(b)
Other expenses 0.15% 0.25% 0.15% 0.15%
- ------------------------- ------------- ------------- ----------- -------------
Total Annual Fund
Operating Expenses 1.20%(a) 1.35%(a) 1.30% 0.85%(b)
</TABLE>
(a)The manager has a voluntary agreement to waive fees so that
Primary Share expenses (exclusive of taxes, interest, brokerage and
extraordinary expenses) do not exceed an annual rate of 1.00% of
average daily net assets attributable to Primary Shares during any
month for Government Intermediate or until its net assets reach
$500 million, and for Investment Grade, or until its net assets
reach $250 million. These voluntary waivers will continue until
August 1, 1999, but may be terminated at any time.
(b)Legg Mason has agreed to waive 0.10% of the 12b-1 service fee
indefinitely, reducing total expenses from 0.85% to 0.75%.
12
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Example:
This example helps you compare the cost of investing in a fund with
the cost of investing in other mutual funds. Although your actual
costs may be higher or lower, you would pay the following expenses on
a $10,000 investment in a fund, assuming (1) a 5% return each year,
(2) the fund's operating expenses remain the same as shown in the
table above, and (3) you redeem all of your shares at the end of the
time periods shown. Actual returns may be higher or lower than 5% per
year.
<TABLE>
<S> <C> <C> <C> <C>
1 Year 3 Years 5 Years 10 Years
- ----------------------- ---------- ----------- ----------- -----------
Government
Intermediate $ 122 $ 381 $ 660 $ 1,455
Investment Grade $ 137 $ 428 $ 739 $ 1,624
High Yield $ 132 $ 412 $ 713 $ 1,568
Government Money
Market $ 87 $ 271 $ 471 $ 1,049
</TABLE>
Under the fee waiver arrangements described above, your costs for the
one, three, five and ten year periods would be: for Government
Intermediate, $102, $318, $552 and $1,225; for Investment Grade, $102,
$318, $552 and $1,225; and for Government Money Market, $77, $240,
$417 and $930.
Legg Mason Income Trust
13
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[GRAPHIC]
MANAGEMENT
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Management and Adviser:
Legg Mason Fund Adviser, Inc., 100 Light Street, Baltimore, Maryland
21202, is the funds' manager. The manager is responsible for the
non-investment affairs of the funds, providing office space and
administrative staff for the funds and directing all matters related
to the operation of the funds. The manager acts as adviser or manager
to twenty investment company portfolios which had aggregate assets
under management of approximately $18.1 billion as of March 31, 1999.
For it services, each fund paid the manager the following percentage
of its average daily net assets for the fiscal year ended December 31,
1998:
<TABLE>
<S> <C>
Government Intermediate 0.35%
Investment Grade 0.25%
High Yield 0.65%
Government Money Market 0.50%
</TABLE>
Western Asset Management Company, 117 East Colorado Boulevard,
Pasadena, California 91105, is the funds' investment adviser. The
adviser is responsible for the actual investment management of the
funds, which includes making investment decisions and placing orders
to buy, sell or hold a particular security. The adviser acts as
investment adviser to investment companies and private accounts with
aggregate assets of $49.2 billion as of March 31, 1999. An investment
committee has been responsible for the day-to-day management of each
fund since its inception.
For its services during the fiscal year ended December 31, 1998, the
manager paid the adviser a fee, which is calculated daily and payable
monthly, at annual rates of each fund's average daily net assets as
follows:
<TABLE>
<S> <C>
Government 0.20%, not to exceed the fee paid to the manager
Intermediate (after any fee waivers)
- ----------------------- ---------------------------------------------------
Investment Grade 0.24%, or 40% of the fee received by the manager
- ----------------------- ---------------------------------------------------
High Yield 0.50%, or 77% of the fee received by the manager
- ----------------------- ---------------------------------------------------
Government Money
Market 0.15%, or 30% of the fee received by the manager
</TABLE>
Distributor of the funds' shares:
Legg Mason Wood Walker, Incorporated, 100 Light Street, Baltimore,
Maryland 21202, distributes the funds' shares. Each fund has adopted a
plan that allows it to pay distribution fees and shareholder service
fees for the sale of its shares and
14
<PAGE>
for services provided to shareholders. Under each plan, Government
Intermediate, Investment Grade and High Yield may pay the distributor
an annual distribution fee and an annual service fee, each of which is
equal to 0.25% of that fund's average daily net assets attributable to
Primary Shares. Government Money Market may pay the distributor an
annual fee equal to 0.20% of its average daily net assets. However,
the Board has authorized payment of only 0.10% annually of the fund's
average daily net assets indefinitely.
Because these fees are paid out of the funds' assets on an ongoing
basis, over time these fees will increase the cost of your investment
and may cost you more than paying other types of sales charges.
The distributor may enter into agreements with other brokers to sell
Primary Shares of each fund. The distributor pays these brokers up to
90% of the distribution and/or shareholder service fee that it
receives from a fund for those sales.
The manager, adviser and distributor are wholly owned subsidiaries of
Legg Mason, Inc., a financial services holding company.
Government Intermediate, Investment Grade and High Yield currently
offer two classes of shares -- Class A (known as "Primary Shares") and
Class Y (known as "Navigator Shares"). The two classes represent
interests in the same pool of assets. A separate vote is taken by a
class of shares if a matter affects just that class of shares. Each
class of shares may bear certain differing class-specific expenses.
Salespersons and others entitled to receive compensation for selling
or servicing fund shares may receive more with respect to one class
than another.
Legg Mason Income Trust
15
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[GRAPHIC]
HOW TO INVEST
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To open a regular account or a retirement account with one or more of the
funds, contact a Legg Mason financial advisor or other entity that has entered
into an agreement with the funds' distributor to sell shares of the Legg Mason
family of funds. A Legg Mason financial advisor will explain the shareholder
services available from our funds and answer any questions you may have. The
minimum initial investment for regular accounts and retirement accounts is
$1,000 and the minimum for each purchase of additional shares is $100, except
as noted below.
Retirement accounts include traditional IRAs, spousal IRAs, education IRAs,
Roth IRAs, simplified employee pension plans, savings incentive match plans
for employees and other qualified retirement plans. Contact your Legg Mason
financial advisor or other entity offering the funds to discuss which one
might be appropriate for you.
<TABLE>
<S> <C>
Once your account is open, you may use the following methods to add to your
account:
- ---------------------------------------------------------------------------------------------------------------
In Person Give your financial advisor a check for $100 or more ($500 or more for Government
Money Market) payable to the fund
- ------------------ -------------------------------------------------------------------------------------------
Mail Mail your check, payable to the fund, for $100 or more ($500 or more for Government
Money Market) to your financial advisor
- ------------------ -------------------------------------------------------------------------------------------
Telephone Call your financial advisor to transfer available cash balances in
or Wire your brokerage account or to transfer money from your bank directly to
Legg Mason. Wire transfers may be subject to a service charge by your bank.
- ------------------ -------------------------------------------------------------------------------------------
Future First Contact your Legg Mason financial advisor to enroll in Legg
Systematic Mason's Future First Systematic Investment Plan. Under this plan,
Investment you may arrange for automatic monthly investments in a fund of $50
Plan or more.The transfer agent will transfer funds monthly from your Legg
Mason account or from your checking account to purchase shares of
the desired fund.
----------------- ---------------------------------------------------------------------------------------------
Automatic Arrangements may be made with some employers and financial
Investments institutions for regular automatic monthly investments of $50 or
more in shares of a fund.You may also reinvest dividends from
certain unit investment trusts in shares of a fund.
----------------- ---------------------------------------------------------------------------------------------
</TABLE>
Call your financial advisor or another entity offering the funds for sale with
any questions regarding the investment options above.
Certain investment methods may be subject to lower minimum initial and
additional investments.
16
<PAGE>
Investments made through entities other than Legg Mason may be subject to
transaction fees or other purchase conditions established by those entities.
You should consult their program literature for further information.
For Government Intermediate, Investment Grade and High Yield:
Purchase orders received by your financial advisor or the entity offering the
funds before the close of the New York Stock Exchange (normally 4:00 p.m.,
Eastern time) will be processed at the fund's net asset value as of the close
of the exchange on that day. Orders received after the close of the exchange
will be processed at the fund's net asset value as of the close of the
exchange on the next day the exchange is open. Payment must be made within
three business days to Legg Mason.
You will begin to earn dividends as of settlement date, which is normally the
third business day after your order is placed with a financial advisor.
For Government Money Market:
Purchase orders received in federal funds form, by either your Legg Mason
financial advisor or the entity offering the fund, on any day that the New
York Stock Exchange is open will be processed as follows:
<TABLE>
<S> <C> <C>
If the purchase order is Shares will be purchased at the Such shares will begin to earn
received net asset value determined on the dividends on the
- ---------------------------------- ----------------------------------- --------------------------------
before 12:00 noon, same day same day
Eastern time
12:00 noon or after, but same day next day
before 4:00 p.m.,
Eastern time
after 4:00 p.m., Eastern time next day next day
</TABLE>
If you do not make payment in federal funds, your order will be processed when
payment is converted into federal funds, which is usually completed in two
days, but may take up to ten days. Most bank wires are federal funds.
Legg Mason Income Trust
17
<PAGE>
[GRAPHIC]
HOW TO SELL YOUR SHARES
--------------------------------------------------------------------------
Redemptions made through entities other than Legg Mason may be subject to
transaction fees or other conditions imposed by those entities. You should
consult their program literature for further information.
<TABLE>
<S> <C>
Any of the following methods may be used to sell your Primary Shares:
Telephone Call your Legg Mason financial advisor or entity
offering the fund and request a redemption.
Telephone redemption requests for shares of
Government Money Market must be for at least $100.
Please have the following information ready when you
call: the name of the fund, the number of shares (or
dollar amount) to be redeemed and your shareholder
account number.
Proceeds will be credited to your brokerage
account or a check will be sent to you, at your
direction, at no charge to you. Wire requests will
be subject to a fee of $18. Be sure that your
financial advisor has your bank account information
on file.
The fund will follow reasonable procedures to
ensure the validity of any telephone redemption
request, such as requesting identifying information
from callers or employing identification numbers.
Unless you specify that you do not wish to have
telephone redemption privileges, you may be held
responsible for any fraudulent telephone order.
Mail Send a letter to the fund requesting redemption of
your shares. The letter should be signed by all of
the owners of the account and, for Government
Intermediate, Investment Grade and High Yield, their
signatures guaranteed without qualification. For
Government Money Market, redemption requests for
shares valued at $10,000 or more or when the
proceeds are to be paid to someone other that the
accountholder will require a signature guarantee.
You may obtain a signature guarantee from most banks
or securities dealers.
Checkwriting The fund offers a free checkwriting service. You may
(Government Money write checks to anyone in amounts of $500 or more.
Market only) The fund's transfer agent will redeem sufficient
shares from your account to pay the checks. You will
continue to earn dividends on your shares until the
check clears at the transfer agent. Please do not
use your checks to close your account.
Payment for Securities Legg Mason has special redemption procedures for
Purchases at investors who wish to purchase stocks, bonds or
Legg Mason other securities at Legg Mason. Once you've placed
(Government Money an order for securities, and have not indicated any
Market only) other payment method, fund shares will be redeemed
on the settlement date for the amount due. Fund
shares may also be redeemed to cover debit balances
in your brokerage account.
</TABLE>
Your order will be processed promptly and you will generally receive the
proceeds within a week. Fund shares will be sold at the next net asset value
calculated after your redemption request is received by your Legg Mason
financial advisor or another entity.
