MENTOR INCOME FUND, INC.
ANNUAL REPORT
OCTOBER 31, 1998
- --------------------------------------------------------------------------------
THE FUND
[ ] 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
[ ] To achieve high monthly income consistent with preservation of capital.
DIVIDEND OBJECTIVE
[ ] 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, 1998. Regardless of
market environment, the Fund's primary mission remains the same, to provide
attractive income and competitive net asset value total returns to
shareholders.
During the year ended October 31, 1998, the Fund paid dividends totaling $0.77
per share, which represents an annualized yield of 9.00% based on the Fund's
closing market price of $8.56 on October 31, 1998. These monthly dividends have
provided the Fund's shareholders with a significant income advantage over the
average yield-to-maturity of 5.33%, attainable during the period from U.S.
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, 1998
- --------------------------------------------------------------------------------
MARKET CONDITIONS
Chart I: A Period of Falling Interest Rates
[CHART]
10/31/97 10/31/98
3 Months 5.19 4.32
6 Months 5.31 4.35
1 Year 5.35 4.18
2 Year 5.61 4.11
5 Year 5.72 4.23
10 Year 5.83 4.6
30 Year 6.15 5.15
Source: Bloomberg
As Chart I indicates, as of October 31, 1998, interest rate levels had fallen
dramatically across the full length of the yield curve. These yield declines
ranged from a 0.87% drop for three-month Treasury bills to a 1.50% decline for
two-year Treasury notes. Two, 10-year, and 30-year Treasuries closed the period
at 4.11%, 4.60%, and 5.15% respectively, each down by over 1.00% from the
beginning of the period.
On September 29th the Federal Reserve initiated its first monetary intervention
in over two years, a 0.25% reduction in the Federal Funds rate. This easing was
followed by an additional 0.25% cut on October 17th. By the end of October the
short-to-intermediate portion of the yield curve was actually inverted
(three-month Treasury bills were yielding more than five-year treasury bonds),
implying market expectations of future monetary easing by the Federal Reserve,
continued benign domestic inflation, and a slowing economy.
In the past few months the market has grown increasingly concerned that a
global deflationary spiral could unfold. The IMF policy prescription of
currency devaluation coupled with tight monetary and fiscal polices appears to
be making economic conditions even worse for Korea, Indonesia, Russia, etc. The
large debt burdens and faltering growth rates of the economies under IMF
supervision have raised the specter of wide scale defaults despite IMF
intervention. Russia's August announcement that it would simultaneously devalue
the ruble and unilaterally reschedule the repayment
2
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MENTOR INCOME FUND, INC.
ANNUAL REPORT
OCTOBER 31, 1998
- --------------------------------------------------------------------------------
terms of its debt brought this fear home to many global investors. As the
implicit guarantee of the IMF loses its credibility, the emerging markets that
had been relatively healthy are being put under increasing pressure. Concerns
about the credit quality of these nations have elevated interest rates in these
economies to the point where a slowdown in economic growth is becoming
inevitable. Such a global slowdown cannot help but put significant downward
pressure on U.S. growth and inflation rates.
The U.S. has not been immune to global credit quality anxiety. The yield spread
between Treasury rates and high quality corporate bonds, a traditional measure
of credit concerns within the economy, ballooned out toward quarter's end to
levels not seen since the last recession. The high yield market has come under
even more stress as investors abandon markets with any hint of credit risk. The
underperformance of spread sectors has caused leveraged investors such as hedge
funds and real estate investment trusts to come under severe funding pressure.
As lenders call their loans or demand more collateral, these leveraged
investors are left with few alternatives but to sell assets into an already
depressed market. These forced asset liquidations have further depressed prices
in corporate bonds and mortgage-backed securities, and in many instances
trading activity has all but ceased in many market sectors.
EFFECT ON THE FUND
Our results for the year ended October 31, 1998 trailed a number of market
indexes that we have traditionally used to assess our relative performance. As
Chart II indicates, the Fund's 5.22% net asset value total return for the 12
months ended October 31, 1998 compares to the 7.40%, 11.34%, and 13.44% returns
posted by the Merrill Lynch Mortgage, Government Bond, and 7-year Treasury
indexes,* respectively. The return of the Fund's Lipper U. S. Mortgage Bond
Fund peer group was 7.34%.** This relatively weak performance when compared to
our traditional benchmarks is explained in large part by the dramatic
outperformance of Treasury securities when compared to virtually all other
fixed-income asset classes. Our exposure to a variety of spread products, in
particular adjustable
3
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MENTOR INCOME FUND, INC.
ANNUAL REPORT
OCTOBER 31, 1998
- --------------------------------------------------------------------------------
rate mortgage backed securities, caused us to lag badly during a period in
which such a premium has been placed on the most liquid and secure credits.
Chart II: Relative Performance
(10/31/97 - 10/31/98)
Mentor Income Fund 5.22%
Lipper Peer Group 7.34%
Mortgage Index 7.40%
Gov't Bond Index 11.34%
7-Year Treasury 13.44%
Source: Lipper Analytical Services, Inc. and Merrill Lynch
The charts above illustrate the dramatic expansion in the spread between the
assets in which the Fund has traditionally invested and U.S. Treasury
securities. The underperformance of mortgages and related securities was
particularly harmful to the Fund's performance. Historically, the Fund has
relied heavily on mortgage related securities to meet its high-income
investment objective. Adjustable rate mortgage (ARM) securities in particular
have been an important part of the Fund's income producing strategies. Early in
1998, approximately half of the Fund's ARM exposure, both on balance sheet and
through our residual CMO interests, was sold. Reducing ARM exposure put
significant pressure on the Fund's earnings power. However, we expected
significant acceleration in prepayments on this asset class, and a poor
relative price performance as a result. The ARMs that were retained within the
portfolio were deemed to be the least vulnerable to increased prepayments.
