<PAGE>
INVESTMENT GRADE MUNICIPAL INCOME FUND INC.
COMMON STOCK
----------------
Investment Grade Municipal Income Fund Inc. ("Fund") is a diversified,
closed-end management investment company. The Fund's investment objective is
to achieve a high level of current income that is exempt from federal income
tax, consistent with the preservation of capital. To achieve this objective,
the Fund normally invests substantially all of its assets in a diversified
portfolio of long-term, tax-exempt Municipal Obligations that have been rated
investment grade or are unrated but have been determined to be of comparable
quality by the Fund's investment adviser. Municipal Obligations rated
investment grade are those that, at the time of investment, are rated within
the four highest grades by Moody's Investors Service, Inc. (Baa or higher) or
Standard & Poor's, a division of The McGraw-Hill Companies, Inc. (BBB or
higher) or have an equivalent rating from another nationally recognized
statistical rating organization. The Fund may invest up to 20% of its total
assets in Municipal Obligations that are unrated but that, at the time of
investment, have been determined by the Fund's investment adviser to be of
comparable quality to those that are rated investment grade. There is no
assurance that the Fund will achieve its investment objective. All or a
portion of the Fund's dividends may be attributable to interest income that is
an item of tax preference for purposes of the federal alternative minimum tax.
The Fund's common stock ("Common Stock") is listed and traded on the New
York Stock Exchange, Inc. ("NYSE") under the symbol "PPM." No additional
shares of Common Stock will be issued in connection with this offering. Shares
of the Common Stock may be offered pursuant to this Prospectus from time to
time in order to effect over-the-counter ("OTC") secondary market sales by
PaineWebber Incorporated ("PaineWebber") in its capacity as a dealer and
secondary market-maker at negotiated prices related to prevailing market
prices on the NYSE at the time of sale. The closing price of the Common Stock
on the NYSE on January 28, 1997 was $13.63 per share. See "Trading History."
The Fund will not receive any proceeds from the sale of any Common Stock
offered pursuant to this Prospectus.
The Fund has outstanding auction preferred shares ("APS") having a
liquidation preference of $80,000,000. The APS have resulted in financial
leverage, which involves special risks. The Fund may engage in additional
leverage through the issuance of additional preferred stock or through
borrowings. SEE "SPECIAL LEVERAGE CONSIDERATIONS" AND "DESCRIPTION OF CAPITAL
STOCK."
Mitchell Hutchins Asset Management Inc. ("Mitchell Hutchins") serves as
investment adviser and administrator of the Fund. This Prospectus concisely
sets forth certain information an investor should know before investing and
should be retained for future reference. A Statement of Additional Information
("SAI") dated January 31, 1997 has been filed with the Securities and Exchange
Commission and is incorporated by reference in its entirety into this
Prospectus. A table of contents for the SAI is set forth as the last section
of this Prospectus. A copy of the SAI can be obtained without charge by
writing to the Fund, by contacting your PaineWebber investment executive or
PaineWebber's Correspondent Firms or by calling toll-free 1-800-852-4750.
----------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES
AND EXCHANGE COMMISSION NOR HAS THE COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO
THE CONTRARY IS A CRIMINAL OFFENSE.
----------------
PAINEWEBBER INCORPORATED
----------------
The date of this Prospectus is January 31, 1997
<PAGE>
FUND EXPENSES
The following tables are intended to assist investors in understanding the
various direct or indirect costs and expenses associated with investing in the
Fund.
SHAREHOLDER TRANSACTION EXPENSES
<TABLE>
<S> <C>
Sales Load (as a percentage of offering price)................. None(1)
Dividend Reinvestment and Cash Purchase Plan Fees.............. None
ANNUAL EXPENSES (AS A PERCENTAGE OF AVERAGE NET ASSETS
ATTRIBUTABLE TO COMMON STOCK)(2)
Investment Advisory and Administration Fees (after fee waiver). 0.96%
Interest Payments on Borrowed Funds(3)......................... 0.00%
Other Expenses................................................. 0.38%
Total Annual Expenses (after fee waiver)..................... 1.34%
</TABLE>
- --------
(1) Prices for the Common Stock traded in the OTC market will reflect ordinary
dealer mark-ups.
(2) The percentages shown reflect the presentation of all expenses expected to
be incurred by the Fund as a percentage of only those average net assets
attributable to the Common Stock. If expressed as a percentage of all of
the Fund's average net assets (regardless of whether such assets are
attributable to the Common Stock or to the APS), such percentages would be
lower. Investment advisory and administration fees are payable to Mitchell
Hutchins at an annual rate of 0.90% of all of the Fund's average weekly net
assets attributable to both common and preferred shares. However, effective
June 1, 1995, Mitchell Hutchins began waiving 0.25% of its 0.90% investment
advisory and administration fees. If the fee waiver were not in effect,
Investment Advisory and Administration Fees and Total Annual Expenses (each
expressed as percentage of average net assets attributable to Common Stock)
would have been 1.33% and 1.71%, respectively. Mitchell Hutchins may
discontinue this fee waiver at any time. See "Management of the Fund" for
additional information. "Other Expenses" have been estimated based upon
expenses actually incurred for the fiscal year ended September 30, 1996.
(3) The Fund may borrow money. See "Special Leverage Considerations--
Borrowings."
EXAMPLE
An investor would directly or indirectly pay the following expenses on a
$1,000 investment in the Fund, assuming (i) a 5% annual return and (ii)
reinvestment of all dividends and other distributions at net asset value:*
<TABLE>
<CAPTION>
ONE YEAR THREE YEARS FIVE YEARS TEN YEARS
-------- ----------- ---------- ---------
<S> <C> <C> <C>
$14 $42 $72 $158
</TABLE>
- --------
* After fee waivers. If fee waivers were not in effect, the amounts that would
be paid by an investor during the one-year, three-year, five-year and ten-
year periods reflected in the table would be $17, $54, $92 and $199,
respectively.
This Example assumes that the percentage amounts listed under Annual Expenses
remain the same in the years shown (except that Annual Expenses have been
reduced to reflect the completion of organization expense amortization after
five years from the commencement of investment operations). The above tables
and the assumptions in the Example of a 5% annual return and reinvestment at
net asset value are required by regulations of the Securities and Exchange
Commission ("SEC") applicable to all closed-end investment companies; the
assumed 5% annual return is not a prediction of, and does not represent, the
projected or actual performance of the Common Stock. In addition, while the
Example assumes reinvestment of all dividends and other distributions at net
asset value, participants in the Fund's Dividend Reinvestment Plan will receive
shares of the Fund's Common Stock purchased by the Plan agent at the market
price in effect at that time, which may be at, above, or below net asset value.
THIS EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF PAST OR FUTURE
EXPENSES, AND THE FUND'S ACTUAL EXPENSES MAY BE MORE OR LESS THAN THOSE SHOWN.
2
<PAGE>
PROSPECTUS SUMMARY
The following summary is qualified in its entirety by reference to the more
detailed information included elsewhere in this Prospectus and in the Statement
of Additional Information ("SAI"). Investors should carefully consider
information set forth under the heading "Special Considerations and Risk
Factors."
The Fund.................. Investment Grade Municipal Income Fund Inc.
("Fund") is a diversified, closed-end management
investment company. See "The Fund."
The Offering.............. No additional shares of the Fund's common stock
("Common Stock") will be issued in connection with
this offering. Shares of Common Stock may be
offered pursuant to this prospectus from time to
time in order to effect over-the-counter ("OTC")
secondary market sales by PaineWebber Incorporated
("PaineWebber") in its capacity as a dealer and
secondary market-maker at negotiated prices related
to prevailing market prices on the New York Stock
Exchange, Inc. ("NYSE") at the time of sale. The
Common Stock is listed and traded on the NYSE under
the symbol "PPM." See "The Offering" and "Trading
History."
Investment Objective and The Fund's investment objective is to achieve a
Policies................. high level of current income that is exempt from
federal income tax, consistent with the
preservation of capital. To achieve this objective,
the Fund normally invests substantially all of its
assets in a diversified portfolio of long-term,
tax-exempt Municipal Obligations that have been
rated investment grade or are unrated but have been
determined to be of comparable quality by the
Fund's investment adviser, Mitchell Hutchins Asset
Management Inc. ("Mitchell Hutchins"). Municipal
Obligations rated investment grade are those that,
at the time of investment, are rated within the
four highest grades by Moody's Investors Service,
Inc. ("Moody's") (Baa or higher) or Standard &
Poor's, a division of The McGraw Hill Companies,
Inc. ("S&P"), (BBB or higher) or have an equivalent
rating from another nationally recognized
statistical rating organization. The Fund may
invest up to 20% of its total assets in Municipal
Obligations that are unrated but that, at the time
of investment, have been determined by Mitchell
Hutchins to be of comparable quality to those that
are rated investment grade. There is no assurance
that the Fund will achieve its investment
objective.
At least 80% of the Fund's net assets normally are
invested in Municipal Obligations the interest on
which is not an item of tax preference for purposes
of the federal alternative minimum tax ("AMT")
("Tax Preference Item"). The Fund may invest in
high quality, short-term, tax-exempt investments,
and with respect to up to 20% of its net assets,
taxable investments, in order to invest cash
reserves, or it may make such investments on a
temporary basis during defensive periods or when,
in the opinion of Mitchell Hutchins, no suitable
long-term Municipal Obligations are available. The
Fund may engage in when-issued and delayed delivery
transactions, enter into stand-by commitments,
purchase illiquid
3
<PAGE>
securities, invest in repurchase agreements, lend
portfolio securities and enter into certain hedging
and related income strategies. The Fund may enter
into options and futures that, at a maximum,
approximate (but that do not exceed) the full value
of its portfolio assets. Certain of these
investment practices entail additional risks and
may give rise to taxable income. Accordingly, under
normal circumstances, the Fund does not intend to
engage in such practices to a significant extent.
See "Investment Objective and Policies," "Other
Investment Practices," "Special Considerations and
Risk Factors," "Taxes" and Appendix A.
Auction Preferred Shares.. The Fund has outstanding 800 shares of Auction
Preferred Shares ("APS") Series A and 800 shares of
APS Series B, having an aggregate liquidation value
of $80,000,000. The APS has resulted in the
financial leveraging of the Common Stock. The APS
pay dividends at rates that are adjusted over
relatively short periods of time and that reflect
prevailing short-term, tax-exempt interest rates.
In accordance with the Fund's investment objective
and policies, the proceeds of the APS have been
invested in long-term Municipal Obligations, which
typically bear interest at rates that are higher
than short-term, tax-exempt interest rates. Through
this leveraging technique, the Fund seeks to obtain
a higher yield for Common Stockholders than would
be available if the APS had not been issued. The
APS have received ratings of aaa from Moody's and
AAA from S&P.
The Fund may engage in additional leverage through
the issuance of additional preferred stock or
through borrowings and reverse repurchase
agreements. There are special risks associated with
leveraging, including the possibility that changes
in the relationship of short- and long-term
interest rates might cause the yield on, and the
net asset value of, the Common Stock to be lower
than would be the case without leveraging.
See "Special Leverage Considerations" and
"Description of Capital Stock."
Investment Adviser and
Administrator............
Mitchell Hutchins, a wholly owned asset management
subsidiary of PaineWebber, serves as the Fund's
investment adviser and administrator. Mitchell
Hutchins provides investment advisory and portfolio
management services to investment companies,
pension funds and other institutional, corporate
and individual clients. As investment adviser and
administrator, Mitchell Hutchins is entitled to
receive from the Fund a fee, computed weekly and
paid monthly, in an amount equal to an annual rate
of 0.90% of the Fund's average weekly net assets.