Redemptions of shares that were recently purchased by check or acquired
through reinvestment of dividends on such shares may be delayed for up to 10
days from the purchase date in order to allow for the check to clear.
Additional documentation may be required from corporations, executors,
partnerships, administrators, trustees or custodians.
18
<PAGE>
[GRAPHIC]
ACCOUNT POLICIES
--------------------------------------------------------------------------
For Government Intermediate, Investment Grade and High Yield:
Net asset value per Primary Share is determined daily, as of the close
of the New York Stock Exchange, on every day the exchange is open. To
calculate each fund's Primary Share price, the fund's assets are
valued and totaled, liabilities are subtracted, and the resulting net
assets are divided by the number of Primary Shares outstanding. Each
fund's securities are valued on the basis of market quotations or,
lacking such quotations, at fair value as determined under the
guidance of the Board of Directors. Securities with remaining
maturities of 60 days or less are valued at amortized cost.
Where a security is traded on more than one market, which may include
foreign markets, the securities are generally valued on the market
considered by the adviser to be the primary market. The fund will
value its foreign securities in U.S. dollars on the basis of the
then-prevailing exchange rates.
For Government Money Market:
To calculate the fund's share price, the fund's assets are valued and
totaled, liabilities are subtracted, and the resulting net assets are
divided by the number of shares outstanding. The fund seeks to
maintain a share price of $1.00 per share. The fund is priced twice a
day, as of 12:00 noon, Eastern time, and at the close of the New York
Stock Exchange (normally 4:00 p.m., Eastern time), on every day the
exchange is open. Like most other money market funds, the fund
normally values its investments using the amortized cost method.
For each fund:
Fund shares may not be held in, or transferred to, an account with any
firm that does not have an agreement with Legg Mason.
If your account falls below $500, the fund may ask you to increase
your balance. If, after 60 days, your account is still below $500, the
fund may close your account and send you the proceeds.
Each fund reserves the right to:
- reject any order for shares or suspend the offering of
shares for a period of time
- change its minimum investment amounts
- delay sending out redemption proceeds for up to seven days.
This generally applies only in cases of very large
redemptions, excessive trading or during unusual market
conditions. The funds may delay redemptions beyond seven
days, or suspend redemptions, only as permitted by the SEC.
Legg Mason Income Trust
19
<PAGE>
[GRAPHIC]
SERVICES FOR INVESTORS
--------------------------------------------------------------------------
For further information regarding any of the services below, please
contact your financial advisor or other entity offering the funds for
sale.
Confirmations and Account Statements:
Confirmations will be sent to you after each transaction involving
Primary Shares of Government Intermediate, Investment Grade and High
Yield (except a reinvestment of dividends or capital gain
distributions and purchases made through the Future First Systematic
Investment Plan or through automatic investments).
Legg Mason or the entity through which you invest will send you
account statements monthly unless there has been no activity in the
account. Legg Mason will send you statements quarterly if there has
been no activity in your account, if you participate in the Future
First Systematic Investment Plan, or if you purchase shares through
automatic investments.
Systematic Withdrawal Plan:
If you are purchasing or already own shares of a fund with a net asset
value of $5,000 or more, you may elect to make systematic withdrawals
from the fund. The minimum amount for each withdrawal is $50. You
should not purchase shares of the fund that is participating in the
plan.
Exchange Privilege:
Primary Shares of a fund may be exchanged for Primary Shares of any of
the other Legg Mason funds, provided these funds are eligible for sale
in your state of residence. You can request an exchange in writing or
by phone. Be sure to read the current prospectus for any fund into
which you are exchanging.
There is currently no fee for exchanges; however, you may be subject
to a sales charge when exchanging into a fund that has one. In
addition, an exchange of a fund's shares will be treated as a sale of
the shares and any gain on the transaction may be subject to tax.
Each fund reserves the right to:
- terminate or limit the exchange privilege of any shareholder
who makes more than four exchanges from the fund in one
calendar year
- terminate or modify the exchange privilege after 60 days'
notice to shareholders
Premier Account Status (Government Money Market only):
Legg Mason offers a Premier Asset Management Account, which combines
your fund account, a preferred customer VISA Gold debit card, a Legg
Mason brokerage account with margin borrowing availability and
unlimited checks with no minimum check amount. Other services include
automatic transfer of free credit balances in your brokerage account
to your fund account and automatic redemption of fund shares to offset
debit balances in your brokerage account. Legg Mason charges an annual
fee for the Premier Account, which is currently $85 for individuals
and $100 for corporations and businesses.
20
<PAGE>
[GRAPHIC]
DIVIDENDS AND TAXES
--------------------------------------------------------------------------
Government Intermediate, Investment Grade and Government Money Market
each declares dividends from its net investment income daily and pays
them monthly. High Yield declares and pays these dividends monthly.
Government Intermediate, Investment Grade and High Yield declare and
pay dividends from net short-term capital gain and distributions of
substantially all net capital gain (the excess of net long-term
capital gain over net short-term capital loss) and, in the case of
High Yield, net realized gains from foreign currency transactions
after the end of the taxable year in which the gain is realized. A
second distribution of net capital gain may be necessary in some years
to avoid imposition of a federal excise tax.
Government Money Market does not expect to realize any capital gain or
loss; however, if the fund realizes any capital gains, it will pay
them at least once every twelve months.
Your dividends and distributions will be automatically reinvested in
additional shares of the distributing fund. If you wish to receive
dividends and/or distributions in cash, you must notify the fund at
least 10 days before the next dividend or distribution is to be paid.
You may also request that your dividends and distributions be
reinvested in shares of another Legg Mason fund.
If the postal or other delivery service is unable to deliver your
check, your distribution option will automatically be converted to
having all dividends and distributions reinvested in fund shares. No
interest will accrue on amounts represented by uncashed distribution
or redemption checks.
Fund dividends and distributions are taxable to most investors (other
than retirement plans and other tax-exempt investors) whether received
in cash or reinvested in additional Primary Shares of the fund.
Dividends of net investment income and any net short-term capital
gains will be taxable as ordinary income. Distributions of a fund's
net capital gain will be taxable as long-term capital gain, regardless
of how long you have held your fund shares.
The sale or exchange of fund shares may result in a taxable gain or
loss, depending on whether the proceeds are more or less than the cost
of your shares.
A tax statement is sent to each investor at the end of each year
detailing the tax status of your distributions.
Each fund will withhold 31% of all dividends, capital gains
distributions and redemption proceeds payable to individuals and
certain other non-corporate shareholders who do not provide the fund
with a valid taxpayer identification number. Government Intermediate,
Investment Grade and High Yield will also withhold 31% of all
dividends and capital gain distributions payable to such shareholders
who are otherwise subject to backup withholding.
Because each investor's tax situation is different, please consult
your tax advisor about federal, state and local tax considerations.
Legg Mason Income Trust
21
<PAGE>
[GRAPHIC]
FINANCIAL HIGHLIGHTS
--------------------------------------------------------------------------
The financial highlights table is intended to help you understand each fund's
financial performance for the past 5 years. Total return represents the rate
that an investor would have earned (or lost) on an investment in a fund,
assuming reinvestment of all dividends and distributions. This information has
been audited by the funds' independent accountants, PricewaterhouseCoopers LLP,
whose report, along with the funds' financial statements, is incorporated by
reference into the Statement of Additional Information (see back cover) and is
included in the annual report. The annual report is available upon request by
calling toll-free 1-800-822-5544.
<TABLE>
<S> <C> <C> <C> <C>
Income from
Investment Operations
-------------------------------------------
Net
Realized &
Unrealized
Gain
For the Net Asset (Loss) On
Years Value, Net Investments, Total From
Ended Beginning Investment Options and Investment
Dec. 31, of Year Income Futures Operations
U.S. Government Intermediate
1998 $ 10.40 $ .56(a) $ .11 $ .67
1997 10.31 .60 (a) .09 .69
1996 10.47 .61 (a) (.16) .45
1995 9.72 .57 (a) .75 1.32
1994 10.43 .51 (a) (.71) (.20)
Investment Grade
1998 $ 10.59 $ .60(b) $ .12 $ .72
1997 10.22 .65 (b) .37 1.02
1996 10.44 .64 (b) (.22) .42
1995 9.27 .65 (b) 1.17 1.82
1994 10.40 .60 (b) (1.09) (.49)
High Yield
1998 $ 16.29 $ 1.32 $ (1.56) $ (.24)
1997 15.37 1.35 .99 2.34
1996 14.62 1.33 .76 2.09
1995 13.57 1.29 1.05 2.34
1994(c) 15.00 1.02 (1.44) (.42)
Government Money Market
1998 $ 1.00 $ .05 $ (Nil) $ .05
1997 1.00 .05 Nil .05
1996 1.00 .05 Nil .05
1995 1.00 .05 Nil .05
1994 1.00 .04 (Nil) .04
<S> <C> <C> <C> <C> <C>
Distributions
-----------------------------------------------------
For the In Excess From Net Net Asset
Years From Net of Net Realized Value,
Ended Investment Investment Gain on Total End of
Dec. 31, Income Income Investments Distributions Year
U.S. Government Intermediate
1998 $ (.55) $ (.01) $ -- $ (.56) $ 10.51
1997 (.59) (.01) -- (.60) 10.40
1996 (.60) (.01) -- (.61) 10.31
1995 (.57) -- -- (.57) 10.47
1994 (.51) -- -- (.51) 9.72
Investment Grade
1998 $ (.60) $ -- $ (.19) $ (.79) $ 10.52
1997 (.65) -- -- (.65) 10.59
1996 (.64) -- -- (.64) 10.22
1995 (.65) -- -- (.65) 10.44
1994 (.60) -- (.04) (.64) 9.27
High Yield
1998 $ (1.32) $ -- $ (.01) $ (1.33) $ 14.72
1997 (1.34) -- (.08) (1.42) 16.29
1996 (1.34) -- -- (1.34) 15.37
1995 (1.29) -- -- (1.29) 14.62
1994(c) (1.01) -- -- (1.01) 13.57
Government Money Market
1998 $ (.05) $ -- $ -- $ (.05) $ 1.00
1997 (.05) -- -- (.05) 1.00
1996 (.05) -- -- (.05) 1.00
1995 (.05) -- -- (.05) 1.00
1994 (.04) -- -- (.04) 1.00
</TABLE>
22
<PAGE>
<TABLE>
<S> <C> <C> <C> <C> <C>
Ratios/Supplemental Data:
----------------------------------------------------------------------------------------------
Ratio of Net Investment
Expenses Income (Loss)
For the to Average to Average Portfolio Net Assets,
Years Ended Total Return Net Assets Net Assets Turnover Rate End of Year
Dec. 31, (%) (%) (%) (%) (thousands -- $)
U.S. Government Intermediate
1998 6.56 1.00(a) 5.30(a) 356 352,729
1997 6.95 1.00(a) 5.84(a) 252 300,952
1996 4.47 .98(a) 5.91(a) 354 293,846
1995 13.88 .93(a) 5.59(a) 290 231,886
1994 -1.93 .90(a) 5.11(a) 316 231,255
Investment Grade
1998 6.99 1.00(b) 5.68(b) 279 169,129
1997 10.31 1.00(b) 6.28(b) 259 122,100
1996 4.31 .97(b) 6.42(b) 383 91,928
1995 20.14 .88(b) 6.49(b) 221 85,633
1994 -4.82 .85(b) 6.09(b) 200 66,196
High Yield
1998 (1.79) 1.30 8.17 107 433,947
1997 15.86 1.30 8.60 116 382,143
1996 14.91 1.35 9.05 77 234,108
1995 18.01 1.47 9.28 47 108,417
1994(c) (2.90)(d) 1.60(e) 8.40(e) 67(e) 53,424
Government Money Market
1998 4.83 .75 4.73 -- 389,466
1997 4.86 .75 4.77 -- 324,696
1996 4.81 .66 4.71 -- 325,210
1995 5.31 .67 5.17 -- 316,646
1994 3.66 .69 3.66 -- 214,576
</TABLE>
(a) Net of fees waived by the manager for expenses exceeding the following
expense limitations: 0.9% until April 30, 1995; 0.95% until April 30, 1996;
and 1.00% until August 1, 1999. If no fees had been waived by LMFA, the
annualized ratio of expenses to average daily net assets for each period
would have been as follows: 1998, 1.20%; 1997, 1.21%; 1996, 1.26%; 1995,
1.24%; and 1994, 1.19%.
