Prospectus
[Logo] Merrill Lynch
Merrill Lynch Adjustable Rate Securities Fund, Inc.
September 28, 1999
This Prospectus contains information you should know before investing, including
information about risks. Please read it before you invest and keep it for future
reference.
The Securities and Exchange Commission has not approved or disapproved these
securities or passed upon the adequacy of this Prospectus. Any representation to
the contrary is a criminal offense.
<PAGE>
[Clipart]
Table of Contents
PAGE
[CLIP ART] KEY FACTS
--------------------------------------------------------------------
Merrill Lynch Adjustable Rate Securities Fund at a Glance ..... 3
Risk/Return Bar Chart ......................................... 5
Fees and Expenses ............................................. 6
[CLIP ART] DETAILS ABOUT THE FUND
--------------------------------------------------------------------
How the Fund Invests .......................................... 8
Investment Risks .............................................. 9
[CLIP ART] YOUR ACCOUNT
--------------------------------------------------------------------
Merrill Lynch Select Pricing(SM) System ....................... 15
How to Buy, Sell, Transfer and Exchange Shares ................ 20
Participation in Merrill Lynch Fee-Based Programs ............. 24
[CLIP ART] MANAGEMENT OF THE FUND
--------------------------------------------------------------------
Merrill Lynch Asset Management ................................ 27
Financial Highlights .......................................... 28
[CLIP ART] FOR MORE INFORMATION
--------------------------------------------------------------------
Shareholder Reports ................................... Back Cover
Statement of Additional Information ................... Back Cover
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
[Clipart] Key Facts
In an effort to help you better
understand the many concepts involved in
making an investment decision, we have
defined highlighted terms in this
prospectus in the sidebar.
Current Income -- income from interest
or dividends.
Mortgage backed securities -- securities
backed by pools of mortgages that in
many cases are guaranteed by government
agencies such as Government National
Mortgage Association ("Ginnie Mae").
Asset backed securities -- debt
securities issued by a trust or other
legal entity established for the purpose
of issuing securities and holding
certain assets, such as credit card
receivables or auto leases, that pay
down over time and generate sufficient
cash to pay holders of the securities.
Index -- a measure of value or rates.
Agencies -- entities that are part of or
sponsored by the Federal government,
such as Ginnie Mae, the Tennessee Valley
Authority or the Federal Housing
Administration.
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND AT A GLANCE
- --------------------------------------------------------------------------------
What is the Fund's investment objective?
The Fund's investment objective is to seek high current income consistent with a
policy of limiting the degree of fluctuation in the net asset value of Fund
shares from movements in interest rates.
What are the Fund's main investment strategies?
The Fund will invest at least 65% of its total assets in adjustable rate
securities of any maturity, consisting primarily of mortgage backed securities,
including collateralized mortgage obligations, and asset backed securities. The
interest payments from adjustable rate securities will vary based on changes in
interest rates or indexes at specific intervals of time (typically ranging from
one to six months). The Fund's manager attempts to keep the price of the Fund's
shares relatively stable compared to a Fund that invests in securities with
fixed interest rates. However, the Fund does not attempt to maintain a share
price that is as stable as that typically found in a money market fund. Some
securities in which the Fund invests may be guaranteed by the government or by
the government agency or instrumentality issuing the security. Some securities
will be issued by private issuers. With respect to the adjustable rate
securities comprising at least 65% of the Fund's total assets, securities issued
by private issuers must be rated at least AA by Standard & Poor's ("S&P") or Aa
by Moody's Investors Services, Inc. ("Moody's") or, if unrated, be of comparable
quality.
Up to 35% of the Fund's total assets may be invested in securities rated in
ratings categories below AA by S&P or Aa by Moody's, however these securities
will be rated at least investment grade, or if unrated, of comparable quality.
No more than 10% of the Fund's total assets will be invested in securities rated
in the lowest category of investment grade or in comparable unrated securities.
In purchasing these securities, the Fund will rely on the Fund manager's
judgment, analysis and experience in evaluating the creditworthiness of the
issuer.
The Fund may also invest in derivative instruments to increase its return and to
hedge its portfolio against movements in interest rates. Derivative instruments
will not, however, be used for speculative purposes.We cannot guarantee that the
Fund will achieve its objective.
What are the main risks of investing in the Fund?
As with any mutual fund, and despite the Fund manager's attempts to minimize
share price fluctuation, the value of the Fund's investments -- and therefore
the value of Fund shares -- may fluctuate. These changes may occur because
interest rates are rising or falling. At other times, there are specific factors
that may affect the value of a particular investment. If the value of the Fund's
investments goes down, you may lose money.
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 3
<PAGE>
[Clipart] Key Facts
Private Issuers -- originators of or
investors in mortgage loans and
receivables such as savings and loan
associations, saving banks, commercial
banks, investment banks, finance
companies and special purpose finance
subsidiaries of any of the above.
Investment Grade -- any of the four
highest debt obligation ratings by
recognized rating agencies, including
Moody's Investors Service, Inc.,
Standard & Poor's or Fitch IBCA, Inc.
Collateralized Mortgage Obligations --
mortgage backed securities that divide the
principal and interest payments collected on a
pool of mortgages into several revenue streams
with different priority rights to various portions of
the underlying mortgage payments.
Although securities rated above investment grade or securities that are
guaranteed by the government or the issuer often involve minimal credit risk,
changes in the value of the Fund's securities may occur in response to interest
rate movements -- generally, when interest rates go up, the value of most
mortgage backed and asset backed securities, like other fixed income
instruments, goes down. Further, mortgage backed and asset backed securities may
involve special risks, including prepayment risk and extension risk, and may be
more volatile than other fixed income securities of similar maturities. While
the interest paid on adjustable rate securities may go up and down in response
to changes in market interest rates or an index to which the security relates,
these securities generally are subject to a maximum amount by which interest
will fluctuate, and these securities may not adjust immediately upon changes in
market or index rates. If an adjustable rate security reaches the maximum level
to which it will adjust, or does not adjust at the same time as a change in the
market rate or index, it may decrease in value.
Although the Fund may invest in derivatives to hedge against risks in its
portfolio, it is not bound to do so and the Fund cannot guarantee the success of
any hedging strategies it does use. Derivatives may be volatile and subject to
liquidity, leverage, credit and other types of risks.
Who should invest?
The Fund may be an appropriate investment for you if you:
o Are investing with long term goals, such as retirement or funding a
child's education
o Want a professionally managed portfolio
o Are looking for an investment that provides income with minimal
credit risk
o Are willing to accept the risk that the value of your investment may
decline as a result of interest rate movements
4 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
RISK/RETURN BAR CHART
- --------------------------------------------------------------------------------
The bar chart and table shown below provide an indication of the risks of
investing in the Fund. The bar chart shows changes in the Fund's performance for
Class B shares for each complete calendar year since the Fund's inception. Sales
charges are not reflected in the bar chart. If these amounts were reflected,
returns would be less than those shown. The table compares the average annual
total returns for each class of the Fund's shares for the periods shown with
those of the Lehman Brothers Short-Government Index (1-2 yr.) and the Salomon
Six Month Treasury Bill. How the Fund performed in the past is not necessarily
an indication of how the Fund will perform in the future.
[The following information was depicted as a bar chart in the printed material]
2.84% 2.83% -0.14% 8.13% 6.16% 5.53% 3.76%
----- ----- ----- ----- ----- ----- -----
1992 1993 1994 1995 1996 1997 1998
During the period shown in the bar chart, the highest return for a quarter was
2.89% (quarter ended March 31, 1995) and the lowest return for a quarter was
- -0.87% (quarter ended June 30, 1994.) The Fund's year-to-date return as of June
30, 1999 was 2.05%.
Average Annual Total Returns (for the Past Past Since
calendar year ended December 31, 1998) One Year Five Years Inception
- --------------------------------------------------------------------------------
Merrill Lynch Adjustable Rate
Securities Fund*-- Class A 0.39% N/A 5.38%+
Lehman Brothers Short-Government Index (1-2yr)** 6.59% N/A 6.69%+++
Salomon Six Month Treasury Bill*** 5.28% N/A 5.52%+++
- --------------------------------------------------------------------------------
Merrill Lynch Adjustable Rate
Securities Fund* -- Class B -0.19% 4.65% 4.25%++
Lehman Brothers Short-Government Index (1-2yr)** 6.59% 5.86% 6.17%#
Salomon Six Month Treasury Bill*** 5.28% 5.28% 4.85%#
- --------------------------------------------------------------------------------
Merrill Lynch Adjustable Rate
Securities Fund*-- Class C 2.63% N/A 5.47%+
Lehman Brothers Short-Government Index (1-2yr)** 6.59% N/A 6.69%+++
Salomon Six Month Treasury Bill*** 5.28% N/A 5.52%+++
- --------------------------------------------------------------------------------
Merrill Lynch Adjustable Rate
Securities Fund*-- Class D 0.13% 4.34% 4.22%++
Lehman Brothers Short-Government Index (1-2yr)** 6.59% 5.86% 6.17%#
Salomon Six Month Treasury Bill*** 5.28% 5.28% 4.85%#
- --------------------------------------------------------------------------------
* Includes sales charge.
** This unmanaged Index is comprised of all U.S. Government agency and Treasury
securities with maturities of one to two years. Past performance is not
predictive of future performance.
*** This unmanaged Index is comprised of all U.S. Treasury bills maturing in up
to six months. Past performance is not predictive of future performance.
+ Inception date is October 21, 1994.
++ Inception date is August 2, 1991.
+++ Since October 31, 1994.
# Since July 31, 1991.
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 5
<PAGE>
[Clipart] Key Facts
UNDERSTANDING
EXPENSES
Fund investors pay various fees and
expenses, either directly or indirectly.
Listed below are some of the main types
of expenses, which all mutual funds may
charge:
Expenses paid directly by the
shareholder:
Shareholder fees -- these
include sales charges which you
may pay when you buy or sell
shares of the Fund.
Expenses paid indirectly by the
shareholder:
Annual Fund Operating
Expenses -- expenses that cover
the costs of operating the Fund.
Management Fee -- a fee paid to the
Manager for managing the Fund.
Distribution Fees -- fees used to
support the Fund's marketing and
distribution efforts, such as
compensating Financial Consultants,
advertising and promotion.
Service (Account Maintenance) Fees --
fees used to compensate securities
dealers for account maintenance
activities.
FEES AND EXPENSES
- --------------------------------------------------------------------------------
The Fund offers four different classes of shares. Although your money will be
invested the same way no matter which class of shares you buy, there are
differences among the fees and expenses associated with each class. Not everyone
is eligible to buy every class. After determining which classes you are eligible
to buy, decide which class best suits your needs. Your Merrill Lynch Financial
Consultant can help you with this decision.
This table shows the different fees and expenses that you may pay if you buy and
hold the different classes of shares of the Fund. Future expenses may be greater
or less than those indicated below.
Shareholder Fees (fees
paid directly from
your investment) (a): Class A Class B(b) Class C Class D
- --------------------------------------------------------------------------------
Maximum Sales Charge
(Load) imposed on
purchases (as a
percentage of
offering price) 4.00%(c) None None 4.00%(c)
- --------------------------------------------------------------------------------
Maximum Deferred Sales
Charge (Load) (as a
percentage of original
purchase price or
redemption proceeds,
whichever is lower) None(d) 4.0%(c) 1.0%(c) None(d)
- --------------------------------------------------------------------------------
Maximum Sales Charge (Load)
imposed on Dividend
Reinvestments None None None None
- --------------------------------------------------------------------------------
Redemption Fee None None None None
- --------------------------------------------------------------------------------
Exchange Fee None None None None
- --------------------------------------------------------------------------------
Annual Fund Operating
Expenses (expenses that
are deducted from
Fund assets):
- --------------------------------------------------------------------------------
Management Fee 0.50% 0.50% 0.50% 0.50%
- --------------------------------------------------------------------------------
Distribution and/or
Service (12b-1)
Fees(e) None 0.75% 0.80% 0.25%
- --------------------------------------------------------------------------------
Other Expenses (including
transfer agency fees)(f) 0.42% 0.45% 0.43% 0.42%
- --------------------------------------------------------------------------------
Total Annual Fund Operating
Expenses 0.92% 1.70% 1.73% 1.17%
- --------------------------------------------------------------------------------
(a) In addition, Merrill Lynch may charge clients a processing fee (currently
$5.35) when a client buys or sells shares.
(b) Class B shares automatically convert to Class D shares about ten years after
you buy them and will no longer be subject to distribution fees.
(c) Some investors may qualify for reductions in the sales charge (load).
(d) You may pay a deferred sales charge if you purchase $1 million or more and
you redeem within one year.
(e) The Fund calls the "Service Fee" an "Account Maintenance Fee." Account
Maintenance Fee is the term used in this Prospectus and in all other Fund
materials. If you hold Class B or Class C shares for a long time, it may
cost you more in distribution (12b-1) fees than the maximum sales charge
that you would have paid if you had bought one of the other classes.
(f) The Fund pays the Transfer Agent $11.00 for each Class A and Class D
shareholder account and $14.00 for each Class B and Class C shareholder
account and reimburses the Transfer Agent's out-of-pocket expenses. The Fund
pays a 0.10% fee for certain accounts that participate in the Merrill Lynch
Mutual Fund Advisor program. The Fund also pays a $0.20 monthly closed
account charge, which is assessed upon all accounts that close during the
year. This fee begins the month following the month the account is closed
and ends at the end of the calendar year. For the fiscal year ended May 31,
1999, the Fund paid the Transfer Agent fees totaling $108,176. The Manager
provides accounting services to the Fund at its cost. For the fiscal year
ended May 31, 1999, the Fund reimbursed the Manager $51,747 for these
services.
6 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
Examples:
These examples are intended to help you compare the cost of investing in the
Fund with the cost of investing in other mutual funds.
These examples assume that you invest $10,000 in the Fund for the time periods
indicated, that your investment has a 5% return each year, that you pay the
sales charges, if any, that apply to the particular class and that the Fund's
operating expenses remain the same. This assumption is not meant to indicate you
will receive a 5% annual rate of return. Your annual return may be more or less
than the 5% used in this example. Although your actual costs may be higher or
lower, based on these assumptions your costs would be:
EXPENSES IF YOU DID REDEEM YOUR SHARES:
---
1 Year 3 Years 5 Years 10 Years
- --------------------------------------------------------------------------------
Class A $490 $682 $889 $1,486
- --------------------------------------------------------------------------------
Class B $573 $736 $923 $2,009
- --------------------------------------------------------------------------------
Class C $276 $545 $939 $2,041
- --------------------------------------------------------------------------------
Class D $514 $757 $1,018 $1,764
- --------------------------------------------------------------------------------
EXPENSES IF YOU DID NOT REDEEM YOUR SHARES:
-------
1 Year 3 Years 5 Years 10 Years
- --------------------------------------------------------------------------------
Class A $490 $682 $889 $1,486
- --------------------------------------------------------------------------------
Class B $173 $536 $923 $2,009
- --------------------------------------------------------------------------------
Class C $176 $545 $939 $2,041
- --------------------------------------------------------------------------------
Class D $514 $757 $1,018 $1,764
- --------------------------------------------------------------------------------
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 7
<PAGE>
[Clipart] Details About the Fund
ABOUT THE
PORTFOLIO MANAGER
Gregory Mark Maunz is a Senior Vice
President and the portfolio manager of
the Fund. Mr. Maunz has been a First
Vice President of Merrill Lynch Asset
Management since 1997, a Portfolio
Manager since 1984 and was Vice
President from 1985 to 1997.
ABOUT THE MANAGER
The Fund is managed by Merrill Lynch
Asset Management.
HOW THE FUND INVESTS
- --------------------------------------------------------------------------------
The Fund's objective is to seek high current income consistent with a policy of
limiting the degree of fluctuation in the net asset value of Fund shares from
movements in interest rates. The Fund tries to achieve this objective by
investing at least 65% of its total assets in adjustable rate securities.
Adjustable rate securities pay interest at rates that increase or decrease at
time intervals in response to changes in market levels or interest rates. The
securities in which the Fund invests will either be issued or guaranteed by
agencies and instrumentalities of the United States or be rated in at least the
second-highest rating category by Standard & Poors ("S&P") or Moody's Investors
Service, Inc. ("Moody's").
The Fund invests primarily in mortgage backed and asset backed securities.
Mortgage backed securities represent the right to receive a portion of principal
and/or interest payments made on a pool of residential or commercial mortgage
loans. Asset backed securities are debt securities issued by a trust or other
legal entity established for the purpose of issuing securities and holding
certain assets, such as credit card receivables or auto leases, that pay down
over time and generate sufficient cash to pay holders of the securities.
Mortgage backed securities in which the Fund invests will primarily be either
guaranteed by the Government National Mortgage Association ("GNMA") or issued by
the Federal National Mortgage Association ("FNMA") or the Federal Home Loan
Mortgage Corporation ("FHLMC"). Some, but not all, of the asset backed
securities in which the Fund will invest will be guaranteed by the Small
Business Administration ("SBA").
The distinguishing feature of adjustable rate securities is that interest
payments will vary in relation to an index at specific intervals of time
typically ranging from one to sixty months. The Fund's Manager believes that
these characteristics make such securities likely to generate current income in
excess of a portfolio of short term money market instruments but with less
volatility in market value than fixed-rate mortgage backed or asset backed
securities and other fixed-rate debt obligations of comparable maturity.
However, an investor should note that the value of the Fund's shares will likely
be more volatile and will fluctuate more than that of a portfolio of money
market securities.
The Fund may also invest up to 35% of its total assets in fixed-rate mortgage
backed and asset backed securities as well as U.S. Treasury securities and U.S.
Agency debentures. These securities must be issued or guaranteed by U.S.
agencies or instrumentalities or be rated investment grade by S&P or Moody's.
The interest rate on a fixed-rate security does not change as the
8 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
market rate of interest changes. Therefore, such securities may carry repayment
and extension risks that are more sensitive to interest rate changes than
adjustable rate securities.
The Fund also, under normal circumstances, may invest up to 35% of its total
assets in money market securities rated in the highest rating category by S&P or
Moody's and for temporary defensive purposes may invest up to 100% of its assets
in such money market securities.
INVESTMENT RISKS
- --------------------------------------------------------------------------------
This section contains a summary discussion of the general risks of investing in
the Fund. As with any fund, there can be no guarantee that the Fund will meet
its goals or that the Fund's performance will be positive for any period of
time.
Market and Selection Risk -- Market risk is the risk that the stock market will
go down in value, including the possibility that the market will go down sharply
and unpredictably. Selection risk is the risk that the investments that Fund
management selects will underperform the stock market or other funds with
similar investment objectives and investment strategies.
Credit Risk -- Credit risk is the risk that the issuer will be unable to pay the
interest or principal when due. The degree of credit risk depends on both the
financial condition of the issuer and the terms of the obligation.
Interest Rate Risk -- Interest rate risk is the risk that prices of bonds
generally increase when interest rates decline and decrease when interest rates
increase. Prices of longer term securities generally change more in response to
interest rate changes than prices of shorter term securities.
Interest Rate "Cap and Floor" Risk -- Many adjustable rate securities are
subject to maximum limitations on the amount their interest rates may increase
or decrease during a stated period. Such maximum limitations are known generally
as "caps" and "floors." During periods in which short term interest rates move
within the caps and floors of portfolio securities, the fluctuation in the
market value of the adjustable rate securities portfolio is expected to be
relatively limited, since the interest rate on the portfolio will adjust to
market rates within a short period of time. In periods of substantial
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 9
<PAGE>
[Clipart] Details About the Fund
short term volatility in short term interest rates, however, the caps and floors
may not permit the interest rates of adjustable rate securities to adjust to the
full extent of the movements in short term rates during any one adjustment
interval. In the event of dramatic increases in interest rates, caps may prevent
such securities from adjusting to prevailing rates over the term of the loan. If
this happens, the market value of adjustable rate securities may be
substantially reduced, causing the Fund's net asset value (price per share) to
fall.
Borrowing and Leverage Risk -- The Fund may borrow for temporary purposes
including to meet redemptions. Borrowing may exaggerate changes in the net asset
value of Fund shares and in the yield on the Fund's portfolio. Borrowing will
cost the Fund interest expense and other fees. The cost of borrowing may reduce
the Fund's return. Certain derivative securities that the Fund buys may create
leverage, including, for example, when-issued securities, forward commitments,
options and reverse repurchase agreements.
Securities Lending -- The Fund may lend securities to financial institutions
which provide government securities as collateral. Securities lending involves
the risk that the borrower may fail to return the securities in a timely manner
or at all. As a result, the Fund may lose money and there may be a delay in
recovering the loaned securities. The Fund could also lose money if it does not
recover the securities and the value of the collateral falls. These events could
trigger adverse tax consequences to the Fund.
Risks associated with certain types of securities in which the Fund may invest
include:
Mortgage Backed Securities -- Mortgage backed securities represent the right to
receive a portion of principal and/or interest payments made on a pool of
residential or commercial mortgage loans. When interest rates fall, borrowers
may refinance or otherwise repay principal on their mortgages earlier than
scheduled. When this happens, certain types of mortgage backed securities will
be paid off more quickly than originally anticipated and the Fund has to invest
the proceeds in securities with lower yields. This risk is known as "prepayment
risk." When interest rates rise, certain types of mortgage backed securities
will be paid off more slowly than originally anticipated and the value of these
securities will fall. This risk is known as "extension risk."
Because of prepayment risk and extension risk mortgage backed securities react
differently to changes in interest rates than other fixed income securities.
Small movements in interest rates (both increase and decrease) may quickly and
significantly reduce the value of certain mortgage backed securities.
10 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
Most mortgage backed securities are issued by Federal government agencies, such
as the Government National Mortgage Association (Ginnie Mae), the Federal Home
Loan Mortgage Corporation (Freddie Mac) or Federal National Mortgage Association
(Fannie Mae). Principal and interest payments on mortgage backed securities
issued by the Federal government agencies are guaranteed by either the Federal
government or the government agency. Such securities have very little credit
risk. Mortgage backed securities that are issued by private corporations rather
than Federal agencies have credit risk as well as prepayment risk and extension
risk.
Mortgage backed securities may be either pass-through securities or
collateralized mortgage obligations (CMOs). Pass-through securities represent a
right to receive principal and interest payments collected on a pool of
mortgages, which are passed through to security holders (less servicing costs).
CMOs are created by dividing the principal and interest payments collected on a
pool of mortgages into several revenue streams (tranches) with different
priority rights to portions of the underlying mortgage payments. Certain CMO
tranches may represent a right to receive interest only (IOs), principal only
(POs) or an amount that remains after other floating-rate tranches are paid (an
inverse floater). These securities are frequently referred to as "mortgage
derivatives" and may be extremely sensitive to changes in interest rates. If the
Fund invests in CMO tranches (including CMOtranches issued by government
agencies) and interest rates move in a manner not anticipated by Fund
management, it is possible that the Fund could lose all or substantially all of
its investment.
Asset Backed Securities -- Like traditional fixed income securities, the value
of asset-backed securities typically increases when interest rates fall and
decreases when interest rates rise. A limited number of asset backed securities
may also be subject to the risk of prepayment. In a period of declining interest
rates, borrowers may pay what they owe on the underlying assets more quickly
than anticipated. Prepayment reduces the yield to maturity and the average life
of the asset backed securities. In addition, when the Fund reinvests the
proceeds of a prepayment it may receive a lower interest rate than the rate on
the security that was prepaid. In a period of rising interest rates, prepayments
may occur at a slower rate than expected. As a result, the average maturity of
the Fund's portfolio will increase. The value of long-term securities generally
changes more widely in response to changes in interest rates than shorter term
securities.
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 11
<PAGE>
[Clipart] Details About the Fund
Indexed and Inverse Floating Rate Securities-- The Fund may invest in securities
whose potential returns are directly related to changes in an underlying index
or interest rate, known as indexed securities. The return on indexed securities
will rise when the underlying index or interest rate rises and
fall when the index or interest rate falls. The Fund may also invest in
securities whose return is inversely related to changes in an interest rate
(inverse floaters). In general, income on inverse floaters will decrease when
interest rates increase and increase when interest rates decrease. Investments
in inverse floaters may subject the Fund to the risks of reduced or eliminated
interest payments and losses of principal. In addition, certain indexed
securities and inverse floaters may increase or decrease in value at a greater
rate than the underlying interest rate, which effectively leverages the Fund's
investment. Indexed securities and inverse floaters are derivative securities
and can be considered speculative. Indexed and inverse securities involve credit
risk and certain indexed and inverse securities may involve leverage risk and
liquidity risk.
Derivatives -- The Fund may use derivative instruments including futures,
forwards, options, indexed securities and inverse securities. Derivatives are
financial instruments whose value is derived from another security, a commodity
(such as oil or gold), or an index such as the Standard & Poor's Composite 500
Index. Derivatives allow the Fund to increase or decrease its risk exposure more
quickly and efficiently than other types of instruments.
Derivatives are volatile and involve significant risks, including:
Credit risk -- the risk that the counterparty (the party on the other
side of the transaction) on a derivative transaction will be unable to
honor its financial obligation to the Fund.
Leverage risk -- the risk associated with certain types of investments
or trading strategies that relatively small market movements may
result in large changes in the value of an investment. Certain
investments or trading strategies that involve leverage can result in
losses that greatly exceed the amount originally invested.
Liquidity risk -- the risk that certain securities may be difficult or
impossible to sell at the time that the seller would like or at the
price that the seller believes the security is currently worth.
12 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
The Fund may use derivatives for hedging purposes, including anticipatory
hedges. Hedging is a strategy in which the Fund uses a derivative to offset the
risk that other Fund holdings may decrease in value. While hedging can reduce
losses, it can also reduce or eliminate gains if the market moves in a different
manner than anticipated by the Fund or if the cost of the derivative outweighs
the benefit of the hedge. Hedging also involves the risk that changes in the
value of the derivative will not match those of the holdings being hedged as
expected by the Fund, in which case any losses on the holdings being hedged may
not be reduced. There can be no assurance that the Fund's hedging strategy will
reduce risk or that hedging transactions will be either available or cost
effective. The Fund is not required to use hedging and may choose not to do so.
Debt Securities -- Debt securities, such as bonds, involve credit risk. This is
the risk that the borrower will not make timely payments of principal and
interest. The degree of credit risk depends on the issuer's financial condition
and on the terms of the bonds. These securities are also subject to interest
rate risk. This is the risk that the value of the security may fall when
interest rates rise. In general, the market price of debt securities with longer
maturities will go up or down more in response to changes in interest rates than
the market price of shorter term securities.
Repurchase Agreement -- The Fund may enter into certain types of repurchase
agreements. Under a repurchase agreement, the seller agrees to repurchase a
security at a mutually agreed upon time and price. If the other party to a
repurchase agreement defaults on its obligation, the Fund may suffer delays and
incur costs or even lose money in exercising its rights under the agreement.
Reverse Repurchase Agreements -- Under a reverse repurchase agreement, the Fund
sells a security to another party and agrees to buy it back at a specific time
and price. The Fund may lose money if it must buy securities back at a higher
price than they are worth.
When Issued Securities, Delayed Delivery Securities and Forward Commitments --
When issued and delayed delivery securities and forward commitments involve the
risk that the security the Fund buys will lose value prior to its delivery.
There also is the risk that the security will not be issued or that the other
party will not meet its obligation. If this occurs, the Fund both loses the
investment opportunity for the assets it has set aside to pay for the security
and any gain in the security's price.
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 13
<PAGE>
[Clipart] Details About the Fund
Illiquid Securities --The Fund may invest up to 15% of its net assets in
illiquid securities that it cannot easily resell within seven days at current
value or that have contractual or legal restrictions on resale. If the Fund buys
illiquid securities it may be unable to quickly resell them or may be able to
sell them only at a price below current value.
Restricted Securities -- Restricted securities have contractual or legal
restrictions on their resale. They may include private placement securities that
the Fund buys directly from the issuer. Private placement and other restricted
securities may not be listed on an exchange and may have no active trading
market.
Restricted securities may be illiquid. The Fund may be unable to sell them on
short notice or may be able to sell them only at a price below current value.
The Fund may get only limited information about the issuer, so it may be less
able to predict a loss. In addition, if Fund management receives material
adverse nonpublic information about the issuer, the Fund will not be able to
sell the security.
Rule 144A Securities -- Rule 144A securities are restricted securities that can
be resold to qualified institutional buyers but not to the general public. Rule
144A securities may have an active trading market, but carry the risk that the
active trading market may not continue.
STATEMENT OF ADDITIONAL INFORMATION
- --------------------------------------------------------------------------------
If you would like further information about the Fund, including how it invests,
please see the Statement of Additional Information.
14 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
[Clipart] Your Account
MERRILL LYNCH SELECT PRICING(SM) SYSTEM
- --------------------------------------------------------------------------------
The Fund offers four share classes, each with its own sales charge and expense
structure, allowing you to invest in the way that best suits your needs. Each
share class represents an ownership interest in the same investment portfolio.
When you choose your class of shares you should consider the size of your
investment and how long you plan to hold your shares. Your Merrill Lynch
Financial Consultant can help you determine which share class is best suited to
your personal financial goals.
For example, if you select Class A or D shares, you generally pay a sales charge
at the time of purchase. If you buy Class D shares, you also pay an ongoing
account maintenance fee of 0.25%. You may be eligible for a sales charge waiver.
The Fund has adopted a plan under Rule 12b-1 to pay distribution fees for the
sale and distribution of its shares. If you select Class B or C shares, you will
invest the full amount of your purchase price, but you will be subject to a
distribution fee of 0.50% for Class B shares and 0.55% for Class C shares and an
account maintenance fee of 0.25% for both classes of shares. Because these fees
are paid out of the Fund's assets on an ongoing basis, over time these fees
increase the cost of your investment and may cost you more than paying an
initial sales charge. In addition, you may be subject to a deferred sales charge
when you sell Class B or C shares.
The Fund's shares are distributed by Merrill Lynch Funds Distributor, a division
of Princeton Funds Distributor, Inc., an affiliate of Merrill Lynch.
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 15
<PAGE>
[Clipart] Your Account
The table below summarizes key features of the Merrill Lynch Select Pricing(SM)
System.
<TABLE>
<CAPTION>
Class A Class B Class C Class D
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Availability Limited to certain Generally available Generally available Generally available
investors including: through Merrill Lynch. through Merrill Lynch. through Merrill Lynch.
o Current Class A Limited availability Limited availability Limited availability
shareholders through other through other through other
o Certain Retirement Plans securities dealers. securities dealers. securities dealers.
o Participants in
certain Merrill Lynch-
sponsored programs
o Certain affiliates of
Merrill Lynch
- ----------------------------------------------------------------------------------------------------------------------------------
Initial Sales Yes. Payable at time No. Entire purchase No. Entire purchase Yes. Payable at time
Charge? of purchase. Lower price is invested in price is invested in of purchase. Lower
sales charges available shares of the Fund. shares of the Fund. sales charges available
for larger investments. for larger investments.
- ----------------------------------------------------------------------------------------------------------------------------------
Deferred Sales No. (May be charged Yes. Payable if you Yes. Payable if you No. (May be charged
Charge? for purchases over redeem within four redeem within one for purchases over
$1 million that are years of purchase. year of purchase. $1 million that are
redeemed within redeemed within
one year.) one year.)
- ----------------------------------------------------------------------------------------------------------------------------------
Account No. 0.25% Account 0.25% Account 0.25% Account
Maintenance and Maintenance Fee Maintenance Fee Maintenance Fee
Distribution Fees? 0.55% Distribution 0.55% Distribution No Distribution Fee.
Fee. Fee.
- ----------------------------------------------------------------------------------------------------------------------------------
Conversion to No. Yes, automatically No. No.
Class D shares? after approximately
ten years
</TABLE>
16 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
Right of Accumulation -- permits you to pay the sales charge that would apply to
the cost or value (whichever is higher) of all shares you own in the Merrill
Lynch mutual funds that offer Select Pricing options.
Letter of Intent -- permits you to pay the sales charge that would be applicable
if you add up all shares of Merrill Lynch Select PricingSM System funds that you
agree to buy within a 13 month period. Certain restrictions apply.
Class A and Class D Shares -- Initial Sales Charge Options
If you select Class A or Class D shares, you will pay a sales charge at the time
of purchase.
Dealer
Compensation
As a % of As a % of as a % of
Your Investment Offering Price Your Investment* Offering Price
- --------------------------------------------------------------------------------
Less than $25,000 4.00% 4.17% 3.75%
- --------------------------------------------------------------------------------
$25,000 but less
than $50,000 3.75% 3.40% 3.50%
- --------------------------------------------------------------------------------
$50,000 but less
than $100,000 3.25% 3.36% 3.00%
- --------------------------------------------------------------------------------
$100,000 but less
than $250,000 2.50% 2.56% 2.25%
- --------------------------------------------------------------------------------
$250,000 but less
than $1,000,000 1.50% 1.52% 1.25%
- --------------------------------------------------------------------------------
$1,000,000 and over** 0.00% 0.00% 0.00%
- --------------------------------------------------------------------------------
* Rounded to the nearest one-hundredth percent.
