<PAGE>
-------------------------------------------------------------------------------
PROSPECT STREET(R)
HIGH INCOME PORTFOLIO INC.
ANNUAL
REPORT
OCTOBER 31, 2000
[LOGO]
<PAGE>
December 14, 2000
LETTER TO SHAREHOLDERS
Dear Shareholders:
On October 31, 2000, the net asset value of the Fund was $5.30, as compared
to $6.98 on October 31, 1999. During the fiscal period ended October 31, 2000
the Fund paid dividends to common stock shareholders in the amount of $1.03 per
share.
2000 SPECIAL STOCKHOLDERS' MEETING:
At the Annual Meeting of Stockholders held on October 27, 2000 the
stockholders approved Ernst & Young LLP as the Fund's independent auditors for
the October 31, 2000 fiscal year audit.
Also at this meeting, the stockholders re-elected five Directors of the
Fund. Two of the independent directors, William C. Carey and Harlan Platt, did
not stand for re-election. In addition, John S. Albanese and Christopher E.
Roshier, non-voting, advisors to the Board, will no longer be serving the Fund's
stockholders. On behalf of the remaining Directors and Highland Capital
Management, L.P., we would like to thank them for their years of dedication and
service to the Fund on behalf of its stockholders.
THE HIGH YIELD MARKET:
Since the fall of the equity markets in March 2000, the high yield market
began a precipitous decline. This was the result of a confluence of factors,
including increasing default rates, reduced liquidity and limited new issue
volume. High yield mutual fund flows experienced a net outflow of $9.387 billion
for the twelve months ended October 31, 2000 as compared to a net inflow of
$4.868 billion for the twelve months ended October 31, 1999. The new issue
market for the twelve months ended October 31, 2000 was $52.2 billion, slightly
over 50% of the new issue volume for the twelve months ended October 31, 1999.
The high yield market, as measured by the B, CCC and Distressed DLJ High
Yield Indices, generated total returns of (1.36%), (17.71%), and (29.47%),
respectively, for the twelve-month period ending October 26, 2000. At October
26, 2000, the spread between high yield securities and comparable U.S.
Government securities stood at 829 basis points up from 657 basis points at
April 27, 2000 and 616 basis points at October 29, 1999. Widening credit spreads
have dramatically reduced primary bond issuance.
THE FUND'S INVESTMENTS:
The total return on the Fund's net assets for the twelve months ended
October 31, 2000, assuming reinvestment of dividends, was approximately (9.31%).
The total investment return on the Fund's per share market price was (15.37%)
for the twelve months ended October 31, 2000. The variation from the total
return on net assets is attributable to the decline in the per share market
value premium from 15.04% to 2.82% during the period.
Factors contributing to this performance were lower valuations of many of
the Fund's investments for some of the reasons discussed above, including
generally prevailing adverse market conditions, attributable to higher default
rates and diminished liquidity in the high-yield sector; and defaulted interest
payments and related non-accrual of investment income with respect to a number
of the Fund's investments.
As of October 31, 2000, the Fund held 123 issues representing 28 industry
groups. Cash and short-term investments represented approximately 0.7% of our
holdings. The average cost of the Fund's high yield securities was 58.89 with an
average coupon of 10.09%.
DIVIDEND REDUCTION:
During the fiscal year ended October 31, 2000, the Board of Directors voted
to reduce the monthly dividend rate twice. The net result of these actions was a
reduction in the dividend to $0.075 per share from $0.105 per share. As a result
of the current market environment at that time and portfolio repositioning, the
dividend was adjusted to be more reflective of the portfolio's current earning
rate.
Also, on June 9, 2000, the Board of Directors adopted a new policy of
declaring dividends on a three-month forward basis.
INVESTMENT OUTLOOK:
The high yield market continues to show signs of sluggishness, as a result
of the reasons noted above. However, while there is still a considerable amount
of negative pressure on the high yield market, there are some events which could
have a positive effect on the high yield market. Some of these are:
1. A change in the Federal Reserve bias towards a rate easing.
2. The leveling off or a decreasing of the actual default rate could
increase bond prices from the currently depressed levels as a result of
increased confidence in the high yield sector.
3. An improvement in market liquidity could give way to a more healthy new
issue calendar.
4. The current yields available in the high yield market continue to offer
attractive returns, particularly in the lower rating categories.
Some of the factors that could negatively impact the high yield market
are:
1. A continuing Federal Reserve policy to raise or not change interest
rates could change investor psychology, as the possibility of a
recession would become more probable.
2. Continued high default rates.
3. Continued credit rating downgrades by the major rating agencies.
4. High levels of cash outflows from high yield mutual funds further
depress bond prices as the funds are forced to sell investments into a
less liquid market.
CONCLUSION:
While continuing its decline since the events in March 2000, the high
yield market still presents investors with an attractive return opportunity.
Management continues to evaluate the Fund's investments, seeking to
maximize the Fund's total return on net assets.
Respectfully submitted,
/s/ James Dondero
James Dondero
President
/s/ Mark Okada
Mark Okada
Executive Vice President
<PAGE>
PROSPECT STREET HIGH INCOME PORTFOLIO INC.