(b) Net of fees waived by the manager for expenses exceeding the following
expense limitations: 0.85% until April 30, 1995; 0.9% until April 30, 1996;
and 1.00% until August 1, 1999. If no fees had been waived by LMFA, the
annualized ratio of expenses to average daily net assets for each period
would have been as follows: 1998, 1.35%; 1997, 1.39%; 1996, 1.43%; 1995,
1.38%; and 1994, 1.40%.
(c) February 1, 1994 (commencement of operations) to December 31, 1994
(d) Not annualized
(e) Annualized
Legg Mason Income Trust
23
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<PAGE>
(THIS PAGE INTENTIONALLY LEFT BLANK)
<PAGE>
Legg Mason Income Trust, Inc.
------------------------------------------------------------------
The following additional information about the funds is available upon
request and without charge:
Statement of Additional Information (SAI) - the SAI is filed with the
Securities and Exchange Commission (SEC) and is incorporated by
reference into (is considered part of) the prospectus. The SAI provides
additional details about each fund and its policies.
Annual and Semiannual Reports - additional information about each
fund's investments is available in the funds' annual and semiannual
reports to shareholders. These reports provide detailed information
about each fund's portfolio holdings and operating results.
To request the SAI or any reports to shareholders, or to obtain
more information:
- call toll-free 1-800-822-5544
- visit us on the Internet via http://www.leggmason.com
- write to us at: Legg Mason Wood Walker, Incorporated
100 Light Street, P.O. Box 1476
Baltimore, Maryland 21203-1476
Information about the funds, including the SAI, can be reviewed and
copied at the SEC's public reference room in Washington, DC (phone
1-800-SEC-0330). Reports and other information about the funds are
available on the SEC's Internet site at http://www.sec.gov. Investors
may also write to: SEC, Public Reference Section, Washington, DC
20549-6009. A fee will be charged for making copies.
LMF-025 SEC file number 811-5029
<PAGE>
THE LEGG MASON INCOME TRUST, INC.:
U.S. GOVERNMENT INTERMEDIATE-TERM PORTFOLIO
INVESTMENT GRADE PORTFOLIO
HIGH YIELD PORTFOLIO
(PRIMARY SHARES AND NAVIGATOR SHARES)
AND
U.S. GOVERNMENT MONEY MARKET PORTFOLIO
STATEMENT OF ADDITIONAL INFORMATION
MAY 3, 1999
This Statement of Additional Information is not a prospectus and should
be read in conjunction with the Prospectus for Primary Shares or for Navigator
Shares, both dated May 3, 1999, which have been filed with the Securities and
Exchange Commission ("SEC"). The funds' annual report is incorporated by
reference into this Statement of Additional Information. A copy of either the
Prospectuses or the annual report is available without charge by writing to or
calling the funds' distributor, Legg Mason Wood Walker, Incorporated ("Legg
Mason") (address and telephone numbers listed below).
LEGG MASON WOOD WALKER,
INCORPORATED
------------------------------------------------------------------------------
100 LIGHT STREET
BALTIMORE, MARYLAND 21202
(410) 539-0000 (800) 822-5544
<PAGE>
TABLE OF CONTENTS
Page
Description of the Funds 3
Fund Policies 3
Investment Strategies and Risks 6
Portfolio Turnover 27
Management of the Fund 28
Management Agreement 30
Investment Advisory Agreement 32
The Fund's Distributor 33
Portfolio Transactions and Brokerage 35
Additional Purchase and Redemption Information 35
Valuation of Fund Shares 39
Additional Tax Information 40
Tax-Deferred Retirement Plans 44
Performance Information 45
Capital Stock Information 51
The Funds' Custodian and Transfer
and Dividend-Disbursing Agent 51
The Corporation's Legal Counsel 51
The Corporation's Independent Accountants 51
Financial Statements 51
Appendix A 53
- --------------------------------------------------------------------------------
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 a fund or its distributor. The Prospectuses
and this Statement of Additional Information do not constitute offerings by the
funds or by the distributor in any jurisdiction in which such offering may not
lawfully be made.
- --------------------------------------------------------------------------------
2
<PAGE>
DESCRIPTION OF THE FUNDS
Legg Mason Income Trust, Inc. is a diversified open-end investment
company which was incorporated in Maryland on April 28, 1987. Legg Mason U.S.
Government Intermediate-Term Portfolio, Legg Mason Investment Grade Income
Portfolio, Legg Mason High Yield Portfolio and Legg Mason U.S. Government Money
Market Portfolio are separate series of Legg Mason Income Trust, Inc..
FUND POLICIES
Each fund has adopted certain fundamental investment limitations that
cannot be changed except by vote of a majority of each fund's outstanding voting
securities.
Government Intermediate and Investment Grade each 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;
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 each fund 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 fund maintains a long position in the same security in an
amount at least equal thereto; provided, however, that the fund 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 25% or more 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 thereafter not more
than 10% of a fund's total assets (taken at market value) would be invested in
such securities;
8. Purchase or sell commodities and commodity contracts, except that
each fund 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, each fund 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;
3
<PAGE>
11. Purchase or sell real estate, except that each fund 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;
12. Purchase or sell interests in oil and gas or other mineral
exploration or development programs; or
13. Issue senior securities, except as permitted under the Investment
Company Act of 1940, as amended ("1940 Act").
High Yield 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;
2. Issue senior securities, except as permitted under the 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.
Government Money Market 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
4
<PAGE>
maintains a long position in the same security in an amount at least equal
thereto;
5. Purchase or sell commodities and commodity contracts;
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;
9. Purchase or sell interests in oil and gas or other mineral
exploration or development programs;
10. Issue senior securities, except as permitted under the 1940 Act;
11. 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.
As noted above, the fundamental investment limitations of each fund,
along with its investment objective, may not be changed without the vote of a
majority of the fund's outstanding voting securities. Under the 1940 Act, a
"vote of a majority of the outstanding voting securities" of a fund means the
affirmative vote of the lesser of (1) more than 50% of the outstanding shares of
the fund or (2) 67% or more of the shares 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 in the Prospectus or
Statement of Additional Information 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 fund 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.
The following are some of the non-fundamental limitations which High
Yield currently observes. High Yield may not:
1. 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;
2. 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);
3. Hold more than 10% of the outstanding voting
securities of any one issuer.
5
<PAGE>
INVESTMENT STRATEGIES AND RISKS
THE FOLLOWING APPLIES TO ALL OF THE FUNDS:
YIELD FACTORS AND RATINGS:
Standard & Poor's ("S&P"), Moody's Investors Service, Inc. ("Moody's")
and other nationally recognized statistical rating organizations ("NRSROs") 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 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.
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. Subsequent to its purchase by
a fund, an issue of obligations may cease to be rated or its rating may be
reduced below the minimum rating required for purchase by that fund. The Adviser
will consider such an event in determining whether a fund (other than Government
Money Market) should continue to hold the obligation, but is not required to
dispose of it. Government Money Market will consider disposing of the obligation
in accordance with Rule 2a-7 under the 1940 Act.
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 a fund invests are
dependent on a variety of factors, including general money market conditions,
general conditions in the bond market, the financial condition of the issuer,
the size of the offering, the maturity of the obligation and its rating. There
may be a wide variation in the quality of bonds, both within a particular
classification and between classifications. A bond issuer's obligations 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 bond
issuers to meet their obligations for the payment of interest and principal.
SECURITIES LENDING:
Each fund may lend portfolio securities to brokers or dealers in
corporate or U.S. government securities (U.S. government securities only, with
respect to Government Intermediate and Government Money Market), 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 funds' custodian. During the time
portfolio securities are on loan, the borrower will pay the lending fund an
amount equivalent to any 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. Each 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, a fund could
experience delays in recovering the securities lent. To the extent that, in the
meantime, the value of the collateral had decreased or the securities lent
increased, the fund could experience a loss. Each 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. Each
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. Each fund presently does not intend to loan more than 5% of
its portfolio securities at any given time.
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REPURCHASE AGREEMENTS:
Repurchase agreements are usually for periods of one week or less, but
may be for longer periods. Repurchase agreements maturing in more than seven
days may be considered illiquid. In a repurchase agreement, the securities are
held for each fund by a custodian bank 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. Each fund bears
a risk of loss in the event that the other party to a repurchase agreement
defaults on its obligations and a fund is delayed or prevented from exercising
its rights to dispose of the collateral securities. Each fund enters into
repurchase agreements only with financial institutions which the Adviser
believes present minimal risk of default during the term of the agreement based
on guidelines established by the Corporation's Board of Directors. Each fund
currently intends to invest in repurchase agreements only 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 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. Each fund (other than Government Money Market) may also enter into
dollar rolls, in which a 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, that 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.
Each fund may engage in reverse repurchase agreements and (with the
exception of Government Money Market) 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. There is a risk that the
contraparty to either a reverse repurchase agreement or a dollar roll will be
unable or unwilling to complete the transaction as scheduled, which may result
in losses to a fund.
When a 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 that fund's assets. If a fund
reinvests the proceeds of the agreement at a rate lower than the cost of the
agreement, engaging in the agreement will lower that fund's yield. While
engaging in reverse repurchase agreements and dollar rolls, each fund will
maintain cash, U.S. Government securities (or other appropriate liquid
securities, with respect to Investment Grade and High Yield) in a segregated
account at its custodian bank with a value at least equal to that fund's
obligation under the agreements.
RESTRICTIONS: The ability of a fund to engage in reverse repurchase agreements
and/or dollar rolls is subject to each 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 a fund's total assets.
WARRANTS:
Although not a fundamental policy subject to shareholder vote, as long
as each fund's shares continue to be registered in certain states, each 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.
With respect to High Yield, 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.
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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 a 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. 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, a 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 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"). Fannie Mae and Freddie Mac each issue pass-through
securities which are guaranteed as to principal and interest by Fannie Mae and
Freddie Mac, 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 FreddieMac participation
certificates ("PCs") because there is a tendency for the conventional and
privately-insured mortgages underlying Freddie MacPCs 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 a 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 a 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
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them. In addition, the mortgage securities market in general may be adversely
affected by changes in governmental regulation or tax policies.
