MENTOR INCOME FUND, INC.
ANNUAL REPORT
OCTOBER 31, 1996
- --------------------------------------------------------------------------------
THE FUND
o A closed-end investment fund that invests primarily in high-quality fixed-
income securities. The Fund is listed on the New York Stock Exchange with
common shares traded under the symbol, MRF.
INVESTMENT OBJECTIVE
o To achieve high monthly income consistent with preservation of capital
DIVIDEND OBJECTIVE
o To distribute monthly income in excess of that attainable from investments in
U.S. Treasury securities having the same maturity as the expected average
life of the Fund's investments.
REPORT FROM THE CHAIRMAN AND PRESIDENT
We appreciate the opportunity to provide the Annual Report to Shareholders for
Mentor Income Fund for the 12 months ended October 31, 1996. Regardless of
market environments, the Fund's primary mission remains the same, to provide
attractive income and competitive net asset value total returns to shareholders
over time.
During the 12 months ended October 31, 1996, the Fund paid dividends totaling
$0.84 per share, which represents an annualized yield of 9.33% based on the
Fund's closing market price of $9.00 on October 31, 1996. These monthly
dividends have provided the Fund's shareholders with a significant income
advantage over the average yield-to-maturity of 6.28%, attainable during the
period from treasury securities having the same approximate maturity as the
average life of the Fund's investments. Of course, treasuries are guaranteed as
to principal and interest, while the Fund's shares are not guaranteed and will
fluctuate in value.
1
<PAGE>
MENTOR INCOME FUND, INC.
ANNUAL REPORT
OCTOBER 31, 1996
- --------------------------------------------------------------------------------
[Graph here]
U.S. Treasury Curve (%)
10/31/95 10/31/96
3 Mo. 5.5 5.1
6 Mo. 5.5 5.3
1 Yr. 5.5 5.4
2 Yr. 5.6 5.7
3 Yr. 5.7 5.9
5 Yr. 5.8 6
10 Yr. 6 6.3
30 Yr. 6.3 6.6
MARKET CONDITIONS
The 12-month period ended October 31, 1996 saw a significant shift in the shape
of the yield curve, with rates under two-years down and rates at two-years and
above higher. Three-month yields fell 0.35%, 30-year rates rose 0.31%. Two and
10-year treasuries closed the period at 5.73% and 6.34%, up 0.12% and 0.32%
respectively from the beginning of the period.
This steepening of the yield curve reflects several factors. First, early in the
period the Federal Reserve chose to lower the short-term federal funds rate (the
rate member banks charge each other for overnight loans) twice by 0.25%. This
monetary easing coupled with other factors created the environment for
accelerating economic growth for most of the period. Fourth quarter 1995 GDP
(gross domestic product) growth of 0.3% was followed by first quarter 1996
growth of 2.0%, accelerating to 4.7% in the second quarter, then returning to
2.0% for the third quarter 1996, based upon preliminary estimates. The economic
momentum of the first two quarters of 1996 caused many market participants to
have increasing concerns that an overheating economy would rekindle inflation.
This scenario could potentially force the Fed to reverse course and raise rates
despite continued modest increases in historical inflation measures.
Changing perceptions regarding the strength of the economy caused 1996 to be a
period of high interest-rate volatility. The most closely watched economic
statistic was the monthly non-farm payroll report. During the first half of
1996, this key indicator of underlying economic
2
<PAGE>
MENTOR INCOME FUND, INC.
ANNUAL REPORT
OCTOBER 31, 1996
- --------------------------------------------------------------------------------
vibrancy surprised the market on several occasions with its strength, causing
immediate market corrections of as much as 0.25%. That volatility and
uncertainty notwithstanding, the Federal Reserve has chosen to leave the fed
funds rate unchanged since January, defying the predictions of both those
calling for a tightening and loosening of monetary policy.
EFFECT ON THE FUND
Given the lack of a consistent trend in the direction of interest rates and the
volatility of the fixed-income markets over the 12-month period ended October
31, the investment environment has proved a challenging one. The Fund's net
asset value total return for the 12 months ending October 31 was 8.08%. The
return of the Fund's Morningstar Government Bond Fund peer group was 4.62%.* The
Mentor Income Fund's return also compares favorably to the 6.82%, 5.03%, and
4.71% returns posted by the Merrill Lynch Mortgage, Government Bond, and 7-year
Treasury indexes, respectively.
Total Return
Mentor Income Fund vs.
Fixed-Income Sectors
[Graph here]
Mentor Income Fund 8.08%
Morningstar PeerGroup 4.62%
Mortgage Index 6.82%
Gov't Bond Index 5.03%
7-Year Treasury 4.71%
Source: Morningstar, Inc. Merrill Lynch Indexes
PORTFOLIO STRATEGY
Throughout the 12-month period common themes continued to support our strategy
for seeking to fulfill our objectives -- to provide attractive income, maintain
risk close to that of intermediate treasuries, and capitalize on the investment
opportunities provided within the guidelines of our investment policy.+ During
the course of this period the duration of the portfolio was adjusted
3
<PAGE>
MENTOR INCOME FUND, INC.
ANNUAL REPORT
OCTOBER 31, 1996
- --------------------------------------------------------------------------------
periodically to try to take advantage of rapidly changing conditions.
At the end of calendar year 1995 the Fund's duration was shortened to a
market-neutral stance from the longer-duration posture which had served us so
well for most of the 1995 rally. This reflected our belief that the market had
adopted a very optimistic scenario of slow growth, low inflation, and budgetary
restraint into its fixed-income pricing. However, once the initial market
correction in February had created pricing more reflective of our view of
underlying value, the Fund's duration was lengthened and maintained at an
above-market-neutral level. However, fixed-income markets continued to weaken in
ensuing months, ultimately convincing us that short-term concerns were
overwhelming longer-term fundamentals. In April we chose to reduce the duration
of our portfolio to a market-neutral posture and have maintained a duration tilt
between market-neutral and 5-10% long our Merrill seven-year treasury benchmark
throughout the remainder of the period. We are currently 5-10% long our Merrill
seven-year treasury benchmark.