SCHEDULE OF INVESTMENTs
October 31, 2000
<TABLE>
<CAPTION>
FIXED INCOME -- 91.56%
Ratings
--------------------
Par Standard Value
Value Description & Poor's Moody's (Note 2)
---------------------------------------------------------------------------------------------
AEROSPACE AND DEFENSE -- 5.26%
$ 7,000,000 Loral Space & Communication, 9.50%, BOND,
<S> <C> <C> <C>
01/15/2006 ............................. B- B1 $ 5,215,000
2,750,000 Orbital Sciences, 5.00%, BOND, 10/01/2002 B- Caa1 1,533,125
19,900,000 Orbital Imaging Corp., 11.63%, BOND, 03/
01/2005 ................................ CCC NR 4,577,000
------------
11,325,125
------------
AUTOMOBILE - 0.67%
3,000,000 Venture Holdings Trust, 12.00%, BOND,
06/01/2009 ............................. B- B3 1,447,500
------------
1,447,500
------------
BEVERAGE, FOOD AND TOBACCO -- 1.33%
1,000,000 North Atlantic Trading Company, Inc.,
11.00%, BOND, 06/15/2004 ............... B B3 830,000
4,000,000 Vlasic Foods, 10.25%, BOND, 07/01/2009 ... CCC Caa1 2,040,000
------------
2,870,000
------------
BROADCASTING AND ENTERTAINMENT -- 17.70%
1,000,000 Star Choice Communications, 13.00%, BOND,
12/15/2005 ............................. B+ B3 1,070,000
5,000,000 XM Satellite Radio, 14.00%, BOND,
03/15/2010 ............................. CCC+ Caa1 4,402,500
6,000,000 CD Radio, 14.50%, BOND, 05/15/2009 ....... CCC+ Caa1 4,942,406
6,500,000 Silver Cinemas Inc., 10.50%, BOND,
04/15/2005* ............................ NR NR 325,000
7,740,000 Orion Network, 11.25%, BOND, 01/15/2007 .. CCC+ B2 3,792,600
11,990,000 Satelites Mexicanos, 10.13%, BOND,
11/01/2004 ............................. B- B3 8,033,300
13,500,000 ICO Global Communications, 15.00%, BOND,
08/01/2005 ............................. NR NR 8,100,000
8,200,000 Innova S DE R.L., 12.88%, BOND, 04/01/2007 B- B3 7,410,750
------------
38,076,556
------------
BUILDINGS AND REAL ESTATE -- 1.40%
1,000,000 Penhall Acquisition Corporation, 12.00%,
BOND, 08/01/2006 ....................... B- B3 910,000
2,000,000 Fortress Group, 13.75%, BOND, 05/15/2003 . NR Caa2 855,000
5,000,000 Kevco, Inc., 10.38%, BOND, 12/01/2007 .... CCC Ca 1,250,000
------------
3,015,000
------------
CARGO TRANSPORT -- 0.47%
1,500,000 MTL, 10.00%, BOND, 06/15/2006 ............ B- Caa1 1,020,000
------------
1,020,000
------------
CHEMICALS, PLASTICS AND RUBBER -- 1.97%
14,150,000 Moll Industries, 10.50%, BOND, 07/01/2008 CC Caa3 4,245,000
------------
4,245,000
------------
CONTAINERS, PACKAGING AND GLASS -- 0.81%
500,000 Portola Packaging, 10.75%, BOND,
10/01/2005 ............................. B B3 380,000
1,500,000 Sweetheart Cup, 10.50%, Sr. Sub Notes,
09/01/2003 ............................. B- Caa1 1,365,000
------------
1,745,000
------------
DIVERSIFIED NATURAL RESOURCES, PRECIOUS
METALS -- 14.52%
2,000,000 American Tissue Inc, 12.50%, BOND,
07/15/2006 ............................. B+ B3 1,900,000
5,999,000 ANKER Coal Group Inc., 14.25%, BOND,
09/01/2007 ............................. CCC Caa2 2,879,520
9,000,000 Repap Enterprises, 6.00%, BOND, 06/30/2005
........................................ BBB+ Baa1 8,550,000
23,000,000 Uniforet, 11.13%, BOND, 10/15/2006 ....... CCC- Ca 16,100,000
2,000,000 Riverwood, 10.88%, BOND, 04/01/2008 ...... CCC+ Caa1 1,805,000
------------
31,234,520
------------
DIVERSIFIED/CONGLOMERATE MANUFACTURING --
0.75%
3,000,000 Pentacon Inc., 12.25%, BOND, 04/01/2009 .. B- B3 1,620,000
------------
1,620,000
------------
DIVERSIFIED/CONGLOMERATE SERVICE -- 1.30%
4,000,000 Localiza Rent, 10.25%, BOND, 10/01/2005 .. B+ B3 2,800,000
------------
2,800,000
------------
ELECTRONICS -- 3.27%
1,700,000 Anacomp, Inc., 10.88%, BOND, 04/01/2004* . D Caa3 425,000
2,000,000 Special Devices Inc., 11.38%, BOND,
12/15/2008 ............................. CCC+ Caa2 340,000
2,500,000 Vialog Corporation, 12.75%, BOND,
11/15/2001 ............................. CCC Caa3 2,378,125
4,000,000 Globix Corporation, 12.50%, BOND,
02/01/2010 ............................. B- NR 2,200,000
11,245,000 Orbcomm Global, 14.00%, Senior Notes,
08/15/2004* ............................ D Caa2 1,686,750
------------
7,029,875
------------
FINANCE -- 0.67%
1,115,625 Altiva Financial, 12.00%, BOND,
06/15/2006* ............................ B- D 0
1,500,000 Life Financial, 13.50%, BOND, 03/15/2004 . NR Caa1 1,440,000
------------
1,440,000
------------
HEALTHCARE, EDUCATION AND CHILDCARE --
0.96%
2,000,000 Global Health, 11.00%, BOND, 05/01/2008* . C C 180,000
3,000,000 La Petite Academy, Incorporated, 10.00%,
BOND, 05/15/2008 ....................... B- B3 1,800,000
5,000,000 PHP Healthcare, 6.50%, BOND, 12/15/2002* . NR NR 75,000
------------
2,055,000
------------
HOME AND OFFICE FURNISHINGS, HOUSEWARES,
AND DURABLES -- 3.19%
2,000,000 Derby Cycle Corp., 10.00%, BOND,
05/15/2008 ............................. CCC Caa2 500,000
15,720,000 U.S. Office Products, 9.75%, BOND,
06/15/2008 ............................. CCC- Ca 2,672,400
5,000,000 O'Sullivan Industries, 13.38%, Notes,
10/15/2009 ............................. B- B3 3,700,000
------------
6,872,400
------------
HOTELS, MOTELS, INNS, AND GAMING -- 1.56%
2,550,000 La Quinta, 7.27%, BOND, 02/26/2007 ....... BB- B1 1,708,500
3,000,000 Epic Resorts, 13.00%, BOND, 06/15/2005 ... B- B3 1,650,000
