SMITH BREEDEN MUTUAL FUNDS
- --------------------------------------------------------------------------------
MARKET OVERVIEW
FIXED-INCOME MARKETS
In the first half of 1998, bond investors benefited from falling interest
rates, as inflation remained subdued largely due to very weak commodity prices.
By mid-year the yield on the ten-year Treasury Note stood at 5.4%, a fall of
0.3% from its level at the beginning of the year. Weak commodity prices,
especially oil prices, while generally beneficial to the U.S. economy, were
wreaking havoc elsewhere. In August 1998, investors began pulling money out of
Russia as quickly as possible, as it became clear that Russia could not support
its debt burden with the price of oil at about $13 a barrel. The Russian ruble
collapsed in value over 50% at the end of August and Russia defaulted on
scheduled debt payments. What followed was a classic flight-to-quality and
liquidity crisis as investors sold riskier debt securities at almost any price
to move assets into U.S. Treasury securities. Yields on the ten-year Note fell
to 4.4% by the end of September, a level actually below that of the six-month
Treasury Bill, which yielded 4.5% at that time. The Federal Reserve responded
to the financial crises by aggressively cutting short-term money-market rates.
The Federal Funds target rate was cut from 5.5% to 4.75% during this period
because the Fed believed the high level of risk aversion shown by investors
posed a threat to continued growth in the U.S. economy. The third rate cut on
October 15, 1998, took investors by surprise and investment surged back into
riskier assets. By cutting rates, the Federal Reserve increased money flows
into the U.S. economy, and so the Fed's actions reassured investors that growth
was likely to continue in the U.S.
Riskier fixed-income assets performed very well in the fourth quarter,
because the extremely high premium that investors had demanded for credit risk
in September shrank. The increase in liquidity in the economy helped drive
interest rates up in the first quarter of 1999, however, and the yield on the
ten-year Note rose to 5.2% by March 31, 1999 from 4.7% at the end of December.
Another factor causing interest rates to rise was the recovery in oil prices.
Oil producers introduced output cuts in order to reduce supply. Falling oil
prices had been one of the factors keeping inflation low through 1998. As a
result, bond investors raised the inflation premium demanded from bond issuers.
Mortgage Securities suffered from some of the turmoil affecting
fixed-income securities in 1998. Mortgages underperformed comparable Treasury
securities in 1998 with the Salomon-Smith Barney Mortgage Index returning 7.0%
in 1998, while the five-year Treasury Note returned 9.6%. Mortgages were less
affected than other bonds by the flight from credit risk because of the high
credit quality of Government agency mortgages, but interest rate volatility
rose substantially in the latter half of the year. Mortgage securities perform
best when interest rates are steady, and so higher volatility hurts mortgage
investors. A second factor hurting mortgages was the fast rate of principal
prepayments, as declining interest rates gave homeowners the opportunity to
refinance at lower rates, and many homeowners refinanced to convert home equity
into cash. In the first quarter of 1999, mortgages performed very well when
compared with both Treasury securities and corporate bonds, as volatility and
prepayment expectations declined. Through March 31, 1999, the Salomon-Smith
Barney Mortgage Index returned 1.0%, while the five-year Note lost 1.3%.
EQUITY MARKETS
The S&P 500 returned 28.6% in 1998. The index has returned over 20% for a
memorable four years in a row. This excellent performance masked a market in
which the average stock actually gained only 5.8%, as measured by the Value
Line Arithmetic Index. The S&P 500 index is weighted by capitalization, and
includes only large U.S. companies. This means that the index is primarily
influenced by the return on the largest stocks in the index, such as Microsoft
and General Electric. By contrast, the Value Line Arithmetic weights each stock
in the average equally, and thus reveals how the average stock, rather than the
largest stocks, performed. The gap between how well the largest companies
performed can be seen even within the S&P 500, as the largest 50 stocks in the
index returned an average of over 40%, while the smaller 450 stocks were up
less than 17%.
Consumer and technology stocks did particularly well in 1998. During the
period of the ruble crisis in August and September 1998, these sectors fared
relatively well. Investors remained generally confident that core consumer and
technology spending in the U.S. would continue, despite the serious financial
condition of Asia and other emerging markets, and the signs of slowing growth
in Europe. After the third Federal Reserve rate cut in October, these sectors
soared in the fourth quarter, driving the large capitalization indexes
dramatically higher. Other sectors did poorly in the third quarter, including
financial stocks due to their exposure to credit risk at a time
<PAGE>
when investors were fleeing to the safety of Treasury securities. The ongoing
decline in oil prices drove energy stocks down in 1998, and these were among
the worst performing stocks.
Earnings in 1998 were better than expected, with the average earnings of
S&P 500 companies rising 6% from the end of 1997. Many analysts had expected
earnings to be lower due to the ongoing effect of the financial crisis in
developing markets. Domestic demand in the United States proved more resilient
than most economists had expected. In fact, U.S. domestic spending was the
primary engine of growth globally in 1998. The moderate gain in earnings,
combined with lower interest rates, with the yield on the ten-year Note
declining 1.1% in the year, provided support for higher stock prices.
The S&P 500 continued to gain in the first quarter of 1999, rising 5.5%,
despite interest rates climbing 0.6% in the quarter. This can be understood
both as an effect of the liquidity provided to the economy and investors by the
Federal Reserve in the fourth quarter, as well as of the rising earning
expectations for future quarters. First Call reports that corporate earnings
are expected on average to rise a striking 17.2% in 1999. Predicting earnings
is a very inexact art, however, and it remains to be seen whether these
earnings will be realized.
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
PERFORMANCE REVIEW
The Smith Breeden Short Duration U.S. Government Fund returned 4.83% in
the year ending March 31, 1999. The Fund's benchmark, six-month U.S. Treasury
Bill, returned 5.29% over the same period as measured by Merrill Lynch. The
Fund's return exceeded the average twelve month yield on money-market funds of
4.73%1. The Graph below shows the Fund's return versus both its benchmark and
the average return of the mutual funds in Morningstar's Ultrashort Bond Fund
category.
[GRAPHIC APPEARS HERE WITH THE FOLLOWING PLOT POINTS:]
CHANGE IN VALUE OF A $10,000 INVESTMENT
<TABLE>
<CAPTION>
3/92 9/92 3/93 9/93 3/94 9/94 3/95 9/95 3/96 9/96 3/97 9/97 3/98 9/98 3/99
---- ----- ---- ----- ---- ----- ---- ----- ---- ----- ---- ----- ---- ----- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Smith Breeden Short
Duration U.S. Gov't
Fund(1) 10,000 10,363 10,567 10,831 10,956 11,222 11,676 11,967 12,254 12,652 13,059 13,490 13,874 14,202 14,544
Morningstar Avg.
Ultrashort Bond 10,000 10,342 10,554 10,798 10,930 11,088 11,404 11,778 12,120 12,467 12,823 13,426 13,604 13,985 14,312
6 Month U.S. T-Bill 10,000 10,258 10,427 10,595 10,753 10,966 11,291 11,643 11,964 12,282 12,611 12,978 13,326 13,721 14,029
- ------------
(1) Fund Returns are net fees and sales charges. Index returns are market returns without deduction of fees or rebalancing
transaction costs.
Past performance is no guarantee of future results.
</TABLE>
<TABLE>
<CAPTION>
AVERAGE ANNUAL TOTAL RETURNS FOR
PERIODS
ENDING MARCH 31, 1999
--------------------------------------
SINCE INCEPTION FINAL VALUE OF
1 YEAR 5 YEARS (3/31/92) $10,000 INVESTMENT
---------- --------- ----------------- -------------------
<S> <C> <C> <C> <C>
Smith Breeden Short Duration U.S. Govt Fund 4.83% 5.83% 5.50% $14,544
Six Month T-Bill ........................... 5.29% 5.46% 4.95% 14,029
Morningstar Avg. Ultrashort Bond Fund ...... 5.20% 5.54% 5.25% 14,312
</TABLE>
For the year ending March 31, 1999, the best performing fixed income
investments were those with the best credit and liquidity characteristics.