** If you invest $1,000,000 or more in Class A or Class D shares, you may not
pay an initial sales charge. However, if you redeem your shares within one
year after purchase, you may be charged a deferred sales charge. This charge
is 1% of the lesser of the original cost of the shares being redeemed or
your redemption proceeds. A sales charge of 0.75% will be charged on
purchases of $1,000,000 or more of Class A or Class D shares by certain
employer- sponsored retirement or savings plans.
No initial sales charge applies to Class A or Class D shares that you buy
through reinvestment of dividends.
A reduced or waived sales charge on a purchase of Class A or Class D shares may
apply for:
o Purchases under a Right of Accumulation or Letter of Intent
o TMA(SM) Managed Trusts
o Certain Merrill Lynch investment or central asset accounts
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 17
<PAGE>
[Clipart] YOUR ACCOUNT
o Certain employer-sponsored retirement or savings plans
o Purchases using proceeds from the sale of certain Merrill Lynch
closed-end funds under certain circumstances
o Certain investors, including directors or trustees of Merrill Lynch
mutual funds and Merrill Lynch employees
o Certain Merrill Lynch fee-based programs
Only certain investors are eligible to buy Class A shares. Your Merrill Lynch
Financial Consultant can help you determine whether you are eligible to buy
Class A shares or to participate in any of these programs.
If you decide to buy shares under the initial sales charge alternative and you
are eligible to buy both Class A and Class D shares, you should buy Class A
since Class D shares are subject to a 0.25% account maintenance fee, while Class
A shares are not.
If you redeem Class A or Class D shares and within 30 days buy new shares of the
same class, you will not pay a sales charge on the new purchase amount. The
amount eligible for this "Reinstatement Privilege" may not exceed the amount of
your redemption proceeds. To exercise the privilege, contact your Merrill Lynch
Financial Consultant or the Fund's Transfer Agent at 1-800-MER-FUND.
As a result of the implementation of the Merrill Lynch Select Pricing(SM)
System, Class A shares of the Fund outstanding prior to October 21, 1994, were
redesignated as Class D shares. The Class A shares offered here differ from the
Class A shares offered prior to October 21, 1994, in many respects, including
eligible investors, sales charges and exchange privileges.
Class B and Class C Shares -- Deferred Sales Charge Options
If you select Class B or Class C shares, you do not pay an initial sales charge
at the time of purchase. However, if you redeem your Class B shares within four
years after purchase or your Class C shares within one year after purchase, you
may be required to pay a deferred sales charge. You will also pay distribution
fees of 0.50% for Class B shares and 0.55% for Class C shares and account
maintenance fees of 0.25% each year under distribution plans that the Fund has
adopted under Rule 12b-1. Because these fees are paid out of the Fund's assets
on an ongoing basis, over time these fees increase the cost of your investment
and may cost you more than paying an initial sales charge. The Distributor uses
the money that it receives from the deferred sales charges and the distribution
fees to cover the costs of marketing, advertising and compensating the Merrill
Lynch Financial Consultant or other securities dealer who assists you in
purchasing Fund shares.
18 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
Class B Shares
If you redeem Class B shares within four years after purchase, you may be
charged a deferred sales charge. The amount of the charge gradually decreases as
you hold your shares over time, according to the following schedule:
Years Since Purchase Sales Charge*
----------------------------------------------------------
0 - 1 4.00%
----------------------------------------------------------
1 - 2 3.00%
----------------------------------------------------------
2 - 3 2.00%
----------------------------------------------------------
3 - 4 1.00%
----------------------------------------------------------
4 and thereafter 0.00%
----------------------------------------------------------
* The percentage charge will apply to the lesser of the original cost of the
shares being redeemed or the proceeds of your redemption. Shares acquired
through reinvestment of dividends are not subject to a deferred sales charge.
Not all Merrill Lynch funds have identical deferred sales charge schedules. If
you exchange your shares for shares of another fund, the higher charge will
apply.
The deferred sales charge relating to Class B shares may be reduced or waived in
certain circumstances, such as:
o Certain post-retirement withdrawals from an IRA or other retirement
plan if you are over 59 1/2 years old
o Redemption by certain eligible 401(a) and 401(k) plans, certain
related accounts, and certain retirement plan rollovers
o Redemption in connection with participation in certain Merrill Lynch
fee-based programs
o Withdrawals resulting from shareholder death or disability as long
as the waiver request is made within one year of death or disability
or, if later, reasonably promptly following completion of probate,
or in connection with involuntary termination of an account in which
Fund shares are held
o Withdrawal through the Merrill Lynch Systematic Withdrawal Plan of
up to 10% per year of your Class B account value at the time the
plan is established
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 19
<PAGE>
[Clipart] YOUR ACCOUNT
Your Class B shares convert automatically into Class D shares approximately ten
years after purchase. Any Class B shares received through reinvestment of
dividends paid on converting shares will also convert at that time. Class D
shares are subject to lower annual expenses than Class B shares. The conversion
of Class B to Class D shares is not a taxable event for Federal income tax
purposes.
Different conversion schedules apply to Class B shares of different Merrill
Lynch mutual funds. For example, Class B shares of a fixed income fund convert
approximately ten years after purchase compared to approximately eight years for
equity funds. If you acquire your Class B shares in an exchange from another
fund with a shorter conversion schedule, the Fund's ten year conversion schedule
will apply. If you exchange your Class B shares in the Fund for Class B shares
of a fund with a longer conversion schedule, the other fund's conversion
schedule will apply. The length of time that you hold both the original and
exchanged Class B shares in both funds will count toward the conversion
schedule. The conversion schedule may be modified in certain other cases as
well.
Class C Shares
If you redeem Class C shares within one year after purchase, you may be charged
a deferred sales charge of 1.00%. The charge will apply to the lesser of the
original cost of the shares being redeemed or the proceeds of your redemption.
You will not be charged a deferred sales charge when you redeem shares that you
acquire through reinvestment of Fund dividends. The deferred sales charge
relative to Class C shares may be reduced or waived in connection with
involuntary termination of an account in which Fund shares are held and
withdrawals through the Merrill Lynch Systematic Withdrawal Plan.
Class C shares do not offer a conversion privilege.
HOW TO BUY, SELL, TRANSFER AND EXCHANGE SHARES
- --------------------------------------------------------------------------------
The chart on the following page summarizes how to buy, sell, transfer and
exchange shares through Merrill Lynch or other securities dealers. You may also
buy shares through the Transfer Agent. To learn more about buying shares through
the Transfer Agent, call 1-800-MER-FUND. Because the selection of a mutual fund
involves many considerations, your Merrill Lynch Financial Consultant may help
you with this decision.
20 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
<TABLE>
<CAPTION>
If You Want to Your Choices Information Important for You to Know
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Buy Shares First, select the share class Refer to the Merrill Lynch Select Pricing table on page 16. Be sure
appropriate for you to read this Prospectus carefully.
-------------------------------------------------------------------------------------------------------------
Next, determine the amount of The minimum initial investment for the Fund is $1,000 for all accounts
your investment except:
o $250 for certain Merrill Lynch fee-based programs
o $100 for retirement plans.
(The minimums for initial investments may be waived under certain
circumstances.)
-------------------------------------------------------------------------------------------------------------
Have your Merrill Lynch The price of your shares is based on the next calculation of net asset
Financial Consultant or value after your order is placed. Any purchase orders placed prior
securities dealer submit to the close of business on the New York Stock Exchange (generally
your purchase order 4:00 p.m Eastern time) will be priced at the net asset value
determined that day.
Purchase orders placed after that time will be priced at the net asset
value determined on the next business day. The Fund may reject any
order to buy shares and may suspend the sale of shares at any time.
Merrill Lynch may charge aprocessing fee to confirm a purchase. This
fee is currently $5.35.
-------------------------------------------------------------------------------------------------------------
Or contact the Transfer To purchase shares directly, call the Transfer Agent at 1-800-MER-FUND
Agent and request a purchase application. Mail the completed purchase
application to the Transfer Agent at the address on the inside back
cover of this Prospectus.
- -----------------------------------------------------------------------------------------------------------------------------------
Add to Your Purchase additional shares The minimum investment for additional purchases is generally $50
Investment except that retirement plans have a minimum additional purchase of $1
and certain programs, such as automatic investment plans, may have
higher minimums.
(The minimum for additional purchases may be waived under certain
circumstances.)
-------------------------------------------------------------------------------------------------------------
Acquire additional shares All dividends are automatically reinvested without a
through the automatic sales charge.
dividend reinvestment plan
-------------------------------------------------------------------------------------------------------------
Participate in the automatic You may invest a specific amount on a periodic basis through
investment plan certain Merrill Lynch investment or central asset accounts.
- -----------------------------------------------------------------------------------------------------------------------------------
Transfer Shares Transfer to a participating You may transfer your Fund shares only to another securities
to Another securities dealer dealer that has entered into an agreement with Merrill
Securities Dealer Lynch. Certain shareholder services may not be available for
the transferred shares. You may only purchase additional
shares of funds previously owned before the transfer. All
future trading of these assets must be coordinated by the
receiving firm.
-------------------------------------------------------------------------------------------------------------
Transfer to a non-participating You must either:
securities dealer o Transfer your shares to an account with the
You must either: Transfer Agent; or
o Sell your shares, paying any applicable CDSC.
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 21
<PAGE>
[Clipart] Your Account
<TABLE>
<CAPTION>
If You Want to Your Choices Information Important for You to Know
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Sell Your Shares Have your Merrill Lynch The price of your shares is based on the next calculation of
Financial Consultant or net asset value after your order is placed. For your
securities dealer submit redemption request to be priced at the net asset value on
your sales order the day of your request, you must submit your request to
your dealer prior to that day's close of business on the New
York Stock Exchange (generally 4:00 p.m. Eastern time). Any
redemption request placed after that time will be priced at
the net asset value at the close of business on the next
business day. Dealers must submit redemption requests to the
Fund not more than thirty minutes after the close of
business on the New York Stock Exchange on the day the
request was received.
Securities dealers, including Merrill Lynch, may charge a
fee to process a redemption of shares. Merrill Lynch
currently charges a fee of $5.35. No processing fee is
charged if you redeem shares directly through the Transfer
Agent.
The Fund may reject an order to sell shares under certain
circumstances.
-------------------------------------------------------------------------------------------------------------
Sell through the Transfer Agent You may sell shares held at the Transfer Agent by writing to
the Transfer Agent at the address on the inside back cover
of this prospectus. All shareholders on the account must
sign the letter. In some cases a signature guarantee may be
required. Please see the Statement of Additional Information
for details on when a signature guarantee is needed. If you
hold stock certificates, you must return the certificates with
the letter so that they may be converted. The Transfer Agent
will normally mail redemption proceeds within seven days following
receipt of a properly completed request. If you make a redemption
request before the Fund has collected payment for the purchase
of shares, the Fund or the Transfer Agent may delay mailing your
proceeds. This delay will usually not exceed ten days.
Check with the Transfer Agent or your Merrill Lynch Financial
Consultant for details.
---------------------------------------------------------------------------------------------------------------
Sell Shares Participate in the Fund's You can choose to receive systematic payments from your Fund
Systematically Systematic Withdrawal Plan account either by check or through direct deposit to your
bank account on a monthly or quarterly basis. If you hold
your Fund shares in a Merrill Lynch CMA(R), CBA(R) or
Retirement Account you can arrange for systematic
redemptions of a fixed dollar amount on a monthly,
bi-monthly, quarterly, semi-annual or annual basis, subject
to certain conditions. Under either method you must have
dividends and other distributions automatically reinvested.
For Class B and C shares your total annual withdrawals
cannot be more than 10% per year of the value of your shares
at the time your plan is established. The deferred sales
charge is waived for systematic redemptions. Ask your
Merrill Lynch Financial Consultant for details.
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
22 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
<TABLE>
<CAPTION>
If You Want to Your Choices Information Important for You to Know
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Exchange Your Select the fund into which you You can exchange your shares of the Fund for shares of many
Shares want to exchange. Be sure to other Merrill Lynch mutual funds. You must have held the
read that fund's prospectus shares used in the exchange for at least 15 calendar days
before you can exchange to another fund.
Each class of Fund shares is generally exchangeable for
shares of the same class of another fund. If you own Class A
shares and wish to exchange into a fund in which you have no
Class A shares, you will exchange into Class D shares.
Some of the Merrill Lynch mutual funds impose a different
initial or deferred sales charge schedule. If you exchange
Class A or D shares for shares of a fund with a higher
initial sales charge than you originally paid, you will be
charged the difference at the time of exchange. If you
exchange Class B shares for shares of a fund with a
different deferred sales charge schedule, the higher
schedule will apply. The time you hold Class B or C shares
in both funds will count when determining your holding
period for calculating a deferred sales charge at
redemption. If you exchange Class A or D shares for money
market fund shares, you will receive Class A shares of
Summit Cash Reserves Fund. Class B or C shares of the Fund
will be exchanged for Class B shares of Summit.
Although there is currently no limit on the number of
exchanges that you can make, the exchange privilege may be
modified or terminated at any time in the future.
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 23
<PAGE>
[Clipart] Your Account
Net Asset Value -- the market value of
the Fund's total assets after deducting
liabilities, divided by the number of
shares outstanding.
HOW SHARES ARE PRICED
- --------------------------------------------------------------------------------
When you buy shares, you pay the net asset value, plus any applicable sales
charge. This is the offering price. Shares are also redeemed at their net asset
value, minus any applicable deferred sales charge. The Fund calculates its net
asset value (generally by using market quotations) each day the New York Stock
Exchange is open, after the close of business on the Exchange (the Exchange
generally closes at 4:00 p.m. Eastern time). The net asset value used in
determining your price is the next one calculated after your purchase or
redemption order is placed. Foreign securities owned by the Fund may trade on
weekends or other days when the Fund does not price its shares. As a result, the
Fund's net asset value may change on days when you will not be able to purchase
or redeem the Fund's shares.
Generally, Class A shares will have the highest net asset value because that
class has the lowest expenses, and Class D shares will have a higher net asset
value than Class B or Class C shares. Also dividends paid on Class A and Class D
shares will generally be higher than dividends paid on Class B and Class C
shares because Class A and Class D shares have lower expenses.
PARTICIPATION IN MERRILL LYNCH FEE-BASED PROGRAMS
- --------------------------------------------------------------------------------
If you participate in certain fee-based programs offered by Merrill Lynch, you
may be able to buy Class A shares at net asset value, including by exchanges
from other share classes. Sales charges on the shares being exchanged may be
reduced or waived under certain circumstances.
You generally cannot transfer shares held through a fee-based program into
another account. Instead, you will have to redeem your shares held through the
program and purchase shares of another class, which may be subject to
distribution and account maintenance fees. This may be a taxable event and you
will pay any applicable sales charges.
If you leave one of these programs, your shares may be redeemed or automatically
exchanged into another class of Fund shares or into a money market fund. The
class you receive may be the class you originally owned when you entered the
program, or in certain cases, a different class. If the
24 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
Dividends -- Ordinary income and capital
gains paid to shareholders. Dividends
may be reinvested in additional Fund
shares as they are paid.
exchange is into Class B shares, the period before conversion to Class D shares
may be modified. Any redemption or exchange will be at net asset value. However,
if you participate in the program for less than a specified period, you may be
charged a fee in accordance with the terms of the program.
Details about these features and the relevant charges are included in the client
agreement for each fee-based program and are available from your Merrill Lynch
Financial Consultant.
DIVIDENDS AND TAXES
- --------------------------------------------------------------------------------
Dividends from net investment income will be paid at least monthly. All net
realized capital gains, if any, will be distributed to the Fund's shareholders
at least annually. The Fund may also pay a special distribution at the end of
the calendar year to comply with Federal tax requirements. If your account is
with Merrill Lynch and you would like to receive dividends in cash, contact your
Merrill Lynch Financial Consultant. If your account is with the Transfer Agent
and you would like to receive dividends in cash, contact the Transfer Agent.
Although this cannot be predicted with any certainty, the Fund anticipates that
the majority of its dividends, if any, will consist of ordinary income, although
it may distribute capital gains as well.
You will pay tax on dividends from the Fund whether you receive them in cash or
additional shares. If you redeem Fund shares or exchange them for shares of
another fund, any gain on the transaction may be subject to tax. Capital gain
dividends are generally taxed at different rates than ordinary income dividends.
If you are neither a lawful permanent resident nor a citizen of the U.S. or if
you are a foreign entity, the Fund's ordinary income dividends (which include
distributions of net short-term capital gains) will generally be subject to a
30% U.S. withholding tax, unless a lower treaty rate applies.
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 25
<PAGE>
[Clipart] Your Account
"BUYING A DIVIDEND"
Unless your investment is in a tax
deferred account, you may want to avoid
buying shares shortly before the Fund
pays a dividend. The reason? If you buy
shares when a fund has realized but not
yet distributed income or capital gains,
you will pay the full price for the
shares and then receive a portion of the
price back in the form of a taxable
dividend. Before investing you may want
to consult your tax adviser.
Dividends and interest received by the Fund may give rise to withholding and
other taxes imposed by foreign countries. Tax conventions between certain
countries and the United States may reduce or eliminate such taxes.
By law, the Fund must withhold 31% of your dividends and proceeds if you have
not provided a taxpayer identification number or social security number or if
the number you have provided is incorrect.
This section summarizes some of the consequences under current Federal tax law
of an investment in the Fund. It is not a substitute for personal tax advice.
Consult your personal tax adviser about the potential tax consequences of an
investment in the Fund under all applicable tax laws.
26 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
[Clipart] Management of the Fund
MERRILL LYNCH ASSET MANAGEMENT
- --------------------------------------------------------------------------------
Merrill Lynch Asset Management, the Fund's Manager, manages the Fund's
investments and its business operations under the overall supervision of the
Fund's Board of Directors. The Manager has the responsibility for making all
investment decisions for the Fund. The Fund pays the Manager a fee at the annual
rate of 0.50% of the average daily net assets of the Fund.
Merrill Lynch Asset Management is part of the Merrill Lynch Asset Management
Group which had approximately $520 billion in investment company and other
portfolio assets under management as of August 1999. This amount includes assets
managed for Merrill Lynch affiliates.
A Note About Year 2000
Many computer systems were designed using only two digits to designate years.
These systems may not be able to distinguish the Year 2000 from the Year 1900
(commonly known as the "Year 2000 Problem"). The Fund could be adversely
affected if the computer systems used by the Fund's management or other Fund
service providers do not properly address this problem before January 1, 2000.
The Fund's management expects to have addressed this problem before then, and
does not anticipate that the services it provides will be adversely affected.
The Fund's other service providers have told Fund management that they also
expect to resolve the Year 2000 Problem, and Fund management will continue to
monitor the situation as the Year 2000 approaches. However, if the problem has
not been fully addressed, the Fund could be negatively affected. The Year 2000
Problem could also have a negative impact on the issuers of securities in which
the Fund invests. This negative impact may be greater for companies in foreign
markets, particularly emerging markets, since they may be less prepared for the
Year 2000 Problem than domestic companies and markets. If the companies in which
the Fund invests have Year 2000 Problems, the Fund's returns could be adversely
affected.
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 27
<PAGE>
[Clipart] Management of the Fund
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
The Financial Highlights table is intended to help you understand the Fund's
financial performance for the periods shown. Certain information reflects
financial results for a single Fund share. The total returns in the table
represent the rate an investor would have earned on an investment in the Fund
(assuming reinvestment of all dividends). This information has been audited by
Deloitte & Touche LLP, whose report, along with the Fund's financial statements,
are included in the Fund's annual report to shareholders, which is available
upon request.
<TABLE>
<CAPTION>
Class A Class B
----------------------------------------- -----------------------------------------------
For the
Period
October
21, 1994+ For the Year Ended
For the Year Ended May 31, to May 31,
Increase (Decrease) in ------------------------------- May 31, -----------------------------------------------
Net Asset Value: 1999 1998 1997++ 1996++ 1995 1999 1998 1997++ 1996++ 1995
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Per Share Operating Performance:
- -----------------------------------------------------------------------------------------------------------------------------------
Net asset value, beginning of
period $ 9.61 $ 9.65 $ 9.54 $ 9.55 $ 9.46 $ 9.58 $ 9.62 $ 9.53 $ 9.56 $ 9.53
- -----------------------------------------------------------------------------------------------------------------------------------
Investment income -- net .53 .57 .59 .56 .36 .46 .50 .51 .52 .46
- -----------------------------------------------------------------------------------------------------------------------------------
Realized and unrealized gain
(loss) on investments-- net (.09) (.04) .10 .03 .09 (.09) (.04) .09 (.02) .04
- -----------------------------------------------------------------------------------------------------------------------------------
Total from investment operations .44 .53 .69 .59 .45 .37 .46 .60 .50 .50
- -----------------------------------------------------------------------------------------------------------------------------------
Less dividends and distributions:
Investment income -- net (.53) (.57) (.58) (.60) (.36) (.46) (.50) (.51) (.53) (.47)
In excess of investment income--
net -- -- -- -- -- -- -- -- -- --
Realized gain on investments--net -- -- -- -- -- -- -- -- -- --
In excess of realized gain on
investments-- net -- -- -- -- -- -- -- -- -- --
- -----------------------------------------------------------------------------------------------------------------------------------
Total dividends and distributions (.53) (.57) (.58) (.60) (.36) (.46) (.50) (.51) (.53) (.47)
- -----------------------------------------------------------------------------------------------------------------------------------
Net asset value, end of period $ 9.52 $ 9.61 $ 9.65 $ 9.54 $ 9.55 $ 9.49 $ 9.58 $ 9.62 $ 9.53 $ 9.56
- -----------------------------------------------------------------------------------------------------------------------------------
Total Investment Return:**
- -----------------------------------------------------------------------------------------------------------------------------------
Based on net asset value per
share 4.59% 5.66% 7.48% 6.41% 4.85%# 3.78% 4.85% 6.44% 5.34% 5.48%
- -----------------------------------------------------------------------------------------------------------------------------------
Ratios to Average Net Assets:
- -----------------------------------------------------------------------------------------------------------------------------------
Expenses .92% .92% .89% .81% .87%* 1.70% 1.70% 1.65% 1.59% 1.59%
- ----------------------------------------------------------------------------------------------------------------------------------
Investment income -- net 5.43% 5.93% 6.13% 6.20% 6.18%* 4.66% 5.19% 5.35% 5.45% 4.88%
- -----------------------------------------------------------------------------------------------------------------------------------
Supplemental Data:
- -----------------------------------------------------------------------------------------------------------------------------------
Net assets, end of period
(in thousands) $ 947 $1,071 $ 265 $ 281 $ 345 $72,875 $85,094 $106,061 $137,387 $202,334
- -----------------------------------------------------------------------------------------------------------------------------------
Portfolio turnover 48.76% 47.55% 18.48% 25.30% 102.55% 48.76% 47.55% 18.48% 25.30% 102.55%
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
* Annualized.
** Total investment returns exclude the effects of sales loads.
+ Commencement of Operations.
++ Based on average shares outstanding.
# Aggregate total investment return.
28 MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
Financial Highlights (concluded)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Class C Class D
----------------------------------------- -----------------------------------------------
For the
Period
October
21, 1994+ For the Year Ended
For the Year Ended May 31, to May 31,
Increase (Decrease) in ------------------------------- May 31, -----------------------------------------------
Net Asset Value: 1999 1998 1997++ 1996++ 1995 1999 1998 1997++ 1996++ 1995
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Per Share Operating Performance:
- -----------------------------------------------------------------------------------------------------------------------------------
Net asset value, beginning of
period $ 9.58 $ 9.63 $ 9.53 $ 9.56 $ 9.46 $ 9.58 $ 9.62 $ 9.52 $ 9.55 $ 9.53
- -----------------------------------------------------------------------------------------------------------------------------------
Investment income -- net .45 .49 .50 .48 .31 .51 .55 .57 .56 .51
- -----------------------------------------------------------------------------------------------------------------------------------
Realized and unrealized gain
(loss) on investments -- net (.09) (.05) .11 .01 .10 (.09) (.04) .09 (.01) .03
- -----------------------------------------------------------------------------------------------------------------------------------
Total from investment operations .36 .44 .61 .49 .41 .42 .51 .66 .55 .54
- -----------------------------------------------------------------------------------------------------------------------------------
Less dividends and distributions
Investment income -- net (.45) (.49) (.51) (.52) (.31) (.51) (.55) (.56) (.58) (.52)
In excess of investment income
-- net -- -- -- -- -- -- -- -- -- --
Realized gain on investments
-- net -- -- -- -- -- -- -- -- -- --
In excess of realized gain on
investments -- net -- -- -- -- -- -- -- -- -- --
- -----------------------------------------------------------------------------------------------------------------------------------
Total dividends and distributions (.45) (.49) (.51) (.52) (.31) (.51) (.55) (.56) (.58) (.52)
- -----------------------------------------------------------------------------------------------------------------------------------
Net asset value, end of period $ 9.49 $ 9.58 $ 9.63 $ 9.53 $ 9.56 $ 9.49 $ 9.58 $ 9.62 $9.52 $ 9.55
- -----------------------------------------------------------------------------------------------------------------------------------
Total Investment Return:**
- -----------------------------------------------------------------------------------------------------------------------------------
Based on net asset value per
share 3.74% 4.71% 6.51% 5.30% 4.47%# 4.32% 5.40% 7.11% 5.91% 5.91%
- -----------------------------------------------------------------------------------------------------------------------------------
Ratios to Average Net Assets:
- -----------------------------------------------------------------------------------------------------------------------------------
Expenses 1.73% 1.74% 1.70% 1.57% 1.68%* 1.17% 1.18% 1.13% 1.06% 1.08%
- -----------------------------------------------------------------------------------------------------------------------------------
Investment income -- net 4.62% 5.15% 5.34% 5.40% 5.51%* 5.18% 5.70% 5.87% 5.98% 5.44%
- -----------------------------------------------------------------------------------------------------------------------------------
Supplemental Data:
- -----------------------------------------------------------------------------------------------------------------------------------
Net assets, end of period
(in thousands) $ 6,256 $4,434 $5,315 $3,078 $1,409 $ 9,408 $19,193 $13,267 $12,800 $16,993
- -----------------------------------------------------------------------------------------------------------------------------------
Portfolio turnover 48.76% 47.55% 18.48% 25.30% 102.55% 48.76% 47.55% 18.48% 25.30% 102.55%
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
* Annualized.
** Total investment returns exclude the effects of sales loads.
+ Commencement of operations.
++ Based on average shares outstanding.
# Aggregate total investment return.
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC. 29
<PAGE>
(This page intentionally left blank)
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
-----------------------------
POTENTIAL
INVESTORS
Open an account (two options)
-----------------------------
(1) (2)
- -------------------------- --------------------------------
MERRILL LYNCH TRANSFER AGENT
FINANCIAL CONSULTANT Financial Data Services, Inc.
or SECURITIES DEALER P.O. Box 45289
Jacksonville, Florida 32232-5289
Advises shareholders on
their Fund investments. Performs recordkeeping and
- -------------------------- reporting services.
--------------------------------
-----------------------------------------------
DISTRIBUTOR
Merrill Lynch Funds Distributor,
a division of Princeton Funds Distributor, Inc.
P.O. Box 9081
Princeton, New Jersey 08543-9081
Arranges for the sale of Fund shares.
-----------------------------------------------
- ------------------------------ --------------------------------
COUNSEL CUSTODIAN
Brown & Wood LLP The Bank of New York
One World Trade Center 90 Washington Street, 12th Floor
New York, New York 10048-0557 New York, New York 10286
Provides legal advice -------------- Holds the Fund's assets
to the Fund. THE FUND for safekeeping.
- ------------------------------ --------------------------------
The Board of
Directors
oversees the Fund.
------------------
- ----------------------------------- ------------------------------------
INDEPENDENT AUDITORS THE MANAGER
Deloitte & Touche LLP Merrill Lynch Asset Management, L.P.
117 Campus Drive
Princeton, New Jersey 08540-6400 ADMINISTRATIVE OFFICES
800 Scudders Mill Road
Audits the financial Plainsboro, New Jersey 08536
statements of the Fund on behalf of
the shareholders. MAILING ADDRESS
- ----------------------------------- P.O. Box 9011
Princeton, New Jersey 08543-9011
TELEPHONE NUMBER
1-800-MER-FUND
Manages the Fund's
day-to-day activities.
------------------------------------
MERRILL LYNCH ADJUSTABLE RATE SECURITIES FUND, INC.
<PAGE>
[Clipart] For More Information
Shareholder Reports
Additional information about the Fund's investments is available in the Fund's
annual and semi-annual reports to shareholders. In the Fund's annual report you
will find a discussion of the market conditions and investment strategies that
significantly affected the Fund's performance during its last fiscal year. You
may obtain these reports at no cost by calling 1-800-MER-FUND.
The Fund will send you one copy of each shareholder report and certain other
mailings, regardless of the number of Fund accounts you have. To receive
separate shareholder reports for each account, call your Merrill Lynch Financial
Consultant or write to the Transfer Agent at its mailing address. Include your
name, address, tax identification number and Merrill Lynch brokerage or mutual
fund account number. If you have any questions, please call your Merrill Lynch
Financial Consultant or the Transfer Agent at 1-800-MER-FUND.
Statement of Additional Information
The Fund's Statement of Additional Information contains further information
about the Fund and is incorporated by reference (legally considered to be part
of this prospectus). You may request a free copy by writing the Fund at
Financial Data Services, Inc. P.O. Box 45289 Jacksonville, Florida 32232-5289 or
by calling 1-800-MER-FUND.
Contact your Merrill Lynch Financial Consultant or the Fund, at the telephone
number or address indicated above, if you have any questions.
Information about the Fund (including the Statement of Additional Information)
can be reviewed and copied at the SEC's Public Reference Room in Washington,
D.C. Call 1-800-SEC-0330 for information on the operation of the public
reference room. This information is also available on the SEC's Internet site at
http://www.sec.gov and copies may be obtained upon payment of a duplicating fee
by writing the Public Reference Section of the SEC, Washington, D.C. 20549-6009.
You should rely only on the information contained in this Prospectus. No one is
authorized to provide you with information that is different from information
contained in this Prospectus
Investment Company Act file #811-6304
Code #13937-09-99
(C)Merrill Lynch Asset Management, L.P.
Prospectus
[Merrill Lynch logo]
Merrill Lynch Adjustable Rate
Securities Fund, Inc.
September 28, 1999
<PAGE>
STATEMENT OF ADDITIONAL INFORMATION
Merrill Lynch Adjustable Rate Securities Fund, Inc.
P.O. Box 9011, Princeton, New Jersey 08543-9011 o Phone No. (609) 282-2800
The investment objective of Merrill Lynch Adjustable Rate Securities Fund,
Inc. (the "Fund") is to seek high current income consistent with a policy of
limiting the degree of fluctuation in the net asset value of Fund shares from
movements in interest rates. The Fund does not attempt to maintain a constant
net asset value per share. The Fund seeks to achieve this objective by investing
at least 65% of its total assets in adjustable rate securities, consisting
principally of mortgage-backed and asset-backed securities. The Fund may invest
in a variety of derivative instuments to enhance income and to hedge against
changes in interest rates. There can be no assurance that the investment
objective of the Fund will be realized.For more information on the Fund's
investment objective and policies, see "Investment Objectives and Policies."
Pursuant to the Merrill Lynch Select Pricing(SM) System, the Fund offers
four classes of shares, each with a different combination of sales charges,
ongoing fees and other features. The Merrill Lynch Select Pricing(SM) System
permits an investor to choose the method of purchasing shares that the investor
believes is most beneficial given the amount of the purchase, the length of time
the investor expects to hold the shares and other relevant circumstances. See
"Purchase of Shares."
--------------------
This Statement of Additional Information of the Fund is not a prospectus
and should be read in conjunction with the Prospectus of the Fund, dated
September 28, 1999 (the "Prospectus"), which has been filed with the Securities
and Exchange Commission (the "Commission") and can be obtained, without charge,
by calling (800) MER-FUND or by writing the Fund at the above address. The
Prospectus is incorporated by reference into this Statement of Additional
Information, and this Statement of Additional Information is incorporated by
reference into the Prospectus. The Fund's audited financial statements are
incorporated in this Statement of Additional Information by reference to its
1999 annual report to shareholders. You may request a copy of the annual report
or the Prospectus at no charge by calling (800) 456-4587 ext. 789 between 8:00
a.m. and 8:00 p.m. on any business day.
--------------------
Merrill Lynch Asset Management -- Manager
Merrill Lynch Funds Distributor -- Distributor
The date of this Statement of Additional Information is September 28, 1999.