------------
3,358,500
------------
LEISURE, AMUSEMENT, ENTERTAINMENT -- 1.72%
1,000,000 Marvel III Holdings Inc., 12.00%, BOND,
06/15/2009* ............................ NR NR 540,000
4,200,000 Booth Creek Ski, 12.50%, BOND, 03/15/2007 CCC+ Caa1 3,150,000
25,750,000 Premier Cruises Ltd., 11.00%, BOND,
03/15/2008* ............................ D Caa2 0
20,125,000 Marvel III Holdings Inc., 0.00%, BOND,
04/15/2008 ............................. NR Caa1 0
------------
3,690,000
------------
MACHINERY (NON AG, NON CONSTRUCT, NON
ELECTRONIC) -- 0.42%
380,000 High Voltage Notes, 10.50%, BOND,
08/15/2004 ............................. B B3 247,000
1,500,000 Grove Worldwide, 9.25%, BOND, 05/01/2008 . CCC Caa1 202,500
3,000,000 Clark Material Handling, 10.75%, BOND,
11/15/2006* ............................ NR Ca 450,000
------------
899,500
------------
MINING, STEEL, IRON AND NONPRECIOUS METALS
-- 3.76%
290,820 Bramalea, 11.125%, BOND, 03/22/2008* ..... NR Caa1 0
2,000,000 WHX, 10.50%, BOND, 04/15/2005 ............ B- Caa1 1,240,000
2,850,000 Renco Steel Holding, 10.88%, BOND,
02/01/2005 ............................. B- Caa2 2,080,500
3,040,000 Haynes International, 11.63%, BOND,
09/01/2004 ............................. B- B3 2,219,200
3,180,000 Reunion Industries Inc., 13.00%, BOND,
05/01/2003 ............................. B- B2 2,544,000
------------
8,083,700
------------
OIL AND GAS -- 1.83%
3,125,000 Belden & Blake, 9.88%, BOND, 06/15/2007 .. CCC- Caa3 2,625,000
3,750,000 First Wave Marine Inc., 11.00%, BOND,
02/01/2008 ............................. B- B3 1,312,500
------------
3,937,500
------------
PERSONAL AND NONDURABLE CONSUMER PRODUCTS
-- 2.24%
1,000,000 Styling Technology Corp., 10.875%, BOND,
07/01/2008* ............................ NR Caa3 80,000
9,515,000 Diamond Brands Incorporated, 10.13%, BOND,
04/15/2008 ............................. CCC Caa1 4,745,606
------------
4,825,606
------------
PERSONAL TRANSPORTATION -- 1.22%
2,000,000 Trans World Airlines, 11.50%, BOND,
12/15/2004 ............................. CCC B2 1,320,000
2,000,000 Trans World Airlines, 12.00%, BOND,
04/01/2002 ............................. NR B2 1,300,000
------------
2,620,000
------------
PERSONAL, FOOD AND MISCELLANEOUS SERVICES
-- 0.22%
1,000,000 Advantica Restaurant, 11.25%, BOND,
01/15/2008 ............................. B B3 480,000
------------
480,000
------------
PRINTING AND PUBLISHING -- 1.85%
18,000,000 American Banknote Corporation, 11.25%,
BOND, 12/01/2007* ...................... D C 3,982,500
------------
3,982,500
------------
RETAIL STORES -- 3.44%
2,000,000 Petro Stopping Center, 10.50%, BOND,
02/01/2007 ............................. B B3 1,700,000
2,250,000 Wickes Lumber Co., 11.63%, BOND,
12/15/2003 ............................. CCC+ Caa1 1,417,500
2,500,000 Cole National Group, 8.63%, BOND,
08/15/2007 ............................. B B2 1,550,000
3,000,000 J. Crew, 10.38%, BOND, 10/15/2007 ........ CCC+ Caa1 2,730,000
------------
7,397,500
------------
STRUCTURED FINANCE OBLIGATIONS -- 1.67%
4,000,000 DLJ CBO LTD., 11.96%, Class C-2 Notes,
04/15/2011 ............................. NR Ba3 3,600,000
------------
3,600,000
------------
TELECOMMUNICATIONS -- 14.80%
500,000 Econophone (Destia Comm.), 13.50%, BOND,
07/15/2007 ............................. NR B3 245,000
1,000,000 Intermedia Communications, 8.60%, BOND,
06/01/2008 ............................. B B2 942,500
1,500,000 Telehub Communications Corporation, 0.00%,
BOND, 07/31/2005* ...................... NR NR 255,000
2,000,000 Viatel Inc., 11.25%, BOND, 04/15/2008* ... B- B3 590,000
2,000,000 Winstar Communications, Inc., 12.75%,
BOND, 04/15/2010 ....................... B- B3 1,410,000
3,000,000 USA Mobile Communication, 9.50%, BOND,
02/01/2004 ............................. B- B3 2,130,000
3,000,000 GST Equipment Funding, 13.25%, BOND,
05/01/2007* ............................ NR NR 1,695,000
3,250,000 Arch Communications, 13.75%, BOND,
04/15/2008 ............................. CCC+ B3 1,787,500
5,000,000 BTI Telecom Corporation, 10.50%, BOND,
09/15/2007 ............................. B B3 2,500,000
TELECOMMUNICATIONS -- CONTINUED
7,000,000 GST Network Funding, 0.00%, BOND,
05/01/2008* ............................ NR NR 3,015,384
7,321,000 Mpower, 13.00%, BOND, 04/01/2010 ......... B- B3 4,099,760
8,500,000 Globalstar, L.P., 11.38%, BOND, 02/15/2004 CCC Caa1 1,105,000
15,480,000 Motient Corporation, 12.25%, BOND,
04/01/2008 ............................. NR NR 11,068,200
2,000,000 Viatel Inc., 11.25%, Units, 04/15/2008 ... Caa1 1,000,000
------------
31,843,344
------------
TEXTILES AND LEATHER -- 2.55%
2,000,000 Galey & Lord Inc., 9.13%, BOND, 03/01/2008 B Ca 1,240,000
2,880,000 Glenoit Corporation, 11.00%, BOND,
04/15/2007* ............................ D Ca 489,600
3,800,000 Norton McNaught, 12.50%, BOND, 06/01/2005 B B2 3,230,000
4,960,000 Converse Inc., 7.00%, BOND, 06/01/2004* .. NR NR 520,800
------------
5,480,400
------------
TOTAL FIXED INCOME (cost 256,140,543)............................ $196,994,526
------------
</TABLE>
COMMON STOCK, PREFERRED STOCK AND WARRANTS -- 3.44%
<TABLE>
<CAPTION>
Value
<S> <C> <C>
Units Description (Note 2)
----- ----------- ---------
2,000 Loral Orion Network Systems Inc., warrants .............. $ 10,376