Portfolio Composition
[Graph here]
Corporate Bonds 12.22%
Fixed-Rate Single-Class Mortgage Backed Securities 22.95%
Interest-Only Securities 0.30%
Residual Interests 11.03%
Asset-Backed Securities 9.62%
Adjustable-Rate Mortgage-Backed Securities 11.18%
U.S. Government Agencies 2.18%
Fixed-Rate Multiple-Class Collateralized Mortgage Obligations 29.44%
Repurchase Agreement 1.08%
MARKET OUTLOOK
The fixed-income markets have displayed high levels of volatility during the
course of the last 12 months, particularly as strong economic statistics have
raised concerns about Federal Reserve tightening. Early indications are that
third quarter 1996 growth saw a significant deceleration from second quarter
levels. To date the Fed has chosen not to raise rates, but factors such as the
continued strength of the equity markets and high levels of consumer confidence
and debt have caused some, including Federal Reserve Chairman Greenspan, to
wonder aloud whether speculative excesses coupled with economic growth and tight
labor markets make an eventual credit tightening unavoidable.
4
<PAGE>
MENTOR INCOME FUND, INC.
ANNUAL REPORT
OCTOBER 31, 1996
- --------------------------------------------------------------------------------
We continue to remain optimistic regarding the long-term prospects for
fixed-income markets, assuming that efforts at continued deficit reduction and
government downsizing remain on track. We intend to maintain a duration slightly
longer than that of our benchmark until more compelling fundamental factors
convince us that a more aggressive posture is warranted. Our primary focus
continues to be on identifying the best assets for the portfolio, rather than on
anticipating interest rates.
DIVIDEND REINVESTMENT PLAN
Shareholders who wish to purchase additional shares can do so through the Fund's
automatic dividend reinvestment plan. Over 60% of the Fund's shareholders
participate in this plan. If you would like to receive information about the
plan, please call our plan agent at (800) 426-5523.
Sincerely,
/s/ Weston E. Edwards
- ----------------------
Weston E. Edwards, CFA
CHAIRMAN
/s/ Paul F. Costello
- --------------------
Paul F. Costello
PRESIDENT
+ While the portfolio managers will endeavor to manage the portfolio in
accordance with this strategy, there are no guarantees that it will be
successful.
* Morningstar, Inc. is an independent mutual fund-rating service. Performance
assumes reinvestment of all distributions, but does not include sales
charges.
** The Merrill Lynch Mortgage Index is a composite of fixed-rate mortgage
pass-through securities. The Merrill Lynch Government Bond Index is a
composite of 2,347 treasury and agency issues with maturities ranging from
one to 30 years.
5
<PAGE>
MENTOR INCOME FUND, INC.
PORTFOLIO OF INVESTMENTS
OCTOBER 31, 1996
<TABLE>
<CAPTION>
PRINCIPAL MARKET
AMOUNT VALUE
<S> <C>
- ---------------------------------------------------------------------------------------------------------
LONG-TERM INVESTMENTS 125.32%
- ---------------------------------------------------------------------------------------------------------
U.S. GOVERNMENT SECURITIES AND AGENCIES 50.27%
- ---------------------------------------------------------------------------------------------------------
Federal Home Loan Mortgage Corporation
6.50%, Series 1422, 2/15/07-REMIC $ 4,565,108 $ 4,407,648
6.50%, Series 1647 B, 11/15/08-REMIC 8,675,966* 8,370,954
9.50%-10.75%, 9/1/09-12/1/09 3,177,005 3,417,971
6.00%, 3/1/11 5,064,214 4,885,387
7.50%, 9/17/11, TBA 7,150,000** 7,271,772
6.00%, Series 48 H, 7/15/20-REMIC 3,500,000 3,166,954
Federal National Mortgage Association
6.50%, Series 1993-18Z,
2/25/08-REMIC 4,035,648 3,721,626
10.50%, 11/1/18 6,673,216* 7,240,439
Government National Mortgage Association
11.50%, 2/15/13-6/15/19 246,877 278,197
7.00%, 15-year Platinum, 12/15/08 5,383,356* 5,434,035
7.00%, 9/20/22 2,350,254*** 2,395,057
7.00%, 10/15/26, TBA 6,000,000** 5,883,750
U.S. Treasury Note, 6.50%, 10/15/06 3,250,000 3,280,940
- ---------------------------------------------------------------------------------------------------------
Total U.S. Government Securities and Agencies (cost
$59,330,801) 59,754,730
- ---------------------------------------------------------------------------------------------------------
CORPORATE BONDS 15.48%
- ---------------------------------------------------------------------------------------------------------
FINANCE 11.81%
Capital One Bank, 7.15%, 9/15/06 4,000,000 4,074,800
Developers Diversified Realty,
7.63%, 5/15/00 2,000,000 2,039,660
Developers Diversified Realty,
6.58%, 2/6/01 2,000,000 1,976,460
Nationsbank, 7.5%, 9/15/06 1,500,000 1,550,490
Sunamerica Inc., 7.34%, 8/30/05 1,750,000 1,758,330
Travelers Inc., 9.50%, 3/1/02 1,000,000 1,130,120
</TABLE>
6
<PAGE>
MENTOR INCOME FUND, INC.