Although the Short Duration Fund has low credit risk and excellent liquidity,
the Fund's return did not exceed the return of the six-month T-Bill for the
year. In general, U.S. Treasury securities were the best performing fixed
income securities in 1998. The main factor that constrained the returns of the
Short Duration Fund was the cost of the prepayment option in the mortgage
securities that comprise most of the Fund's assets. This prepayment option is
more costly to the investor in volatile markets such as those of the last year.
Over longer periods of time, the yield advantage of mortgage securities over
Treasury securities has historically compensated for this prepayment risk.
The second half of 1998 was a difficult period for mortgage securities.
During that period the Fund returned 1.99%, while the six-month T-Bill return
was 2.73%. The markets have been much more favorable so far in 1999. In the
first quarter, the Fund returned 1.52%, 0.41% more than the six-month T-Bill.
- ---------
1 SOURCE: THE WALL STREET JOURNAL
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
SCHEDULE OF INVESTMENTS MARCH 31, 1999
<TABLE>
<CAPTION>
MARKET
FACE AMOUNT SECURITY VALUE
- --------------- --------------------------------------------------------------------------- ---------------
<S> <C> <C>
U.S. GOVERNMENT & AGENCY OBLIGATIONS -- 151.7%
FREDDIE MAC -- 11.2%
Fixed-rate (1)
$ 2,600,000 6.00% 15 Year, due date to be announced ................................... $ 2,582,633
3,997,053 8.50%, due 5/1/25 to 12/1/25 .............................................. 4,198,517
Discount Notes ............................................................
25,000 4.87%, due 9/3/99 (2), (3) ................................................ 24,504
------------
6,805,654
------------
FANNIE MAE -- 100.7%
Interest-only strip (1)
893,940 9.00%, due 7/25/21 ........................................................ 206,679
Fixed-rate (1)
10,000,000 6.00% 15 Year, due date to be announced ................................... 9,909,766
25,839,904 6.00%, due 11/1/13 to 3/1/29 .............................................. 25,317,569
4,100,000 6.50%, due 4/1/29 ......................................................... 4,079,500
4,000,000 7.00%, due 5/1/11 to 10/1/11 .............................................. 4,086,832
9,000,000 7.00% 30 Year, due date to be announced ................................... 9,125,157
1,333,755 7.043%, 30 Year, due 12/1/06 .............................................. 1,397,540
Delegated Underwriting Servicing (DUS) (1)
4,855,146 6.01%, due 12/1/08 ........................................................ 4,841,559
1,363,351 6.04%, due 10/1/08 ........................................................ 1,355,040
857,988 7.033%, due 6/1/07 ........................................................ 899,955
Discount Notes
40,000 4.96%, due 3/22/00 (2), (3) ............................................... 38,159
------------
61,257,756
------------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION -- 39.3%
Adjustable-rate (1)
3,008,525 6.625%, due 7/20/17 to 9/20/22 ............................................ 3,068,702
1,340,122 6.875%, due 3/20/21 to 4/20/24 ............................................ 1,366,283
Fixed-rate (1)
18,426,871 7.00%, due 9/15/27 to 10/15/28 ............................................ 18,720,924
684,020 9.50%, due 7/15/09 to 4/15/25 ............................................. 737,635
------------
23,893,544
------------
U.S. TREASURY NOTES -- 0.5%
120,000 5.875% due 7/31/99 (3) .................................................... 120,488
170,000 6.375% due 5/15/99 (3) .................................................... 170,345
------------
290,833
------------
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(COST $92,187,983)......................................................... 92,247,787
------------
NOTIONAL
AMOUNT
-----------
THREE MONTH LIBOR INTEREST RATE SWAP CONTRACTS -- (2.0%)
$20,000,000 Contract dated 8/31/93 with Salomon Swapco, Expires 8/30/00,
pay rate 5.34% ............................................................ (8,094)
20,000,000 Contract dated 5/15/95 with Salomon Swapco, Expires 5/15/05,
pay rate 6.951% ........................................................... (1,218,116)
------------
TOTAL THREE MONTH LIBOR INTEREST RATE SWAP CONTRACTS ...................... (1,226,210)
------------
THREE MONTH LIBOR INTEREST RATE CAP CONTRACTS -- 0.3%
50,000,000 Contract with Salomon Swapco, expires 4/23/03, Strike rate 7.50% .......... 213,500
------------
TOTAL THREE MONTH LIBOR INTEREST RATE CAP CONTRACTS
(COST $1,336,030).......................................................... 213,500
------------
TOTAL INVESTMENTS -- 150.0% (COST $93,524,013)............................. 91,235,077
------------
</TABLE>
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
SCHEDULE OF INVESTMENTS (CONTINUED) MARCH 31, 1999
<TABLE>
<CAPTION>
MARKET
FACE AMOUNT SECURITY VALUE
- --------------- ------------------------------------------------------------ ----------------
<S> <C> <C>
REVERSE REPURCHASE AGREEMENTS -- (8.2%)
$ (5,000,000) Freddie Mac 5.55% due 4/5/99 dated 3/29/99 (4) ............. $ (5,000,000)
-------------
(5,000,000)
-------------
FORWARD SALES -- (25.6%)
(16,000,000) Fannie Mae 6.00%, due date to be announced (5) ............. (15,546,250)
-------------
(15,546,250)
-------------
LIABILITIES LESS CASH AND OTHER ASSETS -- (16.2%) .......... (9,881,378)
-------------
NET ASSETS -- 100.0% ....................................... $ 60,807,449
=============
</TABLE>
- ---------
(1) 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. Adjustable-rate mortgages have coupon rates that adjust
periodically. The interest rate shown is the rate in effect at March 31,
1999. The adjusted rate is determined by adding a spread to a specified
index.
(2) The interest rate shown for discount notes is the discount rate paid at the
time of purchase by the fund.
(3) Security is held as collateral by Carr Futures, Inc.
(4) Reverse repurchase agreement is collateralized by $4,344,000 face of GNMA
7.0% due 10/15/27 and $1,750,000 face of GNMA 7.0% due 6/15/28.
(5) The forward sale position represents the unsettled sale of securities held
by the Fund.