STEP DOWN PREFERRED SECURITIES:
Some of the securities purchased by Investment Grade and High Yield may
also include step down perpetual preferred securities. These securities are
issued by a real estate investment trust ("REIT") making a mortgage loan to a
single borrower. The dividend rate paid by these securities is initially
relatively high, but steps down yearly. The stock is subject to call if the REIT
suffers an unfavorable tax event, and to tender by the issuer's equity holder in
the 10th year; both events could be on terms unfavorable to the holder of the
preferred stock. The value of this security will be affected by changes in the
value of the underlying mortgage loan. The REIT is not diversified, and the
value of the mortgaged property may not cover its obligations. Step down
perpetual preferred securities are considered restricted securities under the
1933 Act.
ASSET-BACKED SECURITIES:
Asset-backed securities are structurally similar to mortgage-backed
securities, but are secured by an 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 a fund may
invest. Primarily, these securities do not have the benefit of the same security
interest in the related collateral. Asset-backed securities represent direct or
indirect participations in, or are secured by and payable from, pools of assets
such as motor vehicle installment sales contracts, installment loan contracts,
leases of various types of real and personal property, and receivables from
revolving credit agreements. Credit card receivables, for example, 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 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.
THE FOLLOWING APPLIES ONLY TO GOVERNMENT INTERMEDIATE, INVESTMENT GRADE AND HIGH
YIELD UNLESS OTHERWISE STATED:
CORPORATE DEBT SECURITIES
Corporate debt securities may pay fixed or variable rates of interest,
or interest at a rate contingent upon some other factor, such as the price of
some commodity. These securities may be convertible into preferred or common
equity, or may be bought as part of a unit containing common stock. In selecting
corporate debt securities for a fund, the adviser reviews and monitors the
creditworthiness of each issuer and issue. The adviser also analyzes interest
rate trends and specific developments which it believes may affect individual
issuers.
CALLABLE DEBT SECURITIES
A debt security may be callable, i.e., subject to redemption at the
option of the issuer at a price established in the security's governing
instrument. If a debt security held by a fund is called for redemption, that
fund will be required to permit the issuer to redeem the security or sell it to
a third party. Either of these actions could have an adverse effect on a fund's
ability to achieve its investment objectives.
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INFLATION-INDEXED SECURITIES
The funds may also invest in U.S. Treasury securities whose principal
value is adjusted daily in accordance with changes to the Consumer Price Index
(also known as "Treasury Inflation-Protection Securities"). Interest is
calculated on the basis of the adjusted principal value on the payment date. The
principal value of inflation-indexed securities declines in periods of
deflation, but holders at maturity receive no less than par. If inflation is
lower than expected during the period a fund holds the security, the fund may
earn less on it than on a conventional bond. Any increase in principal value is
taxable in the year the increase occurs, even though the holders do not receive
cash representing the increase at that time. Changes in market interest rates
from causes other than inflation will likely affect the market prices of
inflation-indexed securities in the same manner as conventional bonds.
CONVERTIBLE SECURITIES
A convertible security is a bond, debenture, note, preferred stock or
other security that may be converted into or exchanged for a prescribed amount
of common stock of the same or a different issuer within a particular period of
time at a specified price or formula. Convertible securities are usually
subordinated to comparable-tier non-convertible securities but rank senior to
common stock in a corporation's capital structure.
The value of a convertible security is a function of (I) its yield in
comparison with the yields of other securities of comparable maturity and
quality that do not have a conversion privilege and (ii) its worth, at market
value, if converted into the underlying common stock. Convertible securities are
typically issued by smaller capitalized companies, whose stock prices may be
volatile. The price of a convertible security often reflects such variations in
the price of the underlying common stocks in a way that non-convertible debt
does not. A convertible security may be subject to redemption at the option of
the issuer at a price established in the convertible security's governing
instrument, which could have an adverse effect on a fund's ability to achieve
its investment objective.
Government Intermediate and Investment Grade do not intend to exercise
conversion rights for any convertible security they own and do not intend to
hold any security which has been subject to conversion.
ZERO COUPON BONDS
Zero coupon bonds are debt obligations which make no fixed interest
payments but instead are issued at a significant discount from face value. Like
other debt securities, the market price can reflect a premium or discount, in
addition to the original issue discount, reflecting the market's judgment as to
the issuer's creditworthiness, the interest rate or other similar factors. The
original issue discount approximates the total amount of the interest the bonds
will accrue and compound over the period until maturity or the first interest
payment date at a rate of interest reflecting the market rate of the security at
the time of issuance. Because zero coupon bonds do not make periodic interest
payments, their prices can be very volatile when market interest rates change.
The original issue discount on zero coupon bonds must be included in a
fund's income ratably as it accrues. Accordingly, to continue to qualify for tax
treatment as a regulated investment company and to avoid a certain excise tax, a
fund may be required to distribute as a dividend an amount that is greater than
the total amount of cash it actually receives. See "Additional Tax Information."
These distributions must be made from a fund's cash assets or, if necessary,
from the proceeds of sales of portfolio securities. Such sales could occur at a
time which would be disadvantageous to that fund and then that fund would not
otherwise choose to dispose of the assets.
TRUST ORIGINATED PREFERRED SECURITIES
The funds may also invest in trust originated preferred securities, a
type of security issued by
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financial institutions such as banks and insurance companies. Trust originated
preferred securities represent interests in a trust formed by a financial
institution. The trust sells preferred shares and invests the proceeds in notes
issued by the financial institution. These notes may be subordinated and
unsecured. Distributions on the trust originated preferred securities match the
interest payments on the notes; if no interest is paid on the notes, the trust
will not make current payments on its preferred securities. Trust originated
preferred securities currently enjoy favorable tax treatment. If the tax
characterization of these securities were to change adversely, they could be
redeemed by the issuers, which could result in a loss to a fund. In addition,
some trust originated preferred securities are restricted securities available
only to qualified institutional buyers under Rule 144A.
ILLIQUID SECURITIES
SEC Rule 144A permits the sale of certain restricted securities to
qualified institutional buyers. The 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 each fund's
liquidity.
MUNICIPAL OBLIGATIONS
Municipal obligations also include municipal lease obligations. These
obligations, which are issued by state and local governments to acquire land,
equipment and facilities, typically are not fully backed by the municipality's
credit, and, if funds are not appropriated for the following year's lease
payments, a lease may terminate, with the possibility of default on the lease
obligation and significant loss to a fund. The two principal classifications of
municipal obligations are "general obligation" and "revenue" bonds. "General
obligation" bonds are secured by the issuer's pledge of its faith, credit and
taxing power. "Revenue" bonds are payable only from the revenues derived from a
particular facility or class of facilities or from the proceeds of a special
excise tax or other specific revenue source such as the corporate user of the
facility being financed. Industrial development bonds ("IDBs") and private
activity bonds ("PABs") are usually revenue bonds and are not payable from the
unrestricted revenues of the issuer. The credit quality of the IDBs and PABs is
usually directly related to the credit standing of the corporate user of the
facilities. In addition, certain types of IDBs and PABs are issued by or on
behalf of public authorities to finance various privately operated facilities,
including certain pollution control facilities, convention or trade show
facilities, and airport, mass transit, port or parking facilities.
CLOSED END INVESTMENT COMPANIES
Each fund may invest up to 5% of its net assets in the securities of
closed-end investment companies. Such investments may involve the payment of
substantial premiums above the net asset value of such issuers' portfolio
securities, and the total return on such investments will be reduced by the
operating expenses and fees of such investment companies, including advisory
fees. Shares of many closed-end investment companies at times trade at
substantial discounts to their net asset value. A fund will invest in such
funds, when, in the Adviser's judgment, the potential benefits of such
investment justify the payment of any applicable premium or sales charge.
PRIVATE PLACEMENTS
Each 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 each 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 a 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 1933 Act and may involve the payment of
underwriting commissions; accordingly, the proceeds may be less than the
proceeds from the sale of securities of the
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same class which are freely marketable.
RESTRICTIONS: Restricted securities will not be purchased by either Government
Intermediate or Investment Grade if, as a result, more than 5% of that fund's
assets would consist of restricted securities.
THE FOLLOWING INFORMATION ABOUT FUTURES AND OPTIONS APPLIES TO GOVERNMENT
INTERMEDIATE AND INVESTMENT GRADE:
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 ("GNMA")
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.
A 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 wishes to purchase the securities, the
fund would close out the futures contract before delivery.
A 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. Each 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, each fund 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 each fund will not exactly match
the securities that 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 that 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 a fund wishes to hedge
and the standardized futures contracts available to it, a fund may purchase or
sell futures contracts with a greater or lesser value than the securities it
wishes to hedge or intends to purchase. A fund may not use these instruments for
speculation or leverage.
FUTURES TRADING
If a 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
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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. A 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 a fund will be able to offset
a futures position at the time it wishes to, or at a price that is advantageous.
If a 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 a 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 a 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 each 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.
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 a 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 appropriate liquid 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 a 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 a 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. Each fund
will not sell futures contracts with a value exceeding the value of securities
it owns, except that a 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, a fund in effect
becomes exposed to price fluctuations resulting from changes in interest rates,
and by selling a futures contract a fund neutralizes those fluctuations. If
interest rates fall, a fund would expect to profit from an increase in the value
of the instrument underlying a futures contract it has purchased, and if
interest rates rise, a 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, a fund's positions in futures contracts could have a
negative effect on that fund's net asset value. If interest rates rise when a
fund has purchased futures contracts, that fund could suffer a loss in its
futures positions. Similarly, if interest rates fall, losses in a futures
contract that 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 a 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
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interest rate futures contracts is that the market value of the futures
contracts may not move in concert with the value of the securities a fund wishes
to hedge or intends to purchase. This may result from differences between the
instrument underlying the futures contracts and the securities a fund wishes to
hedge or intends to purchase, as would be the case, for example, if a 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 a
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.
Each fund may purchase put options on interest rate futures contracts
to hedge against a decline in the market value of securities that fund owns and
not for speculation or leverage. 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, a 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.
A 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 lost by that 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. A fund is not required to make
futures margin payments when it purchases an option on an interest rate futures
contract.
Compared to the 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 a 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
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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 a 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.
Although the Adviser will purchase 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, a fund might have to
exercise an option it had purchased in order to realize any profit.
OPTIONS WRITING ON DEBT SECURITIES
Each fund may from time to time write (sell) covered call options and
covered put options on certain of its portfolio securities. A fund may write
call options on securities in its portfolio in an attempt to realize, through
the premium that fund receives, a greater current return than would be realized
on the securities alone. A fund may write put options in an attempt to realize
enhanced income when it is willing to purchase the underlying instrument for its
portfolio at the exercise price. A fund may also purchase call options for the
purpose of acquiring the underlying instruments for its portfolio. At times, the
net cost of acquiring instruments in this manner (the exercise price of the call
option plus the premium paid) may be less than the cost of acquiring the
instruments directly.
When it writes a covered call option, a 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 underlying securities or, in the case of options on certain
U.S. government securities, the fund maintains with its custodian in a
segregated account cash or appropriate liquid securities with a value sufficient
to meet its obligations under the call. When a 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.
Each fund may also write covered put options. When a 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 or
appropriate liquid 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 premium
received).
Each 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, each
fund presently does not intend to write options on portfolio securities
exceeding 25% of its total assets. Normally, covered call 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 a fund writes an option, it assumes the risk of fluctuations in
the value of the underlying security in return for a fixed premium, it must be
prepared to satisfy exercise of the option at any time until
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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 a 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.
Each 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.
CERTAIN LIMITATIONS ON FUTURES AND OPTIONS STRATEGIES
The Corporation has filed on behalf of each 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 each fund will use
futures contracts and related options solely for bona fide hedging purposes
within the meaning of the CFTC regulations, provided that each 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, does not exceed 5% of that
fund's net assets; and provided further that each fund may exclude the amount by
which an option is "in the money" in computing such 5%. Each fund will not
purchase futures contracts or related options if as a result more than 33 1/3%
of that fund's total assets would be so invested. Where a 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. There is a risk, however, that the two
positions may not be entirely correlated, and therefore may not offset one
another to the extent expected. In that case, the exposure could unexpectedly
exceed 331/3 of total assets. These limits on a fund's investments in futures
contracts are not fundamental and may be changed by the Board of Directors as
regulatory agencies permit. Each 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 each
fund's shareholders.
