SMITH BREEDEN TRUST, N-30D, 1999-05-28

SMITH BREEDEN TRUST
N-30D, 1999-05-28

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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 U.S. EQUITY MARKET PLUS FUND
- --------------------------------------------------------------------------------
PERFORMANCE REVIEW

The Smith Breeden U.S. Equity Market Plus Fund returned 17.17% in the year
ending March 31, 1999. The S&P 500 Index return was 18.49%, and the average
Growth and Income Fund, as tracked by Morningstar, returned 7.42%, over the
same period.

[GRAPHIC APPEARS HERE WITH THE FOLLOWING PLOT POINTS:]

CHANGE IN VALUE OF A $10,000 INVESTMENT

<TABLE>
<CAPTION>
12/22/97 12/31/97 03/31/98 06/30/98 09/30/98 12/31/98 03/31/99
-------- -------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Smith Breeden Financial Services Fund(1) 10,000 10,100 11,178 11,149 8,135 9,614 9,972
Morningstar Avg. Financial Services Fund 10,000 10,201 11,247 11,421 9,207 10,783 11,067
S&P 500 10,000 10,181 11,601 11,984 10,794 13,093 13,746

- ------------
(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 (6/30/92) $10,000 INVESTMENT
----------- ----------- ----------------- -------------------
<S> <C> <C> <C> <C>
Smith Breeden U.S. Equity Market Plus Fund 17.17% 26.30% 21.99% $38,263
S&P 500 ................................... 18.49% 26.26% 21.30% 36,808
Morningstar Avg. Growth and Income Fund ... 7.42% 20.31% 17.34% 29,432
</TABLE>

The U.S. Equity Fund is comprised of two segments. The equity segment
purchases S&P 500 futures contracts with a total value approximately equal to
Fund net assets. S&P 500 futures contracts have a price at expiration equal to
the value of the S&P Index at that time. Prior to expiration, S&P 500 index
futures are usually priced at the value of the S&P Index at such time, plus a
spread representing the funding cost paid by buyers of futures to sellers of
futures. The income segment invests in mortgage securities, and then reduces
the interest-rate and prepayment risk to a low level using interest-rate
futures and options. The income segment of the fund aims to exceed the funding
cost of the S&P 500 futures plus the Fund's operating expenses.

In the year ending March 31, 1999 the fixed income segment underperformed
the implied funding cost of the S&P 500 futures contracts by about 1.3% after
expenses. This was primarily due to the period from August to October 1998,
when the international financial crisis caused much turmoil in bond and equity
markets. The Fund benefited in the first quarter of 1999 from lower interest
rate volatility and reduced prepayment expectations, which caused mortgage
securities to outperform comparable Treasury securities, and in this period,
despite slowly rising interest rates, the fund outperformed the S&P 500 by
0.5%.

<PAGE>

SMITH BREEDEN U.S. EQUITY MARKET PLUS FUND
- --------------------------------------------------------------------------------
SCHEDULE OF INVESTMENTS MARCH 31, 1999

<TABLE>
<CAPTION>
MARKET
FACE AMOUNT SECURITY VALUE
- -------------- ---------------------------------------------------------------------------------- --------------
<S> <C> <C>
U.S. GOVERNMENT & AGENCY OBLIGATIONS -- 124.0%
FREDDIE MAC -- 56.5% (1)
Fixed-Rate
$ 19,965,620 Gold 6.00%, due 1/1/29 ........................................................... $ 19,419,931
19,000,000 Gold 6.00% 15 Year, due date to be announced ..................................... 18,873,086
63,900,000 Gold 6.50% 30 Year, due date to be announced ..................................... 63,533,074
38,386 9.50%, due 7/1/02 ................................................................ 39,331
Discount Notes
100,000 4.79%, due 5/7/99 (2),(3) ........................................................ 99,526
600,000 4.79%, due 5/20/99 (2),(3) ....................................................... 596,129
1,700,000 4.80%, due 5/26/99 (2),(3) ....................................................... 1,687,663
600,000 4.98%, due 4/19/99 (2),(3) ....................................................... 598,536
------------
104,847,276
------------
FANNIE MAE -- 43.2% (1)
Fixed-Rate
55,000,000 6.00%, due 5/1/28 to 3/1/29 ...................................................... 53,454,635
9,700,000 6.50% 30 Year, due date to be announced .......................................... 9,651,500
14,876,563 7.00%, due 8/1/11 to 11/1/28 ..................................................... 15,154,877
1,250,000 7.00% 30 Year, due date to be announced .......................................... 1,267,383
64,994 12.50%, due 9/1/12 ............................................................... 73,588
Adjustable-Rate
325,363 7.277%, due 9/1/18 ............................................................... 334,330
Discount Notes
200,000 4.81%, due 7/2/99 (2),(3) ........................................................ 197,507
100,000 5.00%, due 10/29/99 (2),(3) ...................................................... 97,193
------------
80,231,013
------------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION -- 20.0% (1)
Fixed-Rate
4,820,668 7.00%, due 3/15/28 ............................................................... 4,897,596
Adjustable-Rate
24,504,314 5.00%, due 1/20/28 to 3/20/28 .................................................... 24,818,325
4,471,040 5.50%, due 3/20/28 ............................................................... 4,532,999
137,378 6.625%, due 9/20/21 to 9/20/22 ................................................... 140,230
2,621,396 6.875%, due 2/20/16 to 5/20/22 ................................................... 2,670,393
------------
37,059,543
------------
U.S. TREASURY OBLIGATIONS -- 4.3%
1,700,000 5.875% Note, due 7/31/99(3) ...................................................... 1,706,906
6,250,000 6.375% Note, due 5/15/99(3) ...................................................... 6,262,695
------------
7,969,601
------------
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(COST $230,560,698)............................................................... 230,107,433
------------
CONTRACTS OPTIONS CONTRACTS -- 0.2%
- ------------
142 Call on Ten-Year US Treasury Note Futures, expires 8/99, strike price $118........ 51,031
40 Call on Thirty-Year US Treasury Bond Futures, expires 5/99, strike price $136..... 625
150 Call on Thirty-Year US Treasury Bond Futures, expires 5/99, strike price $142..... 2,344
415 Put on Thirty-Year US Treasury Bond Futures, expires 8/99, strike price $114...... 272,344
------------
TOTAL OPTIONS CONTRACTS (COST $1,356,144)......................................... 326,344
------------
</TABLE>