While our prepayment forecasts on the retained ARM securities proved to be
accurate, we could not have foreseen the liquidity crisis that struck the
securities market in September and October. This liquidity crisis prompted many
lenders to demand immediate loan repayments from real estate investment trusts
(REITs). REITs, like the Fund, have traditionally been significant investors in
the ARM market. In many instances the REITs were forced to sell their ARM
holdings in response to their lender's repayment demands. These forced
liquidations caused ARM prices to drop dramatically during
4
<PAGE>
MENTOR INCOME FUND, INC.
ANNUAL REPORT
OCTOBER 31, 1998
- --------------------------------------------------------------------------------
the months of September and October, and significantly hurt Fund performance.
The ARMs held by the Fund have continued to prepay in accordance with our
expectations. As a result, we are confident that as market liquidity recovers
so will the prices of these assets.
PORTFOLIO STRATEGY
Throughout the year ended October 31, 1998 we continued to focus on our primary
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.*** Security selection,
sector allocation, and yield curve-weighting strategies remain the fundamental
methods through which we seek to add value.
Our short-term strategy in this tumultuous environment has been to tilt
portfolio durations somewhat long relative to our benchmarks; sector
allocations have been weighted more heavily toward treasury securities than has
historically been the case. Given our long-term confidence in the U.S. economy
we are selectively moving into domestic spread sectors with an eye towards an
even more aggressive weighting as opportunities present themselves. For the
present, credit risks are being taken primarily in those industries that can
best be expected to weather a downturn in economic growth. More aggressive
moves will require that we be convinced that these markets have stabilized,
which will require that the Fed continue to maintain accommodative credit
conditions.
The primary risk we see to our outlook is timing. The U.S. economy has a
tremendous forward momentum and the current yield curve anticipates continued
accommodative monetary policy. Should events unfold more slowly than the market
hopes, the bond market could encounter some short-term turbulence. We would
view these sell-offs as short term in nature and would utilize the higher yield
levels to further extend the Portfolio's duration.
5
<PAGE>
MENTOR INCOME FUND, INC.
ANNUAL REPORT
OCTOBER 31, 1998
- --------------------------------------------------------------------------------
[CHART]
Portfolio Composition
Fixed-Rate Single-Class Mortgage Backed Securities 39.2%
Corporate Bonds 3.1%
Adjustable-Rate Mortgage-Backed Securities 2.5%
Residual Interests 6.7%
Asset-Backed Securities 4.2%
U.S. Treasury Securities 10.5%
Interest-Only Securities 0.1%
Repurchase Agreement 0.5%
Preferred Stocks 3.3%
Fixed-Rate Multiple-Class Collateralized Mortgage
Obligations 29.9%
MARKET OUTLOOK
Economic growth is almost certain to slow in the upcoming year, as the impact
of slower growth overseas and distressed credit markets here at home takes
effect. We do not, however, anticipate a recession for 1999. The United States
has ample policy alternatives to fight any slowing in the domestic economy. As
inflation has fallen, the real rate of interest (the nominal interest rate
minus inflation) implied by the Fed Funds rates has risen appreciably. Assuming
that the turmoil overseas will place continued downward pressure on inflation
rates, the Fed could lower Fed Funds significantly further and still maintain a
real interest rate higher than the historical average. Unlike Japan, the U.S.
has a healthy, well-capitalized banking system and therefore any easing in
monetary conditions will help stimulate demand. For the first time in many
decades, the current budget surplus means that an expansionary fiscal policy
could be implemented without necessarily driving up real interest rates and
therefore crowding out private investment.
Given sufficient aggressive action on the part of the Fed, a recession can be
avoided. With an easing Fed and declining inflation, the backdrop for bonds
remains positive. The market could see rates last observed in the 1950s. The
U.S. and Great Britain currently have by far the highest interest rates within
the G-7 group of industrialized nation. This gap between our relative interest
rates cannot persist indefinitely given the similarity in the inflation rates
experienced by these seven economies. Our outlook is for U.S. rates to converge
down toward the rates currently seen in the economies of Europe, rather than
for their rates to rise to meet ours. Furthermore, as the Fed provides
liquidity to the currently distressed credit markets, corporate bonds and
mortgage backed securities have the potential for
6
<PAGE>
MENTOR INCOME FUND, INC.
ANNUAL REPORT
OCTOBER 31, 1998
- --------------------------------------------------------------------------------
significant outperformance in the upcoming year.
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/ Daniel J. Ludeman
Daniel J. Ludeman
CHAIRMAN
/s/ Paul F. Costello
Paul F. Costello
PRESIDENT
* 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 approximately 2,350 Treasury and Agency issues with
maturities ranging from one to 30 years. The Merrill Lynch 3-Year and
7-Year Treasury Indexes are adjusted to reflect reinvestment of
interest on securities in the index. The Merrill Lynch 7-Year Treasury
Index is not adjusted to reflect sales loads, expenses, or other fees
that the SEC requires to be reflected in the Fund's performance.