PORTFOLIO OF INVESTMENTS
OCTOBER 31, 1996
<TABLE>
<CAPTION>
PRINCIPAL MARKET
AMOUNT VALUE
- ---------------------------------------------------------------------------------------------------------
<S> <C>
CORPORATE BONDS (CONTINUED)
Travelers Inc., 6.88%, 6/1/25 $ 1,500,000 $ 1,507,110
- ---------------------------------------------------------------------------------------------------------
14,036,970
- ---------------------------------------------------------------------------------------------------------
UTILITIES 3.67%
Mississippi Power & Light, 8.80%, 4/1/05 4,250,000 4,369,850
- ---------------------------------------------------------------------------------------------------------
Total Corporate Bonds (cost $18,102,508) 18,406,820
- ---------------------------------------------------------------------------------------------------------
PRIVATE ISSUES 45.59%
- ---------------------------------------------------------------------------------------------------------
ADJUSTABLE RATE MORTGAGES 12.15%
California Federal Bank
Series 1991-2, Class A, 8.75%, 7/15/21 578,807 579,212
Kidder Peabody Acceptance Corporation
Series 1989-3, Class A, 8.91%, 6/20/19 1,089,657 1,090,856
PaineWebber Mortgage Acceptance Corporation
Series 1993-1, Class M-1, 7.91%, 3/25/23 1,851,909 1,885,475
Series 1993-3, Class M-1, 7.59%, 4/25/23 3,022,591 3,077,376
Sears Mortgage Securities Corporation
Series 1992-9, Class A, 7.91%, 10/25/21 1,843,845 1,878,509
Structured Asset Securities Residential Trust
Series 1990-1, Class A, 7.68%, 4/1/20 5,852,527 5,934,831
- ---------------------------------------------------------------------------------------------------------
14,446,259
- ---------------------------------------------------------------------------------------------------------
ASSET-BACKED SECURITIES 14.04%
Advanta Mortgage Loan Trust, Series 1993-3 A5,
5.55%, 1/25/25 1,574,956 1,473,506
AFG Receivables Trust, 6.45%, 9/15/00 1,464,453 1,459,648
First Interstate Bank of California,
8.90%, 11/15/97 5,976,021 6,048,856
Olympic Automobiles Receivables Trust,
6.85%, 6/15/01 2,176,463 2,196,867
Old Stone Credit Corporation Home Equity Trust,
Series 1993-2, 6.20%, 6/15/08 2,044,486 2,019,249
Union Acceptance Corporation, 6.45%, 7/8/03 3,001,529 3,018,998
</TABLE>
7
<PAGE>
MENTOR INCOME FUND, INC.
PORTFOLIO OF INVESTMENTS
OCTOBER 31, 1996
<TABLE>
<CAPTION>
PRINCIPAL MARKET
AMOUNT VALUE
- ---------------------------------------------------------------------------------------------------------
<S> <C>
ASSET-BACKED SECURITIES (CONTINUED)
World Omni, Series 1993, Class B, 5.05%, 8/15/99 $ 470,625 $ 466,361
- ---------------------------------------------------------------------------------------------------------
16,683,485
- ---------------------------------------------------------------------------------------------------------
COLLATERALIZED MORTGAGE OBLIGATION 18.90%
General Electric Capital Mortgage Services
Series 1993-18 B1, 6.00%, 2/25/09 2,179,810 2,052,086
Series 1996-4 B1, 7.00%, 3/25/26 4,481,087 4,220,623
Prudential Home Mortgage Securities
Series 1993-27 M, 7.50%, 5/25/23 3,284,580 3,262,255
Series 1993-22 M, 7.00%, 7/25/23 4,833,212 4,637,617
Series 1994-29 M, 7.00%, 10/25/24 3,237,568 3,111,102
Series 1995-5 M, 7.25%, 9/25/25 2,616,585 2,565,889
Series 1995-5 B1, 7.25%, 9/25/25 2,702,650 2,618,193
- ---------------------------------------------------------------------------------------------------------
22,467,765
- ---------------------------------------------------------------------------------------------------------
MORTGAGE BACKED SECURITIES 0.12%
Republic Federal Savings & Loan Association
Series 1988-03, Class A, 9.75%, 6/1/18 139,492 140,901
- ---------------------------------------------------------------------------------------------------------
INTEREST ONLY SECURITIES 0.38%
Conti-Mortgage
Series 94-3, A3-1, 0.52%, 5/15/09 46,309,638 173,661
Series 94-3, A3-1, 0.13%, 3/15/14 73,050,000 273,938
- ---------------------------------------------------------------------------------------------------------
447,599
- ---------------------------------------------------------------------------------------------------------
Total Private Issues (cost $53,373,111) 54,186,009
- ---------------------------------------------------------------------------------------------------------
RESIDUAL INTERESTS 13.98%
General Mortgage Securities, Inc., 1989-2, 1996,
4/17/19 26,833 1,504,759
General Mortgage Securities II, Inc., 1991-2, 1996,
1/28/30 7,112 866,283
General Mortgage Securities II, Inc., 1991-4, 1996,
3/28/20 776 474,266
</TABLE>
8
<PAGE>
MENTOR INCOME FUND, INC.
PORTFOLIO OF INVESTMENTS
OCTOBER 31, 1996
<TABLE>
<CAPTION>
PRINCIPAL MARKET
AMOUNT VALUE
- ---------------------------------------------------------------------------------------------------------
<S> <C>
RESIDUAL INTERESTS (CONTINUED)
General Mortgage Securities II, Inc., 1991-7, 1995,
6/28/30 $ 4,772 $ 520,224
General Mortgage Securities II, Inc., 1995-1, 1996,
6/25/20 30,299 720,231
General Mortgage Securities II, Inc., 1995-4, 1995,
6/25/23 16,475 584,006
General Mortgage Securities II, Inc., 1996-1, 1996,
11/25/22 16,277 648,145
General Mortgage Securities II, Inc., 1996-3, 1996,
6/20/25 54,721 898,312
National Mortgage Funding I, Inc., 1992-4, 1995,
11/27/22 13,653 897,687
National Mortgage Funding I, Inc., 1993-1, 1996,
6/18/14 54,047 730,064
National Mortgage Funding I, Inc., 1995-1, 1996,
4/28/25 25,129 425,884
National Mortgage Funding I, Inc., 1995-4, 1995,
3/20/21 13,870 232,404
National Mortgage Funding I, Inc., 1995-5, 1995,
3/25/22 8,790 547,713
National Mortgage Funding I, Inc., 1995-7, 1995,
9/17/25 38,552 955,070
National Mortgage Funding I, Inc., 1995-8, 1995,
8/25/22 45,000 788,741
National Mortgage Funding I, Inc., 1995-9, 1995,
11/19/25 42,284 675,707
National Mortgage Funding I, Inc., 1996-1, 1996,
4/25/25 56,184 824,513
National Mortgage Funding I, Inc., 1996-3, 1996,
2/17/26 44,189 1,507,325
National Mortgage Funding I, Inc., 1996-4, 1996,
10/25/21 16,163 611,908
National Mortgage Funding I, Inc., 1996-5, 1996,
5/22/26 87,762 1,384,625
National Mortgage Funding I, Inc., 1996-6, 1996,
5/22/26 58,572 817,803
- ---------------------------------------------------------------------------------------------------------
Total Residual Interests (cost $16,594,726) 16,615,670
- ---------------------------------------------------------------------------------------------------------
TOTAL LONG-TERM INVESTMENTS
(COST $147,401,146) 148,963,229
- ---------------------------------------------------------------------------------------------------------
</TABLE>
9
<PAGE>
MENTOR INCOME FUND, INC.