<PAGE>

SMITH BREEDEN U.S. EQUITY MARKET PLUS FUND
- --------------------------------------------------------------------------------
SCHEDULE OF INVESTMENTS (CONTINUED) MARCH 31, 1999

<TABLE>
<CAPTION>
MARKET
FACE AMOUNT SECURITY VALUE
- ---------------- ------------------------------------------------------------------------------- ----------------
<S> <C> <C>
OPTION CONTRACTS ON THREE-MONTH LIBOR INTEREST-RATE SWAP
AGREEMENTS -- 0.6%
$ 30,000,000 Option to enter a pay-fixed 6.5% interest-rate swap with Deutsche Bank AG
beginning 9/29/03 and expiring 9/29/08 ........................................ $ 762,697
30,000,000 Option to enter a receive-fixed 5.25% interest-rate swap with Deutsche Bank
AG beginning 9/29/03 and expiring 9/29/08 ..................................... 361,239
-------------
TOTAL OPTION CONTRACTS ON THREE-MONTH LIBOR INTEREST-RATE
SWAP AGREEMENTS (COST $1,356,144).............................................. 1,123,936
COMMERCIAL MORTGAGE-BACKED SECURITIES -- 7.8% (1)
5,000,000 First Union-Lehman Brothers-Bank of America Commercial Mortage Trust
6.56%, due 11/18/08 ........................................................... 5,063,332
5,500,000 GMAC Commercial Mortgage Securities 6.42%, due 8/15/08 ........................ 5,518,850
4,000,000 Nomura Asset Securities Corporation Commercial Mortgage Trust 6.59%,
due 3/17/28 ................................................................... 4,014,298
-------------
TOTAL COMMERCIAL MORTGAGE-BACKED SECURITIES
(COST $14,714,492)............................................................. 14,596,480
-------------
TOTAL INVESTMENTS (COST $246,631,334)--132.6%.................................. 246,154,193
-------------
REPURCHASE AGREEMENTS -- 17.0%
27,500,000 Morgan Stanley Dean Witter, 4.83%, due 04/01/99 dated 03/25/99 ................ 27,500,000
4,000,000 Morgan Stanley Dean Witter, 4.88%, due 04/05/99 dated 03/29/99 ................ 4,000,000
-------------
31,500,000
-------------
FORWARD SALES -- (28.8%)
(55,000,000) Fannie Mae 6.00%, due date to be announced (4) ................................ (53,440,234)
-------------
(53,440,234)
-------------
LIABILITIES LESS CASH AND OTHER ASSETS -- (20.8%) ............................. (38,629,838)
-------------
NET ASSETS -- 100.00% ......................................................... $ 185,584,121
=============
</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) 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 U.S. EQUITY MARKET PLUS FUND
- --------------------------------------------------------------------------------
STATEMENT OF ASSETS AND LIABILITIES MARCH 31, 1999

<TABLE>
<S> <C>
ASSETS
Investments at market value (identified cost $246,631,334) (Note 1)...................... $ 246,154,193
Cash .................................................................................... 2,687,349
Repurchase agreements (Cost $31,500,000) (Note 1)........................................ 31,500,000
Receivables:
Subscriptions ......................................................................... 434,172
Interest and maturities ............................................................... 1,166,636
Securities sold ....................................................................... 117,419,101
-------------
TOTAL ASSETS .......................................................................... 399,361,451
-------------
LIABILITIES
Short sales at market value (proceeds $53,401,563)....................................... 53,440,234
Payables:
Variation margin on futures contracts (Note 2) ........................................ 2,905,661
Redemptions ........................................................................... 267,137
Securities purchased .................................................................. 156,924,382
Due to Advisor (Note 3) ................................................................. 112,703
Accrued expenses ........................................................................ 127,213
-------------
TOTAL LIABILITIES ..................................................................... 213,777,330
-------------
NET ASSETS
(Applicable to outstanding shares of 11,058,974; unlimited number of shares of beneficial
interest authorized; no stated par) ................................................... $ 185,584,121
=============
Net asset value, offering price and redemption price per share ($185,584,121 /
11,058,974)............................................................................. $ 16.78
SOURCE OF NET ASSETS
Paid in capital ......................................................................... $ 168,177,438
Undistributed net investment income ..................................................... 1,113,690
Accumulated net realized gain on investments and futures contracts ...................... 15,225,816
Net unrealized depreciation of investments .............................................. (515,812)
Net unrealized appreciation of futures contracts ........................................ 1,582,989
-------------
NET ASSETS ............................................................................ $ 185,584,121
=============
</TABLE>

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

SMITH BREEDEN U.S. EQUITY MARKET PLUS 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 ($10,148)
(Note 1) .............................................................................. $ 8,548,332
EXPENSES
Advisory fees (Note 3) .................................................................. 1,090,372
Accounting and pricing services fees .................................................... 61,513
Custodian fees........................................................................... 46,928
Audit and tax preparation fees .......................................................... 49,057
Legal fees .............................................................................. 49,383
Transfer agent fees ..................................................................... 156,367
Registration fees ....................................................................... 47,991
Trustees fees and expenses .............................................................. 99,339
Insurance expense ....................................................................... 11,698
Other ................................................................................... 9,157
------------
TOTAL EXPENSES BEFORE REIMBURSEMENT ................................................... 1,621,805
Expenses reimbursed by Advisor (Note 3) ............................................... (251,051)
------------
NET EXPENSES .......................................................................... 1,370,754
------------
NET INVESTMENT INCOME ................................................................. 7,177,578
------------
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS
Net realized gain on investments ........................................................ 24,541,887
Change in unrealized depreciation of investments and futures contracts .................. (8,018,115)
------------
Net realized and unrealized gain on investments and futures contracts ................... 16,523,772
------------
Net increase in net assets resulting from operations .................................... $ 23,701,350
============
</TABLE>