** Lipper Analytical Services, an independent rating company, groups funds
by investment objective and calculates performance figures for each
group. Performance does not include sales charges and does include
reinvestment of all distributions.
*** While portfolio managers will endeavor to manage the portfolio in
accordance with this strategy, there are no guarantees that it will be
successful. Past performance does not guarantee future comparable
results. Investment return and principal value will fluctuate so that
an investor's shares, when redeemed, may be worth more or less than
their original cost.
7
<PAGE>
MENTOR INCOME FUND, INC.
PORTFOLIO OF INVESTMENTS
OCTOBER 31, 1998
<TABLE>
<CAPTION>
Principal
Percent of Net Assets Amount Market Value
- ---------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
LONG-TERM INVESTMENTS 143.07%
- ---------------------------------------------------------------------------------------------------
PREFERRED STOCK 4.72%
Home Ownership Funding Corporation
(cost $5,132,788) (a) $ 5,650,000 $ 5,542,305
- ---------------------------------------------------------------------------------------------------
U.S. GOVERNMENT SECURITIES AND AGENCIES 83.03%
Federal Home Loan Mortgage Corporation
Series 1647 B, 6.50%, 11/15/08 7,358,165 7,358,165
Series 1693 Z, REMIC, 6.00%, 3/15/09 6,146,614 6,186,567
7.57% - 10.75%, 9/01/09 - 9/01/28 1,914,790 2,047,934
6.00%, 6/01/28 (d) 5,030,007 4,974,993
Federal National Mortgage Association
6.00%, 12/01/13 - 3/01/28, ARM (d) 11,181,768 11,101,773
10.50%, 11/01/18 (d) 3,950,449 4,333,114
6.00% - 7.48%, 7/01/27 - 2/01/28, ARM 1,774,172 1,753,350
Series 1998-24, Class JZ, 6.50%, 5/18/28 2,868,943 2,847,426
Government National Mortgage Association
15-year Platinum, 7.00%, 12/15/08 (d) 3,659,953 3,801,345
11.50%, 2/15/13 - 6/15/19 168,473 191,888
6.00%, 10/25/25 3,800,000 3,766,750
6.50%, 7/15/28, ARM 1,398,691 1,413,989
6.50% - 7.00%, 3/15/28 - 8/15/28,
ARM (d) 16,869,012 17,207,020
Government National Mortgage
Association, II
4.50% - 7.00%, 12/20/22 - 1/20/28,
ARM 12,797,533 12,773,973
U.S. Treasury Bonds, 6.13%, 11/15/27 (d) 8,400,000 9,469,908
U.S. Treasury Notes, 5.25% - 6.63%,
3/31/02 - 5/15/08 4,000,000 4,249,390
U.S. Treasury Strips, 6.01%, 11/15/21 14,200,000 4,012,963
- ---------------------------------------------------------------------------------------------------
Total U.S. Government Securities and Agencies (cost $95,418,102) 97,490,548
- ---------------------------------------------------------------------------------------------------
</TABLE>
8
<PAGE>
MENTOR INCOME FUND, INC.
PORTFOLIO OF INVESTMENTS
OCTOBER 31, 1998
<TABLE>
<CAPTION>
Principal
Percent of Net Assets Amount Market Value
- -----------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
CORPORATE BONDS 4.42%
- -----------------------------------------------------------------------------------------------------
Capital One Bank, 7.15%, 9/15/06, puttable
9/15/99 $4,000,000 $4,154,844
United Dominion Realty, 7.25%, 1/15/07 1,050,000 1,037,148
- ----------------------------------------------------------------------------------------------------
Total Corporate Bonds (cost $5,062,607) 5,191,992
- ----------------------------------------------------------------------------------------------------
ADJUSTABLE RATE MORTGAGES 3.64%
California Federal Bank, Series 1991-CI2,
Class A, 7.32%, 7/15/21 (b) 367,716 367,707
Kidder Peabody Acceptance Corporation,
Series 1989-3, Class A, 8.90%,
6/20/19 (b) 611,637 611,558
Structured Asset Securities Residential Trust,
Series 1990-1, Class A, 7.78%, 4/01/20 3,296,939 3,291,595
- ----------------------------------------------------------------------------------------------------
Total Adjustable Rate Mortgages (cost $4,380,017) 4,270,860
- ----------------------------------------------------------------------------------------------------
ASSET-BACKED SECURITIES 6.10%
Advanta Mortgage Loan Trust, Series
1993-3, Class A5, 5.55%, 1/25/25 1,072,921 1,076,712
AFG Receivables Trust, Series 1995-A, Class
B, 6.45%, 9/15/00 295,911 296,010
CS First Boston Mortgage Securities
Corporation, Series 1996-2, Class A6,
7.18%, 2/25/18 2,750,000 2,852,017
Olympic Automobiles Receivables Trust,
Series 1994-B, Class A2, 6.85%, 6/15/01 647,249 648,305
Old Stone Credit Corporation Home Equity
Trust, Series 1993-2, 6.20%, 6/15/08 1,002,635 1,000,107
Union Acceptance Corporation Auto Trust,
Series 1996-B, 6.45%, 7/09/03 1,282,586 1,291,669
- ----------------------------------------------------------------------------------------------------
Total Asset-Backed Securities (cost $6,899,676) 7,164,820
- ----------------------------------------------------------------------------------------------------
</TABLE>
9
<PAGE>
MENTOR INCOME FUND, INC.