PORTFOLIO OF INVESTMENTS
OCTOBER 31, 1996
<TABLE>
<CAPTION>
PRINCIPAL MARKET
AMOUNT VALUE
- ---------------------------------------------------------------------------------------------------------
<S> <C>
SHORT-TERM INVESTMENTS 1.36%
- ---------------------------------------------------------------------------------------------------------
REPURCHASE AGREEMENT
Goldman Sachs & Company
Dated 10/31/96, 5.55%, due 11/1/96
collateralized by $1,650,982 Federal National
Mortgage Association,
7.50%, 4/1/26
(cost $1,618,847) $ 1,618,847 $ 1,618,847
- ---------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS (COST $149,019,993) 126.68% 150,582,076
- ---------------------------------------------------------------------------------------------------------
OTHER ASSETS LESS LIABILITIES (26.68%) (31,743,683)
- ---------------------------------------------------------------------------------------------------------
NET ASSETS 100.00% $118,838,393
- ---------------------------------------------------------------------------------------------------------
</TABLE>
* Certain of these securities are used as collateral for a reverse repurchase
agreement.
** Securities with a principal amount of $13,150,000 and a market value of
$13,155,522 used as collateral for dollar roll transactions.
*** Certain of these securities are used as initial margin for futures
contracts.
REMIC -- Real Estate Mortgage Investment Conduit
TBA -- To Be Announced
SEE NOTES TO FINANCIAL STATEMENTS.
10
<PAGE>
MENTOR INCOME FUND, INC.
STATEMENT OF ASSETS AND LIABILITIES
OCTOBER 31, 1996
<TABLE>
<S> <C>
ASSETS
Investments, at value (identified cost $149,019,993) $150,582,076
Receivables
Investments sold 3,342,686
Interest 1,382,821
Other assets 123,715
- ---------------------------------------------------------------------------------------------------------------
Total assets 155,431,298
- ---------------------------------------------------------------------------------------------------------------
LIABILITIES
Reverse repurchase agreement 20,000,000
Dollar roll agreement 13,072,208
Payable for investments purchased 3,283,951
Income dividend payable 202,119
Accrued expenses and other liabilities 34,627
- ---------------------------------------------------------------------------------------------------------------
Total liabilities 36,592,905
- ---------------------------------------------------------------------------------------------------------------
NET ASSETS $118,838,393
- ---------------------------------------------------------------------------------------------------------------
ANALYSIS OF NET ASSETS
Common stock at par value $ 118,178
Accumulated paid-in capital 131,619,599
Accumulated net investment loss (85,254)
Accumulated net realized losses (14,313,729)
Net unrealized appreciation of investments 1,499,599
- ---------------------------------------------------------------------------------------------------------------
Net Assets $118,838,393
Shares Outstanding 11,817,776
- ---------------------------------------------------------------------------------------------------------------
NET ASSET VALUE PER SHARE $ 10.06
- ---------------------------------------------------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS.
11
<PAGE>
MENTOR INCOME FUND, INC.
STATEMENT OF OPERATIONS
YEAR ENDED OCTOBER 31, 1996
<TABLE>
<S> <C>
INVESTMENT INCOME
Interest and net premium earned $13,153,369
- ----------------------------------------------------------------------------------------------------------------
EXPENSES
Investment advisory fee 769,296
Administration fee 118,353
Reports to shareholders 100,302
Custodian and transfer agent fees 98,150
Directors' fees and expenses 77,483
Shareholder servicing expenses 60,163
Audit fees 41,334
Legal fees 31,082
Registration and filing fees 28,921
Miscellaneous 15,505
- ----------------------------------------------------------------------------------------------------------------
Total operating expenses 1,340,589
- ----------------------------------------------------------------------------------------------------------------
Interest expense 2,018,868
- ----------------------------------------------------------------------------------------------------------------
Total expenses 3,359,457
- ----------------------------------------------------------------------------------------------------------------
Net investment income 9,793,912
- ----------------------------------------------------------------------------------------------------------------
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS
Net realized loss on investments (1,781,466)
Net realized loss on options contracts (244,162)
Net realized loss on futures contracts (258,803)
Net realized gain on short sales 422,906
- ----------------------------------------------------------------------------------------------------------------
Net realized loss on investments (1,861,525)
Change in unrealized appreciation
(depreciation) of investments 215,494
- ----------------------------------------------------------------------------------------------------------------
Net realized and unrealized loss on investments (1,646,031)
- ----------------------------------------------------------------------------------------------------------------
Increase in net assets from operations $ 8,147,881
- ----------------------------------------------------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS.
12
<PAGE>
MENTOR INCOME FUND, INC.