Dividends and Other The Fund declares and pays monthly cash dividends
Distributions............ to Common Stockholders at a level rate that, on an
annual basis and after payment
4
<PAGE>
of dividends on the APS and any other preferred
stock, results in the distribution of all of the
Fund's net investment income. The dividend rate on
the Common Stock is adjusted by the Fund's board
of directors as necessary to reflect the
performance of the Fund. The Fund intends to
distribute annually to Common Stockholders
substantially all of the net capital gains
realized by the Fund to the extent that such net
capital gains are not necessary to satisfy
dividend, redemption or liquidation preferences of
the APS or any other preferred stock.
Dividends paid to Common Stockholders are exempt
from federal income tax to the extent such
dividends are properly designated by the Fund as
being derived from interest on tax-exempt
securities. A portion of such dividends may be a
Tax Preference Item. Dividends and other
distributions are subject to federal income tax to
the extent that they are derived from net realized
capital gains, income on non-tax-exempt securities
or any other taxable income of the Fund. The Fund's
dividends and other distributions also may be
subject to state and local income tax. For federal
tax purposes, the Fund is required to allocate tax-
exempt income, net realized capital gains and any
other taxable income among shares of Common Stock,
the APS and shares of any other preferred stock in
proportion to the total dividends and other
distributions paid to each class for the year in
which such tax-exempt income, net realized capital
gains or other taxable income is earned or
realized.
See "Dividends and Other Distributions; Dividend
Reinvestment Plan" and "Taxes."
Dividend Reinvestment The Fund has established a Dividend Reinvestment
Plan..................... Plan ("Plan") under which all Common Stockholders
whose shares are registered in their own names, or
in the name of PaineWebber (or its nominee), have
all dividends and other distributions on their
shares of Common Stock automatically reinvested in
additional shares of Common Stock, unless such
Common Stockholders elect to receive cash. Common
Stockholders who elect to hold their shares in the
name of a broker or nominee other than PaineWebber
(or its nominee) should contact such broker or
other nominee to determine whether, or how, they
may participate in the Plan. Shares of Common
Stock acquired under the Plan are purchased in the
open market, on the NYSE or otherwise, at prices
that may be higher or lower than the net asset
value per share of the Common Stock at the time of
the purchase. The Fund will not issue any new
shares of Common Stock in connection with the
Plan. See "Dividends and Other Distributions;
Dividend Reinvestment Plan."
Common Stock Repurchases
and Tender Offers;
Conversion to Open-End
Fund.....................
In recognition of the possibility that the Common
Stock may trade at a discount from net asset
value, the Fund's board of directors, in
consultation with Mitchell Hutchins, intends to
review at least annually the possibility of open
market repurchases of Common Stock or tender
5
<PAGE>
offers for Common Stock at net asset value. There
can be no assurance that the board of directors
will decide to undertake either of these actions
or that, if undertaken, such actions will result
in the Common Stock trading at a price equal or
close to its net asset value per share. The extent
to which the Fund may engage in Common Stock
repurchases and tender offers may be limited so
long as preferred stock is outstanding. The Fund
may borrow to finance such repurchases and tender
offers. The board of directors also will consider
from time to time the conversion of the Fund to an
open-end investment company. Any such conversion
would require redemption of the APS or any other
outstanding preferred stock, with the result that
the Fund would no longer have the benefit of the
leverage provided by preferred stock. See "Special
Leverage Considerations," "Description of Capital
Stock--Common Stock Repurchases and Tender Offers"
and "Description of Capital Stock--Conversion to
Open-End Investment Company."
Custodian, Transfer and
Dividend Disbursing
Agent and Registrar......
State Street Bank and Trust Company serves as
custodian of the Fund's assets. PNC Bank, National
Association, serves as transfer and dividend
disbursing agent and as registrar with respect to
the Common Stock. See "Custodian, Transfer and
Dividend Disbursing Agent and Registrar."
Special Considerations
and Risk Factors.........
Certain Considerations and Risks Associated with
Municipal Obligations. The yield on a Municipal
Obligation depends on a variety of factors,
including general municipal and fixed-income
security market conditions, the condition of the
issuer, the size of the particular offering, the
maturity, credit quality and rating of the issue
and expectations regarding changes in income tax
rates. The market value of Municipal Obligations,
and accordingly the Fund's net asset value,
normally varies inversely with changes in interest
rates. Municipal Obligations rated Baa by Moody's
are investment grade, but Moody's considers
Municipal Obligations rated Baa to have
speculative characteristics. Certain Municipal
Obligations held by the Fund may permit the issuer
to call or redeem the obligations, in whole or in
part, at its option. If an issuer were to redeem
Municipal Obligations held by the Fund during a
time of declining interest rates, the Fund might
realize capital gains or losses at a time that it
would not otherwise do so, and the Fund might not
be able to reinvest the proceeds of the redemption
in Municipal Obligations providing as high a level
of income as the obligations that were redeemed.
The obligations of issuers of Municipal
Obligations are subject to the provisions of
bankruptcy, insolvency and other laws affecting
the rights and remedies of creditors. Further,
federal, state and local laws may be enacted that
adversely affect the tax-exempt status of interest
on Municipal Obligations or of the exempt-interest
dividends received by the Fund's stockholders or
that impose other constraints upon the
6
<PAGE>
enforcement of such obligations. It is also
possible that, as a result of litigation or other
conditions, the power or ability of issuers to
meet their obligations for the payment of
principal of and interest on their Municipal
Obligations may be materially and adversely
affected.
Alternative Minimum Tax; State and Local Taxation.
The Fund may invest up to 20% of its net assets in
Municipal Obligations the interest on which is a
Tax Preference Item. Accordingly, stockholders who
are individuals may be required to include a
portion of the Fund's exempt interest dividends in
calculating their AMT liability. Corporations that
hold Common Stock must include the entire amount
of any exempt-interest dividends in calculating
their adjusted current earnings for purposes of
the AMT. The Fund may not be an appropriate
investment for investors who are subject to AMT
liability or who would become subject to AMT
liability by reason of an investment in the Fund.
All or a portion of the Fund's dividends also may
be subject to state and local taxation.
Market Price of Common Stock. Shares of the common
stock of closed-end investment companies
frequently trade at a discount to their net asset
value, and the Fund's Common Stock has
historically traded at a discount to its net asset
value. See "Trading History." This market risk is
separate and distinct from the risk that the
Fund's net asset value may decrease. Accordingly,
the Common Stock is designed primarily for long-
term investors and should not be viewed as a
vehicle for trading purposes.
Anti-Takeover Provisions. The Fund's Articles of
Incorporation contain provisions limiting (1) the
ability of other entities or persons to acquire
control of the Fund, (2) the Fund's freedom to
engage in certain transactions and (3) the ability
of the Fund's directors or stockholders to amend
the Articles of Incorporation. These provisions of
the Articles of Incorporation may be regarded as
"anti-takeover" provisions.
See "Investment Objective and Policies," "Special
Leverage Considerations," "Special Considerations
and Risk Factors," "Taxes" and "Description of
Capital Stock."
Special Leverage The APS have resulted in leverage, which poses
Considerations........... special risks for Common Stockholders, including
the possibility of higher volatility of both the
net asset value and the market value of the Common
Stock. Fluctuations in the dividend rates on the
APS affect the dividends on the Common Stock.
There can be no assurance that the Fund will be
able to realize a higher return on its investment
portfolio than the then current dividend rate on
any preferred stock. If the then current dividend
rate on the APS were to exceed the return on the
Fund's portfolio, the Fund's leveraged capital
structure would result in a lower yield to Common
Stockholders than if the Fund were not leveraged.
Moreover, any decline in the value of the Fund's
assets will be borne entirely by Common
Stockholders. Accordingly, the effect of leverage
in a declining market will be a greater decrease
in the net asset value
7
<PAGE>
of the Common Stock than if the Fund were not
leveraged, which may be reflected in a greater
decline in the market price of the Common Stock.
See "Special Leverage Considerations," "Taxes" and
"Description of Capital Stock."
8
<PAGE>
FINANCIAL HIGHLIGHTS
The table below provides selected per share data and ratios for one share of
Common Stock for the periods shown. This information is supplemented by the
financial statements and accompanying notes appearing in the Fund's Annual
Report to Shareholders for the fiscal year ended September 30, 1996, which are
incorporated by reference into the Fund's SAI and can be obtained by
shareholders upon request. The financial statements and notes, as well as
information in the table below have been audited by Price Waterhouse LLP,
independent accountants, whose report thereon is included in the Annual Report
to Shareholders.
<TABLE>
<CAPTION>
FOR THE YEARS ENDED FOR THE PERIOD
SEPTEMBER 30, NOVEMBER 6,
---------------------------------- 1992+ THROUGH
1996 1995 1994 SEPTEMBER 30, 1993
-------- -------- -------- ------------------
<S> <C> <C> <C> <C>
Net asset value,
beginning of period.... $ 15.73 $ 14.72 $ 17.04 $ 15.00
-------- -------- -------- --------
Net investment income... 1.21 1.18 1.17 0.94
Net realized and
unrealized gains
(losses) from
investments............ 0.35 1.03 (2.28) 2.13
-------- -------- -------- --------
Net increase (decrease)
from investment
operations............. 1.56 2.21 (1.11) 3.07
-------- -------- -------- --------
Dividends from net
investment income to:
Common stockholders.... (0.90) (0.90) (0.98) (0.73)
Common share equivalent
of dividends paid to
preferred
stockholders.......... (0.28) (0.30) (0.21) (0.14)
Distributions from net
realized gains from
investment
transactions........... -- -- (0.02) --
-------- -------- -------- --------
Total dividends and
distributions to
stockholders........... (1.18) (1.20) (1.21) (0.87)
-------- -------- -------- --------
Underwriting and
offering costs incurred
with the preferred
stock offering charged
to common stock........ -- -- -- (0.16)
-------- -------- -------- --------
Net asset value, end of
period................. $ 16.11 $ 15.73 $ 14.72 $ 17.04
======== ======== ======== ========
Per share market value,
end of period.......... $ 13.63 $ 13.00 $ 12.38 $ 15.63
======== ======== ======== ========
Total investment
return(1).............. 12.03% 12.63% (15.21)% 9.10%
======== ======== ======== ========
Ratios to average net
assets attributable to
common shares:
Total expenses, net of
waivers from adviser.. 1.34%(2) 1.69%(2) 1.70% 1.55%*
Total expenses, before
waivers from adviser.. 1.71% 1.82% 1.70% 1.55%*
Net investment income
before preferred stock
dividends............. 7.61%(2) 7.87%(2) 7.32% 6.55%*
Preferred stock
dividends............. 1.73% 2.02% 1.33% 0.95%*
Net investment income
available to common
stockholders.......... 5.88%(2) 5.85%(2) 5.99% 5.60%*
Supplemental data:
Net assets, end of
period (000's)........ $246,804 $242,906 $232,406 $256,466
Portfolio turnover
rate.................. 0% 7% 0% 6%
Asset coverage per
share of preferred
stock, end of period.. $154,252 $151,816 $145,254 $160,291
</TABLE>
(Footnotes on following page)
9
<PAGE>
(Footnotes for preceding page)
- --------
+ Commencement of operations
* Annualized
(1) Total investment return is calculated assuming a purchase of common stock
at the current market price on the first day and a sale at the current
market price on the last day of each period reported and assuming
reinvestment of dividends and other distributions to common shareholders at
prices obtained under the Fund's Dividend Reinvestment Plan. Total
investment return for periods of less than one year has not been
annualized. Total investment return does not reflect brokerage commissions.
