<PAGE> 1
GOVERNMENT INCOME FUND
GRADISON
ANNUAL REPORT
DECEMBER 31, 1996
GRADISON
This material is intended for distribution to shareholders of the Gradison
Government Income Fund. it may be distributed to other persons only if it is
preceded or accompanied by a current prospectus of the Gradison Government
Income Fund.
McDonald & Company Securities, Inc. -- Distributor
A Fund Investing in U.S. Government Securities
<PAGE> 2
GRADISON
GOVERNMENT INCOME FUND
LETTER TO SHAREHOLDERS
January 31, 1997
Dear Shareholder:
The year of 1996 was a bumpy ride for investors in U.S. Government and
other high-grade bonds. This was primarily the result of interest rates
finishing the year higher than they began and the significant volatility
(rallies and sell-offs) during the year. Fortunately, the decline was shallow
enough for the received income to exceed the reduced values and, in turn,
produced a positive total return for the year. More specifically, the
shareholders of the Gradison Government Income Fund benefited from management's
decision to overweight Government National Mortgage Association pass throughs
(Ginnie Maes) as these securities had total returns of about 2.83% greater than
U.S. Treasuries. This overweighting will more than likely continue as we go
forward in 1997. Please see performance table on next page.
In retrospect, 1996 did what it should have done. If you will recall in our
1995 letter, we felt that there was excessive optimism regarding lower rates for
1996. The Medicare, increased deficit, poor economy, and low-growth economy
debates preceding the presidential election should have and most likely did
leave investors confused. In addition, the economic indicators such as retail
sales, housing, construction, etc. are all basically at very "neutral" levels
and, therefore, very small deviations can cause disproportionately large
fluctuations in investor perceptions. As many of you know, perception can
sometimes be more important than reality.
Since our economy is now growing at about its natural sustainable rate, I
see no reason at present for the Federal Reserve Board to alter its current
interest rate policy. However, should interest rates change, it will most likely
be due to international political considerations.
Once again, I want to thank you for your continued support and patronage of
Gradison Government Income Fund.
Sincerely,
Gradison Government Income Fund
/s/ Michael J. Link
- --------------------------
Michael J. Link
Executive Vice President and Portfolio Manager
1-800-869-5999 [LOGO]
<PAGE> 3
<TABLE>
<CAPTION>
AVERAGE ANNUAL TOTAL RETURN PERIODS ENDED DECEMBER 31, 1996
SINCE INCEPTION
9/16/87 5 YEARS 1 YEAR
<S> <C> <C> <C> <C>
@ Maximum Offer Price (2% Sales Charge) 8.08% 5.53% 1.44%
@ Net Asset Value (No Sales Charge)* 8.32% 5.97% 3.51%
</TABLE>
- -------------------------------------------------------------------------------
*Certain qualifying group retirement Fund purchases are made without a sales
charge, as are all purchases representing reinvestment of dividends. See pages
6 and 9 of the Prospectus. This performance data does not reflect the
deduction of the sales charge which would reduce the performance illustrated
to the figure of the line above it.
The performance quoted above represents past performance. The investment
return and value of an investment in the Fund will fluctuate so that an
investor's shares, when redeemed, may be worth more or less than the original
cost. Total return includes changes in share value and reinvestment of all
distributions.
COMPARISON OF CHANGE IN VALUE OF A $10,000 INVESTMENT
Effective July 1993, the Securities and Exchange Commission (SEC) requires
that performance information be graphed and compared with the performance of a
broad based index. It should be noted that an actively managed fund has a
variety of expenses that reduces its total return while an index includes no
expenses.