--------------------
<PAGE>
TABLE OF CONTENTS
Page
-----
Investment Objective and Policies ...................................... 2
Types of Issuers/Quality Standards .................................. 3
Description of Adjustable Rate Securities ........................... 5
Description of Other Securities ..................................... 8
Description of Money Market Securities .............................. 9
Special Considerations and Risk Factors ............................. 9
Portfolio Strategies Involving Interest
Rate Transactions, Options and Futures ............................. 10
Other Investment Policies and Practices ............................. 16
Investment Restrictions ............................................. 18
Portfolio Turnover .................................................. 19
Management of the Fund ................................................. 20
Directors and Officers .............................................. 20
Compensation of Directors ........................................... 21
Management and Advisory Arrangements ................................ 21
Code of Ethics ...................................................... 23
Purchase of Shares ..................................................... 23
Initial Sales Charge Alternatives--
Class A and Class D Shares ........................................ 24
Deferred Sales Charge Alternatives--
Class B and Class C Shares ........................................ 27
Distribution Plans .................................................. 30
Limitations on the Payment of Deferred Sales Charges ................ 31
Redemption of Shares .................................................. 32
Redemption ......................................................... 33
Repurchase ......................................................... 33
Reinstatement Privilege-- Class A and Class D Shares ............... 34
Pricing of Shares ..................................................... 34
Determination of Net Asset Value ................................... 34
Computation of Offering Price Per Share ............................ 35
Portfolio Transactions ................................................ 35
Shareholder Services .................................................. 36
Investment Account ................................................. 37
Exchange Privilege ................................................. 37
Fee-Based Programs ................................................. 39
Retirement and Education Savings Plans ............................. 39
Automatic Investment Plans ......................................... 39
Automatic Dividend Reinvestment Plan ............................... 40
Systematic Withdrawal Plan ......................................... 40
Dividends and Taxes ................................................... 41
Dividends .......................................................... 41
Taxes .............................................................. 41
Tax Treatment of Interest Rate Transactions,
Options and Futures .............................................. 43
Performance Data ...................................................... 43
General Information ................................................... 46
Description of Shares .............................................. 46
Independent Auditors ............................................... 46
Custodian .......................................................... 46
Transfer Agent ..................................................... 46
Legal Counsel ...................................................... 47
Reports to Shareholders ............................................ 47
Shareholder Inquiries .............................................. 47
Additional Information ............................................. 47
Financial Statements .................................................. 48
Appendix .............................................................. A-1
<PAGE>
INVESTMENT OBJECTIVE AND POLICIES
The investment objective of the Fund is to seek high current income
consistent with a policy of limiting the degree of fluctuation in the net asset
value of Fund shares from movements in interest rates. The Fund will seek to
achieve its objective by investing at least 65% of its total assets in
adjustable rate securities ("Adjustable Rate Securities"). Adjustable Rate
Securities bear interest at rates that adjust at periodic intervals in
conjunction with changes in market levels of interest rates. The Adjustable Rate
Securities in which the Fund will invest will consist principally of
mortgage-backed and asset-backed securities. Such securities will be issued or
guaranteed by agencies or instrumentalities of the United States or be rated at
least AA by Standard &Poor's ("S&P") or Aa by Moody's Investor Services, Inc.
("Moody's"). The investment objective and policies set forth in the first two
sentences of this paragraph are fundamental policies and may not be changed
without shareholder approval.
The Fund may invest up to 35% of its total assets in debt securities that
are not Adjustable Rate Securities, including fixed rate treasury notes and
bonds, fixed rate mortgage and asset related securities, and derivative
securities relating thereto, including stripped securities. Such securities must
be issued or guaranteed by agencies or instrumentalities of the United States or
be rated "investment grade" by S&P or Moody's. Securities rated investment grade
are obligations rated at the time of purchase within the four highest quality
ratings as determined by either S&P (currently AAA, AA, A and BBB) or Moody's
(currently Aaa, Aa, A and Baa). No more than 10% of the Fund's total assets will
be invested in securities rated in the lowest category of investment grade. The
Fund may also invest in debentures issued by the Federal National Mortgage
Association. The Fund also, under normal circumstances, may invest up to 35% of
its total assets in money market securities rated in the highest rating category
by S&P or Moody's and, for temporary or defensive purposes, may invest up to
100% of its assets in such money market securities.
The Adjustable Rate Securities in which the Fund will invest will consist
principally of mortgage-backed securities (herein sometimes referred to as
"MBSs") and asset-backed securities (herein sometimes referred to as "ABSs").
MBSs are securities that directly or indirectly represent an interest in, or are
backed by and payable from, mortgage loans secured by real property. ABSs
generally consist of structures similar to MBSs, except that the underlying
asset pools are comprised of credit card, automobile or other types of
receivables, or of commercial loans (receivables and commercial loans are
together referred to herein as "financial assets"). MBSs and ABSs are issued in
structured financings wherein the sponsor securitizes the underlying mortgage
loans or financial assets in order to liquify the underlying assets or to
achieve certain other financial goals. The collateral backing MBSs and ABSs is
usually held by an independent bailee, custodian or trustee on behalf of the
holders of the related MBSs or ABSs. In such instances, the holder of the
related MBSs or ABSs (i.e., the Fund) will have either an ownership interest or
security interest in the underlying collateral and can exercise its rights
thereto through such bailee, custodian or trustee. The special considerations
and risks inherent in investments in MBSs and ABSs are discussed more fully
below. See "Investment Objective and Policies -- Special Considerations and Risk
Factors."
The Fund will invest at least 65% of its total assets in Adjustable Rate
Securities. The distinguishing feature of Adjustable Rate Securities is that
interest payments made thereon will vary in relation to a specified index,
typically at a spread over such index. The Manager believes that because of the
characteristics of Adjustable Rate Securities, a portfolio of such securities is
likely to generate current income in excess of a portfolio of money market
securities but with less volatility in market value (and consequently, the
Fund's net asset value) than fixed rate mortgage-backed or asset-backed
securities and other fixed rate debt obligations of comparable maturity. At the
same time, however, the Fund's net asset value will be more volatile than that
of a portfolio of money market securities. Additionally, if interest rates
decrease, the Fund may experience a lower total return than a fund investing in
fixed-rate long-term debt, such as U.S. Treasury bonds.
The Adjustable Rate Securities in which the Fund may invest may also
include debentures of the Federal National Mortgage Association which bear
interest at an adjustable rate. See "Investment Objective and Policies --
Description of Other Securities" for a description of such debentures.
2
<PAGE>
Types of Issuers/Quality Standards
The Fund intends to invest primarily in MBSs and ABSs. The MBSs in which
the Fund may invest will primarily be either guaranteed by the Government
National Mortgage Association or issued by the Federal National Mortgage
Association or the Federal Home Loan Mortgage Corporation. Certain of the ABSs
in which the Fund will invest will be guaranteed by the Small Business
Administration.
Certain of the MBSs and ABSs in which the Fund may invest will be issued by
private issuers. Privately issued MBSs and ABSs may take a form similar to
pass-through MBSs issued by agencies or instrumentalities of the United States,
described below, or may be structured in a manner similar to other types of ABSs
or MBSs, also described below. Private issuers include originators of or
investors in mortgage loans and receivables such as savings and loan
associations, savings banks, commercial banks, investment banks, finance
companies and special purpose finance subsidiaries of any of the above. With
respect to the Adjustable Rate Securities comprising at least 65% of the Fund's
total assets, securities issued by private issuers must be rated at least AA by
S&P or Aa by Moody's or, if unrated, be of comparable quality as determined by
the Manager. The rating may be based, in part, on certain types of credit
enhancements issued in respect of those securities. These credit enhancements
may offer two types of protection: (i) liquidity protection, and (ii) protection
against losses resulting from ultimate default by an obligor and the underlying
assets. Liquidity protection refers to the provision of advances, generally by
the entity administering the pool of assets, to ensure that the receipt of
payments on the underlying pool occurs in a timely fashion. Protection against
losses resulting from ultimate default ensures ultimate payment of the
obligations on at least a portion of the assets in the pool. Such protection may
be provided through guarantees, insurance policies or letters of credit obtained
by the issuer or sponsor from third parties, through various means of
structuring the transaction or through a combination of such approaches. The
Fund will not pay any additional fees for such credit support, although the
existence of credit support may increase the price of a security.
Credit enhancements can come from external providers such as banks or
financial insurance companies. Alternatively, they may come from the structure
of a transaction itself. Examples of credit support arising out of the structure
of the transaction include "senior-subordinated securities" (multiple class
securities with one or more classes subordinate to other classes as to the
payment of principal thereof and interest thereon, with the result that defaults
on the underlying assets are borne first by the holders of the subordinated
class), creation of "reserve funds" (where cash or investments, sometimes funded
from a portion of the payments on the underlying assets, are held in reserve
against future losses) and "overcollateralization" (where the scheduled payments
on, or the principal amount of, the underlying assets exceeds that required to
make payment of the securities and pay any servicing or other fees). The degree
of credit support provided for each issue is generally based on historical
information respecting the level of credit risk associated with the underlying
assets. Delinquencies or losses in excess of those anticipated could adversely
affect the return on an investment in such issue. In addition, the Fund may
purchase subordinated securities which, as noted above, may serve as a form of
credit support for senior securities purchased by other investors. In purchasing
securities for the Fund, the Manager will take into account not only the
creditworthiness of the issuer of the securities, but also the creditworthiness
of the provider of any external credit enhancement of the securities.
Up to 35% of the Fund's total assets may be invested in securities rated in
rating categories below AA by S&P or Aa by Moody's. Any such rated securities
will be rated investment grade by S&P or Moody's. Securities rated investment
grade are obligations rated at the time of purchase within the four highest
quality ratings as determined by either S&P (currently AAA, AA, A and BBB) or
Moody's (currently Aaa, Aa, A and Baa). The Fund may also invest in unrated
securities which possess characteristics which are, in the opinion of the
Manager, similar to those of securities rated at least BBB or Baa. Securities
rated BBB by S&P or Baa by Moody's and comparable unrated securities may be
subject to greater market price fluctuations and are considered more speculative
than more highly rated securities with respect to the capacity to pay interest
and repay principal in accordance with the terms of the security. In purchasing
such securities, the Fund will rely on the Manager's judgment, analysis and
experience in evaluating the creditworthiness of the issuer of such securities.
The Manager will take into consideration, among other things, the underwriting
standards of the originator of the underlying loans, applicable loan-to-value
ratios, regional pressures affecting the housing market, the type of property
underlying the loans, and the general sensitivity of the securities to economic
conditions and trends. Similarly, if an issue of securities rated at the time of
purchase in one of the two highest rating categories by S&P
3
<PAGE>
or Moody's ceases to be rated, or its rating is reduced, the Manager will
consider such factors as price, credit risk, market conditions and interest
rates to determine whether to continue to hold the securities in the Fund's
portfolio. No more than 10% of the Fund's total assets will be invested in
securities rated in the lowest category of investment grade or in comparable
unrated securities. A description of applicable ratings is contained in the
Appendix hereto.
At the present time, the majority of MBSs in which the Fund may invest are
either guaranteed by the Government National Mortgage Association ("GNMA"), or
issued by the Federal National Mortgage Association ("FNMA") or the Federal Home
Loan Mortgage Corporation ("FHLMC"). In addition, the Fund may invest in ABSs
guaranteed by the U.S. Small Business Administration. GNMA, FNMA and FHLMC are
agencies or instrumentalities of the United States, and MBSs issued or
guaranteed by them are generally considered to be of higher quality than
privately issued securities rated AA or Aa. GNMA, FNMA and FHLMC MBSs most often
represent pass-through interests in pools of similarly insured or guaranteed
mortgage loans or pools of conventional mortgage loans or participations
therein. GNMA, FNMA and FHLMC "pass-through" MBSs are so-named because they
represent undivided interests in the underlying mortgage pools and a pro rata
share of both regular interest and principal payments (net of fees assessed by
GNMA, FNMA and FHLMC and any applicable loan servicing fees), as well as
unscheduled early prepayments on the underlying mortgage pool, are passed
through monthly to the holder of the MBSs (i.e., the Fund). Set forth below is a
more detailed description of these agencies and instrumentalities, together with
a description of the types of assets typically comprising the pools underlying
the securities of these entities.
Government National Mortgage Association. GNMA is a wholly-owned corporate
instrumentality of the United States within the Department of Housing and Urban
Development. The National Housing Act of 1934, as amended (the "Housing Act"),
authorizes GNMA to guarantee the timely payment of the principal of and interest
on securities that are based on and backed by a pool of specified mortgage
loans. To qualify such securities for a GNMA guarantee, the underlying mortgages
must be insured by the Federal Housing Administration under the Housing Act, or
Title V of the Housing Act of 1949 ("FHA Loans"), or be guaranteed by the
Veterans' Administration under the Servicemen's Readjustment Act of 1944, as
amended ("VA Loans"), or be pools of other eligible mortgage loans. The Housing
Act provides that the full faith and credit of the United States Government is
pledged to the payment of all amounts that may be required to be paid under any
guarantee. In order to meet its obligations under such guarantee, GNMA is
authorized to borrow from the United States Treasury with no limitations as to
amount.
GNMA pass-through MBSs may represent a pro rata interest in one or more
pools of the following types of mortgage loans: (i) fixed rate level payment
mortgage loans; (ii) fixed rate graduated payment mortgage loans; (iii) fixed
rate growing equity mortgage loans; (iv) fixed rate mortgage loans secured by
manufactured (mobile) homes; (v) mortgage loans on multifamily residential
properties under construction; (vi) mortgage loans on completed multifamily
projects; (vii) fixed rate mortgage loans as to which escrowed funds are used to
reduce the borrower's monthly payments during the early years of the mortgage
loans ("buydown" mortgage loans); (viii) mortgage loans that provide for
adjustments in payments based on periodic changes in interest rates or in other
payment terms of the mortgage loans; and (ix) mortgage-backed serial notes.
Federal National Mortgage Association. FNMA is a federally chartered and
privately owned corporation established under the Federal National Mortgage
Association Charter Act. FNMA was originally organized in 1938 as a United
States Government agency to add greater liquidity to the mortgage market. FNMA
was transformed into a private sector corporation by legislation enacted in
1968. FNMA provides funds to the mortgage market primarily by purchasing home
mortgage loans from local lenders, thereby providing them with funds for
additional lending. FNMA acquires funds to purchase such loans from investors
that may not ordinarily invest in mortgage loans directly, thereby expanding the
total amount of funds available for housing.
Each FNMA pass-through MBS represents a pro rata interest in one or more
pools of FHA Loans, VA Loans or conventional mortgage loans (i.e., mortgage
loans that are not insured or guaranteed by any governmental agency). The loans
contained in those pools consist of: (i) fixed rate level payment mortgage
loans; (ii) fixed rate growing equity mortgage loans; (iii) fixed rate graduated
payment mortgage loans; (iv) variable rate mortgage loans; (v) other adjustable
rate mortgage loans; and (vi) fixed rate mortgage loans secured by multifamily
projects.
4
<PAGE>
Federal Home Loan Mortgage Corporation. FHLMC is a corporate
instrumentality of the United States established by the Emergency Home Finance
Act of 1970, as amended (the "FHLMC Act"). FHLMC was organized primarily for the
purpose of increasing the availability of mortgage credit to finance needed
housing. The operations of FHLMC currently consist primarily of the purchase of
first lien, conventional, residential mortgage loans and participation interests
in such mortgage loans and the resale of the mortgage loans so purchased in the
form of mortgage-backed securities.
FHLMC, a corporate instrumentality of the United States, guarantees (i) the
timely payment of interest on all FHLMC MBSs, (ii) the ultimate collection of
principal with respect to some FHLMC MBSs, and (iii) the timely payment of
principal with respect to other FHLMC MBSs. Neither the obligations of FNMA nor
those of FHLMC are backed by the full faith and credit of the Untied States.
Nevertheless, because of the relationship of each such entity to the United
States, it is widely believed that MBSs issued by such entities are high quality
securities with minimal credit risk.
The mortgage loans underlying the FHLMC MBSs typically consist of fixed
rate or adjustable rate mortgage loans with original terms to maturity of
between ten and thirty years, substantially all of which are secured by first
liens on one- to four-family residential properties or multifamily projects.
Each mortgage loan must meet the applicable standards set forth in the FHLMC
Act. Mortgage loans underlying FHLMC MBSs may include whole loans, participation
interests in whole loans and undivided interests in whole loans and
participations in another FHLMC MBS.
U.S. Small Business Administration. The U.S. Small Business Administration
(the "SBA") is an independent agency of the United States established by the
Small Business Act of 1953. The SBA was organized primarily to assist
independently owned and operated businesses that are not dominant in their
respective markets. The SBA provides financial assistance, management counseling
and training for small businesses, as well as acting generally as an advocate of
small businesses.
The SBA guarantees the payment of principal and interest on portions of
loans made by private lenders to certain small businesses. The loans are
generally commercial loans such as working capital loans and equipment loans.
The SBA is authorized to issue from time to time, through its fiscal and
transfer agent, SBA-guaranteed participation certificates evidencing fractional
undivided interests in pools of these SBA-guaranteed portions of loans made by
private lenders. The SBA's guarantee of such certificates, and its guarantee of
a portion of the underlying loan, are backed by the full faith and credit of the
United States.
The Fund may invest in other similar types of mortgage and asset related
securities, including those which may be developed in the future, without
shareholder approval.
Description of Adjustable Rate Securities
As stated above, the Fund will invest primarily in Adjustable Rate
Securities. The interest paid on Adjustable Rate Securities and, therefore, the
current income earned by the Fund by investing in such securities, will be a
function primarily of the indexes upon which adjustments are based and the
applicable spread relating to such securities. Examples of indexes which may be
used are (i) one, three and five year U.S. Treasury securities adjusted to a
constant maturity index, (ii) U.S. Treasury bills of three or six months, (iii)
the daily Bank Prime Loan Rate made available by the Federal Reserve Board, (iv)
the offered quotations to leading banks in the London interbank market for
Eurodollar deposits of a specified duration ("LIBOR") and (v) the cost of funds
of member institutions for the Federal Home Loan Bank ("FHLB") of San Francisco
("COFI").
There are a number of factors that may affect the COFI and cause it to
behave differently from indexes tied to specific types of securities. The COFI
is dependent upon, among other things, the origination dates and maturities of
the member institution liabilities. Consequently, the COFI may not reflect the
average prevailing market interest rates on new liabilities of similar
maturities. There can be no assurance that the COFI will necessarily move in the
same direction as prevailing interest rates since as longer term deposits or
borrowings mature and are renewed at market interest rates the COFI will rise or
fall depending upon the differential between the prior and the new rates on such
deposits and borrowings. In addition, associations in the thrift industry in
recent years have caused and may continue to cause the cost of funds of thrift
institutions to change for reasons unrelated to changes in general interest rate
levels. Furthermore, any movement in the COFI as compared to other indexes based
upon specific interest rates may be affected by changes instituted by the FHLB
of San Francisco
5
<PAGE>
in the method used to calculate the COFI. To the extent that COFI may reflect
interest changes on a more delayed basis than other indexes, in a period of
rising interest rates any increase may produce a higher yield to holder later
than would be produced by such other indices and in a period of declining
interest rates the COFI may remain higher than other market interest rates which
may result in a higher level of principal prepayments on mortgage loans which
adjust in accordance with COFI than mortgage or other loans which adjust in
accordance with other indices. In addition, to the extent that COFI may lag
behind other indexes in a period of rising interest rates securities based on
COFI may have a lower market value than would result from use of such other
indexes, and in a period of declining interest rates securities based on COFI
may reflect a higher market value than would securities based on other indexes.
The interest rates paid on Adjustable Rate Securities are generally
readjusted periodically to an increment over the chosen interest rate index.
Such readjustments typically occur at intervals ranging from one to sixty
months. The degree of volatility in the market value of the Fund's portfolio and
of the net asset value of Fund shares will be a function primarily of the length
of the adjustment period and the degree of volatility in the applicable indexes.
It will also be a function of the maximum increase or decrease of the interest
rate adjustment on any one adjustment date, in any one year and over the life of
the securities. These maximum increases and decreases are typically referred to
as "caps" and "floors," respectively. The Fund does not seek to maintain an
overall average cap or floor, although the Manager will consider caps or floors
in selecting Adjustable Rate Securities for the Fund.
While the Fund does not attempt to maintain a constant net asset value per
share, during periods in which short term interest rates move within the caps
and floors of the Fund's portfolio the fluctuation in the market value of the
Adjustable Rate Securities portfolio is expected to be relatively limited, since
the interest rate on the portfolio will adjust to market rates within a short
period of time. In periods of substantial short term volatility in short term
interest rates, the value of the portfolio may fluctuate more substantially
because the caps and floors of the Adjustable Rate Securities in the portfolio
may not permit the interest rate to adjust to the full extent of the movements
in short term rates during any one adjustment period. In the event of dramatic
increases in interest rates, the lifetime caps on the Adjustable Rate Securities
may prevent such securities from adjusting to prevailing rates over the term of
the loan. In this circumstance, the market value of the Adjustable Rate
Securities may be substantially reduced with a corresponding decline in the
Fund's net asset value.
Mortgaged Backed Securities. The Fund will invest in pass-through mortgage
backed securities which are collateralized by a pool of adjustable rate
mortgages ("ARMs") on single-family, multi-family residences or commercial
properties. ARMs typically provide for a fixed initial interest rate for the
first three to sixty scheduled monthly payments. Thereafter, the payment of
interest on the remaining principal amount of the ARM is at a rate which is
adjusted on a periodic basis at a spread over the specified index. Thus,
interest payments on ARMs (and, consequently, on adjustable rate MBSs) will
increase or decrease with fluctuations in the specified index, subject to any
applicable caps and floors. Principal payments on the loan are generally
amortized over the stated term of the ARM and there is usually no penalty for
prepayment of principal.
In addition, the Fund will invest in collateralized mortgage obligations
("CMOs") paying adjustable rates of interest. CMOs are debt obligations
collateralized by mortgage loans or mortgage pass-through securities. Typically,
CMOs are collateralized by pass-through MBSs guaranteed by GNMA, or issued by
FNMA or FHLMC. They may, however, also be collateralized by whole loans or by
pass-through MBSs of private issuers. The collateral for CMOs is hereinafter
referred to as "CMO Collateral." The term CMO as used herein also includes
multi-class pass-through securities, which are equity interests in a trust
composed of CMO Collateral. CMOs may be issued by agencies or instrumentalities
of the United States, including FNMA and FHLMC, or by the types of private
issuers described above. The issuer of a series of CMOs may elect to be treated
as a Real Estate Mortgage Investment Conduit ("REMIC").
The funds for payment on the CMOs are derived from payments of principal
and interest on the underlying CMO Collateral, and, to the extent provided in a
particular transaction, any reinvestment income therefrom. In the case of
adjustable rate CMOs, payments are made generally in the manner described above
with respect to Adjustable Rate Securities generally. The interest on some CMOs,
however, may vary inversely with the rate of a specified index. Thus, for
example, the return to the Fund on a CMO that varies inversely with LIBOR will
increase as the LIBOR rate decreases, and vice versa. Since the interest paid on
inverse floating rate CMOs is
6
<PAGE>
generally set at some multiple of an index such as
LIBOR, an increase in the index rate will typically result in an even greater
decrease in the interest paid on the CMOs. See "Indexed and Inverse Securities"
below.
There are many types of CMO Structures. Most CMOs are structured with
multiple classes. Each class is issued at a fixed or, as in the case of
adjustable rate CMOs, a floating coupon rate, and has a specified maturity or
final distribution date. The interest rate paid on CMOs with a floating coupon
rate may adjust regardless of whether the mortgage loans or underlying CMO
Collateral pay a fixed or a floating rate. Principal prepayments on the CMO
Collateral may cause the CMOs to be retired substantially earlier than their
stated maturities or final distribution dates. Interest is paid or accrues on
all classes of the CMOs on a monthly, quarterly or semiannual basis. The
principal of and interest on the CMO Collateral may be allocated among the
several classes of a CMO in many ways. In one structure, payments of principal,
including any principal prepayments, on the CMO Collateral are applied to the
classes of the CMO in the order of their respective stated maturities or final
distribution dates, so that no payment of principal will be made on any class of
CMOs until all other classes having an earlier stated maturity or final
distribution date have been paid in full. For example, parallel pay CMOs are
structured to provide payments of principal on each payment date to more than
one class. These simultaneous payments are taken into account in calculating the
maturity date or final distribution date of each class, which, as with other CMO
structures, must be retired by its stated maturity date or final distribution
date but may be retired earlier. In other structures, certain CMO classes may
pay concurrently or one or more classes may have a priority with respect to
payments on the underlying CMO Collateral up to a specified amount. For example,
Planned Amortization Class CMOs ("PAC Bonds") generally require payments of a
specified amount of principal on each payment date so long as payments on the
underlying pool of mortgage loans remain within a certain range. PAC Bonds are
always parallel pay CMOs with the required principal payment on such securities
having the highest priority after interest has been paid to all classes.
Asset Backed Securities. The Fund will invest in various types of
Adjustable Rate Securities in the form of ABSs. The securitization techniques
used in the context of ABSs are similar to those used for MBSs. Thus, through
the use of trusts and special purpose corporations, various types of
receivables, primarily home equity loans and automobile and credit card
receivables, are securitized in pass-through structures similar to the mortgage
pass-through structures described above or in a pay-through structure similar to
the CMO structure. ABSs are typically bought or sold from or to the same
entities that act as primary dealers in U.S. Government securities.
The Fund's investments in Adjustable Rate Securities consisting of ABSs may
include pass-through securities collateralized by SBA guaranteed loans whose
interest rates adjust in much the same fashion as described above with respect
to ARMs. Such loans generally include commercial loans such as working capital
loans and equipment loans. The underlying loans are originally made by private
lenders and are guaranteed in part by the SBA. It is the guaranteed portion of
such loans that constitute the underlying financial assets in these ABSs.
In general, the collateral supporting ABSs is of shorter maturity than
mortgage loans and may be less likely to experience substantial prepayments. As
with MBSs, ABSs are often backed by a pool of assets representing the
obligations of a number of different parties. Currently, pass-through securities
collateralized by SBA guaranteed loans and home equity loans are the most
prevalent ABSs which are Adjustable Rate Securities. Investments in ABSs that
cannot be disposed of promptly within seven days and in the usual course of
business without taking a reduced price will be considered illiquid and limited
to an amount which, together with other illiquid investments, does not exceed
10% of the value of the Fund's total assets.
Indexed and Inverse Securities. As described above, the Fund may invest in
Adjustable Rate Securities whose potential investment return is based on the
change in particular measurements of value or rate (an "index"). As an
illustration, the Fund may invest in an Adjustable Rate Security that pays
interest and returns principal based on the change in an index of interest rates
such as LIBOR. Interest and principal payable on a security may also be based on
relative changes among particular indices. In addition, the Fund may invest in
Adjustable Rate Securities whose potential investment return is inversely based
on the change in particular indices. For example, the Fund may invest in
securities that pay a higher rate of interest and principal when a particular
index decreases and pay a lower rate of interest and principal when the value of
the index increases. To the extent that the Fund invests in such types of
securities, it will be subject to the risks associated with changes in the
particular indices, which may include reduced or eliminated interest payments
and losses of invested principal.
7
<PAGE>
Certain indexed securities, including certain inverse securities, may have
the effect of providing a degree of investment leverage, because they may
increase or decrease in value at a rate that is a multiple of the changes in
applicable indices. As a result, the market value of such securities will
generally be more volatile than the market values of fixed-rate securities. The
Fund believes that indexed securities, including inverse securities, represent
flexible portfolio management instruments that may allow the Fund to seek
potential investment rewards, hedge other portfolio positions, or vary the
degree of portfolio leverage relatively efficiently under different market
conditions.
Description of Other Securities
The Fund may invest up to 35% of its total assets in securities other than
Adjustable Rate Securities, either alone or in combination with money market
securities. Other securities in which the Fund may invest consist principally of
fixed rate MBSs and ABSs, stripped securities, and fixed rate debt securities of
FNMA which are not MBSs.
Fixed rate MBSs in which the Fund may invest consist primarily of fixed
rate pass-through securities and fixed rate CMOs. As in the case of Adjustable
Rate Securities, these fixed rate securities may be issued either by agencies or
instrumentalities of the United States or by the types of private issuers
described above. Similarly, the basic structures with respect to fixed rate MBSs
are the same as those described above with respect to Adjustable Rate
Securities. The principal difference between fixed rate securities and
Adjustable Rate Securities is that the interest rate on the former type of
securities is set at a predetermined amount and does not vary according to
changes in any index. As in the case of Adjustable Rate Securities, fixed rate
ABSs reflect basically the same structures as fixed rate MBSs.
Stripped mortgage-backed securities ("SMBSs") are derivative multiclass
mortgage-backed securities. Such securities are typically issued by the same
types of issuers as are MBSs generally. The structure of SMBSs, however, is
different. SMBS arrangements commonly involve two classes of securities that
receive different proportions of the interest and principal distributions on a
pool of mortgage assets. A common variety of SMBS is where one class (the
principal-only or PO class) receives some of the interest and most of the
principal from the underlying assets, while the other class (the interest-only
or IO class) receives most of the interest and the remainder of the principal.
In the most extreme case, the IO class receives all of the interest, while the
PO class receives all of the principal. While the Fund may purchase securities
of a PO class, it is more likely to purchase the securities of an IO class. The
yield to maturity of an IO class is extremely sensitive to the rate of principal
payments (including prepayments) on the related underlying assets, and a rate of
principal payments in excess of that considered in pricing the securities will
have a material adverse effect on an IO security's yield to maturity. If the
underlying mortgage assets experience greater than anticipated payments of
principal, the Fund may fail to recoup fully its initial investment in IOs. In
addition, there are certain types of IOs which represent the interest portion of
a particular class as opposed to the interest portion of the entire pool. The
sensitivity of this type of IO to interest rate fluctuations may be increased
because of the characteristics of the principal portion to which they relate. As
a result of the above factors, the Fund generally will purchase IOs only as a
component of so-called "synthetic" securities. This means that purchases of IOs
will be matched with certain purchases of other securities such as inverse
floating rate CMOs or fixed rate securities; as interest rates fall, presenting
a greater risk of unanticipated prepayments of principal, the negative effect on
the Fund because of its holdings of IOs should be diminished somewhat because of
the increased yield on the inverse floating rate CMOs or the increased
appreciation on the fixed rate securities. IOs and POs are considered by the
staff of the Commission to be illiquid securities and, consequently, the Fund
will not invest in IOs or POs in an amount which, taken together with the Fund's
other investments in illiquid securities, exceeds 10% of the Fund's net assets.
The Fund may also purchase debentures issued by FNMA. FNMA debentures are
unsecured general obligations of FNMA. FNMA's obligations have traditionally
been treated as "U.S. Agency" debt in the marketplace and are eligible for
investment by many supervised financial institutions without regard to legal
limits generally imposed on investment securities. However, the debentures
(together with interest thereon) are not guaranteed by the United States and do
not constitute a debt or obligation of the United States or of any agency or
instrumentality thereof other than FNMA. The debentures generally are issued in
book-entry form and are offered through a nationwide group of securities dealers
and dealer banks. FNMA does not generally sell its debentures directly to
investors. The debentures typically bear interest at fixed rates per annum,
payable semiannually in arrears and computed on the basis of a 360-day year of
twelve 30-day months.
8
<PAGE>
Description of Money Market Securities
The money market securities in which the Fund may invest consist of United
States Government securities, United States Government agency or instrumentality
securities, domestic bank or savings institution certificates of deposit and
bankers' acceptances, short-term debt securities such as commercial paper and
other corporate debt, and repurchase agreements. These investments must have a
maturity not in excess of one year from the date of purchase.
The Fund has established the following standards with respect to money
market securities in which the Fund invests. Commercial paper investments at the
time of purchase must be rated "A-1" by S&P or "Prime-1" by Moody's or, if not
rated, be issued by companies having such a rating with respect to comparable
short term debt securities. Investments in corporate bonds and debentures (which
must have maturities at the date of purchase of one year or less) will be
limited to securities of issuers which, at the time of purchase, have a rating
with respect to comparable short-term debt of A-1 by S&P or Prime-1 by Moody's.
The Fund may not invest in any security issued by a commercial bank or a savings
institution unless the bank or institution is organized and operating in the
United States, has total assets of at least one billion dollars and is a member
of the Federal Deposit Insurance Corporation.
Special Considerations and Risk Factors
The types of securities in which the Fund invests have certain unique
attributes that warrant special consideration or that present risks that may not
exist in other types of mutual fund investments. Some of these considerations
and risks pertain to the characteristics of MBSs or ABSs generally, while others
are peculiar to Adjustable Rate Securities. One of the principal risks regarding
MBSs and, to a lesser extent, ABSs is the risk of prepayments. From time to
time, prepayment rates on MBSs have been high. The rate of principal prepayments
on MBSs will depend on the rates of principal payments on the related mortgages.
In general, when prevailing mortgage interest rates decline significantly below
the interest rates on the mortgages, the prepayment rate on the mortgages is
likely to increase, although a number of other factors may also influence the
prepayment rate, such as the acceleration of mortgage payments due to transfers
of mortgaged properties, liquidations due to default and refinancings of
existing loans. No assurance can be given as to the rate and timing of principal
prepayments on mortgage loans underlying MBSs. High prepayment rates may have an
adverse effect on the value of MBS securities and in particular SMBSs, such as
IOs.
Payments of principal of and interest on MBSs and ABSs are made more
frequently than are payments on conventional debt securities. In addition,
holders of MBSs and of certain ABSs (such as ABSs backed by home equity loans)
may receive unscheduled payments of principal at any time representing
prepayments on the underlying mortgage loans or financial assets. Such
prepayments may usually be made by the related obligor without penalty.
Prepayment rates are affected by changes in prevailing interest rates and
numerous other economic, geographic, social and other factors. (ABSs backed by
other than home equity loans do not generally prepay in response to changes in
interest rates, but may be subject to prepayments in response to other factors.)