PORTFOLIO OF INVESTMENTS
OCTOBER 31, 1998
<TABLE>
<CAPTION>
Principal
Percent of Net Assets Amount Market Value
----------------------- ------------- -------------
<S> <C> <C> <C>
COLLATERALIZED MORTGAGE OBLIGATIONS 31.51%
Equifax Credit Corporation Series 1998-A,
6.16%, 4/15/08 $ 1,481,250 $ 1,486,711
General Electric Capital Mortgage Services
Series 1993-18, Class B1, 6.00%,
2/25/09 (a) 1,913,044 1,900,652
Series 1996-4, Class B1, 7.00%, 3/25/26 4,386,365 4,290,874
Series 1997-13, Class M, 6.75%,
12/25/12 1,938,292 1,905,438
Series 1998-1, Class M, 6.75%, 1/25/13 729,032 729,635
Series 1998-3, Class M, 7.00%, 1/25/28 2,727,790 2,708,109
NASCOR
Series 1996-2, Class M, 7.00%, 9/25/11 1,745,172 1,786,875
Series 1997-7, Class M, 7.00%, 5/25/27 1,576,475 1,588,354
Prudential Home Mortgage Securities
Series 1993-27, Class M, 7.50%, 5/25/23 3,071,434 3,129,444
Series 1993-22, Class M, 7.00%, 7/25/23 4,603,791 4,722,145
Series 1995-5, Class M, 7.25%, 9/25/25 2,559,758 2,615,166
Series 1994-29, Class M, 7.00%,
10/25/24 3,153,696 3,223,087
Series 1995-5, Class B1, 7.25%,
9/25/25 (a) 2,643,954 2,699,490
Series 1995-7, Class M, 7.00%, 11/25/25 1,938,329 1,968,691
Series 1996-4, Class M, 6.50%, 4/25/26 583,970 577,106
Series 1996-8, Class M, 6.75%, 6/25/26 1,656,197 1,668,193
- ---------------------------------------------------------------------------------------------------
Total Collateralized Mortgage Obligations (costs $35,256,487) 36,999,970
- ---------------------------------------------------------------------------------------------------
INTEREST ONLY SECURITIES 0.08%
Conti-Mortgage Home Equity Loan Trust
Series 94-3, 0.13%, 3/15/14 (c)
(cost $173,685) 55,476,785 86,599
- ---------------------------------------------------------------------------------------------------
RESIDUAL INTERESTS (A) 9.57%
- ---------------------------------------------------------------------------------------------------
Capital Mortgage Funding, Inc., 1998-1,
1/22/27 43,831 690,617
</TABLE>
10
<PAGE>
MENTOR INCOME FUND, INC.
PORTFOLIO OF INVESTMENTS
OCTOBER 31, 1998
<TABLE>
<CAPTION>
Principal
Percent of Net Assets Amount Market Value
- ---------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
RESIDUAL INTERESTS (A) (CONTINUED)
- ---------------------------------------------------------------------------------------------------
General Mortgage Securities, Inc., 1989-2,
1998, 4/17/19 $16,390 $970,877
General Mortgage Securities II, Inc., 1991-4,
1998, 3/28/20 776 260,816
General Mortgage Securities II, Inc., 1991-7,
1998, 6/28/30 705 291,554
General Mortgage Securities II, Inc., 1995-1,
1998, 6/25/20 13,705 386,483
General Mortgage Securities II, Inc., 1995-4,
1998, 6/25/23 8,670 373,843
General Mortgage Securities II, Inc., 1997-4,
1998, 5/20/22 15,161 586,746
General Mortgage Securities II, Inc., 1997-5,
1997, 7/20/23 22,196 655,770
National Mortgage Funding I, Inc., 1992-4,
1997, 6/01/29 6,175 577,820
National Mortgage Funding I, Inc., 1993-1,
1998, 6/18/14 35,929 531,667
National Mortgage Funding I, Inc., 1995-4,
1998, 3/20/21 6,858 132,543
National Mortgage Funding I, Inc., 1996-1,
1998, 4/25/25 23,333 386,287
National Mortgage Funding I, Inc., 1997-6,
1997, 9/20/21 32,306 607,883
National Mortgage Funding I, Inc., 1997-7,
1997, 7/20/22 34,390 613,117
National Mortgage Funding I, Inc., 1997-8,
1997, 2/20/23 60,340 607,694
National Mortgage Funding I, Inc., 1997-9,
10/20/24 24,762 581,721
National Mortgage Funding I, Inc.,
1997-10, 10/20/24 32,987 434,878
National Mortgage Funding I, Inc., 1998-1,
10/20/22 16,715 399,053
</TABLE>
11
<PAGE>
MENTOR INCOME FUND, INC.