(2) Effective June 1, 1995, Mitchell Hutchins began waiving 0.25% of its 0.90%
advisory and administration fees (expressed as a percentage of the Fund's
average weekly net assets attributable to both common and preferred
shares). If such waivers had not been made, the ratios of total expenses to
average net assets, net investment income before preferred stock dividends,
and net investment income available to Common Stockholders to net assets
attributable to Common Stock would have been 1.82%, 7.74% and 5.72%,
respectively for the fiscal year ended September 30, 1995 and 1.71%, 7.24%
and 5.51% respectively, for the fiscal year ended September 30, 1996.
The following information relates to the APS. See "Special Leverage
Considerations."
<TABLE>
<CAPTION>
INVOLUNTARY
ASSET LIQUIDATING
TOTAL AMOUNT COVERAGE PREFERENCE PER AVERAGE MARKET
SENIOR SECURITIES YEAR OUTSTANDING* PER UNIT UNIT** VALUE PER UNIT***
- ----------------- ---- ------------ -------- -------------- -----------------
<S> <C> <C> <C> <C> <C>
APS Series A...... 1996 $40,000,000 $154,252 $50,000 $ 87,234
APS Series B...... 1996 $40,000,000 $154,252 $50,000 $ 87,234
APS Series A...... 1995 $40,000,000 $151,816 $50,000 $ 82,319
APS Series B...... 1995 $40,000,000 $151,816 $50,000 $ 82,319
APS Series A...... 1994 $40,000,000 $145,254 $50,000 $ 93,257
APS Series B...... 1994 $40,000,000 $145,254 $50,000 $ 93,257
APS Series A...... 1993+ $40,000,000 $160,291 $50,000 $150,157
APS Series B...... 1993+ $40,000,000 $160,291 $50,000 $150,157
</TABLE>
- --------
+ Data reflects period from January 21, 1993 (date of issuance of APS) to
September 30, 1993.
* Based on liquidation value. Number of APS shares outstanding did not change
after the January 21, 1993 issuance date.
** Plus any accrued but unpaid dividends.
*** Calculated by multiplying $50,000 by the result obtained by dividing (a)
the average monthly market value of the Common Stock during the related
fiscal year (or, in the case of 1993, the period from January 21, 1993
(date of issuance of APS) through September 30, 1993) by (b) the average of
the amount of APS outstanding at the end of each such month.
10
<PAGE>
THE FUND
The Fund is a diversified, closed-end management investment company and has
registered as such under the Investment Company Act of 1940 ("1940 Act"). The
Fund was incorporated under the laws of the State of Maryland on August 6,
1992. Prior to January 19, 1996, the name of the Fund was "PaineWebber Premier
Tax-Free Income Fund Inc." The Fund began doing business under the name
"Investment Grade Municipal Income Fund" in August 1995, and the shareholders
of the Fund approved a formal change of the Fund's name to Investment Grade
Municipal Income Fund Inc. on January 18, 1996. The Fund's principal office is
located at 1285 Avenue of the Americas, New York, New York 10019, and its
telephone number is (212) 713-2000.
THE OFFERING
No additional shares of Common Stock will be issued in connection with this
offering. Shares of the Common Stock may be offered pursuant to this
Prospectus from time to time in order to effect OTC secondary market sales by
PaineWebber in its capacity as a dealer and secondary market-maker at
negotiated prices related to prevailing market prices on the NYSE at the time
of sale. Costs incurred in connection with this offering will be paid by
PaineWebber. PaineWebber's principal offices are located at 1285 Avenue of the
Americas, New York, New York 10019. Mitchell Hutchins is a wholly owned
subsidiary of PaineWebber.
USE OF PROCEEDS
The Fund will not receive any proceeds from the sale of any Common Stock
offered pursuant to this Prospectus. Proceeds received by PaineWebber as a
result of its OTC secondary market sales of the Common Stock will be utilized
by PaineWebber in connection with its secondary market operations and for
general corporate purposes.
TRADING HISTORY
Shares of the Common Stock, par value $.001 per share are listed and traded
on the NYSE under the symbol "PPM." The following table sets forth for the
Common Stock for each quarterly period within the two most recent fiscal years
and each fiscal quarter since the beginning of the current fiscal year: (a)
the per share high and low sales prices as reported by the NYSE; (b) the per
share net asset values, based on the Fund's computation as of 4:00 p.m. on the
last NYSE business day for the week corresponding to the dates on which the
respective high and low sales prices were recorded; and (c) the discount or
premium to net asset value represented by the high and low sales prices shown.
The range of net asset values and of premiums and discounts for the Common
Stock during the periods shown may be broader than is shown in this table. On
January 28, 1997, the closing price per share of Common Stock on the NYSE was
$13.63, the Fund's net asset value per share was $16.18 and the discount to
net asset value per share was 15.8%.
<TABLE>
<CAPTION>
(DISCOUNT) OR
PREMIUM
SALES PRICES NET ASSET VALUES TO NET ASSET VALUE
--------------- ----------------- ---------------------
QUARTER ENDED HIGH LOW HIGH LOW HIGH LOW
------------- ------- ------- -------- -------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
12/31/94.......... $12.625 $10.750 $ 14.72 $ 13.50 (14.23)% (20.37)%
03/31/95.......... 13.375 12.000 14.92 14.02 (10.36) (14.41)
06/30/95.......... 13.500 12.375 16.02 15.25 (15.73) (18.85)
09/30/95.......... 13.500 12.625 15.88 15.36 (14.99) (17.81)
12/31/95.......... 14.250 13.000 16.32 15.85 (12.68) (17.98)
03/31/96.......... 14.125 13.250 16.63 16.04 (15.06) (17.39)
06/30/96.......... 13.625 12.875 15.90 15.82 (14.31) (18.62)
09/30/96.......... 13.750 12.875 16.17 15.48 (14.97) (16.83)
12/31/96.......... 14.000 13.500 16.47 16.38 (15.00) (17.58)
</TABLE>
11
<PAGE>
See "Description of Capital Stock--Common Stock Repurchases and Tender
Offers" as to methods that may be undertaken by the Fund to reduce any
discount.
INVESTMENT OBJECTIVE AND POLICIES
The Fund's investment objective is to achieve a high level of current income
that is exempt from federal income tax, consistent with the preservation of
capital. To achieve this objective, the Fund normally invests substantially
all of its assets in a diversified portfolio of long-term, tax-exempt
Municipal Obligations that have been rated investment grade or are unrated but
have been determined to be of comparable quality by Mitchell Hutchins.
Municipal Obligations rated investment grade are those that, at the time of
investment, are rated within the four highest grades by Moody's (Baa or
higher) or S&P (BBB or higher) or have an equivalent rating from another
nationally recognized statistical rating organization. The Fund may invest up
to 20% of its total assets in Municipal Obligations that are unrated but that,
at the time of investment, have been determined by Mitchell Hutchins to be of
comparable quality to those that are rated investment grade. Municipal
Obligations rated Baa by Moody's are investment grade, but Moody's considers
Municipal Obligations rated Baa to have speculative characteristics. Changes
in economic conditions or other circumstances are more likely to lead to a
weakened capacity for Municipal Obligations that are rated BBB or Baa (or that
have equivalent ratings) to make principal and interest payments than is the
case for higher grade Municipal Obligations. At least 80% of the Fund's net
assets normally are invested in Municipal Obligations, the interest on which
is not a Tax Preference Item. The balance of the Fund's assets may be invested
in other Municipal Obligations that are subject to the AMT or in certain other
investments. See "Other Investment Practices." Under normal circumstances, the
Fund invests at least 65% of its total assets in income-producing securities.
There is no assurance that the Fund will achieve its investment objective.
Municipal Obligations are obligations issued by or on behalf of states
(including the District of Columbia), territories or possessions of the United
States or their respective political subdivisions, agencies or
instrumentalities, or by multistate agencies or authorities, the interest on
which is, in the opinion of bond counsel, exempt from federal income tax.
Municipal Obligations are issued for various public purposes, including
construction of public facilities, such as airports, bridges, hospitals,
housing, mass transportation, schools, streets and water and sewer works.
Other public purposes for which Municipal Obligations may be issued include
refinancing outstanding obligations and obtaining funds for general operating
expenses and for loans to other public institutions and facilities. Municipal
Obligations include "public purpose" obligations, which generate interest that
is exempt from federal income tax and is not a Tax Preference Item, and
qualified "private activity" obligations, which generate interest that is
exempt from federal income tax but that, if the obligations were issued after
August 7, 1986, is a Tax Preference Item. Under normal circumstances, no more
than 20% of the Fund's net assets will be invested in Municipal Obligations
the interest on which is a Tax Preference Item. The principal types of
Municipal Obligations in which the Fund may invest are described in Appendix A
to this Prospectus and in the SAI.
Moody's, S&P and the other nationally recognized statistical rating
organizations are private services that provide ratings of the credit quality
of debt obligations, including Municipal Obligations. It should be emphasized
that ratings are general and are not absolute standards of quality.
Consequently, Municipal Obligations with the same maturity, interest rate and
rating may have different market prices. Also, rating agencies may fail to
make timely changes in credit ratings in response to subsequent events, so
that an issuer's financial condition may be better or worse than is indicated
by its rating. Subsequent to its purchase by the Fund, an issue of Municipal
Obligations may cease to be rated or its rating may be reduced below the
minimum rating required for purchase by the Fund. Mitchell Hutchins will
consider such an event in determining whether the Fund should continue to hold
the obligation. In making such a determination, Mitchell Hutchins will
consider such factors as its assessment of the credit quality of the issuer of
the security and the price at which the security could be sold. Mitchell
Hutchins will engage in an orderly disposition of downgraded Municipal
Obligations to the extent necessary to ensure that the Fund's holdings of
Municipal Obligations rated below investment grade will not exceed 5% of the
Fund's net assets. The Fund does not purchase junk bonds. A description of
Moody's and S&P's ratings is included as Appendix A to the SAI.
12
<PAGE>
The Fund may invest 25% or more of its total assets in a particular segment
of the Municipal Obligations market, such as hospital, housing or airport
revenue bonds, or in securities the interest on which is paid from revenues on
similar types of projects, if Mitchell Hutchins determines that the yields
available from obligations in that market segment justify the potential
increase in risk resulting from a large investment in that market segment.
Although such obligations might be supported by the credit of governmental
entities or by non-governmental entities from a number of different
industries, an economic, business, political or other change affecting one
such obligation might also affect other obligations in the same market.
The Fund's investment objective and certain investment limitations described
in the SAI are fundamental policies that may not be changed without
shareholder approval. All other investment policies may be changed by the
Fund's board of directors without shareholder approval.
OTHER INVESTMENT PRACTICES
Certain of the other investment practices in which the Fund may engage and
that are described below may give rise to federal income tax. Under normal
circumstances, the Fund does not intend to engage in those practices to a
significant extent. The Fund's ability to engage in certain of these
investment practices is limited by the rating agency guidelines applicable to
the APS. See "Special Leverage Considerations" and Appendix B to the SAI.