Changes in the rate of prepayments will generally affect the yield to maturity
of the security. Moreover, when the holder of the security attempts to reinvest
prepayments or even the scheduled payments of principal and interest, it may
receive a rate of interest which is higher or lower than the rate on the MBS or
ABS originally held. Another consideration is that to the extent that MBSs or
ABSs are purchased at a premium, mortgage foreclosures and principal prepayments
may result in loss to the extent of premium paid. On the other hand, where such
securities are bought at a discount, both scheduled payments of principal and
unscheduled prepayments will increase current and total returns and will
accelerate the recognition of income which, when distributed to shareholders,
will be taxable as ordinary income. The Manager will consider remaining
maturities or estimated average lives of MBSs and ABSs in selecting them for the
Fund. Finally, ABSs may present certain risks not present in MBSs. Additionally,
assets underlying ABSs such as credit-card receivables are generally unsecured,
and debtors are entitled to the protection of various state and Federal consumer
protection laws. Some of those laws give a right of set-off, which may reduce
the balance owed.
Adjustable Rate Securities have several characteristics that should be
considered before investing in the Fund. As indicated above, the interest rate
reset features of Adjustable Rate Securities held by the Fund will reduce the
effect on the net asset value of Fund shares caused by changes in market
interest rates. See "Investment
9
<PAGE>
Objective and Policies -- Description of Adjustable Rate Securities." However,
the market value of Adjustable Rate Securities and, therefore, the Fund's net
asset value, may vary to the extent that the current interest rate on such
securities differs from market interest rates during periods between the
interest reset dates. These variations in value occur inversely to changes in
the market interest rates. Thus, if market interest rates rise above the current
rates on the securities, the value of the securities will decrease; conversely,
if market interest rates fall below the current rate on the securities, the
value of the securities will rise. If investors in the Fund sold their shares
during periods of rising rates before an adjustment occurred, such investors
could suffer some loss. The longer the adjustment intervals on Adjustable Rate
Securities held by the Fund, the greater the potential for fluctuations in the
Fund's net asset value.
Investors in the Fund will receive increased income as a result of upward
adjustments of the interest rates on Adjustable Rate Securities held by the Fund
in response to market interest rates. However, the Fund and its shareholders
will not benefit from increases in market interest rates once such rates rise to
the point where they cause the rates on such Adjustable Rate Securities to reach
their maximum adjustment date, annual or lifetime caps. In addition, because of
their interest rate adjustment feature, Adjustable Rate Securities are not an
effective means of "locking-in" attractive interest rates for periods in excess
of the adjustment period. Also a consideration, in the case of privately issued
MBSs where the underlying mortgage assets carry no agency or instrumentality
guarantee, is that the mortgagors on the loans underlying Adjustable Rate
Securities are often qualified for such loans on the basis of the original
payment amounts. The mortgagors' income may not be sufficient to enable them to
continue making their loan payments as such payments increase, resulting in a
greater likelihood of default. The Fund seeks to guard against this risk,
however, through the Fund's quality standards, discussed above.
Conversely, any benefits to the Fund and its shareholders from an increase
in the Fund's net asset value caused by falling market interest rates is reduced
by the potential for increased prepayments and a decline in the interest rates
paid on Adjustable Rate Securities held by the Fund. When market rates decline
significantly, the prepayment rate on Adjustable Rate Securities is likely to
increase as borrowers refinance with fixed rate mortgage loans, thereby
decreasing the capital appreciation potential of Adjustable Rate Securities. In
this regard, the Fund is not designed for investors seeking capital
appreciation.
As described above under "Description of Adjustable Rate Securities --
Indexed and Inverse Securities," the Fund may invest in Adjustable Rate
Securities whose potential investment return is inversely based on the change in
particular indices. Such securities may have the effect of providing a degree of
investment leverage because they may increase or decrease in value at a rate
that is a multiple of the changes in applicable indices. As a result, the market
values of such securities will generally be more volatile than the market values
of fixed-rate securities.
Portfolio Strategies Involving Interest Rate Transactions, Options and Futures
The Fund may engage in various portfolio strategies to seek to increase its
return through the use of options on portfolio securities and to hedge its
portfolio against movements in interest rates. The Fund has authority to engage
in interest rate transactions in order to hedge against interest rate movements,
purchase call and put options on securities, write (i.e., sell) covered call and
put options on its portfolio securities, and engage in hedging transactions in
financial futures, and related options on such futures. Each of these portfolio
strategies is described below.
Although certain risks are involved in interest rate, options and futures
transactions, the Manager believes that, because the Fund will (i) write only
covered options on portfolio securities, and (ii) engage in other transactions
only for hedging purposes, these portfolio strategies will not subject the Fund
to the risks frequently associated with the speculative use of such
transactions. While the Fund's use of hedging strategies is intended to reduce
the volatility of the net asset value of Fund shares, the Fund's net asset value
will fluctuate. There can be no assurance that the Fund's hedging transactions
will be effective. Furthermore, the Fund will only engage in hedging activities
from time to time and may not necessarily be engaging in hedging activities when
movements in interest rates occur.
Interest Rate Hedging Transactions and Risk Factors in Such Transactions.
The Fund may hedge all or a portion of its portfolio investments against
fluctuations in interest rates by entering into interest rate transactions, such
as interest rate swaps and the purchase or sale of interest rate caps and
floors. The Fund bears the risk of an
10
<PAGE>
imperfect correlation between the index used in the hedging transaction and that
pertaining to the securities which are the subject of the hedging transaction.
The Fund expects to enter into interest rate transactions primarily to
preserve a return or spread on a particular investment or a portion of its
portfolio or to protect against any increase in the price of securities the Fund
anticipates purchasing at a later date. The Fund intends to use these
transactions to hedge its portfolio of Adjustable Rate Securities against
fluctuations in interest rates and not as a speculative investment. Typically,
the parties with which the Fund will enter into interest rate transactions will
be broker-dealers and other financial institutions. Certain Federal income tax
requirements may, however, limit the Fund's ability to engage in certain
interest rate transactions. Gains from transactions in interest rate swaps
distributed to shareholders will be taxable as ordinary income or, in certain
circumstances, as capital gains to shareholders. See "Dividends and Taxes."
The purchase of an interest rate cap entitles the purchaser, to the extent
that a specified index exceeds a predetermined interest rate, to receive
payments of interest on a notional principal amount from the party selling such
interest rate cap. The purchase of an interest rate cap therefore hedges against
an increase in interest rates above the cap on an Adjustable Rate Security held
by the Fund. Thus, for example, in the case of such a security indexed to COFI,
if COFI increases above the rate paid on the security, the counter-party will
pay the differential to the Fund. The opposite is true in the case of an
interest rate floor; it hedges against a decrease in the index rate below any
floor on the Adjustable Rate Security.
Interest rate swap transactions involve the exchange by the Fund with
another party of their respective commitments to pay or receive interest, such
as an exchange of fixed rate payments for floating rate payments. For example,
if the Fund holds an MBS with an interest rate that is reset only once each
year, it may swap the right to receive interest at this fixed rate for the right
to receive interest at a rate that is reset every week. This would enable the
Fund to offset a decline in the value of the MBS due to rising interest rates,
but would also limit its ability to benefit from falling interest rates.
Conversely, if the Fund holds an MBS with an interest rate that is reset every
week and it would like to lock in what it believes to be a high interest rate
for one year, it may swap the right to receive interest at this variable weekly
rate for the right to receive interest at a rate that is fixed for one year.
Such a swap would protect the Fund from a reduction in yield due to falling
interest rates, but would preclude it from taking full advantage of rising
interest rates.
The Fund usually will enter into interest rate swap transactions on a net
basis, i.e., the two payment streams are netted out, with the Fund receiving or
paying, as the case may be, only the net amount of the two payments. Inasmuch as
these transactions are entered into for good faith hedging purposes, the Manager
believes that such obligations do not constitute senior securities and,
accordingly, will not treat them as being subject to its borrowing restrictions.
The net amount of the excess, if any, of the Fund's obligations over its
entitlements with respect to each interest rate swap will be accrued on a daily
basis, and an amount of cash, cash equivalents or high grade liquid debt
securities having an aggregate net asset value at least equal to the accrued
excess will be maintained in a segregated account by the Fund's custodian. If
the interest rate swap transaction is entered into on other than a net basis,
the full amount of the Fund's obligations will be accrued on a daily basis, and
the full amount of the Fund's obligations will be maintained in a segregated
account by the Fund's custodian. The Fund will not enter into any interest rate
swap transaction unless the credit quality of the unsecured senior debt or the
claims-paying ability of the other party thereto is rated in one of the highest
two rating categories by at least one nationally recognized statistical rating
organization or whose creditworthiness is believed by the Manager to be
equivalent to such rating. If there is a default by the other party to such a
transaction, the Fund will have contractual remedies pursuant to the agreements
related to the transaction. The swap market has grown substantially in recent
years with a large number of banks and investment banking firms acting both as
principals and as agents utilizing standardized swap documentation. As a result,
the swap market has become relatively liquid in comparison with other similar
instruments traded in the interbank market. Caps and floors, however, are less
liquid than swaps. The Fund will not enter into a cap or floor transaction in an
amount which, together with other liquid investments of the Fund exceeds 15% of
the Fund's total assets.
The use of interest rate swaps is a highly specialized activity which
involves investment techniques and risks different from those associated with
ordinary portfolio securities transactions. If the Manager is incorrect in its
forecasts of market values, interest rates and other applicable factors, the
investment performance of the Fund would diminish compared with what it would
have been if these investment techniques were not used.
11
<PAGE>
Interest rate swap transactions do not involve the delivery of securities
or other underlying assets or principal. Accordingly, the risk of loss with
respect to interest rate swaps is limited to the net amount of interest payments
that the Fund is contractually obligated to make. If the MBS or other security
underlying an interest rate swap is prepaid and the Fund continues to be
obligated to make payments to the other party to the swap, the Fund would have
to make such payments from another source. If the other party to an interest
rate swap defaults, the Fund's risk of loss consists of the net amount of
interest payments that the Fund contractually is entitled to receive. Since
interest rate transactions are individually negotiated, the Manager expects to
achieve an acceptable degree of correlation between the Fund's rights to receive
interest on MBSs and its rights and obligations to receive and pay interest
pursuant to interest rate swaps.
Writing Covered Options. The Fund is authorized to write, i.e., sell,
covered call options on the securities in which it may invest and to enter into
closing purchase transactions with respect to certain of such options. A covered
call option is an option where the Fund, in return for a premium, gives another
party a right to buy specified securities owned by the Fund on or before a
specified future date and at a specified price set at the time of the contract.
The principal reason for writing call options is to attempt to realize, through
the receipt of premiums, a greater return than would be realized on the
securities alone. By writing covered call options, the Fund gives up the
opportunity, while the option is in effect, to profit from any price increase in
the underlying security above the option exercise price. In addition, the Fund's
ability to sell the underlying security will be limited while the option is in
effect unless the Fund effects a closing purchase transaction. A closing
purchase transaction cancels out the Fund's position as the writer of an option
by means of an offsetting purchase of an identical option prior to the
expiration of the option it has written. Covered call options serve as a partial
hedge against the price of the underlying security declining.
The writer of a covered call option has no control over when he may be
required to sell his securities since he may be assigned an exercise notice at
any time prior to the termination of his obligation as a writer. If an option
expires unexercised, the writer realizes a gain in the amount of the premium.
Such a gain, of course, may be offset by a decline in the market value of the
underlying security during the option period. If a call option is exercised, the
writer realizes a gain or loss from the sale of the underlying security.
The Fund also may write put options that give the holder of the option the
right to sell the underlying security to the Fund at the stated exercise price.
The Fund will receive a premium for writing a put option that increases the
Fund's return. The Fund writes only covered put options which means that so long
as the Fund is obligated as the writer of the option it will, through its
custodian, have deposited and maintained cash, cash equivalents, U.S. Government
securities or other liquid securities with the Fund's custodian with a value
equal to or greater than the exercise price of the underlying securities. By
writing a put, the Fund will be obligated to purchase the underlying security at
a price that may be higher than the market value of that security at the time of
exercise for as long as the option is outstanding. The Fund may engage in
closing transactions in order to terminate put options that it has written.
Options referred to herein may be options issued by The Options Clearing
Corporation (the "Clearing Corporation") which are currently traded on the
Chicago Board Options Exchange, the American Stock Exchange, the Philadelphia
Stock Exchange, the Pacific Stock Exchange, the New York Stock Exchange (the
"NYSE") or the Midwest Stock Exchange. An option position may be closed out only
on an exchange which provides a secondary market for an option of the same
series. If a secondary market does not exist, it might not be possible to effect
closing transactions in particular options, with the result, in the case of a
covered call option, that the Fund will not be able to sell the underlying
security until the option expires or it delivers the underlying security upon
exercise. Reasons for the absence of a liquid secondary market on an exchange
include the following: (i) there may be insufficient trading interest in certain
options; (ii) restrictions may be imposed by an exchange on opening transactions
or closing transactions or both; (iii) trading halts, suspensions or other
restrictions may be imposed with respect to particular classes or series of
options or underlying securities; (iv) unusual or unforeseen circumstances may
interrupt normal operations on an exchange; (v) the facilities of an exchange or
the Clearing Corporation may not at all times be adequate to handle current
trading volume; or (vi) one or more exchanges could, for economic or other
reasons, decide or be compelled at some future date to discontinue the trading
of options (or a particular class or series of options), in which event the
secondary market on that exchange (or in that class or series of options) would
cease to exist, although outstanding options on that exchange that had been
issued by the Clearing Corporation as a result of trades on that exchange would
continue to be exercisable in accordance with their terms.
12
<PAGE>
The Fund may also enter into over-the-counter option transactions ("OTC
options"), which are two-party contracts with price and terms negotiated between
the buyer and seller. The staff of the Commission has taken the position that
OTC options and the assets used as cover for written OTC options are illiquid
securities. However, if the OTC option is sold by the Fund to a primary U.S.
Government securities dealer recognized by the Federal Reserve Bank of New York
and the Fund has the unconditional contractual right to repurchase such OTC
option from the dealer at a predetermined price, then the Fund will treat as
illiquid such amount of the underlying securities as is equal to the repurchase
price less the amount by which the option is "in-the-money" (i.e., current
market value of the underlying security minus the option's strike price). The
repurchase price with the primary dealers is typically a formula price which is
generally based on a multiple of the premium received for the option, plus the
amount by which the option is "in-the-money." This policy is not a fundamental
policy of the Fund and may be amended by the Directors of the Fund without the
approval of the Fund's shareholders. However, the Fund will not change or modify
this policy prior to the change or modification by the Commission staff of its
positions.
Purchasing Options. The Fund is authorized to purchase put options to hedge
against a decline in the market value of its equity holdings. By buying a put,
the Fund has a right to sell the underlying security at the exercise price, thus
limiting the Fund's risk of loss through a decline in the market value of the
security until the put option expires. The amount of any appreciation in the
value of the underlying security will be partially offset by the amount of the
premium paid for the put option and any related transaction costs. Prior to its
expiration, a put option may be sold in a closing sale transaction and profit or
loss from the sale will depend on whether the amount received is more or less
than the premium paid for the put option plus the related transaction cost. A
closing sale transaction cancels out the Fund's position as the purchaser of an
option by means of an offsetting sale of an identical option prior to the
expiration of the option it has purchased. In certain circumstances, the Fund
may purchase call options on securities held in its portfolio on which it has
written call options or which it intends to purchase. A purchased call option
gives the Fund the right to buy, and obligates the seller to sell, the
underlying security at the exercise price at any time during the option period.
The Fund may purchase either options traded on an exchange or OTC options.
Financial Futures and Options Thereon. The Fund is authorized to engage in
transactions in financial futures contracts ("futures contracts"), and related
options on such futures contracts as a hedge against adverse changes in the
market value of its portfolio securities and interest rates. A futures contract
is an agreement between two parties which obligates the purchaser of the futures
contract to buy and the seller of a futures contract to sell a security for a
set price on a future date or, in the case of an index futures contract, to make
and accept a cash settlement based upon the difference in value of the index
between the time the contract was entered into and the time of its settlement.
Transactions by the Fund in futures contracts and financial futures are subject
to limitations as described below under "Restrictions on the Use of Futures
Transactions."
The Fund may sell financial futures contracts in anticipation of an
increase in the general level of interest rates. Generally, as interest rates
rise, the market values of securities which may be held by the Fund will fall,
thus reducing the net asset value of the Fund. However, as interest rates rise,
the value of the Fund's short position in the futures contract will also tend to
increase, thus offering all or a portion of the depreciation in the market value
of the Fund's investments which are being hedged. While the Fund will incur
commission expenses in selling and closing out futures positions, these
commissions are generally less than the transaction expenses which the Fund
would have incurred had the Fund sold portfolio securities in order to reduce
its exposure to increases in interest rates. The Fund also may purchase
financial futures contracts in anticipation of a decline in interest rates when
it is not fully invested in a particular market in which it intends to make
investments to gain market exposure that may in part or entirely offset an
increase in the cost of securities it intends to purchase. It is anticipated
that, in a substantial majority of these transactions, the Fund will purchase
securities upon termination of the futures contract.
The Fund also has authority to purchase and write call and put options on
futures contracts in connection with its hedging activities. Generally, these
strategies are utilized under the same market and market sector conditions
(i.e., conditions relating to specific types of investments) in which the Fund
enters into futures transactions. The Fund may purchase put options or write
call options on futures contracts rather than selling the underlying futures
contract in anticipation of a decrease in the market value of a security or an
increase in interest rates. Similarly, the Fund may purchase call options, or
write put options on futures contracts, as a substitute for
13
<PAGE>
the purchase of such futures to hedge against the increased cost resulting from
an increase in the market value or a decline in interest rates of securities
which the Fund intends to purchase.
The Fund may engage in options and futures transactions on exchanges and
options in the over-the-counter markets. In general, exchange-traded contracts
are third-party contracts (i.e., performance of the parties' obligations is
guaranteed by an exchange or clearing corporation) with standardized strike
prices and expiration dates. OTC options transactions are two-party contracts
with price and terms negotiated by the buyer and seller. See "Restrictions on
OTC Options" below for information as to restrictions on the use of OTC options.
The purchase or sale of a futures contract differs from the purchase or
sale of a security in that no price or premium is paid or received. Instead, an
amount of cash or securities acceptable to the broker and the relevant contract
market, which varies, but is generally about 5% of the contract amount, must be
deposited with the broker. This amount is known as "initial margin" and
represents a "good faith" deposit assuring the performance of both the purchaser
and seller under the futures contract. Subsequent payments to and from the
broker, called "variation margin," are required to be made on a daily basis as
the price of the futures contracts fluctuates making the long and short
positions in the futures contracts more or less valuable, a process known as
"marking to market." At any time prior to the settlement date of the futures
contract, the position may be closed out by taking an opposite position which
will operate to terminate the position in the futures contract. A final
determination of variation margin is then made, additional cash is required to
be paid to or released by the broker and the purchaser realizes a loss or gain.
In addition, a nominal commission is paid on each completed sale transaction.
The Fund has received an order from the Commission exempting it from the
provisions of Section 17(f) and Section 18(f) of the Investment Company Act of
1940 (the "Investment Company Act") in connection with its strategy of investing
in futures contracts. Section 17(f) relates to the custody of securities and
other assets of an investment company and may be deemed to prohibit certain
arrangements between the Fund and commodities brokers with respect to initial
and variation margin. Section 18(f) of the Investment Company Act prohibits an
open-end investment company such as the Fund from issuing a "senior security"
other than a borrowing from a bank. The staff of the Commission has in the past
indicated that a futures contract may be a "senior security" under the
Investment Company Act.
Restrictions on the Use of Futures Transactions. Regulations of the
Commodity Futures Trading Commission ("CFTC") applicable to the Fund provide
that the futures trading activities described herein will not result in the Fund
being deemed a "commodity pool," as defined under such regulations if the Fund
adheres to certain restrictions. In particular, the Fund may purchase and sell
futures contracts and options thereon (i) for bona fide hedging purposes, and
(ii) for non-hedging purposes, if the aggregate initial margin and premiums
required to establish positions in such contracts and options does not exceed 5%
of the liquidation value of the Fund's portfolio, after taking into account
unrealized profits and unrealized losses on any such contracts and options.
When the Fund purchases a futures contract or writes a put option or
purchases a call option thereon, an amount of cash and cash equivalents will be
deposited in a segregated account with the Fund's custodian so that the amount
so segregated, plus the amount of variation margin held in the account of its
broker, equals the market value of the futures contract, thereby ensuring that
the use of such futures is unleveraged.
An order has been obtained from the Commission which exempts the Fund from
certain provisions of the Investment Company Act of 1940, as amended (the
"Investment Company Act") in connection with transactions involving futures
contracts and options thereon.
Restrictions on OTC Options. The Fund will engage in OTC options only with
member banks of the Federal Reserve System and primary dealers in U.S.
Government securities or with affiliates of such banks or dealers which have
capital of at least $50 million or whose obligations are guaranteed by an entity
having capital of at least $50 million.
The staff of the Commission has taken the position that purchased OTC
options and the assets used as cover for written OTC options are illiquid
securities. Therefore, except to the extent set forth herein, the Fund has
adopted an investment policy pursuant to which it will not purchase or sell OTC
options (including OTC options on futures contracts) if, as a result of such
transaction, the sum of the market value of OTC options currently
14
<PAGE>
outstanding which are held by the Fund, the market value of the underlying
securities covered by OTC options currently outstanding which were sold by the
Fund and margin deposits on the Fund's existing OTC options on futures contracts
exceed 15% of the total assets of the Fund, taken at market value, together with
all other assets of the Fund which are illiquid or are not otherwise readily
marketable. However, if an OTC option is sold by the Fund to a primary U.S.
Government securities dealer recognized by the Federal Reserve Bank of New York
and if the Fund has the unconditional contractual right to repurchase such OTC
option from the dealer at a predetermined price, then the Fund will treat as
illiquid such amount of the underlying securities as is equal to the repurchase
price less the amount by which the option is "in-the-money" (i.e., current
market value of the underlying securities minus the option's strike price). The
repurchase price with the primary dealers is typically a formula price which is
generally based on a multiple of the premium received for the option, plus the
amount by which the option is "in-the-money." This policy as to OTC options is
not a fundamental policy of the Fund and may be amended by the Board of
Directors of the Fund without the approval of the Fund's shareholders. However,
the Fund will not change or modify this policy prior to the change or
modification by the Commission staff of its position.
Risk Factors in Interest Rate Transactions and Options and Futures
Transactions. The use of interest rate transactions is a highly specialized
activity which involves investment techniques and risks different from those
associated with ordinary portfolio securities transactions. Interest rate
transactions involve the risk of an imperfect correlation between the index used
in the hedging transaction and that pertaining to the securities which are the
subject of such transaction. If the Manager is incorrect in its forecasts of
market values, interest rates and other applicable factors, the investment
performance of the Fund would diminish compared with what it would have been if
these investment techniques were not used. In addition, interest rate
transactions that may be entered into by the Fund do not involve the delivery of
securities or other underlying assets or principal. Accordingly, the risk of
loss with respect to interest rate swaps is limited to the net amount of
interest payments that the Fund is contractually obligated to make. If the MBS
or other security underlying an interest rate swap is prepaid and the Fund
continues to be obligated to make payments to the other party to the swap, the
Fund would have to make such payments from another source. If the other party to
an interest rate swap defaults, the Fund's risk of loss consists of the net
amount of interest payments that the Fund contractually is entitled to receive.
In the case of a purchase by the Fund of an interest rate cap or floor, the
amount of loss is limited to the fee paid.
Utilization of options and futures transactions to hedge the portfolio
involves the risk of imperfect correlation in movements in the price of options
and futures and movements in the prices of the securities which are the subject
of the hedge. If the price of the options or futures moves more or less than the
price of the subject of the hedge, the Fund will experience a gain or loss which
will not be completely offset by movements in the price of the subject of the
hedge. This risk particularly applies to the Fund's use of futures and options
thereon since it will generally use such instruments as a so-called
"cross-hedge," which means that the security that is the subject of the futures
contract is different from the security being hedged by the contract. The Fund
will not purchase puts, calls, straddles, spreads or any combination thereof if
by reason thereof the premiums paid for the aggregate investments in such
classes of securities exceed 5% of the Fund's total assets at the time of
purchase. The successful use of options and futures also depends on the
Manager's ability to predict correctly price movements in the market involved in
a particular options or futures transaction.
Prior to exercise or expiration, an exchange-traded option position can
only be terminated by entering into a closing purchase or sale transaction. This
requires a secondary market on an exchange for call or put options of the same
series. The Fund will enter into an option or futures transaction on an exchange
only if there appears to be a liquid secondary market for such options or
futures. However, there can be no assurance that a liquid secondary market will
exist for any particular call or put option or futures contract at any specific
time. Thus, it may not be possible to close an option or futures position. In
the case of a futures position or an option on a futures position written by the
Fund, in the event of adverse price movements, the Fund would continue to be
required to make daily cash payments of variation margin. In such situations, if
the Fund has insufficient cash, it may have to sell portfolio securities to meet
daily variation margin requirements at a time when it may be disadvantageous to
do so. In addition, the Fund may be required to take or make delivery of the
currency underlying futures contracts it holds. The inability to close options
and futures positions also could have an adverse impact on the Fund's ability to
hedge effectively its portfolio. There is also the risk of loss by the Fund
15
<PAGE>
of margin deposits in the event of bankruptcy of a broker with whom the Fund has
an open position in a futures contract or related option. The risk of loss from
investing in futures transactions is theoretically unlimited.
The exchanges on which the Fund intends to conduct options transactions
have generally established limitations governing the maximum number of call or
put options on the same underlying currency (whether or not covered) that may be
written by a single investor, whether acting alone or in concert with others
(regardless of whether such options are written on the same or different
exchanges or are held or written on one or more accounts or through one or more
brokers). "Trading limits" are imposed on the maximum number of contracts that
any person may trade on a particular trading day. An exchange may order the
liquidation of positions found to be in violation of these limits and it may
impose other sanctions or restrictions. The Manager does not believe that these
trading and position limits will have any adverse impact on the portfolio
strategies for hedging the Fund's portfolio.
Other Investment Policies and Practices
Repurchase Agreements and Purchase and Sale Contracts. The Fund may invest
in securities pursuant to repurchase agreements and purchase and sale contracts.
Repurchase agreements and purchase and sale contracts may be entered into only
with a member bank of the Federal Reserve System or primary dealer in U.S.
Government securities or an affiliate thereof. Under such agreements, the bank
or primary dealer or affiliate agrees, upon entering into the contract, to
repurchase the security at a mutually agreed upon time and price, thereby
determining the yield during the term of the agreement. This results in a fixed
rate of return insulated from market fluctuations during such period. In the
case of repurchase agreements, the prices at which the trades are conducted do
not reflect accrued interest on the underlying obligations; whereas, in the case
of purchase and sale contracts, the prices take into account accrued interest.
Such agreements usually cover short periods, such as under one week. Repurchase
agreements may be construed to be collateralized loans by the purchaser to the
seller secured by the securities transferred to the purchaser. In the case of a
repurchase agreement, the Fund will require the seller to provide additional
collateral if the market value of the securities falls below the repurchase
price at any time during the term of the repurchase agreement; the Fund does not
have the right to seek additional collateral in the case of purchase and sale
contracts. In the event of default by the seller under a repurchase agreement
construed to be a collateralized loan, the underlying securities are not owned
by the Fund but only constitute collateral for the seller's obligation to pay
the repurchase price. Therefore, the Fund may suffer time delays and incur costs
or possible losses in connection with the disposition of the collateral. A
purchase and sale contract differs from a repurchase agreement in that the
contract arrangements stipulate that the securities are owned by the Fund. In
the event of a default under such a repurchase agreement or purchase and sale
contract, instead of the contractual fixed rate of return, the rate of return to
the Fund shall be dependent upon intervening fluctuations of the market value of
such security and the accrued interest on the security. In such event, the Fund
would have rights against the seller for breach of contract with respect to any
losses arising from market fluctuations following the failure of the seller to
perform.
Lending of Portfolio Securities. The Fund may from time to time lend
securities from its portfolio with a value not exceeding 33 1/3% of its total
assets, to banks, brokers and other financial institutions and receive
collateral in cash or securities issued or guaranteed by the United States
Government which will be maintained at all times in an amount equal to at least
100% of the current market value of the loaned securities. During the period of
this loan, the Fund receives the income on the loaned securities and either
receives the income on the collateral or other compensation (i.e., negotiated
loan premium or fee) for entering into the loan and thereby increases its yield.
In the event that the borrower defaults on its obligation to return borrowed
securities, because of insolvency or otherwise, the Fund could experience delays
and costs in gaining access to the collateral and could suffer a loss to the
extent that the value of the collateral falls below the market value of the
borrowed securities.
Reverse Repurchase Agreements. The Fund may enter into reverse repurchase
agreements with the same parties with whom it may enter into repurchase
agreements. Under a reverse repurchase agreement, the Fund sells securities and
agrees to repurchase them at a mutually agreed date and price. At the time the
Fund enters into a reverse repurchase agreement, it will establish and maintain
a segregated account with its approved custodian containing cash, cash
equivalents or liquid high grade debt securities having a value not less than
the repurchase price (including accrued interest). Reverse repurchase agreements
involve the risk that the market value of the securities retained in lieu of
sale by the Fund may decline below the price of the securities the Fund
16
<PAGE>
has sold but is obligated to repurchase. In the event the buyer of securities
under a reverse repurchase agreement files for bankruptcy or becomes insolvent,
such buyer or its trustee or receiver may receive an extension of time to
determine whether to enforce the Fund's obligations to repurchase the securities
and the Fund's use of the proceeds of the reverse repurchase agreement may
effectively be restricted pending such decision.
When-Issued Securities, Delayed Delivery Transactions and Dollar Rolls. The
Fund may purchase or sell securities on a delayed delivery basis or a
when-issued basis at fixed purchase terms. These transactions arise when
securities are purchased or sold by the Fund with payment and delivery taking
place in the future. The purchase will be recorded on the date the Fund enters
into the commitment and the value of the obligation will thereafter be reflected
in the calculation of the Fund's net asset value. The value of the obligation on
the delivery date may be more or less than its purchase price. A separate
account of the Fund will be established with its custodian consisting of cash,
cash equivalents or liquid securities having a market value at all times at
least equal to the amount of the forward commitment.
The Fund also may enter into "dollar rolls." A dollar roll is where the
Fund sells mortgage-backed securities for delivery in the current month and
simultaneously contracts to repurchase substantially similar (same type, coupon
and maturity) securities on a specified future date. During the roll period, the
Fund foregoes principal and interest paid on the mortgage-backed securities. The
Fund is compensated by the difference between the current sales price and the
lower forward price for the future purchase (often referred to as the "drop") as
well as by the interest earned on the cash proceeds of the initial sale. A
"covered roll" is a specific type of dollar roll for which there is a segregated
account with liquid securities in an amount equal to the forward price. Money
market securities held by the Fund in such an account will not be subject to the
general limitation that, other than for temporary or defensive purposes, the
Fund will invest no more than 35% of its total assets in money market
securities. Dollar rolls in which the Fund may invest will be limited to covered
rolls.
Illiquid or Restricted Securities. The Fund may invest up to 15% of its
total assets in securities that lack an established secondary trading market or
otherwise are considered illiquid. Liquidity of a security relates to the
ability to dispose easily of the security and the price to be obtained upon
disposition of the security, which may be less than would be obtained for a
comparable more liquid security. Illiquid securities may trade at a discount
from comparable, more liquid investments. Investment of the Fund's assets in
illiquid securities may restrict the ability of the Fund to dispose of its
investments in a timely fashion and for a fair price as well as its ability to
take advantage of market opportunities. The risks associated with illiquidity
will be particularly acute where the Fund's operations require cash, such as
when the Fund redeems shares or pays dividends, and could result in the Fund
borrowing to meet short-term cash requirements or incurring capital losses on
the sale of illiquid investments.
The Fund may invest in securities that are not registered under the
Securities Act or that are subject to trading restrictions under the laws of a
foreign jurisdiction ("restricted securities"). Restricted securities may be
sold in private placement transactions between the issuers and their purchasers
and may be neither listed on an exchange nor traded in other established
markets. In many cases, privately placed securities may not be freely
transferable under the laws of the applicable jurisdiction or due to contractual
restrictions on resale. As a result of the absence of a public trading market,
privately placed securities may be less liquid and more difficult to value than
publicly traded securities. To the extent that privately placed securities may
be resold in privately negotiated transactions, the prices realized from the
sales, due to illiquidity, could be less than those originally paid by the Fund
or less than their fair market value. In addition, issuers whose securities are
not publicly traded may not be subject to the disclosure and other investor
protection requirements that may be applicable if their securities were publicly
traded. If any privately placed securities held by the Fund are required to be
registered under the securities laws of one or more jurisdictions before being
resold, the Fund may be required to bear the expenses of registration. Certain
of the Fund's investments in private placements may consist of direct
investments and may include investments in smaller, less-seasoned issuers, which
may involve greater risks. These issuers may have limited product lines, markets
or financial resources, or they may be dependent on a limited management group.
