As filed with the Securities and Exchange Commission
on July 15, 1996
File No. 33-43089
File No. 811-6431
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
F O R M N-1A
Registration Statement Under the Securities Act of 1933
Post-Effective Amendment No. 13
and
Registration Statement Under the Investment Company Act of 1940
Amendment No. 15
____________________
SMITH BREEDEN SERIES FUND
(Exact Name of Registrant as Specified in Charter)
100 Europa Drive, Suite 200
Chapel Hill, North Carolina 27514
(Address of Principal Executive Office)
(919) 967-7221
(Registrant's Telephone Number, Including Area Code)
MICHAEL J. GIARLA
100 Europa Drive, Suite 200
Chapel Hill, North Carolina 27514
(Name and Address of Agent for Service)
_______________
Please Send Copy of Communications to:
MARIANTHE S. MEWKILL
Smith Breeden Associates, Inc.
100 Europa Drive, Suite 200
Chapel Hill, NC 27514
(919)-967-7221
This filing shall become effective on August 1, 1996 pursuant to
paragraph (b)(1) of Rule 485 under the Securities Act of 1933.
The Registrant has previously registered an indefinite number of
shares of beneficial interest pursuant to Rule 24f-2 under the
Investment Company Act of 1940, as amended. The Rule 24f-2 notice for
the Registrant's most recent fiscal year was filed on May, 30
1996.
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SMITH BREEDEN SERIES FUND
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
(THE "SHORT SERIES")
SMITH BREEDEN INTERMEDIATE DURATION U.S.
GOVERNMENT SERIES
(THE "INTERMEDIATE SERIES")
CROSS REFERENCE SHEET
FORM N-1A
Part A: Information Required in Prospectus
N-1A
Item No. Item Location in the
Registration Statement
by Prospectus Heading
1. Cover Page Cover Page
2. Synopsis Expense Table
3. Condensed Financial
Information Financial Highlights
4. General Description of
Registrant "The Short and Intermediate
Series"; "General Information"
5. Management of the Fund "Management of the Fund"
5a. Management's Discussion
of Fund's Performance Contained in the Fund's
Annual Report to Shareholders
6. Capital Stock and Other
Securities "Dividends, Distributions and
Taxes"; "General Information"
7. Purchase of Securities
Being Offered "Purchase and Redemption of
Shares"; "Valuation of Fund
Shares"
8. Redemption or Repurchase "Purchase and Redemption
of Shares"
9. Pending Legal Proceedings Not Applicable
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Part B: Information Required in
Statement of Additional Information
N-1A
Item No. Item Location in the
by Prospectus Heading
10. Cover Page Cover Page
11. Table of Contents "Contents"
12. General Information and
History See Part A Item 4.
13. Investment Objective and "Miscellaneous Investment
Policies Practices and Risk
Considerations"
14. Management of the
Registrant "Trustees and Officers"
15. Control Persons and
Principal Holders of
Securities "Trustees and Officers"
16. Investment Advisory and "Investment Advisory and
Other Services Other Services"
17. Brokerage Allocation "Policies Regarding
Brokers Used in Portfolio
Transactions"
18. Capital Stock and Other "Additional Information
Securities Regarding Purchases and
Redemptions of Fund Shares"
19. Purchase, Redemption and "Additional Information
Pricing of Securities Regarding Purchases and
Being Offered Redemption of Fund Shares"
20. Tax Status "Additional Information
Regarding Taxation"
21. Underwriters "Additional Information
Regarding Purchases and
Redemptions of Fund Shares"
22. Calculation of "Standard Performance
Performance Data Measures"
23. Financial Statements "Financial Statements"
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SMITH BREEDEN SERIES FUND
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
SMITH BREEDEN INTERMEDIATE DURATION U.S GOVERNMENT SERIES
PROSPECTUS
August 1, 1996
100 Europa Drive, Suite 200
Chapel Hill, North Carolina 27514-2310
(919) 967-7221
Smith Breeden Series Fund (the "Fund") is a no-load, open-end,
diversified management investment company registered under the
Investment Company Act of 1940 (the "1940 Act") whose
shares are offered in two separate series- the Smith Breeden Short
Duration U.S. Government Series and the Smith Breeden Intermediate
Duration U.S. Government Series. Each series generally operates as a
separate fund with its own investment objectives and policies to meet its
specific investment goals.
The Smith Breeden Short Duration U.S. Government Series,
(the "Short Series") seeks a high level of current income, consistent with
low volatility of net asset value. The Short Series seeks to match the
interest-rate risk of a portfolio that invests exclusively in six month U.S.
Treasury securities on a constant maturity basis. The dollar-weighted
average maturity of the portfolio securities of the Short Series may
significantly exceed six months at times. See "Investment Objectives and
Policies."
The Smith Breeden Intermediate Duration U.S. Government
Series (the "Intermediate Series") seeks a total return in excess of the total
return of the major market indices for mortgage-backed securities. The
Intermediate Series consistently seeks to achieve a volatility of net asset
value similar to that of a portfolio that invests exclusively in
mortgage-backed securities, as weighted in the major mortgage market
indices.
The Short Series and Intermediate Series ( each a
"Series") seek to achieve their objectives through investing at
least 70% of their respective assets in securities which are issued or
guaranteed by the U.S. Government, its agencies or instrumentalities and
by employing various hedging techniques. The Short and Intermediate
Series may invest a substantial portion of their respective assets in
mortgage-backed securities that directly or indirectly represent a
participation in, or are collateralized by and payable from, mortgage loans
on real property. The Short and Intermediate Series may employ various
hedging techniques to achieve their investment objectives. On occasion,
the Short and Intermediate Series may borrow or purchase additional
securities with borrowed funds, which may result in a leveraged capital
structure. The net asset values of the Short and Intermediate Series will
respond to increases and decreases in the values of their respective
securities.
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An investment in the Short or Intermediate Series is neither
insured nor guaranteed by the U.S. Government. There can be no
assurance that the Short or Intermediate Series' investment objectives will
be achieved. The investment objectives of the Short and Intermediate
Series are fundamental and cannot be changed without shareholder
approval. Shares of the Short or Intermediate Series may be purchased at
net asset value with no sales charge with a minimum initial investment of
$1000.
This Prospectus is intended to set forth in a clear and concise manner
information about the Series that a prospective investor should know
before investing. Please retain this Prospectus for future reference. A
Statement of Additional Information dated August 1, 1996 provides
additional information about the Series. It has been filed with the
Securities and Exchange Commission and is incorporated herein by
reference. Copies are available without charge from the Fund at 100
Europa Drive, Suite 200, Chapel Hill, NC 27514, or by calling (800)
221-3138.
THESE SECURITIES HAVE NOT BEEN APPROVED OR
DISAPPROVED BY THE SECURITIES AND EXCHANGE
COMMISSION OR ANY STATE SECURITIES COMMISSION NOR
HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY
STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL
OFFENSE.
2
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Contents
Expense Table 4
Financial Highlights - Short Series 6
Financial Highlights - Intermediate Series 7
The Short and Intermediate Series 8
Management of the Fund 28
Purchase and Redemption of Shares 35
Dividends, Distributions and Taxes 42
Valuation of Fund Shares 44
Performance 45
Reports to Depository Institutions 45
Appendix A 46
This Prospectus is not an offering of the securities described herein in any
state in which the offering is unauthorized. No sales representative, dealer
or other person is authorized to give any information or make any
representations other than those contained in this Prospectus.
3
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EXPENSE TABLE
The purpose of this table is to assist an investor in understanding
the various costs and expenses, as a percentage of the average net assets of
each of the Series, that a shareholder will bear directly or indirectly in
connection with an investment in the Short or Intermediate Series.
SHAREHOLDER TRANSACTION EXPENSES
Short Intermediate
Series Series
Maximum Sales Charge Imposed on Purchases None None
(as percentage of offering price)
Maximum Sales Charge Imposed on None None
Reinvested Dividends
(as percentage of offering price)
Deferred Sales Charge None None
Redemption Fees None (1) None (1)
(as percentage of amount redeemed)
ANNUAL SERIES OPERATING EXPENSES
(as percentage of average net assets)
Management Fee .70% .70%
Other Expenses .08% .18%
(after expense limitation)
Total Operating Expenses (2 .78% .88%
(after expense limitation)
_____________________________
1 A transaction cost of $9 may be imposed on redemptions by
wire transfer.
2 The Other Expenses in the table and Total Operating
Expenses reflect undertakings by the Adviser to bear expenses of each of
the Series and/or waive its fees to the extent necessary to limit Total
Operating Expenses to .78% and .88% for the Short and Intermediate
Series, respectively, through March 31, 1997 and are estimates which are
based upon Total Series Operating Expenses for the fiscal year ended
March 31, 1996. Absent the expense limitation, Other Expenses and Total
Operating Expenses would be .23% and .93% for the Short Series and
.44% and 1.14% for the Intermediate Series. Actual Total Operating
Expenses for the fiscal year ended March 31, 1996 for the Short and
Intermediate Series were .78% and .90%, respectively.
Pursuant to a distribution and services plan, in respect of each
Series the Adviser may pay annual distribution and servicing fees of up to
.25% of each of the Series' net assets out of its management fee.
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The following example illustrates the expenses that apply to a $1,000
investment in the Short or Intermediate Series over various time periods
assuming (1) a 5% annual rate of return and (2) redemption or no
redemption at the end of each time period. Except as noted in the table
above, the Fund charges no redemption fees.
Short Duration Series
1 Year 3 Years 5 Years 10 Years
$ 8 $ 25 $ 44 $ 96
Intermediate Duration Series
1 Year 3 Years 5 Years 10 Years
$ 9 $ 28 $ 48 $ 106
This example is based on the annual operating expenses shown
above and should not be considered a representation of past or future
expenses or performance. Actual expenses may be greater or less than
those shown. The annual rate of return may be more or less than 5%.
* * * *
The Short and Intermediate Series may be recommended to
investors by registered investment advisors. Such advisors customarily
impose fees which would be in addition to any fees and expenses
presented in the above table. According to recent financial articles, such
fees may be as high as 2% of assets per year. None of the Short or
Intermediate Series or the Adviser may exercise any control over such
advisory fees and may not be informed of the level of such fees.
5
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SHORT DURATION SERIES
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the fiscal
periods from March 31, 1992 through March 31, 1996 and are a part of
the Short Series' financial statements which have been audited by Deloitte
& Touche LLP, independent auditors. This data should be read in
conjunction with the Short Series' most recent annual audited financial
statements and the report of Deloitte & Touche LLP which appear in the
Series' Statement of Additional Information.
Year Year Year Year
Ended Ended Ended Ended
March 31, March 31, March 31, March 31,
1996 1995 1994 1993 (1)
Net Asset Value,
Beginning of Period $9.90 $ 9.90 $10.00 $10.00
Income From Investment
Operations
Net investment income .621 .628 .432 .552
Net gain (loss) on securities
(both realized and unrealized) (.148) -- (.070) .002
Total From Investment
Operations .473 .628 .362 .554
Less Distributions
Dividends from net
investment income (.621) (.628) (.462)
(.554)
Dividends in excess of
investment income (.012) --- ---- ----
Total Distributions (.633) (.628) (.462) ( .554)
Net Asset Value, End of Period $9.74 $9.90 $ 9.90 $10.00
Total Return 4.95% 6.58% 3.67% 5.67%
______________________________________________
Ratios/Supplemental Data
Net Assets, End of Period $221,825,136 $218,431,665 $218,167,491 $48,531,206
Ratio of Direct Expenses to
Average Net Assets
Before expense limitation .93% .92% 1.00% 2.58%
After expense limitation .78% .78% .78% .78%
Ratio of Net Income to Average
Net Assets
Before expense limitation 6.13% 6.18% 3.95%
2.73%
After expense limitation 6.29% 6.33% 4.17% 4.53%
Portfolio turnover rate 225% 47% 112% 3%
Additional performance information is presented in the Short Series'
Annual Report which will be made available without charge upon request.
1 The Short Series commenced operations on March 31, 1992.
6
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INTERMEDIATE DURATION SERIES
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the fiscal
periods from March 31, 1992 through March 31, 1996 and are a part of the
Intermediate Series' financial statements which have been audited by
Deloitte & Touche LLP, independent auditors. This data should be read
in conjunction with the Intermediate Series' recent annual audited financial
statements and the report of Deloitte & Touche LLP thereon which appear
in the Series' Statement of Additional Information.
Year Year Year Year
Ended, Ended Ended Ended
March 31, March 31, March 31, March 31,
1996 1995 1994 1993 (1)
Net Asset Value,
Beginning of Period $9.83 $10.01 $10.62 $10.00
Income From Investment
Operations
Net investment income .660 .664 1.05 .826
Net gain (loss) on securities
(both realized and unrealized) .277 (.049) (.601) .621
Total From Investment
Operations .937 .615 .449 1.447
Less Distributions
Dividends from net
investment income (.656) (.664) (1.044) (.826)
Dividends in excess of net
investment income -- (0.108) -- --
Distributions from net
realized gains
on investments (.101) -- (.015) --
Distributions in excess
of net realized
gains on investments -- (0.022) -- --
Total Distributions (.757) (0.794) (1.059) (.826)
Net Asset Value,
End of Period $10.01 $9.83 $10.01 $10.62
Total Return 9.69% 6.10% 4.11% 14.93%
______________________________________________
Ratios/Supplemental Data
Net Assets, End of Period $36,446,940 $34,797,495 $6,779,666 $2,923,913
Ratio of Expenses to
Average Net Assets
Before expense limitation 1.14% 2.33% 2.34% 17.52%
After expense limitation .90% .90% .90% .82%
Ratio of Net Income to
Average Net Assets
Before expense limitation 6.26% 4.77% 6.30% (8.52)%
After expense limitation 6.49% 6.20% 7.74% 8.18%
Portfolio turnover rate 193% 557% 84% 42%
Additional performance information is presented in the Intermediate
Series' Annual Report which will be made available without charge
upon request.
1 The Intermediate Series commenced operations on March 31, 1992.
7
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THE SHORT AND INTERMEDIATE SERIES
General
The Short and Intermediate Series are series of the Smith
Breeden Series Fund (the "Fund") , an open-end, diversified management
investment company organized as a Massachusetts business trust on
October 3, 1991. The Fund currently issues shares in two series, which are
the Short and Intermediate Series. The Trustees have authority to issue
shares in an unlimited number of series, the assets and liabilities of which
will each be separate and distinct. All shares, when issued, are fully paid,
non assessable, and redeemable and have equal voting, dividend and
liquidation rights.
Shareholders of the separate series will vote together in
electing trustees and in certain other matters. Shareholders in each series
should be aware that the outcome of the election of trustees and of
certain other matters could be controlled by the shareholders of another
series. The shares have noncumulative voting rights, which means that
holders of more than 50% of the shares voting for the election of the
trustees can elect 100% of the trustees if they choose to do so.
The Fund is not required to hold annual meetings and
does not intend to do so; it may, however, hold special shareholder
meetings for such purposes as changing fundamental policies or new
management agreements. A meeting may also be called by a majority of
the Board of Trustees or by shareholders holding at least 10% of the
shares entitled to vote at the meeting. Shareholders may receive assistance
in communicating with other shareholders in connection with the election
or removal of trustees similar to the provisions contained in Section 16(c)
of the 1940 Act.
Under Massachusetts law, shareholders of a business trust may, under
certain circumstances, be held personally liable as partners for its
obligations. However, the risk of a shareholder incurring financial
loss on account of shareholder liability is limited to circumstances in which
both (i) any liability was greater than the Short or Intermediate Series'
insurance coverage and (ii) a Series itself was unable to meet its
obligations.
Shares of each of the Short and Intermediate Series may
be purchased at net asset value. Generally, the minimum initial investment
is $1,000, with a minimum of $50.00 for subsequent investments. A
minimum initial investment of $1,000 is required for Fund-sponsored
Individual Retirement Accounts; a $50 minimum investment is required
pursuant to an Automatic Investment Plan. See "Purchase and Redemption
of Shares."
Smith Breeden Associates, Inc., Chapel Hill, North Carolina
27514, a registered investment adviser, acts as the investment adviser (the
"Adviser") to each Series.
8
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Investment Objectives
The Short and Intermediate Series each have a different investment
objective and investment policies and are designed to meet different
investment needs. The investment objective and certain investment policies
of each Series, as well as certain investment restrictions, are fundamental
and may not be changed without a vote of shareholders of either of the
Series. There can be no assurance that the Short or Intermediate Series
will be successful in achieving their respective investment objectives. An
investment in the Short or Intermediate Series does not constitute a
complete investment program.
Short Duration Series
The Short Series' investment objective is to provide investors with a
high level of current income, consistent with a volatility of net asset value
similar to that of a portfolio which invests exclusively in six- month U.S.
Treasury securities on a constant maturity basis. There is no assurance
that the Short Series will be able to maintain a low volatility of net
asset value.
Under normal circumstances the Short Series will seek to achieve an
interest-rate risk or duration similar to that of a six-month U.S. Treasury
security on a constant maturity basis. The Short Series expects that, under
normal circumstances, the dollar-weighted average life (or period until the
next reset date) of its portfolio securities will be longer than six months,
sometimes significantly. This is because the maturity of a security
measures only the time until final payment is due; it takes no account of
the pattern of a security's cash flows over time, including how cash flow is
affected by prepayments and by changes in interest rates. This method of
computing duration is known as option-adjusted duration. The Adviser
may use the following techniques to lengthen or shorten the
option-adjusted duration: the acquisition of debt obligations at a premium
or discount, mortgage and interest -rate swaps, interest-rate caps and floors
and interest-rate futures and options and options on such futures.
The Adviser believes that by investing in mortgage securities from a
variety of market sectors on a selective basis and adjusting the overall
option-adjusted duration of the portfolio to approximate that of a
six-month Treasury security, the Short Series will achieve a more
consistent and less volatile net asset value than is characteristic of mutual
funds that invest primarily in mortgage securities paying a fixed rate of
interest or exclusively in adjustable rate mortgage securities. The securities
in which the Short Series may invest may not yield as high a level of
income as other securities which can be invested in by other funds.
However, such other securities may be more volatile and may be issued by
issuers which are less credit worthy.
The Short Series seeks to minimize risk of loss as a result of default
on any securities held by the Short Series by investing only in high credit
quality instruments. Like all investors in interest bearing securities,
however, the Short Series is exposed to the risk that the prices of individual
securities held by the Short Series can fluctuate, in some cases
significantly, in response to changes in prevailing interest rates.
9
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There can also be no assurance that the Short Series will achieve at
all times its targeted option-adjusted duration, because of the risk that the
expected relationship between general interest rate movements and the net
asset value of the Short Series will differ from what would be expected
from an investment in a six-month U.S. Treasury bill. This is because the
Short Series' computation of option-adjusted duration is based on
estimated rather than known factors (which typically affect investments in
Mortgage-Backed Securities), including expected prepayment rates,
valuation of homeowners' prepayment options, and the correlation of
changes between the markets for securities and the hedge instruments
owned by the Short Series (as described in Appendix A).
Intermediate Duration Series
The Intermediate Series' investment objective is to provide investors
with a total return in excess of the total return of major market indices for
mortgage-backed securities. Total return is the change of value of the
investment assuming reinvestment of all distributions. Under normal
circumstances, the Intermediate Series will seek to achieve an interest-rate
risk or duration similar to that of a portfolio that invests exclusively in
mortgage-backed securities, as weighted in the major market indices There
is no assurance that the Intermediate Series will be able to maintain a total
return in excess of the total return of major market indices for
mortgage-backed securities or that it will match the interest-rate risk of
a portfolio investing exclusively in these securities.
The Intermediate Series' duration is a measure of the price sensitivity
of the portfolio, including expected cash flow and mortgage prepayments
under a wide range of interest rate scenarios. The maturity of a security
measures only the time until final payment is due; it takes no account of
the pattern of a security's cash flows over time, including how cash flow is
affected by prepayments and by changes in interest rates. In computing the
duration of the Intermediate Series' portfolio, the Adviser will
estimate the duration of obligations that are subject to prepayment or
redemption by the issuer taking into account the influence of interest rates
on prepayments and coupon flows. As previously stated with respect to the
Short Series, this method of computing duration is known as
option-adjusted duration. The Adviser may use the following techniques to
lengthen or shorten the option-adjusted duration of its portfolio so as to
achieve the Fund's targeted option-adjusted duration: the acquisition of
debt obligations at a premium or discount, mortgage and interest rate
swaps, interest rate caps and floors and interest rate futures and options on
such futures.
There can be no assurance that at all times the targeted
option-adjusted duration will be achieved by the Intermediate Series,
because of the risk that the expected relationship between general interest
rate movements and the net asset value of the Intermediate Series will
differ from what would be expected from an investment in a portfolio
investing in mortgage-backed securities as weighted by the major mortgage
market indices. This is because the Intermediate Series' computation of
option-adjusted duration is based on estimated rather than known factors
(which typically affect investments in Mortgage-Backed Securities),including
expected prepayment rates, valuation of homeowners' prepayment options,
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and the correlation of changes between the markets for securities and the
hedge instruments owned by the Fund (as described in Appendix A). The
Intermediate Series expects that, under normal circumstances, the dollar-
weighted average life (or period until the next reset date) of the
Intermediate Series' portfolio securities will be somewhat shorter or longer
than that of a portfolio that invests exclusively in mortgage-backed
securities, as weighted in the major mortgage indices.
When market interest rates decline, the value of a portfolio invested in
intermediate-term fixed rate obligations can be expected to rise.
Conversely, when market interest rates rise, the value of a portfolio
invested in intermediate-term fixed rate obligations can be expected to fall.
The Intermediate Series seeks to minimize risk of loss as a result of default
on any securities held by the Intermediate Series by investing only in high
credit quality instruments. Like all investors in interest bearing securities,
however, the Intermediate Series is exposed to the risk that the prices of
individual securities held by it can fluctuate, in some cases significantly, in
response to changes in prevailing interest rates.
Investment Policies
The Short and Intermediate Series each seek to achieve their
investment objective by investing, under normal circumstances, at least 70%
of their total assets in fixed-income U.S. Government securities, including
U.S. Treasury Bills, Notes, Bonds and other debt securities issued by the
U.S. Treasury, and obligations issued or guaranteed by the U.S.
Government, its agencies and instrumentalities, including, but not limited
to Government National Mortgage Association ("GNMA"), Federal
National Mortgage Association ("FNMA") and Federal Home Loan
Mortgage Corporation ("FHLMC") securities. With respect to their
remaining assets, the Short and Intermediate Series may invest in fixed
rate and adjustable rate Mortgage-Backed Securities issued by private
originators of, or investors in, mortgage loans issued by private entities that
are rated AAA by Standard & Poor's ("S&P") or Aaa by Moody's Investors
Service ("Moody's") or of credit quality deemed equivalent by the Adviser
and money market instruments of a comparable short-term rating or credit
quality. The Short and Intermediate Series may employ certain active
management techniques both to hedge the interest rate risks associated
with portfolio securities and to seek to minimize fluctuation in net asset
values in accordance with their investment objectives and target
option-adjusted duratoins. These investment policies are fundamental and
may not be changed without shareholder approval.
Each Series may enter into mortgage and interest rate swaps,
interest rate futures and options on such futures, engage in short sales and
purchase interest rate caps, floors and collars in order to hedge against
interest rate fluctuations. In addition, the Short and Intermediate Series
may use stripped Mortgage-Backed Securities to reduce the option-adjusted
duration. Both Series may also employ loans of portfolio securities, dollar
rolls and reverse repurchase agreements as investment techniques. These
techniques will be undertaken to enhance income in the Short Series and
total return in the Intermediate Series.
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As a matter of fundamental policy, which may not be changed
except by vote of the majority of shareholders, the Short and
Intermediate Series will both limit purchases to the following classes of
assets:
1. Securities issued directly or guaranteed by the U.S. Government
or its agencies or instrumentalities;
2. Mortgage-Backed Securities rated AAA by S&P or Aaa by Moody's or
unrated but deemed of equivalent quality by the Adviser;
3. Assets fully collateralized by assets in either of the above classes;
4. Assets which would qualify as liquidity items under federal regulations
if held by a commercial bank or savings institution; or
5. Hedge instruments, which may only be used for risk management
purposes. Any securities described in the "Hedging" section and any
stripped Mortgage-Backed Securities may only be used for risk
management purposes.
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Characteristics of Securities in Which the Short and Intermediate Series
Invest
MORTGAGE-BACKED SECURITIES
Mortgage-Backed Securities are securities that directly or
indirectly represent a participation in, or are collateralized by and payable
from, mortgage loans secured by real property. The term
Mortgage-Backed Securities, as used herein, includes adjustable-rate
mortgage securities, fixed-rate mortgage securities, and derivative mortgage
products such as collateralized mortgage obligations, stripped
Mortgage-Backed Securities and other instruments described below.
There are currently three basic types of Mortgage-Backed
Securities: (i) those issued or guaranteed by the U.S. Government or one
of its agencies or instrumentalities, such as GNMA, FNMA and FHLMC,
described below; (ii) those issued by private issuers that represent an
interest in or are collateralized by Mortgage-Backed Securities issued or
guaranteed by the U.S. Government or one of its agencies or
instrumentalities; and (iii) those issued by private issuers that represent an
interest in or are collateralized by whole mortgage loans or Mortgage-
Backed Securities without a government guarantee but usually having some
form of private credit enhancement.
The Short and Intermediate Series will only purchase
Mortgage-Backed Securities which constitute "Mortgage Related Securities"
for purposes of the Secondary Mortgage Enhancement Act of 1984
The Nature of Adjustable and Fixed Rate Mortgage Loans
The following is a general description of the two general types of
mortgage loans which may be expected to underlie the Mortgage-Backed
Securities in which the Short and Intermediate Series may invest:
fixed-rate and adjustable-rate mortgages.
Adjustable-Rate Mortgage Loans ("ARMs")
ARMs eligible for inclusion in a mortgage pool will generally
provide for a fixed initial mortgage interest rate for a specified period of
time, generally for either the first three, six, twelve, thirteen, thirty-six
or sixty scheduled monthly payments. Thereafter, the interest rates
are subject to periodic adjustment based on changes in the index rate
applicable to the individual loans.
ARMs contain minimum and maximum rates beyond which the
mortgage interest rate may not vary over the lifetime of the loan. In
addition, certain ARMs provide for additional limitations on the maximum
amount by which the mortgage interest rate may adjust for any single
adjustment period. Alternatively, certain ARMs ("Negatively Amortizing
ARMs") may provide limitations on changes in the required monthly
payment. Limitations on monthly payments can result in monthly
payments which are greater or less than the amount necessary to amortize
a Negatively Amortizing ARM by its maturity at the interest rate in effect
in any particular month. In the event that a monthly payment is not
sufficient to pay the interest accruing on a Negatively Amortizing ARM,
any such excess interest is added to the principal balance of the loan,
causing negative amortization, and will be repaid through future monthly
payments. It may take borrowers under Negatively Amortizing ARMs
longer periods of time to increase their net equity in the mortgaged
properties and may increase the likelihood of
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default by such borrowers. In the event that a monthly payment exceeds
the sum of the interest accrued at the current rate and the principal
payment which would have been necessary to amortize the outstanding
principal balance over the remaining term of the loan, the excess further
reduces the principal balance of the ARM. Negatively Amortizing ARMs
do not provide for the extension of their original maturity to accommodate
changes in their mortgage interest rates. As a result, unless there is a
periodic recalculationof the payment amount, the final payment may be
substantially larger than the other payments. Generally, Negatively
Amortizing ARMs do provide for periodic recalculation of the payment
amount. Limitations on periodic increases in interest rates and on changes
in monthly payments protect borrowers from unlimited interest rate and
payment increases.
There are two types of indices which provide the basis for rate
adjustments on ARMs: those based on market rates and those based on a
calculated measure such as a cost of funds index or a moving average of
mortgage rates. Commonly utilized indices include the one-year, three-year
and five-year constant maturity U.S. Treasury rates (as reported by the
Federal Reserve Board), the three-month Treasury Bill rate, the 180-day
Treasury Bill rate, rates on longer-term Treasury securities, the Eleventh
District Federal Home Loan Bank Cost of Funds Index ("COFI"), the
National Median Cost of Funds, the one-month, three-month, six-month or
one year London Interbank Offered Rate ("LIBOR"), the prime rate of a
specific bank, or commercial paper rates. Some indices, such as the
one-year constant maturity Treasury rate or three-month LIBOR, are
highly correlated with changes in market interest rates. Other indices, such
as COFI, tend to lag changes in market rates and tend to be somewhat less
volatile over short periods of time.
Fixed Rate Mortgage Loans
Generally, fixed rate mortgage loans eligible for inclusion in a
mortgage pool will bear simple interest at fixed rates and have original
terms ranging from five to forty years. These loans generally provide for
monthly payments of principal and interest in substantially equal
installments for the contractual term of the mortgage note in sufficient
amounts to fully amortize principal by maturity although certain fixed rate
mortgage loans provide for a large final "balloon" payment at maturity.