6,900 Orbital Imaging Corp., warrants ......................... 35,363
14,206 Vector Group ............................................ 197,996
500 Signature Brands, Inc., warrants ........................ 0
550 CS Wireless Systems Inc. ................................ 1
1,000 Knology Holdings Inc., warrants ......................... 0
1,000 XM Satellite Radio, warrants ............................ 580,500
3,500 Optel Inc., warrants .................................... 0
5,925 Capital PAC Holdings Inc., warrants ..................... 0
9,800 Uniroyal Technology Corp., warrants ..................... 0
131 ANKER Coal Group Inc. ................................... 0
17,251 GP Strategies Corp. ..................................... 95,959
100,000 Commodore Separation Technology ......................... 6,250
100,000 Commodore Separation Technology, warrants ............... 0
4,500 Vialog Corporation, warrants ............................ 1,740
595,258 Altiva Financial ........................................ 0
47,031 AMC Financial Inc. ...................................... 82,304
1,962 O'Sullivan Industries, preferred stock .................. 196
5,000 O'Sullivan Industries, warrants ......................... 12,500
500 Motels of America Inc. .................................. 125
8,862 Equus Gaming Co. L.P. ................................... 12,185
2,000 Epic Resorts, warrants .................................. 0
148,117 Premier Cruises Ltd. .................................... 0
1,500 WHX ..................................................... 9,938
8,774 NS Group Inc. ........................................... 75,018
3,750 Sheffield Steel Corp., warrants ......................... 0
28,000 Gothic Energy Corporation, warrants ..................... 0
9,533 Gothic Energy Corporation, warrants ..................... 0
2,000 Trans World Airlines .................................... 10,000
10,000 GIGA Information Group Inc. ............................. 40,000
291 Mother's Work Inc. ...................................... 2,692
185,900 Ames Department Stores Inc. ............................. 0
1,500 Telehub Communications Corporation ...................... 15
475,000 Motient Corporation ..................................... 5,759,375
450 Mpower, warrants ........................................ 2,925
1,000 Unifi Communications Inc., warrants ..................... 135
13,480 Motient Corporation, warrants ........................... 473,485
-----------
TOTAL COMMON STOCK, PREFERRED STOCK, AND WARRANTS (cost
$12,577,827) ............................................ 7,409,078
-----------
TOTAL INVESTMENT IN SECURITIES (cost 268,718,370) ....... 204,403,604
-----------
SHORT-TERM INVESTMENTS - 0.70%
Par
Value
COMMERCIAL PAPER:
$ 1,504,000 Case Credit, 6.82%, 11/01/2000 .......................... 1,504,000
TOTAL SHORT-TERM INVESTMENTS (cost 1,504,000) ........... 1,504,000
------------
TOTAL INVESTMENTS - 95.71% (COST 270,222,369) ........... 205,907,604
------------
OTHER ASSETS - 4.29% .................................... 9,239,234
------------
TOTAL ASSETS - 100% ..................................... $215,146,838
============
(a) Percentages indicated are based on total assets.
(b) Denotes company has filed for bankruptcy.
(c) Denotes security currently in default.
NR Denotes not rated.
* Non-income producing security.
</TABLE>
<PAGE>
PROSPECT STREET HIGH INCOME PORTFOLIO INC.
STATEMENT OF ASSETS AND LIABILITIES
October 31, 2000
ASSETS
<TABLE>
<CAPTION>
nvestments in securities at value (identified cost $270,222,369; see
<S> <C>
Schedule of Investments and Note 2) .................................... $205,907,604
Cash ................................................................... 968
Receivables:
Investment securities sold ........................................... 897,667
Interest and dividends ............................................... 8,111,539
Prepaid insurance ...................................................... 199,500
Other assets ........................................................... 29,560
------------
Total assets ................................................... $215,146,838
------------
LIABILITIES
Payables:
Investment securities purchased ...................................... $ 841,167
Accrued expenses (Note 3)............................................... 966,351
Bank loan (Note 10)..................................................... 71,000,000
------------
Total liabilities .............................................. $ 72,807,518
------------
Net Assets:
Common stock, $.03 par value --
Authorized -- 100,000,000 shares
Issued and outstanding -- 26,868,932 shares ........................ $ 806,068
Capital in excess of par value ....................................... 287,038,191
Undistributed accumulated net investment income (Note 2) ............. 2,349,980
Accumulated net realized loss from security transactions ............. (83,540,154)
Net unrealized depreciation on investments ........................... (64,314,765)
------------
Total net assets (equivalent to $5.30 per share, based on
26,868,932 shares outstanding) ............................... $142,339,320
============
</TABLE>
<PAGE>
PROSPECT STREET HIGH INCOME PORTFOLIO INC.