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
STATEMENT OF ASSETS AND LIABILITIES MARCH 31, 1999
<TABLE>
<S> <C>
ASSETS
Investments at market value (identified cost $93,524,013) (Note 1)....................... $ 91,235,077
Cash .................................................................................... 513,419
Restricted cash held to cover checkwriting privilege .................................... 6,489
Receivables:
Variation margin on futures contracts (Note 2) ........................................ 50,019
Subscriptions ......................................................................... 22,917
Interest .............................................................................. 446,698
Securities sold ....................................................................... 30,165,367
Other assets ............................................................................ 24,207
-------------
TOTAL ASSETS .......................................................................... 122,464,193
-------------
LIABILITIES
Reverse repurchase agreement (proceeds $5,000,000) (Note 1).............................. 5,000,000
Forward sales at market value (proceeds $15,520,000)..................................... 15,546,250
Payables:
Redemptions ........................................................................... 641,861
Securities purchased .................................................................. 40,317,051
Swap and other interest (Note 2) ...................................................... 57,776
Due to Advisor (Note 3) ................................................................. 45,881
Accrued expenses ........................................................................ 47,925
-------------
TOTAL LIABILITIES ..................................................................... 61,656,744
-------------
NET ASSETS
(Applicable to outstanding shares of 6,120,026 unlimited number of shares of beneficial
interest authorized; no stated par) ................................................... $ 60,807,449
=============
Net asset value, offering price and redemption price per share ($60,807,449 / 6,120,026). $ 9.94
=============
SOURCE OF NET ASSETS
Paid in capital ......................................................................... $ 65,331,014
Overdistributed net investment income ................................................... (463,285)
Accumulated net realized loss on investments and futures contracts ...................... (1,628,551)
Net unrealized depreciation of investments, interest rate swaps, interest rate caps and
forward sales ......................................................................... (2,315,186)
Net unrealized depreciation of futures contracts... ..................................... (116,543)
-------------
NET ASSETS ............................................................................ $ 60,807,449
=============
</TABLE>
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1999
<TABLE>
<S> <C>
INVESTMENT INCOME
Interest and discount earned, net of premium amortization and interest expense ($202,305)
(Note 1) .............................................................................. $ 4,036,991
EXPENSES
Advisory fees (Note 3) .................................................................. 508,343
Accounting and pricing services fees .................................................... 46,826
Custodian fees .......................................................................... 23,868
Audit and tax preparation fees .......................................................... 21,757
Legal fees .............................................................................. 17,825
Transfer agent fees ..................................................................... 27,529
Registration fees ....................................................................... 12,417
Trustees fees and expenses .............................................................. 45,794
Insurance ............................................................................... 9,647
Other ................................................................................... 8,048
------------
TOTAL EXPENSES BEFORE REIMBURSEMENT ................................................... 722,054
Expenses reimbursed by Advisor (Note 3) ............................................... (155,616)
------------
NET EXPENSES .......................................................................... 566,438
------------
NET INVESTMENT INCOME ................................................................. 3,470,553
------------
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS
Net realized gain on investments and futures contracts .................................. 1,074,357
Change in unrealized depreciation of investments, interest rate swaps, interest rate
caps, and futures contracts ............................................................. (1,229,582)
------------
Net realized and unrealized loss on investments and futures contracts ................... (155,225)
------------
Net increase in net assets resulting from operations .................................... $ 3,315,328
============
</TABLE>
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
YEAR ENDED YEAR ENDED
MARCH 31, 1999 MARCH 31, 1998
---------------- ---------------
<S> <C> <C>
OPERATIONS
Net investment income ............................................................ $ 3,470,553 $ 5,485,507
Net realized gain on investments ................................................. 1,074,357 2,886,352
Change in unrealized appreciation (depreciation) of investments, interest rate
swaps, interest rate caps and futures contracts ................................ (1,229,582) (2,022,049)
------------- -------------
Net increase in net assets resulting from operations ............................. 3,315,328 6,349,810
------------- -------------
DISTRIBUTIONS TO SHAREHOLDERS
Dividends from net investment income ............................................. (3,302,565) (5,439,867)
------------- -------------
Total distributions .............................................................. (3,302,565) (5,439,867)
------------- -------------
CAPITAL SHARE TRANSACTIONS
Shares sold ...................................................................... 45,691,681 46,118,603
Shares issued on reinvestment of distributions ................................... 1,845,880 2,600,980
Shares redeemed .................................................................. (65,170,730) (90,190,280)
------------- -------------
Decrease in net assets resulting from capital share transactions (a) ............. (17,633,169) (41,470,697)
------------- -------------
TOTAL INCREASE (DECREASE) IN NET ASSETS ........................................ (17,620,406) (40,560,754)
NET ASSETS
Beginning of period .............................................................. 78,427,855 118,988,609
------------- -------------
End of period .................................................................... $ 60,807,449 $ 78,427,855
============= =============
(a) Transactions in capital shares were as follows:
Shares sold ...................................................................... 4,622,012 4,669,660
Shares issued on reinvestment of distributions ................................... 186,844 264,390
Shares redeemed .................................................................. (6,593,289) (9,136,010)
------------- -------------
Net decrease ..................................................................... (1,784,433) (4,201,960)
Beginning balance ................................................................ 7,904,459 12,106,419
------------- -------------
Ending balance ................................................................... 6,120,026 7,904,459
============= =============
</TABLE>
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
FINANCIAL HIGHLIGHTS
The following average per share data, ratios and supplemental information
have been derived from information provided in the financial statements.
<TABLE>
<CAPTION>
YEAR YEAR YEAR YEAR YEAR
ENDED ENDED ENDED ENDED ENDED
MARCH 31, 1999 MARCH 31, 1998 MARCH 31, 1997 MARCH 31, 1996 MARCH 31, 1995
---------------- ---------------- ---------------- ---------------- ---------------
<S> <C> <C> <C> <C> <C>
NET ASSET VALUE, BEGINNING OF
PERIOD ........................... $ 9.92 $ 9.83 $ 9.74 $ 9.90 $ 9.90
---------- ---------- ----------- ----------- ------------
INCOME FROM INVESTMENT
OPERATIONS
Net investment income ............ 0.442 0.484 0.476 0.621 0.628
Net realized and unrealized
gain (loss) on investments ..... 0.020 0.114 0.146 (0.148) --
----------- ----------- ------------ ------------ ------------
Total from investment
operations ..................... 0.462 0.598 0.622 0.473 0.628
----------- ----------- ------------ ------------ ------------
LESS DISTRIBUTIONS
Dividends from net
investment income .............. (0.447) (0.508) (0.476) (0.621) (0.628)
Dividends in excess of
investment income .............. -- -- (0.056) (0.012) --
----------- ----------- ------------ ------------ ------------
Total distributions ............ (0.447) (0.508) (0.532) (0.633) (0.628)
----------- ----------- ------------ ------------ ------------
NET ASSET VALUE, END OF
PERIOD ........................... $ 9.94 $ 9.92 $ 9.83 $ 9.74 $ 9.90
----------- ----------- ------------ ------------ ------------
TOTAL RETURN ...................... 4.83% 6.24% 6.57% 4.95% 6.58%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of period ........ $60,807,449 $78,427,855 $118,988,609 $221,825,136 $218,431,665
Ratio of net expenses to
average net assets (1) ......... 0.78% 0.78% 0.78% 0.78% 0.78%
Ratio of net investment
income to average net
assets ......................... 4.78% 5.28% 5.04% 6.29% 6.33%
Portfolio turnover rate .......... 298% 626% 556% 225% 47%
Ratio of expenses to average
net assets before
reimbursement of
expenses by the
Advisor (1) .................... 1.00% 1.00% 0.93% 0.93% 0.92%
Ratio of net investment
income to average net
assets before
reimbursement of
expenses by the Advisor ........ 4.56% 5.06% 4.90% 6.13% 6.18%
</TABLE>
- ---------
(1) Through March 31, 1995, expense ratios include both the direct expenses of
the Smith Breeden Short Duration U.S. Government Fund, and the indirect
expenses incurred through the Fund's investment in the Smith Breeden
Institutional Short Duration U.S. Government Fund.
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
<PAGE>
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
The Board of Trustees and Shareholders,
Smith Breeden Short Duration U.S. Government Fund 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 Fund of the Smith Breeden Series Fund (the "Fund") as of March 31,
1999, and the related statement of operations 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
five-year period presented. 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, 1999 by correspondence with the custodian and brokers, and where replies
were not received, we performed other auditing procedures. 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, such financial statements and financial highlights
referred to above present fairly, in all material respects, the financial
positions of the Smith Breeden Short Duration U.S. Government Fund of the Smith
Breeden Series Fund as of March 31, 1999, the results of its operations, 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 14, 1999
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
PERFORMANCE REVIEW
The Smith Breeden Intermediate Duration U.S. Government Fund returned
5.73% in the year ending March 31, 1999. The Salomon-Smith Barney Mortgage
Index, the Fund's benchmark, returned 6.33%, marginally under the 6.53% return
of the five-year Treasury Note. The average Government Mortgage Fund, as
tracked by Morningstar, returned 5.22% over the same period.