In making investments in such securities, the Fund may obtain access to material
nonpublic information which may restrict the Fund's ability to conduct portfolio
transactions in such securities.
144A Securities. The Fund may purchase restricted securities that can be
offered and sold to "qualified institutional buyers" under Rule 144A under the
Securities Act. The Board of Directors has determined to treat as liquid Rule
144A securities that are either freely tradable in their primary markets
offshore or have been
17
<PAGE>
determined to be liquid in accordance with the policies and procedures adopted
by the Fund's Board. The Board of Directors has adopted guidelines and delegated
to the Investment Adviser the daily function of determining and monitoring
liquidity of restricted securities. The Board of Directors, however, will retain
sufficient oversight and be ultimately responsible for the determinations. Since
it is not possible to predict with assurance exactly how this market for
restricted securities sold and offered under Rule 144A will continue to develop,
the Board of Directors will carefully monitor the Fund's investments in these
securities. This investment practice could have the effect of increasing the
level of illiquidity in the Fund to the extent that qualified institutional
buyers become for a time uninterested in purchasing these securities.
Investment Restrictions
The Fund has adopted the following restrictions and policies relating to
the investment of its assets and its activities, which are fundamental policies
and may not be changed without the approval of the holders of a majority of the
Fund's outstanding voting securities (which for this purpose and under the
Investment Company Act means the lesser of (i) 67% of the shares represented at
a meeting at which more than 50% of the outstanding shares are represented or
(ii) more than 50% of the outstanding shares). The Fund may not:
1. Make any investment inconsistent with the Fund's classification as a
diversified company under the Investment Company Act of 1940, as amended (the
"Investment Company Act").
2. Invest more than 25% of its assets, taken at market value, in the
securities of issuers in any particular industry (excluding the U.S.
Government and its agencies and instrumentalities).
3. Make investments for the purpose of exercising control or management.
4. Purchase or sell real estate, except that, to the extent permitted by
applicable law, the Fund may invest in securities directly or indirectly
secured by real estate or interests therein or issued by companies which
invest in real estate or interests therein.
5. Make loans to other persons, except that the acquisition of bonds,
debentures or other corporate debt securities and investment in government
obligations, commercial paper, pass-through instruments, certificates of
deposit, bankers acceptances, repurchase agreements or any similar
instruments shall not be deemed to be the making of a loan, and except
further that the Fund may lend its portfolio securities, provided that the
lending of portfolio securities may be made only in accordance with
applicable law and the guidelines set forth in the Fund's Prospectus and
Statement of Additional Information, as they may be amended from time to
time.
6. Issue senior securities to the extent such issuance would violate
applicable law.
7. Borrow money, except that (i) the Fund may borrow from banks (as
defined in the Investment Company Act) in amounts up to 33 1/3% of its total
assets (including the amount borrowed), (ii) the Fund may, to the extent
permitted by applicable law, borrow up to an additional 5% of its total
assets for temporary purposes, (iii) the Fund may obtain such short-term
credit as may be necessary for the clearance of purchases and sales of
portfolio securities and (iv) the Fund may purchase securities on margin to
the extent permitted by applicable law. The Fund may not pledge its assets
other than to secure such borrowings or, to the extent permitted by the
Fund's investment policies as set forth in its Prospectus and Statement of
Additional Information, as they may be amended from time to time, in
connection with hedging transactions, short sales, when-issued and forward
commitment transactions and similar investment strategies.
8. Underwrite securities of other issuers except insofar as the Fund
technically may be deemed an underwriter under the Securities Act of 1933, as
amended (the "Securities Act") in selling portfolio securities.
9. Purchase or sell commodities or contracts on commodities, except to
the extent that the Fund may do so in accordance with applicable law and the
Fund's Prospectus and Statement of Additional Information, as they may be
amended from time to time, and without registering as a commodity pool
operator under the Commodity Exchange Act.
Under the non-fundamental investment restrictions, the Fund may not:
a. Purchase securities of other investment companies, except to the
extent such purchases are permitted by applicable law. As a matter of policy,
however, the Fund will not purchase shares of any registered open-end
18
<PAGE>
investment company or registered unit investment trust, in reliance on
Section 12(d)(1)(F) or (G) (the "fund of funds" provisions) of the Investment
Company Act at any time the Fund's shares are owned by another investment
company that is part of the same group of investment companies as the Fund.
b. Make short sales of securities or maintain a short position, except
to the extent permitted by applicable law. The Fund currently does not intend
to engage in short sales, except short sales "against the box."
c. Invest in securities which cannot be readily resold because of legal
or contractual restrictions or which cannot otherwise be marketed, redeemed
or put to the issuer or a third party, if at the time of acquisition more
than 15% of its total assets taken at market value would be invested in such
securities. This restriction shall not apply to securities which mature
within seven days or securities which the Board of Directors of the Fund has
otherwise determined to be liquid pursuant to applicable law. Securities
purchased in accordance with Rule 144A under the Securities Act (each, a
"Rule 144A security") and determined to be liquid by the Fund's Board of
Directors are not subject to the limitations set forth in this investment
restriction.
d. Notwithstanding fundamental investment restriction (7) above, borrow
money or pledge its assets in excess of 33 1/3% of its total assets taken at
value (including the amount borrowed) and then only from banks as a temporary
measure for the purpose of meeting redemption requests, distribution
requirements under the Internal Revenue Code of 1986, as amended (the "Code")
or settlement of investment transactions, or for extraordinary or emergency
purposes; provided, however, that for purposes of this restriction,
transactions involving "cover" or for which segregated accounts have been
established as described herein under "Investment Objective and Policies --
Portfolio Strategies Involving Interest Rate Transactions, Options and
Futures" and "Investment Objective and Policies -- Other Investment Policies
and Practices" shall not be considered a borrowing. Usually only "leveraged"
investment companies may borrow in excess of 5% of their assets; however, the
Fund will not borrow to increase income but intends only to borrow to meet
redemption requests, to meet such distribution requirements, to settle
investment transactions which may otherwise require untimely dispositions of
Fund securities or for extraordinary or emergency purposes. Interest paid on
such borrowings will reduce net income.
The Board of Directors may draft guidelines and delegate to the Manager the
daily function of monitoring the liquidity of restricted securities, including
Rule 144A securities. The Board will, however, maintain sufficient oversight and
be ultimately responsible for the determinations. The Board has determined that
securities that are freely tradable in their primary market overseas should be
deemed liquid.
Because of the affiliation of Merrill Lynch, Pierce, Fenner & Smith
Incorporated ("Merrill Lynch") with the Investment Adviser, the Fund is
prohibited from engaging in certain transactions involving such firm or its
affiliates except for brokerage transactions permitted under the Investment
Company Act involving only usual and customary commissions or transactions
pursuant to an exemptive order under the Investment Company Act. See "Portfolio
Transactions and Brokerage." Without such an exemptive order, the Fund would be
prohibited from engaging in portfolio transactions with Merrill Lynch or any of
its affiliates acting as principal.
Portfolio Turnover
Generally, the Fund does not purchase securities for short-term trading
profits. The Manager will effect portfolio transactions without regard to the
time the securities have been held, if, in its judgment, such transactions are
advisable in light of a change in circumstances of a particular company or
within a particular industry or in general market, financial or economic
conditions. As a result of its investment policies, under certain market
conditions the Fund's portfolio turnover rate may be higher than that of other
investment companies; however, it is extremely difficult to predict portfolio
rates with any degree of accuracy. The portfolio turnover rate is calculated by
dividing the lesser of the Fund's annual sales or purchases of portfolio
securities (exclusive of purchases or sales of U.S. government securities and
all other securities whose maturities at the time of acquisition were one year
or less) by the monthly average value of the securities in the portfolio during
the year. A high portfolio turnover may result in negative tax consequences,
such as an increase in capital gain dividends or in ordinary income dividends of
accrued market discount. High portfolio turnover may also involve
correspondingly greater transaction costs in the form of dealer spreads and
brokerage commissions, which are borne directly by the Fund.
19
<PAGE>
MANAGEMENT OF THE FUND
Directors and Officers
The Directors of the Fund consist of seven individuals, five of whom are
not "interested persons" of the Fund as defined in the Investment Company Act
(the "non-interested Directors"). The Directors are responsible for the overall
supervision of the operations of the Fund and perform the various duties imposed
on the directors of investment companies by the Investment Company Act.
Information about the Directors, executive officers and the portfolio manager of
the Fund, including their ages and their principal occupations for at least the
last five years, is set forth below. Unless otherwise noted, the address of each
Director, executive officer and the portfolio manager is P.O. Box 9011,
Princeton, New Jersey 08543-9011.
TERRY K. GLENN (59) -- President and Director(1)(2) -- Executive Vice
President of the Manager and Fund Asset Management, L.P. ("FAM") (which terms as
used herein include their corporate predecessors) since 1983; President of
Princeton Funds Distributors, Inc. ("PFD") since 1986 and Director thereof since
1991; Executive Vice President and Director of Princeton Services, Inc.
("Princeton Services") since 1993; President of Princeton Administrators, L.P.
since 1988.
JOE GRILLS (64) -- Director(2) -- P.O. Box 98, Rapidan, Virginia 22773.
Member of the Committee of Investment of Employee Benefit Assets of the
Financial Executives Institute ("CIEBA") since 1986; Member of CIEBA's Executive
Committee since 1988 and its Chairman from 1991 to 1993; Assistant Treasurer of
International Business Machines Incorporated ("IBM") and Chief Investment
Officer of IBM Retirement Funds from 1986 until 1993; Member of the Investment
Advisory Committee of the State of New York Common Retirement Fund and the
Howard Hughes Medical Institute since 1997; Director, Duke Management Company
since 1992 and Vice Chairman since 1998; Director, LaSalle Street Fund since
1995; Director, Hotchkis and Wiley Mutual Funds since 1996; Director, Kimco
Realty Corporation since January 1997; Member of the Investment Advisory
Committee of the Virginia Retirement System since 1998; Director, Montpelier
Foundation since 1998.
WALTER MINTZ (70) -- Director(2) -- 1114 Avenue of the Americas, New York,
New York 10036. Special Limited Partner of Cumberland Associates (investment
partnership) since 1982.
ROBERT S. SALOMON, JR. (62) -- Director(2) -- 106 Dolphin Cove Quay,
Stamford, Connecticut 06902. Principal of STI Management (investment adviser)
since 1994; Trustee, Common Fund since 1980; Chairman and CEO of Salomon
Brothers Asset Management from 1992 until 1995; Chairman of Salomon Brothers
equity mutual funds from 1992 until 1995; Monthly columnist with Forbes magazine
since 1992; Director of Stock Research and U.S. Equity Strategist at Salomon
Brothers from 1975 until 1991.
MELVIN R. SEIDEN (68) -- Director(2) -- 780 Third Avenue, Suite 2502, New
York, New York 10017. Director of Silbanc Properties, Ltd. (real estate,
investment and consulting) since 1987; Chairman and President of Seiden & de
Cuevas, Inc.(private investment firm) from 1964 to 1987.
STEPHEN B. SWENSRUD (66) -- Director(2) -- 24 Federal Street, Suite 400,
Boston, Massachusetts 02110. Chairman of Fernwood Advisors (investment adviser)
since 1996; Principal, Fernwood Associates (financial consultant) since 1975.
ARTHUR ZEIKEL (67) -- Director(1)(2) -- 300 Woodland Avenue, Westfield,
New Jersey 07090. Chairman of the Manager and FAM from 1997 to 1999 and
President thereof from 1977 to 1997; Chairman of Princeton Services from 1997 to
1999, Director thereof from 1993 to 1999 and President thereof from 1993 to
1997; Executive Vice President of Merrill Lynch & Co., Inc. ("ML & Co.") from
1990 to 1999.
JOSEPH T. MONAGLE, JR. (51) -- Senior Vice President(1)(2)--Senior Vice
President of the Manager and FAM since 1990; Department Head of Global Fixed
Income Division of the Manager and FAM since 1997: Senior Vice President of
Princeton Services since 1993.
JEFFREY B. HEWSON (48) -- Senior Vice President(1)(2)--Director (Global
Fixed Income) of the Manager since 1998; Vice president of the Manager from 1989
to 1998; Portfolio Manager of the Manager since 1985.
GREGORY MARK MAUNZ (46) -- Senior Vice President(1)(2)--First Vice
President of the Manager since 1997; Vice President of the Manager from 1985 to
1997; Portfolio Manager of the Manager since 1984.
THEODORE J. MAGNANI (37) -- Vice President(1)--Vice President of the
Manager since 1992.
20
<PAGE>
DONALD C. BURKE (39) -- Vice President and Treasurer(1)(2) -- Senior Vice
President and Treasurer of the Manager and FAM since 1999; Senior Vice President
and Treasurer of Princeton Services since 1999; First Vice President of the
Investment Adviser from 1997 to 1999; Vice President of the Investment Adviser
from 1990 to 1997; Director of Taxation of the Investment Adviser since 1990;
Vice President of PFD since 1999.
IRA P. SHAPIRO (36) -- Secretary(1)(2)-- First Vice President of the
Manager since 1998; Director (Legal Advisory) of the Manager from 1997 to 1998;
Vice President of the Manager and FAM from 1996 to 1997; Attorney with the
Manager and FAM from 1993 to 1996.
- -----------
(1) Interested person, as defined in the Investment Company Act, of the Fund.
(2) Such Director or officer is a trustee, director or officer of certain
other investment companies for which the Investment Adviser or FAM acts as
the investment adviser or manager.
As of August 31, 1999, the Directors and officers of the Fund as a group
(13 persons) owned an aggregate of less than 1% of the outstanding shares of the
Fund. At such date, Mr. Zeikel, a Director of the Fund, Mr. Glenn, a Director
and officer of the Fund, and the other officers of the Fund owned an aggregate
of less than 1% of the outstanding shares of common stock of ML & Co.
Compensation of Directors
The Fund pays each non-interested Director a fee of $1,500 per year plus
$250 per Board meeting attended. The Fund also compensates each member of the
Audit and Nominating Committee (the "Committee"), which consists of the
non-interested Directors at a rate of $1,500 per year, plus $250 per Committee
meeting attended. The Fund reimburses each non-interested Director for his
out-of-pocket expenses relating to attendance at Board and Committee meetings.
The following table shows the compensation earned by the non-interested
Directors for the fiscal year ended May 31, 1999 and the aggregate compensation
paid to them from all registered investment companies advised by the Manager and
its affiliate, FAM ("MLAM/FAM-advised funds"), for the calendar year ended
December 31, 1998.
<TABLE>
<CAPTION>
Aggregate
Pension or Estimated Compensation from
Retirement Benefits Annual Fund and Other
Position with Compensation Accrued as Part of Benefits upon MLAM/FAM-
Name Fund From Fund Fund Expense Retirement Advised Funds(1)
- ----- ----------- ------------ ----------------- ----------- ----------------
<S> <C> <C> <C> <C> <C>
Joe Grills Director $5,000 None None $198,333
Walter Mintz Director $5,000 None None $178,583
Robert S. Salomon, Jr. Director $5,000 None None $178,583
Melvin R. Seiden Director $5,000 None None $178,583
Stephen B. Swensrud Director $5,000 None None $195,583
</TABLE>
- -----------
(1) The directors serve on the boards of MLAM/FAM-advised funds as follows: Joe
Grills (24 registered investment companies consisting of 56 portfolios),
Walter Mintz (22 registered investment companies consisting of 43
portfolios), Robert S. Salomon, Jr. (22 registered investment companies
consisting of 43 portfolios), Melvin R. Seiden (22 registered investment
companies consisting of 43 portfolios), Stephen B. Swensrud (25 registered
investment companies consisting of 58 portfolios).
Directors of the Fund may purchase Class A shares of the Fund at net asset
value. See "Purchase of Shares--Initial Sales Charge Alternatives -- Class A and
Class D Shares -- Reduced Initial Sales Charges -- Purchase Privilege of Certain
Persons."
Management And Advisory Arrangements
Investment Advisory Services. The Manager provides the Fund with investment
advisory and management services. Subject to the supervision of the Directors,
the Manager is responsible for the actual management of the Fund's portfolio and
constantly reviews the Fund's holdings in light of its own research analysis and
that from other relevant sources. The responsibility for making decisions to
buy, sell or hold a particular security rests with the Manager. The Manager
performs certain of the other administrative services and provides all the
office space, facilities, equipment and necessary personnel for management of
the Fund.
Investment Advisory Fee. The Fund has entered into a management agreement
with the Manager (the "Management Agreement"), pursuant to which the Manager
receives for its services to the Fund monthly
21
<PAGE>
compensation at the annual rate of 0.50% of the average daily net assets of the
Fund. The table below sets forth information about the total management fees
paid by the Fund to the Manager for the periods indicated.
Investment Advisory
Fiscal Year Ended May 31, Fee
------------------------ ----
1999 ............................................. $503,198
1998 ............................................. $593,905
1997 ............................................. $689,185
Payment of Fund Expenses. The Management Agreement obligates the Manager to
provide investment advisory services and to pay all compensation of and furnish
office space for officers and employees of the Fund connected with investment
and economic research, trading and investment management of the Fund, as well as
the fees of all Directors of the Fund who are affiliated persons of the Manager.
The Fund pays all other expenses incurred in the operation of the Fund,
including among other things: taxes, expenses for legal and auditing services,
costs of printing proxies, stock certificates, shareholder reports, prospectuses
and statements of additional information, except to the extent paid by Merrill
Lynch Funds Distributor, a division of PFD (the "Distributor"); charges of the
custodian and sub-custodian, and the transfer agent; expenses of redemption of
shares; SEC fees; expenses of registering the shares under Federal, state or
foreign laws; fees and expenses of non-interested Directors; accounting and
pricing costs (including the daily calculations of net asset value); insurance;
interest; brokerage costs; litigation and other extraordinary or non-recurring
expenses; and other expenses properly payable by the Fund. Accounting services
are provided for the Fund by the Manager and the Fund reimburses the Manager for
its costs in connection with such services on a semi-annual basis. The
Distributor will pay certain promotional expenses of the Fund incurred in
connection with the offering of shares of the Fund. Certain expenses will be
financed by the Fund pursuant to distribution plans in compliance with Rule
12b-1 under the Investment Company Act. See "Purchase of Shares -- Distribution
Plans."
Organization of the Manager. The Manager is a limited partnership, the
partners of which are ML & Co., a financial services holding company and the
parent of Merrill Lynch, and Princeton Services. ML & Co. and Princeton Services
are "controlling persons" of the Manager as defined under the Investment Company
Act because of their ownership of its voting securities or their power to
exercise a controlling influence over its management or policies.
Duration and Termination. Unless earlier terminated as described herein,
the Management Agreement will continue in effect for a period of two years from
the date of execution and will remain in effect from year to year if approved
annually (a) by the Directors of the Fund or by a majority of the outstanding
shares of the Fund and (b) by a majority of the Directors who are not parties to
such contract or interested persons (as defined in the Investment Company Act)
of any such party. Such contracts are not assignable and may be terminated
without penalty on 60 days' written notice at the option of either party or by
vote of the shareholders of the Fund.
Transfer Agency Services. Financial Data Services, Inc. (the "Transfer
Agent"), a subsidiary of ML & Co., acts as the Fund's Transfer Agent pursuant to
a Transfer Agency, Dividend Disbursing Agency and Shareholder Servicing Agency
Agreement (the "Transfer Agency Agreement"). Pursuant to the Transfer Agency
Agreement, the Transfer Agent is responsible for the issuance, transfer and
redemption of shares and the opening and maintenance of shareholder accounts.
Pursuant to the Transfer Agency Agreement, the Transfer Agent receives a fee of
$11.00 per Class A or Class D account and $14.00 per Class B or Class C account
and is entitled to reimbursement for certain transaction charges and
out-of-pocket expenses incurred by the Transfer Agent under the Transfer Agency
Agreement. Additionally, a $.20 monthly closed account charge will be assessed
on all accounts which close during the calendar year. Application of this fee
will commence the month following the month the account is closed. At the end of
the calendar year, no further fees will be due. For purposes of the Transfer
Agency Agreement, the term "account" includes a shareholder account maintained
directly by the Transfer Agent and any other account representing the beneficial
interest of a person in the relevant share class on a recordkeeping system,
provided the recordkeeping system is maintained by a subsidiary of ML & Co.
Distribution Expenses. The Fund has entered into four separate distribution
agreements with the Distributor in connection with the continuous offering of
each class of shares of the Fund (the "Distribution Agreements"). The
Distribution Agreements obligate the Distributor to pay certain expenses in
connection with the offering of each class of shares of the Fund. After the
prospectuses, statements of additional information and periodic reports
22
<PAGE>
have been prepared, set in type and mailed to shareholders, the Distributor pays
for the printing and distribution of copies thereof used in connection with the
offering to dealers and investors. The Distributor also pays for other
supplementary sales literature and advertising costs. The Distribution
Agreements are subject to the same renewal requirements and termination
provisions as the Management Agreement described above.
Code of Ethics
The Board of Directors of the Fund has adopted a Code of Ethics under Rule
17j-1 of the Investment Company Act that incorporates the Code of Ethics of the
Manager (together, the "Codes"). The Codes significantly restrict the personal
investing activities of all employees of the Manager and, as described below,
impose additional, more onerous, restrictions on fund investment personnel.
The Codes require that all employees of the Manager pre-clear any personal
securities investment (with limited exceptions, such as government securities).
The pre-clearance requirement and associated procedures are designed to identify
any substantive prohibition or limitation applicable to the proposed investment.
The substantive restrictions applicable to all employees of the Manager include
a ban on acquiring any securities in a "hot" initial public offering and a
prohibition from profiting on short-term trading in securities. In addition, no
employee may purchase or sell any security that at the time is being purchased
or sold (as the case may be), or to the knowledge of the employee is being
considered for purchase or sale, by any fund advised by the Manager.
Furthermore, the Codes provide for trading "blackout periods" which prohibit
trading by investment personnel of the Fund within periods of trading by the
Fund in the same (or equivalent) security (15 or 30 days depending upon the
transaction).
PURCHASE OF SHARES
Reference is made to "How to Buy, Sell, Transfer and Exchange Shares" in
the Prospectus.
The Fund offers four classes of shares under the Merrill Lynch Select
Pricing(SM) System: shares of Class A and Class D are sold to investors choosing
the initial sales charge alternatives and shares of Class B and Class C are sold
to investors choosing the deferred sales charge alternatives. Each Class A,
Class B, Class C or Class D share of the Fund represents an identical interest
in the investment portfolio of the Fund and has the same rights, except that
Class B, Class C and Class D shares bear the expenses of the ongoing account
maintenance fees (also known as service fees) and Class B and Class C shares
bear the expenses of the ongoing distribution fees and the additional
incremental transfer agency costs resulting from the deferred sales charge
arrangements. The contingent deferred sales charges ("CDSCs"), distribution fees
and account maintenance fees that are imposed on Class B and Class C shares, as
well as the account maintenance fees that are imposed on Class D shares, are
imposed directly against those classes and not against all assets of the Fund
and, accordingly, such charges do not affect the net asset value of any other
class or have any impact on investors choosing another sales charge option.
Dividends paid by the Fund for each class of shares are calculated in the same
manner at the same time and differ only to the extent that account maintenance
and distribution fees and any incremental transfer agency costs relating to a
particular class are borne exclusively by that class. Each class has different
exchange privileges. See "Shareholder Services -- Exchange Privilege."
Investors should understand that the purpose and function of the initial
sales charges with respect to the Class A and Class D shares are the same as
those of the CDSCs and distribution fees with respect to the Class B and Class C
shares in that the sales charges and distribution fees applicable to each class
provide for the financing of the distribution of the shares of the Fund. The
distribution-related revenues paid with respect to a class will not be used to
finance the distribution expenditures of another class. Sales personnel may
receive different compensation for selling different classes of shares.
The Merrill Lynch Select Pricing(SM) System is used by more than 50
registered investment companies advised by the Mangaer or FAM. Funds advised by
the Manager or FAM that utilize the Merrill Lynch Select Pricing(SM) System are
referred to herein as "Select Pricing Funds."
The Fund or the Distributor may suspend the continuous offering of the
Fund's shares of any class at any time in response to conditions in the
securities markets or otherwise and may thereafter resume such offering from
time to time. Any order may be rejected by the Fund or the Distributor. Neither
the Distributor nor the
23
<PAGE>
dealers are permitted to withhold placing orders to benefit themselves by a
price change. Merrill Lynch may charge its customers a processing fee (presently
$5.35) to confirm a sale of shares to such customers. Purchases made directly
through the Transfer Agent are not subject to the processing fee.
Initial Sales Charge Alternatives -- Class A and Class D Shares
Investors who prefer an initial sales charge alternative may elect to
purchase Class D shares or, if an eligible investor, Class A shares. Investors
choosing the initial sales charge alternative who are eligible to purchase Class
A shares should purchase Class A shares rather than Class D shares because there
is an account maintenance fee imposed on Class D shares. Investors qualifying
for significantly reduced initial sales charges may find the initial sales
charge alternative particularly attractive because similar sales charge
reductions are not available with respect to the deferred sales charges imposed
in connection with purchases of Class B or Class C shares. Investors not
qualifying for reduced initial sales charges who expect to maintain their
investment for an extended period of time also may elect to purchase Class A or
Class D shares, because over time the accumulated ongoing account maintenance
and distribution fees on Class B or Class C shares may exceed the initial sales
charges and, in the case of Class D shares, the account maintenance fee.
Although some investors who previously purchased Class A shares may no longer be
eligible to purchase Class A shares of other Select Pricing Funds, those
previously purchased Class A shares, together with Class B, Class C and Class D
share holdings, will count toward a right of accumulation which may qualify the
investor for a reduced initial sales charge on new initial sales charge
purchases. In addition, the ongoing Class B and Class C account maintenance and
distribution fees will cause Class B and Class C shares to have higher expense
ratios, pay lower dividends and have lower total returns than the initial sales
charge shares. The ongoing Class D account maintenance fees will cause Class D
shares to have a higher expense ratio, pay lower dividends and have a lower
total return than Class A shares.
The term "purchase," as used in the Prospectus and this Statement of
Additional Information in connection with an investment in Class A and Class D
shares of the Fund, refers to a single purchase by an individual or to
concurrent purchases, which in the aggregate are at least equal to the
prescribed amounts, by an individual, his or her spouse and their children under
the age of 21 years purchasing shares for his, her or their own account and to
single purchases by a trustee or other fiduciary purchasing shares for a single
trust estate or single fiduciary account although more than one beneficiary is
involved. The term "purchase" also includes purchases by any "company," as that
term is defined in the Investment Company Act, but does not include purchases by
any such company that has not been in existence for at least six months or which
has no purpose other than the purchase of shares of the Fund or shares of other
registered investment companies at a discount; provided, however, that it shall
not include purchases by any group of individuals whose sole organizational
nexus is that the participants therein are credit cardholders of a company,
policyholders of an insurance company, customers of either a bank or
broker-dealer or clients of an investment adviser.
Eligible Class A Investors
Class A shares are offered to a limited group of investors and also will be
issued upon reinvestment of dividends on outstanding Class A shares. Investors
who currently own Class A shares in a shareholder account are entitled to
purchase additional Class A shares of the Fund in that account. Certain
employee-sponsored retirement or savings plans, including eligible 401(k) plans,
may purchase Class A shares at net asset value provided such plans meet the
required minimum number of eligible employees or required amount of assets
advised by MLAM or any of its affiliates. Class A shares are available at net
asset value to corporate warranty insurance reserve fund programs and U.S.
branches of foreign banking institutions provided that the program has $3
million or more initially invested in Select Pricing Funds. Also eligible to
purchase Class A shares at net asset value are participants in certain
investment programs including TMA(SM) Managed Trusts to which Merrill Lynch
Trust Company provides discretionary trustee services, collective investment
trusts for which Merrill Lynch Trust Company serves as trustee and certain
purchases made in connection with certain fee-based programs. In addition, Class
A shares are offered at net asset value to ML & Co. and its subsidiaries and
their directors and employees and to members of the Boards of MLAM-advised
investment companies. Certain persons who acquired shares of certain
MLAM-advised closed-end funds in their initial offerings who wish to reinvest
the net proceeds from a sale of their closed-end fund shares of common stock in
shares of the Fund also may purchase Class A shares of the Fund if certain
conditions are met. In addition, Class A shares of the Fund and certain other
Select Pricing Funds are offered at net asset value to shareholders of Merrill
Lynch Senior Floating Rate Fund, Inc. and, if certain conditions are met, to
shareholders of Merrill Lynch Municipal Strategy Fund, Inc. and Merrill Lynch
High Income Municipal Bond Fund, Inc. who wish to reinvest the net proceeds from
a sale of certain of
24
<PAGE>
their shares of common stock pursuant to a tender offer conducted by such funds
in shares of the Fund and certain other Select Pricing Funds.
Class A and Class D Sales Charge Information
<TABLE>
<CAPTION>
Class A Shares
---------------------------------------------------------------------------------------------
For the Fiscal Year Gross Sales Sales Charges Sales Charges CDSCs Received on
Ended Charges Retained By Paid To Redemption of
May 31, Collected Distributor Merrill Lynch Load-Waived Shares
- ------------------- ---------- ------------ ------------- -------------------
<S> <C> <C> <C> <C>
1999 $453 $0 $453 $0
1998 $ 0 $0 $ 0 $0
1997 $ 0 $0 $ 0 $0
<CAPTION>
Class D Shares
- ---------------------------------------------------------------------------------------------
For the Fiscal Year Gross Sales Sales Charges Sales Charges CDSCs Received on
Ended Charges Retained by Paid to Redemption of
May 31, Collected Distributor Merrill Lynch Load-Waived Shares
- ------------------- ---------- ------------ ------------ ------------------
<S> <C> <C> <C> <C>
1999 $11,029 $ 797 $10,232 $0
1998 $14,227 $1,219 $13,008 $0
1997 $11,286 $ 934 $10,352 $0
</TABLE>
The Distributor may reallow discounts to selected dealers and retain the
balance over such discounts. At times the Distributor may reallow the entire
sales charge to such dealers. Since securities dealers selling Class A and Class
D shares of the Fund will receive a concession equal to most of the sales
charge, they may be deemed to be underwriters under the Securities Act.
Reduced Initial Sales Charges
Reductions in or exemptions from the imposition of a sales load are due to
the nature of the investors and/or the reduced sales efforts that will be needed
in obtaining such investments.
Reinvested Dividends. No initial sales charges are imposed upon Class A and
Class D shares issued as a result of the automatic reinvestment of dividends.
Right of Accumulation. Reduced sales charges are applicable through a right
of accumulation under which eligible investors are permitted to purchase shares
of the Fund subject to an initial sales charge at the offering price applicable
to the total of (a) the public offering price of the shares then being purchased
plus (b) an amount equal to the then current net asset value or cost, whichever
is higher, of the purchaser's combined holdings of all classes of shares of the
Fund and of any other Select Pricing Funds. For any such right of accumulation
to be made available, the Distributor must be provided at the time of purchase,
by the purchaser or the purchaser's securities dealer, with sufficient
information to permit confirmation of qualification. Acceptance of the purchase
order is subject to such confirmation. The right of accumulation may be amended
or terminated at any time. Shares held in the name of a nominee or custodian
under pension, profit-sharing or other employee benefit plans may not be
combined with other shares to qualify for the right of accumulation.
Letter of Intent. Reduced sales charges are applicable to purchases
aggregating $25,000 or more of the Class A or Class D shares of the Fund or any
Select Pricing Funds made within a 13-month period starting with the first
purchase pursuant to a Letter of Intent. The Letter of Intent is available only
to investors whose accounts are established and maintained at the Fund's
Transfer Agent. The Letter of Intent is not available to employee benefit plans
for which Merrill Lynch provides plan participant recordkeeping services. The
Letter of Intent is not a binding obligation to purchase any amount of Class A
or Class D shares; however, its execution will result in the purchaser paying a
lower sales charge at the appropriate quantity purchase level. A purchase not
originally made pursuant to a Letter of Intent may be included under a
subsequent Letter of Intent executed within 90 days of such purchase if the
Distributor is informed in writing of this intent within such 90-day period. The
value of Class A and Class D shares of the Fund and of other Select Pricing
Funds presently held, at cost or maximum offering price (whichever is higher),
on the date of the first purchase under the Letter of Intent, may be included as
a credit toward the completion of such Letter, but the reduced sales charge
applicable to the amount covered by such Letter will be applied only to new
purchases. If the total amount of shares does not equal the amount stated in the
Letter of Intent (minimum of $25,000), the investor will be notified and must
pay, within 20 days
25
<PAGE>
of the expiration of such Letter, the difference between the sales charge on the
Class A or Class D shares purchased at the reduced rate and the sales charge
applicable to the shares actually purchased through the Letter. Class A or Class
D shares equal to at least 5.0% of the intended amount will be held in escrow
during the 13-month period (while remaining registered in the name of the
purchaser) for this purpose. The first purchase under the Letter of Intent must
be at least 5.0% of the dollar amount of such Letter. If a purchase during the
term of such Letter would otherwise be subject to a further reduced sales charge
based on the right of accumulation, the purchaser will be entitled on that
purchase and subsequent purchases to the further reduced percentage sales charge
that would be applicable to a single purchase equal to the total dollar value of
the Class A or Class D shares then being purchased under such Letter, but there
will be no retroactive reduction of the sales charge on any previous purchase.