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

SMITH BREEDEN U.S. EQUITY MARKET PLUS 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 .................................................... $ 7,177,578 $ 2,908,437
Net realized gain on investments ......................................... 24,541,887 9,514,596
Change in unrealized appreciation (depreciation) of investments .......... (8,018,115) 9,573,592
------------- -------------
Net increase in net assets resulting from operations ..................... 23,701,350 21,996,625
------------- -------------
DISTRIBUTIONS TO SHAREHOLDERS
Dividends from net investment income ..................................... (6,376,285) (2,632,273)
Distributions from net realized gains on investments ..................... (17,138,874) (2,556,880)
------------- -------------
Total distributions ...................................................... (23,515,159) (5,189,153)
------------- -------------
CAPITAL SHARE TRANSACTIONS
Shares sold .............................................................. 114,008,937 123,373,056
Shares issued on reinvestment of distributions ........................... 22,832,882 4,918,950
Shares redeemed .......................................................... (88,111,328) (21,939,416)
------------- -------------
Increase in net assets resulting from capital share transactions (a) ..... 48,730,491 106,352,590
------------- -------------
TOTAL INCREASE IN NET ASSETS ........................................... 48,916,682 123,160,062
NET ASSETS
Beginning of period ...................................................... 136,667,439 13,507,377
------------- -------------
End of period ............................................................ $ 185,584,121 $ 136,667,439
============= =============
(a) Transactions in capital shares were as follows:
Shares sold .............................................................. 7,288,068 8,130,007
Shares issued on reinvestment of distributions ........................... 1,546,502 330,714
Shares redeemed .......................................................... (5,883,230) (1,428,596)
------------- -------------
Net increase ............................................................. 2,951,340 7,032,125
Beginning balance ........................................................ 8,107,634 1,075,509
------------- -------------
Ending balance ........................................................... 11,058,974 8,107,634
============= =============
</TABLE>

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

SMITH BREEDEN U.S. EQUITY MARKET PLUS FUND
- --------------------------------------------------------------------------------
FINANCIAL HIGHLIGHTS

The following average per share data, ratios and supplemental information
has 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 ............................ $ 16.86 $ 12.56 $ 12.27 $ 10.84 $ 9.88
----------- ----------- ---------- --------- ---------
INCOME FROM INVESTMENT
OPERATIONS
Net investment income ............. 0.686 0.591 0.592 0.615 0.568
Net realized and unrealized
gain (loss) on investments ...... 1.765 4.940 1.813 2.768 1.081
------------ ------------ ----------- ---------- ----------
Total from investment
operations ...................... 2.451 5.531 2.405 3.383 1.649
------------ ------------ ----------- ---------- ----------
LESS DISTRIBUTIONS
Dividends from net investment
income .......................... ( 0.624) ( 0.586) ( 0.590) ( 0.583) ( 0.568)
Dividends in excess of net
investment income ............... -- -- -- -- ( 0.001)
Distributions from net realized
gains on investments ............ ( 1.905) ( 0.645) ( 1.525) ( 1.370) ( 0.047)
Distributions in excess of net
realized gains on
investments ..................... -- -- -- -- ( 0.073)
------------ ------------ ----------- ---------- ----------
Total distributions ............... ( 2.529) ( 1.231) ( 2.115) ( 1.953) ( 0.689)
------------ ------------ ----------- ---------- ----------
NET ASSET VALUE, END OF
PERIOD ............................ $ 16.78 $ 16.86 $ 12.56 $ 12.27 $ 10.84
------------ ------------ ----------- ---------- ----------
TOTAL RETURN ....................... 17.17% 45.71% 21.41% 32.30% 17.18%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of period ......... $185,584,121 $136,667,439 $13,507,377 $4,766,534 $2,107,346
Ratio of net expenses to
average net assets .............. 0.88% 0.88% 0.88% 0.90% 0.90%
Ratio of net investment
income to average net
assets .......................... 4.62% 4.79% 5.30% 5.53% 7.44%
Portfolio turnover rate ........... 527% 424% 182% 107% 120%
Ratio of expenses to average
net assets before
reimbursement of expenses
by the Advisor .................. 1.04% 1.23% 2.60% 4.58% 7.75%
Ratio of net investment
income to average net
assets before
reimbursement of expenses
by the Advisor .................. 4.45% 4.44% 3.58% 1.85% 0.59%
</TABLE>

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------

The Board of Trustees and Shareholders,
Smith Breeden U.S. Equity Market Plus Fund of the Smith Breeden Trust:

We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of the Smith Breeden U.S. Equity Market
Plus Fund (formerly "Smith Breeden Equity Market Plus" Fund) of the Smith
Breeden Trust (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 U.S. Equity Market Plus Fund of the Smith
Breeden Trust 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 FINANCIAL SERVICES FUND
- --------------------------------------------------------------------------------
PERFORMANCE REVIEW

Financial services funds significantly lagged the Standard and Poor's 500
stock index in performance in the year ended March 31, 1999, as Morningstar's
average financial services fund index returned -1.6%, while the S&P 500
returned +18.5%. The Smith Breeden Financial Services Fund lagged both of these
averages with a return of -10.8%. The graph below shows these results for the
year.

[GRAPHIC APPEARS HERE WITH THE FOLLOWING PLOT POINTS:]

CHANGE IN VALUE OF A $10,000 INVESTMENT

<TABLE>
<CAPTION>
10/15/98 10/31/98 11/30/98 12/31/98 01/31/99 02/26/99 03/31/99
-------- -------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Smith Breeden High Yield Bond Fund 10,000 10,057 10,218 10,133 10,143 10,029 10,039
Merrill Lynch High Yield 175 Index 10,000 10,319 10,855 10,802 11,014 10,903 11,012
Morningstar Avg. High Yield Bond Fund 10,000 10,234 10,785 10,746 10,903 10,875 11,036

- ------------
(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 (12/22/97) $10,000 INVESTMENT
------------ ----------------- -------------------
<S> <C> <C> <C>
Smith Breeden Financial Services Fund ........ -10.79% -0.22% $ 9,972
S&P 500 ...................................... 18.49% 28.44% 13,746
Morningstar Avg. Financial Services Fund ..... -1.60% 8.30% 11,067
</TABLE>

Our fund lagged the average financial services fund for two reasons: (1)
leverage and (2) overweighting of small capitalization (less than $200 million)
banks and thrifts, as well as some mid-sized takeover candidates. We will
discuss each of these factors in turn and then comment on the global
environment that caused the entire financial sector to lag the S&P 500 in
performance.