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Regulation of Mortgage Loans
Mortgage loans are subject to a variety of state and federal regulations
designed to protect mortgagors, which may impair the ability of the
mortgage lender to enforce its rights under the mortgage documents.
These regulations include legal restraints on foreclosures, homeowner
rights of redemption after foreclosure, federal and state bankruptcy and
debtor relief laws, restrictions on enforcement of mortgage loan "due on
sale" clauses and state usury laws. Even though the Short and
Intermediate Series will invest in Mortgage-Backed Securities issued or
guaranteed by the U.S. Government, its agencies or instrumentalities, these
regulations may adversely affect the two Series' investments by delaying
their receipt of principal or interest on mortgage loans affected by such
regulations.
Government Agency Mortgage Pass-Through Securities
The Short and Intermediate Series will invest in Mortgage-Backed
Securities which are issued or guaranteed by the United States Government
or one of its agencies or instrumentalities, including but not limited to
GNMA, FNMA and FHLMC. Under normal circumstances, such
Mortgage-Backed Securities (along with other securities issued or
guaranteed by the U.S. Government or its agencies and instrumentalities)
will comprise at least 70% of the Portfolio. GNMA securities are backed
by the full faith and credit of the U.S. Government, which means that the
U.S. Government guarantees that the interest and principal will be paid
when due. FNMA securities and FHLMC securities are not backed by the
full faith and credit of the U.S. Government; however, the payment of
principal and interest is guaranteed by FNMA and FHLMC, as the case
may be, both of which may borrow from the U.S. Treasury at the discretion
of the Secretary of the Treasury. These guarantees do not extend to the
securities' yield or value, which are likely (except in the case of certain
stripped Mortgage-Backed Securities and CMO bonds) to vary inversely
with fluctuations in interest rates, nor do the guarantees extend to the yield
or value of the Short and Intermediate Series' shares.
U.S. Government Agency Mortgage-Backed Securities provide
for the pass-through to investors of their pro rata share of monthly
payments (including any prepayments) made by the individual borrowers on
the pooled mortgage loans, net of any fees paid to the guarantor of such
securities and the servicer of the underlying mortgage loans.
GNMA Certificates
GNMA is a wholly-owned corporate instrumentality of the United States
within the Department of Housing and Urban Development. GNMA is
authorized to guarantee the timely payment of the principal of and
interest on certificates that are based on and backed by a pool of mortgage
loans insured by the Federal Housing Administration ("FHA Loans"), or
guaranteed by the Veterans Administration ("VA Loans"), or by pools of
other eligible mortgage loans. The National Housing Act of 1934, as
amended, provides that the full faith and credit of the U.S. Government is
pledged to the payment of all amounts that may be required to be paid
under any guaranty. In order to meet its obligations under any guaranty,
GNMA is authorized to borrow from the United States Treasury in an
unlimited amount.
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FNMA Certificates
FNMA is a stockholder-owned corporation chartered under an
act of the United States Congress. Each FNMA Certificate is issued and
guaranteed by FNMA and represents an undivided interest in a pool of
mortgage loans (a "Pool") formed by FNMA. Each Pool consists of
residential mortgage loans either previously owned by FNMA or purchased
by it in connection with the formation of the Pool. The mortgage loans
may be either conventional mortgage loans (i.e., not insured or guaranteed
by any U.S. Government agency) or mortgage loans that are either insured
by the Federal Housing Administration or guaranteed by the Veterans
Administration. The lenders originating and servicing the mortgage loans
are subject to certain eligibility requirements established by FNMA.
FNMA has certain contractual responsibilities. With respect
to each Pool, FNMA is obligated to distribute scheduled monthly
installments of principal and interest after FNMA's servicing and guaranty
fee, whether or not received, to Certificate holders. FNMA also is
obligated to distribute to holders of Certificates an amount equal to the
full principal balance of any foreclosed mortgage loan in the Pool, whether
or not such principal balance is actually recovered. The obligations of
FNMA under its guaranty of its Certificates are obligations solely of
FNMA.
FHLMC Certificates
FHLMC is a corporate instrumentality of the United States.
The principal activity of FHLMC currently is the purchase of first lien,
conventional, residential mortgage loans and participation interests in such
mortgage loans and their resale in the form of mortgage securities,
primarily FHLMC Certificates. A FHLMC Certificate represents a pro
rata interest in a group of mortgage loans or participation in mortgage
loans purchased by FHLMC.
FHLMC guarantees to each registered holder of a FHLMC
Certificate the timely payment of interest at the rate provided for by such
Certificate (whether or not received on the underlying loans). FHLMC
also guarantees to each registered Certificate holder ultimate collection of
all principal of the related mortgage loans, without any offset or deduction,
but does not, generally, guarantee the timely payment of scheduled
principal. However, FHLMC now issues certain mortgage-backed
securities, called "Gold PCs," which guarantee timely payment of principal
reductions. The obligations of FHLMC under its guaranty of FHLMC
Certificates are obligations solely of FHLMC.
Private Mortgage Pass-Through Securities
Private mortgage pass-through securities are structured imilarly to
GNMA, FNMA and FHLMC mortgage pass-through securities and
are issued by originators of and investors in mortgage loans, including
depository institutions, mortgage banks, investment banks and special
purpose subsidiaries of these entities. These securities usually are backed
by a pool of conventional fixed rate or adjustable rate mortgage loans.
Since private mortgage pass-through securities typically are not guaranteed
by an entity having the credit status of GNMA, FNMA and FHLMC, such
securities generally are structured with one or more types of credit
enhancement. The Series will invest in private mortgage pass-through
securities only if they are rated AAA by S&P or Aaa by Moody's or
securities which are unrated but deemed to be of comparable credit quality
by the Adviser.
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Private mortgage pass-through securities are often backed by a pool of
assets representing the obligations of a number of different parties. To
lessen the effect of failures by obligors on underlying assets to make
payments, those securities may contain elements of credit support, which
fall into two categories: (i) liquidity protection and (ii) protection against
losses resulting from ultimate default by an obligor on 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 default ensures ultimate payment of
the obligations on at least a portion of the assets in the pool. This
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 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 a security. The Short and Intermediate Series will not pay
any additional fees for credit support. The existence of credit support may
increase the price of a security to reflect its credit protection and lower
risk. If the Short or Intermediate Series invests in securities backed by
credit support, they may realize a lower yield on a higher-grade security
which contains credit support than on a lower-grade security which does
not.
Multiple Class Pass-Through Securities and Collateralized Mortgage
Obligations
Multiple class pass-through securities are interests in a trust composed of
GNMA, FNMA or FHLMC Certificates or whole loans or private
mortgage pass-through securities (such collateral collectively hereinafter
referred to as "Mortgage Assets"). Types of multiple class pass-through
securities include, among others, collateralized mortgage obligations
("CMOs"), real estate mortgage investment conduit ("REMIC")
pass-through or participation certificates, and stripped mortgage-backed
securities ("SMBS"), which are discussed below. A REMIC is a CMO that
qualifies for special tax treatment under the Internal Revenue Code and
invests in certain mortgages principally secured by interests in real property
and other permitted investments.
CMOs and guaranteed REMIC pass-through certificates
("REMIC Certificates") issued by FNMA and FHLMC are types of
multiple class pass-through securities. Investors may purchase "regular"
beneficial interests in REMICs. The REMIC Certificates represent
beneficial ownership interests in a REMIC trust, generally consisting of
mortgage loans or FNMA, FHLMC or GNMA guaranteed pass-through
certificates. The obligations of FNMA or FHLMC under their respective
guaranty of the REMIC Certificates are obligations solely of FNMA or
FHLMC.
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FNMA REMIC Certificates are issued and guaranteed as to
timely distribution of principal and interest by FNMA. In addition, FNMA
will be obligated to distribute on a timely basis to holders of FNMA
REMIC Certificates required installments of principal and interest and to
distribute the principal balance of each class of REMIC Certificates in full,
whether or not sufficient funds are otherwise available.
For FHLMC REMIC Certificates, FHLMC guarantees the
timely payment of interest and also guarantees the payment of principal as
payments are required to be made on the underlying mortgage
participation certificates ("PCs"). PCs represent undivided interests in
specified level payment, residential mortgages or participation therein
purchased by FHLMC and placed in a PC pool. With respect to principal
payments on PCs, FHLMC generally guarantees ultimate collection of all
principal of the related mortgage loans without offset or deduction.
FHLMC also guarantees timely payment of principal on Gold PCs.
CMOs and REMIC Certificates are issued in multiple classes.
Each class of CMO or REMIC Certificates, often referred to as a
"tranche," is issued at a specific adjustable or fixed interest rate and must
be fully retired no later than its final distribution date. Principal payments
on the Mortgage Assets underlying the CMOs or REMIC Certificates may
cause some or all of the classes of CMOs or REMIC Certificates to be
retired substantially earlier than their final distribution dates. Generally,
interest is paid or accrues on all classes of CMOs or REMICs on a
monthly or quarterly basis.
The principal of and interest on the Mortgage Assets may be
allocated among the several classes of CMOs or REMIC Certificates in
several ways. In certain structures (known as "sequential pay" CMOs or
REMIC Certificates), payments of principal, including any principal
prepayments, on the Mortgage Assets generally are applied to the classes
of CMOs or REMIC Certificates in the order of their respective final
distribution dates. Thus no payment of principal will be made on any class
of sequential pay CMOs or REMIC Certificates until all other classes
having an earlier final distribution date have been paid in full.
Additional structures of CMOs and REMIC Certificates include,
among others, "parallel pay" CMOs and REMIC Certificates. Parallel pay
CMOs and REMIC Certificates are those which are structured to apply
principal payments and prepayments of the Mortgage Assets to two or
more classes concurrently on a proportionate or disproportionate basis.
These simultaneous payments are taken into account in calculating the final
distribution date of each class.
A wide variety of REMIC Certificates may be issued in the parallel pay
or sequential pay structures. These securities include accrual certificates
(also known as "Z-Bonds"), which only accrue interest at a specified rate
until all other certificates having an earlier final distribution date have
been retired and are converted thereafter to an interest-paying security, and
planned amortization class ("PAC") certificates, which are parallel pay
REMIC Certificates which generally require that specified amounts of
principal be applied on each payment date to one or more classes of
REMIC Certificates (the "PAC Certificates"), even though all ther principal
payments and prepayments of the Mortgage Assets are then required to be
applied to one or more other classes of Certificates. The scheduled
principal payments for the PAC Certificates generally have the highest
priority on each payment date after interest due has been paid to all
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classes entitled to receive interest currently. Shortfalls, if any, are added
to the amount payable on the next payment date. The PAC Certificate
payment schedule is taken into account in calculating the final distribution
date of each PAC. In order to create PACs, one or more tranches
generally must be created that absorb most of the volatility in the
underlying mortgage assets. These tranches tend to have market prices and
yields that are much more volatile than the PACs.
In reliance on an interpretation by the Securities and
Exchange Commission ("SEC"), the Short and Intermediate Series'
investments in certain qualifying CMOs and REMICs are not subject to the
Investment Company Act's limitation on acquiring interests in other
investment companies. See "Investment Restrictions" in the Statement of
Additional Information. CMOs and REMICs issued by an agency or
instrumentality of the U.S. Government are considered U.S. Government
securities for purposes of this Prospectus.
Stripped Mortgage-Backed Securities ("SMBS")
The Short and Intermediate Series may invest in SMBS,
which are derivative multi-class mortgage securities. In addition to SMBS
issued by the U.S. Government, its agencies or instrumentalities, the Short
and Intermediate Series may purchase SMBS issued by private originators
of, or investors in, mortgage loans, including depository institutions,
mortgage banks, investment banks and special purpose subsidiaries of
these entities. The two Series will purchase only SMBS that are
collateralized by U.S. Government Agency Mortgage-Backed Securities.
SMBS are usually structured with two classes that receive different
proportions of the interest and principal distributions from a pool of
Mortgage Assets. A common type of SMBS will have one class receiving all
of the interest from the Mortgage Assets, while the other class will receive
all of the principal. However, in some instances, one class will receive some
of the interest and most of the principal while the other class will receive
most of the interest and the remainder of the principal. If the underlying
Mortgage Assets experience greater than anticipated prepayments of
principal, the Series may fail to fully recover its initial investment in
these securities, even if the SMBS are rated AAA by S&P or Aaa by Moody's.
SMBS are unusually volatile in response to changes in interest rates and, in
respect of SMBS that receive all or most of their interest from Mortgage
Assets, there is a risk that the initial investment will not be fully recouped.
The Adviser will seek to manage these risks (and potential benefits) by
investing in a variety of such securities and by using certain hedging
techniques, as described below in "Hedging." The Adviser expects that
interest-only SMBS will be purchased by the Series for their hedging
characteristics. Such SMBS will reduce the variance of the Series'
respective net asset values from targeted option-adjusted duration.
Under no circumstances will the Short or Intermediate Series purchase
SMBS if such purchase would cause SMBS to exceed 5% of the assets of a
Series.
New instruments and variations of existing Mortgage- Backed Securities
continue to be developed. The Short and Intermediate Series may invest
in any such instruments or variations as may be developed, to the extent
consistent with their investment objectives and policies and applicable
regulatory requirements.
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YIELD, MARKET VALUE AND RISK CONSIDERATIONS
OF
MORTGAGE-BACKED SECURITIES
The Short and Intermediate Series may invest in certain
Mortgage-Backed Securities, such as interest-only SMBS, that are
extremely sensitive to changes in prepayments and interest rates. Even
though such securities may be rated in the highest rating categories by S&P
or Moody's or be guaranteed by an agency or instrumentality of the U.S.
Government under certain interest rate or prepayment rate scenarios, the
Short and Intermediate Series may fail to fully recover their investment in
such securities. The Short and Intermediate Series will purchase only
SMBS that are collateralized by U.S. Government Agency
Mortgage-Backed Securities.
The investment characteristics of adjustable and fixed rate
Mortgage-Backed Securities differ from those of traditional fixed income
securities. The major differences include the payment of interest and
principal on Mortgage-Backed Securities on a more frequent (usually
monthly) schedule, and the possibility that principal may be prepaid at any
time due to prepayments on the underlying mortgage loans or other assets.
These differences can result in significantly greater price and yield
volatility than is the case with traditional fixed income securities. As
a result, if the Short or Intermediate Series purchases Mortgage-Backed
Securities at a premium, a faster than expected prepayment rate will reduce
both the market value and the yield to maturity from those which were
anticipated. A prepayment rate that is slower than expected will have the
opposite effect of increasing yield to maturity and market value. Conversely,
if the Short or Intermediate Series purchases Mortgage-Backed Securities at a
discount, faster than expected prepayments will increase, while slower than
expected prepayments will reduce, yield to maturity and market value. The
Adviser will seek to manage these potential risks and benefits by investing
in a variety of Mortgage-Backed Securities and by using certain hedging
techniques. See "Hedging."
Prepayments on a pool of mortgage loans are influenced
by a variety of factors, including changes in mortgagors' housing needs, job
transfers, unemployment, mortgagors' net equity in the mortgage properties
and servicing decisions. The timing and level of prepayments cannot be
predicted with certainty. As with fixed mortgage loans, adjustable rate
mortgage loans may be subject to greater prepayment rates in a declining
interest rate environment. The mortgage loans underlying the Mortgage-
Backed Securities generally may be prepaid at any time without penalty. In
a fluctuating interest rate environment, a predominant factor affecting the
prepayment rate on a pool of mortgage loans is the difference between the
interest rates on the mortgage loans and prevailing mortgage loan interest
rates (giving consideration to the cost of any refinancing). In general, if
mortgage loan interest rates fall sufficiently below the interest rates on
fixed rate mortgage loans underlying mortgage pass-through securities, the
rate of prepayment would be expected to increase. Conversely, if mortgage
loan
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interest rates rise above the interest rates on the fixed rate mortgage loans
underlying the Mortgage-Backed Securities, the rate of prepayment may be
expected to decrease. Since prepayments on fixed rate mortgage loans
generally are likely to increase during a period of falling mortgage interest
rates, the amounts of prepayments available for reinvestment by the Short
and Intermediate Series are likely to be greater during a period of falling
mortgage rates. If general interest rates also decline during such a period,
these higher prepayments are likely to be reinvested at lower rates than
that which the Short or Intermediate Series were earning on the Mortgage-
Backed Securities that were prepaid. Like most traditional fixed-income
securities, most Mortgage-Backed Securities, including those backed by
ARMs, decrease in value as a result of increases in interest rates.
However, many Mortgage-Backed Securities may benefit less than other
fixed income securities from declining interest rates because of the risk of
prepayment.
In general, changes in both prepayment rates and interest rates will
change the yield on Mortgage-Backed Securities backed by ARMs. The
rate of principal prepayments with respect to ARMs has fluctuated in
recent years. As is the case with fixed rate mortgage loans, ARMs may be
subject to a greater rate of principal prepayments in a declining interest
rate environment. For example, if prevailing interest rates fall significantly,
ARMs could be subject to higher prepayment rates than if prevailing
interest rates remain constant because the availability of fixed rate
mortgage loans at competitive interest rates may encourage mortgagors to
refinance their ARMs to obtain a lower fixed interest rate. Conversely, if
prevailing interest rates rise significantly, ARMs may prepay at lower rates
than if prevailing rates were to remain at or below those in effect at the
time such ARMs were originated. There can be no certainty as to the rate
of prepayments on the ARMs in either stable or changing interest rate
environments. In addition, there can be no certainty as to whether
increases in the principal balances of the ARMs due to the addition of
deferred interest may result in a default rate higher than that on ARMs
that do not provide for negative amortization. Other factors affecting
prepayment of ARMs include changes in mortgagors' housing needs, job
transfers, unemployment, mortgagors' net equity in the mortgage properties
and servicing decisions. Unlike investments in fixed-income mortgages
which decline in value during periods of rising interest rates, investments in
ARM-backed securities will allow the Short and Intermediate Series to
participate in increases in interest rates through periodic adjustments in the
coupons of the underlying mortgages, resulting in both higher current
yields and lower price fluctuations. However, the Short and Intermediate
Series will not benefit from increases in interest rates if interest rates rise
to the point where they would cause the current interest rates on the
ARMs underlying its Mortgage- Backed Securities to exceed the maximum
allowable annual or lifetime reset limits, as described above, for a
particular mortgage. The Adviser will seek to manage these risks (and
potential benefits) by using certain hedging techniques. See "Hedging."
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To the extent the Short and Intermediate Series invest
in ARMs, the adjustable rate feature of ARMs generally will act as a
buffer to reduce sharp changes in each Series' respective net asset values
in response to normal interest rate fluctuations. As the interest rates on
the ARMs underlying the each Series' investments are reset periodically,
the yields of each Series' adjustable rate Mortgage-Backed Securities will
gradually align themselves to reflect changes in market rates. As a result,
adjustable rate Mortgage-Backed Securities, on a stand-alone basis, should
fluctuate less dramatically in price than each Series' investments will in
fixed rate Mortgage-Backed Securities on a stand-alone basis. Although
having less risk of decline during periods of rising market interest rates,
adjustable rate Mortgage-Backed Securities, because their coupon rates will
decline in response to market interest rate declines, generally have less
potential for market appreciation than fixed rate Mortgage-Backed
Securities. As described in "Hedging" below, the Adviser will seek to
manage the expected price fluctuations of each Series' securities on an
aggregate basis, and therefore of each Series' net asset values, by using
certain hedging techniques. See "Hedging."
The Short and Intermediate Series' reinvestment of principal payments
and prepayments received on a mortgage pass-through security may be
made at rates higher or lower than the rate payable on such security, thus
affecting the realized return. In addition, the receipt of interest payments
monthly rather than semi-annually by the Short or Intermediate Series has
a compounding effect that may increase the yield relative to that received
on debt obligations that pay interest semi-annually. Due to these factors,
Mortgage-Backed Securities may also be less effective than U.S. Treasury
securities of similar maturity at maintaining yields during periods of
declining interest rates. Prepayments may have a disproportionate effect
on certain Mortgage-Backed Securities such as SMBS and certain other
multiple class pass-through securities. The Short and Intermediate Series
may purchase Mortgage-Backed Securities at a premium or at a discount.
Negatively Amortizing ARMs that are not guaranteed as to full
and timely payment of principal and interest may be subject to increasing
credit exposure. ARMs that are guaranteed as to full and timely payment
of principal and interest may be subject to additional prepayment risk
resulting from increased default rates.
All of the Mortgage-Backed Securities in which the Short
or Intermediate Series may invest are traded in over-the-counter markets
rather than on exchanges. The size of spreads between bid and asked
prices in over-the-counter markets for Mortgage-Backed Securities depends
upon a number of factors, including the outstanding principal amount of
the particular security, the number of dealers making markets in the
security, the length of time that a particular type of security has been
trading in the market and the perceived volatility of the price of the
security. Some of the Mortgage-Backed Securities in which the Short and
Intermediate Series may invest, in particular certain SMBS and private
mortgage pass-through securities, may trade with a wider spread between
the bid and asked quotations than do other fixed-income securities, such as
U.S. Government securities or Mortgage-Backed Securities having current
market fixed coupons.
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The spread between the bid and asked quotations is taken into account,
among other things, in the determination of the value of each security
and, therefore, in the determination of the net asset value per share of
each of the Series. See "Valuation of Fund Shares". If the Short
or Intermediate Series are forced on short notice to sell securities for
which the spread between bid and asked quotations is wide, as a result of
requests for redemption of a large number of shares or for some other
reason, the Short or Intermediate Series may not be able to obtain the
same price for such security as it would if it were able to take a longer
period of time to seek the most efficient execution of its proposed sale.
ILLIQUID SECURITIES
Each of the Series may invest up to 15% of its net assets in securities
for which there are legal or contractual restrictions on resale or for which
there is no readily available market or other illiquid securities, including
non-terminable repurchase agreements having maturities of more than
seven days. See "Investment Restrictions" in the Statement of Additional
Information. The Adviser will monitor the illiquidity of such restricted
securities under the supervision of the Board of Trustees. The
determination of whether interest-only and principal-only SMBS issued
by the U.S. Government are liquid shall be made by the Adviser under
guidelines established by the Board of Trustees. Pursuant to SEC policy,
privately-issued SMBS shall be considered illiquid for purposes of the
limitation on investments in illiquid securities. The staff of the SEC has
taken the position that OTC options, interest-rate swaps, caps, floors and
collars (as discussed in Appendix A) are illiquid securities. The Adviser
disagrees with this position. Nevertheless, the Short and Intermediate
Series have agreed to treat OTC options, interest-rate swaps, caps, floors
and collars as illiquid securities so long as the SEC maintains this position.
HEDGING
The Short and Intermediate Series may employ certain
active management techniques to achieve their duration objectives as
described above in "Investment Objectives and Investment Policies" and to
hedge the interest rate risks associated with the securities in accordance
with such objectives. Since some of the securities may have longer
durations than the Short and Intermediate Series' duration objectives and
some of the securities may have shorter durations, hedging may be
required either to lengthen or to shorten the duration of the aggregate
portfolio to reduce the variance from the duration objectives. Rather
than seeking to profit from changes or "trends" in general interest rate
levels, the Short and Intermediate Series will seek continually to manage
duration within a narrow range.
The Short and Intermediate Series intend to use hedging
transactions as a hedge against interest rate fluctuations and not as
speculative transactions. Hedging transactions may also be used as a
temporary substitute for purchasing particular securities. Each Series may
enter into mortgage and interest rate swaps, purchase or sell interest rate
floors, caps or collars, enter into interest rate futures contracts and related
options, and engage in short sales to hedge against interest rate
fluctuations. In addition, the Short and Intermediate Series expect to use
SMBS to reduce their respective targeted option-adjusted durations.
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Any or all of these techniques may be used at one time.
Use of any particular transaction is a function of market conditions. The
hedging transactions that the Short and Intermediate Series currently
contemplate using are described in detail in Appendix A.
Hedging transactions pose certain risks, which are described
in Appendix A.
OTHER INVESTMENTS AND PRACTICES
Repurchase Transactions
The Short and Intermediate Series may invest in repurchase
agreements, which are agreements pursuant to which securities
are acquired from a third party with the commitment that they will be
repurchased by the seller at a fixed price on an agreed upon date. These
agreements may be made with respect to any of the portfolio securities in
which the Short or Intermediate Series are authorized to invest.
Repurchase agreements may be characterized as loans secured by the
underlying securities. The resale price reflects the purchase price plus an
agreed upon market rate of interest which is unrelated to the coupon rate
or date of maturity of the purchased security. The securities underlying the
repurchase agreement will be held by the Custodian at all times in an
amount at least equal to the repurchase price, including accrued interest
earned on the underlying securities. If the seller defaults on its obligation
to repurchase the underlying securities, as a result of its bankruptcy or
otherwise, and the value of the collateral securing the repurchase
agreement declines, the Short and Intermediate Series may incur a loss.
Repurchase agreements facilitate portfolio management
and allow the two Series to earn additional revenue. The Short and
Intermediate Series may enter into repurchase agreements in order to
increase liquidity or as a temporary investment while the Series are
acquiring suitable long term investments. The Series may enter into
repurchase agreements with (i) member banks of the Federal Reserve
System having total assets in excess of $500 million and (ii) securities
dealers, provided that such banks or dealers meet the creditworthiness
standards established by the Fund's Board of Trustees ("Qualified
Institutions"). The Adviser will monitor the continued creditworthiness of
Qualified Institutions, subject to the oversight of the Fund's Board of
Trustees.
The use of repurchase agreements involves certain risks.
For example, if the seller of securities under a repurchase agreement
defaults, the Short and Intermediate Series will seek to dispose of such
securities, which action could involve costs or delays.
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Reverse Repurchase Agreements and Dollar Roll Agreements
The Short and Intermediate Series may enter into reverse repurchase
agreements and dollar roll agreements with Qualified Institutions to seek
to enhance returns.
Reverse repurchase agreements involve sales by the Short and
Intermediate Series of portfolio assets concurrently with an agreement to
repurchase the same assets at a later date at a fixed price. During the
reverse repurchase agreement period, the Short and Intermediate Series
continue to receive principal and interest payments on these securities.
The Short and Intermediate Series may enter into dollar rolls
whereby the Short or Intermediate Series could sell securities for
delivery in the current month and simultaneously contract to repurchase
substantially similar (same type and coupon) securities on a specified future
date. During the roll period, the Short or Intermediate Series would forgo
principal and interest paid on the securities. The Short or Intermediate
Series would be compensated by the difference between the current sales
price and the 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.
The Short or Intermediate Series will establish a segregated account
with their respective custodians in which each will maintain cash, U.S.
Government securities or other liquid high-grade debt obligations equal in
value to their respective obligations in respect of reverse repurchase
agreements and dollar rolls. Reverse repurchase agreements and dollar
rolls involve the risk that the market value of the securities retained by a
Series may decline below the price of the securities a Series would have
sold but is obligated to repurchase under the agreement. In the event the
buyer of securities under a reverse repurchase agreement files for
bankruptcy or becomes insolvent, the Short or Intermediate Series' use of
the proceeds of the agreement may be restricted pending a determination
by the other party, or its trustee or receiver, whether to enforce either
Series' obligation to repurchase the securities. Reverse repurchase
agreements and dollar rolls are considered borrowings.
When-issued and Delayed Delivery Securities and Forward
Commitments
From time to time, in the ordinary course of business, the
Short and Intermediate Series may purchase securities on a when-issued or
delayed delivery basis or may purchase or sell securities on a forward
commitment basis. When such transactions are negotiated, the price is
fixed at the time of the commitment, but delivery and payment can take
place a month or more after the date of the commitment. While the
Short and Intermediate Series will purchase only securities on a
when-issued, delayed delivery or forward commitment basis with the
intention of acquiring the securities, the Short or Intermediate Series may
sell the securities before the settlement date, if it is deemed advisable. At
the time the Short or Intermediate Series makes the commitment to
purchase securities on a when-issued or delayed delivery basis, the Short
or Intermediate Series will record the transaction and thereafter reflect the
value, each day, of such security in determining its net asset value. At the
time of delivery of the securities, the value may be more or less than the
purchase price. An increase in the percentage of each of the Series' assets
committed to the
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purchase of securities on a when-issued, delayed delivery or forward
commitment basis may increase the volatility of each of the Series' net
asset value. Any increased volatility will be factored into the Adviser's
evaluation of the net option-adjusted duration of net assets and offsetting
positions will generally be present. At the time either of the Series enters
into a transaction on a when-issued or forward commitment basis, a
segregated account consisting of cash, U.S. Government securities or other
liquid high-grade debt securities equal to at least 100% of the value of the
when-issued or forward commitment securities will be established and
maintained with the custodian. Subject to this requirement, the Series
may purchase securities on such basis without limit.