The value of any shares redeemed or otherwise disposed of by the purchaser
prior to termination or completion of the Letter of Intent will be deducted from
the total purchases made under such Letter. An exchange from the Summit Cash
Reserves Fund into the Fund that creates a sales charge will count toward
completing a new or existing Letter of Intent from the Fund.
TMA(SM) Managed Trusts. Class A shares are offered at net asset value to
TMA(SM) Managed Trusts to which Merrill Lynch Trust Company provides
discretionary trustee services.
Employee Access(SM) Accounts. Provided applicable threshold requirements
are met, either Class A or Class D shares are offered at net asset value to
Employee Access(SM) Accounts available through authorized employers. The initial
minimum investment for such accounts is $500, except that the initial minimum
investment for shares purchased for such accounts pursuant to the Automatic
Investment Program is $50.
Employer-Sponsored Retirement or Savings Plans and Certain Other
Arrangements. Certain employer-sponsored retirement or savings plans and certain
other arrangements may purchase Class A or Class D shares at net asset value,
based on the number of employees or number of employees eligible to participate
in the plan, the aggregate amount invested by the plan in specified investments
and/or the services provided by Merrill Lynch to the plan. Additional
information regarding purchases by employer-sponsored retirement or savings
plans and certain other arrangements is available toll-free fromMerrill Lynch
Business Financial Services at (800) 237-7777.
Purchase Privilege of Certain Persons. Directors of the Fund, members of
the Boards of other MLAM/FAM-advised investment companies, ML & Co. and its
subsidiaries (the term "subsidiaries," when used herein with respect to ML &
Co., includes MLAM, FAM and certain other entities directly or indirectly wholly
owned and controlled by ML & Co.) and their directors and employees, and any
trust, pension, profit-sharing or other benefit plan for such persons, may
purchase Class A shares of the Fund at net asset value. The Fund realizes
economies of scale and reduction of sales-related expenses by virtue of the
familiarity of these persons with the Fund. Employees and directors or trustees
wishing to purchase shares of the Fund must satisfy the Fund's suitability
standards.
Class D shares of the Fund are offered at net asset value, without a sales
charge, to an investor that has a business relationship with a Financial
Consultant who joined Merrill Lynch from another investment firm within six
months prior to the date of purchase by such investor, if the following
conditions are satisfied: first, the investor must advise Merrill Lynch that it
will purchase Class D shares of the Fund with proceeds from a redemption of
shares of a mutual fund that was sponsored by the Financial Consultant's
previous firm and was subject to a sales charge either at the time of purchase
or on a deferred basis; and, second, the investor must establish that such
redemption had been made within 60 days prior to the investment in the Fund and
the proceeds from the redemption had been maintained in the interim in cash or a
money market fund.
Class D shares of the Fund are also offered at net asset value, without a
sales charge, to an investor that has a business relationship with a Merrill
Lynch Financial Consultant and that has invested in a mutual fund sponsored by a
non-Merrill Lynch company for which Merrill Lynch has served as a selected
dealer and where Merrill Lynch has either received or given notice that such
arrangement will be terminated ("notice") if the following conditions are
satisfied: first, the investor must purchase Class D shares of the Fund with
proceeds from a redemption of shares of such other mutual fund and the shares of
such other fund were subject to a sales charge either at the time of purchase or
on a deferred basis; and, second, such purchase of Class D shares must be made
within 90 days after such notice.
Class D shares of the Fund are offered at net asset value, without a sales
charge, to an investor that has a business relationship with a Merrill Lynch
Financial Consultant and that has invested in a mutual fund for which
26
<PAGE>
Merrill Lynch has not served as a selected dealer if the following conditions
are satisfied: first, the investor must advise Merrill Lynch that it will
purchase Class D shares of the Fund with proceeds from the redemption of shares
of such other mutual fund and that such shares have been outstanding for a
period of no less than six months; and, second, such purchase of Class D shares
must be made within 60 days after the redemption and the proceeds from the
redemption must be maintained in the interim in cash or a money market fund.
Closed-End Fund Investment Option. Class A shares of the Fund and certain
other Select Pricing Funds ("Eligible Class A Shares") are offered at net asset
value to shareholders of certain closed-end funds advised by FAM or MLAM who
purchased such closed-end fund shares prior to October 21, 1994 (the date the
Merrill Lynch Select Pricing(SM) System commenced operations) and wish to
reinvest the net proceeds from a sale of their closed-end fund shares of common
stock in Eligible Class A Shares, if the conditions set forth below are
satisfied. Alternatively, closed-end fund shareholders who purchased such shares
on or after October 21, 1994 and wish to reinvest the net proceeds from a sale
of their closed-end fund shares are offered Class A shares (if eligible to buy
Class A shares) or Class D shares of the Fund and other Select Pricing Funds
("Eligible Class D Shares"), if the following conditions are met. First, the
sale of closed-end fund shares must be made through Merrill Lynch, and the net
proceeds therefrom must be immediately reinvested in Eligible Class A or
Eligible Class D Shares. Second, the closed-end fund shares must either have
been acquired in the initial public offering or be shares representing dividends
from shares of common stock acquired in such offering. Third, the closed-end
fund shares must have been continuously maintained in a Merrill Lynch securities
account. Fourth, there must be a minimum purchase of $250 to be eligible for the
investment option.
Shareholders of certain MLAM-advised continuously offered closed-end funds
may reinvest at net asset value the net proceeds from a sale of certain shares
of common stock of such funds in shares of the Fund. Upon exercise of this
investment option, shareholders of Merrill Lynch Senior Floating Rate Fund, Inc.
will receive Class A shares of the Fund and shareholders of Merrill Lynch
Municipal Strategy Fund, Inc. and Merrill Lynch High Income Municipal Bond Fund,
Inc. will receive Class D shares of the Fund, except that shareholders already
owning Class A shares of the Fund will be eligible to purchase additional Class
A shares pursuant to this option, if such additional Class A shares will be held
in the same account as the existing Class A shares and the other requirements
pertaining to the reinvestment privilege are met. In order to exercise this
investment option, a shareholder of one of the above-referenced continuously
offered closed-end funds (an "eligible fund") must sell his or her shares of
common stock of the eligible fund (the "eligible shares") back to the eligible
fund in connection with a tender offer conducted by the eligible fund and
reinvest the proceeds immediately in the designated class of shares of the Fund.
This investment option is available only with respect to eligible shares as to
which no Early Withdrawal Charge or CDSC (each as defined in the eligible fund's
prospectus) is applicable. Purchase orders from eligible fund shareholders
wishing to exercise this investment option will be accepted only on the day that
the related tender offer terminates and will be effected at the net asset value
of the designated class of the Fund on such day.
Acquisition of Certain Investment Companies. Class D shares may be offered
at net asset value in connection with the acquisition of the assets of or merger
or consolidation with a personal holding company or a public or private
investment company.
Deferred Sales Charge Alternatives -- Class B and Class C Shares
Investors choosing the deferred sales charge alternatives should consider
Class B shares if they intend to hold their shares for an extended period of
time and Class C shares if they are uncertain as to the length of time they
intend to hold their assets in Select Pricing Funds.
Because no initial sales charges are deducted at the time of the purchase,
Class B and Class C shares provide the benefit of putting all of the investor's
dollars to work from the time the investment is made. The deferred sales charge
alternatives may be particularly appealing to investors that do not qualify for
the reduction in initial sales charges. Both Class B and Class C shares are
subject to ongoing account maintenance fees and distribution fees; however, the
ongoing account maintenance and distribution fees potentially may be offset to
the extent any return is realized on the additional funds initially invested in
Class B or Class C shares. In addition, Class B shares will be converted into
Class D shares of the Fund after a conversion period of approximately ten years,
and thereafter investors will be subject to lower ongoing fees.
27
<PAGE>
The public offering price of Class B and Class C shares for investors
choosing the deferred sales charge alternatives is the next determined net asset
value per share without the imposition of a sales charge at the time of
purchase. See "Pricing of Shares -- Determination of Net Asset Value" below.
Contingent Deferred Sales Charges -- Class B Shares
Class B shares that are redeemed within four years of purchase may be
subject to a CDSC at the rates set forth below charged as a percentage of the
dollar amount subject thereto. In determining whether a CDSC is applicable to a
redemption, the calculation will be determined in the manner that results in the
lowest applicable rate being charged. The charge will be assessed on an amount
equal to the lesser of the proceeds of redemption or the cost of the shares
being redeemed. Accordingly, no CDSC will be imposed on increases in net asset
value above the initial purchase price. In addition, no CDSC will be assessed on
shares derived from reinvestment of dividends. It will be assumed that the
redemption is first of shares held for over four years or shares acquired
pursuant to reinvestment of dividends and then of shares held longest during the
four-year period. A transfer of shares from a shareholder's account to another
account will be assumed to be made in the same order as a redemption.
The following table sets forth the Class B CDSC:
CDSC as a Percentage
of Dollar Amount
Year Since Purchase Payment Made Subject to Charge
------------------------------- ----------------
0-1 .......................................... 4.0%
1-2 .......................................... 3.0%
2-3 .......................................... 2.0%
3-4 .......................................... 1.0%
4 and thereafter ............................. None
To provide an example, assume an investor purchased 100 shares at $10 per
share (at a cost of $1,000) and in the third year after purchase, the net asset
value per share is $12 and, during such time, the investor has acquired 10
additional shares upon dividend reinvestment. If at such time the investor makes
his or her first redemption of 50 shares (proceeds of $600), 10 shares will not
be subject to a CDSC because of dividend reinvestment. With respect to the
remaining 40 shares, the charge is applied only to the original cost of $10 per
share and not to the increase in net asset value of $2 per share. Therefore,
$400 of the $600 redemption proceeds will be charged at a rate of 2.0% (the
applicable rate in the third year after purchase).
The Class B CDSC may be waived on redemptions of shares in connection with
certain post-retirement withdrawals from an Individual Retirement Account
("IRA") or other retirement plan or following the death or disability (as
defined in the Internal Revenue Code of 1986, as amended) of a shareholder
(including one who owns the Class B shares as joint tenant with his or her
spouse), provided the redemption is requested within one year of the death or
initial determination of disability or, if later, reasonably promptly following
completion of probate. The Class B CDSC also may be waived on redemptions of
shares by certain eligible 401(a) and 401(k) plans. The CDSC may also be waived
for any Class B shares that are purchased by eligible 401(k) or eligible 401(a)
plans that are rolled over into a Merrill Lynch or Merrill Lynch Trust Company
custodied IRA and held in such account at the time of redemption. The Class B
CDSC may be waived for any Class B shares that were acquired and held at the
time of the redemption in an Employee Access(SM) Account available through
employers providing eligible 401(k) plans. The Class B CDSC may also be waived
for any Class B shares that are purchased by a Merrill Lynch rollover IRA that
was funded by a rollover from a terminated 401(k) plan managed by the MLAM
Private Portfolio Group and held in such account at the time of redemption. The
Class B CDSC may also be waived or its terms may be modified in connection with
certain fee-based programs. The Class B CDSC may also be waived in connection
with involuntary termination of an account in which Fund shares are held or for
withdrawals through the Merrill Lynch Systematic Withdrawal Plan. See
"Shareholder Services -- Fee Based Programs" and "-- Systematic Withdrawal
Plan."
Employer-Sponsored Retirement or Savings Plans and Certain Other
Arrangements. Certain employer-sponsored retirement or savings plans and certain
other arrangements may purchase Class B shares with a waiver of the CDSC upon
redemption, based on the number of employees or number of employees eligible to
participate in the plan, the aggregate amount invested by the plan in specified
investments and/or the services provided by Merrill Lynch to the plan. Such
Class B shares will convert into Class D shares approximately ten years after
the plan purchases the first share of any Select Pricing Fund. Minimum purchase
requirements may be waived or
28
<PAGE>
varied for such plans. Additional information regarding purchases by
employer-sponsored retirement or savings plans and certain other arrangements is
available toll-free from Merrill Lynch Business Financial Services at (800)
237-7777.
Conversion of Class B Shares to Class D Shares. After approximately ten
years (the "Conversion Period"), Class B shares will be converted automatically
into Class D shares of the Fund. Class D shares are subject to an ongoing
account maintenance fee of 0.25% of the average daily net assets but are not
subject to the distribution fee that is borne by Class B shares. Automatic
conversion of Class B shares into Class D shares will occur at least once each
month (on the "Conversion Date") on the basis of the relative net asset value of
the shares of the two classes on the Conversion Date, without the imposition of
any sales load, fee or other charge. Conversion of Class B shares to Class D
shares will not be deemed a purchase or sale of the shares for Federal income
tax purposes.
In addition, shares purchased through reinvestment of dividends on Class B
shares also will convert automatically to Class D shares. The Conversion Date
for dividend reinvestment shares will be calculated taking into account the
length of time the shares underlying such dividend reinvestment shares were
outstanding. If at the Conversion Date the conversion of Class B shares to Class
D shares of the Fund in a single account will result in less than $50 worth of
Class B shares being left in the account, all of the Class B shares of the Fund
held in the account on the Conversion Date will be converted to Class D shares
of the Fund.
In general, Class B shares of equity Select Pricing Funds will convert
approximately eight years after initial purchase and Class B shares of taxable
and tax-exempt fixed income Select Pricing Funds will convert approximately ten
years after initial purchase. If, during the Conversion Period, a shareholder
exchanges Class B shares with an eight-year Conversion Period for Class B shares
with a ten-year Conversion Period, or vice versa, the Conversion Period
applicable to the Class B shares acquired in the exchange will apply and the
holding period for the shares exchanged will be tacked on to the holding period
for the shares acquired. The Conversion Period also may be modified for
investors that participate in certain fee-based programs. See "Shareholder
Services -- Fee-Based Programs."
Class B shareholders of the Fund exercising the exchange privilege
described under "Shareholder Services -- Exchange Privilege" will continue to be
subject to the Fund's CDSC schedule if such schedule is higher than the CDSC
schedule relating to the Class B shares acquired as a result of the exchange.
Share certificates for Class B shares of the Fund to be converted must be
delivered to the Transfer Agent at least one week prior to the Conversion Date
applicable to those shares. In the event such certificates are not received by
the Transfer Agent at least one week prior to the Conversion Date, the related
Class B shares will convert to Class D shares on the next scheduled Conversion
Date after such certificates are delivered.
Contingent Deferred Sales Charges -- Class C Shares
Class C shares that are redeemed within one year of purchase may be subject
to a 1.0% CDSC charged as a percentage of the dollar amount subject thereto. In
determining whether a Class C CDSC is applicable to a redemption, the
calculation will be determined in the manner that results in the lowest possible
rate being charged. The charge will be assessed on an amount equal to the lesser
of the proceeds of redemption or the cost of the shares being redeemed.
Accordingly, no Class C CDSC will be imposed on increases in net asset value
above the initial purchase price. In addition, no Class C CDSC will be assessed
on shares derived from reinvestment of dividends. It will be assumed that the
redemption is first of shares held for over one year or shares acquired pursuant
to reinvestment of dividends and then of shares held longest during the one-year
period. A transfer of shares from a shareholder's account to another account
will be assumed to be made in the same order as a redemption. The Class C CDSC
may be waived in connection with involuntary termination of an account in which
Fund shares are held and withdrawals through the Merrill Lynch Systematic
Withdrawal Plans. See "Shareholder Services -- Systematic Withdrawal Plan." The
Class C CDSC of the Fund and certain other MLAM-advised mutual funds may be
waived with respect to Class C shares purchased by an investor with the net
proceeds of a tender offer made by certain MLAM-advised closed end funds,
including Merrill Lynch Senior Floating Rate Fund II, Inc. Such waiver is
subject to the requirement that the tendered shares shall have been held by the
investor for a minimum of one year and to such other conditions as are set forth
in the prospectus for the related closed end fund.
29
<PAGE>
Class B and Class C Sales Charge Information
Class B Shares*
----------------------------------------------------------------
For the Fiscal Year CDSCs Received CDSCs Paid to
Ended May 31, by Distributor Merrill Lynch
------------------- -------------- --------------
1999 $122,352 all
1998 $111,551 all
1997 $ 66,930 all
- ----------
* Additional Class B CDSCs payable to the Distributor may have been waived or
converted to a contingent obligation in connection with a shareholder's
participation in certain fee-based programs.
Class C Shares
----------------------------------------------------------------
For the Fiscal Year CDSCs Received CDSCs Paid to
Ended May 31, by Distributor Merrill Lynch
------------------ --------------- --------------
1999 $ 2,898 all
1998 $ 7,199 all
1997 $22,912 all
Merrill Lynch compensates its Financial Consultants for selling Class B and
Class C shares at the time of purchase from its own funds. Proceeds from the
CDSC and the distribution fee are paid to the Distributor and are used in whole
or in part by the Distributor to defray the expenses of dealers (including
Merrill Lynch) related to providing distribution-related services to the Fund in
connection with the sale of the Class B and Class C shares, such as the payment
of compensation to financial consultants for selling Class B and Class C shares
from the dealer's own funds. The combination of the CDSC and the ongoing
distribution fee facilitates the ability of the Fund to sell the Class B and
Class C shares without a sales charge being deducted at the time of purchase.
See "Distribution Plans" below. Imposition of the CDSC and the distribution fee
on Class B and Class C shares is limited by the NASD asset-based sales charge
rule. See "Limitations on the Payment of Deferred Sales Charges" below.
Distribution Plans
Reference is made to "Fees and Expenses" in the Prospectus for certain
information with respect to the separate distribution plans for Class B, Class C
and Class D shares pursuant to Rule 12b-1 under the Investment Company Act (each
a "Distribution Plan") with respect to the account maintenance and/or
distribution fees paid by the Fund to the Distributor with respect to such
classes.
The Distribution Plans for Class B, Class C and Class D shares each
provides that the Fund pay the Distributor an account maintenance fee relating
to the shares of the relevant class, accrued daily and paid monthly, at the
annual rate of 0.25% of the average daily net assets of the Fund attributable to
shares of the relevant class in order to compensate the Distributor and Merrill
Lynch (pursuant to a sub-agreement) in connection with account maintenance
activities with respect to Class B, Class C and Class D shares. Each of those
classes has exclusive voting rights with respect to the Distribution Plan
adopted with respect to such class pursuant to which account maintenance and/or
distribution fees are paid (except that Class B shareholders may vote upon any
material changes to expenses charged under the Class D Distribution Plan).
The Distribution Plans for Class B and Class C shares each provides that
the Fund also pay the Distributor a distribution fee relating to the shares of
the relevant class, accrued daily and paid monthly, at the annual rates of 0.50%
for Class B shares and 0.55% for Class C shares of the average daily net assets
of the Fund attributable to the shares of the relevant class in order to
compensate the Distributor and Merrill Lynch (pursuant to a sub-agreement) for
providing shareholder and distribution services and bearing certain
distribution-related expenses of the Fund, including payments to financial
consultants for selling Class B and Class C shares of the Fund. The Distribution
Plans relating to Class B and Class C shares are designed to permit an investor
to purchase Class B and Class C shares through dealers without the assessment of
an initial sales charge and at the same time permit the dealer to compensate its
financial consultants in connection with the sale of the Class B and Class C
shares.
The Fund's Distribution Plans are subject to the provisions of Rule 12b-1
under the Investment Company Act. In their consideration of each Distribution
Plan, the Directors must consider all factors they deem relevant, including
information as to the benefits of the Distribution Plan to the Fund and each
related class of shareholders. Each Distribution Plan further provides that, so
long as the Distribution Plan remains in effect, the
30
<PAGE>
selection and nomination of non-interested Directors shall be committed to the
discretion of the non-interested Directors then in office. In approving each
Distribution Plan in accordance with Rule 12b-1, the non-interested Directors
concluded that there is reasonable likelihood that each Distribution Plan will
benefit the Fund and its related class of shareholders. Each Distribution Plan
can be terminated at any time, without penalty, by the vote of a majority of the
non-interested Directors or by the vote of the holders of a majority of the
outstanding related class of voting securities of the Fund. A Distribution Plan
cannot be amended to increase materially the amount to be spent by the Fund
without the approval of the related class of shareholders and all material
amendments are required to be approved by the vote of Directors, including a
majority of the non-interested Directors who have no direct or indirect
financial interest in the Distribution Plan, cast in person at a meeting called
for that purpose. Rule 12b-1 further requires that the Fund preserve copies of
the Distribution Plan and any report made pursuant to such plan for a period of
not less than six years from the date of the Distribution Plan or such report,
the first two years in an easily accessible place.
Among other things, each Distribution Plan provides that the Distributor
shall provide and the Directors shall review quarterly reports of the
disbursement of the account maintenance and/or distribution fees paid to the
Distributor. Payments under the Distribution Plans are based on a percentage of
average daily net assets attributable to the shares regardless of the amount of
expenses incurred and, accordingly, distribution-related revenues from the
Distribution Plans may be more or less than distribution-related expenses.
Information with respect to the distribution-related revenues and expenses is
presented to the Directors for their consideration in connection with their
deliberations as to the continuance of the Class B and Class C Distribution
Plans annually, as of December 31 of each year, on a "fully allocated accrual"
basis and quarterly on a "direct expense and revenue/cash" basis. On the fully
allocated accrual basis, revenues consist of the account maintenance fees,
distribution fees, the CDSCs and certain other related revenues, and expenses
consist of financial consultant compensation, branch office and regional
operation center selling and transaction processing expenses, advertising, sales
promotion and marketing expenses, corporate overhead and interest expense. On
the direct expense and revenue/cash basis, revenues consist of the account
maintenance fees, distribution fees and CDSCs and the expenses consist of
financial consultant compensation.
As of December 31, 1998, the fully allocated accrual expenses of the
Distributor and Merrill Lynch for the period since the commencement of
operations of Class B shares exceeded the fully allocated accrual revenues by
approximately $297,000 (.38% of Class B net assets at that date). As of May 31,
1999, direct cash revenues for the period since the commencement of operations
of Class B shares exceeded direct cash expenses by $16,348,830 (.22% of Class B
net assets at that date). As of December 31, 1998, the fully allocated accrual
expenses of the Distributor and Merrill Lynch for the period since the
commencement of operations of Class C shares exceeded the fully allocated
accrual revenues by approximately $22,000 (.48% of Class C net assets at that
date). As of May 31, 1999, direct cash revenues for the period since the
commencement of operations of Class C shares exceeded direct cash expenses by
$110,427 (1.77% of Class C net assets at that date).
For the fiscal year ended May 31, 1999, the Fund paid the Distributor
$588,651 pursuant to the Class B Distribution Plan (based on average daily net
assets subject to such Class B Distribution Plan of approximately $78.5
million), all of which was paid to Merrill Lynch for providing account
maintenance and distribution-related activities and services in connection with
Class B shares. For the fiscal year ended May 31, 1999, the Fund paid the
Distributor $39,923 pursuant to the Class C Distribution Plan (based on average
daily net assets subject to such Class C Distribution Plan of approximately $5.0
million), all of which was paid to Merrill Lynch for providing account
maintenance and distribution-related activities and services in connection with
Class C shares. For the fiscal year ended May 31, 1999, the Fund paid the
Distributor $40,345 pursuant to the Class D Distribution Plan (based on average
daily net assets subject to such Class D Distribution Plan of approximately
$16.1 million), all of which was paid to Merrill Lynch for providing account
maintenance activities in connection with Class D shares.
Limitations on the Payment of Deferred Sales Charges
The maximum sales charge rule in the Conduct Rules of the NASD imposes a
limitation on certain asset-based sales charges such as the distribution fee and
the CDSC borne by the Class B and Class C shares but not the account maintenance
fee. The maximum sales charge rule is applied separately
31
<PAGE>
to each class. As applicable to the Fund, the maximum sales charge rule limits
the aggregate of distribution fee payments and CDSCs payable by the Fund to (1)
6.25% of eligible gross sales of Class B shares and Class C shares, computed
separately (defined to exclude shares issued pursuant to dividend reinvestments
and exchanges), plus (2) interest on the unpaid balance for the respective
class, computed separately, at the prime rate plus 1% (the unpaid balance being
the maximum amount payable minus amounts received from the payment of the
distribution fee and the CDSC). In connection with the Class B shares, the
Distributor has voluntarily agreed to waive interest charges on the unpaid
balance in excess of 0.50% of eligible gross sales. Consequently, the maximum
amount payable to the Distributor (referred to as the "voluntary maximum") in
connection with the Class B shares is 6.75% of eligible gross sales. The
Distributor retains the right to stop waiving the interest charges at any time.
To the extent payments would exceed the voluntary maximum, the Fund will not
make further payments of the distribution fee with respect to Class B shares and
any CDSCs will be paid to the Fund rather than to the Distributor; however, the
Fund will continue to make payments of the account maintenance fee. In certain
circumstances the amount payable pursuant to the voluntary maximum may exceed
the amount payable under the NASD formula. In such circumstances payment in
excess of the amount payable under the NASD formula will not be made.
The following table sets forth comparative information as of May 31, 1999
with respect to the Class B and Class C shares of the Fund indicating the
maximum allowable payments that can be made under the NASD maximum sales charge
rule and, with respect to the Class B shares, the Distributor's voluntary
maximum.
<TABLE>
<CAPTION>
Data Calculated as of May 31, 1999
----------------------------------------------------------------------------------------
(in thousands)
Annual
Distribution
Allowable Amounts Fee at
Eligible Allowable Interest on Maximum Previously Aggregate Current Net
Gross Aggregate Unpaid Amount Paid to Unpaid Asset
Sales(1) Sales Charges(2) Balance(3) Payable Distributor(4) Balance Level(5)
------- ----------------- --------- ------- ------------ --------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Class B Shares for the
period August 2, 1991
(commencement of
operations) to May
31, 1999
Under NASD Rule as
Adopted ........................ $1,030,989 $62,795 $ 42,502 $105,297 $21,443 $ 83,854 $364
Under Distributor's
Voluntary Waiver ............... $1,030,989 $64,437 $ 5,155 $ 69,592 $21,443 $ 48,149 $364
Class C Shares, for
the period
October 21, 1994
(commencement of
operations) to
May 31, 1999
Under NASD Rule as Adopted ........ $ 13,941 $ 871 $ 221 $ 1,092 $ 124 $ 968 $ 34
</TABLE>
- ------------
(1)Purchase price of all eligible Class B or Class C shares sold during the
periods indicated other than shares acquired through dividend reinvestment
and the exchange privilege.
(2)Includes amounts attributable to exchanges from Summit Cash Reserves Fund
("Summit") which are not reflected in Eligible Gross Sales. Shares of Summit
can only be purchased by exchange from another fund (the "redeemed fund").
Upon such an exchange, the maximum allowable sales charge payment to the
redeemed fund is reduced in accordance with the amount of the redemption.
This amount is then added to the maximum allowable sales charge payment with
respect to Summit. Upon an exchange out of Summit, the remaining balance of
this amount is deducted from the maximum allowable sales charge payment to
Summit and added to the maximum allowable sales charge payment to the fund
into which the exchange is made.
(3)Interest is computed on a monthly basis based upon the prime rate, as
reported in The Wall Street Journal, plus 1.0%, as permitted under the NASD
Rule.
(4)Consists of CDSC payments, distribution fee payments and accruals. See "What
are the Fund's fees and expenses?" in the Prospectus. This figure may include
CDSCs that were deferred when a shareholder redeemed shares prior to the
expiration of the applicable CDSC period and invested the proceeds, without
the imposition of a sales charge, in Class A shares in conjunction with the
shareholder's participation in the Merrill Lynch Mutual Fund Advisor (Merrill
Lynch MFASM) Program (the "MFA Program"). The CDSC is booked as a contingent
obligation that may be payable if the shareholder terminates participation in
the MFA Program.
(5)Provided to illustrate the extent to which the current level of distribution
fee payments (not including any CDSC payments) is amortizing the unpaid
balance. No assurance can be given that payments of the distribution fee will
reach either the voluntary maximum (with respect to Class B shares) or the
NASD maximum (with respect to Class B and Class C shares).
REDEMPTION OF SHARES
Reference is made to "How to Buy, Sell, Transfer and Exchange Shares" in
the Prospectus.
The Fund is required to redeem for cash all shares of the Fund upon receipt
of a written request in proper form. The redemption price is the net asset value
per share next determined after the initial receipt of proper notice of
redemption. Except for any CDSC that may be applicable, there will be no charge
for redemption if the redemption request is sent directly to the Transfer Agent.
Shareholders liquidating their holdings will receive upon redemption all
dividends reinvested through the date of redemption.
32
<PAGE>
The right to redeem shares or to receive payment with respect to any such
redemption may be suspended for more than seven days only for any period during
which trading on the New York Stock Exchange (the "NYSE") is restricted as
determined by the Commission or the NYSE is closed (other than customary weekend
and holiday closings), for any period during which an emergency exists as
defined by the Commission as a result of which disposal of portfolio securities
or determination of the net asset value of the Fund is not reasonably
practicable, and for such other periods as the Commission may by order permit
for the protection of shareholders of the Fund.
The value of shares at the time of redemption may be more or less than the
shareholder's cost, depending in part on the market value of the securities held
by the Fund at such time.
Redemption
A shareholder wishing to redeem shares held with the Transfer Agent may do
so without charge by tendering the shares directly to the Transfer Agent at
Financial Data Services, Inc., P.O. Box 45289, Jacksonville, Florida 32232-5289.
Redemption requests delivered other than by mail should be delivered to
Financial Data Services, Inc., 4800 Deer Lake Drive East, Jacksonville, Florida
32246-6484. Proper notice of redemption in the case of shares deposited with the
Transfer Agent may be accomplished by a written letter requesting redemption.
Proper notice of redemption in the case of shares for which certificates have
been issued may be accomplished by a written letter as noted above accompanied
by certificates for the shares to be redeemed. Redemption requests should not be
sent to the Fund. The redemption request in either event requires the
signature(s) of all persons in whose name(s) the shares are registered, signed
exactly as such name(s) appear(s) on the Transfer Agent's register. The
signature on the redemption request may require a guarantee by an "eligible
guarantor institution" as defined in Rule 17Ad-15 under the Securities Exchange
Act of 1934, as amended (the"Exchange Act"), the existence and validity of which
may be verified by the Transfer Agent through the use of industry publications.
In the event a signature guarantee is required, notarized signatures are not
sufficient. In general, signature guarantees are waived on redemptions of less
than $50,000 as long as the following requirements are met: (i) all requests
require the signature(s) of all persons in whose name(s) shares are recorded on
the Transfer Agent's register; (ii) all checks must be mailed to the stencil
address of record on the Transfer Agent's register and (iii) the stencil address
must not have changed within 30 days. Certain rules may apply regarding certain
account types such as but not limited to UGMA/UTMA accounts, Joint Tenancies
With Rights of Survivorship, contra broker transactions, and institutional
accounts. In certain instances, the Transfer Agent may require additional
documents such as, but not limited to, trust instruments, death certificates,
appointments as executor or administrator, or certificates of corporate
authority. For shareholders redeeming directly with the Transfer Agent, payments
will be mailed within seven days of receipt of a proper notice of redemption.
At various times the Fund may be requested to redeem shares for which it
has not yet received good payment (e.g., cash, Federal funds or certified check
drawn on a United States bank). The Fund may delay or cause to be delayed the
mailing of a redemption check until such time as it has assured itself that good
payment (e.g., cash, Federal funds or certified check drawn on a United States
bank) has been collected for the purchase of such Fund shares, which will not
usually exceed 10 days.
Repurchase
The Fund also will repurchase Fund shares through a shareholder's listed
securities dealer. The Fund normally will accept orders to repurchase Fund
shares by wire or telephone from dealers for their customers at the net asset
value next computed after the order is placed. Shares will be priced at the net
asset value calculated on the day the request is received, provided that the
request for repurchase is submitted to the dealer prior to the regular close of
business on the NYSE (generally, the NYSE closes at 4:00 p.m., Eastern time) and
such request is received by the Fund from such dealer not later than 30 minutes
after the close of business on the NYSE on the same day. Dealers have the
responsibility of submitting such repurchase requests to the Fund not later than
30 minutes after the close of business on the NYSE, in order to obtain that
day's closing price.
The foregoing repurchase arrangements are for the convenience of
shareholders and do not involve a charge by the Fund (other than any applicable
CDSC). Securities firms that do not have selected dealer agreements with the
Distributor, however, may impose a transaction charge on the shareholder for
transmitting the notice of repurchase to the Fund. Merrill Lynch may charge its
customers a processing fee (presently $5.35) to confirm a repurchase of shares
to such customers. Repurchases made directly through the Transfer Agent on
accounts held at the Transfer Agent are not subject to the processing fee. The
Fund reserves the right to reject any order for
33
<PAGE>
repurchase, which right of rejection might adversely affect shareholders seeking
redemption through the repurchase procedure. However, a shareholder whose order
for repurchase is rejected by the Fund may redeem Fund shares as set forth
above.