THE FOLLOWING INVESTMENT POLICIES APPLY ONLY TO HIGH YIELD:
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.
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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.
RESTRICTIONS: 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 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 appropriate liquid
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 correlation
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
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the lead bank to assert these rights, or upon a vote of all the lenders to
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.
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 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 net 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 fluctuations in 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 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
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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 or appropriate liquid 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.
Straddles involving currencies are subject to the same risks as other foreign
currency options.
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. 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.
If the fund uses cross-hedging, it may experience losses on both the currency in
which it has invested and the currency used for hedging, if the two currencies
do not vary with the expected degree of correlation.
The fund's ability to establish and close out positions in 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
foreign 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
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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 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 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 securities
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
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foreign currency futures contract to hedge against possible variations in the
exchange rate of the foreign currency in relation to the U.S. dollar 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 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 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 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 sell a put option on a foreign currency to partially
offset an increase in 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 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 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 or appropriate 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. 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
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
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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 other than for bona fide hedging purposes 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 net 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 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 options is subject to the maintenance of a liquid secondary market.
There is no assurance that a liquid secondary market will exist for any
particular futures contract or option at any specific time. 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 (in the case of futures and options written thereon). 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
22
<PAGE>
individual securities. Moreover, futures contracts relate not to the current
level of the underlying instrument but to the anticipated level 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, index, 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 currency and general market conditions.
(5) 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) 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, there may be circumstances when the purchase of an option
on a futures contract would result in a loss to the fund but 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.
(8) 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.
23
<PAGE>
(9) 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. 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 or appropriate liquid 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.
(10) 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
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 may
be required to 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 in 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, but 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
24
<PAGE>
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 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 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 between the currencies
involved moved between the execution dates of the first contract and the
offsetting contract.
25
<PAGE>
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 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 or appropriate
liquid 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 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 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
26
<PAGE>
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 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.
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
appropriate liquid 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 appropriate liquid securities in a
segregated account with its custodian in the amount prescribed, as
marked-to-market daily. Securities, currencies or other options, futures or
forward 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.
PORTFOLIO TURNOVER
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, each fund's (other than
Government Money Market) portfolio turnover rates were as follows:
Fund: 1998 1997
- ----- ---- ----
Government Intermediate 356% 252%
Investment Grade 279% 259%
High Yield 107% 116%
Each fund anticipates that its annual portfolio turnover rate may
exceed 300%. The funds may sell fixed-income securities and buy similar
securities to obtain yield and take advantage of market anomalies, a practice
which increases the turnover rate. A portfolio turnover rate over 100% will
result in higher transaction costs paid by the funds. It may also increase the
amount of net short-term capital gains, if any, realized by a fund.
27
<PAGE>
MANAGEMENT OF THE FUND
The fund's officers are responsible for the operation of the fund under
the direction of the Board of Directors. The officers and directors of the fund,
their date of birth 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 fund as defined by the 1940 Act. The business
address of each officer and director is 100 Light Street, Baltimore, Maryland
21202, unless otherwise indicated.
JOHN F. CURLEY, JR.*, [07/24/39] Chairman of the Board and Director;
Retired Vice Chairman and Director of Legg Mason Wood Walker, Inc. and Legg
Mason, Inc.; Chairman of the Board and Director / Trustee and President and
Director/Trustee of the Legg Mason funds. Formerly: Director of Legg Mason Fund
Adviser, Inc., and Western Asset Management Company (each a registered
investment adviser); Officer and/or Director of various other affiliates of Legg
Mason, Inc.
EDMUND J. CASHMAN, JR.*, [08/31/36] 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/Trustee of various Legg Mason funds.
EDWARD A. TABER, III*, [08/25/43] President; Senior Executive Vice
President of Legg Mason, Inc. and Legg Mason Wood Walker, Inc.; Vice Chairman
and Director of Legg Mason Fund Adviser, Inc.; President/Director/Trustee of
various Legg Mason funds.
RICHARD G. GILMORE, [06/09/27] Director; 948 Kennett Way, West Chester,
Pennsylvania. 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/Trustee of all
Legg Mason funds;. 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 (bank holding company) and Director of Finance, City
of Philadelphia.
ARNOLD L. LEHMAN, [07/18/44] Director; 200 Eastern Parkway, Brooklyn,
New York. Director of the Brooklyn Museum of Art; Director/Trustee of all Legg
Mason funds. Formerly: Director of the Baltimore Museum of Art.
JILL E. McGOVERN, [08/29/44] Director; 400 Seventh St., NW, Washington,
DC. Chief Executive Officer of the Marrow Foundation; Director/Trustee of all
Legg Mason funds. Formerly: Executive Director of the Baltimore International
Festival (January 1991 - March 1993).
T. A. RODGERS, [10/22/34] Director; 2901 Boston Street, Baltimore,
Maryland. Principal, T. A. Rodgers & Associates (management consulting);
Director/Trustee of all Legg Mason funds. Formerly: Director and Vice President
of Corporate Development, Polk Audio, Inc. (manufacturer of audio components)
(1991-1992).
The executive officers of the Corporation, other than those who also
serve as directors, are:
MARIE K. KARPINSKI*, [01/01/49] Vice President and Treasurer; Treasurer
of Legg Mason Fund Adviser, Inc.; Vice President and Treasurer of the Legg Mason
funds; Vice President of Legg Mason.
KATHI D. BAIR*, [12/15/64] Secretary; Secretary of the Legg Mason
funds; Assistant Treasurer of various Legg Mason funds.
BRIAN M. EAKES*, [12/9/69 ] Assistant Treasurer and Assistant
Secretary; Assistant Treasurer and Assistant Secretary of various Legg Mason
funds; employee of Legg Mason, Inc. since July 1995. Formerly: Senior Associate
- - Audit of Coopers & Lybrand L.L.P. (Aug. 1992 - June 1995).
28
<PAGE>
Officers and directors of the fund who are "interested persons" of the
fund, as defined in the 1940 Act, receive no salary or fees from the fund.
Independent directors of the fund receive an annual retainer and a per meeting
fee based on average net assets of each fund at December 31 of the previous
year.
The Nominating Committee of the Board of Directors is responsible for
the selection and nomination of disinterested directors. The Committee is
composed of Messrs. Gilmore and Lehman and Dr. McGovern, each of whom is a
disinterested director as that term is defined in the 1940 Act.
At March 31, 1999, the directors and officers of the Corporation
beneficially owned, in the aggregate, less than 1% of each fund's outstanding
Shares.
Set forth below is a table which contains the name, address and
percentage ownership of each person who is known by each fund to own
beneficially and/or of record five percent or more of its outstanding shares as
of April 1, 1999:
<TABLE>
<CAPTION>
- ---------------------------------------- ------------------------------------- -------------------------------------
Navigator U.S. Government Navigator Investment Grade Portfolio
Name and Address Intermediate Portfolio
- ---------------------------------------- ------------------------------------- -------------------------------------
<S> <C> <C>
Legg Mason Wood Walker, Inc. 79.88% --
P.O. Box 1476
Baltimore, MD 21203-1476
(record)
- ---------------------------------------- ------------------------------------- -------------------------------------
IBAK & Co. 14.85% --
P.O. Box 1700
102 South Clinton
Iowa City, IA 52240-4024
- ---------------------------------------- ------------------------------------- -------------------------------------
Legg Mason Trust Company -- 50%
(record)
Lorraine Coolick Revocable Living
Trust (beneficial)
7 East Redwood Street
Baltimore, MD 21202
- ---------------------------------------- ------------------------------------- -------------------------------------
Legg Mason Trust Company -- 50%
(record)
Allan Coolick Revocable Living Trust
(beneficial)
7 East Redwood Street
Baltimore, MD 21202
- ---------------------------------------- ------------------------------------- -------------------------------------
</TABLE>
The following table provides certain information relating to the
compensation of the Corporation's directors for the fiscal year ended December
31, 1998. None of the Legg Mason funds has any retirement plan for its directors
and officers.
<TABLE>
<CAPTION>
- ---------------------------------------- ------------------------------------ --------------------------------------
Aggregate Compensation From Funds* Total Compensation From Funds and
Name of Person and Position Fund Complex Paid to Directors**
- ---------------------------------------- ------------------------------------ --------------------------------------
<S> <C> <C>
John F. Curley, Jr. -
Chairman of the Board and Director None None
- ---------------------------------------- ------------------------------------ --------------------------------------
Edward A. Taber, III -
President and Director None None
- ---------------------------------------- ------------------------------------ --------------------------------------
29
<PAGE>
- ---------------------------------------- ------------------------------------ --------------------------------------
Edmund J. Cashman, Jr.
Vice Chairman and Director None None
- ---------------------------------------- ------------------------------------ --------------------------------------
Richard G. Gilmore - $ 8,394 $35,100
Director
- ---------------------------------------- ------------------------------------ --------------------------------------
Charles F. Haugh - $ 6,375 $25,800
Director A
- ---------------------------------------- ------------------------------------ --------------------------------------
Arnold L. Lehman - $ 8,394 $30,600
Director
- ---------------------------------------- ------------------------------------ --------------------------------------
Jill E. McGovern - $ 8,394 $35,100
Director
- ---------------------------------------- ------------------------------------ --------------------------------------
T. A. Rodgers - $ 8,394 $35,100
Director
- ---------------------------------------- ------------------------------------ --------------------------------------
</TABLE>
A Mr. Haugh retired as a director in September 1998.
* Represents fees paid to each director during the fiscal year ended
December 31, 1998.
** Represents aggregate compensation paid to each director during the
calendar year ended December 31, 1998. There are eleven open-end
investment companies in the Legg Mason complex (with a total of twenty
funds).
MANAGEMENT AGREEMENT
Legg Mason Fund Adviser, Inc., 100 Light Street, Baltimore, MD 21202,
serves as the manager for each fund under separate management agreements dated
June 19, 1987 for Government Intermediate and Investment Grade, November 1, 1988
for Government Money Market and January 24, 1994 for High Yield (each a
"Management Agreement"). Each Management Agreement provides that, subject to
overall direction by the Board of Directors, the manager will manage the
investment and other affairs of each fund. Under the Management Agreement, the
manager is responsible for managing each fund's portfolio of securities and for
making purchases and sales of securities consistent with the investment
objectives and policies described in each fund's Prospectuses and this Statement
of Additional Information. The manager is obligated to furnish each fund with
office space and certain administrative services as well as executive and other
personnel necessary for the operation of the funds. 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 fund to the
adviser, Western Asset Management Company.
The manager receives for its services a management fee, calculated
daily and payable monthly, at annual rates of each fund's average daily net
assets according to the following:
MANAGEMENT FEE:
Government Intermediate 0.55%
Investment Grade 0.60%
High Yield 0.65%
Government Money Market 0.50%
The manager has agreed to waive its fees and reimburse Government
Intermediate and Investment Grade if and to the extent either fund's 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:
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GOVERNMENT INTERMEDIATE:
PRIMARY SHARES
RATE EXPIRATION DATE ASSET LEVEL
---- --------------- -----------
1.00% August 1, 1999 $500 million
0.95% April 30, 1996 $400 million
0.90% April 30, 1995 $400 million
0.90% October 31, 1994 $400 million
NAVIGATOR SHARES
RATE EXPIRATION DATE ASSET LEVEL
---- --------------- -----------
0.50% August 1, 1999 $500 million
0.45% April 30, 1996 $400 million
0.40% April 30, 1995 $400 million
For the years ended December 31, 1998, 1997 and 1996, the Manager
received management fees of $1,836,004, $1,646,268,and $1,271,172, respectively
(prior to fees waived of $668,052, $638,030, and $626,029, respectively), for
Government Intermediate.