First, our fund employs some leverage, which averaged $1.19 of assets
purchased per $1.00 invested in the fund. As noted, the average financial
services fund lagged the S&P 500 by -20.1%, which means that 19% leverage in a
typical financial services portfolio resulted in incremental negative
performance of 0.19 times -20.1% = -3.8%. Leverage is a two-edged sword: when
financial services stocks underperform the S&P, leverage will hurt performance,
whereas it helps performance when financial services stocks outperform the S&P.
As we believe that financial services stocks are quite reasonably valued
relative to the S&P 500, we expect to continue to use leverage for some time.
The maximum leverage permitted in the fund is $1.50 assets per $1.00 NAV;
however, the maximum leverage used to date has been approximately $1.33 per
$1.00.

The second major reason the fund underperformed last year was its
overweighting of very small bank and thrift stocks, as well as some mid-sized
takeover candidates. We estimate that our overweighting in these stocks caused
the other 5.4% of our underperformance relative to financial sector funds. In
general, takeover premiums declined during the year. As many small bank and
thrift stocks are viewed as takeover candidates, this hurt their

<PAGE>

SMITH BREEDEN FINANCIAL SERVICES FUND
- --------------------------------------------------------------------------------
PERFORMANCE REVIEW (CONT.)

stock performance, as well as the performance of mid-sized bank takeover
candidates. One reason given by some analysts for this decline in potential
takeover stocks' prices is the lower likelihood of takeovers as the end of the
millenium nears, i.e., the "Year 2000" (Y2K) issue. As takeover premiums have
been reduced during this past year, the fund has increased its weighting in
stocks that are believed to have a greater than normal chance of takeovers. Our
view is that the takeover premiums are now small enough that these institutions
offer excellent values even if they are not taken over.

The financial sector lagged the entire stock market in the past year due
to increasing global economic turmoil. This began in Asia and quickly moved to
other global markets, including Eastern Europe and South America. Global
problems generally affect the quality of loans, as well as earnings growth at
financial companies. Additionally, there are concerns of "systemic risk" in
financial stocks, as the problems of a major international financial
institution could affect its dealings with other banks and thrifts, which may
not have any direct global exposure.

Market volatility and uncertainty reached a peak in late summer and early
fall of 1998 following the Russian bond default and currency devaluation. In
response to increased market volatility, the U.S. Federal Reserve reduced
short-term interest rates three times. The financial markets reacted positively
to these Fed moves, as financial stocks recovered much of their September 1998
quarter losses in the December 1998 quarter, but still ended the year well
behind the S&P 500.

In early 1999, the global financial markets have stabilized and the
environment appears to be better for financial sector stocks. Some markets in
Asia appear to have stabilized and have begun to grow again. However, Y2K
concerns periodically worry investors in financial sector equities, and these
concerns probably will not be totally allayed until the year 2000 is entered
and the problems are known and resolved. Aside from those concerns,
profitability of financial services firms is nearly the highest it has ever
been in the 20th century.

In summary, we are dismayed by the poor performance of our fund in the
past year. However, we continue to believe that our fund holds a portfolio of
excellent investments, which will provide a fine risk/reward combination in
coming years.

<PAGE>

SMITH BREEDEN FINANCIAL SERVICES FUND
- --------------------------------------------------------------------------------
SCHEDULE OF INVESTMENTS MARCH 31, 1999

<TABLE>
<CAPTION>
MARKET
SHARES SECURITY VALUE
- -------- ------------------------------------------------------------ ---------------
<S> <C> <C>
EQUITY HOLDINGS -- 127.9%
COMMERCIAL BANKING -- 54.7%
12,000 Bank One Corp. ............................................. $ 660,750
9,000 First Union Corp. .......................................... 480,938
13,000 KeyCorp .................................................... 394,062
9,000 Mercantile Bancorporation Inc. ............................. 427,500
18,000 Pacific Century Financial Corp. ............................ 375,750
11,000 PNC Bank Corp. ............................................. 611,188
12,000 U.S. Bancorp ............................................... 408,750
11,000 Wells Fargo Company ........................................ 385,687
------------
3,744,625
------------
INVESTMENT BANKING AND BROKERAGE -- 4.4%
5,000 Lehman Brothers, Inc. ...................................... 298,750
------------
298,750
------------
MONEY CENTER BANKING -- 19.3%
6,000 BankAmerica Corp. .......................................... 423,750
7,000 BankBoston Corporation ..................................... 303,188
5,000 Chase Manhattan Corp. ...................................... 406,562
1,000 Citigroup .................................................. 63,875
1,000 J.P. Morgan & Co. .......................................... 123,375
------------
1,320,750
------------
INVESTMENT MANAGEMENT AND ADVISORY -- 11.7%
10,000 Franklin Resources, Inc. ................................... 281,250
11,000 PIMCO Advisors Holdings LP (1) ............................. 345,813
5,000 Price (T. Rowe) Assoc., Inc. ............................... 171,875
------------
798,938
------------
CONSUMER FINANCE -- 5.3%
8,000 Household International, Inc. .............................. 365,000
------------
365,000
------------
SAVINGS & LOANS -- 32.5%
2,000 Community Bank Shares of Indiana, Inc. ..................... 32,750
1,000 First Oak Brook Bancshares, Inc. -- Class A ................ 17,438
22,000 First Security Corporation ................................. 424,874
14,500 Home Federal Bancorp ....................................... 319,906
18,500 Indiana United Bancorp ..................................... 388,500
11,000 Marion Capital Holdings, Inc. .............................. 242,000
26,700 Piedmont Bancorp, Inc. ..................................... 226,950
14,000 Washington Mutual, Inc. .................................... 572,250
------------
2,224,668
------------
TOTAL EQUITY HOLDINGS (COST $8,654,885)..................... 8,752,731
------------
LIABILITIES LESS CASH AND OTHER ASSETS -- (27.9%) .......... (1,910,317)
------------
NET ASSETS -- 100.0% ....................................... $ 6,842,414
============
</TABLE>