Settlements in the ordinary course, which may take substantially more
than five business days for Mortgage-Backed Securities, are not treated by
either Series as when-issued or forward commitment transactions and,
accordingly, are not subject to the foregoing limitations even though some
of the risks described above may be present in such transactions.
Lending of Portfolio Securities
The Short or Intermediate Series may lend their respective portfolio
securities to Qualified Institutions. By lending their portfolio securities,
the Short or Intermediate Series will attempt to increase income through the
receipt of interest on the loan. Any gain or loss in the market price of the
securities loaned that may occur during the term of the loan will be for the
account of the Short or Intermediate Series. Under present regulatory
policies, the borrower must pledge and maintain with either Series
collateral consisting of cash, cash equivalents, U.S. Government securities
or other liquid high-grade debt securities in an amount not less than 100%
of the value of the loaned securities.
Neither the Short nor the Intermediate Series will lend portfolio
securities if, as a result, the aggregate of such loans exceeds 33 1/3% of the
total asset value (including such loans). All relevant facts and
circumstances, including the creditworthiness of the Qualified Institution,
will be monitored by the Adviser, and will be considered in making
decisions with respect to lending of securities, subject to review by the
Fund's Board of Trustees. The Series may pay reasonable negotiated fees
in connection with loaned securities, so long as such fees are set forth in a
written contract and their reasonableness is determined by the Fund's
Board of Trustees.
Other Investments
The Short or Intermediate Series may also invest in other instruments
including obligations of the United States, notes, bonds, and discount notes
of other U.S. Government agencies or instrumentalities, including but not
limited to: Federal National Mortgage Association, Government National
Mortgage Association, Federal Home Loan Mortgage Corporation, Federal
Home Loan Banks, Bank for Cooperatives, Farm Credit Banks, Tennessee
Valley Authority, Federal Financing Bank, Small Business Administration
and Federal Agricultural Mortgage Corporation. The Series may also
invest in time and savings deposits (including fixed or adjustable rate
certificates of deposit) in commercial banks or in institutions whose
accounts are insured by the FDIC, BIF or SAIF.
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Borrowing
The Short or Intermediate Series may borrow from banks
and enter into reverse repurchase agreements or dollar rolls up to 33 1/3%
of the value of the total assets for each of the Series (computed at the
time the loan is made) to take advantage of investment opportunities and
for temporary, extraordinary or emergency purposes, or for the clearance
of transactions. A Series may pledge up to 33 1/3% of the total assets for
each of the Series to secure these borrowings. If a Series' asset coverage
for borrowings falls below 300%, the Series will take prompt action to
reduce its borrowings even though it may be disadvantageous at that time
from an investment point of view. The Short and Intermediate Series will
incur borrowing costs when it leverages, including payment of interest and
any fee necessary to maintain a line of credit, and may be required to
maintain a minimum average balance. If the income and appreciation on
assets acquired with borrowed funds exceed their borrowing cost, the
Short or Intermediate Series' investment performances will increase,
whereas if the income and appreciation on assets acquired with borrowed
funds are less than their borrowing costs, investment performances will
decrease. In addition, if the Short or Intermediate Series borrows to
invest in securities, any investment gains made on the securities in excess of
the costs of the borrowing, and any gain or loss on hedging, will cause the
net asset value of the shares of each of the Series to rise faster than would
otherwise be the case. On the other hand, if the investment performance
of the additional securities purchased fails to cover their cost (including any
interest paid on the money borrowed) to each of the Series, the net asset
value of each of the Series' shares will decrease faster than would
otherwise be the case. This is the speculative characteristic known as
"leverage."
INVESTMENT RESTRICTIONS
The Short and Intermediate Series are subject to certain
investment restrictions which, as described in more detail in the Statement
of Additional Information, have been adopted by the Trustees on behalf of
each of the Series as fundamental policies that cannot be changed without
the approval of a majority of the outstanding shares of the respective
Series.
PORTFOLIO TURNOVER
Neither of the Series has a fixed policy with respect to portfolio
turnover. The portfolio turnover rate is calculated by dividing the lesser of
sales or purchases of portfolio securities by the average monthly
value of the portfolio securities, excluding securities having a maturity at
the date of purchase of one year or less. While the Short or Intermediate
Series will pay commissions in connection with its options and future
transactions, the other securities in which a Series will invest are generally
traded on a "net" basis with dealers acting as principals for their own
account without a stated commission. Nevertheless, high portfolio turnover
may involve correspondingly greater brokerage commissions and other
transaction costs which will be borne directly by a Series. See "Portfolio
Transactions" in the Statement of Additional Information. Another
potential consequence of high portfolio turnover is that, if 30% or more of
each of the Series' gross income for a taxable year were derived from
gains from the sale or other disposition of securities and certain other
investments held for less than three months, neither of the Series would
qualify as a regulated investment company and, therefore, a Series would
be subject to corporate income tax during that taxable year. The Adviser
endeavors to manage the
27
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investment compositions of the Series and to adjust the portfolio turnover
of each of the Series, if necessary, to insure the Series' treatment as
regulated investment companies. See "Additional Information Regarding
Taxation -- Taxation of the Fund" in the Statement of Additional
Information. The Portfolio turnover rates for the last fiscal period are
shown in the tables under the heading Financial Highlights.
MANAGEMENT OF THE FUND
Trustees and Officers
The Fund's Board of Trustees is responsible for deciding matters of
general policy and reviewing the actions of the Adviser, distributor and
transfer agent. The officers of the Series conduct and supervise the
Fund's daily business operations. The Fund's trustees and officers are
identified below. The Fund's trustees also serve as trustees of other
mutual funds in the Smith Breeden Family of Funds.
BOARD OF TRUSTEES
AFFILIATED WITH
TRUSTEE ADVISER SINCE
Douglas T. Breeden* 1982
Dr. Breeden, the Chairman of the Board of Smith Breeden
Associates, co-founded the firm in 1982. Dr. Breeden has served on
business school faculties at Duke University, Stanford University and the
University of Chicago, and as a visiting professor at Yale University and at
the Massachusetts Institute of Technology. He is the Editor of the Journal
of Fixed Income. Dr. Breeden has served as Associate Editor for five
journals in financial economics, and was elected to the Board of Directors
of the American Finance Association. He has published several well
cited-articles in finance and economics journals. He holds a Ph.D. in
Finance from the Stanford University Graduate School of Business, and a
B.S. in Management Science from the Massachusetts Institute of
Technology. He serves as a Director for Roosevelt Financial Group of
St. Louis, Missouri. He also serves as Chairman of the Board of
Harrington Financial Group, the holding company for Harrington Bank,
F.S.B. of Richmond, Indiana.
Michael J. Giarla* 1985
Principal, Executive Vice President, Director and Chief Operating
Officer, Smith Breeden Associates, Inc., President, Smith Breeden Family
of Funds, Associate Editor, Journal of Fixed Income 1991-1993. He serves
as a director of Harrington Financial Group, the holding company for
Harrington Bank, F.S.B. of Richmond, Indiana. He has published
several book chapters and articles regarding mortgage-backed securities
investments, risk management and hedging. MBA with concentration in
Finance, Arjay Miller Scholar, Stanford University. BS in statistics, summa
cum laude, Phi Beta Kappa, Harvard Club of Boston Scholar, Harvard
University. Trustee, the Roxbury Latin School, Boston, MA.
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Stephen M. Schaefer
Stephen M. Schaefer is Esmee Fairbairn Professor of Finance at the
London Business School. Previously on the Faculty of the
Graduate School of Business of Stanford University, he has also taught at
the Universities of California (Berkeley), Chicago, British Columbia and
Venice. His research interests focus on capital markets and financial
regulation. He has served on the editorial board of a number of
professional journals including, currently, the Journal of Fixed Income, the
Review of Derivative Research and Ricerche Economiche. He consults for
a number of leading financial institutions and is an Independent Board
Member of the Securities and Futures Authority of Great Britain.
Myron S. Scholes
Myron S. Scholes is the Frank E. Buck Professor of Finance at the
Graduate School of Business Stanford University (since 1983); a Senior
Research Fellow at the Hoover Institution (since 1987); and is currently on
leave as a Professor of Law, Stanford Law School. He is a principal in the
money management firm Long-Term Capital Management Co. (since
1993). He is a Research Associate of the National Bureau of Economic
Research and is a member of the Econometric Society. Professor Scholes
was also a managing director and co-head of the fixed income derivatives
group at Salomon Brothers between 1991-1993. Prior to coming to
Stanford University, Professor Scholes was the Edward Eagle Brown
Professor of Finance at the Graduate School of Business, University of
Chicago (1974-1983). He served as the Director of the University of
Chicago's Center for Research in Security Prices from 1974-1980. Prior to
coming to the University of Chicago, Professor Scholes was first an
Assistant Professor then an Associate Professor at the Sloan School of
Management, at M.I.T. from 1968 to 1973. He received his Ph.D. in 1969
from the Graduate School of Business, University of Chicago. He has
honorary Doctor of Law degrees from the University of Paris and
McMaster University. He is a past president of the American Finance
Association (1990).
Dr. Scholes has published numerous articles in academic journals and in
professional volumes. He is most noted as the co-originator of the Black-
Scholes Options Pricing Model as described in a paper, "The Pricing of
Options and Corporate Liabilities," published in the Journal of Political
Economy (May 1973) (with Fischer Black). His other papers include such
topics as risk-return relations, the effects of dividend policy on stock prices,
the effects of taxes and tax policy on corporate decision making. His book
with Mark Wolfson (Stanford University) "Taxes and Business Strategy: A
Planning Approach" was published by Prentice Hall in 1991.
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<PAGE>
William F. Sharpe
William F. Sharpe is the STANCO 25 Professor of Finance at
Stanford University's Graduate School of Business. He is best known
as one of the developers of the Capital Asset Pricing Model, including the
beta
and alpha concepts used in risk analysis and performance measurement.
He developed the widely-used binomial method for the valuation of
options and other contingent claims. He also developed the computer
algorithm used in many asset allocation procedures, and a procedure for
estimating the style of an investment manager from its historic returns.
Dr. Sharpe has published articles in a number of professional
journals. He has also written six books, including Portfolio Theory and
Capital Markets, (McGraw-Hill, 1970), Asset Allocation Tools, (Scientific
Press, 1987), Fundamentals of Investments (with Gordon J. Alexander and
Jeffery Bailey, Prentice-Hall, 1993) and Investments (with Gordon J.
Alexander and Jeffrey Bailey, Prentice-Hall, 1990). Dr. Sharpe is a past
President of the American Finance Association. He has also served as
consultant to a number of corporations and investment organizations.
He is also a member of the Board of Trustees of Rosenberg Series Trust,
an investment company, and a director at CATS Software and Stanford
Management Company. He received the Nobel Prize in Economic
Sciences in 1990.
*Interested party
OFFICERS
Affiliated With
Officer Title Adviser Since
Douglas T. Breeden Chairman 1982
Michael J. Giarla President and Chief 1985
Executive Officer
Daniel C. Dektar Vice President, 1986
Portfolio Adviser
Director of Trading, Principal and Director of Smith Breeden Associates,
Inc. Mr. Dektar has been primarily responsible for the day-to-day
management of the Portfolio and Series from their commencement of
operations in 1992. He currently manages four mortgage securities
portfolios and serves as an adviser on one account. While with Smith
Breeden, Mr. Dektar has provided trade and portfolio analysis in support
of several mortgage security portfolios.
Previously employed in investment banking capacities at Morgan Stanley &
Co. Earned an MBA with a concentration in Finance, Arjay Miller
Scholar, Stanford University, and a B.S. in Business Administration, summa
cum laude, Phi Beta Kappa, Phi Eta Sigma, White Award as top student in
finance and Regents Scholar at the University of California at Berkeley.
Marianthe S. Mewkill Vice President, 1992
Secretary, Treasurer, and
Chief Accounting Officer
Principal of Smith Breeden Associates, Inc. She was previously
employed as a Controller for the Hunt Alternatives Fund and as an
Associate at Goldman Sachs & Co. and Arthur Anderson & Co. She
earned an M.B.A. with concentrations in Finance and Accounting from
New York University, and graduated from Wellesley College, magna cum
laude with a B.A. in History and French, and a minor in Economics.
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Investment Management
Smith Breeden Associates, Inc., Chapel Hill, North Carolina 27514, a
registered investment adviser (the "Adviser"), acts as the investment adviser
to each Series. The Adviser also serves as the investment adviser to the
other fund in the Smith Breeden Family of Funds. Douglas T. Breeden,
Chairman and President of the Adviser, owned approximately 71% of the
Adviser's voting stock as of March 31, 1996.
Under its Investment Advisory Agreement with each of the
Series, the Adviser, subject to the general supervision of the Fund's Board
of Trustees, manages each Series and provides for the administration of
each of the Series' other affairs. It is the responsibility of the Adviser to
place purchase and sale orders for the each of the Series' security
transactions.
The Adviser has extensive experience providing investment
advisory services on a discretionary and non-discretionary basis to financial
institutions, insurance, pension and charitable foundation clients. The
Adviser has provided such services since 1982 with assets under
management exceeding $1 billion since 1984. Current mortgage security
assets under management exceed $20 billion. In addition, a number of
governmental agencies have engaged the Adviser to provide services in the
areas of securities risk analysis, securities disposition and portfolio
management. The Adviser has advised the Smith Breeden Family of Funds
since 1992.
The Adviser was one of the first market participants to develop
effective option adjusted evaluation models. For over ten years, the
Adviser has developed and traded on proprietary mortgage prepayment
projections. Such projections are available only to advisory clients and, in
contrast to prepayment projections developed by securities firms, are not
used for any broker trading or arbitrage operations.
The principals and staff of the Adviser collectively have
accumulated over 100 years of experience analyzing, investing in and
controlling the risks of mortgage securities while in the employ of the
Adviser. Key employees of the Adviser who may contribute investment
ideas, research and analysis for the benefit of each of the Series and who
are not officers or Trustees of the Fund are:
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Associated with Adviser
Since
Michael L. Bamburg 1986
Principal, Smith Breeden Associates, Inc. Mr. Bamburg assists in
analyzing, trading, designing, and hedging mortgage asset portfolios for
clients of Smith Breeden Associates. He supervises client data for
consistency and integrity. He also supervises monthly analyses, including
total rate of return, mark-to-market net worth, spread income and hedge
performance. Previously was a corporate management associate with
Volume Shoe Corporation, a division of the May Company. Earned an
MBA and a BS with concentrations in Finance, University of Kansas.
Received the Ford Finance Scholarship for graduate business studies at
Kansas University.
Carl D. Bell 1991
As a member of the firm's Research Group, Mr. Bell develops computer
programs to value and hedge interest rate sensitive securities and provides
research support to the client service and trading functions. Mr. Bell
manages Smith Breeden's library of analytical software and is active in the
analysis and modeling of mortgage prepayment behavior. Previously, Mr.
Bell has been a Staff Consultant at Andersen Consulting and a Research
Assistant with Putnam, Hayes & Bartlett. He received a Master of
Business Administration with a Concentration in Finance from the Fuqua
School of Business, Duke University, where he received the Hanes
Scholarship and was designated a Fuqua Scholar. Mr. Bell holds a
Bachelor of Science in Mathematics with a Minor in Industrial
Management from Carnegie Mellon University.
Craig J. Cerny 1985
Executive Vice President, Principal and Director of Smith Breeden
Associates, Inc. President of Financial Research Corporation, and
Chairman and CEO of Harrington Bank, FSB. Mr. Cerny has made
numerous presentations to financial institutions and federal regulators
regarding investments and risk management. While with Smith Breeden,
he has participated in trade and portfolio analysis in support of the
management of twenty-five mortgage security portfolios. Previously was
the Director of Financial Planning/Analysis and Region Controller for field
operations for Pizza Hut, Inc. Earned an MBA in Finance with Distinction
and BS in Finance, Honors Convocation from Arizona State University.
Stephen A. Eason 1988
Principal and Director of Smith Breeden Associates, Inc. While with Smith
Breeden, Mr. Eason has participated in trade and portfolio decisions
regarding the management of five mortgage security portfolios. Previously,
Vice President-Institutional Sales at Salomon Brothers and Assistant
Treasurer at Chase Manhattan Bank., N.A. Earned an MBA with a
concentration in Finance, Wharton School, and a BS in Business
Administration, University of Arkansas.
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<PAGE>
Gerald J. Madigan 1984
Executive Vice President, Principal and Director of Smith Breeden
Associates, Inc. President, Smith Breeden Mutual Funds 1992 to 1994.
Chairman, Peoples Federal Savings Association, Richmond, Indiana 1989
to 1992. Mr. Madigan has provided portfolio advice to ten of Smith
Breeden's financial institution clients. He oversaw the disposition of the
complex mortgage securities portfolio of Silverado Banking. Previously
employed by Touche Ross & Co. as Senior Management Consultant,
Hallmark Cards Incorporated, Arthur Andersen & Co., Indiana University
as an instructor, and Federal Deposit Insurance Corporation. MBA,
concentration in Finance, with distinction from the Honors Program,
Indiana University. BS in Accounting with High Distinction, Indiana
University. Phi Eta Sigma, Beta Alpha Psi and Beta Gamma Sigma,
Indiana University.
William F. Quinn 1986
Principal, Director of Client Services, Smith Breeden Associates, Inc. Mr.
Quinn currently advises several mortgage securities portfolios and has
advised on seven additional portfolios during his tenure with Smith
Breeden. He is actively involved in the formulation and implementation of
investment and risk management policies and procedures as well as clients'
strategic plans and business plans. Earned an MS with concentrations in
Finance, MIS and System Dynamics, Sloan School of Management, M.I.T,
and a BS in Management Science from M.I.T.
Timothy D. Rowe 1988
Principal, Smith Breeden Associates. Mr. Rowe has expertise in mortgage
portfolio management, portfolio restructuring, financial institution loan and
deposit pricing, and the profitability of branch operations. He currently
advises two mortgage securities portfolios and has advised three other
mortgage security portfolios. Previously was an Assistant Economist at the
Federal Reserve Bank of Richmond. Earned an MBA with a
concentration in Finance, University of Chicago, a BA in Economics and
History, magna cum laude, Class Honors, Duke University.
John B. Sprow 1987
Portfolio Adviser for the Smith Breeden Market Tracking Fund, Principal,
Smith Breeden Associates, Inc. Mr. Sprow is the trading coordinator for
all client investments. He has been primarily responsible for the day-to-day
management of the Market Tracking Fund since its inception in 1992. Mr.
Sprow currently advises three mortgage securities portfolios. He previously
was a research assistant at Duke University and Cornell University.
Earned an MBA with a concentration in Finance, Duke University and a
BS in Materials Science and Engineering from Cornell University where he
was awarded the Carpenter Technology Scholarship for three consecutive
years.
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<PAGE>
As compensation for the services rendered to each of the Series
by the Adviser pursuant to the Investment Advisory Agreement, and the
assumption by the Adviser of the related expenses, each of the Series pays
the Adviser a fee, computed daily and payable monthly, at an annual rate
equal to 0.70% of each of the Series' average daily net asset value. As
part of the advisory fee, the Adviser provides administration services to
each Series.
Transfer Agent, Custodian and Principal Underwriter
Fund/Plan Services, Inc. (the "Transfer Agent") serves as each
Series' transfer agent, acts as each Series' dividend disbursing agent
and performs certain shareholder service activities. Fund/Plan Services
Inc.'s main office is at #2 West Elm Street, P.O. Box 874, Conshohocken,
Pennsylvania 19428-0874. In addition, Fund/Plan Services, Inc. maintains
certain records of each of the Series pursuant to an Accounting Services
Agreement.
The Bank of New York acts as the custodian of each of the
Series' including its portfolio securities and cash. The Bank of New
York's office is at 48 Wall Street, New York, New York, 10286.
Fund/Plan Broker Services (the "Principal Underwriter") serves as
each of the Series' underwriter. The Principal Underwriter's offices are
located at #2 West Elm Street P.O. Box 874, Conshohocken PA, 19428-
0874.
Expenses
The Short and Intermediate Series each pay all of their
respective expenses, including: the compensation of their respective
Trustees who are not affiliated with the Adviser; governmental fees;
interest
charges; brokerage commissions; taxes; membership dues in the
Investment Company Institute allocable to each Series; fees and expenses
of independent auditors, tax preparers and tax consultants, of legal counsel
and of the transfer and dividend disbursing agent and custodian ; insurance
premiums; amortization of organizational expenses; expenses of calculating
the net asset value of the shares of each of the Series; and the investment
management fees paid by the Series to the Adviser. Each of the Series
also pays all expenses of issuing and redeeming shares and servicing
shareholder accounts; expenses of preparing, printing and mailing
prospectuses, reports, notices, proxy statements and reports to
shareholders and to governmental offices and commissions; expenses of
shareholder meetings; and expenses relating to the registration and
qualification of shares of each of the Series.
The Adviser has voluntarily agreed to bear the normal operating
expenses of the Series and, if necessary, to waive the advisory fees for the
Series, for the period ending March 31, 1997 so that the total normal
operating expenses would not exceed 0.78% of the average net assets of
the Short Series and .88% of the Intermediate Series. Normal operating
expenses do not include litigation costs, indemnification or other
extraordinary expenses.
Each of the Series has entered into a separate underwriting
agreement with the Principal Underwriter pursuant to which the Principal
Underwriter receives a fee for each Series of $8,333 that is paid by the
Adviser under each Series' Distributions and Services Plan discussed below.
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<PAGE>
PURCHASE AND REDEMPTION OF SHARES
Shares of either of the Series may be purchased at net asset
value (with no sales charge) on a continuous basis . The minimum initial
investment is $1,000 and subsequent investments must be $50 or more.
The Series and the Principal Underwriter reserve the right to refuse any
order for the purchase of shares.
Investments may be made by mail or wire. Direct purchase orders
received by the Transfer Agent, or other agent designated by the Fund,
by 4:00 p.m., Eastern time, and accompanied by check or wire, are
confirmed at that day's net asset value. Direct purchase orders
accompanied by check or wire received by the Transfer Agent, or other
agent designated by the Fund after 4:00 p.m., Eastern time are
confirmed at the net asset value determined on the following business day.
Investments to be made by mail should be sent to the following
address: Smith Breeden Family of Funds, Fund/Plan Broker Services, Inc.,
P.O. Box, 874, Conshohocken PA 19428-9979.
Federal funds wires should be sent to United Missouri Bank, KC,
N.A., ABA #10-10-00695, for credit to Fund/Plan Services, Inc.
A/C 98-7037-071-9, for further credit to: Smith Breeden Short Duration
U.S. Government Series (include shareholder name and shareholder
account number) or Smith Breeden Intermediate Duration U.S.
Government Series (include shareholder name and shareholder account
number). To obtain a number for a new account, an investor should call
the Transfer Agent at (800) 221-3137 by 12:00 noon, Eastern time.
Shares of either of the Series may be purchased through
investment dealers who, as part of the services they provide, must transmit
orders promptly. They may charge for these services. The Fund will refer
shareholders to a dealer upon the shareholder's request. Wire orders for
shares of either of the Series received by dealers prior to 4:00 p.m. will
receive the net asset value of that business day. Orders received by dealers
after 4:00 p.m., Eastern time, are confirmed at the net asset value on the
following business day.
Confirmations
Shareholders will receive confirmation statements each time there
is a transaction which affects an account. The reinvestment of dividends
will be reported on regular monthly statements which will also show the
total number of shares of the Short or Intermediate Series owned by a
shareholder.
Share Certificates
Shares for an initial investment as well as subsequent investments,
including the reinvestment of dividends and capital gain distributions, are
generally credited to an account in the name of an investor on the books of
the Fund, without the issuance of a share certificate. Maintaining shares in
uncertificated form (also known as "plan balance") minimizes the risk of
loss or theft of a share certificate. A certificate will be issued if requested
in writing by the shareholder or by his broker.
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<PAGE>
Telephone Transactions
Shareholders may elect the privilege to initiate transactions by
telephone by checking the appropriate box on the account application
form. The Fund, on behalf of each Series, will employ reasonable
procedures to ensure that instructions communicated by telephone are
genuine. These procedures include, but are not limited to, recording
telephone instructions and written confirmation of requests. In the event
of a fraudulent telephone transaction, the Fund will not be liable unless the
Fund did not employ reasonable procedures to ensure that the instructions
were genuine.
Automatic Investment Plan
The plan provides a convenient method by which an investor may
have amounts deducted directly from his or her checking account for
investment in either the Short or Intermediate Series. The minimum
initial investment is $50 and minimum subsequent investments are $50 per
month.
Purchasing Shares of the Series in Connection with Retirement Plans
Shares of either of the Series may be used in a Fund-sponsored
individual retirement account ("IRA") providing for tax-deferred
investments for individuals. Shareholders wishing to establish an IRA
account should consult their tax adviser regarding (1) their individual
qualifying status and (2) any current changes to the tax regulations
governing these accounts. A shareholder may hold shares of a Series in
an IRA sponsored by the Fund for a $12.00 annual fee. The Short or
Intermediate Series also may be used as an investment for a variety of
other retirement programs.
Purchases Through Securities Dealers
Shares of the Short or Intermediate Series may be purchased
through investment dealers who, as part of the services they provide, must
transmit orders promptly. They may charge for these services. The Fund,
on behalf of each Series, will refer shareholders to a dealer upon the
shareholder's request.
Securities dealers and other firms provide varying arrangements
for their clients to purchase and redeem shares in the Short or
Intermediate Series. Some may establish higher minimum investment
requirements than set forth above. Firms may arrange with their clients for
other investment or administrative services. Such firms may independently
establish and charge additional amounts to their clients for such services,
which charges would reduce the clients' return. Firms also may hold
shares in the Short or Intermediate Series in nominee or street name as
agent for and on behalf of their customers. In such instances, the transfer
agent for the Short and Intermediate Series will have no information with
respect to or control over accounts of specific shareholders. Such
shareholders may obtain access to their accounts and information about
their accounts only from their firm. Certain of these firms may receive
compensation from the Series' shareholder service agent for record
keeping and other expenses relating to these nominee accounts. In
addition, certain privileges with respect to the purchase and redemption of
shares or the reinvestment of dividends may not be available through such
firms. Some firms may participate in a program allowing them access to
their clients' accounts for servicing including, without limitation, transfers
of registration and dividend payee changes; and may perform functions
such as generation of confirmation statements and disbursement of cash
dividends. This Prospectus should be read in connection with such firms'
material about their fees and services.
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Systematic Withdrawal Plan
A shareholder may establish a Systematic Withdrawal Plan and receive
regular periodic payments from the account. An initial balance of $10,000
is required to establish an account. There are no service charges for
establishing or maintaining a Systematic Withdrawal Plan. The minimum
amount which the shareholder may withdraw periodically is $100. Capital
gain distributions and income dividends to the shareholder's account are
received in additional shares at net asset value. Payments are then made
from the liquidation of shares at net asset value to meet the specified
withdrawals. Liquidation of shares may reduce or possibly exhaust the
shares in the shareholder's account, to the extent withdrawals exceed
shares earned through dividends and distributions, particularly in the event
of a market decline. No payment pursuant to a Systematic Withdrawal
Plan will be made if there are insufficient shares on deposit on the date of
the scheduled distribution. A subsequent deposit of shares will not result
in a payment under the plan retroactive to the distribution date. As with
other redemptions, a liquidation to make a withdrawal payment is a sale
for federal income tax purposes. The entire Systematic Withdrawal Plan
payment cannot be considered as actual yield or income since part of such
a Systematic Withdrawal Plan payment may be a return of capital.
A Systematic Withdrawal Plan may be terminated on written
notice by the shareholder, or the Fund on behalf of each Series upon 30
days written notice, and it will terminate automatically if all shares are
liquidated or withdrawn from the account, or upon the Fund's receipt of
notification of the death or incapacity of the shareholder. Shareholders
may change the amount (but not below the specified minimums), and
schedule of withdrawal payments, or suspend such payments, by giving
written notice to the Transfer Agent at least five business days prior to the
next scheduled payment. Share certificates may not be issued while a
Systematic Withdrawal Plan is in effect.
Exchange Privilege
Shares of either of the Series may be exchanged for shares of
any other fund in the Smith Breeden Family of Funds if it is eligible for
sale in the shareholder's state of residence. Exchanges are made on the
basis of the relative net asset values. Because the exchange is considered a
redemption and purchase of shares, the shareholder may recognize gain or
loss for federal income tax purposes. Backup withholding and information
reporting may also apply. Additional information regarding the possible
tax consequences of such an exchange is included under the caption
"Additional Information on Distributions and Taxation" in the Statement of
Additional Information.