PORTFOLIO OF INVESTMENTS
OCTOBER 31, 1998
<TABLE>
<CAPTION>
Principal
Percent of Net Assets Amount Market Value
- ---------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
RESIDUAL INTERESTS (A) (CONTINUED)
- -----------------------------------------------------------------------------------------------------
National Mortgage Funding I, Inc., 1998-2,
10/20/23 $ 18,535 $ 428,458
National Mortgage Funding I, Inc., 1998-3,
11/20/23 19,110 428,540
National Mortgage Funding I, Inc., 1998-4,
10/25/29 784 475,902
National Mortgage Funding I, Inc., 1998-5,
11/25/22 6,797 362,277
National Mortgage Funding I, Inc., 1998-9,
11/20/22 28,133 443,692
- ---------------------------------------------------------------------------------------------------
Total Residual Interests (cost $13,532,316) 11,228,238
- ---------------------------------------------------------------------------------------------------
TOTAL LONG-TERM INVESTMENTS (COST $165,855,678) 167,975,332
- ---------------------------------------------------------------------------------------------------
SHORT-TERM INVESTMENT 0.72%
- ---------------------------------------------------------------------------------------------------
REPURCHASE AGREEMENT
Goldman Sachs & Company
Dated 10/30/98, 5.44%, due 11/02/98
collateralized by $836,192 Federal
Home Loan Mortgage Corporation,
6.86%, 9/25/26, market value
$865,459 (cost $847,585) 847,585 847,585
- ---------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS (COST $166,703,263) 143.79% 168,822,917
- ---------------------------------------------------------------------------------------------------
OTHER ASSETS LESS LIABILITIES (43.79%) (51,409,495)
- ---------------------------------------------------------------------------------------------------
NET ASSETS 100.00% $ 117,413,422
- ---------------------------------------------------------------------------------------------------
</TABLE>
ARM - Adjustable Rate Mortgage
CMO - Collateralized Mortgage Obligation
REMIC - Real Estate Mortgage Investment Conduit
12
<PAGE>
MENTOR INCOME FUND, INC.
PORTFOLIO OF INVESTMENTS
OCTOBER 31, 1998
(a) These are securities that may be resold to "qualified institutional buyers"
under Rule 144A or securities offered pursuant to Section 4(2) of the
Securities Act of 1933, as amended. These securities have been determined
to be liquid under guidelines established by the Board of Directors.
(b) All or a portion of these securities are illiquid securities, and are
valued using market quotations where readily available. In the absence of
market quotations, the securities are valued based upon their fair value
determined under procedures approved by the Board of Directors.
(c) Notional principal amount.
(d) A portion of these securities have been segregated as collateral for
reverse repurchase agreements.
INVESTMENT TRANSACTIONS
Cost of purchases and proceeds from sales of securities, other than short-term
securities, aggregated $153,491,978 and $133,871,500, respectively.
INCOME TAX INFORMATION
At October 31, 1998, the aggregated cost of investment securities for federal
income tax purposes was $167,548,618. Net unrealized appreciation aggregated
$1,274,299, of which $5,096,585, related to appreciated investment securities
and $3,822,286, related to depreciated investment securities.
SEE NOTES TO FINANCIAL STATEMENTS.
13
<PAGE>
MENTOR INCOME FUND, INC.
STATEMENT OF ASSETS AND LIABILITIES
OCTOBER 31, 1998
- --------------------------------------------------------------------------------
<TABLE>
<S> <C>
ASSETS
Investments, at market value (cost $166,703,263) $168,822,917
Cash 260,096
Receivables
Investments sold 4,864,262
Interest 1,266,668
Other assets 250,432
- --------------------------------------------------------------------------------
Total assets 175,464,375
- --------------------------------------------------------------------------------
LIABILITIES
Payables
Reverse repurchase agreements 54,000,000
Investments purchased 3,798,892
Income dividends 153,938
Accrued expenses and other liabilities 98,123
- --------------------------------------------------------------------------------
Total liabilities 58,050,953
- --------------------------------------------------------------------------------
NET ASSETS $117,413,422
- --------------------------------------------------------------------------------
NET ASSETS REPRESENTED BY:
Common stock at par value 118,178
Additional paid-in capital $131,092,850
Accumulated undistributed net investment loss (153,938)
Accumulated net realized loss on investment
transactions (15,763,322)
Net unrealized appreciation on investments 2,119,654
- --------------------------------------------------------------------------------
Net Assets $117,413,422
Shares Outstanding 11,817,776
- --------------------------------------------------------------------------------
NET ASSET VALUE PER SHARE $ 9.94
- --------------------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS.
14
<PAGE>
MENTOR INCOME FUND, INC.
STATEMENT OF OPERATIONS
YEAR ENDED OCTOBER 31, 1998
- --------------------------------------------------------------------------------
<TABLE>
<S> <C>
INVESTMENT INCOME
Interest (b) (Note 2) $ 11,519,802
- --------------------------------------------------------------------------------
EXPENSES
Management fee 771,866
Administration fee 118,712
Shareholders reports and postage expenses 77,779
Shareholder service fee 59,999
Custodian fee 58,135
Transfer agent fee 51,069
Legal fees 36,012
Registration and filing fees 29,315
Directors' fees and expenses 5,028
Audit fees 3,565
Miscellaneous 3,890
- --------------------------------------------------------------------------------
Total operating expenses 1,215,370
- --------------------------------------------------------------------------------
Interest expense 2,699,217
- --------------------------------------------------------------------------------
Total expenses 3,914,587
- --------------------------------------------------------------------------------
Net investment income 7,605,215
- --------------------------------------------------------------------------------
REALIZED AND UNREALIZED LOSS ON INVESTMENTS AND
INTEREST-RATE SWAPS
Net realized loss on investments and interest-rate swaps (958,710)
Change in unrealized appreciation on investments (1,445,672)
- --------------------------------------------------------------------------------
Net loss on investments and interest-rate swaps (2,404,382)
Net increase in net assets resulting from operations $ 5,200,833
- --------------------------------------------------------------------------------
</TABLE>
(b) Net of interest expense on interest-rate swaps of $664,854.