- ---------
(1) Limited partnership units

<PAGE>

SMITH BREEDEN FINANCIAL SERVICES FUND
- --------------------------------------------------------------------------------
STATEMENT OF ASSETS AND LIABILITIES MARCH 31, 1999

<TABLE>
<S> <C>
ASSETS
Investments at market value (identified cost $8,654,885) (Note 1)..................... $ 8,752,731
Cash ................................................................................. 59,057
Receivables:
Variation margin on futures contracts (Note 2) ..................................... 152,600
Dividends .......................................................................... 22,949
Due from Advisor (Note 3) .......................................................... 16,871
Other assets ......................................................................... 4,611
-----------
TOTAL ASSETS ....................................................................... 9,008,819
-----------
LIABILITIES
Bank loan (Note 5) ................................................................... 2,125,000
Payables:
Redemption ......................................................................... 12
Interest and loan fees ............................................................. 29,036
Accrued expenses ..................................................................... 12,357
-----------
TOTAL LIABILITIES .................................................................. 2,166,405
-----------
NET ASSETS
(Applicable to outstanding shares of 768,736; unlimited number of shares of beneficial
interest authorized; no stated par) ................................................ $ 6,842,414
===========
Net asset value, offering price and redemption price per share ($6,842,414 / 768,736). $ 8.90
===========
SOURCE OF NET ASSETS
Paid in capital ...................................................................... $ 7,048,508
Undistributed net investment income .................................................. 2,066
Accumulated net realized loss on investments and futures contracts ................... (248,379)
Net unrealized appreciation of investments ........................................... 97,846
Net unrealized depreciation of futures contracts ..................................... (57,627)
-----------
NET ASSETS ......................................................................... $ 6,842,414
===========
</TABLE>

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

SMITH BREEDEN FINANCIAL SERVICES FUND
- --------------------------------------------------------------------------------
STATEMENT OF OPERATIONS

FOR THE YEAR ENDED MARCH 31, 1999

<TABLE>
<S> <C>
INVESTMENT INCOME
Dividends and interest earned net of interest expense ($87,491) (Note 1).... $ 112,276
EXPENSES
Advisory fees (Note 3) ..................................................... 107,863
Accounting and pricing services fees ....................................... 25,878
Custodian fees.............................................................. 8,440
Audit and tax preparation fees ............................................. 2,136
Legal fees ................................................................. 11,336
Transfer agent fees ........................................................ 25,270
Registration fees .......................................................... 31,236
Trustees fees and expenses ................................................. 4,701
Insurance expense .......................................................... 3,228
Other ...................................................................... 4,085
----------
TOTAL EXPENSES BEFORE REIMBURSEMENT ...................................... 224,173
Expenses reimbursed by Advisor (Note 3) .................................. (117,431)
----------
NET EXPENSES ............................................................. 106,742
----------
NET INVESTMENT INCOME .................................................... 5,534
----------
REALIZED AND UNREALIZED LOSS ON INVESTMENTS .................................
Net realized loss on investments and futures contracts ..................... (248,893)
Change in unrealized depreciation of investments and futures contracts ..... (638,575)
----------
Net realized and unrealized loss on investments and futures contracts ...... (887,468)
----------
Net decrease in net assets resulting from operations ....................... $ (881,934)
==========
</TABLE>

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

SMITH BREEDEN FINANCIAL SERVICES FUND
- --------------------------------------------------------------------------------
STATEMENTS OF CHANGES IN NET ASSETS

<TABLE>
<CAPTION>
YEAR ENDED PERIOD ENDED
MARCH 31, 1999 MARCH 31, 1998 (1)
---------------- -------------------
<S> <C> <C>
OPERATIONS
Net investment income .................................................... $ 5,534 $ 12,415
Net realized gain (loss) on investments .................................. (248,893) 50,408
Net unrealized appreciation (depreciation) of investments ................ (638,575) 678,794
------------ ----------
Net increase (decrease) in net assets resulting from operations .......... (881,934) 741,617
------------ ----------
DISTRIBUTIONS TO SHAREHOLDERS
Dividends from net investment income ..................................... (15,881) --
Distributions from net realized gains on investments ..................... (49,896) --
------------ ----------
Total distributions ...................................................... (65,777) --
------------ ----------
CAPITAL SHARE TRANSACTIONS
Shares sold .............................................................. 1,911,182 6,588,508
Shares issued on reinvestment of distributions ........................... 54,326 --
Shares redeemed .......................................................... (1,492,099) (13,409)
------------ ----------
Increase in net assets resulting from capital share transactions (a) ..... 473,409 6,575,099
------------ ----------
TOTAL INCREASE (DECREASE) IN NET ASSETS ................................. (474,302) 7,316,716
NET ASSETS
Beginning of period ...................................................... 7,316,716 --
------------ ----------
End of period ............................................................ $ 6,842,414 $7,316,716
============ ==========
(a) Transactions in capital shares were as follows:
Shares sold .............................................................. 206,371 729,112
Shares issued on reinvestment of distributions ........................... 5,482 --
Shares redeemed .......................................................... (170,725) (1,504)
------------ ----------
Net increase ............................................................. 41,128 727,608
Beginning balance ........................................................ 727,608 --
------------ ----------
Ending balance ........................................................... 768,736 727,608
============ ==========
</TABLE>

- ---------
(1) Commenced operations on December 22, 1997

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

SMITH BREEDEN FINANCIAL SERVICES FUND
- --------------------------------------------------------------------------------
STATEMENT OF CASH FLOWS