[GRAPHIC APPEARS HERE WITH THE FOLLOWING PLOT POINTS:]
CHANGE IN VALUE OF A $10,000 INVESTMENT
<TABLE>
<CAPTION>
3/92 9/92 3/93 9/93 3/94 9/94 3/95 9/95 3/96 9/96 3/97 9/97 3/98 9/98 3/99
---- ----- ---- ----- ---- ----- ---- ----- ---- ----- ---- ----- ---- ----- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Smith Breeden
Intermediate
Duration U.S. Gov't
Fund(1) 10,000 10,954 11,493 12,255 11,967 11,982 12,695 13,610 13,925 14,330 14,748 15,682 16,318 16,864 17,252
Morningstar Avg.
Gov't Bond
Mortgage 10,000 10,748 11,141 11,533 11,270 11,161 11,692 12,512 12,812 13,089 13,429 14,277 14,807 15,486 15,579
5yr/SBMI (2) 10,000 11,037 11,428 11,988 11,678 11,708 12,380 13,284 13,681 14,065 14,486 15,446 16,066 16,768 17,082
- ------------
(1) Fund Returns are net fees and sales charges. Index returns are market returns without deduction of fees or rebalancing
transaction costs.
(2) 5-Year Treasury Note to 12/31/93 and the Salomon-Smith Barney Mortgage Index ("SBMI") to 3/31/99. The fund changed its
investment objective 1/1/94.
Past performance is no guarantee of future results.
</TABLE>
<TABLE>
<CAPTION>
AVERAGE ANNUAL TOTAL RETURNS FOR
PERIODS ENDING MARCH 31, 1999
--------------------------------------
SINCE INCEPTION FINAL VALUE OF
1 YEAR 5 YEARS (3/31/92) $10,000 INVESTMENT
---------- --------- ----------------- -------------------
<S> <C> <C> <C> <C>
Smith Breeden Intermediate Dur. U.S. Govt. Fund ... 5.73% 7.59% 8.10% $17,252
SBMI/5-Year U.S. Treasury (2) ..................... 6.33% 7.90% 7.95% 17,082
Morningstar Avg. Government Mortgage Fund ......... 5.22% 6.69% 6.54% 15,579
</TABLE>
The Intermediate Fund aims to match closely the interest-rate and
prepayment risk of the Salomon-Smith Barney Mortgage Index. This index is
representative of the universe of fixed-rate Government agency mortgages, and
has a duration ranging from about two to four years, depending on the overall
level of interest rates.
The Intermediate Fund was invested 60% in fixed-rate mortgages and 40% in
adjustable-rate mortgages (ARMs) at the end of June 1998. In the third quarter,
the Fund added AAA-rated commercial mortgage-backed securities to its holdings.
Commercial mortgage-backed securities (MBS) suffered in the flight-to quality
in the August to October period, and consequently the Fund underperformed its
benchmark by about 0.9% in the third quarter. Commercial MBS performed
exceedingly well in the fourth quarter, and the fund outperformed it's
benchmark by 0.5% in this period. Mortgage securities in general performed very
well compared to other bond classes in the first quarter of 1999, and the Fund
returned 0.9% in this period, in line with the benchmark Salomon Index return
of 1.0%. By contrast, the five-year Note lost 1.3% in this period due to rising
interest rates. The Fund reduced its ARM holdings in the third and fourth
quarters to about 13% of net assets, as ARMs became richly priced relative to
other mortgage securities.
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
SCHEDULE OF INVESTMENTS MARCH 31, 1999
<TABLE>
<CAPTION>
MARKET
FACE AMOUNT SECURITY VALUE
- --------------- ------------------------------------------------------------------------ ---------------
<S> <C> <C>
U.S. GOVERNMENT & AGENCY OBLIGATIONS -- 103.6%
FREDDIE MAC -- 30.7% (1)
Fixed-rate
$ 4,982,385 6.00%, due 1/1/29 ...................................................... $ 4,846,209
10,000,000 6.50% 30 Year, due date to be announced ................................ 9,942,578
2,095,828 7.50%, due date 11/1/27 to 1/1/28 ...................................... 2,151,975
------------
16,940,762
------------
FANNIE MAE -- 41.3% (1)
Fixed-rate
9,874,418 6.00%, due 1/1/14 to 3/1/29 ............................................ 9,635,778
7,217,482 6.50%, due 6/1/13 to 11/1/28 ........................................... 7,243,554
730,663 6.98%, due 6/1/07 ...................................................... 763,645
5,000,001 7.00%, due 12/1/07 to 3/1/08 ........................................... 5,108,541
------------
22,751,518
------------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION -- 31.2% (1)
Fixed-rate
7,121,230 7.00%, due 3/15/26 to 1/15/28 .......................................... 7,234,877
4,299,359 7.50%, due 9/15/28 ..................................................... 4,428,551
Adjustable-rate
2,433,341 5.50%, due 6/20/28 ..................................................... 2,466,308
411,811 6.125%, due 11/20/17 to 12/20/17 ....................................... 419,430
1,005,599 6.625%, due 8/20/17 to 8/20/18 ......................................... 1,025,628
1,598,569 6.875%, due 3/20/16 to 4/20/22 ......................................... 1,629,276
------------
17,204,070
------------
U.S. TREASURY NOTES -- 0.4%
175,000 5.875%, due 7/31/99 (2) ................................................ 175,711
40,000 6.375%, due 5/15/99 (2) ................................................ 40,081
------------
215,792
------------
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS (COST $57,223,788)........... 57,112,142
------------
COMMERCIAL MORTGAGE-BACKED SECURITIES -- 16.4% (1)
2,000,000 First Union-Lehman Brothers-Bank of America Commercial Mortage Trust
6.56%, due 11/18/08 .................................................... 2,025,333
2,000,000 GMAC Commercial Mortgage Securities 6.42%, due 8/15/08 ................. 2,006,854
5,000,000 Nomura Asset Securities Corporation Commercial Mortgage Trust 6.59%, due
3/17/28 ................................................................ 5,017,872
------------
TOTAL COMMERCIAL MORTGAGE-BACKED SECURITIES
(COST $9,149,637)....................................................... 9,050,059
------------
TOTAL INVESTMENTS (COST $66,373,425)--120.0%............................ 66,162,201
------------
FORWARD SALES -- (14.1%)
(8,000,000) Fannie Mae 6.00%, due date to be announced (3) ......................... (7,773,125)
------------
(7,773,125)
------------
LIABILITIES LESS CASH AND OTHER ASSETS -- (5.9%) ....................... (3,263,279)
------------
NET ASSETS -- 100.0% ................................................... $ 55,125,797
============
</TABLE>
- ---------
(1) 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. Adjustable-rate mortgages have coupon rates that adjust
periodically. The interest rate shown is the rate in effect at March 31,
1999. The adjusted rate is determined by adding a spread to a specified
index.
(2) Security is held as collateral by Carr Futures, Inc.
(3) The forward sale position represents the unsettled sale of securities held
by the Fund.