SEE NOTES TO FINANCIAL STATEMENTS.
15
<PAGE>
MENTOR INCOME FUND, INC.
STATEMENT OF CASH FLOWS
YEAR ENDED OCTOBER 31, 1998
- --------------------------------------------------------------------------------
<TABLE>
<S> <C>
INCREASE IN CASH
CASH FLOWS FROM OPERATING ACTIVITIES:
Net increase in net assets from operations $ 5,200,833
Adjustments to reconcile net increase in net assets from
operations to net cash provided by operating activities:
Purchase of investment securities (153,491,978)
Proceeds from disposition of investment securities 168,194,663
Sale of short-term investment securities, net (505,418)
Increase in variation margin on interest-rate swaps 95,885
Decrease in interest receivable 409,096
Decrease in receivable for securities sold 813,409
Decrease in other assets 2,486
Decrease in payable for securities purchased (18,310,505)
Decrease in accrued expenses and other liabilities (253,116)
Decrease in unrealized appreciation on investments 1,445,672
Net realized loss from investments and interest-rate swaps 958,710
- --------------------------------------------------------------------------------
Net cash provided by operating activities 4,559,737
- --------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Increase in reverse repurchase agreements 4,763,769
Cash distributions paid (9,064,620)
- --------------------------------------------------------------------------------
Net cash used in financing activities (4,300,851)
- --------------------------------------------------------------------------------
Net increase in cash 258,886
- --------------------------------------------------------------------------------
CASH:
Beginning of year 1,210
- --------------------------------------------------------------------------------
End of year $ 260,096
- --------------------------------------------------------------------------------
</TABLE>
Cash paid for interest on indebtedness for the year was $2,964,593.
SEE NOTES TO FINANCIAL STATEMENTS.
16
<PAGE>
MENTOR INCOME FUND, INC.
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
Year Ended Year Ended
10/31/98 10/31/97
----------------- -----------------
<S> <C> <C>
NET INCREASE (DECREASE) IN NET ASSETS
OPERATIONS
Net investment income $ 7,605,215 $ 9,736,025
Net realized gain (loss) on investments and interest-rate
swaps (958,710) 602,516
Change in unrealized appreciation on investments (1,445,672) 2,065,727
- -------------------------------------------------------------------------------------------------
Increase in net assets resulting from operations 5,200,833 12,404,268
- -------------------------------------------------------------------------------------------------
DISTRIBUTIONS TO SHAREHOLDERS FROM
Net investment income (8,419,461) (9,930,537)
Tax return of capital (680,074) -
- -------------------------------------------------------------------------------------------------
Total distributions to Shareholders (9,099,535) 9,930,537
- -------------------------------------------------------------------------------------------------
Increase (decrease) in net assets (3,898,702) 2,473,731
NET ASSETS
Beginning of year 121,312,124 118,838,393
- -------------------------------------------------------------------------------------------------
End of year (including accumulated undistributed net
investment income (loss) of ($153,938), and
$860,161, respectively) $ 117,413,422 $ 121,312,124
- -------------------------------------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS.
17
<PAGE>
MENTOR INCOME FUND, INC.
FINANCIAL HIGHLIGHTS
<TABLE>
<CAPTION>
Year Ended October 31,
------------------------------------------------------------------------
1998 1997 1996 1995 1994
------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE
NET ASSET VALUE, BEGINNING OF YEAR $ 10.27 $ 10.06 $ 10.21 $ 9.60 $ 11.29
- -------------------------------------------------------------------------------------------------------------------
INCOME FROM INVESTMENT OPERATIONS
Net investment income 0.64 0.82 0.83 0.80 1.02
Net realized and unrealized gain (loss)
on investments and interest-rate
swaps (0.20) 0.23 (0.14) 0.70 (1.75)
- -------------------------------------------------------------------------------------------------------------------
Total from investment operations 0.44 1.05 0.69 1.50 (0.73)
- -------------------------------------------------------------------------------------------------------------------
LESS DISTRIBUTIONS FROM
Net investment income (0.71) (0.84) (0.84) (0.89) (0.96)
Tax return of capital (0.06) - - - -
- -------------------------------------------------------------------------------------------------------------------
Total distributions (0.77) (0.84) (0.84) (0.89) (0.96)
- -------------------------------------------------------------------------------------------------------------------
NET ASSET VALUE, END OF YEAR $ 9.94 $ 10.27 $ 10.06 $ 10.21 $ 9.60
- -------------------------------------------------------------------------------------------------------------------
Per share market price, end of year $ 8.56 $ 9.38 $ 9.00 $ 8.88 $ 8.25
Total Investment Return
Based on market price (0.74%) 13.92% 11.24% 18.83% (13.32%)
Based on net asset value 5.22% 11.65% 8.08% 17.48% (6.19%)
- -------------------------------------------------------------------------------------------------------------------
RATIOS/SUPPLEMENTAL DATA
Net assets, end of year (in thousands) $ 117,413 $121,312 $118,838 $120,617 $113,401
Ratio of investment income to average
net assets 9.68% 10.97% 11.12% 10.58% 12.18%
Ratio of operating expenses to average
net assets 1.02% 1.08% 1.13% 1.09% 1.22%
Ratio of total expenses to average net
assets 3.29% 2.78% 2.84% 2.39% 2.38%
Ratio of net investment income to
average net assets 6.39% 8.19% 8.28% 8.19% 9.80%
Portfolio turnover rate 79.70% 70.50% 189.71% 153.92% 173.71%
Shares outstanding at end of year
(in thousands) 11,818 11,818 11,818 11,818 11,818
- -------------------------------------------------------------------------------------------------------------------
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS.