FOR THE YEAR ENDED MARCH 31, 1999

<TABLE>
<S> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net decrease in net assets resulting from operations ................................ $ (881,934)
Change in net realized and unrealized loss on investments ........................... 887,468
-------------
Net investment income ............................................................. 5,534
ADJUSTMENTS TO RECONCILE NET INVESTMENT INCOME TO NET CASH PROVIDED BY
OPERATING ACTIVITIES
Increase in interest and dividends receivable ....................................... (9,796)
Limited partnership income accrual .................................................. (11,126)
Limited partnership distributions ................................................... 23,675
Decrease in other assets ............................................................ 11,813
Increase in other liabilities ....................................................... 25,351
-------------
Net cash provided by operating activities ......................................... 45,451
-------------
CASH FLOWS FROM INVESTING ACTIVITIES
Payments for futures variation ...................................................... (392,418)
Proceeds from sales of long-term investments ........................................ 8,965,506
Purchases of long-term investments .................................................. (11,055,264)
-------------
Net cash used in investing activities ............................................. (2,482,176)
-------------
CASH FLOWS FROM FINANCING ACTIVITIES
Increase in bank borrowings ......................................................... 2,125,000
Proceeds from shares tendered ....................................................... 1,856,856
Payments for shares redeemed ........................................................ (1,492,111)
Cash paid for distributions of net investment income and realized capital gains ..... (11,451)
-------------
Net cash provided by financing activities ......................................... 2,478,294
-------------
Net increase in cash .............................................................. 41,569
CASH AT BEGINNING OF YEAR ............................................................ 17,488
-------------
CASH AT END OF YEAR .................................................................. $ 59,057
-------------
NONCASH FINANCING ACTIVITIES
Market value of shares issued to stockholders through reinvestment of dividends ..... $ 54,326
-------------
SUPPLEMENTAL DISCLOSURE
Interest and loan fees paid ......................................................... $ 87,491
-------------
</TABLE>

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

SMITH BREEDEN FINANCIAL SERVICES FUND
- --------------------------------------------------------------------------------
FINANCIAL HIGHLIGHTS

The following average per share data, ratios and supplemental information
has been derived from information provided in the financial statements.

<TABLE>
<CAPTION>
YEAR ENDED PERIOD ENDED
MARCH 31, 1999 MARCH 31, 1998 (1)
---------------- -------------------
<S> <C> <C>
NET ASSET VALUE, BEGINNING OF PERIOD ......................................... $ 10.06 $ 9.00
--------- --------
INCOME FROM INVESTMENT OPERATIONS
Net investment income ....................................................... 0.006 0.017
Net realized and unrealized gain (loss) on investments ...................... ( 1.082) 1.043
---------- ---------
Total from investment operations ............................................ ( 1.076) 1.060
---------- ---------
LESS DISTRIBUTIONS
Dividends from net investment income ........................................ ( 0.020) --
Dividends in excess of net investment income ................................ -- --
Distributions from net realized gains on investments ........................ ( 0.063) --
Distributions in excess of net realized gains on investments ................ -- --
---------- ---------
Total distributions ....................................................... ( 0.083) --
---------- ---------
NET ASSET VALUE, END OF PERIOD ............................................... $ 8.90 $ 10.06
---------- ---------
TOTAL RETURN ................................................................. (10.79%) 11.78 %
RATIOS/SUPPLEMENTAL DATA
Net assets, end of period ................................................... $6,842,414 $7,316,716
Ratio of net expenses to average net assets ................................. 1.48% 1.48%*
Ratio of net investment income to average net assets ........................ 0.08% 0.79%*
Portfolio turnover rate ..................................................... 105% 85%
Ratio of expenses to average net assets before reimbursement of expenses
by the Advisor ............................................................ 3.12% 3.20%*
Ratio of net investment income to average net assets before reimbursement
of expenses by the Advisor ................................................ ( 1.56%) ( 0.92 %)*
</TABLE>

- ---------
(1) Commenced operations on December 22, 1997.

* Annualized

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------

The Board of Trustees and Shareholders,
Smith Breeden Financial Services Fund of the Smith Breeden Trust:

We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of the Smith Breeden Financial Services
Fund of the Smith Breeden Trust (the "Fund") as of March 31, 1999, and the
related statement of operations and statement of cash flows for the year then
ended, the statements of changes in net assets for each of the periods in the
two-year period then ended, and the financial highlights for each of the years
in the two-year periods 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.

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 Financial Services Fund of the Smith Breeden
Trust 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 HIGH YIELD BOND FUND
- --------------------------------------------------------------------------------
PERFORMANCE REVIEW

The Smith Breeden High Yield Bond Fund commenced operations on October 15,
1998. Through March 31, 1999, the Fund generated a total return of 0.39%. The
return of the Merrill Lynch High Yield 175 Index was 10.12% for the same
period. The graph below shows the return on the Fund compared to the Merrill
Lynch High Yield 175 Index, as well as the average High Yield Fund as measured
by Morningstar.

[GRAPHIC]

<TABLE>
<CAPTION>
TOTAL RETURN FROM 10/15/98 TO
3/31/99
--------------------------------
SINCE
INCEPTION FINAL VALUE OF
(10/15/98) $10,000 INVESTMENT
------------ -------------------
<S> <C> <C>
Smith Breeden High Yield Bond Fund ............ 0.39% $10,039
Merrill Lynch High Yield 175 Index ............ 10.12% 11,012
Morningstar Avg. High Yield Bond Fund ......... 10.36% 11,036
</TABLE>

The Fund opened on October 15, 1998 with a 100% cash weighting and with
the surprise announcement by the Federal Reserve that rates were being lowered
by 0.25%. The rate cut by the Fed sparked equities and high yield bonds to
record returns for the remainder of the year. The high yield market, where it
was difficult to sell a bond in August and September 1998 due to investor's
avoidance of risk, sprang to life quickly, reversing the trend and making it
difficult to find quality bonds for sale. The High Yield Fund, which continued
to selectively purchase securities, was fully invested in the high yield market
by the end of 1998, but missed most of the fourth quarter returns.

Returns in the first quarter of 1999 were negatively influenced by the
price movement of two of the Fund's investments: ForceEnergy and Iridium. The
remainder of the portfolio (without Iridium and ForceEnergy) performed
strongly.

<PAGE>

SMITH BREEDEN HIGH YIELD BOND FUND
- --------------------------------------------------------------------------------
PERFORMANCE REVIEW (CONT.)