<TABLE>
<CAPTION>
LEHMAN BROTHERS LEHMAN BROTHERS LEHMAN BROTHERS GRADISON-MCDONALD
AGGREGATE BOND TREASURY GNMA GOVERNMENT INCOME
INDEX INDEX INDEX FUND
<S> <C> <C> <C> <C>
9/16/87 $10,000 $10,000 $10,000 $ 9,800
12/31/87 10,467 10,465 10,474 10,302
12/31/88 11,293 11,197 11,395 11,036
12/31/89 12,934 12,807 13,183 12,442
12/31/90 14,093 13,901 14,578 13,536
12/31/91 16,348 16,027 16,917 15,441
12/31/92 17,558 17,183 18,170 16,414
12/31/93 19,270 19,018 19,365 17,650
12/31/94 18,707 18,376 19,071 16,981
12/31/95 22,161 21,760 22,321 19,902
12/31/96 22,965 22,342 23,555 20,600
</TABLE>
<TABLE>
<CAPTION>
DISTRIBUTIONS PER SHARE
INVESTMENT PAID-IN
INCOME CAPITAL TOTAL
<S> <C> <C> <C>
1996 $0.768 - $0.768
1995 $0.787 $0.035 $0.822
</TABLE>
- -------------------------------------------------------------------------------
See accompanying notes to financial statements.
2
<PAGE> 4
<TABLE>
<CAPTION>
FINANCIAL HIGHLIGHTS (For a share outstanding throughout each year)
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------
1996 1995 1994 1993 1992
<S> <C> <C> <C> <C> <C>
Net asset value at beginning of year ........... $ 13.214 $ 12.018 $ 13.373 $ 13.327 $ 13.553
-------- -------- -------- -------- --------
INCOME FROM INVESTMENT OPERATIONS:
Net investment income ...................... .778 .786 .755 .749 .856
Net realized and unrealized gain (loss)
on investments ........................... (.340) 1.232 (1.244) .239 (.050)
-------- -------- -------- -------- --------
Total income (loss) from investment operations .438 2.018 (.489) .988 .806
-------- -------- -------- -------- --------
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment income ....... (.768) (.787) (.779) (.738) (.859)
Dividends in excess of net investment income -- -- (.013) -- --
Distributions from realized capital gains .. -- -- (.053) (.204) (.173)
Distributions from paid-in capital ......... -- (.035) (.021) -- --
-------- -------- -------- -------- --------
Total distributions to shareholders .......... (.768) (.822) (.866) (.942) (1.032)
-------- -------- -------- -------- --------
Net asset value at end of year ............... $ 12.884 $ 13.214 $ 12.018 $ 13.373 $ 13.327
======== ======== ======== ======== ========
Total return (1) ............................. 3.51% 17.20% (3.69%) 7.52% 6.29%
======== ======== ======== ======== ========
RATIOS/SUPPLEMENTAL DATA:
Net assets at end of year (in millions) ...... $ 162.9 $ 185.4 $ 184.0 $ 266.0 $ 210.9
Ratio of expenses to average net assets ...... .90% .92% .90% .90% .94%
Ratio of net investment income to
average net assets ......................... 6.06% 6.19% 6.03% 5.48% 6.39%
Portfolio turnover rate ...................... 13.33% 15.84% 20.91% 133.88% 83.36%
</TABLE>
(1)Total return is based upon an initial investment purchased without a sales
charge.
See accompanying notes to financial statements.