WHEN-ISSUED AND DELAYED DELIVERY SECURITIES
The Fund may purchase Municipal Obligations on a when-issued basis, or may
purchase or sell Municipal Obligations for delayed delivery. In when-issued or
delayed delivery transactions, delivery of the securities occurs beyond normal
settlement periods, but no payment on delivery will be made by the Fund prior
to the actual delivery or payment by the other party to the transaction. The
Fund will not accrue income with respect to a when-issued or delayed delivery
security prior to its stated delivery date. When the Fund purchases securities
on a when-issued or delayed delivery basis, however, it immediately assumes
the risks of ownership, including the risk of price fluctuation. Depending on
market conditions, the Fund's when-issued and delayed delivery purchase
commitments could cause its net asset value per share (and thus its market
value per share) to be more volatile because such securities may increase the
amount by which the Fund's total assets, including the value of when-issued
and delayed delivery securities held by the Fund, exceed its net assets.
Failure to deliver a security purchased on a when-issued or delayed delivery
basis may result in a loss or missed opportunity to make an alternative
investment.
SHORT-TERM TAX-EXEMPT AND TAXABLE INVESTMENTS
The Fund normally invests substantially all of its assets in long-term
Municipal Obligations. However, in order to invest cash reserves or when, in
the opinion of Mitchell Hutchins, no suitable long-term Municipal Obligations
are available, the Fund may invest in high quality short-term Municipal
Obligations that are rated, at the time of investment, no lower than MIG-2 by
Moody's, SP-2 by S&P or, if unrated, that are determined by Mitchell Hutchins
to be of comparable quality to Municipal Obligations that are rated at least
MIG-2 or SP-2. These Municipal Obligations may include variable or floating
rate demand notes and similar instruments that trade as short-term
obligations. The Fund also may invest in such high quality short-term
Municipal Obligations for temporary defensive purposes.
In addition, if in the opinion of Mitchell Hutchins no suitable short-term
Municipal Obligations are available, the Fund temporarily may hold cash and,
with respect to up to 20% of its net assets, invest in taxable money market
instruments, including: (1) U.S. government securities; (2) high quality
commercial paper that is rated, at the time of purchase, no lower than Prime-2
by Moody's or A-2 by S&P or, if unrated, that is determined by Mitchell
Hutchins to be of comparable quality to commercial paper that is rated at
least Prime-2 or A-2; (3) bank obligations (including certificates of deposit,
time deposits and bankers' acceptances of domestic banks); and (4) repurchase
agreements with respect to any of the foregoing. Interest earned from such
taxable investments will be taxable to stockholders as ordinary income when
distributed. If the Fund were to hold cash, the cash would not earn interest,
and the Fund's yield would be lower than if the cash had been invested.
13
<PAGE>
REPURCHASE AGREEMENTS
The Fund is authorized to enter into repurchase agreements with respect to
any obligation issued or guaranteed by the U.S. government, its agencies or
instrumentalities and also with respect to commercial paper, bank certificates
of deposit and bankers' acceptances. Repurchase agreements are transactions in
which the Fund would purchase securities from a bank or recognized securities
dealer and simultaneously commit to resell those securities to the bank or
dealer at an agreed-upon date or upon demand and at a price reflecting a
market rate of interest unrelated to the coupon rate or maturity of the
purchased securities. The Fund would maintain custody of the underlying
securities prior to their repurchase; thus, the obligation of the bank or
securities dealer to pay the repurchase price on the date agreed to would, in
effect, be secured by such securities. If the value of such securities were
less than the repurchase price, plus any agreed-upon additional amount, the
other party to the agreement would be required to provide additional
collateral so that at all times the collateral is at least equal to the
repurchase price, plus any agreed-upon additional amount. The difference
between the total amount to be received upon repurchase of the securities and
the price which was paid by the Fund upon acquisition would be accrued as
interest and included in the Fund's net investment income.
Repurchase agreements carry certain risks not associated with direct
investments in securities, including possible declines in the market value of
the underlying securities and delays and costs to the Fund if the other party
to the repurchase agreement becomes insolvent. The Fund intends to enter into
repurchase agreements only with banks and dealers in transactions believed by
Mitchell Hutchins to present minimal credit risks in accordance with
guidelines established by the Fund's board of directors. Mitchell Hutchins
will review and monitor the creditworthiness of such institutions under the
board's general supervision.
REVERSE REPURCHASE AGREEMENTS
The Fund may enter into reverse repurchase agreements with the same parties
with whom it may enter into repurchase agreements. Under a reverse repurchase
agreement, the Fund would sell securities and agree to repurchase (and the
buyer would be required to resell) them at a mutually agreed date or upon
demand and at a price reflecting a market rate of interest. At the time the
Fund enters into a reverse repurchase agreement, it will establish and
maintain a segregated account with an approved custodian containing cash or
liquid securities, marked to market daily, having a value not less than the
repurchase price (including accrued interest). The market value of securities
sold under reverse repurchase agreements typically is greater than the
proceeds of the sale, and accordingly, the market value of the securities sold
is likely to be greater than the value of the securities in which the Fund
invests those proceeds. Thus, reverse repurchase agreements involve the risk
that the Fund might be unable to reacquire the securities that it has sold. In
the event the buyer of securities under a reverse repurchase agreement files
for bankruptcy or becomes insolvent, such buyer or its trustee or receiver may
receive an extension of time to determine whether to enforce the Fund's
obligation to repurchase the securities, and the Fund's use of the proceeds of
the reverse repurchase agreement may effectively be restricted pending such
decision. Reverse repurchase agreements will be treated as borrowings for
purposes of calculating the Fund's borrowing limitation. See "Borrowings".
LENDING OF PORTFOLIO SECURITIES
To attempt to enhance income (which would be taxable income) the Fund is
authorized to lend up to 33 1/3% of the total value of its portfolio
securities to broker-dealers or institutional investors that Mitchell Hutchins
deems qualified, but only if doing so would not adversely affect the rating of
the APS by S&P and only when the borrower maintains acceptable collateral with
the Fund's custodian in an amount, marked to market daily, at least equal to
the market value of the securities loaned, plus accrued interest and
dividends. Acceptable collateral is limited to cash, U.S. government
securities and irrevocable letters of credit that meet certain guidelines
established by Mitchell Hutchins. In determining whether to lend securities to
a particular broker-dealer or institutional investor, Mitchell Hutchins will
consider, and during the period of the loan will monitor, all relevant facts
and circumstances, including the creditworthiness of the borrower. The Fund
will retain authority to terminate any loans at any time. The Fund may pay
reasonable administrative and custodial fees in connection
14
<PAGE>
with a loan and may pay a negotiated portion of the interest earned on the
cash held as collateral to the borrower or placing broker. The Fund will
receive reasonable interest on the loan or a flat fee from the borrower, and
amounts equivalent to any dividends, interest or other distributions on the
securities loaned. The Fund will regain record ownership of loaned securities
to exercise beneficial rights, such as voting and subscription rights, when
regaining such rights is considered to be in the Fund's interest.
OTHER PRACTICES
The Fund may invest up to 20% of its total assets in illiquid securities.
The term "illiquid securities" for this purpose means securities that cannot
be disposed of within seven days in the ordinary course of business at
approximately the amount at which the Fund has valued the securities and
includes, among other things, securities subject to contractual restrictions
on resale, repurchase agreements maturing in more than seven days and
municipal lease obligations (including certificates of participation) other
than those that Mitchell Hutchins has determined are liquid pursuant to
guidelines established by the board of directors. To the extent the Fund
invests in illiquid securities, the Fund may not be able to readily liquidate
such investments, and would have to sell other investments if necessary to
raise cash to meet its obligations. The lack of a liquid secondary market for
illiquid securities may make it more difficult for the Fund to assign a value
to those securities for purposes of valuing the Fund's portfolio and
calculating its net asset value. The Fund also may invest in stand-by
commitments with respect to Municipal Obligations it purchases or holds.
Although it has no present intention to do so during the coming year, the Fund
may use options (both exchange-traded and OTC) to attempt to enhance income
(which would be taxable income) and also may attempt to reduce the overall
risk of its investments (hedge) by using options, futures contracts and
interest rate protection transactions.
SPECIAL LEVERAGE CONSIDERATIONS
PREFERRED STOCK
On January 21, 1993, the Fund issued 800 shares of APS Series A and 800
shares of APS Series B having an aggregate liquidation value of $80,000,000.
The net proceeds to the Fund of the sale of the APS, after deduction of
underwriting discounts and offering expenses, was $78,333,671. The Fund has
the right to issue additional APS or other preferred stock to the maximum
extent permitted under the 1940 Act.
The APS has resulted (and any issuance of other preferred stock would
result) in the financial leveraging of the Common Stock. The use of leverage
is a speculative investment technique and involves special risks to the Common
Stockholders. These include the possibility of higher volatility of both the
net asset value and the market value of the Common Stock. Also, fluctuations
in the dividend rate on the APS will affect the dividends on the Common Stock.
So long as the Fund is able to realize a higher net rate of return on its
investment portfolio than the then current dividend rate on the APS (or on any
other preferred stock issued by the Fund) together with other related
expenses, the effect of the leverage will be to cause Common Stockholders to
realize higher current net investment income than if the Fund were not so
leveraged. There can be no assurance, however, that the Fund will be able to
realize such a net return. To the extent that the then current dividend rate
on the APS approaches the net return on the Fund's investment portfolio, the
benefit of leverage to Common Stockholders will be reduced, and if the then
current dividend rate on the APS were to exceed the net return on the Fund's
portfolio, the Fund's leveraged capital structure would result in a lower
yield to Common Stockholders than if the Fund were not so leveraged.
Each Series of APS pays dividends at rates that normally are tax-exempt and
that are adjusted to market based on an auction process. Rates normally are
adjusted every 28 days on APS Series A and every three months on APS Series B.
As of September 30, 1996, the dividend rate payable on APS Series A was
3.449%, and the dividend rate payable on APS Series B was 3.624%. Based on
those dividend rates, the Fund must experience a net annual return of 1.15% in
order to cover the annual dividend payments on APS. There can be no assurance
that the Fund will continue to realize a higher net rate of return on its
investment portfolio than the dividend rate that must be paid on the APS. The
following table may assist the investor in understanding the effects of
leverage
15
<PAGE>
by illustrating the effect of leverage on return to a holder of Common Stock.
The figures appearing in the table are hypothetical and actual returns may be
greater or less than those appearing in the table.
<TABLE>
<S> <C> <C> <C> <C> <C>
Assumed Return on Portfolio (Net of Ex-
penses).................................... -10% -5% 0% 5% 10%
Corresponding Return to Common Stockholder.. -16.49% -9.09% -1.70% 5.70% 13.10%
</TABLE>
Any decline in the net asset value of the Fund's investments will be borne
entirely by holders of Common Stock. Accordingly, the effect of leverage in a
declining market would be a greater decrease in the net asset value of the
Common Stock than if the Fund were not leveraged and could adversely affect
the Fund's ability to make dividend payments on its Common Stock. Any such
decrease may be reflected in a greater decline in the market price of the
Common Stock. If the Fund's current investment income were not sufficient to
meet dividend requirements on the APS, it could become necessary for the Fund
to liquidate certain of its investments, thereby reducing net assets and,
therefore, the net asset value of the Common Stock. Such liquidations would
cause the Fund to incur transaction costs and might also cause the Fund to
realize gains on securities held for less than three months. Because under
current tax laws less than 30% of the Fund's annual gross income may be
derived from the sale or other disposition of stocks or other securities held
for less than three months to maintain the Fund's status as a regulated
investment company ("RIC"), such gains would limit the ability of the Fund to
sell other securities held for less than three months that the Fund might wish
to sell in the ordinary course of its portfolio management and thus might
adversely affect the Fund's yield. Moreover, while dividends on the APS, which
are cumulative, are unpaid, no dividends or other distributions would be
permitted to be paid on Common Stock until the Fund resumed its payments of
dividends on the preferred stock as required.