ForceEnergy, an oil and gas exploration and production company, had a
planned equity cash infusion fall through in January and filed for Chapter 11
Bankruptcy reorganization in March. ForceEnergy was hurt by the prolonged
period of low oil prices. With the rise in energy prices, ForceEnergy's assets
are regaining their value and we are hopeful the company will emerge quickly
from bankruptcy protection.

Iridium, a satellite communications company, missed its revenue and
subscriber estimates in March 1999 which led to management changes at the top
of the organization. Iridium is a company in transition, changing its focus
from building and launching satellites to marketing the telecommunications
services it kicked off late last year.

Overall, we feel the high yield bond sector remains attractive. The sector
has regained a large portion of the losses associated with the August-September
1998 period, but junk bond yields continue to be offered at spreads to
comparable US Treasuries that are wide in relationship to their 1998 levels.
Spreads to US Treasuries peaked in October 1998 near 750 basis points* and as
of March 1999 were at 575 bps, still above their long term average of 500 bps
and well above their March 1998 level of 350 bps. We believe that the risk of
bond defaults is more than compensated by these higher yields. The last time
this risk was priced with yields of 750 bps above US Treasuries was in 1991,
when high yield bond defaults were over 10% annually. In 1998, high yield
defaults were 3.31%, according to Moody's. Although defaults have been
increasing, the increase has not been dramatic. Moody's trailing-twelve-month
default rate (percentage of issuers) reached 3.68% in March, the highest level
since April 1993, but well below 1990-1991 levels. We believe long term
investors are being well rewarded by the added yield spreads for taking on
these levels of default risk.
- ---------
* 100 basis points (bps) = 1%

<PAGE>

SMITH BREEDEN HIGH YIELD BOND FUND
- --------------------------------------------------------------------------------
SCHEDULE OF INVESTMENTS MARCH 31, 1999

<TABLE>
<CAPTION>
FACE MARKET
AMOUNT SECURITY VALUE
- --------- ---------------------------------------------------------------- -------------
<S> <C> <C>
CORPORATE BOND HOLDINGS -- 99.9%
MEDIA AND COMMUNICATIONS -- 37.4%
100,000 Chancellor Media 12/15/07 8.125% ............................... $ 102,250
100,000 Echostar DBS Corp. 2/1/09 9.375% (1) ........................... 104,375
100,000 Intermedia Communications 7/15/07 Step-up, 11.07% (3) .......... 76,250
100,000 Iridium LLC/CAP 7/15/05 10.875% ................................ 38,000
100,000 Level 3 Communications 5/1/08 9.125% ........................... 101,250
100,000 Pegasus Communication 12/1/06 9.75% (1) ........................ 104,000
100,000 PSINet Inc. 2/15/05 10.00% ..................................... 106,250
200,000 Qwest Communications Int. 10/15/07 Step-up, 8.02% (3) .......... 160,000
----------
792,375
----------
HOUSING -- 9.6%
100,000 American Standard Companies 2/15/10 7.625% ..................... 98,500
100,000 Kaufman & Broad 11/15/06 9.625% ................................ 105,250
----------
203,750
----------
INFORMATION TECHNOLOGY -- 9.5%
100,000 Apple Computer Inc. 2/15/04 6.50% .............................. 91,625
100,000 Unisys Corp. 4/15/03 12.00% .................................... 110,500
----------
202,125
----------
GAMING AND LEISURE -- 9.5%
100,000 HMH Properties 8/1/05 7.875% ................................... 98,250
100,000 Hollywood Park 8/1/07 9.50% .................................... 103,000
----------
201,250
----------
HEALTHCARE -- 9.4%
200,000 Tenet Healthcare Corp. 1/15/07 8.625% .......................... 201,000
----------
201,000
----------
ENERGY -- 6.6%
100,000 ForceEnergy, Inc. 11/1/06 9.50% (2) ............................ 47,500
100,000 Pogo Producing Co. 5/15/07 8.75% ............................... 92,500
----------
140,000
----------
AEROSPACE -- 4.7%
100,000 Atlas Air, Inc. 11/15/06 9.375% ................................ 100,500
----------
100,500
----------
FOOD AND DRUG -- 4.7%
100,000 Great Atlantic & Pacific 4/15/07 7.75% ......................... 99,107
----------
99,107
----------
FINANCIAL -- 4.4%
100,000 Conseco Financing 11/15/26 8.70% ............................... 92,738
----------
92,738
----------
INTERNATIONAL -- 4.1%
100,000 Asia Pulp & Paper Intl. 10/1/00 10.25% ......................... 88,250
----------
88,250
----------
TOTAL CORPORATE BOND HOLDINGS (COST $2,195,739)................. 2,121,095
----------
CASH AND OTHER ASSETS LESS LIABILITIES -- 0.1% ................. 291
----------
NET ASSETS -- 100.0% ........................................... $2,121,386
==========
</TABLE>

- ---------
(1) Security exempt from registration under Rule 144A of the Securities Act of
1933. Such securities may be resold in transactions exempt from
registration, normally to qualified insitutional buyers. In total, 144A
securities represent 9.8% of net assets.

(2) Security is in default on interest payments due to Chapter 11 bankruptcy
reorganization by the issuing company. The security in default represents
2.2% of net assets.

(3) Yield shown is the purchased yield to maturity for step-up bonds.