There are differences among funds. Before making an exchange,
a shareholder should obtain and review a current prospectus of the fund
into which the shareholder wishes to transfer. When exchanging shares,
shareholders should be aware that the funds may have different dividend
payment dates. The dividend payment schedules should be checked before
exchanging shares. The amount of any accumulated but unpaid dividend
is included in the net asset value per share. Exchanges will be effected
upon receipt of written instructions signed by all account owners and
accompanied by any outstanding share certificates properly endorsed.
However, shareholders who complete the Telephone Exchange
authorization portion of the Shareholder Application will be able to effect
exchanges from either Series into an identically registered account in
another mutual fund in the Smith Breeden Family. The Telephone
Exchange Privilege is available only for uncertificated shares.
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During periods of drastic economic or market changes, it is
possible that the Telephone Exchange Privilege may be difficult to
implement. In this event, shareholders should follow the other exchange
procedures discussed in this section, including the procedures for
processing exchanges through broker/dealers. The Telephone Exchange
Privilege may be modified or discontinued by the Fund, on behalf of each
Series, at any time upon 60 days' notice to shareholders. Exchanges out
of any single series will be limited to four per calendar year. This limit
does not include reinvestment of dividends in a different fund.
Exchanges Through Securities Dealers.
As is the case with all purchases and redemptions of the Short
or Intermediate Series shares, the Fund will accept exchange orders by
telephone or other means of electronic transmission from securities dealers
who execute a dealer agreement with the Principal Underwriter. Such a
dealer-ordered exchange will be effective only for uncertificated shares on
deposit in the shareholder's account or for which certificates have
previously been deposited with Fund/Plan Services. A securities dealer
may charge a fee for handling an exchange. The use of the exchange
program may be discontinued or modified by the Fund at any time upon 60
day's written notice to shareholders.
Distribution and Services Plans
The Fund has adopted a Distribution and Services Plan (the
"Plan") for each of the Series pursuant to Rule 12b-1 under the 1940 Act.
The purpose of the Plan is to permit the Adviser to compensate
investment dealers and other persons involved in servicing shareholder
accounts for services provided and expenses incurred in promoting the sale
of shares of the Short or Intermediate Series, reducing redemptions, or
otherwise maintaining or improving services provided to shareholders by
such dealers or other persons. The Plan provides for payments by the
Adviser out of its advisory fee to dealers and other persons at the annual
rate of up to 0.25% of the average net assets of either the Short or
Intermediate Series subject to the authority of the Trustees of the Fund to
reduce the amount of payments permitted under the Plan or to suspend
the Plan for such periods as they may determine. Subject to these
limitations, the amount of such payments and the purposes for which they
are made shall be determined by the Adviser. (Pursuant to the terms of
the Plan the Adviser currently pays the Principal Underwriter $8,333 per
annum for each of the Series as compensation for its distribution and
servicing activities.)
Any distribution and servicing related payments made by the Adviser
to investment dealers or other persons under a Plan is subject to the
continuation of such Plan, the terms of any related service agreements, and
any applicable limits imposed by the National Association of Securities
Dealers, Inc.
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How to Sell Shares
If a shareholder has not elected the privilege to initiate
transactions by telephone, a shareholder may liquidate shares owned at any
time and receive from the Fund, on behalf of each Series, the value of the
shares redeemed by forwarding a written request signed by all registered
owners to Fund/Plan Services, Inc., P. O. Box 874, #2 West Elm Street,
Conshohocken, Pennsylvania 19428-0874. The shareholder will then
receive the value of the shares based upon the net asset value per share
of the respective Series next computed after the written request in proper
form is received by Fund/Plan Services, Inc. less the redemption fee, if any.
Redemption requests received after the time at which the net asset value is
calculated each day (as described herein) will receive the price calculated
on the following business day. In order to be in proper form, the
shareholder's written request must be accompanied by share certificates
which have been issued, if any, properly endorsed and in order for
transfer.
To be considered in proper form, signature(s) must be guaranteed if
the redemption request involves any of the following:
(1) the proceeds of the redemption are over $25,000;
(2) the proceeds (in any amount) are to be paid to
someone other than the registered owner(s) of the
account;
(3) the proceeds (in any amount) are to be sent to any
address other than the shareholder's address of
record, pre-authorized bank account or brokerage
firm account; or
(4) share certificates, if the redemption proceeds are in
excess of $25,000.
A shareholder will be charged $10 for redemptions by wire.
Signatures must be guaranteed by an "eligible guarantor institution" as
defined in Rule 17Ad-15 under the Securities Exchange Act of 1934.
Eligible guarantor institutions include banks, brokers, dealers, credit
unions, national securities exchanges, registered securities associations,
clearing agencies and savings associations. A broker-dealer guaranteeing
signatures must be a member of a clearing corporation or maintain net
capital of at least $100,000. Credit unions must be authorized to issue
signature guarantees. Signature guarantees will be accepted from any
eligible guarantor institution which participates in a signature guarantee
program. A notarized signature will not be sufficient for the request to be
in proper form.
The signature guarantee of a redemption may be waived for certain
broker-dealers, institutions, or service organizations which have been
previously approved by the Fund.
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Where shares to be redeemed are represented by share certificates,
the request for redemption must be accompanied by the share certificate
and a share assignment form signed by the registered shareholders exactly
as the account is registered, with the signature(s) guaranteed as referenced
above. Shareholders are advised, for their own protection, to send the
share certificate and assignment form in separate envelopes if they are
being mailed in for redemption.
Liquidation requests of corporate, partnership, trust and custodianship
accounts, accounts under court jurisdiction and retirement plan accounts
may require additional documentation to be in proper form.
The redemption price is the net asset value per share next
determined after receipt of the redemption request in the proper form
described above, less the redemption fee, if any; wire redemption requests
received by dealers prior to 4:00 p.m., Eastern time are confirmed at that
day's net asset value per share.
Payment for redeemed shares will be sent to the shareholder within
seven days after receipt of the request in proper form, except that the
Fund may delay the mailing of the redemption check, or a portion thereof,
until the Fund's depository bank has made fully available for withdrawal
the check used to purchase Fund shares, which may take up to 15 days or
more. Although the use of a certified or cashier's check will generally
reduce this delay, shares purchased with these checks will also be held
pending clearance. Shares purchased by federal funds wire are available
for immediate redemption. In addition, the right of redemption may be
suspended or the date of payment postponed if the New York Stock
Exchange is closed (other than customary closing) or upon the
determination of the SEC that trading on the New York Stock Exchange is
restricted or an emergency exists, or if the SEC permits it, by order, for the
protection of shareholders. Of course, the amount received may be more
or less than the amount invested by the shareholder, depending on
fluctuations in the market value of securities owned by the Fund.
In order to reduce its expenses, the Fund, on behalf of the Short
or Intermediate Series may, from time to time (not more than
semi-annually) upon the authorization of the Board of Trustees, redeem at
its option the shares of any shareholder whose account has been in
existence for at least 12 months and whose account contains, due to
redemptions, less than a minimum amount to be determined by the Board
of Trustees (but not to exceed $1,000). In the event it is determined that
such a redemption should be made by the Series, at least two months'
written notice of the Series' intention to redeem will be given, during which
period the shareholder can increase the value of its account to the
minimum amount, thereby avoiding the redemption of its account.
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Check Writing
In addition to telephone and written redemption requests, the Short
Series offers redemption through check writing. Shareholders electing this
option will receive checks that my be used like personal or business checks.
There is no limit on the number of checks you may write. Checks must be
at least $100 and may not exceed $25,000. There is a $30 fee for returned
checks. Because dividends declared on shares held in a shareholder's
account, prior redemptions, and possible changes in net asset value may
cause the value of the account to change, shareholders should not write a
check for the entire value of the account or close the account by writing a
check.
In using the check writing privilege, shareholders bear the
responsibility of ensuring that the check amount does not exceed the value
of their account on the day the check is presented to the transfer agent for
payment. The day the check is presented for payment is the day the
redemption of funds shares takes place. If insufficient shares are in the
account, the check will be returned and no shares will be redeemed.
The clearing agent for the check writing facility is United Missouri
Bank. Shareholders utilizing check writing are subject to United Missouri
Bank's rules governing checking accounts. However, this check writing
facility is purely a means to redeem fund shares. No facilities characteristic
of bank accounts, such as deposit insurance, are being provided along with
the check writing option.
If you would like to initiate check writing, you may call Shareholder
Services at 1-800-221-3137.
Selling Shares Through Securities Dealers
Shares of a Series may also be sold by contacting your
securities dealer or investment firm (by telephone or in writing). Securities
dealers and investment firms that have entered into a selling group
agreement with the Principal Underwriter can effect redemptions on the
shareholder's behalf by telephone or other expedited means at the net asset
value next calculated after receiving the shareholder's request in proper
form. The securities dealer or investment firm is responsible for prompt
transmission of redemption request to the Transfer Agent, or other Agent
as designated by the Adviser and may charge a fee for handling such
requests.
Shareholder Inquiries
Any questions or communications regarding a shareholder's account
should be directed to Fund/Plan Services, Inc., #2 West Elm Street,
P. O. Box 874, Conshohocken, Pennsylvania 19428-0874, or by calling 1-
800-221-3137, Monday through Friday, from 9 a.m. to 7 p.m., Eastern time.
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DIVIDENDS, DISTRIBUTIONS AND TAXES
Distributions to Shareholders
Each Series intends to make monthly distributions to its
shareholders of net investment income. Each Series reserves the right to
include net short-term gains, if any, in such monthly distributions.
The amount of income dividend payments by a Series is
dependent upon the amount of net investment income received by the
Series from its Portfolio holdings, is not guaranteed and is subject to the
discretion of the Board of Trustees. Thus, the amount of dividends paid
likely will vary month to month. Monthly notices will be provided in
accordance with Section 19(a) of the 1940 Act.
The Short Series' shares are quoted ex-dividend on the business
day after the record date. Shareholders may request to have their
dividends paid out monthly in cash with a dividend payment date generally
one week after record date.
The Intermediate Series will declare daily dividends for
shareholders of record. These dividends will be paid generally on the last
business day of the month. Shares begin accruing dividends on the
business day after federal funds (funds credited to a member bank's
account at the Federal Reserve Bank) are available from the purchase
payment for such shares and continue to accrue dividends through, and
including, the day the redemption order for the shares is executed. Net
realized capital gains ( including short- term capital gains), if any, will be
declared and distributed by the Intermediate Series at least annually.
Distributions are payable in the form of additional shares of the
Intermediate Series which are valued at the net asset value per share at the
close of business on the payment date. If an investor closes his account,
any accrued dividends through, and including, the day of redemption will
be paid as part of the redemption proceeds.
Long-term capital gains and previously undistributed net short-
term gains, if any, will be distributed at least once annually. "Net
investment income," as used above, includes all dividends, interest and
other income earned by a Series, net of a Series' expenses and is the
income from which income dividends may be distributed. The Short and
Intermediate Series will each send written notice to shareholders regarding
the tax status of all distributions made during each calendar year.
In order to be entitled to a dividend or a distribution, an investor
must acquire a Series' shares on or before the record date. Caution
should be exercised, however, before purchasing shares immediately prior
to a distribution record date. Because the value of the Series' shares is
based directly on the amount of its net assets, rather than on the principle
of supply and demand, any distribution of income or capital gain will result
in a decrease in the value of its shares equal to the amount of the
distribution. While a dividend or capital gain distribution received shortly
after purchasing shares represents, in effect, a return of the shareholder's
investment, it may be taxable as dividend income or capital gain.
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Tax Matters
The following discussion reflects some of the provisions of the tax
considerations that affect mutual funds and their shareholders.
Taxation of the Series. Each Series intends to qualify as a
regulated investment company under Subchapter M of the Internal
Revenue Code of 1986, as amended, (the "Code"), so that by distributing
substantially all of its net investment income and any net realized
short-term and long-term capital gains for a taxable year, a Series will not
be liable for federal income or excise taxes. Because the Short Series'
current policy is to declare distributions monthly on the record date and to
pay cash dividends generally one week after the record date, the Series
may be subject to a 4% excise tax during a calendar year to the extent that
the actual amount distributed during that year falls short of the amount
required to be distributed in order to avoid the excise tax.
Under present law, the Series will not be subject to any excise or
income taxes in Massachusetts as long as they qualify as regulated
investment companies under the Code.
Taxation of Shareholders. For federal income tax purposes, any
income dividends received from the Short or Intermediate Series, as well
as any distributions derived from the excess of net short-term capital gain
over net long-term capital loss, are treated as ordinary income whether
received in cash or in additional shares. Distributions derived from the
excess of net long-term capital gain over net short-term capital loss are
treated as long-term capital gain regardless of the length of time a
shareholder may have owned a Series' shares and regardless of whether
distributions were received in cash or in additional shares. It is not
expected that any of the distributions to be paid by the Short or
Intermediate Series will qualify either for the corporate dividends-received
deduction or tax-exempt interest income. The Short and Intermediate
Series will inform shareholders of the source of dividends and distributions
at the time they are paid and will promptly after the close of each calendar
year advise shareholders of the status for federal income tax purposes of
such dividends and distributions.
Distributions also may be subject to state and local taxes
depending on each shareholder's tax situation. While many states grant
tax-free status to dividends paid to shareholders of mutual funds from
interest income earned from direct obligations of the U.S. Government,
none of the distributions of the Short or Intermediate Series generally are
expected to qualify for such tax-free treatment. Investments in
mortgage-backed securities (including GNMA, FNMA and FHLMC
securities) and repurchase agreements collateralized by U.S. Government
securities do not qualify as direct federal obligations in most states.
Shareholders should consult their tax advisers with respect to the
applicability of state and local income taxes to distributions and redemption
proceeds received from a Series.
Shareholders who are not U.S. persons for purposes of federal income
taxation should consult with their financial or tax advisers regarding the
applicability of U.S. withholding taxes to distributions received by them
from the Series. Such distributions generally will be subject to U.S.
withholding tax.
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The Short or Intermediate Series may be required to report to the
Internal Revenue Service ("IRS") any taxable dividend or other reportable
payment (including share redemption proceeds) and withhold the required
tax on any such payments made to individuals and other non-exempt
shareholders who have not provided a correct taxpayer identification
number and made certain required certifications that appear in the
Shareholder Application. A shareholder may also be subject to backup
withholding if the IRS or a broker notifies the Short or Intermediate
Series that the number furnished by the shareholder is incorrect or that the
shareholder is subject to backup withholding for previous under reporting
of interest or dividend income.
The foregoing discussion is a general summary of certain of the
current federal income tax laws regarding the two Series and investment in
their shares. The discussion does not purport to deal with all of the
federal income tax consequences applicable to an investment in either the
Short or Intermediate Series, or to all categories of investors, some of
which may be subject to special rules. Investors should consult their own
tax advisors regarding the tax consequences to them of investments in
shares.
VALUATION OF FUND SHARES
The net asset values per share of the Short and Intermediate
Series are determined as of the close of trading (currently 4:00 p.m.,
Eastern time) each day that the Adviser and Transfer Agent are open for
business and on which there is a sufficient degree of trading in the
Portfolio's securities that the net asset value of each Series' shares might
be affected. As of the date of this Prospectus, current holiday schedules
indicate that the net asset value will not be calculated on New Year's Day,
Presidents' Day, Martin Luther King Day, Good Friday, Memorial
Day, Independence Day, Labor Day, Columbus Day, Veteran's Day,
Thanksgiving Day, the day following Thanksgiving, Christmas Eve, and
Christmas Day.
The net asset value per share of each of the Series is determined
in the following manner: The aggregate of all liabilities, including accrued
expenses and taxes and any necessary reserves, are deducted from the
aggregate gross value of all assets, and the difference is divided by the
number of shares of the Series outstanding at the time. For the purposes
of determining the aggregate net assets of the Short or Intermediate Series,
cash and receivables will be valued at their realizable amounts. Interest
will be recorded as accrued. Under procedures approved by the Board
of Trustees, the mortgage securities are valued at current market value
provided by a pricing service, bank or broker/dealer experienced in such
matters, when over-the-counter market quotations are readily available.
Securities and other assets for which market prices are not readily available
are valued at fair market value as determined following procedures
approved by the Board of Trustees.
All money market instruments with a maturity of more than 60 days
are valued at current market, as discussed above. The fair value of debt
securities originally purchased with remaining maturities of 60 days or less
shall be their amortized cost value, as determined in accordance with the
1940 Act and the rules and regulations promulgated
thereunder, unless conditions dictate otherwise.
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PERFORMANCE
Advertisements, sales literature and communications to
shareholders may contain various measures of the Short or Intermediate
Series' performance including current yield, various expressions of total
return and current distribution rate. They may occasionally cite statistics to
reflect the Short or Intermediate Series' volatility or risk.
Average annual total return figures, as prescribed by the SEC,
represent the average annual percentage change in the value of $1,000 for
one, five and ten year periods, or portion thereof, to the extent applicable,
through the end of the most recent calendar quarter, assuming
reinvestment of all distributions. The Fund may also furnish total return
quotations for other periods, based on investments at net asset value. For
such purposes total return equals the total of all income and capital gain
paid to shareholders, assuming reinvestment of all distributions, plus (or
minus) the change in the value of the original investment, expressed as a
percentage of the purchase price.
Current yield reflects the income per share earned by the Short
or Intermediate Series' portfolio investments; it is calculated by dividing a
Series' net investment income per share during a recent 30-day period by
a Series' net asset value on the last day of that period and annualizing the
result.
Yield, which is calculated according to a formula prescribed by
the SEC (see the Statement of Additional Information), is not indicative of
the dividends or distributions which were or will be paid to a Series'
shareholders. Dividends or distributions paid to shareholders are reflected
in the current distribution rate which may be quoted to shareholders.
In each case performance figures normally are based upon past
performance and reflect all recurring charges against the Short or
Intermediate Series' income; if, at any time, gross returns are compared to
gross returns of other portfolios, specific disclosure to that respect will be
made. The investment results of the Short and Intermediate Series, like all
others, will fluctuate over time; thus, performance figures should not be
considered to represent what an investment may earn in the future or what
a Series' yield, distribution rate or total return may be in any future
period.
REPORTS TO DEPOSITORY INSTITUTIONS
Upon a shareholder's written notification to the Adviser that it is
a depository institution, the Adviser will deliver to the shareholder monthly
and quarterly reports which analyze the Short or Intermediate Series'
investments according to regulatory risk-based asset categories. Due to
regulatory requirements applicable to each depository financial institution,
each such shareholder should consult with legal counsel regarding its
investment in the Short or Intermediate Series.
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APPENDIX A
Hedging Transactions
Mortgage Swaps, Interest Rate Swaps, Caps, Floors and Collars
Interest rate swaps involve the exchange by a Series with another party
of their respective commitments to pay or receive interest, for example, an
exchange of floating rate payments for fixed rate payments. Mortgage
swaps are similar to interest rate swaps in that they represent commitments
to pay and receive interest. The notional principal amount, however, is
tied to a reference pool or pools of mortgages. 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 floor entitles the purchaser, to the
extent that a specified index falls below a predetermined interest rate, to
receive payments of interest on a notional principal amount from the party
selling such interest rate floor. An interest rate collar combines the
elements of purchasing a cap and selling a floor. The collar protects
against an interest rate rise above the maximum amount but gives up the
benefits of an interest rate decline below the minimum amount.
The Short or Intermediate Series will enter into interest rate
swaps only on a net basis, i.e., the two payment streams are netted out,
with a Series receiving or paying, as the case may be, only the net amount
of the two payments. Inasmuch as these hedging transactions are entered
into for good faith hedging purposes, the Adviser and the Series believe
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 a Series' obligations over its entitlement
with respect to each interest rate swap will be accrued on a daily basis and
an amount of cash or liquid securities having an aggregate net asset value
at least equal to the accrued excess will be maintained in a segregated
account by a custodian that satisfies the requirements of the 1940 Act. A
Series will not write interest rate caps, floors and collars and will not enter
into any interest rate swap, cap, floor or collar transaction unless the
unsecured commercial paper, unsecured senior debt or the claims-paying
ability of the other party thereto is rated either AA or A-1 or better by
Standard & Poor's Corporation or Aa or P-1 or better by Moody's
Investors Service, Inc., at the time of entering into such transaction. If
there is a default by the other party to such a transaction, a Series will
have contractual remedies pursuant to the agreements related to the
transaction. There is no assurance that interest-rate swap, cap, floor or
collar counterparties will be able to meet their obligations pursuant to their
contracts, or that, in the event of default, a Series will succeed in pursuing
contractual remedies. The Short or Intermediate Series thus assumes the
risk that it may be delayed in or prevented from obtaining payments owed
to it pursuant to interest rate swaps, caps, floors or collars. 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, although the Short and Intermediate Series
will still treat swaps as illiquid investments subject to the limitation on such
investments described in the Prospectus at "Illiquid Securities". Caps,
floors and collars are more recent innovations for which standardized
documentation has not yet been
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developed and, accordingly, they are less liquid than swaps. Caps, floors
and collars are accordingly also considered to be illiquid investments
subject to the same limitation.
There can be no assurance that the Short or Intermediate Series
will be able to enter into interest rate swaps, caps, floors or collars on
favorable terms. Furthermore, there can be no assurance that either
Series will be able to terminate an interest rate swap or sell or offset
interest rate caps, floors or collars notwithstanding any terms in the
agreements providing for such termination.
Hedging and risk management techniques require different skills from
those involved in the selection of portfolio securities. One such skill is
the ability to predict the correlation of interest rate changes between
markets. The Adviser has been engaged in hedging target duration
portfolios for more than ten years. There can be no assurance that the
Adviser will accurately predict market movements which accompany
interest rate changes, in which event a Series' overall performance may be
less than if the Portfolio had not entered into hedging transactions.
Short Sales
A Series may make short sales of securities. A short sale is a
transaction in which a Series sells a security it does not own in anticipation
that the market price of that security will decline. A Series expects to
make short sales both as a form of hedging to shorten the overall duration
of the portfolio and in order to maintain portfolio flexibility.
When the Short or Intermediate Series makes a short sale, it may have
to borrow the security sold short and deliver it to the broker-dealer
through which it made the short sale as collateral for its obligation to
deliver the security upon conclusion of the sale. A Series may have to pay
a fee to borrow particular securities and is often obligated to pay over any
payments received on such borrowed securities.
Until the Short or Intermediate Series owns the security which it
sold short or replaces a borrowed security, it will maintain daily a
segregated account with an institution (other than a broker) containing
cash, U.S. Government securities or other liquid high-grade debt securities,
at such a level that (i) the amount deposited in the account plus any cash,
U.S. Government securities or other liquid high-grade debt securities
deposited with the broker as collateral will equal the current value of the
security sold short and (ii) the amount deposited in the segregated account
plus the amount deposited with the broker as collateral will not be less
than the market value of the security at the time it was sold short.
Depending on arrangements made with the broker-dealer from which it
borrowed the security regarding payment over of any payments received by
a Series on such security, a Series may not receive any payments
(including interest) on its collateral deposited with such broker-dealer.
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If the price of the security sold short increases between the time
of the short sale and the time a Series replaces the borrowed security, the
Series will incur a loss; conversely, if the price declines, the Portfolio will
realize a capital gain. Although a Series' gain is limited to the price at
which it sold the security short, its potential loss is limited only by the
maximum attainable price of the security less the price at which the
security was sold. Unless market interest rates become negative, for a fixed
income security this maximum attainable price is equal to the undiscounted
sum of the largest possible payments of principal and interest.
The Short or Intermediate Series will not make a short sale if,
after giving effect to such sale, the market value of all securities sold short
exceeds 25% of the value of its net assets or the aggregate short sales of
a particular class of securities exceeds 25% of the outstanding securities of
that class. A Series may also make short sales "against the box" without
respect to such limitations. In this type of short sale, at the time of the
sale, the Short or Intermediate Series would own or has the immediate
and unconditional right to acquire at no additional cost the identical
security.
Calls and Puts on Securities; Futures and Related Options
In order to reduce fluctuations in net asset value relative to its targeted
option-adjusted duration, the Short or Intermediate Series may purchase
call or put options (or sell options which it owns) on United States
Treasury securities, Mortgage-Backed Securities and Eurodollar
instruments that are traded on United States and foreign-securities
exchanges and in over-the-counter markets ("OTC Options"). A Series
will not sell options which it does not own. Some contracts are "cash
settled" (i.e., the seller pays the difference between the call and market
price in cash when the market price is higher).
The Short and Intermediate Series will not purchase a put or call
option on U.S. Government securities or Mortgage-Backed Securities if, as
a result of such purchase, more than 10% of the total assets of its assets
would be invested in such options. The Short or Intermediate Series'
ability to purchase put and call options may be limited by the Code's
requirements for qualification as a regulated investment company.
The Adviser monitors the creditworthiness of dealers with whom
a Series would enter into OTC option transactions under the general
supervision of the Board of Trustees. The Short and Intermediate Series
will engage in OTC option transactions only with primary United States
government securities dealers recognized by the Federal Reserve Bank of
New York.
The general characteristics and risks of calls and puts on securities
and futures are described below.
In order to reduce fluctuations in net asset value relative to its
targeted option-adjusted duration or to employ temporary substitutes for
anticipated future transactions, the Short or Intermediate Series may buy
or sell financial futures contracts or purchase options (or sell options which
it owns) on such futures.
48
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A Series' use of futures and options on futures contracts will in
all cases be consistent with applicable regulatory requirements and in
particular the rules and regulations of the Commodity Futures Trading
Commission with which a Series' must comply in order not to be deemed
a commodity pool operator within the meaning and intent of the
Commodity Exchange Act and the regulations promulgated thereunder. As
a practical matter, these regulations are not expected to impose substantive
limits.
Options and futures transactions involve costs and may result in
losses. The effective use of options and futures strategies depends on the
Short or Intermediate Series' ability to terminate options and futures
positions at times when the Advisor deems it desirable to do so.
The use of options and futures strategies also involves the risk of
imperfect correlation among movements in the values of the securities
underlying the futures and options purchased and sold by a Series, of the
option and futures contract itself, and of the securities which are the
subject of a hedge.
The Short or Intermediate Series' ability to engage in options and
futures transactions and to sell related securities may be limited by tax
considerations and by certain regulatory requirements. See "Additional
Information Regarding Taxation" in the Statement of Additional
Information.
49
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SMITH BREEDEN SERIES FUND
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
STATEMENT OF ADDITIONAL INFORMATION
AUGUST 1, 1996
100 Europa Drive, Suite 200
Chapel Hill, North Carolina 27514-2310
(919) 967-7221
Smith Breeden Series Fund (the "Fund") is a no-load open-end
management investment company offering redeemable shares of beneficial
interest in two separate series, the Smith Breeden Short Duration U.S.
Government Series (the "Short Series") and the Smith Breeden
Intermediate Duration U.S. Government Series ( the "Intermediate
Series").
This Statement of Additional Information is not a prospectus.
It contains information in addition to and in more detail than set forth in
the Prospectus. This Statement of Additional Information is only
authorized for distribution when accompanied or preceded by the
Prospectus of the Fund dated August 1, 1996, as may be amended from
time to time. This Statement should be read with the Prospectus.
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Contents
Page
MISCELLANEOUS INVESTMENT PRACTICES AND RISK
CONSIDERATIONS. . . . . . . . . . . . . . . . . . . . . . . 3
INVESTMENT RESTRICTIONS. . . . . . . . . . . . . . . . . . . . . 6
TRUSTEES AND OFFICERS. . . . . . . . . . . . . . . . . . . . . . 9
INVESTMENT ADVISORY AND OTHER SERVICES . . . . . . . . . . . . . 10
POLICIES REGARDING BROKERS USED IN PORTFOLIO
TRANSACTIONS. . . . . . . . . . . . . . . . . . . . . . . 12
ADDITIONAL INFORMATION REGARDING PURCHASES
AND REDEMPTIONS OF FUND SHARES. . . . . . . . . . . . . . 13
ADDITIONAL INFORMATION REGARDING TAXATION. . . . . . . . . . . 15
STANDARD PERFORMANCE MEASURES. . . . . . . . . . . . . . . . . 19
ADDITIONAL INFORMATION FOR INSTITUTIONAL
INVESTORS . . . . . . . . . . . . . . . . . . . . . . . . . 23
EXPERTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . 24
APPENDIX........................................................ 25
2
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MISCELLANEOUS INVESTMENT PRACTICES AND RISK CONSIDERATIONS
Investment Policies
The following supplements the information contained in the
Prospectus about the investment policies of the Short and Intermediate
Series. Terms used herein have the same meanings as in the
Prospectus.
General Characteristics and Risks of Options and Futures
Options
A put option gives the purchaser of the option the right to sell and
the writer the obligation, if the purchaser exercises his right, to buy the
underlying security at the exercise price during the option period. A call
option gives the purchaser of the option the right to buy and the writer the
obligation, if the purchaser exercises his right, to sell the underlying
security at the exercise price during the option period. Listed options are
issued by the Options Clearing Corporation ("OCC") which guarantees the
performance of the obligations of the parties to such options.