STATEMENT OF OPERATIONS
For the year ended October 31, 2000
<TABLE>
<CAPTION>
INVESTMENT INCOME (Note 2):
<S> <C>
Interest income ...................................................... $ 32,756,892
Dividend income ...................................................... 360,689
Accretion of discount and other miscellaneous income ................. 4,616,618
-------------
Total investment income ........................................ $ 37,734,199
=============
EXPENSES:
Interest expense ..................................................... $ 4,727,474
Investment advisory fees (Note 3) .................................... 1,660,674
Custodian and transfer agent fees .................................... 284,078
Insurance expense .................................................... 94,079
Professional fees .................................................... 315,843
Directors' fees ...................................................... 116,814
Excise Tax ........................................................... 150,942
Miscellaneous expense ................................................ 356,917
-------------
Total expenses ................................................. $ 7,706,821
-------------
Net investment income .......................................... $ 30,027,378
-------------
REALIZED AND UNREALIZED LOSS ON INVESTMENTS:
Net realized loss on investments sold ................................ $ (35,396,240)
Net change in unrealized depreciation of investments (Note 2) ........ (12,125,584)
-------------
Net realized and unrealized loss on investments ................ $ (47,521,824)
-------------
Net decrease in net assets resulting from operations ........... $ (17,494,446)
=============
</TABLE>
<PAGE>
PROSPECT STREET HIGH INCOME PORTFOLIO INC.
STATEMENT OF CASH FLOWS
For the year ended October 31, 2000
CASH FLOWS FROM OPERATING ACTIVITIES:
<TABLE>
<CAPTION>
<S> <C>
Interest and dividends received ..................................... $ 32,863,846
Operating expenses paid ............................................. (7,182,356)
-------------
Net cash provided by operating activities ..................... $ 25,681,490
-------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of portfolio securities .................................... $(257,860,402)
Sales and maturities of portfolio securities ........................ 237,486,928
-------------
Net cash used in investing activities ......................... $ (20,373,474)
-------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from bank loan ............................................. $ 25,000,000
Repayments of bank loan ............................................. (4,000,000)
Common stock dividends paid from operations ......................... (27,557,848)
Shares issued to common stockholders for reinvestment of dividends .. 1,224,804
-------------
Net cash provided by financing activities ..................... $ (5,333,044)
-------------
NET DECREASE IN CASH .................................................. $ (25,028)
CASH, BEGINNING OF YEAR ............................................... 25,996
-------------
CASH, END OF YEAR ..................................................... $ 968
=============
RECONCILIATION OF NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS
TO NET CASH PROVIDED BY OPERATING ACTIVITIES:
Net decrease in net assets resulting from operations ................ $ (17,494,446)
Increase in interest and dividend receivables ....................... (1,209,256)
Increase in prepaid insurance ....................................... (124,365)
Increase in other assets ............................................ (25,714)
Increase in accrued expenses ........................................ 585,858
Net realized loss on investments .................................... 35,396,240
Change in net unrealized loss on investments ........................ 12,125,584
Accretion of bond discount .......................................... (3,572,411)
-------------
Net Cash Provided By Operating Activities ..................... $ 25,681,490
=============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for interest .............................. $ 4,837,094
Cash paid during the year for excise taxes .......................... $ --
=============
</TABLE>
<PAGE>
PROSPECT STREET HIGH INCOME PORTFOLIO INC.
STATEMENT OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
Fiscal Year Ended October 31,
------------------------------
2000 1999
------------- -------------
<S> <C> <C>
FROM OPERATIONS:
Net investment income .................................. $ 30,027,378 $ 26,901,413
Net realized loss on investments sold .................. (35,396,240) (38,743,202)
Change in net unrealized depreciation of investments ... (12,125,584) 13,820,247
------------- -------------
Net (decrease) increase in net assets resulting
from operations ................................ $ (17,494,446) $ 1,978,458
------------- -------------
FROM FUND SHARE TRANSACTIONS:
Shares issued (195,029 and 237,917 shares, respectively)
to common stockholders for reinvestment of dividends . $ 1,224,804 $ 2,063,366
Net proceeds from sale of common stock (0 and 6,630,663
shares, respectively, after deducting $0 and
$2,691,261 of soliciting fees and other expenses,
respectively) ........................................ -- 54,995,507
------------- -------------
Net increase in net assets resulting from fund
share transactions ............................. $ 1,224,804 $ 57,058,873
------------- -------------
DISTRIBUTIONS TO STOCKHOLDERS:
Common dividends ($1.03 and $1.26 per share,
respectively) from operations ........................ $ (27,557,848) $ (30,583,565)
Common dividends ($0 and $0 per share, respectively) in
excess of net investment income ...................... -- (87,410)
------------- -------------
Net decrease in net assets resulting from
distributions .................................. $ (27,557,848) $ (30,670,975)
------------- -------------
Total (decrease) increase in net assets .......... $ (43,827,490) $ 28,366,356
NET ASSETS:
Beginning of year ...................................... 186,166,810 157,800,454
------------- -------------
End of year (including $2,746,495 undistributed and
$119,650 of distributions in excess of accumulated net
investment income as of October 31, 2000 and 1999,
respectively) ........................................ $ 142,339,320 $ 186,166,810
============= =============
</TABLE>
<PAGE>
PROSPECT STREET HIGH INCOME PORTFOLIO INC.