Under the 1940 Act, the value of the Fund's total assets, less all
liabilities and indebtedness not deemed to be senior securities under the 1940
Act, must be at least equal to 200% of the aggregate liquidation value of the
preferred stock (plus any outstanding indebtedness deemed to be senior
securities) at any time that the Fund pays a dividend or makes any other
distribution on Common Stock (other than a distribution payable in Common
Stock) or any time the Fund repurchases Common Stock, in each case after
giving effect to such dividend, distribution or repurchase. This requirement
could impair the ability of the Fund to maintain its qualification as a RIC
for federal tax purposes. To the extent necessary, the Fund intends to
purchase or redeem preferred stock in order to maintain asset coverage at the
required 200% level. In such circumstances, the Fund may have to liquidate
portfolio securities in order to meet redemption requirements. This could have
the effect of reducing the Fund's future net income. Such liquidations would
cause the Fund to incur related transaction costs. In addition, such
liquidations might require the Fund to realize capital gains or losses at a
time that it would not otherwise do so and might limit the ability of the Fund
to dispose of other securities that it might wish to sell in the ordinary
course of portfolio management, thereby adversely affecting the Fund's yield.
Such redemptions could also require the Fund to pay redemption premiums, which
would adversely affect the Common Stockholders.
The APS have received ratings of Aaa from Moody's and AAA from S&P. The
rating agencies have established guidelines and other requirements with which
the Fund has agreed to comply for so long as the APS are outstanding and are
rated by Moody's and S&P. The rating agencies' portfolio guidelines establish
a set of tests for portfolio composition and asset coverage that supplement
(and in some cases are more restrictive than) the applicable requirements
under the 1940 Act and the Fund's investment policies. Such guidelines include
asset coverage requirements which are more restrictive than those under the
1940 Act, restrictions on certain portfolio investments and investment
practices, requirements that the Fund maintain a portion of its assets in
short-term high quality fixed-income securities and certain mandatory
redemption requirements. The rating agency requirements also impose certain
minimum issue size, geographic diversification and other requirements for
determining portfolio assets that are eligible for computing compliance with
their asset coverage requirements. The ability of the Fund to comply with such
asset coverage maintenance ratios may be subject to circumstances which are
beyond the control of the Fund, such as market conditions for its portfolio
securities. The terms of the APS prohibit the payment of dividends or
distributions on the Common Stock in the event the Fund fails to meet such
asset coverage maintenance ratios and, in such circumstances, also provide for
mandatory redemption of the APS, with the potential adverse effects discussed
above. For additional information concerning rating agency guidelines and
restrictions, see Appendix B to the SAI.
16
<PAGE>
In accordance with the 1940 Act, the holders of the APS have special voting
rights, including the right to elect at least two directors at all times. See
"Description of Capital Stock--Auction Preferred Shares--Voting Rights."
The issuance of the APS has entailed certain costs and expenses, such as
underwriting discounts, fees associated with the registration of the preferred
stock with the SEC, filings under state securities laws, rating agency fees,
legal and accounting fees and printing costs, and will entail certain other
ongoing expenses, such as administrative and accounting fees. These costs and
expenses have been or will be borne by the Fund. The initial costs and
expenses of the APS have been reflected as a reduction in the net asset value
of the Common Stock. Ongoing expenses associated with the APS will be
reflected as a reduction in the investment income that otherwise would be
available for distribution to Common Stockholders.
The Fund does not expect to realize significant taxable income. For federal
tax purposes, however, net realized capital gains and other taxable income, if
any, will be allocated (along with tax-exempt income) between Common
Stockholders and the holders of the APS in proportion to total distributions
paid to each class of stockholders for the year in which such capital gains or
other taxable income is realized or earned. The holders of the APS are
entitled to receive dividends on a cumulative basis before any dividend or
other distribution may be paid to Common Stockholders. Moreover, the terms of
the APS require that, if any portion of a dividend or other distribution to
the holders of the APS is taxable, the Fund must pay an additional dividend on
the APS in an amount such that the net after-tax return on the APS will be the
same as the net after-tax return that would have been derived if the initial
dividends paid to the holders of the APS had qualified in their entirety as
tax-exempt income. Any such additional dividends paid to holders of the APS
will reduce the net investment income of the Fund available for distribution
to Common Stockholders.
BORROWINGS
The Fund is permitted to borrow money to finance Common Stock repurchases
and tender offers or for investment purposes from banks and other entities or
through reverse repurchase agreements in an amount not in excess of 33 1/3% of
total assets (including the amount of the borrowing and any other senior
securities representing indebtedness issued, but reduced by any liabilities
and indebtedness not constituting senior securities). Borrowing by the Fund
would create leverage and would entail speculative factors similar to those
applicable to the issuance of preferred stock. If borrowings are made on a
secured basis, the custodian will segregate the pledged assets for the benefit
of the lender or arrangements will be made with a suitable subcustodian, which
may include the lender. See "Description of Capital Stock--Common Stock
Repurchases and Tender Offers."
SPECIAL CONSIDERATIONS AND RISK FACTORS
The yield on a Municipal Obligation depends on a variety of factors,
including general municipal and fixed-income security market conditions, the
financial condition of the issuer, the size of the particular offering, the
maturity, credit quality and rating of the issue and expectations regarding
changes in income tax rates. Generally, the longer the maturity of a Municipal
Obligation, the higher the yield and the greater the volatility. The market
value of Municipal Obligations, and accordingly the net asset value of the
Common Stock, normally will vary inversely with changes in interest rates.
Such changes in the values of Municipal Obligations held by the Fund will not
affect the interest income derived from them but will affect the net asset
value of shares of the Common Stock.
Certain Municipal Obligations held by the Fund may permit the issuer to call
or redeem the obligations, in whole or in part, at its option. If an issuer
were to redeem Municipal Obligations held by the Fund during a time of
declining interest rates, the Fund might realize capital gains or losses at a
time that it would not otherwise do so, and the Fund might not be able to
reinvest the proceeds of the redemption in Municipal Obligations providing as
high a level of income as the obligations that were redeemed. The Fund may be
able to purchase detachable call options on Municipal Obligations it holds to
protect its investments from the risk of issuer redemptions. See Appendix A to
this Prospectus.
17
<PAGE>
Opinions relating to the validity of Municipal Obligations and to the
exemption of interest thereon from regular federal income tax (and also, when
applicable, from treatment as a Tax Preference Item) are rendered by bond
counsel to the issuer at the time of issuance. Neither the Fund nor Mitchell
Hutchins will review the proceedings relating to the issuance of Municipal
Obligations or the basis for such opinions. Federal, state and local laws may
be enacted that adversely affect the tax-exempt status of interest on
Municipal Obligations or of the exempt-interest dividends received by the
Fund's stockholders or that impose other constraints upon enforcement of such
obligations. It is also possible that, as a result of litigation or other
conditions, the power or ability of issuers to meet their obligations for the
payment of principal of and interest on their Municipal Obligations may be
materially and adversely affected. The obligations of issuers of Municipal
Obligations are subject to the provisions of bankruptcy, insolvency and other
laws affecting the rights and remedies of creditors. In the event of a
bankruptcy of such an issuer, the Fund could experience delays and limitations
with respect to the collection of principal and interest on such Municipal
Obligations, and in some circumstances, the Fund might not be able to collect
all principal and interest to which it is entitled. To enforce its rights in
the event of a default in the payment of interest or repayment of principal,
or both, the Fund might take possession of and manage the assets or have a
receiver appointed to collect and disburse pledged revenues securing the
issuer's obligations on such securities; any such action might increase the
Fund's operating expenses and might adversely affect the net asset value of
the Fund.
The Fund may invest up to 20% of its net assets in Municipal Obligations the
interest on which is a Tax Preference Item. Accordingly, stockholders who are
individuals may be required to include a portion of the Fund's exempt interest
dividends in calculating their AMT liability. Corporations that hold Common
Stock must include the entire amount of any exempt-interest dividends
(including any portion that is not a Tax Preference Item) in calculating their
adjusted current earnings for purposes of the AMT. The Fund may not be an
appropriate investment for investors who are subject to AMT liability or who
would become subject to AMT liability by reason of an investment in the Fund.
All or a portion of the Fund's dividends also may be subject to state and
local taxation. See "Taxes."
Shares of the common stock of closed-end investment companies frequently
trade at a discount to their net asset values, and the Fund's Common Stock has
historically traded at a discount to its net asset value. Accordingly, there
is a risk that, for example, a Common Stockholder who sells shares at a time
when the Common Stock is trading at a discount could incur a loss of capital
even if the Fund's net asset value has not declined since the stockholder
purchased his shares. This market risk is separate and distinct from the risk
that the Fund's net asset value may decrease. Accordingly, the Common Stock is
designed primarily for long-term investors and should not be viewed as a
vehicle for trading purposes.
MANAGEMENT OF THE FUND
Subject to the supervision of the Fund's board of directors, investment
advisory and administration services are provided to the Fund by Mitchell
Hutchins pursuant to an Investment Advisory and Administration Contract dated
October 15, 1992 ("Advisory Contract"). Mitchell Hutchins' principal business
address is 1285 Avenue of the Americas, New York, New York 10019. Mitchell
Hutchins is a wholly owned subsidiary of PaineWebber, which is a wholly owned
subsidiary of Paine Webber Group Inc., a publicly held financial services
holding company. Mitchell Hutchins provides investment advisory and portfolio
management services to investment companies, pension funds and other
institutional, corporate and individual clients. As of December 31, 1996,
total assets under Mitchell Hutchins' management were approximately $43.9
billion. As of that date, Mitchell Hutchins served as investment adviser or
sub-adviser to 30 registered investment companies with 64 separate portfolios
having aggregate assets of over $31.4 billion.
Pursuant to the Advisory Contract, Mitchell Hutchins provides a continuous
investment program for the Fund and makes investment decisions and places
orders to buy, sell or hold particular securities; Mitchell Hutchins also
supervises all matters relating to the operation of the Fund and obtains for
it corporate officers, clerical staff, office space, equipment and services.
As compensation for its services, Mitchell Hutchins is entitled
18
<PAGE>
to receive a fee, computed weekly and paid monthly, in an amount equal to the
annual rate of 0.90% of the Fund's average weekly net assets. Effective June
1, 1995, Mitchell Hutchins began waiving 0.25% of its investment advisory and
administration fees. Mitchell Hutchins may discontinue this fee waiver at any
time.
Elbridge (Ebby) T. Gerry III and Cynthia N. Bow are co-portfolio managers on
the Fund. Mr. Gerry, a senior vice president of Mitchell Hutchins, is
responsible for the day-to-day management of the Fund's portfolio. Mr. Gerry
has held his Fund responsibilities since January 22, 1996. From 1981 until
1996, Mr. Gerry was associated with J.P. Morgan Private Banking and was
responsible for managing municipal assets, including several municipal bond
funds. Mr. Gerry oversees or manages over $4.2 billion in municipal assets at
Mitchell Hutchins, including municipal bond and money funds and private
accounts. Ms. Bow is a vice president of Mitchell Hutchins. Ms. Bow has held
her Fund responsibilities since October 1, 1996. Ms. Bow has been with
Mitchell Hutchins since 1982. Other members of Mitchell Hutchins' tax-exempt
investments group provide input on market outlook, interest rate forecasts and
other considerations pertaining to tax-exempt investments.