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
STATEMENT OF ASSETS AND LIABILITIES MARCH 31, 1999
<TABLE>
<S> <C>
ASSETS
Investments at market value (identified cost $66,373,425) (Note 1)....................... $ 66,162,201
Receivables:
Variation margin on futures contracts (Note 2) ........................................ 17,063
Subscriptions ......................................................................... 63,068
Interest .............................................................................. 328,063
Securities sold ....................................................................... 17,778,394
Prepaid expenses ...................................................................... 5,547
------------
TOTAL ASSETS ......................................................................... 84,354,336
------------
LIABILITIES
Bank overdraft .......................................................................... 1,402,577
Forward sales at market value (proceeds $7,760,000)...................................... 7,773,125
Payables:
Securities purchased .................................................................. 19,911,736
Redemptions ........................................................................... 65,098
Distributions ......................................................................... 8,417
Due to Advisor (Note 3) ................................................................. 33,945
Accrued expenses ........................................................................ 33,641
------------
TOTAL LIABILITIES .................................................................... 29,228,539
------------
NET ASSETS
(Applicable to outstanding shares of 5,559,865; unlimited number of shares of beneficial
interest authorized; no stated par) ................................................... $ 55,125,797
============
Net asset value, offering price and redemption price per share ($55,125,797 / 5,559,865). $ 9.91
============
SOURCE OF NET ASSETS
Paid in capital ......................................................................... $ 55,613,189
Overdistribution of net investment income ............................................... (134,448)
Accumulated net realized loss on investments and futures contracts ...................... (205,949)
Net unrealized depreciation of investments and forward sales ............................ (224,349)
Net unrealized appreciation of futures contracts ........................................ 77,354
------------
NET ASSETS ........................................................................... $ 55,125,797
============
</TABLE>
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1999
<TABLE>
<S> <C>
INVESTMENT INCOME
Interest and discount earned, net of premium amortization and interest expense ($20,002)
(Note 1) .............................................................................. $3,077,235
EXPENSES
Advisory fees (Note 3) ................................................................. 355,620
Accounting and pricing services fees ................................................... 40,922
Custodian fees ......................................................................... 20,350
Audit & tax preparation fees ........................................................... 14,402
Legal fees ............................................................................. 10,381
Transfer agent fees .................................................................... 28,175
Registration fees ...................................................................... 21,002
Trustees fees and expenses ............................................................. 29,452
Insurance .............................................................................. 4,722
Other .................................................................................. 5,474
----------
TOTAL EXPENSES BEFORE REIMBURSEMENT ................................................... 530,500
Expenses reimbursed by Advisor (Note 3) ............................................... (83,434)
----------
NET EXPENSES .......................................................................... 447,066
----------
NET INVESTMENT INCOME ................................................................. 2,630,169
----------
REALIZED AND UNREALIZED GAIN ON INVESTMENTS
Net realized gain on investments and futures contracts ................................. 247,095
Change in unrealized depreciation of investments and futures contracts ................. (209,534)
----------
Net realized and unrealized gain on investments and futures contracts .................. 37,561
----------
Net increase in net assets resulting from operations ................................... $2,667,730
==========
</TABLE>
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
YEAR ENDED YEAR ENDED
MARCH 31, 1999 MARCH 31, 1998
---------------- ---------------
<S> <C> <C>
OPERATIONS
Net investment income .................................................... $ 2,630,169 $ 2,175,424
Net realized gain on investments ......................................... 247,095 1,835,038
Change in unrealized depreciation of investments ......................... (209,534) (73,907)
------------- -------------
Net increase in net assets resulting from operations ..................... 2,667,730 3,936,555
------------- -------------
DISTRIBUTIONS TO SHAREHOLDERS
Dividends from net investment income ..................................... (2,630,169) (2,175,424)
Dividends in excess of net investment income ............................. -- (10,140)
Distributions from net realized gains on investments ..................... (576,411) (880,968)
------------- -------------
Total distributions ...................................................... (3,206,580) (3,066,532)
------------- -------------
CAPITAL SHARE TRANSACTIONS
Shares sold .............................................................. 45,066,774 34,884,833
Shares issued on reinvestment of distributions ........................... 3,096,717 1,570,705
Shares redeemed .......................................................... (31,140,723) (36,419,207)
------------- -------------
Increase in net assets resulting from capital share transactions (a) ..... 17,022,768 36,331
------------- -------------
TOTAL INCREASE IN NET ASSETS ........................................... 16,483,918 906,354
NET ASSETS
Beginning of period ...................................................... 38,641,879 37,735,525
------------- -------------
End of period ............................................................ $ 55,125,797 $ 38,641,879
============= =============
(a) Transactions in capital shares were as follows:
Shares sold .............................................................. 4,529,253 3,494,156
Shares issued on reinvestment of distributions ........................... 311,881 157,456
Shares redeemed .......................................................... (3,146,761) (3,664,130)
------------- -------------
Net increase (decrease) .................................................. 1,694,373 (12,518)
Beginning balance ........................................................ 3,865,492 3,878,010
------------- -------------
Ending balance ........................................................... 5,559,865 3,865,492
============= =============
</TABLE>
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
- --------------------------------------------------------------------------------
FINANCIAL HIGHLIGHTS
The following average per share data, ratios and supplemental information
have been derived from information provided in the financial statements.
<TABLE>
<CAPTION>
YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED
MARCH 31, 1999 MARCH 31, 1998 MARCH 31, 1997 MARCH 31, 1996 MARCH 31, 1995
---------------- ---------------- ---------------- ---------------- ---------------
<S> <C> <C> <C> <C> <C>
NET ASSET VALUE, BEGINNING OF
PERIOD ............................ $ 10.00 $ 9.73 $ 10.01 $ 9.83 $ 10.01
---------- ---------- ---------- ---------- ----------
INCOME FROM INVESTMENT
OPERATIONS
Net investment income ............. 0.525 0.590 0.599 0.660 0.664
Net realized and unrealized
(loss) gain on investments ...... 0.030 0.419 ( 0.024) 0.277 ( 0.049)
----------- ----------- ----------- ----------- -----------
Total from investment
operations ...................... 0.555 1.009 0.575 0.937 0.615
----------- ----------- ----------- ----------- -----------
LESS DISTRIBUTIONS
Dividends from net investment
income .......................... ( 0.515) ( 0.561) ( 0.604) ( 0.656) ( 0.664)
Dividends in excess of net
investment income ............... -- -- -- -- ( 0.108)
Distributions from net realized
gains on investments ............ ( 0.130) ( 0.178) ( 0.251) ( 0.101) --
Distributions in excess of net
realized gains on
investments ..................... -- -- -- -- ( 0.022)
----------- ----------- ----------- ----------- -----------
Total distributions ............. ( 0.645) ( 0.739) ( 0.855) ( 0.757) ( 0.794)
----------- ----------- ----------- ----------- -----------
NET ASSET VALUE, END OF PERIOD ..... $ 9.91 $ 10.00 $ 9.73 $ 10.01 $ 9.83
----------- ----------- ----------- ----------- -----------
TOTAL RETURN ....................... 5.73% 10.65% 5.92% 9.69% 6.10%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of period ......... $55,125,797 $38,641,879 $37,735,525 $36,446,940 $34,797,496
Ratio of net expenses to
average net assets (1) .......... 0.88% 0.88% 0.89% 0.90% 0.90%
Ratio of net investment income
to average net assets ........... 5.25% 5.61% 6.19% 6.49% 6.20%
Portfolio turnover rate ........... 423% 583% 409% 193% 557%
Ratio of expenses to average
net assets before
reimbursement of expenses
by the Advisor (1) .............. 1.06% 1.13% 1.16% 1.14% 2.33%
Ratio of net investment income
to average net assets before
reimbursement of expenses
by the Advisor .................. 5.08% 5.36% 5.92% 6.26% 4.77%
</TABLE>
- ---------
(1) Through August 1, 1994, expense ratios include both the direct expenses of
the Intermediate Duration U.S. Government Fund, and the indirect expenses
incurred through the Fund's investment in the Smith Breeden Institutional
Intermediate Duration U.S. Government Fund.