STATEMENT OF CASH FLOWS
YEAR ENDED OCTOBER 31, 1996
<TABLE>
<S> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Interest received $ 13,329,458
Interest paid (2,053,795)
Operating expenses paid (1,379,136)
- -------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 9,896,527
- -------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of portfolio securities (290,249,997)
Proceeds from disposition of portfolio securities 305,424,265
Variation margin on futures and options contracts (563,027)
- -------------------------------------------------------------------------------------------------------------
Net cash used in investing activities 14,611,241
- -------------------------------------------------------------------------------------------------------------
Net cash provided by operating and investing activities 24,507,768
- -------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net payments to liquidate reverse repurchase agreements (16,000,000)
Net proceeds from dollar roll transactions 25,443
Cash dividends paid (9,949,841)
- -------------------------------------------------------------------------------------------------------------
Net cash used in financing activities (25,924,398)
- -------------------------------------------------------------------------------------------------------------
Net decrease in cash (1,416,630)
Cash at beginning of year 1,416,630
- -------------------------------------------------------------------------------------------------------------
Cash at end of year $ -
- -------------------------------------------------------------------------------------------------------------
RECONCILIATION OF INCREASE IN NET ASSETS FROM OPERATIONS
TO NET CASH PROVIDED BY OPERATING AND INVESTING ACTIVITIES
Increase in net assets from operations $ 8,147,881
Decrease in investments-net 583,226
Increase in receivable for investment securities sold (1,807,297)
Decrease in interest receivable 176,089
Decrease in other assets 191,484
Increase in payable for investments purchased 15,643,828
Decrease in accrued expenses and other liabilities (73,474)
Net realized loss 1,861,525
Net unrealized appreciation (215,494)
- -------------------------------------------------------------------------------------------------------------
Net cash provided by operating and investing activities $ 24,507,768
- -------------------------------------------------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS.
13
<PAGE>
MENTOR INCOME FUND, INC.
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
YEAR ENDED OCTOBER 31, 1996 1995
<S> <C>
- -------------------------------------------------------------------------------------------------------------
INCREASE (DECREASE) IN NET ASSETS
OPERATIONS
Net investment income $ 9,793,912 $ 9,495,392
Net realized gain (loss) on investments (1,861,525) 2,065,575
Change in unrealized appreciation
(depreciation) of investments 215,494 6,167,593
- -------------------------------------------------------------------------------------------------------------
Increase in net assets from operations 8,147,881 17,728,560
- -------------------------------------------------------------------------------------------------------------
DISTRIBUTIONS TO SHAREHOLDERS
Net investment income (9,926,059) (10,513,052)
- -------------------------------------------------------------------------------------------------------------
Increase (decrease) in net assets (1,778,178) 7,215,508
NET ASSETS
Beginning of year 120,616,571 113,401,063
- -------------------------------------------------------------------------------------------------------------
End of year $118,838,393 $120,616,571
- -------------------------------------------------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS.
14
<PAGE>
MENTOR INCOME FUND, INC.
FINANCIAL HIGHLIGHTS
<TABLE>
<CAPTION>
YEAR ENDED OCTOBER 31, 1996 1995 1994 1993 1992
<S> <C>
- ---------------------------------------------------------------------------------------------------------
PER SHARE OPERATING PERFORMANCE
NET ASSET VALUE, BEGINNING OF YEAR $ 10.21 $ 9.60 $ 11.29 $ 11.06 $ 11.57
INCOME FROM INVESTMENT OPERATIONS
Net investment income 0.83 0.80 1.02 1.05 1.23
Net realized and unrealized gain (loss) on
investments (0.14) 0.70 (1.75) 0.23 (0.46)
- ---------------------------------------------------------------------------------------------------------
Total from investment operations 0.69 1.50 (0.73) 1.28 0.77
LESS DISTRIBUTIONS AND CAPITALIZED EXPENSES
Distributions from net investment income (0.84) (0.89) (0.96) (1.05) (1.26)
Initial and equity rights offering
expenses charged to capital - - - - (0.02)
- ---------------------------------------------------------------------------------------------------------
Total distributions and capitalized
expenses (0.84) (0.89) (0.96) (1.05) (1.28)
- ---------------------------------------------------------------------------------------------------------
NET ASSET VALUE, END OF YEAR $ 10.06 $ 10.21 $ 9.60 $ 11.29 $ 11.06
- ---------------------------------------------------------------------------------------------------------
Per share market price, end of year $ 9.00 $ 8.88 $ 8.25 $ 10.50 $ 12.38
Total Investment Return
Based on market price 11.24% 18.83% (13.32%) (6.91%) 14.62%
Based on net asset value 8.08% 17.48% (6.19%) 12.00% 6.24%
- ---------------------------------------------------------------------------------------------------------
RATIOS/SUPPLEMENTAL DATA
- ---------------------------------------------------------------------------------------------------------
Net assets, end of year (in thousands) $118,838 $120,617 $113,401 $133,077 $126,947
Ratio of gross investment income to average
net assets 11.12% 10.58% 12.18% 11.79% 12.84%
Ratio of operating expenses to average net
assets 1.13% 1.09% 1.22% 1.09% 1.13%
Ratio of total expenses to average net
assets 2.84% 2.39% 2.38% 2.48% 2.04%
Ratio of net investment income to average
net assets 8.28% 8.19% 9.80% 9.31% 10.80%
Portfolio turnover rate 189.71% 153.92% 173.71% 269.16% 219.43%
Shares outstanding at end of year (in
thousands) 11,818 11,818 11,818 11,786 11,478
- ---------------------------------------------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS.
15
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
OCTOBER 31, 1996
NOTE 1: ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Mentor Income Fund,
Inc. (the "Fund") is registered under the Investment Company Act of 1940 as a
diversified, closed-end management investment company.
The following is a summary of significant accounting policies consistently
followed by the Fund in the preparation of the financial statements. The
policies are in conformity with generally accepted accounting principles which
require management to make estimates and assumptions that affect amounts
reported therein. Although actual results could differ from these estimates, any
such differences are expected to be immaterial to the net assets of the Fund.
Security Valuation
The Fund values mortgage-backed securities, mortgage-related, asset-backed and
other debt-related securities on the basis of valuations provided by dealers
approved by the Fund's Board of Directors. In determining value, the dealers use
information with respect to transactions in such securities, various
relationships between securities, and yield to maturity. Exchange-traded options
are valued at the closing sales price or the average of the quoted bid and asked
price. Any securities or other assets for which current market quotations are
not readily available are valued at their fair value as determined in good faith
under procedures established by and under the general supervision and
responsibility of the Fund's Board of Directors.