3
<PAGE> 5
PORTFOLIO OF INVESTEMENTS DECEMBER 31,1996
<TABLE>
<CAPTION>
PAR COUPON
AMOUNT MORTGAGE-BACKED SECURITIES - 60.75% RATE MATURITY VALUE
<S> <C> <C> <C> <C> <C>
$10,581,043 Government National Mortgage Association 6.50% 11/15/08-5/15/09 $ 10,438,860
724,688 Government National Mortgage Association 6.55 11/15/13 700,456
20,000,871 Government National Mortgage Association 7.00 4/15/23-9/15/23 19,563,352
21,178,452 Government National Mortgage Association 7.50 4/15/23-3/15/24 21,185,071
20,989,906 Government National Mortgage Association 8.00 7/15/02-7/15/26 21,504,328
3,768,815 Government National Mortgage Association 8.25 6/15/35 3,874,813
8,491,255 Government National Mortgage Association 8.50 4/15/21-11/15/22 8,799,063
2,620,657 Government National Mortgage Association 8.75 4/15/22 2,738,177
2,072,460 Government National Mortgage Association 9.00 1/15/20-8/15/21 2,183,207
3,286,489 Government National Mortgage Association 9.50 10/15/02-6/15/21 3,536,946
2,983,780 Government National Mortgage Association 10.00 5/15/12-6/15/21 3,282,158
------------
Total Mortgage-Backed Securities
(Cost $99,040,668) 97,806,431
------------
- -------------------------------------------------------------------------------
<CAPTION>
U.S. TREASURY OBLIGATIONS - 38.16%
<S> <C> <C> <C> <C>
10,000,000 U.S. Treasury Bond 5.88 11/15/05 9,643,750
20,000,000 U.S. Treasury Note 6.25 2/15/03 19,981,250
10,000,000 U.S. Treasury Note 6.38 1/15/00 10,096,875
10,000,000 U.S. Treasury Bond 7.63 2/15/07 10,487,500
10,000,000 U.S. Treasury Bond 8.75 11/15/08 11,225,000
------------
Total U.S. Treasury Obligations
(Cost $62,545,313) 61,434,375
------------
- -------------------------------------------------------------------------------
<CAPTION>
FACE INTEREST
AMOUNT REPURCHASE AGREEMENT - 1.09% RATE (1)
<S> <C> <C> <C>
1,755,000 Fuji Securities, dated 12/31/96, collateral:
U.S. Treasury Note, 8%; due 8/15/99
with a market value of $1,787,573
(repurchase proceeds: $1,755,629)
(Cost $1,755,000) 6.54 1/2/97 1,755,000
------------
TOTAL INVESTMENTS, at value (Note 1)
(Cost $163,340,981) - 100% $160,995,806
============
</TABLE>
- -------------------------------------------------------------------------------
(1) For repurchase agreements, the rate shown reflects the actual rate of
return to the Fund.
See accompanying notes to financial statements.
4
<PAGE> 6
<TABLE>
<CAPTION>
STATEMENT OF ASSETS AND LIABILITIES
December 31, 1996
<S> <C> <C> <C>
Assets
Investments in securities, at value (Note 1) (Cost $163,340,981) $160,995,806
Receivable for Fund shares sold 393,094
Interest receivable 1,866,683
Prepaid expenses and other assets 12,858
------------
Total Assets 163,268,441
------------
Liabilities
Payable for Fund shares redeemed 260,985
Accrued investment advisory fee (Note 2) 67,259
Other accrued expenses payable to adviser (Note 2) 41,690
Other accrued expenses and liabilities 24,664
------------
Total Liabilities 394,598
------------
Net Assets $162,873,843
============
Net assets consist of:
Aggregate paid-in capital $171,212,390
Distributions in excess of net investment income (Note 1) (59,323)
Accumulated net realized loss (5,934,049)
Net unrealized depreciation of investments (2,345,175)
------------
Net Assets $162,873,843
============
Shares of capital stock outstanding
(no par value - unlimited number of shares authorized) 12,640,897
============
Net asset value and redemption price per share (Note 1) $12.88
============
Maximum offering price per share (Note 1) $13.14
============
</TABLE>
See accompanying notes to financial statements.
5
<PAGE> 7
<TABLE>
<CAPTION>
STATEMENT OF OPERATIONS
YEAR ENDED
DECEMBER 31, 1996
<S> <C> <C>
Interest income $11,993,991
Expenses:
Investment advisory fee (Note 2) $ 866,440
Distribution (Note 2) 427,632
Personnel costs (Note 2) 59,036
Data Processing fee (Note 2) 45,119
Professional fees 34,774
Trustees' fees (Note 2) 22,612
Registration fees 21,072
Custodian fees 19,416
Postage and mailing 16,221
Printing 14,640
ICI dues 9,077
Other 15,522
---------
Total expenses 1,551,561
----------
Net investment income 10,442,430
Net realized and unrealized gain (loss)
on investments:
Net realized loss on investments (768,575)
Net realized gain on written call options 232,031
Net change in unrealized depreciation of investments (4,448,606)
----------
Net realized and unrealized loss on investments (4,985,150)
----------
Net increase in net assets resulting from operations $ 5,457,280
===========
</TABLE>
See accompanying notes to financial statements.