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
<PAGE>
INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------
The Board of Trustees and Shareholders,
Smith Breeden Intermediate Duration U.S. Government Fund 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 Fund of the Smith Breeden Series Fund (the "Fund") as
of March 31, 1999, and the related statement of operations 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 five-year period presented. 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, 1999 by correspondence with the custodian and brokers, and where replies
were not received, we performed other auditing procedures. 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, such financial statements and financial highlights
referred to above present fairly, in all material respects, the financial
positions of the Smith Breeden Intermediate Duration U.S. Government Fund of
the Smith Breeden Series Fund as of March 31, 1999, the results of its
operations, 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 14, 1999
<PAGE>
SMITH BREEDEN MUTUAL FUNDS
- --------------------------------------------------------------------------------
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Series Fund and the Smith Breeden Trust (the "Trusts") are
open-end, diversified management investment companies registered under the
Investment Company Act of 1940, as amended. The Smith Breeden Series Fund
offers shares in two series: the Smith Breeden Short Duration U.S. Government
Fund (the "Short Fund") and the Smith Breeden Intermediate Duration U.S.
Government Fund (the "Intermediate Fund"). The Smith Breeden Trust offers
shares in three series: the Smith Breeden U.S. Equity Market Plus Fund (the
"U.S. Equity Fund", formerly the Smith Breeden Equity Market Plus Fund), the
Smith Breeden High Yield Bond Fund (the "High Yield Fund"), and the Smith
Breeden Financial Services Fund (the "Financial Services Fund"). The following
is a summary of accounting policies consistently followed by the Short Fund,
the Intermediate Fund, the High Yield Fund, the U.S. Equity Fund and the
Financial Services Fund (collectively, the "Funds").
A. SECURITY VALUATION: Portfolio securities are valued at the 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. REPURCHASE AGREEMENTS: Each Fund may enter into repurchase agreements with
member banks of the Federal Reserve System with 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, a
Fund 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
Funds' custodian maintains control or custody of the securities collateralizing
the repurchase agreement until maturity. The value of the collateral is
monitored daily, and, if necessary, additional collateral is received to ensure
that the market value of the collateral remains sufficient to protect the Fund
in the event of the seller's default. However, in the event of default or
bankruptcy of the seller, the Fund's right to the collateral may be subject to
legal proceedings.
C. REVERSE REPURCHASE AGREEMENTS: A reverse repurchase agreement involves the
sale of portfolio assets together with an agreement to repurchase the same
assets later at a fixed price. Additional assets are maintained in a segregated
account with the custodian, and are marked to market daily. The segregated
assets may consist of cash, U.S. Government securities, or other liquid
high-grade debt obligations at least 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, a
Fund's 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.
D. DOLLAR ROLL AND REVERSE DOLLAR ROLL AGREEMENTS: A dollar roll is an
agreement to sell securities for delivery in the current month and 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. When a Fund invests in a dollar roll, it 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
earnings on the cash proceeds of the initial sale.
A reverse dollar roll is agreement to buy securities for delivery in the
current month and to sell substantially similar (same type and coupon)
securities on a specified future date, typically at a lower price. During the
roll period, the fund receives the principal and interest on the securities
purchased in compensation for the cash invested in the transaction.
E. DISTRIBUTIONS AND TAXES: Dividends to shareholders are recorded on the
ex-dividend date. Each Fund intends to continue to qualify for and elect the
special tax treatment afforded to regulated investment companies under
Subchapter M of the Internal Revenue Code, thereby relieving the Funds of
Federal income taxes. To so qualify, the Funds intend to distribute
substantially all net investment income and net realized capital gains, if any,
less any available capital loss carryforward. The following table summarized
the available capital loss carryforwards for each Fund.
<PAGE>
SMITH BREEDEN MUTUAL FUNDS
- --------------------------------------------------------------------------------
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. SIGNIFICANT ACCOUNTING POLICIES -- CONTINUED
<TABLE>
<CAPTION>
CAPITAL LOSS CAPITAL LOSS CAPITAL LOSS
CARRYFORWARD CARRYFORWARD CARRYFORWARD
FUND EXPIRES 3/31/2004 EXPIRES 3/31/2005 EXPIRES 3/31/2007
- ---------------------------------- ------------------- ------------------- ------------------
<S> <C> <C> <C>
Short Duration Fund ........ $658,505 $829,556 $ 0
Intermediate Duration Fund . 0 0 126,641
U.S. Equity Fund ........... 0 0 0
Financial Services Fund .... 0 0 196,832
High Yield Bond Fund ....... 0 0 0
</TABLE>
F. SECURITIES TRANSACTIONS, INVESTMENT INCOME AND OPERATING EXPENSES:
Securities transactions are recorded on the trade date. Interest income is
accrued daily, and includes net amortization from the purchase of fixed-income
securities. Discounts and premiums on fixed-income securities purchased are
amortized over the life of the respective securities. Dividend income is
recorded on the ex-dividend date. Gains or losses on the sale of securities are
calculated for accounting and tax purposes on the identified cost basis.
Expenses are accrued daily. Common expenses incurred by the Trusts are
generally allocated among the funds comprising the Trusts based on the ratio of
net assets of each Fund to the combined net assets of each Trust. Other
expenses are charged to each Fund on a specific identification basis.
G. ACCOUNTING ESTIMATES: The preparation of financial statements in accordance
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the financial statements and the amounts of income
and expense during the reporting period. Actual results could differ from those
estimates.
2. FINANCIAL INSTRUMENTS
A. FUTURES CONTRACTS HELD OR ISSUED FOR PURPOSES OTHER THAN TRADING: The Short
Fund, Intermediate Fund, and U.S. Equity Fund use interest-rate futures
contracts for risk management purposes in order to reduce fluctuations in the
Funds' net asset values relative to the Funds' targeted option-adjusted
durations. The Financial Services Fund uses S&P 500 futures contracts for risk
management purposes in order to manage the Fund's equity market risk relative
to its benchmark. On entering into a futures contract, either cash or
securities in an amount equal to a certain percentage of the contract value
(initial margin) must be deposited with the futures broker. Subsequent payments
(variation margin) are made or received each day. The variation margin payments
equal the daily changes in the contract value and are recorded as unrealized
gains or losses. The Funds recognize 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>
SMITH BREEDEN MUTUAL FUNDS
- --------------------------------------------------------------------------------
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
2. FINANCIAL INSTRUMENTS -- CONTINUED
The Short Fund had the following open futures contracts as of March 31, 1999:
<TABLE>
<CAPTION>
NUMBER OF EXPIRATION UNREALIZED
TYPE CONTRACTS POSITION MONTH GAIN/(LOSS)
- ---------------------------- ----------- ---------- ----------------- --------------
<S> <C> <C> <C> <C>
5 Year Treasury ............ 43 Short June, 1999 $ 7,791
10 Year Treasury ........... 113 Short June, 1999 53,226
3 Month Eurodollar ......... 31 Short June, 1999 (1,140)