Repurchase Agreements
All repurchase agreements are fully collateralized by U.S. Government Agency
securities and such collateral is in the possession of the Fund's custodian. To
the extent that any repurchase agreement exceeds one business day, the value of
the collateral is marked-to-market on a daily basis to ensure the adequacy of
the collateral. There is a potential loss to the Fund in the event the Fund is
delayed or prevented from exercising its right to dispose of the collateral,
including the risk of a decline in value of the underlying collateral.
Options Written or Purchased
The Fund may use option contracts to manage its exposure to the fixed income
market and fluctuations in interest rates. When the Fund writes or purchases an
option, an amount equal to the premium received or paid by the Fund is recorded
as a liability or an asset and is subsequently adjusted to the current market
value of the option sold or purchased. The difference between the premium and
the amount paid
16
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
(CONTINUED)
or received on effecting a closing purchase or sale transaction, including
brokerage commissions, is treated as a realized gain or loss. If an option is
exercised, the premium paid or received is added to the proceeds from the sale
or cost of the purchase of the underlying security in determining whether the
Fund has realized a gain or loss on investment transactions. During the year,
the Fund only entered into purchase options. The risk associated with purchasing
options is limited to the premium originally paid.
Futures Contracts
The Fund may use futures contracts to manage its exposure to the fixed income
market and fluctuations in interest rates. A futures contract is an agreement
between two parties to buy and sell a financial instrument for a set price on a
future date. Initial margin deposits are made upon entering into futures
contracts and can be either cash or securities. During the period the futures
contract is open, changes in the value of the contract are recognized as
unrealized gains or losses by marking to market on a daily basis to reflect the
market value of the contract at the end of each day's trading. Variation margin
payments are made or received, depending upon whether unrealized gains or losses
are incurred. When the contract is closed, the Fund records a realized gain or
loss equal to the difference between the proceeds from (or cost of) the closing
transaction and the Fund's basis in the contract. Futures contracts involve the
risk of loss in excess of unrealized depreciation included in the financial
statements. The risks of entering into futures contracts arise from the
movements in the value of the investments and interest rates. In addition, there
is a risk that the Fund may not be able to enter into a closing transaction
because of an illiquid secondary market. At October 31, 1996, the Fund had
positions in the following futures contracts:
Number
of Unrealized
Security Contracts Expiration Position Depreciation
- ---------------- --------- ---------- -------- ------------
2-year
U.S. Treasuries 31 12/96 open $ (62,484)
Government National Mortgage Association securities with a market value of
$117,192 were pledged as initial margin on these contracts.
Dollar Rolls
A dollar roll is a simultaneous agreement to sell a security held in the Fund's
portfolio with a purchase of a similar security at a future date at an
agreed-upon price. The difference between the sale and repurchase price is
recorded as interest income to the Fund. Dollar rolls are accounted for as
financing transactions by
17
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
(CONTINUED)
the Fund and no gain or loss is recognized, provided that the sale and
subsequent repurchase involve substantially identical securities. If the
counterparty to the transaction is rendered insolvent, the ultimate realization
of the securities to be repurchased by the Fund may be delayed or limited.
Short Sales
A short sale is a transaction in which the Fund sells a security it does not own
in anticipation that the market price of the security will decline. If the price
of the security sold short increases between the time of the short sale and the
time the Fund must deliver the security, the Fund realizes a loss.
Interest-Rate Swap
The Fund enters into interest-rate swaps to manage its exposure to the fixed
income market and fluctuations in interest rates. An interest-rate swap is a
contract between two parties on a specified principal amount (referred to as the
notional principal) for a specified period. In the most common instance, a swap
involves the exchange of streams of variable and fixed-rate interest payments.
During the term of the swap, changes in the value of the swap are recognized as
unrealized gains or losses by marking-to-market to reflect the market value of
the swap. When the swap is terminated, the Fund will record a realized gain or
loss. The Fund did not enter into interest rate swaps during the year.
Interest-Rate Cap
An interest-rate cap is similar to an interest-rate swap, except that one party
agrees to pay a fee, while the other party pays the excess, if any, of a
floating rate over a specified fixed rate. No collateral is provided by the
counterparty to the transaction and as such the Fund is exposed to credit risk
in the event of non-performance by the other party to the interest-rate cap. The
Fund did not enter into any interest rate caps during the year.
Residual Interests
A derivative security is any investment that derives its value from an
underlying security, asset, or market index. The Fund invests in mortgage
security residual interest ("residuals") which are considered derivative
securities. The Fund's investment in residuals has been primarily in securities
issued by proprietary mortgage trusts. While these entities have been highly
leveraged, often having indebtedness of up to 95% of their total value, the Fund
has not incurred any indebtedness in the course of making these residual
18
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
(CONTINUED)
investments; nor have the Fund's assets been pledged to secure the indebtedness
of the issuing structure or the Fund's investment in the residuals. In
consideration of the risk associated with investment in residual securities, it
is the Fund's policy to limit its exposure at the time of purchase to no more
than 20% of its total assets. The Fund will continue to invest in residual
securities because, in the opinion of the Investment Manager, these investments
can play a key role in fulfilling the Fund's objective of achieving high monthly
income through providing a means of economic leverage.
Security Transactions and Investment Income
Security transactions are recorded on the trade date. Realized gains and losses
from security transactions are reported on an identified-cost basis. Income and
expenses are recorded on the accrual basis with interest income on
principal-only securities, interest-only securities and residual interests
determined using the effective-yield method based upon estimates of future net
cash flows. Estimated effective yields are periodically updated consistent with
changes in interest rates and prepayment assumptions. Premiums and discounts on
mortgage securities and CMOs are amortized into interest income using the
effective-yield method.
Federal Income Taxes
No provision for federal income or excise taxes is required since the Fund
intends to continue to qualify as a regulated investment company and distribute
substantially all of its taxable income to its shareholders.