FINANCIAL HIGHLIGHTS
SELECTED PER SHARE DATA AND RATIOS
FOR EACH SHARE OF COMMON STOCK OUTSTANDING THROUGHOUT THE PERIODS PRESENTED
<TABLE>
<CAPTION>
For the Years Ended October 31, (b)
----------------------------------------------------------------------------------
2000 1999 1998 1997 1996
------------ ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Net asset value, beginning of year ...... $ 6.98 $ 7.97 $ 1.94 $ 11.70 $ 11.10
-------- -------- -------- --------- --------
Net investment income ................... $ 1.12# $ 1.08# $ 1.30# $ 1.38# $ 1.50#
Net realized and unrealized gain (loss)
on investments ........................ (1.77)# (1.00)# (3.76)# .72# .60#
-------- -------- -------- --------- --------
Total from investment operations $ (0.65) $ 0.08 $ (2.46) $ 2.10 $ 2.10
-------- -------- -------- --------- --------
Distributions:
Dividends from accumulated net investment
income
To preferred stockholders ........... $ -- $ -- 0 $ (.03) $ (.09) $ (.12)
To common stockholders .............. (1.03) (1.26) (1.26) (1.26) (1.26)
-------- -------- -------- --------- --------
Total distributions ............. $ (1.03) $ (1.26) $ .29) $ (1.35) $ (1.38)
-------- -------- -------- --------- --------
Effect of sale of common stock and
related expenses from rights offerings . $ -- $ .19 $ (.22) $ (.51) $ (.12)
-------- -------- -------- --------- --------
Net asset value, end of year ............ $ 5.30 $ 6.98 $ 7.97 $ 11.94 $ 11.70
======== ======== ======== ========= ========
Per share market value, end of year ..... $ 5.69 $ 7.94 $ 10.25 $ 12.39 $ 12.00
======== ======== ======== ========= ========
Total investment return ................. (8.31)% (11.78)% (7.63)% 14.82% 15.29%
======== ======== ======== ========= ========
Net assets, end of year, applicable to
common stock (a) ...................... $142,339 $186,167 $157,800 $ 175,909 $120,711
======== ======== ======== ========= ========
Net assets, end of period, applicable to
preferred stock (a) $ -- $ -- $ -- $ 20,000 $ 20,000
======== ======== ======== ========= ========
Net assets, end of year (a) ............. $142,339 $186,167 $157,800 $ 195,909 $140,711
======== ======== ======== ========= ========
Ratio of operating expenses to average
net assets, applicable to common stock 4.46% 2.67% 2.67% 2.30% 3.06%
Ratio of net investment income to average
net assets, applicable to common stock 17.59% 13.72% 11.92% 11.94% 13.20%
Portfolio turnover rate ................. 104.99% 126.45% 156.48% 176.04% 108.33%
(a) Dollars in thousands.
(b) The selected per share data and ratios have been restated, where applicable, for all periods to give effect for the one-
for-three reverse stock split in April of 1998. (Note 10).
# Calculation is based on average shares outstanding during the indicated period due to the per share effect of the Fund's
rights offerings.
</TABLE>
<PAGE>
PROSPECT STREET HIGH INCOME PORTFOLIO INC.
INFORMATION REGARDING SENIOR SECURITIES
<TABLE>
<CAPTION>
As of October 31,
----------------------------------------------------------------------------------------------------
2000 1999 1998 1997 1996 1995
----------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Total Amount
Outstanding:
Indebtedness $71,000,000 $50,000,000 $40,000,000 $20,000,000 $20,000,000 $20,000,000
Preferred
stock -- -- -- 20,000,000 20,000,000 20,000,000
Asset Coverage:
Per
Indebtedness
(a) 330% 472% 495% 1,080% 804% 667%
Per preferred
stock share (b) N/A N/A 540% 402% 333% 330%
Involuntary Liquidation Preference:
Per preferred
stock share (c) N/A N/A N/A $ 100,000 $ 100,000 $ 100,000
Approximate Market Value:
Per note N/A N/A N/A $ 1,003.80 $ 990.00 $ 987.50
Per preferred
stock share N/A N/A N/A 100,000 100,000 100,000
(a) Calculated by subtracting the Fund's total liabilities (not including bank loans and senior securities)
from the Fund's total assets and dividing such amount by the principal amount of the debt outstanding.
(b) Calculated by subtracting the Fund's total liabilities (not including bank loans and senior securities)
from the Fund's total assets and dividing such amount by the principal amount of the debt outstanding and
aggregate liquidation preference of the outstanding shares of Taxable Auction Rate Preferred Stock.
(c) Plus accumulated and unpaid dividends.
</TABLE>
<PAGE>
PROSPECT STREET HIGH INCOME PORTFOLIO INC.
NOTES TO FINANCIAL STATEMENTS
OCTOBER 31, 2000
(1) ORGANIZATION AND OPERATIONS
Prospect Street High Income Portfolio Inc. (the "Fund") was organized as a
corporation in the state of Maryland on May 13, 1988 and is registered with
the Securities and Exchange Commission as a diversified, closed-end,
management investment company under the Investment Company Act of 1940. The
Fund commenced operations on December 5, 1988. The Fund's financial statements
have been prepared in conformity with accounting principles generally accepted
in the United States, which requires the management of the Fund to make
estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of income and expenses
during the reporting periods. Actual results could differ from those
estimates. The following is a summary of significant accounting policies
consistently followed by the Fund, which are in conformity with those
generally accepted in the investment company industry.
The Fund invests primarily in securities of fixed-maturity, corporate debt
securities and in redeemable preferred stocks that are rated less than
investment grade. Risk of loss upon default by the issuer is significantly
greater with respect to such securities compared to investment-grade
securities because these securities are generally unsecured and are often
subordinated to other creditors of the issuer, and because these issuers
usually have high levels of indebtedness and are more sensitive to adverse
economic conditions, such as a recession, than are investment-grade issuers.
In some cases, the collection of principal and timely receipt of interest is
dependent upon the issuer attaining improved operating results, selling assets
or obtaining additional financing.
See the schedule of investments for information on individual securities, as
well as industry diversification and credit quality ratings.
(2) SIGNIFICANT ACCOUNTING POLICIES
(a) VALUATION OF INVESTMENTS
Investments for which listed market quotations are readily available are
stated at market value, which is determined using the last reported sale price
or, if no sales are reported, as in the case of some securities traded over-
the-counter, the last reported bid price. Short-term investments having
remaining maturities of 60 days or less are stated at amortized cost, which
approximates market.