Reinstatement Privilege -- Class A and Class D Shares
Shareholders who have redeemed their Class A or Class D shares of the Fund
have a privilege to reinstate their accounts by purchasing Class A or Class D
shares, as the case may be, of the Fund at net asset value without a sales
charge up to the dollar amount redeemed. The reinstatement privilege may be
exercised by sending a notice of exercise along with a check for the amount to
be reinstated to the Transfer Agent within 30 days after the date the request
for redemption was accepted by the Transfer Agent or the Distributor.
Alternatively, the reinstatement privilege may be exercised through the
investor's Merrill Lynch Financial Consultant within 30 days after the date the
request for redemption was accepted by the Transfer Agent or the Distributor.
The reinstatement will be made at the net asset value per share next determined
after the notice of reinstatement is received and cannot exceed the amount of
the redemption proceeds.
PRICING OF SHARES
Determination of Net Asset Value
Reference is made to "How Shares are Priced" in the Prospectus.
The net asset value of the shares of all classes of the Fund is determined
once daily Monday through Friday after the close of business on the NYSE on each
day the NYSE is open for trading. The NYSE generally closes at 4:00 p.m.,
Eastern time. Any assets or liabilities initially expressed in terms of non-U.S.
dollar currencies are translated into U.S. dollars at the prevailing market
rates as quoted by one or more banks or dealers on the day of valuation. The
NYSE is not open for trading on New Year's Day, Martin Luther King, Jr. Day,
Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day,
Thanksgiving Day and Christmas Day.
Net asset value is computed by dividing the value of the securities held by
the Fund plus any cash or other assets (including interest and dividends accrued
but not yet received) minus all liabilities (including accrued expenses) by the
total number of shares outstanding at such time, rounded to the nearest cent.
Expenses, including the fees payable to the Manager and Distributor are accrued
daily.
The per share net asset value of Class B, Class C and Class D shares
generally will be lower than the per share net asset value of Class A shares,
reflecting the daily expense accruals of the account maintenance, distribution
and higher transfer agency fees applicable with respect to Class B and Class C
shares, and the daily expense accruals of the account maintenance fees
applicable with respect to the Class D shares; moreover, the per share net asset
value of the Class B and Class C shares generally will be lower than the per
share net asset value of Class D shares reflecting the daily expense accruals of
the distribution fees and higher transfer agency fees applicable with respect to
Class B and Class C shares of the Fund. It is expected, however, that the per
share net asset value of the four classes will tend to converge (although not
necessarily meet) immediately after the payment of dividends, which will differ
by approximately the amount of the expense accrual differentials between the
classes.
Portfolio securities that are traded on stock exchanges are valued at the
last sale price (regular way) on the exchange on which such securities are
traded as of the close of business on the day the securities are being valued
or, lacking any sales, at the last available bid price for long positions, and
at the last available ask price for short positions. In cases where securities
are traded on more than one exchange, the securities are valued on the exchange
designated by or under the authority of the Directors as the primary market.
Long positions in securities traded in the OTC market are valued at the last
available bid price in the OTC market prior to the time of valuation. Short
positions in securities traded in the OTC market are valued at the last
available ask price in the OTC market prior to the time of valuation. Portfolio
securities that are traded both in the OTC market and on a stock exchange are
valued according to the broadest and most representative market. When the Fund
writes an option, the amount of the premium received is recorded on the books of
the Fund as an asset and an equivalent liability. The amount of the liability is
subsequently valued to reflect the current market value of the option written,
based upon the last sale price in the case of exchange-traded options or, in the
case of options traded in the OTC market, the last asked price. Options
purchased by the Fund are valued at their last sale price in the case of
exchange-traded options or, in the case
34
<PAGE>
of options traded in the OTC market, the last bid price. Other investments,
including financial futures contracts and related options, are stated at market
value. Securities and assets for which market quotations are not readily
available are stated at fair value as determined in good faith by or under the
direction of the Directors of the Fund. Where there is no market quotation on
securities or options fair, fair market value will be determined in good faith
by or under the direction of the Directors of the Fund. Such valuations and
procedures will be reviewed periodically by the Directors.
Generally, trading in mortgage-backed or other securities issued or
guaranteed by United States Government agencies or instrumentalities is
substantially completed each day at various times prior to the close of business
on the NYSE. The values of such securities used in computing the net asset value
of the Fund's shares are determined as of such times. Foreign currency exchange
rates are also generally determined prior to the close of business on the NYSE.
Occasionally, events affecting the values of such securities and such exchange
rates may occur between the times at which they are determined and the close of
business on the NYSE that may not be reflected in the computation of the Fund's
net asset value. If events materially affecting the value of such securities
occur during such period, then these securities will be valued at their fair
value as determined in good faith by the Directors.
Computation of Offering Price Per Share
An illustration of the computation of the offering price for Class A, Class
B, Class C and Class D shares of the Fund based on the value of the Fund's net
assets and number of shares outstanding on May 31, 1999 is set forth below.
<TABLE>
<CAPTION>
Class A Class B Class C Class D
---------- ------------- ------------- ------------
<S> <C> <C> <C> <C>
Net Assets .................................... $947,440 $72,875,392 $6,255,526 $9,407,654
========== ============= ============= ============
Number of Shares Outstanding .................. 99,487 7,677,912 658,894 991,544
========== ============= ============= ============
Net Asset Value Per Share (net assets
divided by number of shares
outstanding) ................................ $ 9.52 $ 9.49 $ 9.49 $ 9.49
Sales Charge (for Class A and Class D
shares: 4.00% of offering price; 4.17%
of net asset value per share)* .............. .40 ** ** .40
========== ============= ============= ============
Offering Price ................................ $ 9.92 $ 9.49 $ 9.49 $ 9.89
========== ============= ============= ============
</TABLE>
- ----------
* Rounded to the nearest one-hundredth percent; assumes maximum sales charge is
applicable.
** Class B and Class C shares are not subject to an initial sales charge but may
be subject to a CDSC on redemption of shares. See "Purchase of Shares
--Deferred Sales Charges Alternatives -- Class B and Class C Shares" herein.
PORTFOLIO TRANSACTIONS
Subject to policies established by the Board of Directors of the Fund, the
Manager is primarily responsible for the execution of the Fund's portfolio
transactions and the allocation of brokerage. The Fund has no obligation to deal
with any broker or group of brokers in the execution of transactions in
portfolio securities and does not use any particular broker or dealer. In
executing transactions with brokers and dealers, the Manager seeks to obtain the
best net results for the Fund, taking into account such factors as price
(including the applicable brokerage commission or dealer spread), size of order,
difficulty of execution and operational facilities of the firm and the firm's
risk in positioning a block of securities. While the Manager generally seeks
reasonably competitive commission rates, the Fund does not necessarily pay the
lowest spread or commission available. In addition, consistent with the Conduct
Rules of the NASD and policies established by the Board of Directors of the
Fund, the Manager may consider sales of shares of the Fund as a factor in the
selection of brokers or dealers to execute portfolio transactions for the Fund;
however, whether or not a particular broker or dealer sells shares of the Fund
neither qualifies nor disqualifies such broker or dealer to execute transactions
for the Fund.
Subject to obtaining the best price and execution, brokers who provide
supplemental investment research services to the Manager may receive orders for
transactions by the Fund. Such supplemental research services ordinarily consist
of assessments and analysis of the business or prospects of a company, industry
or economic sector. Information so received will be in addition to and not in
lieu of the services required to be performed by
35
<PAGE>
the Manager under the Management Agreement, and the expenses of the Manager will
not necessarily be reduced as a result of the receipt of such supplemental
information. If in the judgment of the Manager the Fund will benefit from
supplemental research services, the Manager is authorized to pay brokerage
commissions to a broker furnishing such services that are in excess of
commissions that another broker may have charged for effecting the same
transaction. Certain supplemental research services may primarily benefit one or
more other investment companies or other accounts for which the Manager
exercises investment discretion. Conversely, the Fund may be the primary
beneficiary of the supplemental research services received as a result of
portfolio transactions effected for such other accounts or investment companies.
For the fiscal years ended May 31, 1997, 1998 and 1999, the Fund paid no
brokerage commissions.
The Fund invests primarily in certain securities traded in the OTC market
and intends to deal directly with the dealers who make a market in securities
involved, except in those circumstances in which better prices and execution are
available elsewhere. Under the Investment Company Act, persons affiliated with
the Fund and persons who are affiliated with such affiliated persons are
prohibited from dealing with the Fund as principal in the purchase and sale of
securities unless a permissive order allowing such transactions is obtained from
the Commission. Since transactions in the OTC market usually involve
transactions with the dealers acting as principal for their own accounts, the
Fund will not deal with affiliated persons, including Merrill Lynch and its
affiliates, in connection with such transactions. However, an affiliated person
of the Fund may serve as its broker in OTC transactions conducted on an agency
basis provided that, among other things, the fee or commission received by such
affiliated broker is reasonable and fair compared to the fee or commission
received by non-affiliated brokers in connection with comparable transactions.
In addition, the Fund may not purchase securities during the existence of any
underwriting syndicate for such securities of which Merrill Lynch is a member or
in a private placement in which Merrill Lynch serves as placement agent except
pursuant to procedures approved by the Board of Directors of the Fund that
either comply with rules adopted by the Commission or with interpretations of
the Commission staff. See "Investment Objective and Policies -- Investment
Restrictions."
Section 11(a) of the Exchange Act generally prohibits members of the United
States national securities exchanges from executing exchange transactions for
their affiliates and institutional accounts that they manage unless the member
(i) has obtained prior express authorization from the account to effect such
transactions, (ii) at least annually furnishes the account with the aggregate
compensation received by the member in effecting such transactions, and (iii)
complies with any rules the Commission has prescribed with respect to the
requirements of clauses (i) and (ii). To the extent Section 11(a) would apply to
Merrill Lynch acting as a broker for the Fund in any of its portfolio
transactions executed on any such securities exchange of which it is a member,
appropriate consents have been obtained from the Fund and annual statements as
to aggregate compensation will be provided to the Fund.
The Board of Directors of the Fund has considered the possibility of
seeking to recapture for the benefit of the Fund brokerage commissions and other
expenses of possible portfolio transactions by conducting portfolio transactions
through affiliated entities. For example, brokerage commissions received by
affiliated brokers could be offset against the advisory fee paid by the Fund to
the Manager. After considering all factors deemed relevant, the Board of
Directors made a determination not to seek such recapture. The Board will
reconsider this matter from time to time.
Because of different objectives or other factors, a particular security may
be bought for one or more clients of the Manager or an affiliate when one or
more clients of the Manager or an affiliate are selling the same security. If
purchases or sales of securities arise for consideration at or about the same
time that would involve the Fund or other clients or funds for which the Manager
or an affiliate acts as manager transactions in such securities will be made,
insofar as feasible, for the respective funds and clients in a manner deemed
equitable to all. To the extent that transactions on behalf of more than one
client of the Manager or an affiliate during the same period may increase the
demand for securities being purchased or the supply of securities being sold,
there may be an adverse effect on price.
SHAREHOLDER SERVICES
The Fund offers a number of shareholder services and investment plans
described below that are designed to facilitate investment in shares of the
Fund. Full details as to each of such services, copies of the various plans
36
<PAGE>
and instructions as to how to participate in the various services or plans, or
how to change options with respect thereto, can be obtained from the Fund, by
calling the telephone number on the cover page hereof, or from the Distributor
or Merrill Lynch. Certain of these services are available only to U.S. investors
and certain of these services are not available to investors who place orders
through the Merrill Lynch Blueprint(SM) Program.
Investment Account
Shareholders may transfer their Fund shares from Merrill Lynch to another
securities dealer that has entered into a selected dealer agreement with Merrill
Lynch. Certain shareholder services may not be available for the transferred
shares. After the transfer, the shareholder may purchase additional shares of
funds owned before the transfer and all future trading of these assets must be
coordinated by the new firm. If a shareholder wishes to transfer his or her
shares to a securities dealer that has not entered into a selected dealer
agreement with Merrill Lynch, the shareholder must either (i) redeem his or her
shares, paying any applicable CDSC or (ii) continue to maintain an Investment
Account at the Transfer Agent for those shares. The shareholder may also request
the new securities dealer to maintain the shares in an account at the Transfer
Agent registered in the name of the securities dealer for the benefit of the
shareholder whether the securities dealer has entered into a selected dealer
agreement with Merrill Lynch or not.
Shareholders considering transferring a tax-deferred retirement account,
such as an individual retirement account, from Merrill Lynch to another
securities dealer should be aware that, if the firm to which the retirement
account is to be transferred will not take delivery of shares of the Fund, a
shareholder must either redeem the shares, paying any applicable CDSC, so that
the cash proceeds can be transferred to the account at the new firm, or such
shareholder must continue to maintain a retirement account at Merrill Lynch for
those shares.
Exchange Privilege
U.S. shareholders of each class of shares of the Fund have an exchange
privilege with certain other Select Pricing Funds and Summit Cash Reserves Fund
("Summit"), a series of Financial Institutions Series Trust, which is a Merrill
Lynch-sponsored money market fund specifically designated for exchange by
holders of Class A, Class B, Class C and Class D shares of Select Pricing Funds.
Shares with a net asset value of at least $100 are required to qualify for the
exchange privilege and any shares utilized in an exchange must have been held by
the shareholder for at least 15 days. Before effecting an exchange, shareholders
should obtain a currently effective prospectus of the fund into which the
exchange is to be made. Exercise of the exchange privilege is treated as a sale
of the exchanged shares and a purchase of the acquired shares for Federal income
tax purposes.
Exchanges of Class A and Class D Shares. Class A shareholders may exchange
Class A shares of the Fund for Class A shares of a second Select Pricing Fund if
the shareholder holds any Class A shares of the second fund in the account in
which the exchange is made at the time of the exchange or is otherwise eligible
to purchase Class A shares of the second fund. If the Class A shareholder wants
to exchange Class A shares for shares of a second Select Pricing Fund, but does
not hold Class A shares of the second fund in his or her account at the time of
the exchange and is not otherwise eligible to acquire Class A shares of the
second fund, the shareholder will receive Class D shares of the second fund as a
result of the exchange. Class D shares also may be exchanged for Class A shares
of a second Select Pricing Fund at any time as long as, at the time of the
exchange, the shareholder holds Class A shares of the second fund in the account
in which the exchange is made or is otherwise eligible to purchase Class A
shares of the second fund. Class D shares are exchangeable with shares of the
same class of other Select Pricing Funds.
Exchanges of Class A or Class D shares outstanding ("outstanding Class A or
Class D shares") for Class A or Class D shares of other Select Pricing Funds or
for Class A shares of Summit, ("new Class A or Class D shares") are transacted
on the basis of relative net asset value per Class A or Class D share,
respectively, plus an amount equal to the difference, if any, between the sales
charge previously paid on the outstanding Class A or Class D shares and the
sales charge payable at the time of the exchange on the new Class A or Class D
shares. With respect to outstanding Class A or Class D shares as to which
previous exchanges have taken place, the "sales charge previously paid" shall
include the aggregate of the sales charges paid with respect to such Class A or
Class D shares in the initial purchase and any subsequent exchange. Class A or
Class D shares issued pursuant to dividend reinvestment are sold on a no-load
basis in each of the funds offering Class A or Class D shares. For purposes of
the exchange privilege, Class A or Class D shares acquired through dividend
reinvestment shall be
37
<PAGE>
deemed to have been sold with a sales charge equal to the sales charge
previously paid on the Class A or Class D shares on which the dividend was paid.
Based on this formula, Class A and Class D shares generally may be exchanged
into the Class A or Class D shares, respectively, of the other funds with a
reduced sales charge or without a sales charge.
Exchanges of Class B and Class C Shares. Certain Select Pricing Funds with
Class B or Class C shares outstanding ("outstanding Class B or Class C shares")
offer to exchange their Class B or Class C shares for Class B or Class C shares,
respectively, of certain other Select Pricing Funds or for Class B shares of
Summit ("new Class B or Class C shares") on the basis of relative net asset
value per Class B or Class C share, without the payment of any CDSC that might
otherwise be due on redemption of the outstanding shares. Class B shareholders
of the Fund exercising the exchange privilege will continue to be subject to the
Fund's CDSC schedule if such schedule is higher than the CDSC schedule relating
to the new Class B shares acquired through use of the exchange privilege. In
addition, Class B shares of the Fund acquired through use of the exchange
privilege will be subject to the Fund's CDSC schedule if such schedule is higher
than the CDSC schedule relating to the Class B shares of the fund from which the
exchange has been made. For purposes of computing the CDSC that may be payable
on a disposition of the new Class B or Class C shares, the holding period for
the outstanding Class B or Class C shares is "tacked" to the holding period of
the new Class B or Class C shares. For example, an investor may exchange Class B
shares of the Fund for those of Merrill Lynch Special Value Fund, Inc. ("Special
Value Fund") after having held the Fund's Class B shares for two and a half
years. The 2% CDSC that generally would apply to a redemption would not apply to
the exchange. Three years later the investor may decide to redeem the Class B
shares of Special Value Fund and receive cash. There will be no CDSC due on this
redemption, since by "tacking" the two and a half year holding period of Fund
Class B shares to the three-year holding period for the Special Value Fund Class
B shares, the investor will be deemed to have held the Special Value Fund Class
B shares for more than five years.
Exchanges for Shares of a Money Market Fund. Class A and Class D shares are
exchangeable for Class A shares of Summit and Class B and Class C shares are
exchangeable for Class B shares of Summit. Class A shares of Summit have an
exchange privilege back into Class A or Class D shares of Select Pricing Funds;
Class B shares of Summit have an exchange privilege back into Class B or Class C
shares of Select Pricing Funds and, in the event of such an exchange, the period
of time that Class B shares of Summit are held will count toward satisfaction of
the holding period requirement for purposes of reducing any CDSC and toward
satisfaction of any Conversion Period with respect to Class B shares. Class B
shares of Summit will be subject to a distribution fee at an annual rate of
0.75% of average daily net assets of such Class B shares. This exchange
privilege does not apply with respect to certain Merrill Lynch fee-based
programs for which alternative exchange arrangements may exist. Please see your
Merrill Lynch Financial Consultant for further information.
Prior to October 12, 1998, exchanges from the Fund and other Select Pricing
Funds into a money market fund were directed to certain Merrill Lynch-sponsored
money market funds other than Summit. Shareholders who exchanged Select Pricing
Fund shares for shares of such other money market funds and subsequently wish to
exchange those money market fund shares for shares of the Fund will be subject
to the CDSC schedule applicable to such Fund shares, if any. The holding period
for the money market fund shares will not count toward satisfaction of the
holding period requirement for reduction of the CDSC imposed on such shares, if
any, and, with respect to Class B shares, toward satisfaction of the Conversion
Period.
Exchanges by Participants in the MFA Program. The exchange privilege is
modified with respect to certain retirement plans which participate in the MFA
Program. Such retirement plans may exchange Class B, Class C or Class D shares
that have been held for at least one year for Class A shares of the same fund on
the basis of relative net asset values in connection with the commencement of
participation in the MFA Program, i.e., no CDSC will apply. The one year holding
period does not apply to shares acquired through reinvestment of dividends. Upon
termination of participation in the MFA Program, Class A shares will be
re-exchanged for the class of shares originally held. For purposes of computing
any CDSC that may be payable upon redemption of Class B or Class C shares so
reacquired, or the Conversion Period for Class B shares so reacquired, the
holding period for the Class A shares will be "tacked" to the holding period for
the Class B or Class C shares originally held. The Fund's exchange privilege is
also modified with respect to purchases of Class A and Class D shares by
non-retirement plan investors under the MFA Program. First, the initial
allocation of assets is made under the MFA Program. Then, any subsequent
exchange under the MFA Program of Class A or Class D shares of a Select
38
<PAGE>
Pricing Fund for Class A or Class D shares of the Fund will be made solely on
the basis of the relative net asset values of the shares being exchanged.
Therefore, there will not be a charge for any difference between the sales
charge previously paid on the shares of the other Select Pricing Fund and the
sales charge payable on the shares of the Fund being acquired in the exchange
under the MFA Program.
Exercise of the Exchange Privilege. To exercise the exchange privilege, a
shareholder should contact his or her Merrill Lynch Financial Consultant, who
will advise the Fund of the exchange. Shareholders of the Fund, and shareholders
of the other Select Pricing Funds with shares for which certificates have not
been issued, may exercise the exchange privilege by wire through their
securities dealers. The Fund reserves the right to require a properly completed
Exchange Application. This exchange privilege may be modified or terminated in
accordance with the rules of the Commission. The Fund reserves the right to
limit the number of times an investor may exercise the exchange privilege.
Certain funds may suspend the continuous offering of their shares to the general
public at any time and may thereafter resume such offering from time to time.
The exchange privilege is available only to U.S. shareholders in states where
the exchange legally may be made. It is contemplated that the exchange privilege
may be applicable to other new mutual funds whose shares may be distributed by
the Distributor.
Fee-Based Programs
Certain Merrill Lynch fee-based programs, including pricing alternatives
for securities transactions (each referred to in this paragraph as a "Program"),
may permit the purchase of Class A shares at net asset value. Under specified
circumstances, participants in certain Programs may deposit other classes of
shares which will be exchanged for Class A shares. Initial or deferred sales
charges otherwise due in connection with such exchanges may be waived or
modified, as may the Conversion Period applicable to the deposited shares.
Termination of participation in a Program may result in the redemption of shares
held therein or the automatic exchange thereof to another class at net asset
value, which may be shares of a money market fund. In addition, upon termination
of participation in a Program, shares that have been held for less than
specified periods within such Program may be subject to a fee based upon the
current value of such shares. These Programs also generally prohibit such shares
from being transferred to another account at Merrill Lynch, to another
broker-dealer or to the Transfer Agent. Except in limited circumstances (which
may also involve an exchange as described above), such shares must be redeemed
and another class of shares purchased (which may involve the imposition of
initial or deferred sales charges and distribution and account maintenance fees)
in order for the investment not to be subject to Program fees. Additional
information regarding a specific Program (including charges and limitations on
transferability applicable to shares that may be held in such Program) is
available in such Program's client agreement and from the Transfer Agent at
1-800-MER-FUND (1-(800)-637-3863).
Retirement and Education Savings Plans
Individual retirement accounts and other retirement and education savings
plans are available from Merrill Lynch. Under these plans, investments may be
made in the Fund and certain of the other mutual funds sponsored by Merrill
Lynch as well as in other securities. Merrill Lynch may charge an initial
establishment fee and an annual fee for each account. Information with respect
to these plans is available on request from Merrill Lynch.
Capital gains and ordinary income received in each of the plans referred to
above are exempt from Federal taxation until distributed from the plans.
Different tax rules apply to RothIRA plans and education savings plans.
Investors considering participation in any retirement or education savings plan
should review specific tax laws relating thereto and should consult their
attorneys or tax advisers with respect to the establishment and maintenance of
any such plan.
Automatic Investment Plans
A shareholder may make additions to an Investment Account at any time by
purchasing Class A shares (if he or she is an eligible Class A investor) or
Class B, Class C or Class D shares at the applicable public offering price.
These purchases may be made either through the shareholder's securities dealer,
or by mail directly to the Transfer Agent, acting as agent for such securities
dealer. Voluntary accumulation also can be made through a service known as the
Fund's Automatic Investment Plan. The Fund would be authorized, on a regular
basis, to provide systematic additions to the Investment Account of such
shareholder through charges of $50 or more to the regular bank account of the
shareholder by either pre-authorized checks or automated clearing house debits.
39
<PAGE>
Alternatively, an investor that maintains a CMA(R) or CBA(R) account may arrange
to have periodic investments made in the Fund in amounts of $100 ($1 for
retirement accounts) or more through the CMA(R) or CBA(R) Automated Investment
Program.
Automatic Dividend Reinvestment Plan
Unless specific instructions are given as to the method of payment,
dividends will be automatically reinvested, without sales charge, in additional
full and fractional shares of the Fund. Such reinvestment will be at the net
asset value of shares of the Fund as of the close of business on the NYSE on the
monthly payment date for such dividends. No CDSC will be imposed upon redemption
of shares issued as a result of the automatic reinvestment of dividends.
Shareholders may, at any time, by written notification to Merrill Lynch if
their account is maintained with Merrill Lynch, or by written notification or by
telephone (1-800-MER-FUND) to the Transfer Agent, if their account is maintained
with the Transfer Agent elect to have subsequent dividends paid in cash, rather
than reinvested in shares of the Fund or vice versa (provided that, in the event
that a payment on an account maintained at the Transfer Agent would amount to
$10.00 or less, a shareholder will not receive such payment in cash and such
payment will automatically be reinvested in additional shares). Commencing ten
days after the receipt by the Transfer Agent of such notice, those instructions
will be effected. The Fund is not responsible for any failure of delivery to the
shareholder's address of record and no interest will accrue on amounts
represented by uncashed dividend checks. Cash payments can also be directly
deposited to the shareholder's bank account.
Systematic Withdrawal Plan
A shareholder may elect to receive systematic withdrawals from his or her
Investment Account by check or through automatic payment by direct deposit to
his or her bank account on either a monthly or quarterly basis as provided
below. Quarterly withdrawals are available for shareholders that have acquired
shares of the Fund having a value, based on cost or the current offering price,
of $5,000 or more, and monthly withdrawals are available for shareholders with
shares having a value of $10,000 or more.
At the time of each withdrawal payment, sufficient shares are redeemed from
those on deposit in the shareholder's account to provide the withdrawal payment
specified by the shareholder. The shareholder may specify the dollar amount and
the class of shares to be redeemed. Redemptions will be made at net asset value
as determined 15 minutes after the close of business on the NYSE (generally, the
NYSE closes at 4:00 p.m., Eastern time) on the 24th day of each month or the
24th day of the last month of each quarter, whichever is applicable. If the NYSE
is not open for business on such date, the shares will be redeemed at the close
of business on the following business day. The check for the withdrawal payment
will be made, on the next business day following redemption. When a shareholder
is making systematic withdrawals, dividends on all shares in the Investment
Account are reinvested automatically in Fund shares. A shareholder's Systematic
Withdrawal Plan may be terminated at any time, without charge or penalty, by the
shareholder, the Fund, the Transfer Agent or the Distributor.
With respect to redemptions of Class B or Class C shares pursuant to a
systematic withdrawal plan, the maximum number of Class B or Class C shares that
can be redeemed from an account annually shall not exceed 10% of the value of
shares of such class in that account at the time the election to join the
systematic withdrawal plan was made. Any CDSC that otherwise might be due on
such redemption of Class B or Class C shares will be waived. Shares redeemed
pursuant to a systematic withdrawal plan will be redeemed in the same order as
Class B or Class C shares are otherwise redeemed. See "Purchase of Shares --
Deferred Sales Charge Alternatives -- Class B and Class C Shares." Where the
systematic withdrawal plan is applied to Class B shares, upon conversion of the
last Class B shares in an account to Class D shares, the systematic withdrawal
plan will be applied thereafter to Class D shares if the shareholder so elects.
If an investor wishes to change the amount being withdrawn in a systematic
withdrawal plan the investor should contact his or her Merrill Lynch Financial
Consultant.
Withdrawal payments should not be considered as dividends. Each withdrawal
is a taxable event. If periodic withdrawals continuously exceed reinvested
dividends, the shareholder's original investment may be reduced correspondingly.
Purchases of additional shares concurrent with withdrawals are ordinarily
disadvantageous to
40
<PAGE>
the shareholder because of sales charges and tax liabilities. The Fund will not
knowingly accept purchase orders for shares of the Fund from investors that
maintain a Systematic Withdrawal Plan unless such purchase is equal to at least
one year's scheduled withdrawals or $1,200, whichever is greater. Automatic
investments may not be made into an Investment Account in which the shareholder
has elected to make systematic withdrawals.
Alternatively, a shareholder whose shares are held within a CMA(R) or
CBA(R) Account may elect to have shares redeemed on a monthly, bimonthly,
quarterly, semiannual or annual basis through the CMA(R) or CBA(R) Systematic
Redemption Program. The minimum fixed dollar amount redeemable is $50. The
proceeds of systematic redemptions will be posted to the shareholder's account
three business days after the date the shares are redeemed. All redemptions are
made at net asset value. A shareholder may elect to have his or her shares
redeemed on the first, second, third or fourth Monday of each month, in the case
of monthly redemptions, or of every other month, in the case of bimonthly
redemptions. For quarterly, semiannual or annual redemptions, the shareholder
may select the month in which the shares are to be redeemed and may designate
whether the redemption is to be made on the first, second, third or fourth
Monday of the month. If the Monday selected is not a business day, the
redemption will be processed at net asset value on the next business day. The
CMA(R) or CBA(R) Systematic Redemption Program is not available if Fund shares
are being purchased within the account pursuant to the Automated Investment
Program. For more information on the CMA(R) or CBA(R) Systematic Redemption
Program, eligible shareholders should contact their Merrill Lynch Financial
Consultant.
DIVIDENDS AND TAXES
Dividends
The Fund intends to distribute substantially all of its net investment
income, if any. Dividends from such net investment income will be paid at least
monthly. All net realized capital gains, if any, will be distributed to the
Fund's shareholders at least annually. From time to time, the Fund may declare a
special distribution at or about the end of the calendar year in order to comply
with Federal tax requirements that certain percentages of its ordinary income
and capital gains be distributed during the year. If in any fiscal year, the
Fund has net income from certain foreign currency transactions, such income will
be distributed at least annually.
See "Shareholder Services -- Automatic Dividend Reinvestment Plan" for
information concerning the manner in which dividends may be reinvested
automatically in shares of the Fund. A shareholder whose account is maintained
at the Transfer Agent or whose account is maintained through Merrill Lynch may
elect in writing to receive any such dividends in cash. Dividends are taxable to
shareholders, as discussed below, whether they are reinvested in shares of the
Fund or received in cash. The per share dividends on Class B and Class C shares
will be lower than the per share dividends on Class A and Class D shares as a
result of the account maintenance, distribution and higher transfer agency fees
applicable with respect to the Class B and Class C shares; similarly, the per
share dividends on Class D shares will be lower than the per share dividends on
Class A shares as a result of the account maintenance fees applicable with
respect to the Class D shares. See "Pricing of Shares -- Determination of Net
Asset Value."
Taxes
The Fund intends to continue to qualify for the special tax treatment
afforded regulated investment companies ("RICs") under the Internal Revenue Code
of 1986, as amended (the "Code"). As long as it so qualifies, the Fund (but not
its shareholders) will not be subject to Federal income tax on the part of its
net ordinary income and net realized capital gains which it distributes to Class
A, Class B, Class C and Class D shareholders (together, the "shareholders").
The Fund intends to distribute substantially all of such income.
Dividends paid by the Fund from its ordinary income or from an excess of
net short-term capital gains over net long-term capital losses (together
referred to hereafter as "ordinary income dividends") are taxable to
shareholders as ordinary income. Distributions made from an excess of net
long-term capital gains over net short-term capital losses (including gains or
losses from certain transactions in futures and options) ("capital gain
dividends") are taxable to shareholders as long-term capital gains, regardless
of the length of time the shareholder has owned Fund shares. Any loss upon the
sale or exchange of Fund shares held for six months or less will be treated as
long-term capital loss to the extent of any capital gain dividends received by
the
41
<PAGE>
shareholder. Distributions in excess of the Fund's earnings and profits will
first reduce the adjusted tax basis of a holder's shares and, after such
adjusted tax basis is reduced to zero, will constitute capital gains to such
holder (assuming the shares are held as a capital asset). Certain categories of
capital gains are taxable at different rates. Generally not later than 60 days
after the close of its taxable year, the Fund will provide its shareholders with
a written notice designating the amounts of any capital gain dividends, as well
as the amount of capital gain dividends in different categories of capital gain
referred to above.
Dividends are taxable to shareholders even though they are reinvested in
additional shares of the Fund. Distributions by the Fund, whether from ordinary
income or capital gains, will not be eligible for the dividends received
deduction allowed to corporations under the Code. If the Fund pays a dividend in
January which was declared in the previous October, November or December to
shareholders of record on a specified date in one of such months, then such
dividend will be treated for tax purposes as being paid by the Fund and received
by its shareholders on December 31 of the year in which such dividend was
declared.
Ordinary income dividends paid to shareholders who are nonresident aliens
or foreign entities will be subject to a 30% United States withholding tax under
existing provisions of the Code applicable to foreign individuals and entities
unless a reduced rate of withholding or a withholding exemption is provided
under applicable treaty law. Nonresident shareholders are urged to consult their
own tax advisers concerning the applicability of the United States withholding
tax.
Dividends and interest received by the Fund may give rise to withholding
and other taxes imposed by foreign countries. Tax conventions between certain
countries and the United States may reduce or eliminate such taxes.
Under certain provisions of the Code, some shareholders may be subject to a
31% withholding tax on ordinary income dividends, capital gain dividends and
redemption payments ("backup withholding"). Generally, shareholders subject to
backup withholding will be those for whom no certified taxpayer identification
number is on file with the Fund or who, to the Fund's knowledge, have furnished
an incorrect number. When establishing an account, an investor must certify
under penalty of perjury that such number is correct and that the investor is
not otherwise subject to backup withholding.
No gain or loss will be recognized by Class B shareholders on the
conversion of their Class B shares into Class D shares. A shareholder's basis in
the Class D shares acquired will be the same as such shareholder's basis in the
Class B shares converted, and the holding period of the acquired Class D shares
will include the holding period for the converted Class B shares.