6
<PAGE> 8
<TABLE>
<CAPTION>
STATEMENT OF CHANGES IN NET ASSETS
YEAR ENDED DECEMBER 31,
-----------------------
<S> <C> <C>
1996 1995
From operations:
Net investment income $ 10,442,430 $ 11,374,446
Net realized loss on investments (536,544) (3,220,413)
Net change in unrealized appreciation/depreciation of investments (4,448,606) 21,179,573
------------ ------------
Net increase in net assets resulting from operations 5,457,280 29,333,606
------------ ------------
From distributions to shareholders:
Net investment income (10,293,237) (11,374,395)
Paid-in capital (Note 1) - (495,716)
------------ ------------
Decrease in net assets from distributions to shareholders (10,293,237) (11,870,111)
------------ ------------
From Fund share transactions:
Proceeds from shares sold 28,763,172 32,626,195
Net asset value of shares issued as distributions 8,597,718 9,872,425
Payments for Fund shares redeemed (55,084,613) (58,557,288)
------------ ------------
Net decrease in net assets from Fund share transactions (17,723,723) (16,058,668)
------------ ------------
Total (decrease) increase in net assets (22,559,680) 1,404,827
Net assets:
Beginning of year 185,433,523 184,028,696
------------ ------------
End of year (including distributions in excess of net investment
income of $59,323 and $208,516, respectively) (Note 1) $162,873,843 $185,433,523
============ ============
Number of Fund shares:
Sold 2,230,737 2,562,741
Issued as distributions to shareholders 670,451 774,962
Redeemed (4,293,141) (4,618,139)
------------ ------------
Net decrease in shares outstanding (1,391,953) (1,280,436)
Outstanding at beginning of year 14,032,850 15,313,286
------------ ------------
Outstanding at end of year 12,640,897 14,032,850
============ ============
</TABLE>
See accompanying notes to financial statements.
7
<PAGE> 9
NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1996
Note 1 - Significant Accounting Policies
===============================================================================
Gradison Custodian Trust (the "Trust") is registered under the Investment
Company Act of 1940, as amended, as a diversified, open-end management
investment company. The Trust was created under Ohio law by a Declaration of
Trust dated June 3, 1987; it commenced investment operations and the public
offering of its shares on September 16, 1987. There is currently one series,
the Gradison Government Income Fund (The "Fund"). The Fund's investment
objective is to seek high current income through investment in U.S. Government
obligations and obligations of agencies or instrumentalities of the U.S.
Government.
The following is a summary of significant accounting policies followed by the
Fund in the preparation of its financial statements. The policies are in
conformity with generally accepted accounting principles. The preparation of
financial statements requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amount of income and expenses for the
period. Actual results could differ from those estimates.
SECURITIES VALUATION - Portfolio securities for which over-the-counter market
quotations are readily available are valued at the latest bid price. Debt
securities maturing within 60 days are valued at amortized cost, which
approximates market value. Portfolio securities for which market quotations
are not readily available are valued at their fair value as determined by
management using procedures approved by the Board of Trustees.
Repurchase agreements, which are collateralized by U.S. Government
obligations, are valued at cost which, together with accrued interest,
approximates market. Collateral for repurchase agreements is held in
safekeeping in the customer-only account of the Fund's custodian. At the time
the Fund enters into a repurchase agreement, the seller agrees that the value
of the underlying security, including accrued interest, will be equal to or
exceed the face amount of the repurchase agreement. In the event of a
bankruptcy or other default of the seller of a repurchase agreement, the Fund
could experience both delays in liquidating the underlying security and
losses. These losses would not exceed an amount equal to the difference
between the liquidating value of the underlying security and the face amount
of the repurchase agreement and accrued interest. To minimize the possibility
of loss, the Fund enters into repurchase agreements only with selected
domestic banks and securities dealers which the Fund's investment adviser
believes present minimal credit risk. Refer to the Fund's Portfolio of
Investments for the face amount of repurchase agreements and repurchase
proceeds as of December 31, 1996.