Reclassification of Capital Accounts
Distributions are determined in accordance with income tax regulations which may
differ from generally accepted accounting principles. Accordingly, periodic
reclassifications are made within the Fund's capital accounts to reflect income
and gains available for distribution under income tax regulations.
Distributions to Shareholders
The Fund declares and distributes dividends monthly from net investment income
and annually from net realized capital gains after offsetting capital-loss
carryovers. Reinvestment of income distribution is a non-cash transaction.
NOTE 2: INVESTMENT TRANSACTIONS
Purchases and sales of investment securities, other than short-term investments,
options, caps, dollar rolls, and futures transactions, aggregated
19
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
(CONTINUED)
$291,202,771 and $288,205,439 respectively, for the year ended October 31, 1996.
At October 31, 1996, the cost of securities for federal income-tax purposes was
$150,125,540 and net unrealized appreciation aggregated $456,536 of which
$2,005,530 related to appreciated securities and $1,548,994 related to
depreciated securities. The Fund had an unused realized capital loss
carryforward for income-tax purposes of $14,376,213 at October 31, 1996, of
which $721,487 expires in 2000, $11,955,561 expires in 2002 and $1,699,165
expires in 2004.
NOTE 3: INVESTMENT MANAGEMENT AND ADMINISTRATION AGREEMENTS
The Mentor Income Fund has entered into an Investment Advisory and Management
Agreement with Commonwealth Investment Counsel, Inc. ("Commonwealth"), a
wholly-owned subsidiary of Mentor Investment Group, Inc., which is a
wholly-owned subsidiary of Wheat First Butcher Singer, Inc. Pursuant to this
agreement, the Fund pays Commonwealth a monthly management fee at the annual
rate of 0.65% of average daily net assets. Mentor Investment Group provides
administrative personnel and services to the Fund at an annual rate of 0.10% of
the Fund's average daily net assets.
Effective November 1, 1996, Commonwealth Investment Counsel, Inc. became Mentor
Investment Advisors, LLC ("Mentor Advisors"). Mentor Advisors is a wholly-owned
subsidiary of Mentor Investment Group, LLC (formerly, Mentor Investment Group,
Inc.). Mentor Investment Group, LLC is a subsidiary of Wheat First Butcher
Singer, Inc.
Also effective November 1, 1996, EVEREN Capital Corporation, a previously
unrelated broker dealer, acquired a 20% ownership interest in Mentor Investment
Group, LLC from Wheat First Butcher Singer, Inc. As part of the acquisition
agreement, EVEREN may acquire additional ownership based principally on the
amount of Mentor Investment Group, LLC's revenues derived from clients of EVEREN
Securities, Inc. and assets attributable to its affiliates.
NOTE 4: BORROWINGS
The Fund enters into reverse repurchase agreements with qualified third-party
broker-dealers as determined by and under the direction of the Fund's Board of
Directors. Interest on the value of reverse repurchase agreements issued and
outstanding is based upon competitive market rates at the time of issuance. At
the time the Fund enters into a reverse repurchase agreement, it will establish
and
20
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
(CONTINUED)
maintain a segregated account with the lender containing securities having a
value not less than the repurchase price (including accrued interest). If the
counterparty to the transaction is rendered insolvent, the ultimate realization
of the securities to be repurchased by the Fund may be delayed or limited.
The average daily balance of reverse repurchase agreements outstanding during
the year ended October 31, 1996 was approximately $36,629,846 or $3.10 per share
based on average shares outstanding of 11,817,776 during the period at a
weighted average interest rate of 5.42%. The maximum amount of borrowings
outstanding at any week-end during the period was $61,051,153 (including accrued
interest) as of March 1, 1996, at a weighted average interest rate of 5.03%, and
was 27.42% of total assets. The rate on the October 31, 1996, borrowing was
5.36% and matures on November 6, 1996.
NOTE 5: CAPITAL
The Fund has authorized 200,000,000 shares of $.01 par value common stock. At
October 31, 1996, there were 11,817,776 shares issued and outstanding,
including, 1,151,463 shares issued under the Fund's reinvestment plan and
666,313 from an equity rights offering which occurred from December 23, 1991 to
January 31, 1992. During the year ended October 31, 1996, no shares were issued.
NOTE 6: QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
Shown in thousands of dollars and per common share:
<TABLE>
<CAPTION>
Increase
(Decrease)
Investment Net Investment Net Gain (Loss) in Net Assets
Income Income on Investments from Operations
---------------- ---------------- ------------------ ------------------
Per Per Per Per
Quarter End Total Share Total Share Total Share Total Share
- ----------------- ------ ----- ------ ----- ------- ------ ------- ------
<S> <C>
1996
October 31, 1996 $3,074 $0.30 $2,405 $0.21 $ 3,495 $ 0.30 $ 5,900 $ 0.51
July 31, 1996 3,278 0.28 2,486 0.21 (1,545) (0.13) 941 0.08
April 30, 1996 3,596 0.30 2,530 0.21 (6,726) (0.57) (4,196) (0.36)
January 31, 1996 3,205 0.27 2,373 0.20 3,130 0.26 5,503 0.46
1995
October 31, 1995 $3,215 $0.27 $2,439 $0.20 $ 2,867 $ 0.25 $ 5,306 $ 0.45
July 31, 1995 3,366 0.28 2,386 0.20 2,020 0.17 4,406 0.37
April 30, 1995 2,761 0.23 2,030 0.18 5,117 0.43 7,147 0.61
January 31, 1995 2,930 0.25 2,640 0.22 (1,771) (0.15) 869 0.07
</TABLE>
21
<PAGE>
MENTOR INCOME FUND, INC.
REPORT OF INDEPENDENT ACCOUNTANTS
- --------------------------------------------------------------------------------
TO THE SHAREHOLDERS AND BOARD OF DIRECTORS
OF MENTOR INCOME FUND, INC.