Other investments, which comprise the major portion of the Fund's portfolio
holdings, are primarily non-investment-grade corporate debt securities, for
which market quotations are not readily available due to a thinly traded
market with a limited number of market makers. These investments are stated at
fair value on the basis of subjective valuations furnished by an independent
pricing service or broker dealers, subject to review and adjustment by the
investment adviser based upon quotations obtained from market makers. The
independent pricing service determines value based primarily on quotations
from dealers and brokers, market transactions, accessing data from quotation
services, offering sheets obtained from dealers and various relationships
between securities. The independent pricing service utilizes the last sales
price based on odd-lot trades, if available. If such price is not available,
the price furnished is based on round-lot or institutional size trades. These
procedures have been approved by the Board of Directors.
The fair value of restricted securities is determined by the investment
adviser pursuant to procedures approved by the Board of Directors.
Gains and losses on sales of investments are calculated on the identified
cost method for both financial reporting and federal income tax purposes. It
is the Fund's practice to first select for sale those securities that have the
highest cost and also qualify for long-term capital gain or loss treatment for
tax purposes.
(b) SECURITY TRANSACTIONS AND RELATED INVESTMENT INCOME
Realized gains and losses on investments sold are recorded on the
identified-cost basis. Interest income and accretion of discounts are recorded
on the accrual basis. It is the Fund's policy to place securities on non-
accrual status when collection of interest is doubtful.
(c) FEDERAL INCOME TAXES
It is the Fund's policy to comply with the requirements of the Internal
Revenue Code of 1986, as amended, applicable to regulated investment
companies, and to distribute substantially all of its investment company
taxable income to its stockholders each year. At October 31, 2000, the Fund
had a tax provision of $150,942.
At October 31, 2000, the Fund had the following capital loss carryovers
available to offset future capital gains, if any, to the extent provided by
regulations:
CARRYOVER
AVAILABLE EXPIRATION DATE
$ 808,396 October 31, 2002
3,703,531 October 31, 2003
4,688,248 October 31, 2006
37,335,815 October 31, 2007
35,790,515 October 31, 2008
----------
$82,326,505
===========
(D) COMMON STOCK AND TAXABLE AUCTION RATE PREFERRED STOCK (PREFERRED STOCK),
AND OFFERING COSTS
The costs incurred by the Fund in connection with the initial sale of the
common and preferred stock as well as the common stock rights offerings have
been recorded as a reduction of the common stock proceeds.
(e) CASH FLOW INFORMATION
The Fund invests primarily in corporate debt securities and distributes
dividends from net investment income, which are paid in cash or shares of
common stock of the Fund. These activities are reported in the accompanying
statement of changes in net assets, and additional information on cash
receipts and cash payments is presented in the accompanying statement of cash
flows.
(3) INVESTMENT ADVISORY AGREEMENT
Prospect Street Investment Management Co., Inc. ("PSIM") entered into an
agreement to sell certain of its assets and goodwill relating to the
management of the Fund to Highland Capital Management, L.P. ("Highland", or
"Investment Adviser") effective January 21, 2000. During the period between
November 1, 1999 and January 21, 2000, PSIM earned $338,412 in management
fees.
As of January 21, 2000, the Fund entered into a new advisory agreement with
Highland. Highland earned $973,000 in management fees for the period from
January 21, 2000 to October 31, 2000. Management fees paid by the Fund to both
PSIM and Highland were calculated at .65% (on an annual basis) of the average
weekly net asset value defined as, total assets of the Fund less accrued
liabilities (excluding the principal amount of the bank loan, notes and the
liquidation preference of the preferred stock and including accrued and unpaid
dividends on the preferred stock), up to and including $175,000,000 of net
assets, .55% on the next $50,000,000 of net assets and .50% of the excess of
net assets over $225,000,000. At October 31, 2000, the fee payable to the
Investment Adviser was $369,000, which was included in accrued expenses in the
accompanying statement of assets and liabilities.
(4) PURCHASES AND SALES OF SECURITIES
For the period ended October 31, 2000, the aggregate cost of purchases and
proceeds from sales of investment securities other than U.S. Government
obligations and short-term investments aggregated approximately $257,860,000
and $237,487,000, respectively. There were no purchases or sales of U.S.
Government obligations during the period ended October 31, 2000.
(5) CERTAIN TRANSACTIONS
Certain officers of the Investment Adviser serve on the Board of Directors
of the Fund. They receive no compensation in this capacity.
Directors who are not officers or employees of the Investment Adviser
receive a fee of $10,000 per year plus $2,000 per Directors' meetings
attended, together with the reimbursement of actual out-of-pocket expenses
incurred relating to attendance at such meetings and $1,000 per conference
call meeting. In addition, members of the Fund's audit committee, which
consists of certain of the Fund's noninterested Directors, receive $1,000 per
audit committee meeting attended, together with the reimbursement of actual
out-of-pocket expenses incurred relating to attendance at such meeting.
(6) DIVIDENDS AND DISTRIBUTIONS
The Board of Directors of the Fund declared regular dividends on the common
stock of $.105 per share payable on November 30, 1999, $.095 per share payable
on December 31, 1999 and January 31, February 29, March 31 and April 30, 2000
and $.075 per share payable on May 30, June 30, July 31, August 31, September
30, and October 31, 2000.
Distributions on common stock are declared based on annual projections of
the Fund's net investment income (defined as dividends and interest income,
net of Fund expenses). The Fund plans to pay monthly distributions to common
shareholders. Meanwhile, as a result of market conditions or investment
decisions, the amount of distributions may exceed net investment income earned
at certain times throughout the period. It is anticipated that, on an annual
basis, the amount of distributions to common shareholders will not exceed net
investment income (as defined) applicable to common shareholders on a tax
basis. All shareholders of the Fund are automatically considered participants
in the Dividend Reinvestment Plan (the "Plan") unless they elect otherwise.