INVESTMENT GRADE:
PRIMARY SHARES
RATE EXPIRATION DATE ASSET LEVEL
---- --------------- -----------
1.00% August 1, 1999 $250 million
0.90% April 30, 1996 $100 million
0.85% April 30, 1995 $100 million
0.85% October 31, 1994 $100 million
NAVIGATOR SHARES
RATE EXPIRATION DATE ASSET LEVEL
---- --------------- -----------
0.50% August 1, 1999 $250 million
0.40% April 30, 1996 $100 million
For the years ended December 31, 1998, 1997 and 1996, the Manager
received management fees of $858,091, $609,203,and $519,989, respectively (prior
to fees waived of $500,620, $395,225, and $400,971, respectively), for
Investment Grade.
For the years ended December 31, 1998, 1997 and 1996, High Yield paid
management fees of $3,035,999, $1,989,139, and $1,093,156, respectively, to the
manager.
During the fiscal years ended December 31, 1998, 1997 and 1996,
Government Money Market paid management fees of $1,784,853, $1,670,048, and
$1,658,682, respectively, to the manager.
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 fund in
connection with the performance of the respective 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.
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 that
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 respective fund.
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Each 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 funds' distributor,
compensation of the independent directors, legal, accounting and audit expenses,
insurance expenses, expenses of registering and qualifying shares of each fund
for sale under federal and state law, governmental fees and expenses incurred in
connection with membership in investment company organizations. Each fund also
is liable for such nonrecurring expenses as may arise, including litigation to
which a fund may be a party. Each fund may also have an obligation to indemnify
the directors and officers of the Corporation with respect to any such
litigation.
Under each Management Agreement, each 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.
The manager is a wholly owned subsidiary of Legg Mason, Inc.
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 each fund under separate Investment Advisory Agreements, dated June
19, 1987 for Government Intermediate and Investment Grade; November 1, 1988 for
Government Money Market and January 24, 1994 for High Yield, between the adviser
and the manager (each an "Advisory Agreement").
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 each 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 each fund, the manager (not the fund)
pays the adviser a fee, computed daily and payable monthly, at an annual rate of
the fee received by the manager equal to the following:
FUND ADVISORY FEE:
- ---- -------------
Government Intermediate .20%*
Investment Grade 40%
Government Money Market 30%
High Yield 77%
* Effective October 1, 1994, the adviser agreed to waive payments by the manager
with respect to Government Intermediate in excess of 0.20% annually of
Government Intermediate's average daily net assets. This does not affect the fee
paid by the fund.
For the fiscal years ended December 31, 1998, 1997 and 1996, the manager paid
the following fees to the adviser on behalf of the funds:
Fund: 1998 1997 1996
- ----- ---- ---- ----
Government Intermediate $ 424,709 $ 598,643 $462,253
Investment Grade $ 142,988 $ 85,591 $ 47,237
High Yield $2,337,719 $1,530,286 $842,642
Government Money Market $ 535,456 $ 501,014 $497,604
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 a 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
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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 each fund's outstanding voting securities,
by the manager or by the adviser, on not less than 60 days' notice to the
respective 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 each fund.
To mitigate the possibility that a 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 FUNDS' DISTRIBUTOR
Legg Mason Wood Walker, Incorporated, 100 Light Street, Baltimore,
Maryland, acts as distributor of each 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 a fund's shares,
including compensation to its financial advisors. 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 each
fund's expense, and for supplementary sales literature and advertising costs.
For the year ended December 31, 1998, Legg Mason incurred the following
expenses with respect to Primary Shares of each fund:
<TABLE>
<CAPTION>
GOVERNMENT INVESTMENT GOVERNMENT
INTERMEDIATE GRADE HIGH YIELD MONEY MARKET
------------ ---------- ---------- ------------
<S> <C> <C> <C> <C>
COMPENSATION TO SALES 1,004,000 422,000 1,438,000 233,000
PERSONNEL
PRINTING AND MAILING OF
PROSPECTUSES TO PROSPECTIVE
SHAREHOLDERS 77,000 133,000 160,000 156,000
ADVERTISING 56,000 87,000 111,000 100,000
OTHER 655,000 897,000 1,461,000 738,000
------- ------- --------- -------
TOTAL EXPENSES 1,792,000 1,539,000 3,170,000 1,227,000
====================================================================
</TABLE>
The foregoing are estimated and do not include all expenses fairly
allocable to Legg Mason's or its affiliates' efforts to distribute Primary
Shares. The figures for "Other" include allocations of overhead amounts using
methods believed by Legg Mason to be reasonable.
Legg Mason does not receive any compensation from the funds for its
activities in selling
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<PAGE>
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 (for Government Intermediate and Investment Grade), October 27,
1988 (for Government Money Market) and October 22, 1993 (for High Yield),
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"). Continuation of the Plan was most recently
approved by the Board of Directors on November 13, 1998, 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 each
fund and its present and future Primary Class shareholders. The directors noted
that, to the extent the Plan results in additional sales of Primary Shares of a
fund, the Plan may enable the fund to achieve economies of scale that could
reduce expenses and to minimize the prospects that the fund will experience net
redemptions and the accompanying disruption of portfolio management. The Plan
was also approved by the vote of a majority of Government Intermediate's and
Investment Grade'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 each
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 a fund. Any change in the
Plan that would materially increase the distribution cost to a 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 a 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 a 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 each equivalent to 0.25% of
each fund's average daily net assets (other than Government Money Market which
has a fee of 0.10%) attributable to Primary Shares in accordance with the Plan.
The distribution and service fees are computed daily and paid monthly. For the
fiscal years ended December 31, 1998, 1997 and 1996, each fund paid distribution
and service fees to Legg Mason, pursuant to the Underwriting Agreement from
assets attributable to Primary Shares as follows:
Government Intermediate paid $1,628,986, $1,459,883, and $1,135,296,
respectively; Investment Grade paid $713,744, $506,442,and $432,122,
respectively; and High Yield paid $2,328,481, $1,523,715,and $840,822,
respectively.
Pursuant to the Plan, Government Money Market is authorized to pay Legg
Mason distribution and service fees not to exceed an annual rate of 0.20% of its
average daily net assets. Legg Mason has agreed that it will not request payment
of more than 0.10% annually from the fund indefinitely. For the years ended
December 31, 1998 and 1997, Government Money Market paid $356,971 and $326,047
respectively to Legg Mason.
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<PAGE>
PORTFOLIO TRANSACTIONS AND BROKERAGE
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 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. A fund may not always pay the
lowest commission or spread available. Rather, in placing orders on behalf of a
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 funds. On the other hand,
research and analysis received by the adviser from broker-dealers executing
orders for clients other than the funds may be used for the fund's benefit. The
adviser's fee is not reduced by reason of its receiving such brokerage and
research services. For the years ended December 31, the following funds paid
commissions to broker-dealers who acted as agents in executing options and
futures trades.
Fund: 1998 1997 1996
- ----- ---- ---- ----
Government Intermediate $86,235 $85,935 $25,230
Investment Grade $60,600 $51,240 $39,683
No fund may 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 a 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 each 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 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.
ADDITIONAL PURCHASE AND REDEMPTION INFORMATION
Government Intermediate, Investment Grade and High Yield each 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 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, to clients
of Bartlett who, as of December 19, 1996, were shareholders of Bartlett Short
Term Bond Fund or Bartlett Fixed Income Fund and for whom Bartlett acts as ERISA
fiduciary, and to any qualified retirement plan of Legg Mason, Inc., or of any
of its affiliates. 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.
Government Money
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<PAGE>
Market offers only one class of shares which corresponds to the Primary Class of
other Legg Mason funds.
FUTURE FIRST SYSTEMATIC INVESTMENT PLAN AND TRANSFER OF FUNDS FROM FINANCIAL
INSTITUTIONS
The Primary Shares Prospectus 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 funds'
transfer agent, to transfer funds to be used to buy Primary Shares at the per
share net asset value determined on the day the funds are sent to your bank. You
will receive a quarterly 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.
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 a 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 own Primary Shares with a net asset value of $5,000 or more, you
may also elect to make systematic withdrawals from your fund account of a
minimum of $50 on a monthly basis. 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,
Simplified Employee Pension Plan, Savings Incentive Match Plan for Employees or
other qualified retirement plan (collectively referred to as "Retirement
Plans"). You may change the monthly amount to be paid to you without charge not
more than once a year by notifying your Financial Advisor or Service Provider.
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
("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 Primary Shares' 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. Each 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 other 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.
Ordinarily, you should not purchase additional shares of the fund in
which you have an account if you maintain a Systematic Withdrawal Plan because
you may incur tax liabilities in connection with such purchases and withdrawals.
Each fund will not knowingly accept purchase orders from you for additional
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<PAGE>
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.
THE FOLLOWING INFORMATION APPLIES ONLY TO GOVERNMENT MONEY MARKET:
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 fund who have cash or negotiable securities
(including Government Money Market 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 account and his or her Brokerage Account. Premier
provides shareholders with a convenient method to invest in the fund 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 into your designated money market fund.
Premier is a comprehensive financial service which combines a
shareholder's fund account, a preferred customer VISA Gold debit card, a Legg
Mason Brokerage Account and unlimited checkwriting 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 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 fund. If fund 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 fund transactions, securities
activity, check writing activity and VISA Gold purchases and cash advances.
BancOne Columbus ("BancOne"), 757 Carolyn Avenue, Columbus, Ohio 43271,
is the fund'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 fund
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
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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
fund 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 fund shares
weekly.
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 of $100 or more will be invested
automatically in fund shares on the next business day following the day the
transaction is credited to the Brokerage Account.
Fund 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 fund.
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
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 Financial Advisor or Service Provider. 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 Financial Advisor or Service
Provider or Legg Mason's Premier Client Services.
OTHER INFORMATION REGARDING REDEMPTION
Government Money Market 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 Government Money Market'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 Government Money Market maintained
with State Street. When honoring a check presented for payment, the fund will
cause State Street to redeem exactly enough full and fractional shares from your
account to cover the amount of the check. Canceled checks will be returned to
you.
Check redemption is subject to State Street's rules and regulations
governing checking accounts.
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Checks should not be used to close a Government Money Market 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 ALL OF THE FUNDS:
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 a fund normally utilizes is
restricted, or an emergency, as defined by rules and regulations of the SEC,
exists, making disposal of that 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 a 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.
Each 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, totaling $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 that 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. Each 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.
VALUATION OF FUND SHARES
FOR GOVERNMENT INTERMEDIATE, INVESTMENT GRADE AND HIGH YIELD:
Net asset value of a fund share is determined daily for each Class as
of the close of the Exchange, 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,
Martin Luther King, Jr. 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.
FOR GOVERNMENT MONEY MARKET:
Government Money Market 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
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Directors continually assesses the appropriateness of this method of valuation.
The fund'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 fund's investment objective.