We have audited the accompanying statement of assets and liabilities of Mentor
Income Fund, Inc., including the portfolio of investments, as of October 31,
1996, and the related statements of operations and cash flows for the year then
ended, the statement of changes in net assets for each of the two years in the
period then ended, and the financial highlights for each of the five years in
the period 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
audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit 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 investments owned as of
October 31, 1996, by correspondence with the custodian and brokers. 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 Mentor
Income Fund, Inc., as of October 31, 1996, the results of its operations, its
cash flows, the changes in its net assets, and the financial highlights for each
of the respective periods stated in the first paragraph, in conformity with
generally accepted accounting principles.
COOPERS & LYBRAND L.L.P.
Baltimore, Maryland
December 19, 1996
22
<PAGE>
MENTOR INCOME FUND, INC.
DIVIDEND REINVESTMENT PLAN
- --------------------------------------------------------------------------------
A Dividend Reinvestment Plan (the "Plan") is provided to shareholders of the
Fund pursuant to which they have all distributions of dividends and capital
gains automatically reinvested by State Street Bank and Trust Company (the "Plan
Agent") in additional fund shares. Shareholders who elect not to participate in
the Plan will receive all distributions in cash paid by check mailed directly to
the shareholder of record (or if the shares are held in street or other nominee
name, then to the nominee) by the Fund's Custodian, as Dividend Disbursing
Agent.
The Plan Agent serves as Agent for shareholders in administering the Plan. When
the Fund declares a dividend or determines to make a capital gain distribution,
nonparticipants in the Plan will receive cash. If you participate in the Plan,
you will receive the equivalent in shares of the Fund as follows: (1) if the
market price of the shares on the payment date of the dividend or distribution
is equal to or exceeds the Fund's net asset value, participants will be issued
Fund shares at the higher of net asset value or 95% of the market price; or (2)
if the market price is lower than net asset value, the Plan Agent will receive
the dividend or capital gain distributions in cash and apply them to buy Fund
shares on your behalf in the open market, on the New York Stock Exchange or
elsewhere, for your account. If the market price exceeds the net asset value of
the Fund's shares before the Plan Agent has completed its purchases, the average
per-share purchase price paid by the Plan Agent may exceed the net asset value
of the Fund's shares. This would result in the acquisition of fewer shares than
if the dividend or capital gain distributions had been paid in shares issued by
the Fund.
Participants in the Plan may withdraw from the Plan upon written notice (not
less than 10 business days prior to any dividend record date) to the Plan Agent.
When a participant withdraws from the Plan or upon termination of the Plan by
the Fund, certificates for whole shares credited to his or her account under the
Plan will be issued and a cash payment will be made for any fraction of a share
credited to such account. In lieu of receiving a certificate, you may request
the Plan Agent to sell part or all of your reinvested shares held by the Agent
at market price and remit the proceeds to you, net of any brokerage commissions.
A $2.50 fee is charged by the Plan Agent upon any cash withdrawal or
termination. The Plan may be terminated by the Agent of the Fund upon written
notice mailed to each participant at least 90 days prior to any record date for
the payment of any dividend or capital gain distribution by the Fund.
There is no charge to participants for reinvesting dividends or capital gain
distributions, except for certain brokerage commissions, as described below. The
Plan Agent's fees for the handling of the reinvestment of dividends and
distributions are paid by the Fund. There are no brokerage commissions charged
with respect to shares issued directly by the Fund. However, each participant
will pay a pro-rata share of brokerage commissions incurred with respect to the
Plan Agent's open-market purchases in connection with the reinvestment of
dividends and distributions. It is anticipated that these commissions will be
lower than those would normally incur individually, since these shares are
purchased in large blocks by the Plan Agent.
The automatic reinvestment of dividends and distributions will not relieve
participants of any federal income tax that may be payable on such dividends or
distributions.
If you hold shares of the Fund in your own name, you are an automatic
participant in this Plan unless you elect to withdraw. If your shares are held
in the name of a brokerage firm, bank, or other nominee, you should contact your
nominee to see if it will participate in the Plan on your behalf. If your
nominee is able to participate in the Plan, dividend and capital gain
distributions will be credited to your account. If your nominee is unable to
participate in the Plan on your behalf, you may want to request that your shares
be re-registered in your name so that you can participate in the Plan. If your
shares are registered in your name, and you desire to receive your dividends and
capital gain distributions in cash, you must notify the Plan Agent, State Street
Bank and Trust Company, by calling 1-800-426-5523.
23
<PAGE>
SHAREHOLDER INFORMATION
INVESTMENT MANAGER
CORPORATE OFFICE
Mentor Investment Advisors, LLC
Riverfront Plaza, 901 East Byrd Street
Richmond, Virginia 23219
INVESTOR RELATIONS OFFICE
1-800-382-0016
OPERATIONS OFFICE
Riverfront Plaza, 901 East Byrd Street
Richmond, Virginia 23219
TRANSFER AGENT AND REGISTRAR
State Street Bank & Trust Company
Post Office Box 366
Boston, Massachusetts 02101
(800) 426-5523
CUSTODIAN
Investor Fiduciary Trust Company
811 Main - 11th Floor
Kansas City, Missouri 64105
INDEPENDENT AUDITORS
Coopers & Lybrand L.L.P.
217 East Redwood Street
Baltimore, Maryland 21202
LEGAL COUNSEL
Dechert Price & Rhoads
1500 K Street, N.W.
Washington, D.C. 20005
DIRECTORS AND OFFICERS
DIRECTORS
Weston E. Edwards, CHAIRMAN
Jerry R. Barrentine
Daniel J. Ludeman
J. Garnett Nelson
OFFICERS
Paul F. Costello, PRESIDENT
Terry L. Perkins, TREASURER
John M. Ivan, SECRETARY
Michael A. Wade, ASSISTANT TREASURER
Sander M. Bieber, ASSISTANT SECRETARY
MENTOR INCOME FUND, INC.
--------------------------
ANNUAL REPORT
--------------------------
OCTOBER 31, 1996
[MENTOR LOGO HERE]