OPTION ACCOUNTING PRINCIPLES - When the Fund writes a call option, an amount
equal to the premium received by the Fund is recorded as an asset and as an
equivalent liability. The amount of the liability is subsequently
marked-to-market to reflect the current market value of the written option.
The current market value of a traded option is the last ask price on the
principal exchange on which such option is traded. If the option expires on
its stipulated expiration date or if the Fund enters into a closing purchase
transaction, the Fund will realize a gain or loss without regard to any
unrealized gain or loss on the underlying security and liability related to
such option will be extinguished.
The risk in writing a call option on a security which the Fund owns is that
the Fund limits the profit potential from an increase in the market price of
the security. The Fund may also be subject to the additional risk of not being
able to enter into a closing transaction if a liquid secondary market does not
exist. The Fund also writes over-the-counter options where the Fund's ability
to successfully extinguish its obligation is dependent upon the credit
standing of the other party.
SECURITIES TRANSACTIONS AND INVESTMENT INCOME - Securities transactions are
accounted for on the trade date (the date the order to buy or sell is
executed). Interest income is accrued as earned. Gains and losses on sales of
investments are calculated on the identified cost basis for financial
reporting and tax purposes.
8
<PAGE> 10
NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1996
SECURITIES PURCHASED ON A WHEN-ISSUED OR DELAYED DELIVERY BASIS - When the
Fund purchases securities on a when-issued or delayed delivery basis, the
transaction may be entered into a month or more before delivery and payment
are made. Such securities are subject to market fluctuation during this
period. In the event that the seller fails to deliver the securities, the Fund
could experience a loss to the extent of any appreciation, or a gain to the
extent of any depreciation, in the price of the securities.
The Fund will maintain, in a segregated account with its custodian, cash or
U.S. Government securities having an aggregate value at least equal to the
amount of such purchase commitments. At December 31, 1996, the Fund had not
committed to the purchase of any when-issued of delayed delivery securities.
TAXES - It is the Fund's policy to comply with the provisions of the Internal
Revenue Code available to regulated investment companies. As provided therein,
in any fiscal year in which the Fund so qualifies, and distributes at least
90% of its taxable net income, the Fund will be relieved of federal income tax
on the income distributed. Accordingly, no provision for income taxes has been
made.
In order to avoid imposition of the excise tax applicable to regulated
investment companies, it is also the Fund's intention to declare as dividends
in each calendar year, at least 98% of its net investment income (earned
during the calendar year) and 98% of its net realized capital gains, if any
(earned during the twelve months ended October 31), plus undistributed
amounts from prior years.
The tax basis of investments is substantially equal to the cost as shown on
the Statement of Assets and Liabilities.
For both financial reporting and tax purposes, gross unrealized appreciation
and gross unrealized depreciation of securities at December 31, 1996 was
$1,380,038 and $3,725,213, respectively.
As of December 31, 1996, the Fund had a capital loss carryforward for Federal
income tax purposes of approximately $5,890,000 which may be utilized to
offset future net realized capital gains through December 31, 2004 prior to
distributing such gains to shareholders.
FUND SHARE VALUATION - The net asset value per share is computed by dividing
the net asset value of the Fund (total assets less total liabilities) by the
number of shares outstanding. The maximum offering price per share is equal to
the net asset value per share plus 2.04% of net asset value (or 2% of the
offering price). The offering price per share is reduced on sales of $100,000
or more. The redemption price per share is equal to the net asset value per
share.