The purchaser of an option risks losing his entire investment in a
short period of time. If an option is not sold while it has remaining value,
or if during the life of an option the underlying interest does not
appreciate, in the case of a call option, or depreciate, in the case of a put
option, the purchaser of such option may lose his entire investment. On
the other hand, given the same market conditions, if the potential
purchaser of a call option purchases the underlying interest directly without
purchasing a call option or if the potential purchaser of a put option
decides not to purchase the put option, such potential purchaser might
have less of a loss. An option purchaser does not have the choice of
"waiting out" an unexpected decrease or increase in the underlying
instrument's price beyond the expiration date of the option. The more that
an option is out-of-the-money and the shorter its remaining term to
expiration, the greater the risk that a purchaser of the option will lose all
or part of his investment. Further, except where the value of the
remaining life of an option may be realized in the secondary market, for an
option purchase to be profitable the market price of the underlying interest
must exceed or, as applicable, be below the exercise price by more than the
premium and transaction costs paid in connection with the purchase of the
option and its sale or exercise.
A Series' ability to close out its position as a purchaser of an
exchange-listed option is dependent upon the existence of a liquid
secondary market on option exchanges. Among the possible reasons for
the absence of a liquid secondary market on an exchange are (i)
insufficient trading interest in certain options; (ii) restrictions on
transactions imposed by an exchange; (iii) trading halts, suspensions or
other restrictions imposed with respect to particular classes or series of
options or underlying securities; (iv) interruption of the normal operations
on an exchange; (v) inadequacy of the facilities of an exchange or the OCC
to handle current trading volume, or
3
<PAGE>
(vi) a decision by one or more exchanges 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 listed by the OCC as a result of trades on that
exchange would generally continue to be exercisable in accordance with
their terms. OTC Options are purchased from or sold to dealers or
financial institutions which have entered into direct agreement a Series.
With OTC Options, such variables as expiration date, exercise price and
premium will be agreed upon between the Series and the transacting
dealer, without the intermediation of a third party such as the OCC. If the
transacting dealer fails to make or take delivery of the securities underlying
an option it has written, in accordance with the terms of that option as
written, a Series would lose the premium paid for the option as well as
any anticipated benefit of the transaction. OTC Options and their
underlying securities are considered illiquid. A Series will engage in OTC
Option transactions only with primary United States government securities
dealers recognized by the Federal Reserve Bank of New York. The
Adviser monitors the creditworthiness of dealers with whom the a Series
enters into OTC options transactions under the general supervision of the
Fund's Board of Trustees.
The hours of trading for options on debt securities may not conform
to the hours during which the underlying securities are traded. To the
extent that the option markets close before the markets for the underlying
securities, significant price and rate movements can take place in the
underlying markets that cannot be reflected in the option markets.
Futures Contracts and Related Options
As a purchaser of an interest rate futures contract, a Series
incurs an obligation to take delivery of a specified amount of the obligation
underlying the futures contract at a specified time in the future for a
specified price or, in "cash settlement" futures contracts, to pay to (or
receive from) the seller in cash the difference between the original price in
the futures contract and the market price of the instrument on the
specified date, if the market price is lower (or higher, as the case may be).
A futures contract sale creates an obligation by a Series, as seller, to
deliver the specified type of financial instrument called for in the contract
at a specified future time for a specified price or, in "cash settlement"
futures contracts, to pay to (or receive from) the buyer in cash the
difference between the original price in the futures contract and the market
price of the instrument on the specified date, if the market price is higher
(or lower, as the case may be). Options on futures contracts are similar to
options on securities except that an option on a futures contract gives the
purchaser the right in return for the premium paid to assume a position in
a futures contract (a long position if the option is a call and short position
if the option is a put).
4
<PAGE>
Although most futures contracts call for actual delivery or acceptance
of securities, the contracts usually are closed out before the settlement date
without the making or taking of delivery. A futures contract sale is closed
out by effecting a futures contract purchase for the same aggregate amount
of the specific type of security and the same delivery date. If the sale price
exceeds the offsetting purchase price, the seller would be paid the
difference and would realize a gain. If the offsetting purchase price
exceeds the sale price, the seller would pay the difference and would
realize a loss. Similarly, a futures contract purchase is closed out by
effecting a futures contract sale for the same aggregate amount of the
specific type of security and the same delivery date. If the offsetting sale
price exceeds the purchase price, the purchaser would realize a gain,
whereas if the purchase price exceeds the offsetting sale price, the
purchaser would realize a loss. There is no assurance that the Short or
Intermediate Series will be able to enter into a closing transaction.
Initial margin in futures transactions is different from margin in
securities transactions in that initial margin does not involve the borrowing
of funds by a broker's client but is, rather, a good faith deposit on the
futures contract which will be returned to the Short or Intermediate Series
upon the proper termination of the futures contract. The margin deposits
made are marked to market daily and a Series may be required to make
subsequent deposits into the segregated account, maintained at its
Custodian for that purpose, or cash, U.S. Government securities or other
liquid high-grade debt securities, called "variation margin", in the name of
the broker, which are reflective of price fluctuations in the futures contract.
Currently, interest rate futures contracts can be purchased on debt
securities such as U.S. Treasury Bills and Bonds, Eurodollar instruments,
U.S. Treasury Notes and GNMA Certificates.
Exchanges limit the amount by which the price of a futures
contract may move on any day. If the price moves equal the daily limit on
successive days, then it may prove impossible to liquidate a futures position
until the daily limit moves have ceased. In the event of adverse price
movements, a Series would continue to be required to make daily cash
payments of variation margin on open futures positions. In such situations,
if a Short Series has insufficient cash, it may be disadvantageous to do so.
In addition, a Series may be required to take or make delivery of the
instruments underlying interest rate futures contracts it holds at a time
when it is disadvantageous to do so. An inability to close out options and
futures positions could also have an adverse impact a Series' ability to
effectively hedge its portfolio.
In the event of the bankruptcy of a broker through which the
Short or Intermediate Series engages in transactions in futures or options ,
either Series could experience delays and/or losses in liquidating open
positions purchased or sold through the broker and/or incur a loss of all or
part of its margin deposits with the broker. Transactions are entered into
by a Series only with broker or financial institutions deemed creditworthy
by the Adviser.
5
<PAGE>
The variable degree of correlation between price movements of
futures contracts and price movements in the position being hedged creates
the possibility that losses on the hedge may be greater than gains in the
value of the Short Intermediate's position. In addition, futures and
futures option markets may not be liquid in all circumstances. As a result,
in volatile markets, a Series may not be able to close out a transaction
without incurring losses substantially greater than the initial deposit.
Although the contemplated use of these contracts should tend to minimize
the risk of loss due to a decline in the value of the hedged position, at the
same time they tend to limit any potential gain which might result from an
increase in the value of such position. The ability of the Short or
Intermediate Series to hedge successfully will depend on the Adviser's
ability to forecast pertinent market movements, which cannot be assured.
In order to achieve its investment objective, the a Series may sell interest
rate futures in a different dollar amount than the dollar amount of
securities being hedged depending on the expected relationship between
the volatility of the prices of such securities and the volatility of the
futures contracts, based on duration calculations by the Adviser. If the
actual price movements of the securities and futures are inconsistent with
their durations as so calculated, the hedge may not be fully effective.
The Short and Intermediate Series will not maintain open short
positions in interest rate futures contracts if, in the aggregate, the value of
the open positions (marked to market) exceeds the current market value of
its securities portfolio plus or minus the unrealized gain or loss on those
open positions, adjusted for the expected volatility relationship between the
Series and the futures contracts based on duration calculations. If this
limitation should be exceeded at any time, the Short or Intermediate
Series will take prompt action to close out the appropriate number of open
contracts to bring its open futures position into compliance with this
limitation.
Finally, the daily deposit requirements in futures contracts
create an ongoing greater potential financial risk than do options
transactions, where the exposure is limited to the cost of the initial
premium. Losses due to hedging transactions may reduce net asset value.
Income earned by the Short or Intermediate Series from its hedging
activities generally will be treated as capital gains.
INVESTMENT RESTRICTIONS
The following restrictions (except as noted) have been adopted
as fundamental policies for both the Short and Intermediate Series, which
means that they may not be changed without the approval of a majority of
the outstanding shares of each of the Series , as the case may be (as
defined in the Investment Company Act). A Series may not (except that
none of the following investment restrictions shall prevent a Series from
investing all of its assets (other than assets which are not "investment
securities" as defined in the Investment Company Act) in an open-end
investment company with substantially the same investment
objectives):
6
<PAGE>
1. Issue senior securities, borrow money or pledge its assets,
except that the Short or Intermediate Series may borrow from banks or
through reverse repurchase agreements or dollar rolls up to 33 1/3% of the
value of its respective total assets (calculated when the loan is made) for
temporary, extraordinary or emergency purposes and to take advantage of
investment opportunities and may pledge up to 33 1/3% of the value of its
total assets to secure such borrowings. For purposes of this restriction, the
purchase or sale of securities on a "when-issued" or delayed delivery basis,
the purchase and sale of futures contracts, the entry into reverse
repurchase agreements and dollar roll transactions, short sales, interest rate
swaps, mortgage swaps, over-the-counter options, and collateral
arrangements with respect thereto are not deemed to be a pledge of assets
and none of such transactions or arrangements nor obligations of a Series
to Trustees pursuant to deferred compensation arrangements are deemed
to be the issuance of a senior security.
2. Act as underwriter except to the extent that, in connection with
the disposition of portfolio securities, it may be deemed to be an
underwriter under certain federal securities laws.
3. Purchase any security (other than obligations of the U.S.
Government, its agencies and instrumentalities) if as a result: (i) with
respect to 75% of its total assets, more than 5% of the Short or
Intermediate Series' total assets (determined at the time of investment)
would then be invested in securities of a single issuer, or (ii) 25% or more
of a Series' total assets (determined at the time of investment) would be
invested in one or more issuers having their principal business activities in
the same industry.
4. Purchase the securities of any issuer which would result in
owning more than 10% of any class of the outstanding voting securities of
such issuer.
5. Purchase any security, other than Mortgage-Backed
Securities, or obligations of the U.S. Government, its agencies or
instrumentalities, if as a result the Short or Intermediate Series would
have
invested more than 5% of its respective total assets in securities of issuers
(including predecessors) having a record of less than three years of
continuous operation; except for investments in regulated investment
companies with the same objective.
6. Acquire, lease or hold real estate. (Does not preclude
investments in securities collateralized by real estate or interests therein.)
7. Purchase or sell commodities or commodity contracts except for
hedging purposes.
8. Invest in interests in oil, gas or other mineral exploration or
development program.
9. Invest in companies for the purpose of exercising control or
management.
10. Purchase securities of other investment companies, except to
the extent permitted by the Investment Company Act.
7
<PAGE>
11. Make loans of money or property to any person, except
through loans of portfolio securities to Qualified Institutions, the purchase
of debt obligations in which the Short or Intermediate Series may invest
consistently with its investment objectives and policies and investment
limitations or the investment in repurchase agreements with Qualified
Institutions. The Short or Intermediate Series will not lend portfolio
securities if, as a result, the aggregate of such loans exceeds 33 1/3% of the
value of a Series' respective total assets (including such loans).
12. Purchase securities on margin (but the Short or Intermediate
Series may obtain such short-term credits as may be necessary for the
clearance of transactions); provided that the deposit or payment by a
Series of initial or variation margin in connection with options or futures
contracts is not considered the purchase of a security on margin.
13. Make short sales of securities or maintain a short position if,
when added together, more than 25% of the value of the Short or
Intermediate Series' net assets would be (i) deposited as collateral for the
obligation to replace securities borrowed to effect short sales, and (ii)
allocated to segregated accounts in connection with short sales. Short sales
"against-the box" are not subject to this limitation.
Whenever any fundamental investment policy or investment
restriction states a maximum percentage of assets, it is intended that if the
percentage limitation is met at the time the investment is made, a later
change in percentage resulting from changing total or net asset values will
not be considered a violation of such policy. However, in the event that
the asset coverage for borrowings falls below 300%, the Short and
Intermediate Series will take prompt action to reduce its borrowings as
required by applicable laws.
In order to change any of the foregoing restrictions which are
fundamental policies, approval must be obtained by shareholders of the
Short or Intermediate Series, as the case may be. Such approval requires
the affirmative vote of the lesser of (i) 67% or more of the voting
securities present at a meeting if the holders of more than 50% of voting
securities are represented at that meeting or (ii) more than 50% of the
outstanding voting securities of either the Short or Intermediate Series.
In addition, as non-fundamental policies, the Short and
Intermediate Series each may not:
(a) sell over-the-counter options which it does not own;
(b) sell options on futures contracts which options it does not own;
or
(c) invest in residual interests in a REMIC or a CMO.
8
<PAGE>
Other Policies
There are no restrictions or limitations on investments in
obligations of the United States, or of corporations chartered by Congress
as federal government instrumentalities. The underlying assets of the
Short or Intermediate Series may be retained in cash, including cash
equivalents which are Treasury bills, and short-term bank obligations such
as certificates of deposit, bankers' acceptances and repurchase agreements.
However, it is intended that only so much of the underlying assets of the
the Short or Intermediate Series be retained in cash as is deemed desirable
or expedient under then-existing market conditions. As noted in the
Prospectus, a Series may invest up to 15% of its respective total net assets
in illiquid securities.
In order to comply with certain "blue sky" restrictions, a Short
and Intermediate Series will not as a matter of operating policy, invest in
securities of any issuer if, to the knowledge of a Series, any officer or
Trustee of the Fund or the Adviser owns more than 1/2 of 1% of the
outstanding securities of such issuer, and such officers and Trustees who
own more than 1/2 of 1% own in the aggregate more than 5% of the
outstanding securities of such issuer.
The Short and Intermediate Series may make commitments more
restrictive than the restrictions listed above so as to permit the sale of
shares of a Series in certain states. Should the Fund determine that a
commitment is no longer required or in the best interest of the Fund and
its shareholders, the Short or Intermediate Series will revoke the
commitment by terminating the sale of shares of the Series in the state
involved.
TRUSTEES AND OFFICERS
The Board of Trustees has the responsibility for the overall
management of the Fund and each of the Short and Intermediate Series,
including general supervision and review of its investment activities. The
Trustees, in turn, elect the officers of the Fund who are responsible for
administering the day-to-day operations of the Fund. Trustees and officers
of the Fund are identified in the Prospectus.
The table below shows the fees paid to each Director by each Series
for 1996 fiscal year. The Trustees do not receive pension or retirement
benefits. The Trustees did receive compensation from the other Fund in
the Smith Breeden Family of Funds in addition to the compensation listed
below.
Director Aggregate Compensation Aggregate
Compensation
from Short Series from Intermediate Series
Stephen M. Schaefer $31,250 $6,500
Myron S. Scholes $33,250 $2,500
William F. Sharpe $32,250 $1,250
The Fund's Declaration of Trust provides that it will indemnify
its Trustees and officers against liabilities and expenses incurred in
connection with litigation in which they may be involved because of their
offices with the Fund, unless it is determined that they had acted with
willful misfeasance, bad faith, gross negligence or reckless disregard of the
duties involved in their offices or had not acted in good faith in the
reasonable belief that their actions were in the best interests of the
Fund.
<PAGE>
9
INVESTMENT ADVISORY AND OTHER SERVICES
The investment manager of each Series is Smith Breeden
Associates, Inc. (the "Adviser"). The table in the Prospectus indicates
which officers and Trustees are affiliated persons of the Adviser.
Pursuant to an Investment Advisory Agreement with each
Series (the "Advisory Agreement"), the Adviser provides investment
research and portfolio management services, including the selection of
securities to purchase, hold or sell, and the selection of brokers and
dealers through whom portfolio transactions are executed. The Adviser's
activities are subject to the review and supervision of the Board of
Trustees to whom the Adviser renders periodic reports of the two Series'
investment activities. The Adviser, at its own expense, furnishes the Short
and Intermediate Series with office space and office furnishings, facilities
and equipment required for managing the business affairs of the Series;
maintains all internal bookkeeping, clerical, secretarial and administrative
personnel and services; carries fidelity insurance on its own officers and
directors for the protection of the Series; and provides certain telephone
and other mechanical services. Except for the expense limitation in place
through March 31, 1997, each Series bears all expenses related to its
operation not borne by the Adviser, as discussed in the Prospectus.
Each Advisory Agreement is in effect until August 1, 1997.
Thereafter, it may continue in effect for successive periods not exceeding
one year, providing such continuance is specifically approved at least
annually by a vote of the Fund's Board of Trustees or by a vote of the
holders of a majority of each of the Series' outstanding voting securities,
and in either event by a majority of the Fund's' Trustees who are not
parties to the Agreement or interested persons of any such party (other
than as Trustees of the Fund), cast in person at a meeting called for that
purpose. Each Advisory Agreement may be terminated without penalty at
any time by the Fund, on behalf of each Series, or by the Adviser on sixty
days' written notice and will automatically terminate in the event of its
assignment as defined in the Investment Company Act. The Advisory
Agreement provides that the Adviser will not be liable for any error of
judgment or for any loss suffered by either Series in connection with
matters to which the Advisory Agreement relates, except a loss resulting
from willful misfeasance, bad faith gross negligence or reckless disregard of
duty.
As compensation for the services rendered to each Series by
the Adviser under the terms of the Advisory Agreement, and the
assumption by
the Adviser of the related expenses, the Short and Intermediate Series
each pays the Adviser a fee, computed daily and payable monthly, at an
annual rate equal to 0.70% of the respective Series' average daily net asset
value. For the last three fiscal years ended March 31, the Adviser
received no fees from the Short Series in 1994 or 1995, and
received $1,717,748 for the fiscal year ended March 31, 1996.
The Short Series, prior to April 1, 1995, indirectly bore investment advisory
fees through its investment in the Smith Breeden Short Duration U.S.
Government Fund. On March 31, 1995, this two tier structure
was consolidated, resulting in the Short Series becoming a stand-alone
fund. The Adviser received no fees from the Intermediate Series for the
fiscal year ended March 31, 1994, but received $132,174 from the
Intermediate Series for the fiscal year ended March 31, 1995 and $256,075
for the fiscal year ended March 31, 1996. The Intermediate Series prior to
August 1, 1994 indirectly bore investment advisory fees through its
investment in the Smith Breeden Institutional Intermediate Duration U.S.
Government Fund. On August 1, 1994, this two-tier was eliminated,
resulting in the Intermediate Series becoming a stand-alone fund. During
the three year period ended March 31, the Adviser reimbursed the Short
Series $179,527, $146,256, $364,865 for the periods ended 1994, 1995, and
1996, respectively, under expense limitation provisions. The Intermediate
Series was reimbursed $100,750, $123,390, and $85,364 for the same
periods under expense limitation provisions.
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Under the terms of its Advisory agreement with each Series,
the Adviser also provides certain administrative services.
Fund/Plan Services, Inc. is the shareholder servicing, accounting,
transfer and dividend paying-agent. Each Series' pays its own expenses,
including, but not limited to auditing, legal, tax preparation and consulting,
insurance, custodial, accounting, shareholder servicing and shareholder
report expenses. Fees paid to Fund/Plan Services are determined by
contract as approved by the Trustees.
Bank of New York, 48 Wall Street, New York, NY, 10286 acts
as custodian of the securities and other assets of the Portfolio. A
custodian's responsibilities include generally safeguarding and controlling a
Series's cash and securities, handling the receipt and delivery of securities,
and collecting interest and dividends on a Series' investments. The
custodian does not participate in decisions relating to the purchase and sale
of portfolio securities.
Deloitte & Touche, 117 Campus Drive, Princeton, New Jersey
08540, are the Fund's independent auditors, providing audit services, tax
return preparation and other tax consulting services, and assistance and
consultation in connection with the review of various Securities and
Exchange commission filings. Ropes & Gray, One International Place,
Boston, Massachusetts, 02110-2624, are legal counsel to the Fund.
Listed below are the names and addresses of those shareholders
who, to the best knowledge of the Fund, as of June 30, 1996, owned
5% or more of the shares of the Short Duration Series.
Carver Federal Savings Bank
2815 Atlantic Avenue
Brooklyn, NY 11207 28.14%
Cascade Savings Bank
2828 Colby Avenue
Everett WA 98201 9.31%
Dell USA L.P
2112 Kramer Lane
Austin Texas, 78758 5.68%
Hemet Federal Savings & Loan
445 E. Florida Ave.
Hemet, CA 92543 6.75%
Watsonville Federal Savings & Loan
35 East Lake Avenue
Watsonville, CA 95076 6.49%
The Officers and Trustees of the Fund together as a group owned
less than 1.00% of the shares of the Short Duration Series as of June 30,
1996.
Listed below are the names and addresses of those shareholders,
who as of March 31, 1996, to the best knowledge of the Fund, owned 5%
or more of shares of the Intermediate Series.
Roosevelt Bank
900 Roosevelt Pkwy
Chesterfield, MO 70.72%
Public School Retirement System
1 Mercantile Ctr.
St. Louis, MO 18.79%
The Officers and Trustees of the Fund together as a group owned
less than 1.00% of the shares of the Intermediate Duration Series as of
June 30, 1996.
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Potential Conflicts of Interest
Principals of the Adviser as individuals own approximately 67% of
the common stock of Financial Research Corporation, the holding
company for Harrington Bank, FSB (the "Association"). As of May 31,
1996, the Association had total assets of $356 million. The Association
invests in assets of the same types as those to be held by the Short and
Intermediate Series.
Douglas T. Breeden, in combination with immediate family
members, controls over 75% of the common stock of Community First
Financial Group, Inc., ("CFFG") the holding company for certain banks
and thrifts, to which the Adviser renders certain Investment Advisory
Services. The Fund will transact no business directly or indirectly with
either CFFG or the banks and thrifts which it owns. CFFG and its
subsidiaries invest in assets of the same types as those to be held by the
Short and Intermediate Series.
The Adviser may also manage advisory accounts with investment
objectives similar to or the same as those of the Short or Intermediate
Series, or different from the two Series, but trading in the same type of
securities and instruments. Portfolio decisions and results of the two
Series' investments may differ from those of such accounts managed by the
Adviser. When two or more accounts managed by the Adviser seek to
purchase or sell the same assets, the assets actually purchased or sold may
be allocated among the accounts on a basis determined by the Adviser in
its good faith discretion to be equitable. In some cases, this system may
adversely affect the size or the price of the position obtainable for the
Short or Intermediate Series.
POLICIES REGARDING BROKERS USED IN PORTFOLIO TRANSACTIONS
Under the Advisory Agreement, the selection of brokers and
dealers to execute transactions on behalf of a Series is made by the
Adviser in accordance with criteria set forth in the Advisory Agreement
and any directions which the Board of Trustees may give. However, each
of the Short and Intermediate Series do not anticipate that it will incur a
significant amount of brokerage expense because brokerage commissions
are not normally incurred on investments in Mortgage Securities, which are
generally traded on a "net" basis; that is, in principal amounts without the
addition or deduction of brokerage commissions. The Short and
Intermediate Series paid $46,156 and $3,483, respectively, in brokerage
commissions on futures and options for the year end March 31, 1996. For
the year end March 31, 1995, the Short and Intermediate Series paid
$0 and $3,483, respectively in brokerage commissions. Neither Series paid
any brokerage commissions for the year ended March 31, 1994. Prior to
March 31, 1995, the Short Series paid brokerage commissions indirectly by
virtue of its investment in the Smith Breeden Short Duration U.S.
Government Fund. Prior to August 1, 1994, the Intermediate Series paid
brokerage commissions indirectly by virtue of its investment in the Smith
Breeden Institutional Intermediate U.S. Government Fund. (See
"Investment Advisory and Other Services". )
When placing a portfolio transaction, the Adviser attempts to
obtain the best net price and execution of the transaction. On portfolio
transactions which are done on a securities exchange, the amount of
commission paid by the Short or Intermediate Series is negotiated
between the Adviser and the broker executing the transaction. The
Adviser seeks to obtain the lowest commission rate available from brokers
which are felt to be capable of efficient execution of the transactions. The
determination and evaluation of the reasonableness of the brokerage
commissions paid in connection with portfolio transactions are based to a
large degree on the professional opinions of the persons responsible for the
placement and review of such transactions.
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These opinions are formed on the basis of, among other things, the
experience of these individuals in the securities industry and information
available to them concerning the level of commissions being paid by other
institutional investors of comparable size.
Securities may be purchased directly from issuers or from
underwriters. Where possible, purchase and sale transactions will be
effected through dealers (including banks) which specialize in the types of
securities which the Portfolio will be holding, unless better executions are
available elsewhere. Dealers and underwriters usually act as principal for
their own account. Purchases from underwriters will include a concession
paid by the issuer to the underwriter and purchases from dealers will
include the spread between the bid and the asked price. No broker or
dealer affiliated with the Portfolio or with the Adviser may purchase
securities from, or sell securities to, the Portfolio.
When it is felt that several brokers or dealers are equally able
to provide the best net price and execution, the Adviser may decide to
execute transactions through brokers or dealers who provide quotations
and other services to the Short or Intermediate Series, specifically
including the quotations necessary to determine each of the Series' net
assets, in such amount of total brokerage as may reasonably be required in
light of such services, and through brokers and dealers who supply
statistical and other data to the two Series in such amount of total
brokerage as may reasonably be required.
The Adviser conducts extensive proprietary fixed income research
with emphasis on mortgage-backed securities. The Adviser is not
dependent on any broker for such research and analysis and, thus is able to
transact business with brokers regardless of the brokers' research
capabilities or provision of such research to brokerage customers. The
Adviser uses multiple electronic quotation services for trading and pricing
purposes. The Adviser pays for these services directly out of its advisory
fees. The Adviser is not involved in any soft dollar arrangements. The
Adviser does utilize broker pricing guidance for certain assets not
consistently available through electronic quotation services.
ADDITIONAL INFORMATION REGARDING
PURCHASES AND REDEMPTIONS OF FUND SHARES
All checks, drafts, wires and other payment mediums used for
purchasing or redeeming shares of either Series must be denominated in
U.S. Dollars. The Fund reserves the right, in its sole discretion, to either
(a) reject any order for the purchase or sale of shares denominated in any
other currency, or (b) to honor the transaction or make adjustments to
shareholder's account for the transaction as of a date and with a foreign
currency exchange factor determined by the drawee bank.
Dividend checks which are returned to the Fund marked
"unable to forward" by the postal service will be deemed to be a request to
change the dividend option and the proceeds will be reinvested in
additional shares at the current net asset value until new instructions are
received.
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Redemptions in Kind
The Short and Intermediate Series have committed themselves
to pay in cash all requests for redemption by any shareholder of record,
limited in amount, however, during any 90-day period to the lesser of
$250,000 or 1% of the value of the either Series' net assets at the
beginning of such period. Such commitment is irrevocable without the
prior approval of the Securities and Exchange Commission. In the case of
requests for redemption in excess of such amounts, the Trustees reserve
the right to make payments in whole or in part in securities or other assets
of either Series in case of an emergency, or if the payment of such
redemption in cash would be detrimental to the existing shareholders of
either Series. In such circumstances, the securities distributed would be
valued at the price used to compute the Short or Intermediate Series' net
assets. Should the Short or Intermediate Series do so, a shareholder may
incur brokerage fees or other transaction costs in converting the securities
to cash.
Principal Underwriter
Fund/Plan Broker Services, Inc. (the "Principal Underwriter"), #2
West Elm Street, P. O. Box 874, Conshohocken, Pennsylvania 19428-0874,
is the principal underwriter for the Fund, and is acting on a best efforts
basis. The Principal Underwriter is registered as a broker-dealer under the
Securities Exchange Act of 1934 and is a member of the National
Association of Securities Dealers, Inc. The offering of the Fund's shares is
continuous.
The Fund's underwriting agreement with the Principal Underwriter
provides that the Fund will pay all fees and expenses in connection with:
registering and qualifying its shares under the various state "blue sky" laws;
preparing, setting in type, printing, and mailing its prospectuses and reports
to shareholders; and issuing its shares, including expenses of confirming
purchase orders. See the description of the Distribution Plan in the
Prospectus.
The Principal Underwriter acts as the agent of both the Short
and Intermediate Series in connection with the sale of their shares in all
states in which the shares are qualified and in which the Principal
Underwriter is qualified as a broker-dealer. Under the underwriting
agreement, the Principal Underwriter may accept orders for either Series
shares at the offering price. The Principal Underwriter may enter into
agreements with other broker-dealers for the sale of Short or Intermediate
Series shares by them.
The Principal Underwriter is paid approximately $17,000 in total by
the Adviser for its services to the two Series. In addition, for the year
March 31, 1996, the Principal Underwriter received no sales charges or
commissions.