Mitchell Hutchins investment personnel may engage in securities transactions
for their own accounts pursuant to a code of ethics that establishes
procedures for personal investing and restricts certain transactions.
DIVIDENDS AND OTHER DISTRIBUTIONS; DIVIDEND REINVESTMENT PLAN
DIVIDENDS AND OTHER DISTRIBUTIONS
The Fund declares and pays monthly cash dividends to Common Stockholders at
a rate that, on an annual basis, results in the distribution of all of the
Fund's net investment income remaining after the payment of dividends on the
APS and any other outstanding preferred stock. The dividend rate is adjusted
by the Fund's board of directors as necessary to reflect the performance of
the Fund. Dividend levels are determined by the Fund's board of directors
after giving consideration to a number of factors, including the Fund's
undistributed net investment income, historical and projected net investment
income, expenses and projected payments to preferred stockholders. The Fund's
policy to pay dividends on the Common Stock on this basis may be changed by
its board of directors without notice to stockholders.
The Fund intends to distribute annually to Common Stockholders substantially
all of its realized net capital gain (the excess of net long-term capital gain
over net short-term capital loss) and its realized net short-term capital gain
to the extent that such capital gains are not necessary to satisfy the
dividend, redemption or liquidation preference of any shares of the APS or any
other preferred stock. Substantially all of the Fund's net investment income
not previously distributed for any fiscal year will be distributed to
stockholders after the end of that year.
To enable the Fund to maintain level monthly dividends, the Fund anticipates
that its monthly dividends may from time to time represent less or more than
the entire amount of net investment income earned by the Fund in the period to
which the dividend relates. Undistributed net investment income would be
available to supplement future distributions which might otherwise have been
reduced by reason of a decrease in the Fund's monthly net income due to
fluctuations or expenses or due to an increase in the dividend rate on the APS
or shares of any other outstanding preferred stock. As a result, dividends
paid by the Fund for any particular monthly period may be more or less than
the amount of net investment income earned by the Fund during the related
period. Undistributed net investment income will be reflected in the Fund's
net asset value, and correspondingly, distributions of undistributed net
investment income will reduce the Fund's net asset value.
For federal tax purposes, the Fund is required to allocate tax-exempt
income, net realized capital gains and any other taxable income among shares
of Common Stock, the APS and shares of any other preferred stock in proportion
to the total dividends and other distributions paid to each class for the year
in which such tax-exempt income, net realized capital gains or other taxable
income is earned or realized.
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<PAGE>
While any shares of the APS are outstanding, the Fund may not declare any
cash dividend or other distribution on the Common Stock unless at the time of
such declaration: (1) all accrued dividends on the APS have been paid; (2) any
required redemptions of the APS have been made; (3) after giving effect to the
dividend or other distribution, the asset coverage requirements imposed by the
rating agencies then rating the APS would be satisfied; and (4) the Fund's
total assets, less all liabilities and indebtedness not deemed to be senior
securities under the 1940 Act (determined after deducting the amount of such
dividend or other distribution), are at least 200% of the liquidation value of
the outstanding preferred stock (plus any outstanding indebtedness deemed to
be senior securities). Under certain circumstances, these limitations could
impair the ability of the Fund to maintain its qualification for treatment as
a RIC. See "Taxes." For further information regarding the impact of the
issuance of the APS on the payment of dividends and other distributions on the
Common Stock, see "Special Leverage Considerations."
DIVIDEND REINVESTMENT PLAN
The Fund has established the Plan, under which all Common Stockholders whose
shares are registered in their own names, or in the name of PaineWebber (or
its nominee), have all dividends and other distributions on their shares of
Common Stock automatically reinvested in additional shares, unless such Common
Stockholders elect to receive cash. Common Stockholders may affirmatively
elect to receive all dividends and other distributions in cash paid by check
mailed directly to the stockholders by PNC Bank, National Association
("Transfer Agent"), as dividend disbursing agent. Common Stockholders who
elect to hold their shares in the name of a broker or nominee other than
PaineWebber (or its nominee) should contact such broker or other nominee to
determine whether, or how, they may participate in the Plan. The ability of
such Common Stockholders to participate in the Plan may change if their shares
of the Common Stock are transferred into the name of another broker or
nominee.
The Transfer Agent serves as agent for the Common Stockholders in
administering the Plan. After the Fund declares a dividend or determines to
make a capital gain distribution, the Transfer Agent, as agent for the
participants, receives the cash payment and uses it to buy shares of Common
Stock in the open market, on the NYSE or otherwise, for the participants'
accounts. Such shares may be purchased at prices that are higher or lower than
the net asset value per share of the Common Stock at the time of purchase. The
number of shares of Common Stock purchased with each dividend will be equal to
the result obtained by dividing the amount of the dividend payable to a
particular stockholder by the average price per share (including applicable
brokerage commissions) that the Transfer Agent was able to obtain in the open
market. The Fund will not issue any new shares of Common Stock in connection
with the Plan. The Transfer Agent will maintain all stockholder accounts in
the Plan and furnish written confirmations of all transactions in the
accounts, including information needed by stockholders for personal and tax
records. Shares in the account of each Plan participant will be held by the
Transfer Agent in non-certificated form in the name of the participant, and
each stockholder's proxy will include those shares of Common Stock purchased
pursuant to the Plan.
There is no charge to participants for reinvesting dividends or other
distributions. The Transfer Agent's fees for the handling of reinvestment of
distributions will be paid by the Fund. However, each participant will pay a
pro rata share of brokerage commissions incurred with respect to the Transfer
Agent's open market purchases of Fund shares in connection with the
reinvestment of distributions.
The automatic reinvestment of dividends and other distributions in shares of
Common Stock will not relieve participants of any income tax that may be
payable on such distributions. See "Taxes."
A holder who has elected to participate in the Plan may terminate
participation in the Plan at any time without penalty, and Common Stockholders
who have previously terminated participation in the Plan may rejoin it at any
time. Changes in elections must be made in writing to the Transfer Agent and
should include the stockholder's name and address as they appear on the share
certificate or in the Transfer Agent's records. An election to terminate
participation in the Plan, until such election is changed, will be deemed to
be an election by a Common Stockholder to take all subsequent distributions in
cash. An election will be effective only for distributions declared and having
a record date at least ten days after the date on which the election is
received.
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<PAGE>
Experience under the Plan may indicate that changes are desirable.
Accordingly, the Fund reserves the right to amend or terminate the Plan with
respect to any dividend or other distribution if notice of the change is sent
to Plan participants at least 30 days before the record date for such
distribution. The Plan also may be amended or terminated by the Transfer Agent
by at least 30 days' written notice to all Plan participants. All
correspondence concerning the Plan should be directed to the Transfer Agent at
PNC Bank, National Association, c/o PFPC Inc., P.O. Box 8950, Wilmington,
Delaware 19899.
TAXES
The Fund intends to continue to qualify for treatment as a RIC under the
Internal Revenue Code of 1986. For each taxable year that the Fund so
qualifies, it will be relieved of federal income tax on that part of its
investment company taxable income (consisting generally of taxable net
investment income, net short-term capital gain and net realized gains from
certain hedging transactions) and net capital gain that is distributed to its
stockholders.
Distributions by the Fund of the excess of tax-exempt interest income over
certain amounts disallowed as deductions, which the Fund designates as
"exempt-interest dividends," generally may be excluded from gross income by
the Common Stockholders for federal income tax purposes; those distributions
may, however, be taxable for state and local tax purposes. In order to pay
exempt-interest dividends, the Fund must (and intends to continue to) satisfy
the requirement that, at the close of each quarter of its taxable year, at
least 50% of the value of its total assets consists of obligations the
interest on which is tax-exempt.
If the Fund invests in any instruments that generate taxable income, under
the circumstances described in "Other Investment Practices--Short-Term Tax-
Exempt and Taxable Investments," distributions of the interest earned thereon
will be taxable to the Fund's stockholders as ordinary income to the extent of
its earnings and profits. Moreover, if the Fund realizes capital gains as a
result of market transactions, distributions of those gains also will be
taxable to stockholders.
Interest on indebtedness incurred or continued by a stockholder to purchase
or carry shares of Common Stock is not deductible to the extent that interest
relates to exempt-interest dividends received from the Fund. If the Fund
invests in certain private activity bonds ("PABs"), the portion of the Fund's
exempt-interest dividends that is attributable to the interest it earns
thereon and that is specified in an annual notice from the Fund must be
treated by its stockholders as a Tax Preference Item in calculating their
liability for the AMT. Corporate stockholders, however, must include all of
their exempt-interest dividends in calculating their adjusted current earnings
for purposes of the AMT.
The Fund notifies its stockholders following the end of each calendar year
of the amounts of exempt-interest dividends, taxable dividends and capital
gain distributions paid (or deemed paid) that year and of any portion thereof
that is a Tax Preference Item. Dividends and other distributions declared by
the Fund in October, November or December of any year and payable to
stockholders of record on a date in any of those months will be deemed to have
been paid by the Fund and received by the stockholders on December 31 of that
year if the distributions are paid by the Fund during the following January.
Accordingly, those distributions will be reported by stockholders for the year
in which that December 31 falls.
Upon a sale or exchange of shares of Common Stock, including a sale pursuant
to a share repurchase or tender offer by the Fund, a Common Stockholder
generally will recognize a taxable gain or loss (equal to the difference
between his adjusted basis for the shares and the amount realized), which will
be treated as a capital gain or loss if the shares are capital assets in the
stockholder's hands and will be a long-term capital gain or loss if the shares
have been held for more than one year. Notwithstanding this general rule,
however, any loss realized on a sale or exchange of shares of Common Stock (1)
will be disallowed to the extent of any exempt-interest dividends received on
those shares, and any allowed loss will be treated as a long-term, rather than
as a short-term, capital loss to the extent of any capital gain distributions
received thereon, if the shares were held for six months or less; and (2) will
be disallowed to the extent those shares are replaced by other shares of
Common Stock within a period of 61 days beginning 30 days before and ending 30
days after the date of disposition of the shares (which could occur, for
example, as the result of participation in the Dividend Reinvestment Plan), in
which event the replacement shares' basis will be adjusted to reflect the
disallowed loss.
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<PAGE>
Investors should also be aware that if shares of the Common Stock are
purchased shortly before the record date for any distribution, the investor
will pay full price for the shares and could receive some portion of the price
back as an exempt-interest dividend, a taxable dividend or a capital gain
distribution.
The foregoing is only a summary of some of the important federal tax
considerations generally affecting the Fund and the Common Stockholders; see
the SAI for a further discussion. There may be other federal, state or local
tax considerations applicable to a particular investor. Prospective
stockholders are therefore urged to consult their tax advisers.
DESCRIPTION OF CAPITAL STOCK
The Fund is authorized to issue 200 million shares of capital stock, $.001
par value. Currently, 800 shares of capital stock are classified as APS Series
A and 800 shares of capital stock are classified as APS Series B. All
remaining shares of capital stock are classified as Common Stock. The
following description is subject to the provisions contained in the Fund's
Articles of Incorporation and Bylaws.