DISTRIBUTIONS TO SHAREHOLDERS - Dividends arising from net investment income
are declared daily and paid monthly. Distributions of net realized short-term
capital gains, if any, are declared and paid monthly on all shares of record
on established record dates. Net realized long-term capital gains, if any, are
distributed at least annually.
Note 2 - TRANSACTIONS WITH AFFILIATES
The Fund's investments are managed, subject to the general supervision and
control of the Fund's Board of Trustees, by the Gradison Division of McDonald
& Company Securities, Inc. (Gradison), a registered investment adviser and
securities dealer, pursuant to the terms of an Investment Advisory Agreement
(the Agreement). Under the terms of the Agreement, the Fund pays Gradison a
fee computed and accrued daily and paid monthly based upon the Fund's daily
net assets at the annual rate of .50%.
Under the terms of the Agreement, the Fund reimburses Gradison for the cost
of furnishing personnel to perform shareholder and certain other services
for the Fund. The Agreement also provides that Gradison bear the costs of
salaries and related expenses of executive officers of the Fund who are
necessary for the management and operations of the Fund. In
9
<PAGE> 11
NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1996
addition, Gradison bears the costs of preparing, printing and mailing sales
literature and other advertising materials, and compensates the Fund's
trustees who are affiliated with Gradison. All expenses not specifically
assumed by Gradison are borne by the Fund.
Under the terms of a Data Processing Agreement between the Trust and Gradison,
the Fund pays Gradison a monthly fee at an annual rate of $8.25 per
shareholder non-zero balance account for data processing services provided to
the Fund.
In accordance with the terms of a Distribution Service Plan adopted under Rule
12b-1 of the Investment Company Act of 1940, the Fund pays Gradison a
distribution service fee at an annual rate of .25% of average daily net
assets.
During the year ended December 31, 1996, Gradison received sales charges
aggregating $110,078 on sales of shares of the Fund.
The officers of the Trust are also officers of McDonald & Company Securities,
Inc.
Each trustee of the Trust who is not affiliated with Gradison receives fees
from the Trust for services as a trustee. The amounts of such fees for each
trustee are as follows: (a) an annual fee of $3,500 payable in quarterly
installments for service during each fiscal quarter and (b) $500 for each
Board of Trustees or committee meeting attended.
Note 3 - Summary of Securities Transactions
===============================================================================
For the year ended December 31, 1996, purchases and proceeds from the sale of
securities, excluding short-term securities, amounted to $23,844,705 and
$22,415,852, respectively. Transactions in written options on U.S. Treasury
Notes and Bonds were as follows:
NO. OF CONTRACTS PREMIUM
Outstanding at December 31, 1995 0 $ 0
Written 4,500 302,344
Closed (1,500) (113,281)
Exercised (1,000) (65,625)
Expired (2,000) (123,438)
------- --------
Outstanding at December 31, 1996 0 $ 0
======= ========
10
<PAGE> 12
[LOGO - LETTERHEAD - ARTHUR ANDERSEN]
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Shareholders and Board of Trustees of the
Gradison Government Income Fund
of the Gradison Custodian Trust:
We have audited the accompanying statement of assets and liabilities of the
Gradison Government Income Fund of the Gradison Custodian Trust (an Ohio
business trust), including the portfolio of investments, as of December 31,
1996, and the related statement of operations for the year then ended, the
statements of changes in net assets for the two years then ended and the
financial highlights for the five years then ended. These financial
statements and financial highlights are the responsibility of the Trust's
management. Our responsibility is to express an opinion on these financial
statements and financial highlights based upon our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements and
financial highlights are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. Our procedures included confirmation of
securities owned as of December 31, 1996, by correspondence with the
custodian and broker. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to
above present fairly, in all material respects, the financial position of the
Gradison Government Income Fund of the Gradison Custodian Trust as of
December 31, 1996, the results of its operations for the year then ended, the
changes in its net assets for the two years then ended and the financial
highlights for the five years then ended, in conformity with generally
accepted accounting principles.
Cincinnati, Ohio,
January 31, 1997
/s/ Arthur Anderson LLP
11