MONITORING PROCEDURES The fund'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 fund to limit its
investments to instruments that, (i)in the opinion of the Adviser, present
minimal credit risk and (ii) (a) are rated in one of the two highest rating
categories by at least two NRSROs (or one, if only one NRSRO has rated the
security) or, (b) if unrated, are determined to be of comparable quality by the
Adviser, all pursuant to procedures determined by the Board of Directors
("Eligible Securities"). The fund 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 fund 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 fund 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 can be purchased by the
fund; except that the fund 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 fund will
invest its available cash to reduce the average maturity to 90 days or less as
soon as possible.
It is the fund'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 fund'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 fund, computed by dividing the annualized daily income on the
fund'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 fund 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.
ADDITIONAL TAX INFORMATION
The following is a general summary of certain federal tax
considerations affecting each fund and its shareholders. Investors are urged to
consult their own tax advisers for more detailed information regarding any
federal, state or local taxes that may apply to them.
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GENERAL For federal tax purposes, each 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"), each 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, in the case of High Yield, any net gains from
certain foreign currency transactions) ("Distribution Requirement") and must
meet several additional requirements. For each fund, these requirements include
the following: (1) The fund must derive at least 90% of its gross income each
taxable year from dividends, interest, payments with respect to securities loans
and gains from the sale or other disposition of securities (or foreign
currencies in the case of High Yield), or other income (including gains from
options or futures contracts (or forward contracts in the case of High Yield))
derived with respect to its business of investing in securities (or those
currencies in the case of High Yield)("Income Requirement"); (2) at the close of
each quarter of a 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 (3) at the close of each quarter of a
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 any fund failed to qualify for treatment as
a RIC for any taxable year, (i) it would be taxed at corporate rates on the full
amount of its taxable income for that year without being able to deduct the
distributions it makes to its shareholders and (ii) the shareholders would treat
all those distributions, including distributions of net capital gain (i.e., the
excess of net long-term capital gain over net short-term capital loss), as
dividends (that is, ordinary income) to the extent of the fund's earnings and
profits. In addition, the fund could be required to recognize unrealized gains,
pay substantial taxes and interest, and make substantial distributions before
requalifying for RIC treatment.
Each 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 a 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 that 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.
THE FOLLOWING APPLIES ONLY TO GOVERNMENT INTERMEDIATE, INVESTMENT GRADE AND HIGH
YIELD:
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, capital
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.
Dividends and interest received by a fund, and gains realized thereby,
may be subject to income, withholding or other taxes imposed by foreign
countries and U.S. possessions that would reduce the yield and/or total return
on its 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.
HEDGING INSTRUMENTS The use of hedging instruments, such as writing
(selling) and purchasing options and futures contracts and, in the case of High
Yield, entering into forward contracts, involves complex rules that will
determine for income tax purposes the amount, character and timing of
recognition of the gains and losses a fund realizes in connection therewith.
Gains from High Yield's disposition of foreign currencies (except certain gains
that may be excluded by future regulations), and gains from options, futures
and, in the case of High Yield, forward currency contracts derived with respect
to its business of investing in securities (or, in the case of High Yield,
foreign currencies) will qualify as permissible income under the Income
Requirement.
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Certain futures and foreign currency contracts in which a fund may
invest will be "section 1256 contracts." Section 1256 contracts held by a fund
at the end of each taxable year, other than section 1256 contracts that are part
of a "mixed straddle" with respect to which the fund has made an election not to
have the following rules apply, must be "marked-to-market" (that is, treated as
having been sold for their fair market value) for federal income tax purposes,
with the result that unrealized gains or losses will be treated as though they
were realized. Sixty percent of any net gain or loss recognized on these deemed
sales, and 60% of any net realized gain or loss from any actual sales of section
1256 contracts, will be treated as long-term capital gain or loss, and the
balance will be treated as short-term capital gain or loss. These rules may
operate to increase the amount that a fund must distribute to satisfy the
Distribution Requirement, which will be taxable to its shareholders as ordinary
income, and to increase the net capital gain recognized by a fund, without in
either case increasing the cash available to the fund.
Code section 1092 (dealing with straddles) also may affect the taxation
of options, futures and forward contracts in which a fund may invest. Section
1092 defines a "straddle" as offsetting positions with respect to actively
traded personal property; for these purposes, options, futures and forward
contracts are personal property. Under that section, any loss from the
disposition of a position in a straddle generally may be deducted only to the
extent the loss exceeds the unrealized gain on the offsetting positions(s) of
the straddle. The regulations under section 1092 also provide certain "wash
sale" rules, which apply to transactions where a position is sold at a loss and
a new offsetting position is acquired within a prescribed period, and "short
sale" rules applicable to straddles. If a fund makes certain elections, the
amount, character and timing of the recognition of gains and losses from the
affected straddle positions would be determined under rules that vary according
to the elections made. Because only a few of the regulations implementing the
straddle rules have been promulgated, the tax consequences to a fund of straddle
transactions are not entirely clear.
If a fund has an "appreciated financial position" -- generally, an
interest (including an interest through an option, futures or forward contract
or short sale) with respect to any stock, debt instrument (other than "straight
debt") or partnership interest the fair market value of which exceeds its
adjusted basis -- and enters into a "constructive sale" of the same or
substantially similar property, the fund will be treated as having made an
actual sale thereof, with the result that gain will be recognized at that time.
A constructive sale generally consists of a short sale, an offsetting notional
principal contract or futures or forward contract entered into by a fund or a
related person with respect to the same or substantially similar property. In
addition, if the appreciated financial position is itself a short sale or such a
contract, acquisition of the underlying property or substantially similar
property will be deemed a constructive sale. The foregoing will not apply,
however, to any transaction during any taxable year that otherwise would be
treated as a constructive sale if the transaction is closed within 30 days after
the end of that year and a fund holds the appreciated financial position
unhedged for 60 days after that closing (i.e., at no time during that 60 day
period is the fund's risk of loss regarding that position reduced by reason of
certain specified transactions with respect to substantially similar or related
property, such as having an option to sell, being contractually obligated to
sell, making a short sale, or granting an option to buy substantially identical
stock or securities.
ZERO COUPON AND PAY-IN-KIND BONDS Each fund may acquire zero coupon
bonds or other debt securities issued with original issue discount. As a holder
of those securities, a 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,
High Yield must include in its gross income securities it receives as "interest"
on pay-in-kind securities. Because each 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
a fund's cash assets or from the proceeds of sales of portfolio securities, if
necessary. A 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.
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THE FOLLOWING INFORMATION APPLIES ONLY TO HIGH YIELD:
PASSIVE FOREIGN INVESTMENT COMPANIES The fund may invest in the stock
of "passive foreign investment companies" ("PFICs"). A PFIC is a foreign
corporation -- other than a "controlled foreign corporation" (i.e., a foreign
corporation in which, on any day during its taxable year, more than 50% of the
total voting power of all voting stock therein or the total value of all stock
therein is owned, directly, indirectly, or constructively, by "U.S.
shareholders," defined as U.S. persons that individually own, directly,
indirectly, or constructively, at least 10% of that voting power) as to which
the fund is a U.S. shareholder -- 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 disposition 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" ("QEF"), then in lieu of the foregoing tax and
interest obligation, the fund would be required to include in income each year
its pro rata share of the QEF's annual ordinary earnings and net capital gain --
which probably would have to be distributed by the fund to satisfy the
Distribution Requirement and avoid imposition of the Excise Tax -- even if those
earnings and gain were not distributed to the fund by the QEF. In most instances
it will be very difficult, if not impossible, to make this election because of
certain requirements thereof.
The fund may elect to "mark to market" its stock in any PFIC.
"Marking-to-market," in this context, means including in ordinary income each
taxable year the excess, if any, of the fair market value of the stock over the
fund's adjusted basis therein as of the end of that year. Pursuant to the
election, the fund also will be allowed to deduct (as an ordinary, not capital,
loss) the excess, if any, of its adjusted basis in PFIC stock over the fair
market value thereof as of the taxable year-end, but only to the extent of any
net mark-to-market gains with respect to that stock included in income by the
fund for prior taxable years. The fund's adjusted basis in each PFIC's stock
subject to the election will be adjusted to reflect the amounts of income
included and deductions taken thereunder. Regulations proposed in 1992 would
provide a similar election with respect to the stock of certain PFICs.
FOREIGN CURRENCIES Gains or losses (1) from the disposition of foreign
currencies, (2) from the disposition of a debt security denominated in a foreign
currency that are attributable to fluctuations in the value of the foreign
currency between the dates of acquisition and disposition of the security, and
(3) that are 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 will be
treated as ordinary income or ordinary 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 federal alternative
minimum tax.
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TAX-DEFERRED RETIREMENT PLANS
In general, income earned through the investment of assets of qualified
retirement accounts and plans is not taxed to the beneficiaries thereof until
the income is distributed to them. 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 through regular
payroll deductions may be arranged with your Financial Advisor or Service
Provider and your employer. Additional information with respect to these plans
is available upon request from Legg Mason or affiliated financial advisor.
TRADITIONAL IRA. Certain Primary Share investors may obtain tax
advantages by establishing an IRA. Specifically, except as noted below, 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, each
of 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. A
married investor who is not an active participant in such a plan and files a
joint income tax return with his or her spouse (and their combined adjusted
gross income does not exceed $150,000) is not affected by the spouse's active
participant status. 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 $4,000 to the two IRAs, provided that neither contribution exceeds
$2,000. If your employer's plan qualifies as a SIMPLE, 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
nondeductible IRA contributions, up to certain limits, because all dividends and
other 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.
ROTH IRA. A shareholder whose adjusted gross income (or combined
adjusted gross income with his or her spouse) does not exceed certain levels may
establish and contribute up to $2,000 per tax year to a Roth IRA. In addition,
for a shareholder whose adjusted gross income does not exceed $100,000 (or is
not married filing a separate return), certain distributions from traditional
IRAs may be rolled over to a Roth IRA and any of the shareholder's traditional
IRAs may be converted to a Roth IRA; these rollover distributions and
conversions are, however, subject to federal income tax.
Contributions to a Roth IRA are not deductible; however, earnings
accumulate tax-free in a Roth IRA, and withdrawals of earnings are not subject
to federal income tax if the account has been held for at least five years (or
in the case of earnings attributable to rollover contributions from or
conversions of a traditional IRA, the rollover or conversion occurred more than
five years before the withdrawal) and the account holder has reached age 59 1/2
(or certain other conditions apply).
EDUCATION IRA. Although not technically for retirement savings,
Education IRAs provide a vehicle for saving for a child's higher education. An
Education IRA may be established for the benefit of any minor and any person
whose adjusted gross income does not exceed certain levels may contribute to an
Education IRA, provided that no more than $500 may be contributed for any year
to Education IRAs for the same beneficiary. Contributions are not deductible and
may not be made after the beneficiary reaches age 18; however, earnings
accumulate tax-free, and withdrawals are not subject to tax if used to pay the
qualified higher education expenses of the beneficiary (or transferred to an
Education IRA of a qualified family member).
Simplified Employee Pension Plan -- SEP
Legg Mason makes available to corporate and other employers a SEP for
investment in Primary
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Shares.
Savings Incentive Match Plan for Employees - SIMPLE
An employer with no more than 100 employees that does not maintain
another retirement plan instead may establish a SIMPLE either as separate IRAs
or as part of a Code section 401(k) plan. A SIMPLE, which is not subject to the
complicated nondiscrimination rules that generally apply to qualified retirement
plans, will allow certain employees to make elective contributions of up to
$6,000 per year and will require the employer to make either matching
contributions up to 3% of each such employee's salary or a 2% nonelective
contribution.
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 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.