Calculation of Net Asset Value
As noted in the Prospectus, the Short and Intermediate Series
will generally calculate their net asset value as of the close of trading each
Monday through Friday that the Adviser and Transfer Agent are open for
business and sufficient trading takes place to impact the value of the Short
or Intermediate Series assets. As of the date of this Statement, current
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holiday schedules indicate that the net asset value will not be calculated on:
New Year's Day, Presidents' Day, Martin Luther King Day, Good Friday,
Memorial Day, Independence Day, Labor Day, Columbus Day, Veteran's
Day, Thanksgiving Day, the day following Thanksgiving, Christmas Eve,
and Christmas Day.
Reinvestment Date
The dividend reinvestment date is the date on which the additional
shares are purchased for the investor who has his dividends reinvested.
This date will vary from month to month and is not necessarily the same
date as the record date or the payable date for cash dividends.
Ownership and Authority Disputes
In the event of disputes involving multiple claims of ownership or
authority to control a shareholder's account, the Fund has the right (but
has no obligation) to (a) require the written agreement of all persons
deemed by the Fund to have a potential property interest in the account,
prior to executing instructions regarding the account; (b) interplead
disputed funds or account with a court of competent jurisdiction or (c)
surrender ownership of all or a portion of the account to the Internal
Revenue Service in response to a Notice of Levy.
ADDITIONAL INFORMATION REGARDING TAXATION
Taxation of the Series
For federal income tax purposes, each Series will be treated as
a separate corporation. Each of the Short and Intermediate Series intend
to qualify each year and elect to be treated as regulated investment
companies ("RICs") for federal income tax purposes. To so qualify, the
Short and Intermediate Series must, among other things: (i) derive at least
90% of their gross income for each taxable year from dividends, interest,
payments with respect to loans of securities and gains from the sale or
other disposition of securities or certain other related income; (ii) generally
derive less than 30% of their gross income for each taxable year from gains
from the sale or other disposition of securities and certain other
investments held for less than three months; and (iii) diversify their
holdings so that at the end of each quarter of the taxable year (A) at least
50% of the value of each of the Short and Intermediate Series' assets
would be represented by cash, U.S. Government securities, securities of
other RICs, and other securities which, with respect to any one issuer, do
not represent more than 5% of the value of each of the Series' assets nor
more than 10% of the voting securities of such issuer and (B) not more
than 25% of the value of each of the Series' assets are invested in the
securities of any one issuer (other than U.S. Government securities or the
securities of other RICs).
The requirement that each Series derive less than 30% of its
gross income from gains from the sale or other disposition of securities and
certain other investments held for less than three months (the "Short-Short
Rule") may cause the Short or Intermediate Series to (i) hold certain
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<PAGE>
investments that it otherwise would have sold or (ii) sell certain
investments that it otherwise would have held. In addition, if the Short or
Intermediate Series were to experience a large quantity of share
redemptions during a taxable year, either Series may have difficulty
satisfying the Short-Short Rule during that year. If the Short or
Intermediate Series fails to satisfy the Short-Short Rule in a taxable year,
it would lose its RIC status for that year. Each Series, however, will
endeavor to select investments for sale during a taxable year in such a way
that they will satisfy the Short-Short Rule.
If the Short and Intermediate Series qualify as RICs and
distribute to their shareholders at least 90% of its net investment income
(including tax-exempt interest and net short-term capital gain but not net
capital gain, which is the excess of net long-term capital gains over net
short-term capital losses), then the Short and Intermediate Series will not
be subject to federal income tax on the income so distributed. However,
the Short and Intermediate Series will be subject to corporate income tax
on any undistributed income. In addition, either Series would be subject
to a nondeductible 4% excise tax on the amount by which the income it
distributed in any calendar year would be less than a minimum distribution
amount. The minimum distribution amount required to avoid the excise
tax for a calendar year equals the sum of (i) 98% of a Series' ordinary
income (excluding tax-exempt interest income) for such calendar year; (ii)
98% of the excess of capital gains over capital losses for the one-year
period ending on October 31 (or another date if elected by a Series) of
each year; and (iii) 100% of the undistributed ordinary income and gains
from prior years. For purposes of the excise tax, any income or capital
gains retained by, and taxed in the hands of, either Series will be treated
as having been distributed.
Both the Short and Intermediate Series intend to distribute
sufficient income so as to avoid both corporate income tax and excise tax.
The Short Series may be subject to a 4% excise tax to the extent that the
amount of ordinary income distributed during the calendar year is less than
98% of the ordinary income (excluding tax-exempt interest income) for the
year. The Short Series will endeavor to pay dividends in such a manner
that an excise tax will not be incurred. The Series also may elect to retain
all or a portion of their net capital gain, as described under "Taxation of
Shareholders Distributions" below.
Any capital losses resulting from the disposition of securities can
be used only to offset capital gains and cannot be used to reduce a Series'
ordinary income. Such capital losses may be carried forward for eight
years. If any capital losses have not been utilized at the time a Series
terminates, such capital losses will become unusable.
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<PAGE>
Taxation of Shareholders
Distributions. In general, all distributions to shareholders
attributable to the Short or Intermediate Series' net investment income
(including any tax-exempt interest income distributed) will be taxable as
ordinary dividend income whether paid in cash or in additional
shares.
To the extent either the Short or Intermediate Series does
realize net capital gains, it intends to distribute such gains at least annually
and designate them as capital gain dividends. Capital gain dividends are
taxable as capital gains, whether paid in cash or in additional shares,
regardless of how long the shares have been held. The Short or
Intermediate Series may elect to retain net capital gains and pay corporate
income tax thereon. In such event, the Short or Intermediate Series would
most likely make an election that would require each shareholder of record
on the last day of the Series' taxable year to include in income for tax
purposes his proportionate share of the Series' undistributed net capital
gain. If such an election is made, each shareholder would be entitled to
credit his proportionate share of the tax paid by the Series against his
federal income tax liabilities and to claim refunds to the extent that the
credit exceeds such liabilities. In addition, the shareholder would be
entitled to increase the basis of his shares for federal tax purposes by an
amount equal to 66% of his proportionate share of the undistributed net
capital gain.
Shareholders receiving distributions in the form of additional shares
will be treated for federal income tax purposes as receiving an equivalent
amount of cash. In general, the basis of such shares will equal the amount
of cash that the shareholder would have received if he had elected to
receive distributions in cash.
Liquidating distributions which in the aggregate exceed a
shareholder's basis in shares will be treated as gain from the sale of shares.
If a shareholder receives, in the aggregate, liquidating distributions which
are less than such basis, such shareholder will recognize a loss to that
extent. Dividends and other distributions by either the Short or
Intermediate Series are generally taxable to the shareholders at the time
the dividend or distribution is made.
If a shareholder purchases shares at a cost that reflects an anticipated
dividend, such dividend will be taxable even though it represents
economically a return of part of the purchase price. Investors should
consider the tax implications of buying shares shortly prior to a
distribution.
Sales of Shares. In general, if a share is sold, the seller will
recognize gain or loss equal to the difference between the amount realized
on the sale and the seller's adjusted basis in the share. However, any loss
recognized by a shareholder within six months of purchasing the shares will
be treated as a long-term loss to the extent of any long-term capital gain
distributions received by the shareholder and the shareholder's share of
undistributed long-term capital gains. In addition, any loss realized on a
sale of shares will be disallowed to the extent the shares disposed of are
replaced within a period of 61 days beginning 30 days before the
disposition of the shares. In such a case, the basis of the shares acquired
will be adjusted to reflect the disallowed loss. Any gain or loss realized
upon a sale of shares by a shareholder who is not a dealer in securities will
be treated as capital gain or loss.
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If a shareholder exchanges shares of one fund in the Smith Breeden
Family of Funds for shares of another fund, the shareholder generally will
recognize gain or loss as if the shares had been redeemed.
Tax-Exempt Investors. If a shareholder that is a benefit plan
investor (e.g., an individual retirement account, pension plan 401(k) plan,
or Keogh plan) or charitable organization (a "Tax-Exempt Investor") incurs
debt to finance the acquisition of its shares, a portion of the income
received by the Tax-Exempt Investor with respect to its shares would
constitute unrelated business taxable income ("UBTI"). In that case, the
UBTI portion of the Tax-Exempt Investor's income from its investment in
the Short or Intermediate Series for the year would equal the total income
recognized by the Tax-Exempt Investor in that year multiplied by the ratio
of the Tax-Exempt Investor's average acquisition debt balance to the
average tax basis of its shares for the year. A Tax-Exempt Investor
generally is subject to federal income tax to the extent that its UBTI for a
taxable year exceeds its annual $1,000 exclusion.
Consequences of Certain Fund Investments
Hedging Transactions. Each Series intends to engage in
various hedging transactions. Under various provisions of the Code, the
result of such investments and transactions may be to change the character
of recognized gains and losses, accelerate the recognition of certain gains
and losses, and defer the recognition of certain losses. For example, the
tax treatment of futures contracts entered into by a Series as well as listed
non-equity options written or purchased by a Series on U.S. exchanges
(including options on debt securities and options on futures contracts) will
be governed by section 1256 of the Code. Absent a tax election for "mixed
straddles" (described below), each such position held by a Series on the
last business day of each taxable year of the Series will be marked to
market (i.e., treated as if it were closed out), and all resulting gain or loss
will be treated as 60% long-term capital gain or loss and 40% short-term
capital gain or loss, with subsequent adjustments made to any gain or loss
realized upon an actual disposition of such positions. When a Series holds
an option or contract governed by section 1256 which substantially
diminishes the Series' risk of loss with respect to another position of the
Portfolio not governed by section 1256 (as might occur in some hedging
transactions), that combination of positions generally will be a "mixed
straddle" that is subject to the straddles rules of section 1092 of the Code.
The application of Section 1092 might result in deferral of losses,
adjustments in the holding periods of the Series' securities and conversion
of short-term capital losses into long-term capital losses. Either Series may
make certain tax elections for its "mixed straddles" that could alter certain
effects of section 1256 or section 1092. The extent to which a Series is
able to use such hedging techniques may be limited by the Short-Short
Rule, which is discussed above. In determining compliance with the Short-
Short Rule, however, gains from certain types of hedging positions that are
part of designated hedges and are held by a Series for less than three
months will be netted against losses (whether recognized or unrecognized)
incurred with respect to the offsetting position in the designated hedge.
That special netting provision, if employed by a Series, could reduce the
risk that active hedging techniques will run afoul of the Short-Short
Rule.
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The character of the Short or Intermediate Series' taxable income will
in most cases be determined on the basis of reports made to the Series by
the issuers of the securities in which they invest. The tax treatment of
certain securities in which a Series may invest is not free from doubt and
it is possible that an IRS examination of the issuers of such securities
could result in adjustments to the income of a Series.
The foregoing discussion is a general summary of certain of the
current federal income tax laws regarding the both Series and investors in
the shares. The discussion does not purport to deal with all of the federal
income tax consequences applicable to the Series or to all categories of
investors, some of which maybe subject to special rules. Investors should
consult their own tax advisers regarding the tax consequences to them of
investments in shares.
STANDARD PERFORMANCE MEASURES
Performance
As noted in the Prospectus, the Fund may from time to time
quote various performance figures to illustrate the past performance of
either Series. It may occasionally cite statistics to reflect its volatility or
risk.
Performance quotations by investment companies are subject to rules
adopted by the Securities and Exchange Commission ("SEC"). These rules
require the use of standardized performance quotations or alternatively,
that every non-standardized performance quotation furnished by the Fund
be accompanied by certain standardized performance information
computed as required by the SEC. Current yield and average annual
compounded total return quotations used by the Fund are based on the
standardized methods of computing performance mandated by the SEC.
An explanation of those and other methods used by the Fund to compute
or express performance follows.
Total Return
The average annual total return is determined by finding the
average annual compounded rates of return over one, five, and ten year
periods (or for the life of a Series, if shorter) that would equate an initial
hypothetical $1,000 investment to its ending redeemable value. The
calculation assumes no sales charge is deducted from the initial $1,000
purchase order, capital gains and all income dividends are reinvested at net
asset value on the reinvestment dates during the period. The quotation
assumes the account was completely redeemed at the end of each one, five
and ten year period and the deduction of all applicable charges and fees.
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The Series' average annual compounded rate of return is determined
by reference to a hypothetical $1,000 investment, according to the following
formula:
P(1+T)n = ERV
where:
P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1,000
payment made at the beginning of the 1, 5, or 10
year periods at the end of said 1, 5, or 10 year
periods (or fractional portion thereof).
As discussed in the Prospectus, the Fund may quote total rates of
return in addition to its average annual total return. Such quotations are
computed in the same manner as the Fund's average annual compounded
rate, except that such quotations will be based on the Fund's actual
aggregate return for a specified period as opposed to its average return
over certain periods.
Yield
Current yield reflects the income per share earned by the Fund's
portfolio investments. Current yield is determined by dividing the net
investment income per share earned during a 30-day base period by the
offering price or net asset value per share, as the case may be, on the last
day of the period and analyzing the result, according to the following
formula:
Yield = 2 [(a-b + 1)6 -1]
cd
where:
a = dividends and interest earned during the
period.
b = expenses accrued for the period (net of
reimbursements).
c = the average daily number of shares
outstanding during the period that were
entitled to receive dividends.
d = the maximum offering price or net asset
value per share, as the case may be, on
the last day of the period.
The following table shows the average annual total return for
the periods stated, and yield for the Short and Intermediate Series for the
30 day period ended March 31, 1996.
AVERAGE ANNUAL TOTAL RETURN
ONE YEAR THREE YEARS INCEPTION 30-DAY
YIELD
SHORT SERIES 4.95% 5.06% 5.20% 5.81%
INTERMEDIATE
SERIES 9.69% 6.61% 8.62% 6.41%
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The investment results of the Short and Intermediate Series,
like all others, fluctuate over time. Thus, performance figures should not
be considered to represent what an investment may earn in the future or
what the Short or Intermediate Series' yield or total return may be for any
future period.
Current Distribution Rate
Yield which is calculated according to a formula prescribed by
the SEC is not indicative of the amounts which will be paid to the Series'
shareholders. Amounts paid to shareholders are reflected in the quoted
"current distribution rate." The current distribution rate is computed by
dividing the total amount of dividends, excluding long-term capital gains,
per share paid by a Series during the past twelve months by its current net
asset value. Under certain circumstances, such as when there has been a
change in the amount of dividend payout, or a fundamental change in
investment policies, it might be appropriate to annualize the dividends paid
over the period such policies were in effect, rather than using the dividends
during the past twelve months. The current distribution rate differs from
the current yield computation because it may include distributions to
shareholders from sources other than dividends and interest, such as short-
term capital gains and net equalization credits and is calculated over a
different period of time.
Volatility
Occasionally statistics may be used to specify a Series volatility
or risk. Measures of volatility or risk are generally used to compare fund
net asset value or performance relative to a market index. One measure of
volatility is beta. The ratio of the expected excess return on a Series to
the expected excess return on the market index is called beta. Equity funds
commonly use the S&P 500 as their market index. A beta of more than
1.00 indicates volatility greater than the market, and a beta of less that 1.00
indicates volatility less than the market. Another measure of volatility or
risk is standard deviation. Standard deviation is used to measure variability
of net asset value or total return around an average, over a specified period
of time. The premise is that greater volatility connotes greater risk
undertaken in achieving performance.
A statistic often used by sophisticated institutional investors
when comparing the relative performance of portfolios is the Sharpe Ratio.
This statistic is a Series' excess return (relative to T-Bills) divided by the
standard deviation of its returns.
Comparisons and Advertisements
To help investors better evaluate how an investment in a Series
might satisfy their objective, advertisements regarding either Series may
discuss various measures of a Series' performance as reported by various
financial publications. Advertisements may also compare performance (as
calculated above) to performance as reported by other investments, indices,
and averages. The following publications, indices, and averages may be
used:
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a) Lipper - Mutual Fund Performance Analysis, Lipper-Fixed
Income Analysis, and Lipper Mutual Fund Indices - measures total return
and average current yield for the mutual fund industry and ranks individual
mutual fund performance over specified time periods assuming
reinvestment of all distributions, exclusive of sales charges.
b) CDA Mutual Fund Report, published by CDA Investment
Technologies, Inc. - analyzes price, current yield, risk, total return, and
average rate of return (average annual compounded growth rate) over
specified time periods for the mutual fund industry.
c) Mutual Fund Source book, published by Morningstar, Inc. -
analyzes price, yield, risk, and total return for equity and fixed income
funds.
d) Financial publications: Barron's, Business Week, Changing
Times, Financial World, Forbes, Fortune, and Money magazines - rate fund
performance over specified time periods.
e) Consumer Price Index (or Cost Of Living Index), published by
the U.S. Bureau of Labor Statistics - a statistical measure of change, over
time, in the price of goods and services, in major expenditure groups.
f) Stocks, Bonds, Bills, and Inflation, published by Ibbotson
Associates -historical measure of yield, price, and total return for common
and small company stock, long-term government bonds, treasury bills, and
inflation.
g) Savings and Loan Historical Interest Rates - as published in the
U.S. Savings & Loan League Fact Book.
h) Salomon Brothers Broad Bond Index - The Broad Index
measures yield, price, and total return for Treasury, Agency, Corporate,
and
Mortgage bonds. All issues mature in one year or more and have at least
$50 million outstanding, with the exception of mortgages. The entry
criteria
for mortgage issues is $200 million for each coupon.
i) Salomon Brothers Mortgage Index - The Salomon Brothers
Mortgage Index measures only the mortgage component of the Salomon
Brothers Broad Bond Index.
j) Salomon Brothers Composite High Yield Index or its
component indices -The High Yield Index measures yield, price and total
return for Long-Term High-Yield Index, Intermediate-Term High-Yield
Index and Long-Term Utility High-Yield Index.
k) Lehman Brothers Aggregate Bond Index or its component
indices - The Aggregate Bond Index measures yield, price and total return
for Treasury, Agency, Corporate, Mortgage, and Yankee bonds.
l) Lehman Brothers Government/Corporate Bond Index.
m) Standard & Poor's Bond Indices - measure yield and price of
Corporate, Municipal, and Government bonds.
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n) Other taxable investments including certificates of deposit
(CD's), money market deposit accounts (MMDA's), checking accounts,
savings accounts, money market mutual funds, repurchase agreements, and
government securities.
o) Historical data supplied by the research departments of
Lehman Brothers, First Boston Corporation, Morgan Stanley, Salomon
Brothers, Merrill Lynch, Goldman Sachs, Prudential Securities and
Donaldson Lufkin and Jenrette.
p) Donoghues's Money Fund Report - industry averages for 7-day
annualized and compounded yields of taxable, tax-free and government
money funds.
q) Total returns and yields for Treasury Securities and fixed
income indices as published by Ryan Laboratories or other suppliers.
In assessing such comparisons of performance, an investor
should keep in mind that the composition of the investments in the
reported indices and averages is not identical, and in some cases is very
different, to a Series' portfolio, that the averages are generally unmanaged
and that the items included in the calculations of such averages may not be
identical to the formula used by a Series to calculate its figures. In
addition there can be no assurance that a Series will continue its
performance as compared to such other averages.
Shareholders should note that the investment results of the
Short or Intermediate Series will fluctuate over time, and any presentation
of a Series' current yield or total return for any period should not be
considered as a representation of what an investment may earn or what a
shareholder's yield or total return may be in any future period.
Shareholders should also note that although the Series believe that there
are substantial benefits to be realized by investing in its shares, such
investments also involve certain risks. (See "Investment Objectives and
Policies of the Fund - Risks of Mortgage Securities" in the Fund's
Prospectus.)
ADDITIONAL INFORMATION FOR INSTITUTIONAL INVESTORS
As the investments permitted to the Series are primarily in
mortgage securities issued or guaranteed by the U.S. Government or its
agencies and instrumentalities, the shares of either the Short or
Intermediate Series may be eligible for investment by federally chartered
credit unions, federally chartered thrifts, and national banks. Either Series
may be a permissible investment for certain state chartered institutions as
well, including state and local government authorities and agencies. Any
financial institution or agency considering an investment in either Series
should refer to the applicable laws and regulations governing its operations
in order to determine if a Series is a permissible investment.
EXPERTS
The financial statements of both the Short and Intermediate
Series and related notes thereto included in this Statement of Additional
Information have been so included in reliance upon the report of Deloitte
& Touche LLP, independent auditors, given in authority of said firm as
experts in auditing and accounting.
23
<PAGE>
FINANCIAL STATEMENTS
The financial statements of the Fund are attached and follow the
Appendix.<PAGE>
24
<PAGE>
APPENDIX
Description of Moody's Investors Service, Inc.'s corporate bond 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-edged." 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 - 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 predominantly
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 the desirable
investment. 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.
25
<PAGE>
Description of Standard & Poor's Corporation's corporate bond ratings:
AAA - This is the highest rating assigned by Standard & Poor's to a debt
obligation and indicates an extremely strong capacity to pay principal and
AA - Bonds rated AA also qualify as high-quality debt obligations.
Capacity to pay principal and interest is very strong, and in the majority of
instances they differ from AAA issues only in small degree.
A - Bonds rated A have a strong capacity to pay principal and interest,
although they are somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions.
BBB - Bonds rated BBB are regarded as having an adequate capacity to
pay principal and interest. Whereas they normally exhibit protection
parameters, adverse economic conditions or changing circumstances are
more likely to lead to a weakened capacity to pay principal and interest for
bonds in this capacity than for bonds in the A category.
BB, B, CCC, CC - Bonds rated BB, B, CCC and CC are regarded, on
balance, predominantly speculative with respect to the issuer's capacity to
pay interest and repay principal in accordance with the terms of the
obligations. BB indicates the lowest degree of speculation and CC the
highest degree of speculation. While such bonds will likely have some
quality and protective characteristics, these are outweighed by large
uncertainties or major risk exposures to adverse conditions.
26
<PAGE>
PERFORMANCE REVIEW
The Smith Breeden Short Duration U.S. Government Series provided a
total return of 4.95% in the year ended March 31, 1996, while the
return on the Series' benchmark, the six month U.S. Treasury Bill,
was 5.96%. The Series' annualized return from inception on March
31, 1992 through March 31, 1996 was 5.20%, while the benchmark six
month Treasury Bill's annualized return over the same period was
4.58%.
The Series underperformed its benchmark by 1.01% in the year ending
March 31, 1996. The Series invests in mortgage securities, and its
performance relative to its benchmark is adversely affected when
the price of mortgage securities appreciates by less than the price
of Treasury securities in a falling interest rate environment.
This is what occurred during 1995. The yield on the ten year U.S.
Treasury Note fell from 7.19% in March 1995 to 5.58% in December
1995, or 1.61% in total. Over the same period the yield on par
coupon FNMA thirty year fixed-rate mortgages (that is, mortgage
securities which are priced at 100 or par) fell 1.46% from 8.26% to
6.80%. Mortgage securities underperformed U.S. Treasury securities
due to investors' concerns about prepayment risk. Prepayment risk
is the risk that homeowners will take advantage of lower interest
rates to prepay their mortgages. The mortgage investor is at a
disadvantage since the funds from these payments can be reinvested
only at a lower yield.
THE LINE GRAPH DETAILING PERFORMANCE VERSUS THE
SERIES' INDEX ACCORDING TO ITEM 5a. OF FORM N1-A IS
LOCATED HERE IN THE TEXT AND IS DESCRIBED
BELOW IN ACCORDANCE WITH REG. 232.304 OF REGULATION
S-T:
THE GRAPH DEPICTS THE CHANGE IN VALUE OF A $10,000
INVESTMENT IN THE SHORT SERIES VERSUS THAT OF ITS
BENCHMARK, THE SIX MONTH US TREASURY BILL.
FROM INCEPTION OF MARCH 31, 1992 THROUGH MARCH 31,
1996, AN INVESTMENT OF $10,000 IN THE SERIES WOULD HAVE
GROWN TO $11,964, VERSUS $12,254, IF INVESTED IN THE
SIX MONTH US TREASURY BILL. THE RETURN IN THE
SEREIS IS NET OF FEES AND SALES CHARGES; THE RETURN OF THE SIX
MONTH US TREASURY DOES NOT REFLECT FEES OR TRANSACTION COSTS. THE
ANNUALIZED ONE YEAR RETURN FOR THE SERIES IS 4.95%, THE ANNUALIZED THREE
YEAR RETURN IS 5.06%, AND THE ANNUALIZED RETURN SINCE INCEPTION IS
5.20%.
During the first quarter of 1996 the yield on the ten year U.S.
Treasury Note began to climb, rising to 6.32% on March 31, 1996.
The Series' performance for the quarter was in line with its benchmark,
providing a return of 1.26% as compared with the U.S. Treasury Bill
return of 1.20%. Prepayment concerns dissipated somewhat with the
increase in interest rates, but yields on mortgages remained at
relatively high levels when compared with U.S. Treasury securities,
which precluded the Series' outperforming the benchmark by a large
margin. The short duration of the Series provided superior performance
in the quarter relative to the universe of bonds, however, as rising
interest rates produced losses for investors holding U.S. Treasury
securities with maturities of three years or more.
The portfolio turnover rate for the Series was 225% for the year.
This measure, which is calculated by dividing the lesser of
portfolio purchases and sales for the year by average net assets,
provides an indication of how much active trading is conducted in
a portfolio. In order to meet the Series' objective of providing
a return exceeding that of the Series' benchmark, while maintaining
the same approximate interest rate risk as the benchmark, the
Series aims to own at any given time those mortgage securities
offering a superior risk-adjusted yield. Hence, short term
opportunities to exchange mortgage securities with a lower
risk-adjusted yield for those with a higher risk-adjusted yield are
exploited whenever it is economical and prudent to do so. Equally,
when the mortgage securities sector as a whole offers a superior
yield to U.S. Treasury securities, the Series will increase its
holdings of mortgages as a percentage of net assets. Accordingly,
the Series took advantage of rising yield spreads to increase its
holdings of mortgages, and the Series' holdings of mortgages as a
percent of net assets rose from 107% in March 1995 to 122% in March
1996. The weight of GNMA adjustable-rate securities in the
portfolio also increased as the yields offered on these securities
relative to estimated prepayment risk increased.
As actively as the Series may trade in the mortgage market, the
securities purchased and sold are of the highest credit quality,
can be priced using reliable sources. Transaction costs are
therefore relatively small, especially in relation to the yield
advantage. In addition, whenever a trade is executed, and on a
daily basis, the hedges in the portfolio are evaluated to ensure
that the Series continues to maintain its interest rate risk target
at a level approximating that of the six month U.S. Treasury Bill.
In the next fiscal year, the Series will continue to maintain this
strategy, which has resulted in a positive return over all calendar
quarters since the Series' inception.
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
SCHEDULE OF INVESTMENTS MARCH 31,
1996
Market
Face Amount Security Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS -
120.94%
FEDERAL HOME LOAN MORTGAGE CORP. - 24.92% *
FHLMC GOLD:
$44,000,000 6.50%, due (a) ............................ $41,896,250
7,000,000 7.00%, due (a) ............................ 6,833,750
3,909,482 7.50%, due 6/1/24 to 10/1/25 .............. 3,906,185
1,142,037 8.00%, due 9/1/24 to 5/1/25 ............... 1,163,917
1,470,825 8.50% Balloon Mortgages,
due 4/1/96 to 11/1/96 .............. 1,471,228
TOTAL FEDERAL HOME LOAN MORTGAGE CORP.
(Cost $56,327,564)........................ 55,271,330
FEDERAL NATIONAL MORTGAGE ASSOCIATION -
14.96% *
FNMA:
30,808,916 7.50%, due 8/01/25 to 9/1/25 .............. 30,763,387
FNMA ARM:
410,630 7.136%, due 12/1/15 ....................... 416,551
546,625 7.571%, due 1/1/18 ........................ 558,693
634,882 7.692%, due 6/20/20 ....................... 654,061
200,693 7.839%, due 12/1/26 ....................... 208,135
FNMA INTEREST ONLY **:
1,988,264 9.00%, due 7/25/21 ........................ 590,476
TOTAL FEDERAL NATIONAL MORTGAGE
ASSOCIATION
(Cost $32,977,247)........................ 33,191,303
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION
- - 81.06% *
GNMA:
27,238,097 7.00%, due 11/15/22 to 3/15/24 ............ 26,560,093
1,689,664 9.50%, due 7/15/09 to 4/15/25 ............. 1,832,898
GNMA ARM:
98,681,809 5.50%, due 10/20/25 to 3/20/26 ............ 97,726,368
33,917,962 6.00%, due 7/20/25 to 9/20/25 ............. 34,109,528
19,212,423 7.00%, due 5/20/25 ........................ 19,589,106
TOTAL GOVERNMENT NATIONAL MORTGAGE
ASSOCIATION
(Cost $180,387,686)....................... 179,817,993
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $269,692,497)....................... 268,280,626
Notional
Amount INTEREST RATE SWAP CONTRACTS - 0.24%
$20,000,000 Contract dated 6/22/93 with Prudential
Global Funding, Expires 6/22/98 ............ 197,553
20,000,000 Contract dated 8/31/93 with Salomon Swapco,
Expires 8/31/00 ........................... 725,807
20,000,000 Contract dated 12/2/93 with Morgan Guaranty,
Expires 12/2/00 ........................... 387,516
40,000,000 Contract dated 5/15/95 with Salomon Swapco,
Expires 5/15/05 ........................... (786,983)
TOTAL INTEREST RATE SWAP CONTRACTS ........