Under the Plan, when the market price of common stock is equal to or exceeds
the net asset value on the record date for a distribution, participants will
receive all dividends and distributions in full and fractional shares of the
Fund at the most recently determined net asset value but in no event less than
95% of market price. If, on the record date for distributions, the net asset
value of the common stock exceeds its market price, or if the Fund shall
declare a dividend or capital gains distribution payable only in cash, the
dividend-paying agent will buy common stock in the open market for the
participants' accounts. Participants are not charged a service fee for the
Plan but are subject to a pro rata share of brokerage fees incurred with
respect to open market purchases of common stock.
(7) FAIR VALUE OF LONG-TERM DEBT
The fair value of the Fund's long-term debt is estimated based on the quoted
market prices for the same issue or on the current rates offered to the Fund
for debt of the same remaining maturities. At October 31, 2000, the fair value
of the bank term loan was $71,000,000.
(8) REVERSE STOCK SPLIT
In March of 1998, the shareholders of the Fund approved a one-for-three
reverse stock split which became effective on April 1, 1998. Certain per share
amounts included in the accompanying financial statements have been restated
to give effect to this reverse stock split.
(9) RIGHTS OFFERING
On January 26, 1999, the Fund commenced a rights offering whereby the Fund
issued to its shareholders of record, as of that date, nontransferable rights
entitling the holders thereof to subscribe for an aggregate of 6,630,663
shares of the Fund's common stock. Each record date shareholder received one
right for each whole share of common stock held. The rights allowed the rights
holder to subscribe for shares of common stock at the rate of one share of
common stock for every three rights held. The subscription period for the
rights offering expired on February 19, 1999 and the Fund issued, on a post-
split basis, 6,630,663 shares of common stock at $8.70 per share. Proceeds to
the Fund amounted to $54,995,507, net of soliciting fees and offering expenses
of $2,691,261.
(10) BANK LOAN
Effective January 21,2000, the Fund has entered into a $75 million credit
agreement ("the Agreement") with a lending institution. The Fund's ability to
utilize this facility extends until January 19, 2001, though there are
provisions in the Agreement which allow for its modification, including
extension, termination and reduction of the facility amount. The applicable
interest rate is LIBOR plus 0.55%. Under the terms of the loan agreement the
Fund is required to maintain certain financial covenants. The Agreement also
provides for commitment fees at a rate of 0.10% per year on the daily amount
by which the aggregate amount of the commitment amount of $75 million exceeds
the aggregate outstanding principal of the bank loans. At October 31, 2000,
the outstanding loan balance was $71 million.
Prior to January 21, 2000, the Fund had a $50 million credit agreement with
another lending institution. This loan was repaid with funds drawn from the
$75 million agreement. The weighted average balance and interest rate on these
agreements were $73,423,000 and 7.07%, respectively for the twelve month
period ending October 31, 2000. The average interest rate on the outstanding
balance at October 31, 2000 was 7.26%.
<PAGE>
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Shareholders of
Prospect Street High Income Portfolio Inc.:
We have audited the accompanying statement of assets and liabilities of
Prospect Street High Income Portfolio Inc., including the schedule of
investments, as of October 31, 2000 and the related statements of operations,
cash flows and changes in net assets and the financial highlights for the year
then ended. These financial statements and financial highlights are the
responsibility of the Fund's management. Our responsibility is to express an
opinion on these financial statements and financial highlights based on our
audit. The financial statements and financial highlights of Prospect Street
High Income Portfolio Inc. for the year ended October 31, 1999 and for the
four years then ended were audited by other auditors whose report dated
December 17, 1999 expressed an unqualified opinion on those statements and
financial highlights.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements. 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 audit provides 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
Prospect Street High Income Portfolio Inc. as of October 31, 2000, and the
results of its operations, cash flows, changes in net assets and financial
highlights for the year then ended in conformity with accounting principles
generally accepted in the United States.
ERNST & YOUNG LLP
Dallas, Texas
December 14, 2000
<PAGE>
PROSPECT STREET HIGH INCOME PORTFOLIO INC.
INVESTMENT ADVISER AUDITORS
Highland Capital Management, L.P. Ernst & Young LLP
13455 Noel Road Suite 1300 Dallas, TX
Dallas, TX 75240
TRANSFER AND SHAREHOLDERS' SERVICING
OFFICERS AGENT
James Dondero -- President State Street Bank and Trust Company
Mark Okada -- Executive Vice-President P.O. Box 8200
R. Joseph Dougherty -- Senior Vice- Boston, MA 02266
President (800) 426-5523
and Secretary
CUSTODIAN
DIRECTORS State Street Bank and Trust Company
John S. Albanese Boston, MA
C. William Carey
James Dondero Listed: NYSE
John Honis Symbol: PHY
Timothy Hui
Scott Kavanaugh
James Leary
Mark Okada
Harlan D. Platt
Christopher E. Roshier
LEGAL ADVISER
Stroock & Stroock & Lavan LLP
180 Maiden Lane
New York, NY 10038-4982
<PAGE>
FACTS FOR SHAREHOLDERS:
Prospect Street High Income Portfolio Inc. is listed on the New York Stock
Exchange under the symbol "PHY". The Wall Street Journal and Wall Street
Journal Online publish Friday's closing net asset value of the Fund every
Monday and lists the market price of the Fund daily. They are also published
in Barron's Market Week every Saturday. Our website is prospectstreet.net.
QUESTIONS REGARDING YOUR ACCOUNT: Please telephone State Street Bank & Trust
Company at their toll free number 1-800-426-5523 Monday through Friday from
9:00 a.m. to 5:00 p.m.
WRITTEN CORRESPONDENCE REGARDING YOUR ACCOUNT: Please mail all correspondence
directly to Prospect Street High Income Portfolio Inc., c/o State Street Bank
& Trust Company, P.O. Box 8200, Boston, MA 02266. For express mail the address
is Prospect Street High Income Portfolio Inc., c/o State Street Bank & Trust
Company, 2 Heritage Drive, Corporate Stock Transfer -- 4th floor, North
Quincy, MA 02171.
<PAGE>
PROSPECT STREET HIGH INCOME PORTFOLIO INC.
13455 Noel Road LB#45
Dallas, TX 75240