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

SMITH BREEDEN HIGH YIELD BOND FUND
- --------------------------------------------------------------------------------
STATEMENT OF ASSETS AND LIABILITIES MARCH 31, 1999

<TABLE>
<S> <C>
ASSETS
Investments at market value (identified cost $2,195,739) (Note 1)........................ $ 2,121,095
Cash .................................................................................... 11,780
Interest receivable ..................................................................... 49,964
Due from Advisor (Note 3) ............................................................... 12,068
Other assets ............................................................................ 91
-----------
TOTAL ASSETS .......................................................................... 2,194,998
-----------
LIABILITIES
Bank loan (Note 5) ...................................................................... 60,000
Interest and loan fees payable .......................................................... 637
Accrued expenses ........................................................................ 12,975
-----------
TOTAL LIABILITIES ..................................................................... 73,612
-----------
NET ASSETS:
(Applicable to outstanding shares of 243,392; unlimited number of shares of beneficial
interest authorized; no stated par) ..................................................... $ 2,121,386
===========
Net asset value, offering price and redemption price per share ($2,121,386 / 243,392).... $ 8.72
===========
SOURCE OF NET ASSETS
Paid in capital ......................................................................... $ 2,195,571
Accumulated net realized gain on investments ............................................ 459
Net unrealized depreciation of investments .............................................. (74,644)
-----------
NET ASSETS ............................................................................ $ 2,121,386
===========
</TABLE>

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

SMITH BREEDEN HIGH YIELD BOND FUND
- --------------------------------------------------------------------------------
STATEMENT OF OPERATIONS

FOR THE PERIOD ENDED MARCH 31, 1999 (1)

<TABLE>
<S> <C>
INVESTMENT INCOME
Interest and discount earned, net of premium amortization and interest expense ($637) $ 79,890
(Note 1) ---------
EXPENSES
Advisory fees (Note 3) .................................................................. 6,058
Accounting and pricing services fees .................................................... 13,750
Custodian fees........................................................................... 1,962
Audit and tax preparation fees .......................................................... 5,220
Legal fees .............................................................................. 1,644
Transfer agent fees ..................................................................... 9,144
Registration fees ....................................................................... 17,875
Trustees fees and expenses .............................................................. 337
Insurance expense ....................................................................... 2,400
Other ................................................................................... 639
---------
TOTAL EXPENSES BEFORE REIMBURSEMENT ................................................... 59,029
Expenses reimbursed by Advisor (Note 3) ............................................... (50,547)
---------
NET EXPENSES .......................................................................... 8,482
---------
NET INVESTMENT INCOME ................................................................. 71,408
---------
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS
Net realized gain on investments ........................................................ 459
Change in unrealized depreciation of investments ........................................ (74,644)
---------
Net realized and unrealized loss on investments ......................................... (74,185)
---------
Net decrease in net assets resulting from operations .................................... $ (2,777)
=========
</TABLE>

- ---------
(1) Commenced operations on October 15, 1998

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

SMITH BREEDEN HIGH YIELD BOND FUND
- --------------------------------------------------------------------------------
STATEMENT OF CHANGES IN NET ASSETS

<TABLE>
<CAPTION>
PERIOD ENDED
MARCH 31, 1999 (1)
-------------------
<S> <C>
OPERATIONS
Net investment income .................................................... $ 71,408
Net realized gain on investments ......................................... 459
Net unrealized depreciation of investments ............................... (74,644)
----------
Net decrease in net assets resulting from operations ..................... (2,777)
----------
DISTRIBUTIONS TO SHAREHOLDERS
Dividends from net investment income ..................................... (71,405)
----------
Total distributions ...................................................... (71,405)
----------
CAPITAL SHARE TRANSACTIONS
Shares sold .............................................................. 2,126,127
Shares issued on reinvestment of distributions ........................... 71,423
Shares redeemed .......................................................... (1,982)
----------
Increase in net assets resulting from capital share transactions (a) ..... 2,195,568
----------
TOTAL INCREASE IN NET ASSETS ........................................... 2,121,386
NET ASSETS
Beginning of period ...................................................... --
----------
End of period ............................................................ $2,121,386
==========
(a) Transactions in capital shares were as follows:
Shares sold .............................................................. 235,588
Shares issued on reinvestment of distributions ........................... 8,031
Shares redeemed .......................................................... (227)
----------
Net increase ............................................................. 243,392
Beginning balance ........................................................ --
----------
Ending balance ........................................................... 243,392
==========
</TABLE>

- ---------
(1) Commenced operations on October 15, 1998

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

SMITH BREEDEN HIGH YIELD BOND FUND
- --------------------------------------------------------------------------------
FINANCIAL HIGHLIGHTS

The following average per share data, ratios and supplemental information
has been derived from information provided in the financial statements.

<TABLE>
<CAPTION>
PERIOD ENDED
MARCH 31, 1999 (1)
-------------------
<S> <C>
NET ASSET VALUE, BEGINNING OF PERIOD ..................................................... $ 9.00
--------
INCOME FROM INVESTMENT OPERATIONS
Net investment income ................................................................... 0.318
Net realized and unrealized loss on investments ......................................... (0.280)
---------
Total from investment operations ........................................................ 0.038
---------
LESS DISTRIBUTIONS
Dividends from net investment income .................................................... (0.318)
Dividends in excess of net investment income ............................................ --
Distributions from net realized gains on investments .................................... --
Distributions in excess of net realized gains on investments ............................ --
---------
Total distributions ................................................................... (0.318)
---------
NET ASSET VALUE, END OF PERIOD ........................................................... $ 8.72
---------
TOTAL RETURN ............................................................................. 0.39 %
RATIOS/SUPPLEMENTAL DATA
Net assets, end of period ............................................................... $2,121,386
Ratio of net expenses to average net assets ............................................. 0.98%*
Ratio of net investment income to average net assets .................................... 8.30%*
Portfolio turnover rate ................................................................. 12%
Ratio of expenses to average net assets before reimbursement of expenses by the
Advisor ............................................................................... 6.86%*
Ratio of net investment income to average net assets before reimbursement of expenses
by the Advisor ........................................................................ 2.43%*
</TABLE>

- ---------
(1) Commenced operations on October 15, 1998.

* Annualized

- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.

<PAGE>

INDEPENDENT AUDITORS' REPORT
- --------------------------------------------------------------------------------

The Board of Trustees and Shareholders,
Smith Breeden High Yield Bond Fund of the Smith Breeden Trust:

We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of the Smith Breeden High Yield Bond
Fund of the Smith Breeden Trust (the "Fund") as of March 31, 1999, and the
related statement of operations, the statement of changes in net assets, and
the financial highlights for the period October 15, 1998 (commencement of
operations) to March 31, 1999. 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 audit.

We conducted our audit 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 audit provides 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
position of the Smith Breeden High Yield Bond Fund of the Smith Breeden Trust
as of March 31, 1999, the results of its operations, the changes in its net
assets, and the financial highlights for the respective stated period 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:

<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.