18
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
OCTOBER 31, 1998
NOTE 1: ORGANIZATION
Mentor Income Fund, Inc. ("the Fund") is registered under the Investment
Company Act of 1940 as a diversified, closed-end management investment company.
NOTE 2: SIGNIFICANT ACCOUNTING POLICIES
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.
(a) Valuation of Securities -- 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 the
Fund's Board of Directors.
(b) Repurchase Agreements -- It is the policy of the Fund to require the
custodian bank to take possession, to have legally segregated in the Federal
Reserve Book entry system all securities held as collateral in support of
repurchase agreement investments. Additionally, procedures have been
established by the Fund to monitor, on a daily basis, the market value of each
repurchase agreement's underlying securities to ensure the existence of a
proper level of collateral.
The Fund will only enter into repurchase agreements with banks and other
recognized financial institutions such as broker/dealers which are deemed by
the Fund's advisor to be creditworthy pursuant to guidelines established by the
Fund's Board of Directors. Risks may arise from the potential inability of
19
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
(CONTINUED)
counterparties to honor the terms of the repurchase agreement. Accordingly, the
Fund could receive less than the repurchase price on the sale of collateral
securities.
(c) Options -- In order to produce incremental earnings or protect against
changes in the value of portfolio securities, the Fund may buy and sell put and
call options and write covered call options on portfolio securities.
The Fund may purchase put options or writes covered call options to hedge
against adverse movements in the value of portfolio holdings. The Fund may also
use options for speculative purposes, although it does not employ options for
this at the present time. The Fund will segregate assets to cover their
obligations under option contracts.
Options contracts are valued daily based upon the last sales price on the
principal exchange on which the option is traded and unrealized appreciation or
depreciation is recorded. The Fund will realize a gain or loss upon the
expiration or closing of the option transaction. When an option is exercised,
the proceeds on sales for a written call option, the purchase cost for a
written put option, or the cost of the security for a purchased put or call
option is adjusted by the amount of premium received or paid.
The risk in writing a call option is that the Fund gives up the opportunity for
profit if the market price of the security increases and the option is
exercised. The risk in writing a put option is that the Fund may incur a loss
if the market price of the security decreases and the option is exercised. The
risk in buying an option is that the Fund pays a premium whether or not the
option is exercised. The Fund also has the additional risk of not being able to
enter into a closing transaction if a liquid secondary market does not exist.
The Fund may also write over-the-counter options where the completion of the
obligation is dependent upon the credit standing of the counterparty.
(d) Futures Contracts -- In order to gain exposure to or protect against
declines in security values, the Fund may buy and sell futures contracts. The
Fund may also buy
20
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
(CONTINUED)
or write put or call options on these futures contracts.
The Fund generally sells futures contracts to hedge against declines in the
value of portfolio securities. The Fund may also purchase futures contracts to
gain exposure to market changes as it may be more efficient or cost effective
than actually buying securities. The Fund will segregate assets to cover its
commitments under such speculative futures contracts.
Upon entering into a futures contract, the Fund is required to deposit either
cash or securities in an amount (initial margin) equal to a certain percentage
of the contract value. Subsequent payments (variation margin) are made or
received by the Fund each day. The variation margin payments are equal to the
daily changes in the contract value and are recorded as unrealized gains and
losses. The Fund recognizes a realized gain or loss when the contract is
closed.
Risks of entering into futures contracts (and related options) include the
possibility that there may be an illiquid market and that a change in the value
of the contract or option may not correlate with changes in the value of the
underlying securities. At October 31, 1998, the Fund had no open futures
contracts.
(e) 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 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.
(f) 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
21
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
(CONTINUED)
short sale and the time the Fund must deliver the security, the Fund realizes a
loss.
(g) Interest-Rate Swaps -- 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 and 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. For
the year ended October 31, 1998, the Fund had realized losses of $44,201 in
connection with closed interest-rate swap agreements. As of October 31, 1998,
the Fund had no outstanding interest-rate swap contracts.
(h) 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.
(i) Residual Interests -- The Fund invests in mortgage security residual
interests ("residuals") which are considered derivative securities. A
derivative security is any investment that derives its value from an underlying
security, asset, or market index. 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 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.
22
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
(CONTINUED)
(j) 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 collateralized mortgage obligations are amortized into interest
income using the effective-yield method.
(k) 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 all of its taxable income to its
shareholders.