PERFORMANCE INFORMATION
FOR GOVERNMENT INTERMEDIATE, INVESTMENT GRADE AND HIGH YIELD:
TOTAL RETURN CALCULATIONS Average annual total return quotes used in a
fund's advertising and other promotional materials ("performance
advertisements") are calculated separately for each Class according to the
following formula:
P(1+T)n = 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 a fund are assumed to have been reinvested
at net asset value on the reinvestment dates during the period.
YIELD Yields used in a fund's performance advertisements for each Class
of Shares are calculated by dividing a 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:
Yield = 2 [(a-b +1)6 - 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
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d = the maximum offering price per share on the last day of the Period.
Except as noted below, in determining interest earned during the Period
(variable "a" in the above formula), a fund calculates interest earned on each
debt obligation held by it during the Period by (1) computing the obligation's
yield to maturity based on the market value of the obligation (including actual
accrued interest) on the last business day of the Period or, if the obligation
was purchased during the Period, the purchase price plus accrued interest and
(2) dividing the yield to maturity by 360, and multiplying the resulting
quotient by the market value of the obligation (including actual accrued
interest). Once interest earned is calculated in this fashion for each debt
obligation held by the fund, interest earned during the Period is then
determined by totaling the interest earned on all debt obligations. For the
purposes of these calculations, the maturity of an obligation with one or more
call provisions is assumed to be the next call date 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) a fund
accounts for gain or loss attributable to actual paydowns as an increase or
decrease to interest income during the period and (2) a 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 of Government Intermediate, Investment
Grade and High Yield for the 30-day period ended December 31, 1998 was 4.58%,
5.03% and 7.87%, respectively. The 30-day yield for Navigator Shares of
Government Intermediate, Investment Grade and High Yield for the same period was
5.13%, 5.59% and 8.33%, respectively. Yields of Government Intermediate and
Investment Grade would have been lower if Legg Mason Fund Adviser, Inc.
("Manager") had not waived a portion of those funds' expenses.
FOR GOVERNMENT MONEY MARKET:
YIELD The current annualized yield for the fund is based upon a
seven-day period and is computed by determining the net change in the value of a
hypothetical account in the fund. 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 realized gains and losses or unrealized
appreciation and depreciation. In addition, the fund 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 fund'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 fund's current
yield will fluctuate and that shareholders' principal is not guaranteed or
insured should be considered in comparing the fund's yield with yields on
fixed-income investments, such as insured savings certificates. In comparing the
yield of the fund 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 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
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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. Each fund also may refer in such materials to
mutual fund performance rankings and other data, such as comparative asset,
expense and fee levels, published by Lipper, CDA, Wiesenberger or Morningstar.
Performance advertisements also may refer to discussions of a Class of a fund
and comparative mutual fund data and ratings reported in independent
periodicals, including THE WALL STREET JOURNAL, MONEY Magazine, FORBES, BUSINESS
WEEK, FINANCIAL WORLD, BARRON'S, FORTUNE and THE NEW YORK TIMES.
Each 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.
Each fund may include discussions or illustrations of the effects of
compounding in performance advertisements. "Compounding" refers to the fact
that, if dividends or other distributions on an investment in a fund are
reinvested in additional 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 shares received through reinvestment. As a result, the
value of the fund investment would increase more quickly than if dividends or
other distributions had been paid in cash.
Each fund may also compare 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 a 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, each 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. Each fund may use other recognized
sources as they become available.
Each 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.
Each 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
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<PAGE>
as the Lehman Brothers Long-Term Government Bond Index.
Each fund may also include in advertising biographical information on
key investment and managerial personnel.
Each 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.
Each 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 to private accounts
and mutual funds with approximately $89 billion in assets as of March 31, 1999.
In advertising, each 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 ($15,000 for High Yield) made in each
fund at commencement of operations of each class of fund shares. The tables
assume that all dividends and other distributions are reinvested in each
respective 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 funds, 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.
GOVERNMENT INTERMEDIATE:
PRIMARY SHARES
<TABLE>
<CAPTION>
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>
1987* $9,920 $302 $10,222
1988 9,800 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
1995 11,652 7,716 19,368
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<PAGE>
1996 11,474 8,760 20,234
1997 11,574 10,067 21,641
1998 11,696 11,364 23,060
</TABLE>
*August 7, 1987 (commencement of operations) to December 31, 1987.
NAVIGATOR SHARES
<TABLE>
<CAPTION>
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
1995 10,470 710 11,180
1996 10,310 1,439 11,749
1997 10,400 2,227 12,627
1998 10,510 3,018 13,528
</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, 1998 would have been $10,510 and the investor
would have received a total of $3,111 in distributions. With 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,
1998 would have been $10,510, and the investor would have received a total of
$2,604 in distributions. Returns would have been lower if the Manager had not
waived certain fees during the fiscal years 1987 through 1998.
INVESTMENT GRADE:
PRIMARY SHARES
<TABLE>
<CAPTION>
Value of Original Shares Plus
Shares Obtained Through Value of Shares Acquired Through
Reinvestment of Capital Gain Reinvestment of Income Dividends Total
Fiscal Year Distributions Value
- ----------------------- ---------------------------------- ---------------------------------- -----------------
<S> <C> <C> <C> <C>
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
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<PAGE>
1994 10,717 6,590 17,307
1995 12,069 8,724 20,793
1996 11,815 9,874 21,689
1997 12,243 11,682 23,925
1998 12,601 12,996 25,597
</TABLE>
*August 7, 1987 (commencement of operations) to December 31, 1987.
NAVIGATOR SHARES
<TABLE>
<CAPTION>
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>
1995* $10,440 $27 $10,467
1996 10,220 758 10,978
1997 10,590 1,590 12,180
1998 10,744 2,358 13,102
</TABLE>
*December 1, 1995 (commencement of operations) to December 31, 1995.
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, 1998 would have been $10,520, and the investor
would have received a total of $8,959 in distributions. With 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,
1998 would have been $10,520, and the investor would have received a total of
$2,097 in distributions. Returns would have been lower if the Manager had not
waived certain fees during the fiscal years 1987 through 1998.
HIGH YIELD:
PRIMARY SHARES:
<TABLE>
<CAPTION>
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* $13,560 $1,006 $14,566
1995 14,620 2,570 17,190
1996 15,370 4,383 19,753
1997 16,405 6,480 22,885
1998 14,802 7,613 22,415
</TABLE>
*February 1, 1994 (commencement of operations) to December 31, 1994.
50
<PAGE>
If the investor had not reinvested dividends and other distributions,
the total value of the hypothetical investment as of December 31, 1998 would
have been $14,680, and the investor would have received a total of $6,300 in
distributions.
NAVIGATOR SHARES:
<TABLE>
<CAPTION>
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>
1998* $14,643 $1,000 $15,643
</TABLE>
*May 5, 1998 (commencement of operations) to December 31, 1998.
If the investor had not reinvested dividends and other distributions,
the total value of the hypothetical investment as of December 31, 1998 would
have been $14,630, and the investor would have received a total of $1,062 in
distributions.
CAPITAL STOCK INFORMATION
The Articles of Incorporation of the corporation permit the Board of
Directors to create additional series (or portfolios), each of which may issue
separate classes of shares. The corporation has authorized one billion shares of
common stock, par value $0.001 per share. Government Intermediate, Investment
Grade and High Yield currently offer two classes of shares - Class A, known as
Primary Shares and Class Y, known as Navigator Shares. The two classes represent
interests in the same pool of assets. A separate vote is taken by a class of
shares of a fund if a matter affects just that class. Each class may bear
certain differing class-specific expenses.
Shareholders of the funds are entitled to one vote per share and
fractional votes for fractional shares held. Voting rights are not cumulative.
All shares of the funds are fully paid and nonassessable and have no preemptive
or conversion rights.
THE FUNDS' CUSTODIAN AND TRANSFER AND DIVIDEND-DISBURSING AGENT
State Street Bank and Trust Company, P.O. Box 1713, Boston,
Massachusetts 02105, serves as custodian of each 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.
Shareholders who request an historical transcript of their account will be
charged a fee based upon the number of years researched. Each 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 Massachusetts Avenue, N.W.,
Washington, D.C. 20036-1800, serves as counsel to the Corporation.
THE CORPORATION'S INDEPENDENT ACCOUNTANTS
PricewaterhouseCoopers LLP, 250 W. Pratt Street, Baltimore, MD 21201,
has been selected by the Directors to serve as the Corporation's independent
accountants.
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<PAGE>
FINANCIAL STATEMENTS
The Statement of Net Assets as of December 31, 1998; the Statement of
Operations for the year ended December 31, 1998; the Statement of Changes in Net
Assets for the years ended December 31, 1998 and 1997; 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 each fund's Annual
Report to Shareholders for the year ended December 31, 1998, are hereby
incorporated by reference in this Statement of Additional Information.
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<PAGE>
APPENDIX A
The following are descriptions of hedging instruments which may be used
by Government Intermediate, Investment Grade or High Yield:
OPTIONS ON SECURITIES AND FOREIGN CURRENCIES--A call option is a
short-term contract pursuant to which the purchaser of the option, in return for
a premium, has the right to buy the security or currency underlying the option
at a specified price at any time during the term of the option. The writer of
the call option, who receives the premium, has the obligation, upon exercise of
the option during the option term, to deliver the underlying security or
currency against payment of the exercise price. A put option is a similar
contract that gives its purchaser, in return for a premium, the right to sell
the underlying security or currency at a specified price during the option term.
The writer of the put option, who receives the premium, has the obligation, upon
exercise of the option during the option term, to buy the underlying security or
currency at the exercise price.
OPTION ON A SECURITIES INDEX--An option on a securities index is
similar to an option on a security or foreign currency, except that settlement
of an index option is effected with a cash payment based on the value of the
index and does not involve the delivery of the securities included in the index.
Thus, upon settlement of an index option, the purchaser will realize, and the
writer will pay, an amount based on the difference between the exercise price of
the option and the closing price of the index.
INTEREST RATE AND FOREIGN CURRENCY FUTURES CONTRACTS--Interest rate and
foreign currency futures contracts are bilateral agreements pursuant to which
one party agrees to make, and the other party agrees to accept, delivery of a
specified type of debt security or currency at a specified future time and at a
specified price. Although such futures contracts by their terms call for actual
delivery or acceptance of debt securities or currency, in most cases the
contracts are closed out before the settlement date without the making or taking
of delivery. An index futures contract is similar to any other futures contract
except that settlement of an index futures contract is effected with a cash
payment based on the value of the index and does not involve the delivery of the
securities included in the index.
OPTIONS ON FUTURES CONTRACTS--Options on futures contracts are similar
to options on securities or currency, except that an option on a futures
contract gives the purchaser the right, in return for the premium, to assume a
position in a futures contract (a long position if the option is a call and a
short position if the option is a put), rather than to purchase or sell a
security or currency, at a specified price at any time during the option term.
Upon exercise of the option, the delivery of the futures position to the holder
of the option will be accompanied by delivery of the accumulated balance that
represents the amount by which the market price of the futures contract exceeds,
in the case of a call, or is less than, in the case of a put, the exercise price
of the option on the future. The writer of an option, upon exercise, will assume
a short position in the case of a call and a long position in the case of a put.
An option on a bond index futures contract is similar to any other option on a
futures contract except that the purchaser has the right, in return for the
premium, to assume a position in a bond index futures contract at a specified
price at any time during the option term.
FORWARD CURRENCY CONTRACTS--A forward currency contract involves an
obligation to purchase or sell a specific currency at a specified future date,
which may be any fixed number of days from the contract date agreed upon by the
parties, at a price set at the time the contract is entered into.
53