3 Month Eurodollar ......... 55 Short September, 1999 (9,898)
3 Month Eurodollar ......... 12 Long December, 1999 (6,054)
3 Month Eurodollar ......... 12 Long March, 2000 (10,004)
3 Month Eurodollar ......... 12 Long June, 2000 (10,891)
3 Month Eurodollar ......... 12 Long September, 2000 (11,429)
3 Month Eurodollar ......... 12 Long December, 2000 (10,541)
3 Month Eurodollar ......... 12 Long March, 2001 (11,429)
3 Month Eurodollar ......... 12 Long June, 2001 (11,729)
3 Month Eurodollar ......... 62 Long September, 2001 94,284
3 Month Eurodollar ......... 12 Long December, 2001 (10,529)
3 Month Eurodollar ......... 12 Long March, 2002 (11,980)
3 Month Eurodollar ......... 12 Long June, 2002 (12,305)
3 Month Eurodollar ......... 12 Long September, 2002 (12,342)
3 Month Eurodollar ......... 12 Long December, 2002 (10,804)
3 Month Eurodollar ......... 12 Long March, 2003 (12,241)
3 Month Eurodollar ......... 12 Long June, 2003 (12,316)
3 Month Eurodollar ......... 12 Long September, 2003 (12,316)
3 Month Eurodollar ......... 12 Long December, 2003 (10,841)
3 Month Eurodollar ......... 12 Long March, 2004 (11,804)
3 Month Eurodollar ......... 12 Long June, 2004 (11,879)
3 Month Eurodollar ......... 12 Long September, 2004 (12,079)
3 Month Eurodollar ......... 12 Long December, 2004 (10,854)
3 Month Eurodollar ......... 12 Long March, 2005 (11,579)
3 Month Eurodollar ......... 12 Long June, 2005 (11,654)
3 Month Eurodollar ......... 12 Long September, 2005 (11,479)
3 Month Eurodollar ......... 4 Long December, 2005 (1,168)
3 Month Eurodollar ......... 2 Long March, 2006 (559)
---------
Total ($ 116,543)
=========
</TABLE>
The Intermediate Fund had the following open futures contracts as of March 31,
1999:
<TABLE>
<CAPTION>
NUMBER OF EXPIRATION UNREALIZED
TYPE CONTRACTS POSITION MONTH GAIN/(LOSS)
- -------------------------- ----------- ---------- --------------- ------------
<S> <C> <C> <C> <C>
5 Year Treasury .......... 32 Long June, 1999 ($ 10,246)
10 Year Treasury ......... 82 Short June, 1999 87,600
--------
Total $ 77,354
========
</TABLE>
<PAGE>
SMITH BREEDEN MUTUAL FUNDS
- --------------------------------------------------------------------------------
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
2. FINANCIAL INSTRUMENTS -- CONTINUED
The U.S. Equity Fund had the following open interest-rate futures contracts as
of March 31, 1999:
<TABLE>
<CAPTION>
NUMBER OF EXPIRATION UNREALIZED
TYPE CONTRACTS POSITION MONTH GAIN/(LOSS)
- ---------------------------- ----------- ---------- ----------------- --------------
<S> <C> <C> <C> <C>
5 Year Treasury ............ 126 Short June, 1999 $ 18,527
10 Year Treasury ........... 81 Short June, 1999 60,409
3 Month Eurodollar ......... 185 Long June, 1999 31,543
3 Month Eurodollar ......... 166 Short September, 1999 (214,510)
3 Month Eurodollar ......... 18 Short December, 1999 7,819
3 Month Eurodollar ......... 55 Short March, 2000 (31,048)
3 Month Eurodollar ......... 18 Short June, 2000 15,032
3 Month Eurodollar ......... 127 Short September, 2000 (164,284)
3 Month Eurodollar ......... 18 Short December, 2000 14,007
3 Month Eurodollar ......... 49 Short March, 2001 (3,208)
3 Month Eurodollar ......... 18 Short June, 2001 15,132
3 Month Eurodollar ......... 123 Short September, 2001 (148,704)
3 Month Eurodollar ......... 18 Short December, 2001 12,769
3 Month Eurodollar ......... 48 Short March, 2002 3,059
3 Month Eurodollar ......... 18 Short June, 2002 15,494
3 Month Eurodollar ......... 117 Short September, 2002 (35,589)
3 Month Eurodollar ......... 18 Short December, 2002 13,369
3 Month Eurodollar ......... 62 Short March, 2003 (3,129)
3 Month Eurodollar ......... 18 Short June, 2003 15,544
3 Month Eurodollar ......... 102 Short September, 2003 35,204
3 Month Eurodollar ......... 16 Short December, 2003 10,803
3 Month Eurodollar ......... 65 Short March, 2004 9,645
3 Month Eurodollar ......... 16 Short June, 2004 12,803
3 Month Eurodollar ......... 16 Short September, 2004 13,103
3 Month Eurodollar ......... 16 Short December, 2004 11,678
3 Month Eurodollar ......... 135 Short March, 2005 26,768
3 Month Eurodollar ......... 16 Short June, 2005 13,003
3 Month Eurodollar ......... 13 Short September, 2005 11,167
3 Month Eurodollar ......... 4 Short December, 2005 2,007
3 Month Eurodollar ......... 78 Short March, 2006 18,424
3 Month Eurodollar ......... 24 Short March, 2007 8,292
---------
Total ($ 204,874)
=========
</TABLE>
The Financial Services Fund had the following open futures contracts on the S&P
500 Index as of March 31, 1999:
<TABLE>
<CAPTION>
NUMBER OF UNREALIZED
TYPE CONTRACTS POSITION EXPIRATION MONTH GAIN/(LOSS)
- ----------------- ----------- ---------- ------------------ ------------
<S> <C> <C> <C> <C>
S&P 500 ......... 7 Short June, 1999 ($ 57,627)
--------
Total ($ 57,627)
========
</TABLE>
Futures transactions involve costs and may result in losses. The effective use
of futures depends on the Funds' ability to close futures positions at times
when the Funds' Advisor 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 Funds, of the
futures contract themselves, and of the securities that are the subject of a
hedge.
<PAGE>
SMITH BREEDEN MUTUAL FUNDS
- --------------------------------------------------------------------------------
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
2. FINANCIAL INSTRUMENTS -- CONTINUED
B. DERIVATIVE FINANCIAL INSTRUMENTS HELD OR ISSUED FOR TRADING PURPOSES: The
U.S. Equity Fund invests in futures contracts on the S&P 500 Index whose
returns are expected to track movements in the S&P 500 Index.
The U.S. Equity Fund had the following open futures contracts on the S&P 500
Index as of March 31, 1999:
<TABLE>
<CAPTION>
NUMBER OF EXPIRATION UNREALIZED
TYPE CONTRACTS POSITION MONTH GAIN/(LOSS)
- ------------------- ----------- ---------- ------------ ------------
<S> <C> <C> <C> <C>
S&P 500 ......... 580 Long June, 1999 $1,787,863
----------
Total $1,787,863
==========
</TABLE>
C. ASSETS PLEDGED TO COVER MARGIN REQUIREMENTS FOR OPEN FUTURES POSITIONS: The
aggregate market value of assets pledged to cover margin requirements for the
open futures positions at March 31, 1999 was:
<TABLE>
<CAPTION>
FUND ASSETS PLEDGED
- ------------------------------- ---------------
<S> <C>
Short Fund .................. $ 353,496
Intermediate Fund ........... 215,792
U.S. Equity Fund ............ 11,246,155
Financial Services Fund ..... 115,500
</TABLE>
E. INTEREST-RATE SWAP CONTRACTS: The Funds may use interest-rate swap contracts
to help manage interest-rate risk. Interest-rate swaps represent an agreement
between counterparties to exchange cash flows based on the difference between
two interest rates, applied to a notional principal amount for a specified
period. The most common type of interest-rate swap involves the exchange of
fixed-rate cash flows for variable-rate cash flows. Interest-rate swaps do not
involve the exchange of principal between the parties. The Funds will not enter
into interest-rate swap contracts unless the unsecured commercial paper,
unsecured senior debt or the claims-paying ability of the counterparty is rated
either AA or A or better by Standard & Poor's Corporation, or Aa or P-1 or
better by Moody's Investors Service, Inc. (or is otherwise acceptable to either
agency) at the time of entering into such a transaction. If the counterparty to
the swap transaction defaults, the Funds will be limited to contractual
remedies pursuant to the agreements governing the transaction. There is no
assurance that interest-rate swap contract counterparties will be able to meet
their obligations under the swap contracts or that, in the event of default,
the Funds will succeed in pursuing contractual remedies. The Funds may thus
assume the risk that payments owed the Funds under a swap contract will be
delayed, or not received at all. Should interest rates move unexpectedly, the
Funds may not achieve the anticipated benefits of the interest-rate swaps, and
may realize a loss. The Funds recognize gains and losses under interest-rate
swap contracts as realized gains or losses on investments upon sale of the swap
contracts.
As of March 31, 1999, the Short Fund had two open interest-rate swap contracts.