The Fund had an unused realized capital loss carryforward for income-tax
purposes of $14,721,588 at October 31, 1998, of which $108,152 expires on
October 31, 2001, $11,955,561 expires on October 31, 2003, $1,699,165 expires
on October 31, 2004 and $958,710 expires on October 31, 2006.
(l) 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.
(m) Distributions to Shareholders -- The Fund declares and distributes
dividends monthly from net investment income and annually from net realized
capital gains, if any, after offsetting capital-loss carryovers. Reinvestment
of income distribution is a non-cash transaction.
NOTE 3: INVESTMENT MANAGEMENT AND ADMINISTRATION AGREEMENTS
Mentor Advisors, LLC ("Mentor Advisors"), the Fund's investment advisor,
receives for its services an annual investment advisory fee of 0.65% of average
weekly net assets. Mentor
23
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
(CONTINUED)
Advisors is a wholly-owned subsidiary of Mentor Investment Group, LLC
("Mentor"), which is in turn a partially owned subsidiary of Wheat First Union
and EVEREN Capital Corporation. Mentor provides administrative personnel and
services to the Fund at an annual rate of 0.10% of the Fund's average weekly
net assets.
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 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, 1998 was approximately $22,020,634 or $1.86 per
share based on average shares outstanding of 11,817,776 during the period at a
weighted average interest rate of 5.51%. The maximum amount of borrowings
outstanding at any day during the period was $52,056,926 (including accrued
interest) as of November 24, 1997, at a weighted average interest rate of
4.94%, and was 27.03% of total assets. The average rate on the October 31,
1998, borrowing was 5.21% and matures on November 11, 1998.
NOTE 5: CAPITAL SHARE TRANSACTIONS
The Fund has authorized 200,000,000 shares of $.01 par value common stock. At
October 31, 1998, 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, 1998, no shares were
issued.
24
<PAGE>
MENTOR INCOME FUND, INC.
NOTES TO FINANCIAL STATEMENTS
(CONTINUED)
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> <C> <C> <C> <C> <C> <C> <C>
1998
October 31, 1998 $ 2,104 $ 0.18 $ 1,719 $ 0.15 $ (254) $ (0.02) $ 1,465 $ 0.13
July 31, 1998 2,761 0.23 1,875 0.16 500 0.04 2,375 0.20
April 30, 1998 2,898 0.25 1,900 0.16 (1,937) (0.16) (37) (0.00)
January 31, 1998 3,757 0.32 2,111 0.17 (713) (0.06) 1,398 0.11
1997
October 31, 1997 $ 3,095 $ 0.26 $ 2,459 $ 0.21 $ (512) $ (0.04) $ 1,947 $ 0.16
July 31, 1997 3,545 0.30 2,551 0.21 4,579 0.39 7,130 0.60
April 30, 1997 3,303 0.28 2,423 0.21 11 0.00 2,434 0.21
January 31, 1997 3,096 0.26 2,303 0.19 (1,410) (0.12) 893 0.08
</TABLE>
ADDITIONAL INFORMATION
YEAR 2000 (UNAUDITED)
The Fund receives services from a number of providers which rely on the
effective functioning of their respective systems and the systems of others to
perform those services. It is generally recognized that certain systems in use
today may not be able to perform their intended functions adequately after 1999
because of the inability of computer software to distinguish the year 2000 from
the year 1900. Mentor Advisors is taking steps that it believes are reasonably
designed to address this potential "Year 2000" problem and to obtain
satisfactory assurances that comparable steps are being taken by the Fund's
other major service providers. There can be no assurance, however, that these
steps will be sufficient to avoid any adverse impact on the Fund from this
problem.
25
<PAGE>
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
THE BOARD OF DIRECTORS AND SHAREHOLDERS
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,
1998, and the related statements of operations and cash flows for the year then
ended, the statements of changes in net assets and financial highlights for
each of the years in the two-year 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. The financial highlights for each of
the years in the three-year period ended October 31, 1996 were audited by other
auditors whose report dated December 19, 1996 expressed an unqualified opinion
on those financial highlights.
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 securities owned as of
October 31, 1998 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, 1998, the results of its operations,
cash flows, changes in its net assets and financial highlights for the periods
specified in the first paragraph above, in conformity with generally accepted
accounting principles.
/s/ KPMG PEAT MARWICK LLP
Boston, Massachusetts
December 18, 1998
26
<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.
27
<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
KPMG Peat Marwick LLP
99 High Street
Boston, Massachuetts 02110
LEGAL COUNSEL
Ropes & Gray
One International Place
Boston, Massachusetts 02110
DIRECTORS AND OFFICERS
DIRECTORS
Daniel J. Ludeman, CHAIRMAN
Arch T. Allen III
Jerry R. Barrentine
Arnold H. Dreyfuss
Weston E. Edwards
Thomas F. Keller
Louis W. Molechert
J. Garnett Nelson
Troy A. Peery
Peter J. Quinn
OFFICERS
Paul F. Costello, PRESIDENT
Terry L. Perkins, TREASURER
Geoffry B. Sale, SECRETARY
Michael A. Wade, ASSISTANT TREASURER
MK#1309
Mentor Income Fund, Inc.
--------------------------
ANNUAL REPORT
--------------------------
October 31, 1998
[MENTOR INVESTMENT GROUP LOGO]