COMMON STOCK
Shares of the Common Stock have no preemptive, conversion, exchange or
redemption rights. Each share has equal voting, dividend, distribution and
liquidation rights. The outstanding shares of Common Stock are fully paid and
nonassessable. Except as otherwise indicated in this Prospectus and except as
otherwise required by applicable law, holders of shares of the APS have equal
voting rights with holders of shares of Common Stock (one vote per share) and
will vote together with holders of Common Stock as a single class. All voting
rights for the election of directors are noncumulative, which means that the
holders of more than 50% of the shares can elect 100% of the directors then
nominated for election if they choose to do so and, in such event, the holders
of the remaining shares will not be able to elect any directors. However, the
holders of the APS, voting as a class, can elect two directors. The rights of
the holders of the Common Stock to elect directors and to vote on other
matters are subject to the voting rights of the APS, as discussed below under
"Description of Capital Stock--Auction Preferred Shares."
Under the rules of the NYSE applicable to listed companies, the Fund
normally is required to hold an annual meeting of stockholders in each year.
If the Fund is converted to an open-end investment company or if for any other
reason the Fund's shares are no longer listed on the NYSE (or any other
national securities exchange the rules of which require annual meetings of
stockholders), the Fund may decide not to hold annual meetings of
stockholders. See "Description of Capital Stock--Common Stock Repurchases and
Tender Offers; Description of Capital Stock--Conversion to Open-End Investment
Company."
Any additional offerings of the Common Stock, if made, will require approval
of the Fund's board of directors and will be subject to the requirement of the
1940 Act that shares may not be sold at a price below the then current net
asset value, exclusive of underwriting discounts and commissions, except,
among other things, in connection with an offering to existing stockholders or
with the consent of a majority of the holders of the Fund's outstanding voting
securities.
The following chart indicates the Fund's preferred and common shares
outstanding as of November 21, 1996.
<TABLE>
<CAPTION>
AMOUNT OUTSTANDING
AMOUNT HELD BY EXCLUSIVE OF AMOUNT HELD
REGISTRANT OR FOR ITS BY REGISTRANT OR FOR ITS
TITLE OF CLASS AMOUNT AUTHORIZED ACCOUNT ACCOUNT
- -------------- ----------------- --------------------- ------------------------
<S> <C> <C> <C>
Common Stock.. 199,998,400 -- 10,356,667
APS Series A.. 800 -- 800
APS Series B.. 800 -- 800
</TABLE>
22
<PAGE>
AUCTION PREFERRED SHARES
General. Holders of the APS are entitled to receive cumulative cash
dividends at an adjustable rate determined through an auction process. See
"Special Leverage Considerations--Preferred Stock." All outstanding shares of
APS are fully paid and non-assessable, have no pre-emptive or conversion
rights and are not subject to any sinking fund provisions. As long as the APS
are outstanding, the composition of the Fund's investment portfolio will
reflect guidelines established by the rating agencies rating the APS. See
"Investment Policies and Restrictions--APS Rating Agency Guidelines" in the
SAI and "Appendix B" to the SAI.
Liquidation Preference. Upon a liquidation of the Fund, whether voluntary or
involuntary, the holders of the APS then outstanding will be entitled to
receive and to be paid out of the assets of the Fund available for
distribution to its stockholders, before any payment or distribution shall be
made on the Common Stock or on any other class of stock of the Fund ranking
junior to the APS upon liquidation, an amount equal to the liquidation
preference with respect to the APS. The liquidation preference for the APS is
$50,000 per share, plus an amount equal to all dividends thereon (whether or
not earned or declared) accumulated but unpaid to the date of final
distribution. After the payment to the holders of the APS of the full
preferential amounts, the holders of APS as such shall have no right or claim
to any of the remaining assets of the Fund. Neither the sale of all or
substantially all the property or business of the Fund, nor the merger or
consolidation of the Fund into or with any other corporation nor the merger or
consolidation of any other corporation into or with the Fund shall be a
liquidation, whether voluntary or involuntary, for the purposes of this
paragraph.
Voting Rights. Holders of the APS generally will have equal voting rights
with holders of Common Stock (one vote per share) and generally will vote
together with holders of Common Stock as a single class. However, in
connection with the election of the Fund's directors, holders of outstanding
shares of preferred stock, including any APS, voting as a separate class, are
entitled to elect two of the Fund's directors; the remaining directors are
elected by Common Stockholders and preferred stockholders, including any APS,
voting as a single class. In addition, if at any time dividends (whether or
not earned or declared) on any outstanding preferred stock, including the APS,
shall be due and unpaid in an amount equal to two full years' dividends
thereon, then the holders of the preferred stock, including any outstanding
APS, voting as a separate class, will be entitled to elect a majority of the
total number of directors of the Fund so long as such dividends remain unpaid.
So long as any of the APS are outstanding, the Fund will not, without the
affirmative vote of a majority of the outstanding APS, determined with
reference to a "majority of outstanding voting securities" as that term is
defined in Section 2(a)(42) of the 1940 Act (voting separately as one class):
(a) authorize, create or issue any class or series of stock ranking prior to
or on a parity with the APS with respect to the payment of dividends or the
distribution of assets upon liquidation or increase the authorized amount of
APS (except that the Fund may, without the vote of the holders of APS,
authorize, create or issue classes or series of preferred stock ranking on a
parity with the APS with respect to the payment of dividends and the
distribution of assets upon liquidation subject to continuing compliance by
the Fund with the asset coverage requirement of the 1940 Act and APS basic
maintenance amount requirements established by Moody's or S&P; provided that
the Fund obtains written confirmation from Moody's (if Moody's is then rating
the APS) and S&P (if S&P is then rating the APS) that the issuance of any such
additional class or series of preferred stock would not impair the rating then
assigned by such rating agency to the APS), (b) amend, alter or repeal the
Fund's Articles of Incorporation insofar as they relate to the APS ("APS
Provisions"), whether by merger, consolidation or otherwise, so as to affect
any preference, right or power of such APS or the holders thereof; provided
that (i) none of the actions permitted by the exception to (a) above will be
deemed to affect such preferences, rights or powers and (ii) the
authorization, creation and issuance of classes or series of stock ranking
junior to the APS with respect to payment of dividends and the distribution of
assets upon liquidation will be deemed to affect such preferences, rights or
powers only if Moody's or S&P is then rating the Fund and such issuance would,
at the time thereof, cause the Fund not to satisfy the assets coverage or APS
basic maintenance amounts referred to above, or (c) file a voluntary
application for relief under federal bankruptcy law or any similar application
under state law for so long as the Fund is solvent and does not foresee
becoming insolvent.
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<PAGE>
The Fund's board of directors may, however, without approval of the holders
of APS, amend, alter or repeal any or all of the definitions required to be
contained in the APS Provisions by the rating agencies in the event the Fund
receives written confirmation from the appropriate rating agency that any such
amendment, alteration or repeal would not impair the ratings then assigned to
the APS by such rating agency. Unless a higher percentage is provided for
under "Description of Capital Stock--Certain Anti-Takeover Provisions of the
Articles of Incorporation," the affirmative vote of the holders of a majority
of the outstanding APS, voting as a separate class, will be required to
approve any plan of reorganization (as such term is defined under the 1940
Act) adversely affecting such shares or any action requiring a vote of
security holders under Section 13(a) of the 1940 Act including, among other
things, changes in the Fund's investment objective or changes in the
investment restrictions described as fundamental policies under "Investment
Limitations" in the SAI. The class vote of holders of APS described above will
in each case be in addition to a separate vote of the requisite percentage of
shares of Common Stock necessary to authorize the action in question. To the
extent permitted by the 1940 Act, each series of APS may vote as a separate
series in certain circumstances.
The foregoing voting provisions will not apply with respect to APS if, at or
prior to the time when a vote is required, such APS shall have been (i)
redeemed or (ii) called for redemption and sufficient funds shall have been
deposited in trust to effect such redemption.
Redemption, Purchase and Sale of Preferred Stock by the Fund. The APS are
redeemable by the Fund in whole or in part at the original purchase price per
share plus accrued dividends per share and any applicable redemption premium.
Any redemption or purchase of shares of preferred stock by the Fund will
reduce the leverage applicable to shares of Common Stock, while any resale of
shares by the Fund will increase such leverage. See "Special Leverage
Considerations."
The board of directors, without the approval of the holders of Common Stock,
may authorize an additional offering of preferred stock and may fix the terms
of the preferred stock to be offered.
COMMON STOCK REPURCHASES AND TENDER OFFERS
In recognition of the possibility that the Common Stock might trade at a
discount to net asset value and that any such discount may not be in the best
interest of Common Stockholders, the Fund's board of directors has determined
that it will from time to time consider taking action to attempt to reduce or
eliminate any discount. To that end, the board may, in consultation with
Mitchell Hutchins, from time to time consider action either to repurchase
shares of the Common Stock in the open market or to make a tender offer for
shares of the Common Stock at their net asset value. The board currently
intends at least annually to consider making such open market repurchases or
tender offers and at such time may consider such factors as the market price
of the Common Stock, the net asset value of the Common Stock, the liquidity of
the assets of the Fund, whether such transactions would impair the Fund's
status as a RIC or result in a failure to comply with applicable asset
coverage requirements, general economic conditions and such other events or
conditions that may have material effect on the Fund's ability to consummate
such transactions. The board may at any time, however, decide that the Fund
should not repurchase shares or make a tender offer. Common Stock will not be
repurchased unless after such repurchase the Fund would continue to satisfy
the asset coverage requirements imposed under the 1940 Act with respect to the
APS and asset coverage requirements imposed by any rating agency as a
condition of its rating of the APS. The Fund may borrow to finance repurchases
and tender offers. Interest on any such borrowings will reduce the Fund's net
income. See "Special Leverage Considerations--Borrowings."
There is no assurance that repurchases or tender offers will result in the
Common Stock trading at a price that is equal or close to its net asset value
per share. Although the board of directors believes that share repurchases and
tender offers generally would have a favorable effect on the market price of
the Common Stock, it should be recognized that the Fund's acquisition of
shares of the Common Stock would decrease the Fund's total assets and
therefore have the effect of increasing the Fund's expense ratio and
decreasing the asset coverage with respect to any outstanding APS. Because of
the nature of the Fund's investment objective, policies and portfolio, under
current market conditions Mitchell Hutchins anticipates that repurchases and
tender offers generally should not have a material, adverse effect on the
Fund's investment performance and that Mitchell Hutchins generally should not
have any material difficulty in disposing of portfolio securities in order to
consummate share repurchases and tender offers; however, this may not always
be the case.
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<PAGE>
Any tender offer made by the Fund for shares of the Common Stock generally
would be at a price equal to the net asset value of the shares on a date
subsequent to the Fund's receipt of all tenders. Each offer would be made, and
the Common Stockholders would be notified, in accordance with the requirements
of the Securities Exchange Act of 1934 and the 1940 Act, either by publication
or mailing or both. Each person tendering shares would pay to the Fund's
Transfer Agent a service charge to help defray certain costs, including the
processing of tender forms, effecting payment, postage and handling. The Fund
expects that the costs of effecting a tender offer would exceed the aggregate
of all service charges received from those who tender their shares. Costs
associated with the tender would be charged against capital.
Tendered shares of Common Stock that have been accepted and purchased by the
Fund will be held in the Fund's treasury until retired by the board. If
tendered shares are not retired, the Fund may hold, sell or otherwise dispose
of the shares for any lawful corporate purpose as determined by the board of
directors.