In each of the contracts, the Short Fund has agreed to pay a fixed rate and
receive a floating rate. The Short Fund's interest-rate swap contracts have
been entered into on a net basis, i.e., the two payment streams are netted out,
with the Short Fund receiving or paying, as the case may be, only the net
amount of the two payments. The floating rate on the contracts resets quarterly
and is the three-month London Inter-Bank Offered Rate ("LIBOR"). The Short
Fund's interest payable on the interest-rate swap contracts as of March 31,
1999 was $57,776. No collateral is required under these contracts.
F. 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 Fund had one
interest-rate cap contract open at March 31, 1999.
<PAGE>
SMITH BREEDEN MUTUAL FUNDS
- --------------------------------------------------------------------------------
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
2. FINANCIAL INSTRUMENTS -- CONTINUED
G. OPTIONS ON INTEREST-RATE SWAP CONTRACTS: The Funds may enter into
over-the-counter transactions swapping interest rates, or purchase options to
enter into such contracts. Purchased options on interest-rate swap contracts
("swaptions") give the right, but not the obligation, to enter into a swap
contract with the counterparty which has written the option on a date, at an
interest rate, and with a notional amount as specified in the swaption
agreement.
As of March 31, 1999, the U.S. Equity Fund had two open swaptions. In each of
the contracts, the Fund has paid a sum of money, called a premium, to the
counterparty, in return for the swaptions. These swaptions may be exercised by
entering into a swap contract with the counterparty only on the date specified
in each contract. If the swaptions are exercised, the Fund will enter into a
swap either to pay a specified fixed interest rate in return for receiving a
floating rate, or receive a fixed rate in return for paying a floating rate,
based on the respective contracts, or both. The floating rate on the swap
contracts as specified in the swaption agreements resets quarterly and is the
three-month London Inter-Bank Offered Rate ("LIBOR"). If the counterparty to
the swaption transaction defaults, the Fund will be limited to contractual
remedies pursuant to the agreements governing the transaction. There is no
assurance that the interest rate swap or swaption contract counterparty will be
able to meet its obligation under the contracts, or that, in the event of
default, the Fund will succeed in pursuing contractual remedies. The Fund thus
assumes the risk that it may be delayed in, or prevented from, receiving
payments owed to it under the swaption, or swap contracts should the swaptions
be exercised. Should interest rates move unexpectedly, the Fund may not achieve
the anticipated benefits of the swaptions, and may realize a loss. The Fund
recognizes gains and losses under swaptions as realized gains or losses on
investments upon sale or expiration of the contracts.
3. INVESTMENT ADVISORY FEES AND OTHER TRANSACTIONS WITH AFFILIATES
Smith Breeden Associates, Inc. (the "Advisor"), a registered Investment
Advisor, provides the Funds with investment management services. As
compensation for these services, the Funds pay the Advisor a fee computed daily
and payable monthly at a fixed annual rate based on the Funds' average daily
net assets.
The Advisor has voluntarily agreed to reimburse normal business expenses of the
Funds through August 1, 1999 so that total direct and indirect operating
expenses do not exceed the percentages listed below of each fund's average net
assets. This voluntary agreement may be terminated or modified at any time by
the Advisor in its sole discretion except that the Advisor has agreed to limit
expenses to these levels until August 1, 1999. The table below lists the fees
received by the Advisor and the expenses reimbursed by the Advisor to each Fund
during the year ending March 31, 1999.
<TABLE>
<CAPTION>
NET EXPENSE FEES RECEIVED EXPENSES REIMBURSED
FUND RATIO BY ADVISOR BY ADVISOR
- ------------------------------- ------------- --------------- --------------------
<S> <C> <C> <C>
Short Fund .............. 0.78% $ 508,343 $ 155,616
Intermediate Fund ....... 0.88% 355,620 83,434
U.S. Equity Fund ........ 0.88% 1,090,372 251,051
Financial Services Fund . 1.48% 107,863 117,431
High Yield Bond Fund .... 0.98% 6,058 50,547
</TABLE>
The Funds have adopted a Distribution and Services Plan (the "Plan") under Rule
12b-1 under the Investment Company Act of 1940. The purpose of the Plan is to
permit the Advisor 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 Funds, reducing redemptions, or
otherwise maintaining or improving services provided to shareholders by such
dealers or other persons. The Plan provides for payments by the Advisor, which
may come out of the advisory fee, to dealers and other persons at the annual
rate of up to 0.25% of each Fund's average net assets, 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 Advisor shall determine the amount of such payments
and the purposes for which they are made.
<PAGE>
SMITH BREEDEN MUTUAL FUNDS
- --------------------------------------------------------------------------------
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
3. INVESTMENT ADVISORY FEES AND OTHER TRANSACTIONS WITH AFFILIATES -- CONTINUED
Certain officers and trustees of the Fund are also officers and directors of
the Advisor.
4. INVESTMENT TRANSACTIONS
During the year ended March 31, 1999 purchases and proceeds from sales of
securities, other than short-term investments, aggregated:
<TABLE>
<CAPTION>
PURCHASES OF PROCEEDS FROM
FUND SECURITIES SALES OF SECURITIES
- ------------------------------- ---------------- --------------------
<S> <C> <C>
Short Fund .................. $ 257,690,659 $ 254,290,486
Intermediate Fund ........... 259,809,711 229,277,078
U.S. Equity Fund ............ 875,819,709 790,168,109
Financial Services Fund ..... 11,055,264 8,877,443
High Yield Bond Fund ........ 2,398,197 213,563
</TABLE>
The cost of securities held for Federal tax purposes, and the net unrealized
appreciation (depreciation) of investments, short sales and futures contracts
is as follows:
<TABLE>
<CAPTION>
COST OF SECURITIES NET UNREALIZED
FOR FEDERAL TAX GROSS UNREALIZED GROSS UNREALIZED APPRECIATION
FUND PURPOSES APPRECIATION DEPRECIATION (DEPRECIATION)
- ------------------------------ -------------------- ------------------ ------------------ -----------------
<S> <C> <C> <C> <C>
Short Fund .................. $ 93,524,013 $ 1,102,601 ($ 3,534,330) ($ 2,431,729)
Intermediate Fund ........... 66,373,425 213,025 (360,020) (146,995)
U.S. Equity Fund ............ 246,631,334 2,443,797 (1,376,620) 1,067,177
Financial Services Fund ..... 8,654,885 503,012 (462,793) 40,219
High Yield Bond Fund ........ 2,195,739 46,929 (121,573) (74,644)
</TABLE>
5. CREDIT FACILITY
The High Yield Bond Fund and the Financial Services Funds have available
unsecured lines of credit from Bank of New York, the Funds' custodian. Total
borrowing allowed under the lines of credit is limited to the lesser of:
a) The amount of the line of credit;
b) 33 1/3% of the amount by which each Fund's total assets exceed each Fund's
total liabilities at the time a borrowing request is made;
c) The maximum amount the Funds are permitted to borrow under the Investment
Company Act of 1940, as amended; or
d) The maximum amount the Bank of New York is permitted to loan to the Funds
under regulations promulgated by the Board of Governors of the Federal Reserve
System.
The Financial Services Fund pays a fee of 0.15% per annum, and the High Yield
Fund pays a fee of 0.25% per annum on the total line of credit, whether used or
unused. In addition, the Financial Services Fund pays interest at a rate per
annum equal to the overnight Federal Funds Rate plus 1%, and the High Yield
Fund pays interest at a rate per annum equal to the overnight Federal Funds
Rate plus 1 1/4%, on amounts borrowed under the lines of credit. The total
amount of the line of credit is $2,500,000 for the Financial Services Fund and
$1,000,000 for the High Yield Bond Fund. As of March 31, 1999, the Financial
Services Fund had borrowed $2,125,000 and the High Yield Bond Fund had borrowed
$60,000 under the Funds' respective lines of credit.