523,893
<PAGE>
THREE MONTH LIBOR INTEREST RATE CAP
CONTRACTS - 0.76
$40,000,000 Contract with Salomon SwapCo, expires 11/1/96,
Strike rate 5.00% ......................... 113,600
40,000,000 Contract with Salomon SwapCo, expires 11/15/97,
Strike rate 5.00% ......................... 504,360
40,000,000 Contract with Morgan Guaranty, expires 10/15/98,
Strike rate 5.00% ......................... 1,060,800
TOTAL THREE-MO. LIBOR INTEREST RATE CAP
CONTRACTS
(Cost $1,875,834)......................... 1,678,760
Contracts FUTURES OPTION CONTRACTS - 0.35%
50 Call on 10 Year UST Note futures,
expires 6/96, strike price $116............ 781
50 Call on 10 Year UST Note futures,
expires 6/96, strike price $117............ 781
100 Put on 10 Year UST Note futures,
expires 6/96, strike price $109............ 117,187
100 Put on 10 Year UST Note futures,
expires 6/96, strike price $110............ 173,438
50 Put on 10 Year UST Note futures,
expires 6/96, strike price $111............ 121,094
100 Put on 10 Year UST Note futures,
expires 6/96, strike price $112............ 325,000
50 Put on 30 Year UST Bond futures,
expires 6/96, strike price $108............ 28,125
TOTAL FUTURES OPTION CONTRACTS
(Cost $249,908) .......................... 766,406
TOTAL INVESTMENTS (Cost $271,818,239) .....
271,249,685
Face Amount REVERSE REPURCHASE AGREEMENTS- (0.45%):
($1,000,000) FHLMC, 5.51%, due 4/4/96 dated 3/29/96 .... (1,000,000)
TOTAL REVERSE REPURCHASE AGREEMENTS .......
(1,000,000)
OTHER LIABILITIES LESS CASH AND OTHER ASSETS -
(21.84%).................................. (48,424,549)
NET ASSETS - 100.00% $221,825,136
* Mortgage-backed obligations are subject to principal paydowns as a
result of prepayments or refinancings of the underlying mortgage
instruments. As a result, the average life may be substantially
less than the original maturity. The interest rate shown is the rate
in effect at March 31, 1996. ARMs have coupon rates which adjust
periodically. The adjusted rate is determined by adding a spread
to a specified index.
** Represents an interest only stripped mortgage-backed security.
(a) To be announced
Portfolio Abbreviations:
ARM - Adjustable-Rate Mortgage
FHLMC - Federal Home Loan Mortgage Corporation
FNMA - Federal National Mortgage Association
GNMA - Government National Mortgage Association
The accompanying notes are an integral part of these financial
statements.
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENT OF ASSETS AND LIABILITIES
MARCH 31, 1996
ASSETS:
Investments at market value (identified
cost $271,818,239)(Note 1)...................... $271,249,685
Cash............................................... 514,603
Receivables:
Variation margin on futures contracts (Note 1).. 58,000
Interest........................................ 1,352,131
Deferred organization expenses (Note 1)............ 9,548
TOTAL ASSETS.................................. 273,183,967
LIABILITIES:
Reverse repurchase agreement (Note 1).............. 1,000,000
Payables:
Securities purchased............................ 50,014,306
Swap interest................................... 92,380
Due to adviser (Note 3)......................... 113,212
Accrued expenses................................... 138,933
TOTAL LIABILITIES............................. 51,358,831
NET ASSETS:
(Applicable to outstanding shares of 22,769,456
unlimited number of shares of beneficial
interest authorized; no stated par)............. $221,825,136
Net asset value, offering price and redemption
price per share ($221,825,136 / 22,769,456)..... $9.74
SOURCE OF NET ASSETS:
Paid in capital.................................... $229,328,831
Accumulated net realized loss on investments....... (6,435,945)
Net unrealized depreciation of investments......... (1,067,750)
NET ASSETS.................................... $221,825,136
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1996
INVESTMENT INCOME:
Interest and discount earned, net of premium
amortization and interest expense (Note 1) .... $17,326,843
EXPENSES:
Advisory fees (Note 3)......................... 1,717,748
Accounting and pricing services fees........... 73,827
Custodian fees................................. 76,145
Audit and tax preparation fees................. 92,199
Legal fees..................................... 80,126
Amortization of organization expenses (Note 1). 9,629
Transfer agent fees............................ 33,767
Registration fees.............................. 24,996
Trustees fees and expenses..................... 103,888
Insurance...................................... 31,961
Other.......................................... 34,641
TOTAL EXPENSES BEFORE REIMBURSEMENT........
2,278,927
Expenses reimbursed by Adviser (Note 3).... (364,865)
NET EXPENSES............................... 1,914,062
NET INVESTMENT INCOME ..................... 15,412,781
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized gain on investments............... 4,639,312
Change in unrealized appreciation of
investments.................................. (8,342,309)
Net realized and unrealized loss on
investments.................................. (3,702,997)
Net increase in net assets resulting
from operations.............................. $11,709,784
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENTS OF CHANGES IN NET ASSETS
FOR THE YEARS ENDED MARCH 31, 1996 AND 1995
Year Ended Year Ended
March 31, 1996 March 31, 1995
OPERATIONS:
Net investment income............. $15,412,781 $13,504,268
Net realized gain (loss)
on investments.................... 4,639,312 (1,414,168)
Change in unrealized appreciation
(depreciation) of investments..... (8,342,309) 1,365,349
Net increase in net assets
resulting from operations......... 11,709,784 13,455,449
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment
income............................ (15,412,781) (13,504,268)
Dividends in excess of net
investment income................. (269,331) (90)
Total distributions............... (15,682,112) (13,504,358)
CAPITAL SHARE TRANSACTIONS:
Shares sold....................... 93,214,276 94,549,923
Shares issued on reinvestment of
distributions..................... 3,773,450 4,346,125
Shares redeemed................... (89,621,927) (98,582,965)
Increase in net assets resulting
from capital share
transactions (a).................. 7,365,799 313,083
TOTAL INCREASE IN NET ASSETS............... 3,393,471
264,174
NET ASSETS:
Beginning of year................. 218,431,665 218,167,491
End of year....................... $221,825,136 $218,431,665
(a) Transactions in capital shares were as follows:
Shares sold....................... 9,500,348 9,582,171
Shares issued on reinvestment
of distributions.................. 386,101 441,809
Shares redeemed................... (9,167,732) (10,018,137)
Net increase...................... 718,717 5,843
Beginning balance ................ 22,050,739 22,044,896
Ending balance.................... 22,769,456 22,050,739
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN SHORT DURATION US GOVERNMENT SERIES
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED MARCH 31, 1996
Year Ended
March 31, 1996
Cash flows from operating activities:
Net increase in net assets resulting from operations.... $11,709,784
Net realized and unrealized loss on investments......... 3,702,997
Net investment income................................. 15,412,781
Adjustments to reconcile net investment income
to net cash provided by operating activities:
Interest rate cap and interest-only strip amortization.. 643,641
Paydown gains and losses................................ (15,635)
Increase in interest receivable......................... (430,707)
Decrease in other assets................................ 74,098
Increase in other liabilities........................... 168,021
Net cash provided by operating activities............. 15,852,199
Cash flows from investing activities:
Payments for futures variations......................... (2,465,409)
Proceeds from sales of long-term investments............ 291,400,731
Proceeds from sales of short-term investments........... 2,807,926
Proceeds from maturities of short-term investments...... 1,539,970,000
Proceeds from paydowns of long-term investments......... 19,239,211
Purchases of long-term investments...................... (423,241,572)
Purchases of short-term investments.....................(1,435,805,067)
Net cash used in investing activities................. (8,094,180)
Cash flows from financing activities:
Increase in collateralized borrowings................... 1,000,000
Purchase of shares tendered............................. 3,592,349
Dividends from net investment income.................... (11,908,662)
Net cash used in financing activities................. (7,316,313)
Net increase in cash.................................. 441,706
Cash at beginning of year.................................. 72,897
Cash at end of year........................................ $514,603
Noncash financing activities:
Market value of shares issued to stockholders
through reinvestment of dividends..................... $3,773,450
Supplemental disclosure:
Interest paid........................................... $373,480
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
FINANCIAL HIGHLIGHTS
The following average per share data, ratios and supplemental information
have been derived from information provided in the financial statements.
Year Year Year For the Period
Ended Ended Ended March 31, 1992 (1)
March 31, 1996 March 31, 1995 March 31, 1994 to March 31,
1993
Net Asset Value,
Beginning of
Period....... $9.90 $9.90 $10.00 $10.00
Income From
Investment Operations
Net investment
income..... 0.621 0.628 0.432 0.552
Net realized
and unrealized
gain (loss) on
investments. (0.148) - (0.070) 0.002
Total from
investment
operations. 0.473 0.628 0.362 0.554
Less Distributions
Dividends from
net investment
income....... (0.621) (0.628) (0.462) (0.554)
Dividends in
excess of
investment
income....... (0.012) - - -
Total
distributions (0.633) (0.628) (0.462) (0.554)
Net Asset Value,
End of Period.. $9.74 $9.90 $9.90 $10.00
Total Return .. 4.95% 6.58% 3.67% 5.67%
Ratios/Supplemental Data
Net assets, end
of period..... $221,825,136 $218,431,665 $218,167,491 $48,531,206
Ratio of expenses
to average
net assets (2) 0.78% 0.78% 0.78% 0.78%
Ratio of net
investment
income to average
net assets (3) 6.29% 6.33% 4.17% 4.53%
Portfolio turnover
rate.......... 225% 47% 112% 3%
______________________
(1) Commencement of operations.
(2) The annualized operating expense ratios prior to reimbursement of
expenses by the Adviser were 0.93%, 0.92%, 1.00%, and 2.58% for the
Short Duration U.S. Government Series for the years ended March 31,
1996, March 31, 1995, March 31, 1994 and the period ended March 31,
1993, respectively. Expense ratios include both the direct expenses
of the Short Duration U.S.Government Series, and the indirect
expenses
incurred through the Series' investment in the Short Duration U.S.
Government Fund (Note 1).
(3) The annualized net investment income ratios prior to reimbursement
of
both direct and indirect expenses by the Adviser were 6.13%, 6.18%,
3.95%, and 2.73% for the Short Duration U.S. Government Series for
the
years ended March 31, 1996, March 31, 1995, March 31, 1994, and the
period ended March 31, 1993, respectively.
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Series Fund (the "Fund") is an open-end,
diversified management investment company registered under the
Investment Company Act of 1940, as amended. The Fund offers shares
in two series: the Smith Breeden Short Duration U.S. Government
Series (the "Short Series" or "Series") and the Smith Breeden
Intermediate Duration U.S. Government Series ("Intermediate
Duration Series"). Prior to April 1, 1995, the Short Series sought
to achieve its investment objective by investing all of its assets
in the Smith Breeden Short Duration U.S. Government Fund (the
"Short Fund"), an open-end, diversified management investment
company having the same investment objective as the Series.
However, at the close of business on March 31, 1995, pursuant to a
plan of liquidation adopted March 1, 1995 by the Board of Trustees
of the Short Fund, and approved by the Board of Trustees of the
Short Series, the Short Series redeemed in-kind its shares of the
Short Fund. The assets of the Short Fund were transferred in
proportion to the Short Series' ownership of the Short Fund in
cancellation of its shares.
A. Security Valuation: Securities are valued at current market
value provided by a pricing service or by a bank or broker/dealer
experienced in such matters, when over-the-counter market
quotations are readily available. Securities and other assets for
which market prices are not readily available are valued at fair
market value as determined in accordance with the procedures
approved by the Board of Trustees.
B. Repurchase Agreements: Repurchase agreements may be entered
into with member banks of the Federal Reserve System having total
assets in excess of $500 million and securities dealers, provided
that such banks or dealers meet the credit guidelines of the Funds'
Board of Trustees. In a repurchase agreement, securities are
acquired from a third party with the commitment that they will be
repurchased by the seller at a fixed price on an agreed upon date.
The custodian maintains control or custody of securities
collateralizing repurchase agreements until maturity of the
repurchase agreements. The value of the collateral will be
monitored daily, and if necessary, additional collateral is
received to ensure that the market value of the underlying assets
remains sufficient to protect the Series in the event of the
seller's default. However, in the event of default or bankruptcy
of the seller, the right to the collateral may be subject to legal
proceedings.
C. Reverse Repurchase Agreements: A reverse repurchase agreement
involves the sale of portfolio assets concurrently with an
agreement to repurchase the same assets at a later date at a fixed
price. Assets will be maintained in a segregated account with the
custodian, which will be marked to market daily, consisting of
cash, U.S. Government securities or other liquid high-grade debt
obligations equal in value to the obligations under the reverse
repurchase agreements. In the event the buyer of securities under
a reverse repurchase agreement files for bankruptcy or becomes
insolvent, the use of the proceeds under the agreement may be
restricted pending a determination by the other party, or its
trustee or receiver whether to enforce the obligation to repurchase
the securities.
<PAGE>
D. Dollar Roll Agreements: A dollar roll is an agreement to sell
securities for delivery in the current month and simultaneously
contract to repurchase substantially similar (same type and coupon)
securities on a specified future date. During the roll period,
principal and interest paid on these securities are not received.
Compensation under the dollar roll agreement is represented by the
difference between the current sales price and the 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.
E. Distributions and Taxes: The Short Series intends to continue
to qualify for and elect the special tax treatment afforded
regulated investment companies under Subchapter M of the Internal
Revenue Code, thereby relieving the Series of Federal income taxes.
To so qualify, the Series intends to distribute substantially all
of its net investment income and net realized capital gains, if
any, less any available capital loss carryforward. As of March 31,
1996, the Series had a net capital loss carryforward of $2,340,576,
with $589 expiring on March 31, 2001, $75,461 expiring on March 31,
2002, $905,312 expiring on March 31, 2003, and $1,359,214 expiring
on March 31, 2004.
F. Determination of Gains or Losses on Sales of Securities:
Gains or losses on the sale of securities are calculated for
accounting and tax purposes on the identified cost basis.
G. Deferred Organization Expenses: Deferred organization
expenses are being amortized on a straight-line basis over five
years.
H. Securities Transactions and Investment Income: Interest
income is accrued daily on both long-term bonds and short-term
investments. Interest income also includes net amortization from
the purchase of fixed-income securities. Transactions are recorded
on the first business day following the trade date. Realized gains
and losses from security transactions are determined and accounted
for on the basis of identified cost.
2. FINANCIAL INSTRUMENTS
Derivative Financial Instruments Held or Issued for Purposes other
than Trading: Interest rate futures, swaps, caps and options
contracts are used for risk management purposes in order to reduce
fluctuations in net asset value relative to the targeted option-
adjusted duration.
A. Futures Contracts: Upon entering into a futures contract,
either cash or securities in an amount (initial margin) equal to a
certain percentage of the contract value is required to be
deposited in a segregated account. Subsequent payments (variation
margin) are made or received each day. The variation margin
payments are equal to the daily changes in the contract value and
are recorded as unrealized gains or losses. A realized gain or
loss is recognized when the contract is closed or
expires equal to the difference between the value of the contract
at the time it was opened and the value at the time it was closed.
<PAGE>
The Short Series had the following open futures contracts as of
March 31, 1996:
Notional Expiration Unrealized
Type Amount Position Month Gain/(Loss)
10 year Treasury $ 4,000,000 Short June, 1996 $ 9,820
3 month Treasury 70,000,000 Long June, 1996 (87,815)
3 month Eurodollar 77,000,000 Long June, 1996 (76,021)
3 month Eurodollar 75,000,000 Long September, 1996 (99,712)
3 month Eurodollar 52,000,000 Short March, 1997 (28,584)
3 month Eurodollar 6,000,000 Short March, 1998 3,573
3 month Eurodollar 34,000,000 Short March, 1999 20,247
3 month Eurodollar 77,000,000 Short March, 2000 (199,897)
3 month Eurodollar 28,000,000 Short March, 2001 (57,526)
3 month Eurodollar 32,000,000 Short March, 2002 (36,394)
3 month Eurodollar 30,000,000 Short March, 2003 53,115
$ (499,194)
Futures transactions involve costs and may result in losses. The
effective use of futures strategies depends on the Series' ability
to terminate futures positions at times when the Series' investment
adviser deems it desirable to do so. The use of futures also
involves the risk of imperfect correlation among movements in the
values of the securities underlying the futures purchased and sold
by the Series, of the futures contract itself, and of the
securities which are the subject of a hedge.
B. Interest Rate Swap Contracts: Interest rate swaps involve the
exchange by one party with another party of their respective
commitments to pay or receive interest. The interest rate swap
contracts assigned by the Short Fund to the Short Series had been
entered into on a net basis, i.e., the two payment streams are
netted out, with the Short Series receiving or paying, as the case
may be, only the net amount of the two payments. As of March 31,
1996, the Short Series had open three interest rate swap contracts.
In each of the contracts, the Short Fund had agreed to pay a fixed
rate and receive a floating rate. The floating rate on the three
contracts resets quarterly and is the three month London Interbank
Offered Rate ("LIBOR"). Interest rate swap contracts will not be
entered into unless the unsecured commercial paper, unsecured senior debt
or the claims-paying ability of the other party thereto is rated
either AA or A-1 or better by Standard & Poor's Corporation or Aa
or P-1 or better by Moody's Investors Service, Inc. (or is otherwise
<PAGE>
acceptable to either agency) at the time of entering into such
transaction. If there is a default by the other party to the swap
transaction, the Short Series will be limited to contractual
remedies pursuant to the agreements related to the transaction.
There is no assurance that interest rate swap contract counterparties
will be able to meet their obligations pursuant to the swap contracts
or that, in the event of default, the Short Series will succeed in
pursuing contractual remedies. The Short Series thus assumes the
risk that it may be delayed in, or prevented from, obtaining payments
owed to it pursuant to the swap contracts.
The Short Series' interest payable on the interest rate swap
contracts was $92,380, and swap contract interest receivable was
$478. No collateral is required to be maintained on these
contracts.
C. Interest Rate Cap Contracts: 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 caps. The Short Series' interest receivable on the
interest rate cap contracts at March 31, 1996 was $91,632.
3. TRANSACTIONS WITH AFFILIATES
Smith Breeden Associates, Inc. (the "Adviser"), a registered
investment adviser, provides the Short Series with investment
management services.
The Adviser voluntarily agreed to reimburse normal business
expenses of the Short Series through March 31, 1996 so that total
direct and indirect operating expenses would not exceed 0.78% of
its average net assets. This voluntary agreement may be terminated
at any time by the Adviser in its sole discretion after March 31,
1996. The Adviser has also agreed to reduce its fees payable (to
the extent of such fees) by the amount the Series' direct and
indirect expenses would, absent the fee reduction, exceed the
applicable expenses limitations imposed by state securities
administrators. For the year ended March 31, 1996, the Adviser
received $1,717,748 in fees and reimbursed the Short Series $364,865.
Certain officers and trustees of the Fund are also officers and
directors of the Adviser.
Pursuant to Rule 12b-1 under the Investment Company Act of 1940
("1940 Act"), the Series adopted, effective August 1, 1994, a
Distribution and Services Plan (the "Plan"). The purpose of the
Plan is to permit the Adviser to compensate investment dealers and
other persons involved in servicing shareholder accounts for
services provided and expenses incurred in promoting the sale of
shares of the Short Series, reducing redemptions, or otherwise
maintaining or improving services provided to shareholders by such
dealers or other persons. The Plan provides for payments by the
Adviser, out of the advisory fee paid to it by the Short Series, to
dealers and other persons at the annual rate of up to 0.25% of the
Short Series' average net assets, subject to the authority the
Trustees of the Short Series, to reduce the amount of payments
permitted under the Plan or to suspend the Plan for such periods as
they may determine. Subject to these limitations, the amount of
such payments and the purposes for which they are made shall be
determined by the Adviser.
<PAGE>
4. INVESTMENT TRANSACTIONS
During the year ended March 31, 1996, purchases and proceeds from
sales of securities, other than short-term investments, aggregated
$690,002,566 and $690,050,141 respectively for the Series. The
cost of the Short Series' securities for federal income tax
purposes at March 31, 1996, is $271,818,239. Net unrealized
depreciation of investments and futures contracts consists of:
Gross unrealized appreciation $ 2,957,098
Gross unrealized depreciation (4,024,848)
Net unrealized depreciation $ (1,067,750)
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Trustees and Shareholders,
Smith Breeden Short Duration U.S. Government Series
of the Smith Breeden Series Fund:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of the Smith Breeden Short
Duration U.S. Government Series of the Smith Breeden Series Fund as
of March 31, 1996, and the related statements of operations and cash
flows for the year then ended, the statements of changes in net assets
for each of the years in the two-year period then ended and the financial
highlights for each of the years in the three-year period then ended and
the period March 31, 1992 (commencement of operations) to March 31,
1993.
These financial statements and the financial highlights are the
responsibility of the Fund's management. Our responsibility is to express
an opinion on these financial statements and the financial highlights
based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements and the
financial highlights are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. Our procedures included confirmation of
securities owned at March 31, 1996 by correspondence with the custodian
and brokers. An audit also includes assessing the accounting principles
used
and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits
provide
a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred
to above present fairly, in all material respects, the financial position
of the Smith Breeden Short Duration U.S. Government Series of the Smith
Breeden Series Fund as of March 31, 1996, the results of its operations
and its cash flows, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with generally
accepted accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 10, 1996
<PAGE>
PERFORMANCE REVIEW
The Smith Breeden Intermediate Duration U.S. Government Series
provided a total return of 9.69% in the year ended March 31,
1996, while the return on the Series' benchmark, the Salomon
Brothers Mortgage Index, was 10.51%.
The period from March 1995 to December 1995 saw a strong rally
in bonds, as inflation fears lessened and the Federal Reserve
lowered its target rate for Federal Funds from 6.0% in March to
5.5% in December. The Series return from March through December
1995 was 10.39%. The return on the five year U.S. Treasury
Note, which has roughly the same duration as the Series, was
11.66%. The return on the Salomon Brothers Mortgage Index over
the same period was 10.91%.
During the nine month period ended December 31, 1995, mortgage
securities underperformed U.S. Treasury Notes of comparable
duration because of investors' concerns about prepayment risk.
Prepayment risk is the risk that homeowners will take advantage
of lower interest rates to prepay their mortgages. The mortgage
investor is at a disadvantage since the funds from these
payments can be invested only at a lower yield.
The advantage enjoyed by U.S. Treasury securities in 1995 was
reversed in the first quarter of 1996. The five year U.S.
Treasury Note yield rose 0.69% from 5.39% to 6.08% as a series
of strong employment statistics reawakened fears of inflation
among investors.
IN ACCORDANCE WITH REG. 232.304 OF REGULATION S-T, THE
FOLLOWING
IS A DESCRIPTION OF THE GRAPH PRESENTED HERE IN THE
TEXT IN
COMPLIANCE WITH ITEM 5a. OF FORM N1-A:
THE GRAPH PRESENTED COMPARES THE CHANGE FOR THE
PERIOD
FROM
MARCH 31, 1992 THROUGH MARCH 31, 1996 OF A $10,000
INVESTMENT IN
THE SERIES VERSUS ITS BENCHMARK. FOR THE PERIOD
FROM THE
SERIES'
INCEPTION, MARCH 31, 1992, THROUGH MARCH 31, 1996, THE
SERIES'
BENCHMARK WAS THE FIVE YEAR US TREASURY, AS
TRACKED BY
SALOMON
BROTHERS, INC. AFTER DECEMBER 31, 1993, UPON APPROVAL
OF A
MAJORITY
OF SHAREHOLDERS, THE SERIES' BENCHMARK WAS CHANGED
TO THE
SALOMON
BROTHERS MORTGAGE INDEX. THE SERIES AVERAGE
ANNUAL RETURN
WAS 9.69%
FOR THE ONE YEAR PERIOD, 6.61% FOR THE THREE YEAR
PERIOD, AND
8.62%
FOR THE PERIOD SINCE INCEPTION. FROM INCEPTION OF
MARCH 31, 1992
THROUGH MARCH 31, 1996, AN INVESTMENT OF $10,000 IN THE
SERIES
WOULD
HAVE GROWN TO $13,927, VERSUS $13,686, IF INVESTED IN THE
BENCHMARK.
<PAGE>
Interestingly, the Federal Reserve Board didn't
seem to share those inflation fears, and it actually cut the
target rate for Federal Funds to 5.25% in January 1996. The five
year U.S. Treasury Note posted a loss of 1.54% in the first
quarter, while the Intermediate Series posted a loss of 0.63%,
and the Salomon Brothers Mortgage Index loss was 0.37%. Mortgage
securities outperformed U.S. Treasury securities in the first
quarter as investor's fears about prepayment risk lessened.
The portfolio turnover rate for the Series was 193% for the
year. This measure, which is calculated by dividing the lesser
of portfolio purchases and sales for the year by average net
assets, provides an indication of how much active trading is
conducted in a portfolio. In order to meet the Series'
objective of providing a return exceeding that of the Series'
benchmark, while also covering the 0.90% annual fund expense
ratio, and maintaining the same approximate interest rate risk
as the benchmark, the Series aims to own at any given time those
mortgage securities offering a superior risk-adjusted yield.
Hence, short term opportunities to exchange mortgage securities
with a lower risk-adjusted yield for those with a higher risk-
adjusted yield are exploited whenever it is economical and
prudent to do so. Equally, when the mortgage securities sector
as a whole offers an attractive risk-adjusted yield advantage
over U.S. Treasury securities the Series will increase its
holdings of mortgages as a percentage of net assets.
Accordingly, the Series took advantage of rising yield spreads
of mortgages to U.S. Treasury securities to increase its
holdings of mortgages as a percent of net assets, which rose
from 100% in March 1995 to 134% in March 1996. The weighting of
GNMA adjustable-rate securities in the portfolio was also
increased from 19% of net assets in March 1995 to 36% in March
1996, as the risk-adjusted yields offered on these securities
increased relative to U.S. Treasury securities. Although
adjustable-rate mortgages are not included in the Salomon
Brothers Mortgage Index, the Series will hold adjustable-rate
mortgages in its portfolio when they offer a risk-adjusted yield
advantage over fixed-rate mortgages.
As actively as the Series may trade in the mortgage market, the
securities purchased and sold are of the highest credit quality,
and can be priced using reliable sources. Transaction costs are
therefore relatively small, especially in relation to the yield
advantage. In addition, whenever a trade is executed, and on a
daily basis, the hedges in the portfolio are evaluated to ensure
that the Series continues to maintain its interest rate risk at
approximately the same level as that of the Salomon Brothers
Mortgage Index. In the next fiscal year, the Series will
continue its strategy of purchasing securities in the mortgage
sector which offer superior risk-adjusted yields. This strategy
has enabled the Series to provide an annualized total return
from inception of 8.62%, comfortably exceeding the return of
8.15% on its benchmark, while maintaining a similar level of
interest rate risk.
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
SCHEDULE OF INVESTMENTS MARCH 31,
1996
Market
Face Amount Security Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS - 134.39%
FEDERAL HOME LOAN MORTGAGE CORP. - 41.74% *
FHLMC GOLD:
$7,000,000 6.50, due (a) ......................... $6,719,063
6,000,000 7.00%, due (a) ........................ 5,857,500
2,578,648 8.00%, due 9/1/24 to 10/19/24.......... 2,635,324
TOTAL FEDERAL HOME LOAN MORTGAGE CORP.
(Cost $15,456,817)..................... 15,211,887
FEDERAL NATIONAL MORTGAGE ASSOC. - 32.09% *
FNMA ARM:
1,369,074 5.98%, due 9/1/25 ..................... 1,403,379
158,720 7.692%, due 8/25/22 ................... 163,515
FNMA:
3,491,642 7.00%, due 8/1/23 to 6/1/24 ........... 3,406,702
3,631,118 7.50%, due 8/1/25 ..................... 3,625,752
1,277,596 8.50%, due 9/14/24 to 2/1/25 .......... 1,322,721
1,643,028 9.50%, due 7/1/16 to 5/1/22 ........... 1,773,567
TOTAL FEDERAL NATIONAL MORTGAGE ASSOC.