If a shareholder exercises an exchange privilege within 90 days of
acquiring the shares, then the loss the shareholder can recognize on the
exchange will be reduced (or the gain increased) to the extent any sales charge
paid to the Fund on the exchanged shares reduces any sales charge the
shareholder would have owed upon the purchase of the new shares in the absence
of the exchange privilege. Instead, such sales charge will be treated as an
amount paid for the new shares.
A loss realized on a sale or exchange of shares of the Fund will be
disallowed if other Fund shares are acquired (whether through the automatic
reinvestment of dividends or otherwise) within a 61-day period beginning 30 days
before and ending 30 days after the date that the shares are disposed of. In
such a case, the basis of the shares acquired will be adjusted to reflect the
disallowed loss.
The Code requires a RIC to pay a nondeductible 4% excise tax to the extent
the RIC does not distribute, during each calendar year, 98% of its ordinary
income, determined on a calendar year basis, and 98% of its capital gains,
determined, in general, on an October 31 year end, plus certain undistributed
amounts from previous years. While the Fund intends to distribute its income and
capital gains in the manner necessary to minimize imposition of the 4% excise
tax, there can be no assurance that sufficient amounts of the Fund's taxable
income and capital gains will be distributed to avoid entirely the imposition of
the tax. In such event, the Fund will be liable for the tax only on the amount
by which it does not meet the foregoing distribution requirements.
The Fund may make investments that produce taxable income that is not
matched by a corresponding receipt of cash or an offsetting loss deduction. Such
investments would include dollar rolls and obligations that have original issue
discount (such as SMBSs), that accrue discount or are subordinated in the
mortgage-backed securities structure. Such taxable income would be treated as
income earned by the Fund and would be subject
42
<PAGE>
to the distribution requirements of the Code. Because such income may not be
matched by a corresponding receipt of cash by the Fund or an offsetting loss
deduction, the Fund may be required to borrow money or dispose of other
securities to be able to make distributions to shareholders. The Fund intends to
make sufficient and timely distributions to shareholders so as to qualify for
treatment as a RIC at all times.
Tax Treatment of Interest Rate Transactions, Options and Futures
The Fund may write, purchase or sell options and futures. In general,
unless an election is available to the Fund or an exception applies, such
options and futures contracts that are "Section 1256 contracts" will be "marked
to market" for Federal income tax purposes at the end of each taxable year,
i.e., each such option or futures contract will be treated as sold for its fair
market value on the last day of the taxable year, and any gain or loss
attributable to Section 1256 contracts will be 60% long-term and 40% short-term
capital gain or loss. Application of these rules to Section 1256 contracts held
by the Fund may alter the timing and character of distributions to shareholders.
The mark-to-market rules outlined above, however, will not apply to certain
transactions entered into by the Fund solely to reduce the risk of changes in
price or interest rates with respect to its investments.
Code Section 1092, which applies to certain "straddles," may affect the
taxation of the Fund's sales of securities and transactions in options and
futures contracts. Under Section 1092, the Fund may be required to postpone
recognition for tax purposes of losses incurred in certain sales of securities
and closing transactions in options and futures contracts.
The Federal income tax rules governing the taxation of interest rate swaps
are not entirely clear and may require the Fund to treat payments received under
such arrangements as ordinary income and to amortize such payments under certain
circumstances. The Fund will limit its activity in this regard in order to
maintain its qualification as a RIC.
The foregoing is a general and abbreviated summary of the applicable
provisions of the Code and Treasury regulations presently in effect. For the
complete provisions, reference should be made to the pertinent Code sections and
the Treasury regulations promulgated thereunder. The Code and the Treasury
regulations are subject to change by legislative, judicial or administrative
action either prospectively or retroactively.
Ordinary income and capital gain dividends may also be subject to state and
local taxes.
Certain states exempt from state income taxation dividends paid by RICs
which are derived from interest on U.S. Government obligations. State law varies
as to whether dividend income attributable to U.S. Government obligations is
exempt from state income tax. In general, state law does not consider income
derived from MBSs to be income attributable to U.S. Government obligations.
Shareholders are urged to consult their own tax advisers regarding
specific questions as to Federal, foreign, state or local taxes. Foreign
investors should consider applicable foreign taxes in their evaluation of an
investment in the Fund.
PERFORMANCE DATA
From time to time the Fund may include its average annual total return and
other total return data in advertisements or information furnished to present or
prospective shareholders. Total return figures are based on the Fund's
historical performance and are not intended to indicate future performance.
Average annual total return is determined separately for Class A, Class B, Class
C and Class D shares in accordance with formulas specified by the Commission.
Average annual total return quotations for the specified periods are
computed by finding the average annual compounded rates of return (based on net
investment income and any realized and unrealized capital gains or losses on
portfolio investments over such periods) that would equate the initial amount
invested to the redeemable value of such investment at the end of each period.
Average annual total return is computed assuming all dividends and distributions
are reinvested and taking into account all applicable recurring and nonrecurring
expenses, including the maximum sales charge in the case of Class A and Class D
shares and the CDSC that would be applicable to a complete redemption of the
investment at the end of the specified period as in the case of Class B and
Class C shares and the maximum sales charge in the case of Class A and D shares.
Dividends
43
<PAGE>
paid by the Fund with respect to all shares, to the extent any dividends are
paid, will be calculated in the same manner at the same time on the same day and
will be in the same amount, except that account maintenance and distribution
charges and any incremental transfer agency costs relating to each class of
shares will be borne exclusively by that class. The Fund will include
performance data for all classes of shares of the Fund in any advertisement or
information including performance data of the Fund.
The Fund also may quote annual, average annual and annualized total return
and aggregate total return performance data, both as a percentage and as a
dollar amount based on a hypothetical $1,000 investment, for various periods
other than those noted below. Such data will be computed as described above,
except that (1) as required by the periods of the quotations, actual annual,
annualized or aggregate data, rather than average annual data, may be quoted and
(2) the maximum applicable sales charges will not be included with respect to
annual or annualized rates of return calculations. Aside from the impact on the
performance data calculations of including or excluding the maximum applicable
sales charges, actual annual or annualized total return data generally will be
lower than average annual total return data since the average rates of return
reflect compounding of return; aggregate total return data generally will be
higher than average annual total return data since the aggregate rates of return
reflect compounding over a longer period of time. In advertisements distributed
to investors whose purchases are subject to waiver of the CDSC in the case of
Class B and Class C shares (such as investors in certain retirement plans) or to
reduced sales loads in the case of Class A and Class D shares, the performance
data may take into account the reduced, and not the maximum, sales charge or may
not take into account the CDSC and therefore may reflect greater total return
since, due to the reduced sales charges or waiver of the CDSC, a lower amount of
expenses is deducted. See "Purchase of Shares." The Fund's total return may be
expressed either as a percentage or as a dollar amount in order to illustrate
such total return on a hypothetical $1,000 investment in the Fund at the
beginning of each specified period.
Set forth below is total return information for the Class A, Class B, Class
C and Class D shares of the Fund for the periods indicated.
<TABLE>
<CAPTION>
Class A Shares Class B Shares
----------------------------------- -----------------------------------
Expressed as Redeemable Value Expressed as Redeemable Value
a percentage of a hypothetical a percentage of a hypothetical
based on a $1,000 investment based on a $1,000 investment
hypothetical at the end of hypothetical at the end of
Period $1,000 investment the period $1,000 investment the period
- ------ ---------------- ---------------- ----------------- -----------------
Average Annual Total Return
(including maximum applicable sales charges)
<S> <C> <C> <C> <C>
One Year Ended May 31, 1999 .......... .40% $ 1,004.00 (0.18)% $ 998.20
Five Years Ended May 31,1999 ......... -- -- 5.18% $ 1,287.00
Inception (October 21, 1994)
to May 31, 1999 .................... 5.37% $ 1,272.30 -- --
Inception (August 2, 1991)
to May 31, 1999 .................... -- -- 4.26% $ 1,386.60
Annual Total Return
(excluding maximum applicable sales charges)
Year Ended May 31,
1999 .............................. 4.59% $ 1,045.90 3.78% $ 1,037.80
1998 .............................. 5.66% $ 1,056.60 4.85% $ 1,048.50
1997 .............................. 7.48% $ 1,074.80 6.44% $ 1,064.40
1996 .............................. 6.41% $ 1,064.10 5.34% $ 1,053.40
1995 .............................. -- -- 5.48% $ 1,054.80
1994 .............................. -- -- 0.77% $ 1,007.70
1993 .............................. -- -- 2.48% $ 1,024.80
Inception (October 21, 1994) to
May 31, 1995 ...................... 4.85% 1,048.50 -- --
Inception (August 2, 1991) to
May 31, 1992 ...................... -- -- 4.33% $ 1,043.30
Aggregate Total Return
(including maximum applicable sales charges)
Inception (October 21, 1994) to
May 31, 1999 ...................... 27.23% $1,272.30 -- --
Inception (August 2, 1991) to
May 31, 1999 ...................... -- -- 38.66% $ 1,386.60
</TABLE>
44
<PAGE>
<TABLE>
<CAPTION>
Class C Shares Class D Shares
----------------------------------- -----------------------------------
Expressed as Redeemable Value Expressed as Redeemable Value
a percentage of a hypothetical a percentage of a hypothetical
based on a $1,000 investment based on a $1,000 investment
hypothetical at the end of hypothetical at the end of
Period $1,000 investment the period $1,000 investment the period
- ------ ---------------- ---------------- ----------------- -----------------
Average Annual Total Return
(including maximum applicable sales charges)
<S> <C> <C> <C> <C>
One Year Ended May 31, 1999 .......... 2.75% $ 1,027.50 0.15% $ 1,001.50
Five Years Ended May 31, 1999 ........ -- -- 4.87% $ 1,268.20
Inception (October 21, 1994) to
May 31, 1999 ...................... 5.37% $ 1,272.80 -- --
Inception (August 2, 1991) to
May 31, 1999 ...................... -- -- 4.26% $ 1,385.60
Annual Total Return
(excluding maximum applicable sales charges)
Year Ended May 31,
1999 .............................. 3.74% $ 1,037.40 4.32% $ 1,043.20
1998 .............................. 4.71% $ 1,047.10 5.40% $ 1,054.00
1997 .............................. 6.51% $ 1,065.10 7.11% $ 1,071.10
1996 .............................. 5.30% $ 1,053.00 5.91% $ 1,059.10
1995 .............................. -- 5.91% $ 1,059.10
1994 .............................. -- 1.28% $ 1,012.80
1993 .............................. -- 2.99% $ 1,029.90
Inception (October 21, 1994) to
May 31, 1995 ...................... 4.47% $ 1,044.70 -- --
Inception (August 2, 1991) to
May 31, 1992....................... 4.75% $ 1,047.50
Aggregate Total Return
(including maximum applicable sales charges)
Inception (October 21, 1994) to
May 31, 1999 ...................... 27.28% $ 1,272.80 -- --
Inception (August 2, 1991) to
May 31, 1999 ...................... -- -- 38.56% $ 1,385.60
</TABLE>
In order to reflect the reduced sales charges in the case of Class A or
Class D shares, or the waiver of the CDSC in the case of Class B or Class C
shares applicable to certain investors, as described under "Purchase of Shares,"
the total return data quoted by the Fund in advertisements directed to such
investors may take into account the reduced, and not the maximum, sales charge
or may not take into account the CDSC, and therefore may reflect greater total
return since, due to the reduced sales charges or the waiver of CDSCs, a lower
amount of expenses may be deducted.
On occasion, the Fund may compare its performance to various indices
including the Standard & Poor's 500 Index, the Dow Jones Industrial Average, or
to performance data published by Lipper Analytical Services, Inc., Morningstar
Publications, Inc. ("Morningstar"), CDA Investment Technology, Inc., Money
Magazine, U.S. News & World Report, Business Week, Forbes Magazine, Fortune
Magazine or other industry publications. When comparing its performance to a
market index, the Fund may refer to various statistical measures derived from
the historic performance of the Fund and the index, such as standard deviation
and beta. In addition, from time to time, the Fund may include the Fund's
Morningstar risk-adjusted performance ratings in advertisements or supplemental
sales literature. As with other performance data, performance comparisons should
not be considered indicative of the Fund's relative performance for any future
period.
Total return figures are based on the Fund's historical performance and are
not intended to indicate future performance. The Fund's total return will vary
depending on market conditions, the securities comprising the Fund's portfolio,
the Fund's operating expenses and the amount of realized and unrealized net
capital gains or losses during the period. The value of an investment in the
Fund will fluctuate and an investor's shares, when redeemed, may be worth more
or less than their original cost.
45
<PAGE>
GENERAL INFORMATION
Description of Shares
The Fund was incorporated under Maryland law on April 19, 1991. It has an
authorized capital of 1,000,000,000 shares of Common Stock, par value $0.10 per
share, divided into four classes, designated Class A, Class B, Class C and Class
D Common Stock. Class A and Class C each consists of 100,000,000 shares, Class B
consists of 600,000,000 shares and Class D consists of 200,000,000 shares. Class
A, Class B, Class C and Class D Common Stock all represent an interest in the
same assets of the Fund and are identical in all respects except that the Class
B, Class C and Class D shares bear certain expenses related to the account
maintenance and/or distribution of such shares and have exclusive voting rights
with respect to matters relating to such account maintenance and/or distribution
expenditures. The Board of Directors of the Fund may classify and reclassify the
shares of the Fund into additional classes of Common Stock at a future date.
Shareholders are entitled to one vote for each full share held and
fractional votes for fractional shares held and will vote on the election of
Directors and any other matter submitted to a shareholder vote. The Fund does
not intend to hold meetings of shareholders in any year in which the Investment
Company Act of 1940 does not require shareholders to act upon any of the
following matters: (i) election of Directors; (ii) approval of an investment
advisory agreement; (iii) approval of a distribution agreement; and (iv)
ratification of selection of independent accountants. Generally, under Maryland
law, a meeting of shareholders may be called for any purpose on the written
request of the holders of at least 25% of the outstanding shares of the Fund.
Voting rights for Directors are not cumulative. Shares issued are fully paid and
non-assessable and have no preemptive rights. Redemption and conversion rights
are discussed elsewhere herein and in the Prospectus. Each share of Common Stock
is entitled to participate equally in dividends and distributions declared by
the Fund and in the net assets of the Fund upon liquidation or dissolution after
satisfaction of outstanding liabilities, except that, as noted above, expenses
related to the account maintenance and/or distribution of the shares of a class
will be borne solely by such class. Stock certificates will be issued by the
Transfer Agent only on specific request. Certificates for fractional shares are
not issued in any case.
The Manager provided the initial capital for the Fund by purchasing 10,000
shares for $100,000. Such shares will be acquired for investment and can only be
disposed by redemption. The organizational expenses of the Fund were paid by the
Fund and amortized over a period not exceeding five years. The proceeds realized
by the Manager (or any subsequent holder) upon redemption of any of such shares
will be reduced by the proportionate amount of the unamortized organizational
expenses which the number of shares redeemed bears to the number of shares
initially purchased.
Independent Auditors
Deloitte & Touche LLP, 117 Campus Drive, Princeton, New Jersey 08540 has
been selected as the independent auditors of the Fund. The selection of
independent auditors is subject to approval by the non-interested Directors of
the Fund. The independent auditors are responsible for auditing the annual
financial statements of the Fund.
Custodian
The Bank of New York, (the "Custodian"), 90 Washington Street, 12th Floor,
New York, New York 10286, acts as the custodian of the Fund's assets. Under its
contract with the Fund, the Custodian is authorized, among other things, to
establish separate accounts in foreign currencies and to cause foreign
securities owned by the Fund to be held in its offices outside of the United
States and with certain foreign banks and securities depositories. The Custodian
is responsible for safeguarding and controlling the Fund's cash and securities,
handling the receipt and delivery of securities and collecting interest and
dividends on the Fund's investments.
Transfer Agent
Financial Data Services, Inc., 4800 Deer Lake Drive East, Jacksonville,
Florida 32246-6484, acts as the Fund's Transfer Agent. The Transfer Agent is
responsible for the issuance, transfer and redemption of shares and the opening,
maintenance and servicing of shareholder accounts. See "How to Buy, Sell,
Transfer and Exchange Shares -- Through the Transfer Agent" in the Prospectus.
46
<PAGE>
Legal Counsel
Brown & Wood LLP, One World Trade Center, New York, New York 10048-0557, is
counsel for the Fund.
Reports to Shareholders
The fiscal year of the Fund ends on May 31 of each year. The Fund sends to
its shareholders at least semi-annually reports showing the Fund's portfolio and
other information. An annual report, containing financial statements audited by
independent auditors, is sent to shareholders each year. After the end of each
year, shareholders will receive Federal income tax information regarding
dividends and capital gains distributions.
Shareholder Inquiries
Shareholder inquiries may be addressed to the Fund at the address or
telephone number set forth on the cover page of this Statement of Additional
Information.
Additional Information
The Prospectus and this Statement of Additional Information do not contain
all the information set forth in the Registration Statement and the exhibits
relating thereto, which the Fund has filed with the Securities and Exchange
Commission, Washington, D.C., under the Securities Act and the Investment
Company Act, to which reference is hereby made.
Under a separate agreement, ML & Co. has granted the Fund the right to use
the "Merrill Lynch" name and has reserved the right to withdraw its consent to
the use of such name by the Fund at any time or to grant the use of such name to
any other company, and the Fund has granted ML & Co. under certain conditions,
the use of any other name it might assume in the future, with respect to any
corporation organized by ML & Co.
To the knowledge of the Fund, the following persons or entities owned
beneficially 5% or more of a class of the Fund's shares as of August 31, 1999:
<TABLE>
<CAPTION>
Name Address Class Percentage
- -------------------------------------- ----------------------------- ----- ----------
<S> <C> <C> <C>
Mr. Gregory M. Maunz 4 Jacob Drive A 28.4%
Lawrenceville, NJ 08646
Merrill Lynch Trust Co. P.O. Box 30531 A 18.9%
Successor Trustee New Brunswick, NJ 08989
Florence L. Codman Irrevocable Trust
Attn: Shirley White
Michael Normile and 878 Scioto Drive A 13.0%
Eileen Normile JTWTROS Franklin Lakes, NJ 07417
1998 Deferred Compensation 400 Atrium Drive A 7.20%
Attn: Victoria Niles Somerset, NJ 08873
MLPF&S CUST FPO 1571 Littlefield CT A 6.2%
Lisa A. Garrity Ita Lake Forest, IL 60045
FBO Lisa A Garrity
99 Short Term Global Deferral 400 Atrium Drive A 5.6%
Attn: Victoria Niles Somerset, NJ 08873
Merrill Lynch Trust Company P O Box 30532 A 5.4%
Trustee FBO MLSIP New Brunswick, NJ 08989
Investment Account
Attn: Robert Arimenta, Jr.
Universities Research Associates 1111 19th Street NW #400 C 7.1%
Attn: Dr. Gail Young Washington, D.C. 20036
</TABLE>
47
<PAGE>
<TABLE>
<CAPTION>
Name Address Class Percentage
- -------------------------------------- ----------------------------- ----- ----------
<S> <C> <C> <C>
Sang Hoon Hahn and 57 Spanish Bay Circle C 6.7%
Haijoung Hahn JTWTROS Pebble Beach, CA 93953
Young President's Organization Inc. 451 S. Decker Drive #200 D 11.8%
Attn: Kelly Parker Irving, TX 75062
San Fernando Comm Hospital 14850 Roscoe Boulevard D 10.2%
DBA Mission Comm Hospitals Panorama City, CA 91402
Operating Account PC
Attn: Bruce Donaldson
Money PRCH Pension PLN Hills CL 500 Galland Building D 8.5%
L. Peterson, M. Clark, G. Martin, Jr. 1221 Second Avenue
Seattle, WA 98101
PFT Sharing PLN HILLS CL 500 Galland Building D 7.5%
L. Peterson, M. Clark, G. Martin, Jr. 1221 Second Avenue
Seattle, WA 98101
</TABLE>
FINANCIAL STATEMENTS
The Fund's audited financial statements are incorporated in this Statement
of Additional Information by reference to its 1999 annual report to
shareholders. You may request a copy of the annual report at no charge by
calling (800) 456-4587 ext. 789 between 8:00 a.m. and 8:00 p.m. on any business
day.
48
<PAGE>
APPENDIX: LONG-TERM AND SHORT-TERM OBLIGATION RATINGS
(INCLUDING MORTGAGE-BACKED AND ASSET-BACKED SECURITIES)
Description of Standard & Poor's ("S&P") Long-Term Issue Credit Ratings
An S&P issue credit rating is a current opinion of the creditworthiness of
an obligor with respect to a specific financial obligation, a specific class of
financial obligations, or a specific financial program (including ratings on
medium term note programs and commercial paper programs). It takes into
consideration the creditworthiness of guarantors, insurers, or other forms of
credit enhancement on the obligation and takes into account the currency in
which the obligation is denominated. The issue credit rating is not a
recommendation to purchase, sell, or hold a financial obligation, inasmuch as it
does not comment as to market price or suitability for a particular investor.
Issue credit ratings are based on current information furnished by the
obligors or obtained by S&P from other sources it considers reliable. S&P does
not perform an audit in connection with any credit rating and may, on occasion,
rely on unaudited financial information. Credit ratings may be changed,
suspended, or withdrawn as a result of changes in, or unavailability of, such
information, or based on other circumstances.
Issue credit ratings can be either long-term or short-term. Short-term
ratings are generally assigned to those obligations considered short-term in the
relevant market. In the U.S., for example, that means obligations with an
original maturity of no more than 365 days including commercial paper.
Short-term ratings are also used to indicate the creditworthiness of an obligor
with respect to put features on long-term obligations. The result is a dual
rating, in which the short-term rating addresses the put feature, in addition to
the usual long-term rating. Medium-term notes are assigned long-term ratings.
Issue credit ratings are based, in varying degrees, on the following
considerations:
1. Likelihood of payment capacity and willingness of the obligor to meet
its financial commitment on an obligation in accordance with the terms of the
obligation;
2. Nature of and provisions of the obligation;
3. Protection afforded by, and relative position of, the obligation in the
event of bankruptcy, reorganization, or other arrangement under the laws of
bankruptcy and other laws affecting creditors' rights.
The issue rating definitions are expressed in terms of default risk. As
such, they pertain to senior obligations of an entity. Junior obligations are
typically rated lower than senior obligations, to reflect the lower priority in
bankruptcy, as noted above. (Such differentiation applies when an entity has
both senior and subordinated obligations, secured and unsecured obligations, or
operating company and holding company obligations.) Accordingly, in the case of
junior debt, the rating may not conform exactly with the category definition.
AAA An obligation rated AAA has the highest rating assigned by S&P. The
obligor's capacity to meet its financial commitment is extremely
strong.
AA An obligation rated AA differs from the highest rated obligations only
in small degree. The obligor's capacity to meet its financial
commitment is very strong.
A An obligation rated A is somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than
obligations in higher rated categories. However, the obligor's
capacity to meet its financial commitment on the obligation is still
strong.
BBB An obligation rated BBB exhibits adequate protection parameters.
However, adverse economic conditions or changing circumstances are
more likely to lead to a weakened capacity of the obligor to meet its
financial commitment on the obligation.
Obligations rated BB, B, CCC, CC and C are regarded as having
significant speculative characteristics. BB indicates the least degree
of speculation and C the highest. While such obligations will likely
have some quality and protective characteristics, these may be
outweighed by large uncertainties or major exposures to adverse
conditions.
A-1
<PAGE>
BB An obligation rated BB is less vulnerable to nonpayment than other
speculative issues. However, it faces major ongoing uncertainties or
exposure to adverse business, financial, or economic conditions which
could lead to the obligor's inadequate capacity to meet its financial
commitment on the obligation.
B An obligation rated B is more vulnerable to nonpayment than
obligations rated BB, but the obligor currently has the capacity to
meet its financial commitment on the obligation. Adverse business,
financial, or economic conditions will likely impair the obligor's
capacity or willingness to meet its financial commitment on the
obligation. The B rating category is also used for debt subordinated
to senior debt that is assigned an actual or implied BB or BB- rating.
CCC An obligation rated CCC is currently vulnerable to nonpayment, and is
dependent upon favorable business, financial, and economic conditions
to meet timely payment of interest and repayment of principal. In the
event of adverse business, financial, or economic conditions, it is
not likely to have the capacity to pay interest and repay principal.
The CCC rating category is also used for debt subordinated to senior
debt that is assigned an actual or implied B or B- rating.
CC An obligation rated CC is currently highly vulnerable to nonpayment.
C The C rating may be used to cover a situation where a bankruptcy
petition has been filed or similar action has been taken, but payments
on this obligation are continued.
CI The rating CI is reserved for income bonds on which no interest is
being paid.
D An obligation rated D is in payment default. The D rating category is
used when payments on an obligation are not made on the date due even
if the applicable grace period has not expired, unless Standard &
Poor's believes that such payments will be made during such grace
period. The D rating also will be used upon the filing of a bankruptcy
petition or the taking of similar action if payments on an obligation
are jeopardized.
Plus (+) The ratings from AAA to CCC may be modified by the addition of a
or Minus plus or minus sign to show relative standing within the major rating
(-): categories.
c The letter c indicates that the holder's option to tender the security
for purchase may be canceled under certain prestated conditions
enumerated in the tender option documents.
L The letter L indicates that the rating pertains to the principal
amount of those bonds to the extent that the underlying deposit
collateral is federally insured and interest is adequately
collateralized. In the case of certificates of deposit, the letter L
indicates that the deposit, combined with other deposits being held in
the same right and capacity, will be honored for principal and accrued
pre-default interest up to the federal insurance limits within 30 days
after closing of the insured institution or, in the event that the
deposit is assumed by a successor insured institution, upon maturity.
p The letter p indicates that the rating is provisional. A provisional
rating assumes the successful completion of the project being financed
by the debt being rated and indicates that payment of debt service
requirements is largely or entirely dependent upon the successful and
timely completion of the project. This rating, however, while
addressing credit quality subsequent to completion of the project,
makes no comment on the likelihood of, or the risk of default upon
failure of, such completion. The investor should exercise his own
judgment with respect to such likelihood and risk.
* Continuance of the rating is contingent upon S&P's receipt of an
executed copy of the escrow agreement or closing documentation
confirming investments and cash flows.
N.R. Not rated.
Obligations of issuers outside the United States and its territories are
rated on the same basis as domestic long-term and short-term issues. The ratings
measure the creditworthiness of the obligor but do not take into account
currency exchange and related uncertainties.
Bond Investment Quality Standards: Under present commercial bank
regulations issued by the Comptroller of the Currency, bonds rated in the top
four categories ("AAA", "AA", "A", "BBB", commonly known as
A-2
<PAGE>
"Investment Grade" ratings) are generally regarded as eligible for bank
investment. In addition, the laws of various states governing legal investments
impose certain rating or other standards for obligations eligible for investment
by savings banks, trust companies, insurance companies and fiduciaries
generally.
Description of S&P's Short-Term Issue Credit Ratings
An S&P short-term issue credit rating is a current opinion of the
likelihood of timely payment of an obligation considered short-term in the
relevant market. Ratings are graded into several categories, ranging from A-1
for the highest quality obligations to D for the lowest. These categories are as
follows:
A-1 A short-term obligation rated "A-1" is rated in the highest category
by S&P. The obligor's capacity to meet its financial commitment on the
obligation is strong. Within this category, certain obligations are
designated with a plus sign (+). This indicates that the obligor's
capacity to meet its financial commitment on these obligations is
extremely strong.
A-2 An obligation rated "A-2" is somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than
obligations in higher rating categories. However, the obligor's
capacity to meet its financial commitment on the obligation is
satisfactory.
A-3 An obligation rated "A-3" exhibits adequate protection parameters.
However, adverse economic conditions or changing circumstances are
more likely to lead to a weakened capacity of the obligor to meet its
financial commitment on the obligation.
B An obligation rated "B" is regarded as having significant speculative
characteristics. The obligor currently has the capacity to meet its
financial commitment on the obligation; however, it faces major
ongoing uncertainties which could lead to the obligor's inadequate
capacity to meet its financial commitment on the obligation.
C An obligation rated "C" is currently vulnerable to nonpayment and is
dependent upon favorable business, financial, and economic conditions
for the obligor to meet its financial commitment on the obligation.
D An obligation rated "D" is in payment default. The "D" rating category
is used when payments on an obligation are not made on the date due
even if the applicable grace period has not expired, unless S&P
believes that such payments will be made during such grace period. The
"D" rating also will be used upon the filing of a bankruptcy petition
or the taking of a similar action if payments on an obligation are
jeopardized.
A short-term issue credit rating is not a recommendation to purchase,
sell, or hold a security inasmuch as it does not comment as to market
price or suitability for a particular investor. The ratings are based
on current information furnished to S&P by the issuer or obtained by
S&P from other sources it considers reliable. S&P does not perform an
audit in connection with any rating and may, on occasion, rely on
unaudited financial information. The ratings may be changed,
suspended, or withdrawn as a result of changes in, or unavailability
of, such information, or based on other circumstances.
Description of Moody's Investors Service, Inc. ("Moody's") Long-Term Debt
Ratings
Aaa Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally
referred to as "gilt edge." Interest payments are protected by a large
or by an exceptionally stable margin and principal is secure. While
the various protective elements are likely to change, such changes as
can be visualized are most unlikely to impair the fundamentally strong
position of such issues.
Aa Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are
generally known as high grade bonds. They are rated lower than the
best bonds because margins of protection may not be as large as in Aaa
securities or fluctuation of protective elements may be of greater
amplitude or there may be other elements present which make the
long-term risks appear somewhat larger than in Aaa securities.
A-3
<PAGE>
A Bonds which are rated A possess many favorable investment attributes
and are to be considered as upper medium grade obligations. Factors
giving security to principal and interest are considered adequate, but
elements may be present which suggest a susceptibility to impairment
sometime in the future.
Baa Bonds which are rated Baa are considered as medium grade obligations,
i.e., they are neither highly protected nor poorly secured. Interest
payments and principal security appear adequate for the present but
certain protective elements may be lacking or may be
characteristically unreliable over any great length of time. Such
bonds lack outstanding investment characteristics and in fact have
speculative characteristics as well.
Ba Bonds which are rated Ba are judged to have speculative elements;
their future cannot be considered as well assured. Often the
protection of interest and principal payments may be very moderate and
thereby not well safeguarded during both good and bad times over the
future. Uncertainty of position characterizes bonds in this class.
B Bonds which are rated B generally lack characteristics of desirable
investments. Assurance of interest and principal payments or of
maintenance of other terms of the contract over any long period of
time may be small.
Caa Bonds which are rated Caa are of poor standing. Such issues may be in
default or there may be present elements of danger with respect to
principal or interest.
Ca Bonds which are rated Ca represent obligations which are speculative
in a high degree. Such issues are often in default or have other
marked shortcomings.
C Bonds which are rated C are the lowest rated class of bonds, and
issues so rated can be regarded as having extremely poor prospects of
ever attaining any real investment standing.
Note: Moody's applies numerical modifiers 1, 2 and 3 in each generic rating
classification from Aa through Caa. The modifier 1 indicates that the security
ranks in the higher end of its generic rating category; the modifier 2 indicates
a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of
its generic rating category.
Description of Moody's Short-Term Debt Ratings
Moody's short-term debt ratings are opinions of the ability of issuers to
repay punctually senior debt obligations. These obligations have an original
maturity not exceeding one year, unless explicitly noted. Moody's employs the
following three designations, all judged to be investment grade, to indicate the
relative repayment ability of rated issuers.
Issuers rated Prime-1 (or supporting institutions) have a superior ability
for repayment of short-term promissory obligations. Prime-1 repayment ability
will often be evidenced by many of the following characteristics:
-- Leading market positions in well-established industries.
-- High rates of return on funds employed.
-- Conservative capitalization structure with moderate reliance on debt
and ample asset protection.
-- Broad margins in earnings coverage of fixed financial charges and high
internal cash generation.
-- Well-established access to a range of financial markets and assured
sources of alternate liquidity.
Issuers rated Prime-2 (or supporting institutions) have a strong ability
for repayment of short-term debt obligations. This will normally be evidenced by
many of the characteristics cited above but to a lesser degree. Earnings trends
and coverage ratios, while sound, may be more subject to variation.
Capitalization characteristics, while still appropriate, may be more affected by
external conditions. Ample alternate liquidity is maintained.
A-4
<PAGE>
Issuers rated Prime-3 (or supporting institutions) have an acceptable
ability for repayment of senior short-term obligations. The effect of industry
characteristics and market compositions may be more pronounced. Variability in
earnings and profitability may result in changes in the level of debt protection
measurements and may require relatively high financial leverage. Adequate
alternate liquidity is maintained.
Issuers rated Not Prime do not fall within any of the Prime rating
categories.
If an issuer represents to Moody's that its short-term debt obligations are
supported by the credit of another entity or entities, in assigning ratings to
such issuers, Moody's evaluates the financial strength of the affiliated
corporations, commercial banks, insurance companies, foreign governments or
other entities, but only as one factor in the total rating assessment. Moody's
makes no representation and gives no opinion on the legal validity or
enforceability of any support arrangement.
A-5
<PAGE>
CODE #: 13937-09-99