(Cost $11,368,709)..................... 11,695,636
GOVERNMENT NATIONAL MORTGAGE ASSOC. - 60.13%
*
GNMA ARM:
7,472,926 5.50%, due 10/20/25 to 1/20/26 ........ 7,400,934
5,726,103 6.00%, due 9/20/25 .................... 5,758,443
GNMA:
7,189,552 7.00%, due 11/21/14 to 3/15/24 ........ 7,010,593
1,686,432 8.00%, due 12/15/06 to 4/15/09 ........ 1,747,195
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOC.
(Cost $21,694,608)..................... 21,917,165
UNITED STATES TREASURY BILLS - 0.43% **
140,000 5.02 due 6/27/96 ...................... 138,309
20,000 4.96 due 6/27/96 ...................... 19,760
TOTAL UNITED STATES TREASURY BILLS
(Cost $158,062) ....................... 158,069
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $48,678,196)..................... 48,982,757
Contracts FUTURES OPTION CONTRACTS- 0.01%
50 Call on 10 Year UST Note futures,
expires 6/96, strike price $115........ 1,562
30 Call on 10 Year UST Note futures,
expires 6/96, strike price $116........ 469
TOTAL FUTURES OPTION CONTRACTS
(Cost $69,423) ........................ 2,031
TOTAL INVESTMENTS (Cost $48,747,619) -
134.40% ............................... 48,984,788
CASH AND OTHER ASSETS LESS LIABILITIES -
(34.40%) .............................. (12,537,848)
NET ASSETS - 100.00% .................... $36,446,940
* Mortgage-backed obligations are subject to principal paydowns as
a result of prepayments or refinancings of the underlying securities
instruments. As a result, the average life may be substantially
less than the original maturity. The interest rate shown is the rate
in effect at March 31, 1996. ARMs have coupon rates which adjust
periodically. The adjusted rate is determined by adding a spread
to a specified index.
** The interest rate shown is the discount rate paid at the time of
purchase by the Fund.
(a) To be announced
Portfolio Abbreviations:
ARM - Adjustable-Rate Mortgage
FHLMC- Federal Home Loan Mortgage Corporation
FNMA - Federal National Mortgage Association
GNMA - Government National Mortgage Association
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
STATEMENT OF ASSETS AND LIABILITIES
MARCH 31, 1996
ASSETS:
Investments at market value
(identified cost $48,747,619)(Note 1)............... $48,984,788
Cash................................................ 312,247
Receivables:
Variation margin on futures contracts............ 25,950
Interest......................................... 232,324
Prepaid expenses.................................... 6,057
Deferred organization expenses (Note 1)............. 10,159
TOTAL ASSETS................................... 49,571,525
LIABILITIES:
Payables:
Securities purchased............................. 12,938,923
Distributions payable............................ 135,382
Due to advisor (Note 3).......................... 15,102
Accrued expenses.................................... 35,178
TOTAL LIABILITIES.............................. 13,124,585
NET ASSETS:
(Applicable to outstanding shares of 3,639,328;
unlimited number of shares of beneficial
interest authorized; no stated par).............. $36,446,940
Net asset value, offering price and redemption
price per share ($36,446,940 3,639,328)........ $10.01
SOURCE OF NET ASSETS:
Paid in capital..................................... $36,286,422
Overdistributed net investment income............... (98,690)
Accumulated net realized gain on investments........ 28,769
Net unrealized appreciation of investments.......... 230,439
NET ASSETS..................................... $36,446,940
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1996
INVESTMENT INCOME:
Interest and discount earned, net of premium
amortization and interest expense (Note 1) ......... $2,698,898
EXPENSES:
Advisory fees (Note 3) ............................. 256,075
Accounting and pricing services fees ............... 38,954
Custodian fees ..................................... 22,593
Audit & tax preparation fees ....................... 11,452
Legal fees ......................................... 8,987
Amortization of organization expenses (Note 1) ..... 9,428
Transfer agent fees ................................ 28,915
Registration fees .................................. 20,004
Trustees fees and expenses ......................... 11,365
Insurance .......................................... 3,576
Other .............................................. 3,242
TOTAL EXPENSES BEFORE REIMBURSEMENT ............
414,591
Expenses reimbursed by Adviser (Note 3) ........ (85,364)
NET EXPENSES ................................... 329,227
NET INVESTMENT INCOME .......................... 2,369,671
REALIZED AND UNREALIZED GAIN ON INVESTMENTS:
Net realized gain on investments ................... 1,227,064
Change in unrealized appreciation of investments.... (257,447)
Net realized and unrealized gain on investments .... 969,617
Net increase in net assets resulting from operations $3,339,288
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
STATEMENTS OF CHANGES IN NET ASSETS
FOR THE YEARS ENDED MARCH 31, 1996 AND 1995
Year Ended Year Ended
March 31, 1996 March 31, 1995
OPERATIONS:
Net investment income............... $2,369,671 $1,346,839
Net realized gain (loss) on investments 1,227,064 (248,302)
Change in unrealized appreciation
(depreciation) of investments....... (257,447) 778,903
Net increase in net assets resulting
from operations..................... 3,339,288 1,877,440
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment income. (2,358,436) (1,346,839)
Dividends in excess of net investment
income.............................. - (140,634)
Distributions from net realized
capital gains....................... (367,107) -
Distributions in excess of net
realized capital gains.............. - (28,444)
Total distributions................. (2,725,543) (1,515,917)
CAPITAL SHARE TRANSACTIONS:
Shares sold......................... 1,030,079 31,506,439
Shares issued on reinvestment of
distributions....................... 702,855 669,611
Shares redeemed..................... (697,235) (4,519,742)
Increase in net assets resulting
from capital share transactions (a) 1,035,699 27,656,308
TOTAL INCREASE IN NET ASSETS.... 1,649,444 28,017,831
NET ASSETS:
Beginning of year................... 34,797,496 6,779,665
End of year......................... $36,446,940 $34,797,496
(a) Transactions in capital shares
were as follows:
Shares sold.................... 100,992 3,257,497
Shares issued on
reinvestment of distributions.. 69,235 68,948
Shares redeemed................ (69,182) (465,316)
Net increase................... 101,045 2,861,129
Beginning balance ............. 3,538,283 677,154
Ending balance................. 3,639,328 3,538,283
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION US
GOVERNMENT SERIES
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED MARCH 31, 1996
Year Ended
March 31, 1996
Cash flows from operating activities:
Net increase in net assets resulting from
operations....................................... $3,339,288
Net realized and unrealized gain on investments.. (969,617)
Net investment income.......................... 2,369,671
Adjustments to reconcile net investment income
to net cash provided by operating activities:
Net paydown gains and losses..................... (40,951)
Increase in interest receivable.................. (36,556)
Decrease in other assets......................... 3,025
Increase in other liabilities.................... 25,598
Net cash provided by operating activities...... 2,320,787
Cash flows from investing activities:
Proceeds from futures variations................. 157,418
Proceeds from sales of long-term investments..... 55,165,384
Proceeds from sales of short-term investments.... 20,254
Proceeds from maturities of short-term
investments...................................... 81,940,000
Proceeds from paydowns of long-term investments.. 3,311,979
Purchases of long-term investments............... (61,937,619)
Purchases of short-term investments.............. (82,161,200)
Net cash used in investing activities.......... (3,503,784)
Cash flows from financing activities:
Purchase of shares tendered...................... 332,844
Dividends from net investment income and
realized capital gains........................... (2,035,111)
Net cash used in financing activities........ (1,702,267)
Net decrease in cash......................... (2,885,264)
Cash at beginning of year.......................... 3,197,511
Cash at end of year................................ $312,247
Noncash financing activities:
Market value of shares issued to stockholders
through reinvestment of dividends.............. $702,855
Supplemental disclosure:
Interest paid.................................... $191,436
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
FINANCIAL HIGHLIGHTS
The following average per share data, ratios and supplemental information
have been derived from information provided in the financial statements.
Year Year Year Period
Ended Ended Ended Ended
March 31, 1996 March 31, 1995 March 31, 1994 March 31,
1993*
Net Asset Value,
Beginning
of Period..... $9.83 $10.01 $10.62 $10.00
Income From
Investment
Operations
Net investment
income....... 0.660 0.664 1.050 0.826
Net gain (loss)
on securities
(both realized
and unrealized) 0.227 (0.049) (0.601) 0.621
Total from
investment
operations.. 0.937 0.615 0.449 1.447
Less Distributions
Dividends from
net investment
income........ (0.656) (0.664) (1.044) (0.826)
Dividends in
excess of net
investment
income........ - (0.108) - -
Distributions
from net realized
gains on
investments... (0.101) - (0.015) -
Distributions in
excess of net
realized gains on
investments... - (0.022) - -
Total
distributions (0.757) (0.794) (1.059) (0.826)
Net Asset Value,
End of Period.. $10.01 $9.83 $10.01 $10.62
Total Return... 9.69% 6.10% 4.11% 14.93%
Ratios/Supplemental Data
Net assets, end
of period.... $36,446,940 $34,797,496 $6,779,666 $2,923,913
Ratio of expenses
to average net
assets (1)... 0.90% 0.90% 0.90% 0.82%
Ratio of net
investment income
to average net
assets (2)... 6.49% 6.20% 7.74% 8.18%
Portfolio
turnover rate 193% 557% 84% 42%
______________________
(1) The annualized ratio of expenses to average net assets prior to
reimbursement of expenses by the Adviser was 2.28%, 2.33%, 2.34%,
and 17.52% for the years ended March 31, 1996, March 31, 1995 and
March 31, 1994, and for the period ended March 31, 1993,
respectively.
Expense ratios include both the direct expenses of the Intermediate
Duration U.S. Government Series, and the indirect expenses incurred
through the Series' investment in the Institutional Intermediate
Duration U.S. Government Fund (Note 5).
(2) The annualized ratio of net investment income to average net assets
prior to reimbursement of both direct and indirect expenses by the
Adviser was 6.26%, 4.77%, 6.30% and (8.52)% for the years ended
March 31, 1996, March 31, 1995 and March 31, 1994, and for the
period
ended March 31, 1993, respectively.
* The Intermediate Duration U.S. Government Series commenced
operations
on March 31, 1992.
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S.
GOVERNMENT SERIES
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Series Fund (the "Fund") is an open-end,
diversified management investment company registered under the
Investment Company Act of 1940, as amended. The Fund offers shares
in two series: the Smith Breeden Short Duration U.S. Government
Series and the Smith Breeden Intermediate Duration U.S. Government
Series ("Intermediate Series" or "Series"). The following is a
summary of significant accounting policies consistently followed by
the Intermediate Series.
A. Security Valuation: Portfolio securities are valued at
current market value provided by a pricing service or by a bank or
broker/dealer experienced in such matters, when over- the-counter
market quotations are readily available. Securities and other
assets for which market prices are not readily available are valued
at fair market value as determined in accordance with procedures
approved by the Board of Trustees.
B. Distributions and Taxes: The Intermediate Series intends to
continue to qualify for and elect the special tax treatment
afforded regulated investment companies under Subchapter M of the
Internal Revenue Code, thereby relieving the Series of Federal
income taxes. To so qualify, the Series intends to distribute
substantially all of its net investment income and net realized
capital gains, if any, less any available capital loss
carryforward. As of March 31, 1996, the Series had no capital loss
carryforward.
C. Repurchase Agreements: The Intermediate Series may enter into
repurchase agreements with member banks of the Federal Reserve
System having total assets in excess of $500 million and securities
dealers, provided that such banks or dealers meet the credit
guidelines of the Series' Board of Trustees. In a repurchase
agreement, the Series acquires securities from a third party with
the commitment that they will be repurchased by the seller at a
fixed price on an agreed upon date. The Intermediate Series'
custodian maintains control or custody of these securities
collateralizing the repurchase agreements until maturity of the
repurchase agreements. The value of the collateral is monitored
daily, and if necessary, additional collateral is received to
ensure that the market value of the underlying assets remains
sufficient to protect the Series in the event of the seller's
default. However, in the event of default or bankruptcy of the
seller, the Series' right to the collateral may be subject to legal
proceedings.
D. Reverse Repurchase Agreements: A reverse repurchase agreement
involves the sale by the Intermediate Series of portfolio assets
concurrently with an agreement by the Series to repurchase the same
assets at a later date at a fixed price. The Series will maintain
a segregated account with its custodian, which will be marked to
market daily, consisting of cash, U.S. Government securities or
other liquid high-grade debt obligations equal in value to its
obligations under reverse repurchase agreements. In the event the
buyer of securities under a reverse repurchase agreement files for
<PAGE>
bankruptcy or becomes insolvent, the Series' use of the proceeds of
the agreement may be restricted pending a determination by the other
party, or its trustee or receiver whether to enforce the Series'
obligation to repurchase the securities.
E. Dollar Roll Agreements: The Intermediate Series may enter
into dollar rolls in which the Series sells securities for delivery
in the current month and simultaneously contracts to repurchase
substantially similar (same type and coupon) securities on a
specified future date. During the roll period, the Series forgoes
principal and interest paid on these securities. The Series is
compensated by the difference between the current sales price and
the 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.
F. Determination Of Gains Or Losses On Sales Of Securities:
Gains or losses on the sale of securities are calculated for
accounting and tax purposes on the identified cost basis.
G. Deferred Organizational Expenses: Deferred organizational
expenses are being amortized on a straight-line basis over five
periods.
H. Securities Transactions and Investment Income: Interest
income is accrued daily on both long-term bonds and short-term
investments. Interest income also includes net amortization from
the purchase of fixed-income securities. Transactions are recorded
on the first business day following the trade date. Realized gains
and losses from security transactions are determined and accounted
for on the basis of identified cost.
2. FINANCIAL INSTRUMENTS
A. Derivative Financial Instruments Held or Issued for Purposes
other than Trading:
The Intermediate Series uses interest rate futures contracts for
risk management purposes in order to reduce fluctuation of the
Series' net asset value relative to its targeted option-adjusted
duration. Upon entering into a futures contract, the Series is
required to deposit either cash or securities in an amount (initial
margin) equal to a certain percentage of the contract value.
Subsequent payments (variation margin) are made or received by the
Series each day. The variation margin payments are equal to the
daily changes in the contract value and are recorded as unrealized
gains or losses. The Series recognizes a realized gain or loss
when the contract is closed or expires equal to the difference
between the value of the contract at the time it was opened and the
value at the time it was closed.
<PAGE>
The Intermediate Series had the following open futures contracts as
of March 31, 1996:
Notional Expiration Unrealized
Type Amount Position Month Gain/(Loss)
10 Year
Treasury $ 7,200,000 Long June, 1996 $ 184,176
3 Month
Eurodollar 22,000,000 Short March, 1998 (94,607)
3 month
Eurodollar 6,000,000 Short March, 1999 (27,027)
3 month
Eurodollar 16,000,000 Short March, 2000 (69,272)
$ (6,730)
Futures transactions involve costs and may result in losses. The
effective use of futures strategies depends on the Series' ability
to terminate futures positions at times when the Series' investment
adviser deems it desirable to do so. The use of futures also
involves the risk of imperfect correlation among movements in the
values of the securities underlying the futures purchased and sold
by the Series, of the futures contract itself, and of the
securities which are the subject of a hedge.
The aggregate market value of investments pledged to cover margin
requirements for the open positions at March 31, 1996 was $158,069.
3. INVESTMENT ADVISORY FEES AND OTHER
TRANSACTIONS WITH
AFFILIATES
Smith Breeden Associates, Inc. (the "Adviser"), a registered
investment adviser, provides the Series with investment management
services. As compensation for these services, the Intermediate
Series pays the Adviser a fee computed daily and payable monthly,
at an annual rate equal to 0.70% of the Series' average daily net
asset value.
The Adviser has voluntarily agreed to reduce or otherwise limit
other expenses of the Intermediate Series (excluding advisory fees
and litigation, indemnification and other extraordinary expenses)
to 0.90% of the Series' average daily net assets. This voluntary
agreement may be terminated or modified at any time by the Adviser
in its sole discretion. The Adviser has agreed to reduce the fees
payable (to the extent of such fees) by the amount the Series'
expenses would, absent the fee reduction, exceed the applicable
expense limitations imposed by state securities administrators.
For the year ended March 31, 1996, the Adviser received fees of
$256,075 and reimbursed the Series $85,364.
<PAGE>
Effective August 1, 1994, the Series adopted a Distribution and
Services Plan (the "Plan") pursuant to Rule 12b-1 under the 1940
Act. The purpose of the Plan is to permit the Adviser to
compensate investment dealers and other persons involved in
servicing shareholder accounts for services provided and expenses
incurred in promoting the sale of shares of the Series, reducing
redemptions, or otherwise maintaining or improving services
provided to shareholders by such dealers or other persons.
The Plan provides for payments by the Adviser, out of its advisory
fee, to dealers and other persons at the annual rate of up to 0.25%
of the Intermediate Series' average net assets subject to the
authority of the Trustees of the Series to reduce the amount of
payments permitted under the Plan or to suspend the Plan for such
periods as they may determine. Subject to these limitations, the
amount of such payments and the purposes for which they are made
shall be determined by the Adviser.
Certain officers and trustees of the Series are also officers and
directors of the Adviser.
4. INVESTMENT TRANSACTIONS
During the year ended March 31, 1996, purchases and proceeds from
sales of securities, other than short-term investments, aggregated
$87,639,428 and $87,338,696, respectively. The purchases and
proceeds shown above do not include dollar roll agreements which
are considered borrowings by the Intermediate Series. The cost of
securities for federal income tax purposes is $48,747,619. Net
unrealized appreciation of investments and futures contracts
consists of:
Gross unrealized appreciation .................. $773,535
Gross unrealized depreciation .................. (543,096)
Net unrealized appreciation .................... $230,439
5. LIQUIDATION OF THE INSTITUTIONAL INTERMEDIATE
FUND
From its inception until August 1, 1994, the Intermediate
Series sought to achieve its investment objective by investing
all of its assets in the Smith Breeden Institutional
Intermediate Duration U.S. Government Fund (the "Institutional
Fund"), an open-end, diversified management investment company
having the same investment objective as the Series. However,
at the close of business on August 1, 1994, pursuant to a plan
of liquidation adopted by the Trustees of the Institutional
Fund, and approved by the Trustees of the Intermediate Series,
the Intermediate Series redeemed in-kind its shares of the
Institutional Fund. The assets of the Institutional Fund were
transferred in proportion to the Intermediate Series' ownership
of the Institutional Fund in cancellation of its shares.
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Trustees and Shareholders,
Smith Breeden Intermediate Duration U.S. Government Series of
the Smith Breeden Series Fund:
We have audited the accompanying statement of assets and
liabilities, including the schedule of investments, of the Smith
Breeden Intermediate Duration U.S. Government Series of the
Smith Breeden Series Fund as of March 31, 1996, and the related
statements of operations and cash flows for the year then ended,
the statements of changes in net assets for each of the years in
the two-year period then ended and the financial highlights for
each of the years in the three-year period then ended and the
period March 31, 1992 (commencement of operations) to March 31,
1993. These financial statements and the financial highlights
are the responsibility of the Fund's management. Our
responsibility is to express an opinion on these financial
statements and the financial highlights based on our audits.
We conducted our audits in accordance with generally accepted
auditing standards. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether
the financial statements and the financial highlights are free
of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in
the financial statements. Our procedures included confirmation
of securities owned at March 31, 1996 by correspondence with the
custodian and brokers. An audit also includes assessing the
accounting principles used and significant estimates made by
management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements and financial
highlights referred to above present fairly, in all material
respects, the financial position of the Smith Breeden
Intermediate Duration U.S. Government Series of the Smith
Breeden Series Fund as of March 31, 1996, the results of its
operations and its cash flows, the changes in its net assets,
and the financial highlights for the respective stated periods
in conformity with generally accepted accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 10, 1996
<PAGE>
SMITH BREEDEN SERIES FUND
FORM N-1A
PART C. OTHER INFORMATION
Item 24. Financial Statements and Exhibits.
(a) Financial Statement filed with Part B
(b) Exhibits:
(1) Declaration of Trust: Incorporated by Reference
(2) By-Laws: Incorporated by Reference
(3) Voting Trust Agreement: Not Applicable
(4) Specimen Share Certificate: Incorporated by
Reference
(5)(a) Form of Investment Advisory Agreement
for Smith Breeden Intermediate Duration
Series: Incorporated by Reference
(5)(b) Form of Investment Advisory Agreement
for Smith Breeden Short Duration Series:
Incorporated by Reference
(6) Form of Underwriting or Distribution
Agreement: Incorporated by Reference
(7) Bonus, Profit Sharing, Pension and Other
Similar Arrangements: Not Applicable
(8) Custodian Agreement: Incorporated by Reference
(9)(a) Shareholder Services Agreement: Incorporated by
Reference
(9)(b) Accounting Services Agreement: Incorporated by
Reference
(9)(c) Sub-Administration Agreement: Not Applicable
(10) Opinion and Consent of Counsel
(a) Incorporated by Reference to Post-Effective
Amendment No. 12 filed on May 30, 1996.
(11) Independent Auditors' Consent
(12) Financial Statements Omitted from Item 23:
Not Applicable
(13) Letter of Understanding relating to
initial capital--Incorporated by Reference
(14) Model Retirement Plan -- Not Applicable
(15)(a) Form of Rule 12b-1 Plan for Smith
Breeden Intermediate Duration Series: Incorporated by
Reference
(15)(b) Form of Rule 12b-1 Plan for Smith
Breeden Short Duration Series: Incorporated by
Reference
(16) Performance Calculation --
Not Applicable
(17) Powers of Attorney--Incorporated by Reference
(18) Financial Data Schedule
<PAGE>
Item 25. Persons Controlled by or under Common Control with
Registrant.
Carver Federal Savings Bank may be deemed to control the Smith
Breeden Short Duration Series by virtue of it owning 28.3% of the
outstanding shares of this series on May 31, 1996.
Roosevelt Bank FSB may be deemed to control the Smith Breeden
Intermediate Duration U.S. Government Series by virtue of it
owning 71.11% of the outstanding shares of the fund on May 31,
1996.
Item 26. Number of Holders of Securities.
NUMBER OF RECORD HOLDERS
TITLE OF CLASS AS OF JUNE 30, 1996
Smith Breeden Short Duration
U.S. Government Series 116
Shares of Beneficial Interest
Smith Breeden Intermediate
Duration U.S. Government Series 81
Shares of Beneficial Interest
Item 27. Indemnification.
Reference is made to Article IV, Sections 4.2 and 4.3 of
Registrant's Declaration of Trust (Exhibit 1(a)) with respect to
indemnification of the Trustees and officers of Registrant
against liabilities which may be incurred by them in such
capacities.
Insofar as indemnification for liability arising under the
Securities Act of 1933, as amended (the "Act"), may be permitted
to directors, officers and controlling persons of the Registrant
pursuant to the foregoing provisions, or otherwise, the
Registrant has been advised that, in the opinion of the
Securities and Exchange Commission ("SEC"), such indemnification
is against public policy as expressed in the Act, and is,
therefore, unenforceable. In the event that a claim for
indemnification against such liabilities (other than the payment
by the Registrant of expenses incurred or paid by a trustee, an
officer or a controlling person of the Registrant in the
successful defense of any action, suit or proceeding) is asserted
by such trustee, officer or controlling person in connection with
the securities being registered, the Registrant will, unless in
the opinion of its counsel the matter has been settled by
controlling precedent, submit to a court of appropriate
jurisdiction the question whether such indemnification by it is
against public policy as expressed in the Act and will be
governed by the final adjudication of such issue.
Each disinterested Trustee has entered into an indemnity
agreement with the Adviser whereby the Adviser indemnifies each
disinterested Trustee against defense costs in connection with a
civil claim which involves the Trustee by virtue of his position
with the Fund.
<PAGE>
Item 28. Business and Other Connections of Adviser.
Smith Breeden Associates, Inc. (the "Adviser") acts as investment
adviser to financial institution, insurance, pension, charitable foundation
clients and other registered investment companies. For a description of
the officers and directors of the Adviser and their business affiliations,
see "Management of the Fund" in the Prospectus contained within this
Registration Statement.
Item 29. Principal Underwriters
Fund/Plan Broker Services, Inc., located at #2 West Elm Street, P.O. Box
874, Conshohocken, Pennsylvania 19428-0874, is the principal underwriter.
Fund/Plan Broker Services also serves as the Principal Underwriter for The
Brinson Funds, Inc., CT&T Funds, First Mutual Fund, Inc.,
Focus Trust, Inc., IAA Trust Mutual Funds, Matthews International Funds,
McMorgan Mutual Funds, Smith Breeden Series Fund,
Smith Breeden Trust, The Stratton Funds, Inc. Stratton Growth Fund,
Inc., Stratton Monthly Dividend Shares, Inc. and The Timothy Plan.
(b) The table below sets forth certain information as to the
Underwriter's Directors, Officers and Control Persons:
NAME AND PRINCIPAL POSITION AND OFFICES
POSITION AND
BUSINESS ADDRESS WITH UNDERWRITER
OFFICES WITH
REGISTRANT
Kenneth J. Kempf Director, President and None
#2 West Elm Street Principal
Conshohocken, PA 19428-0874
Rocco C. Cavalieri Director and Vice President None
#2 West Elm Street
Conshohocken, PA 19428-0874
Gerald J. Holland Director and Vice President None
#2 West Elm Street
Conshohocken, PA 19428-0874
Joseph M. O'Donnell Director and Vice President None
#2 West Elm Street
Conshohocken, PA 19428-0874
Sandra L. Adams Assistant Vice President None
#2 West Elm Street and Principal
Conshohocken, PA 19428-0874
John H. Leven Treasurer None
#2 West Elm Street
Conshohocken, PA 19428-0874
Mary P. Efstration Secretary None
#2 West Elm Street
Conshohocken, PA 19428-0874
James W. Stratton may be considered a control person of the Underwriter
due
to his direct or indirect ownership of Fund/Plan Services, Inc., the parent
of the Underwriter.
(c) Not Applicable.
<PAGE>
Item 30. Locations of Accounts and Records.
The accounts, books or other documents required to be maintained by
Section 31(a) of the Investment Company Act of 1940 and the Rules
thereunder will be kept by the Registrant at the following offices.
(1) Fund/Plan Services, Inc., #2 West Elm Street, P. O. Box 874,
Conshohocken, Pennsylvania 19428-0874
(2) Smith Breeden Associates, Inc., 100 Europa Drive, Suite 200,
Chapel Hill, NC 27514
Item 31. Management Services.
There are no management-related service contracts not discussed in
Part A or Part B.
Item 32. Undertakings.
(a) The Registrant previously has undertaken to promptly call a
meeting of shareholders for the purpose of voting upon the question of
removal of any trustee or trustees when requested in writing to do so by
the record holders of not less than 10 percent of the Registrant's
outstanding shares and to assist its shareholders in accordance with the
requirements of Section 16(c) of the Investment Company Act of 1940
relating to shareholder communications.
(b) The registrant hereby undertakes to furnish to each person to
whom a prospectus is delivered a copy of the Registrant's latest annual
report to shareholders upon request and without charge.
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, as
amended, and the Investment Company Act of 1940, as amended, the
Registrant certifies that it meets all of the requirements for
effectiveness of this Registration Statement pursuant to Rule 485 (b)
under the Securities Act of 1933 and has duly caused this Amendment
to the Registration Statement to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Chapel Hill,
the State of North Carolina, on the 12 day of July, 1996.
SMITH BREEDEN SERIES FUND
By
Michael J. Giarla
President
Pursuant to the requirements of the Securities Act of 1933, this
Amendment to the Registration Statement has been signed below by the
following persons in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
Michael J. Giarla President, Principal July 12, 1996
Executive Officer, and Trustee
Douglas T. Breeden* Trustee July 12, 1996
Stephen M. Schaefer* Trustee July 12, 1996
Myron S. Scholes* Trustee July 12, 1996
William F. Sharpe* Trustee July 12, 1996
Marianthe S. Mewkill Principal Financial and July 12, 1996
Accounting Officer
* By
Marianthe S. Mewkill
*Attorney-in-Fact pursuant to power-of-attorney filed previously.
<PAGE>
INDEPENDENT AUDITORS' CONSENT
Smith Breeden Series Trust:
We consent to the use in Post-Effective Amendment No. 13 to Registration
Statement No. 33-43089 of our reports of Smith Breeden Short Duration U.S.
Government Series and Smith Breeden Intermediate Duration U.S. Government
Series of Smith Breeden Series Trust dated May 10, 1996 appearing in the
Statement of Additional Information, which is a part of such Registration
Statement, and to the reference to us under the captions "Experts" appearing
in the Statement of Additional Information and "Financial Highlights",
appearing in the Prospectus, which also is a part of such Registration
Statement.
DELOITTE & TOUCHE LLP
Princeton, New Jersey
July 12, 1996
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