CONVERSION TO OPEN-END INVESTMENT COMPANY
The Fund's board of directors will consider from time to time whether it
would be in the best interests of the Fund and its Common Stockholders to
convert the Fund to an open-end investment company. If the board of directors
determines that such a conversion would be in the best interests of the Fund
and its Common Stockholders and is consistent with the 1940 Act, the board
will submit to the Fund's stockholders, at the next succeeding annual or
special meeting, a proposal to amend the Fund's Articles of Incorporation to
so convert the Fund. Such amendment would provide that, upon its adoption by
the holders of at least a majority of the Fund's outstanding shares entitled
to vote thereon, the Fund will convert from a closed-end to an open-end
investment company. If the Fund converted to an open-end investment company,
it would be able to continuously issue and offer for sale shares of the Common
Stock, and each such share would be redeemable at the option of the holder
thereof at a price based on the then current net asset value per share. In
such event, the Fund could be required to liquidate portfolio securities to
meet requests for redemption, the Common Stock would no longer be listed on
the NYSE and certain investment policies of the Fund would require amendment.
In addition, conversion to an open-end investment company would require that
the Fund redeem any outstanding shares of APS. See "Special Leverage
Considerations."
In considering whether to propose that the Fund convert to an open-end
investment company, the board of directors will consider various factors,
including, without limitation, the potential benefits and detriments to the
Fund and its stockholders of conversion, the potential alternatives and the
benefits and detriments associated therewith, and the feasibility of
conversion given, among other things, the Fund's investment objective and
policies. There can be no assurance that the board will conclude that such a
conversion is in the best interest of the Fund or Common Stockholders. In the
event of a conversion to an open-end investment company, the Fund may charge
fees in connection with the sale or redemption of its shares. As an open-end
investment company, the Fund may reserve the right to honor any request for
redemption by making payment in whole or in part in securities chosen by the
Fund and valued in the same way as they would be valued for purposes of
computing the Fund's net asset value. If payment is made in securities, a
shareholder may incur brokerage expenses in converting these securities into
cash.
CERTAIN ANTI-TAKEOVER PROVISIONS OF THE ARTICLES OF INCORPORATION
The Fund presently has provisions in its Articles of Incorporation that have
the effect of limiting: (1) the ability of other entities or persons to
acquire control of the Fund; (2) the Fund's freedom to engage in certain
transactions; and (3) the ability of the Fund's directors or stockholders to
amend the Articles of Incorporation. These provisions of the Articles of
Incorporation may be regarded as "anti-takeover" provisions. Under Maryland
law and the Fund's Articles of Incorporation, the affirmative vote of the
holders of at least a majority of the votes entitled to be cast is required
for the consolidation of the Fund with another corporation, a merger of the
Fund with or into another corporation (except for certain mergers in which the
Fund is the successor), a statutory share exchange in which the Fund is not
the successor, a sale or transfer of all or substantially all of the Fund's
assets, the dissolution of the Fund and any amendment to the Fund's Articles
of Incorporation. In addition, the affirmative vote of the holders of at least
66 2/3% (which is higher than that required under Maryland law or the 1940
Act) of the outstanding shares of the Fund's capital stock is required
generally to authorize any of the following transactions or to amend the
provisions of the Articles of Incorporation relating to such transactions:
25
<PAGE>
(1) merger, consolidation or statutory share exchange of the Fund with or
into any other corporation;
(2) issuance of any securities of the Fund to any person or entity for
cash;
(3) sale, lease or exchange of all or any substantial part of the assets
of the Fund to any entity or person (except assets having an aggregate
market value of less than $1,000,000); or
(4) sale, lease or exchange to the Fund, in exchange for securities of
the Fund, of any assets of any entity or person (except assets having an
aggregate fair market value of less than $1,000,000)
if such corporation, person or entity is directly, or indirectly through
affiliates, the beneficial owner of more than 5% of the outstanding shares of
the Fund (a "Principal Shareholder"). A similar vote also would be required
for any amendment of the Articles of Incorporation to convert the Fund to an
open-end investment company by making any class of the Fund's capital stock a
"redeemable security," as that term is defined in the 1940 Act. Such vote
would not be required with respect to any of the foregoing transactions,
however, when, under certain conditions, the board of directors approves the
transaction, although in certain cases involving merger, consolidation or
statutory share exchange or sale of all or substantially all of the Fund's
assets or the conversion of the Fund to an open-end investment company, the
affirmative vote of the holders of a majority of the outstanding shares of the
Fund's capital stock would nevertheless be required. Reference is made to the
Articles of Incorporation of the Fund, on file with the SEC, for the full text
of these provisions. These voting rights are in addition to the rights of the
holders of any outstanding APS to vote as a single class on certain matters.
See "Description of Capital Stock--Auction Preferred Shares."
The provisions of the Articles of Incorporation described above and the
Fund's right to repurchase or make a tender offer for its shares could have
the effect of depriving the Common Stockholders of opportunities to sell their
shares at a premium over prevailing market prices by discouraging a third
party from seeking to obtain control of the Fund in a tender offer or similar
transaction. See "Description of Capital Stock--Common Stock Repurchases and
Tender Offers" and "Description of Capital Stock--Conversion to Open-End
Investment Company." The overall effect of these provisions is to render more
difficult the accomplishment of a merger or the assumption of control by a
Principal Shareholder. They provide, however, the advantage of potentially
requiring persons seeking control of the Fund to negotiate with its management
regarding the price to be paid and facilitating the continuity of the Fund's
management, investment objective and policies. The board of directors of the
Fund has considered the foregoing anti-takeover provisions and concluded that
they are in the best interests of the Fund and its stockholders.
CUSTODIAN, TRANSFER AND DIVIDEND DISBURSING AGENT AND REGISTRAR
State Street Bank and Trust Company, One Heritage Drive, North Quincy,
Massachusetts 02171, serves as custodian of the Fund's assets. PNC Bank,
National Association, whose principal business address is Broad and Chestnut
Streets, Philadelphia, Pennsylvania 19110, serves as transfer and dividend
disbursing agent and as registrar with respect to the Common Stock. Bankers
Trust Company, Four Albany Street, New York, New York 10006, serves as the
Auction Agent with respect to the APS and acts as transfer agent, registrar,
dividend disbursing agent and agent for certain notifications for the Fund in
connection with the APS.
FURTHER INFORMATION
Further information concerning these securities and the Fund may be found in
the Registration Statement, of which this Prospectus and the Fund's SAI
constitute a part, on file with the SEC.
26
<PAGE>
TABLE OF CONTENTS OF
STATEMENT OF ADDITIONAL INFORMATION
The Table of Contents for the SAI is as follows:
<TABLE>
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PAGE
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<S> <C>
Investment Policies and Restrictions.................................... 1
Hedging and Related Income Strategies................................... 7
Directors and Officers.................................................. 14
Control Persons and Principal Holders of Securities..................... 21
Investment Advisory Arrangements........................................ 22
Portfolio Transactions.................................................. 23
Valuation of Common Stock............................................... 24
Taxes................................................................... 25
Additional Information.................................................. 27
Financial Statements.................................................... 28
Appendix A.............................................................. A-1
Appendix B.............................................................. B-1
</TABLE>
27
<PAGE>
APPENDIX A
TYPES OF MUNICIPAL OBLIGATIONS
The Fund may invest in the following types of Municipal Obligations and in
such other types of Municipal Obligations as are described in the SAI or as
become available on the market from time to time.
MUNICIPAL BONDS
Municipal bonds are debt obligations issued to obtain funds for various
public purposes. The two principal classifications of municipal bonds are
"general obligation" and "revenue" bonds. General obligation bonds are secured
by the issuer's pledge of its full faith, credit and taxing power for the
payment of principal and interest. Revenue bonds are payable only from the
revenues derived from a particular facility or class of facilities or, in some
cases, from the proceeds of a special excise tax or from another specific
source, such as the user of the facility being financed. Certain municipal
bonds are "moral obligation" issues, which normally are issued by special
purpose public authorities. In the case of such issues, an express or implied
"moral obligation" of a related government unit is pledged to the payment of
the debt service but is usually subject to annual budget appropriations.
INDUSTRIAL DEVELOPMENT BONDS AND PRIVATE ACTIVITY BONDS
Industrial development bonds ("IDBs") and PABs are municipal bonds issued by
or on behalf of public authorities to finance various privately operated
facilities, such as airports or pollution control facilities. IDBs and PABs
are generally revenue bonds and thus are not payable from the unrestricted
revenue of the issuer. The credit quality of IDBs and PABs is usually directly
related to the credit standing of the user of the facilities being financed.
The Fund may invest more than 25% of its assets in IDBs and PABs.
IDBs issued after August 15, 1986 generally are considered PABs, and to the
extent the Fund invests in such PABs, stockholders generally will be required
to include a portion of their exempt-interest dividends in calculating their
liability for the AMT. See "Taxes."
MUNICIPAL LEASE OBLIGATIONS
Municipal lease obligations are Municipal Obligations that may take the form
of leases, installment purchase contracts or conditional sales contracts, or
certificates of participation with respect to such contracts or leases.
Municipal lease obligations are issued by state and local governments and
authorities to purchase land or various types of equipment and facilities.
Although municipal lease obligations do not constitute general obligations of
the municipality for which the municipality's taxing power is pledged, they
ordinarily are backed by the municipality's covenant to budget for,
appropriate and make the payments due under the lease obligation. The leases
underlying certain Municipal Obligations, however, provide that lease payments
are subject to partial or full abatement if, because of material damage or
destruction of the leased property, there is substantial interference with the
lessee's use or occupancy of such property. This "abatement risk" may be
reduced by the existence of insurance covering the leased property, the
maintenance by the lessee of reserve funds or the provision of credit
enhancements such as letters of credit.
The liquidity of municipal lease obligations varies. See "Other Investment
Practices." Certain municipal lease obligations contain "non-appropriation"
clauses which provide that the municipality has no obligation to make lease or
installment purchase payments in future years unless money is appropriated for
such purpose on a yearly basis. In the case of a "non-appropriation" lease,
the Fund's ability to recover under the lease in the event of non-
appropriation or default will be limited solely to the repossession of the
leased property, without recourse to the general credit of the lessee, and
disposition of the property in the event of foreclosure might prove difficult.
The Fund does not intend to invest a significant portion of its assets in such
"non-appropriation" municipal lease obligations. There is no limitation on the
Fund's ability to invest in other municipal lease obligations.
A-1
<PAGE>
ZERO COUPON OBLIGATIONS
The Fund may invest up to 10% of its total assets in zero coupon Municipal
Obligations. Such obligations include "pure zero" obligations, which pay no
interest for their entire life (either because they bear no stated rate of
interest or because their stated rate of interest is not payable until
maturity), and "zero/fixed" obligations, which pay no interest for an initial
period and thereafter pay interest currently. Zero coupon obligations also
include securities representing the principal-only components of Municipal
Obligations from which the interest components have been stripped and sold
separately by the holders of the underlying Municipal Obligations. Zero coupon
securities usually trade at a deep discount from their face or par value and
will be subject to greater fluctuations in market value in response to
changing interest rates than obligations of comparable maturities that make
current distributions of interest. While zero coupon Municipal Obligations
will not contribute to the cash available to the Fund for purposes of paying
dividends to stockholders, Mitchell Hutchins believes that limited investments
in such securities may facilitate the Fund's ability to preserve capital while
generating income through the accrual of original issue discount. Zero coupon
Municipal Obligations will not be counted as income-producing securities for
purposes of the Fund's policy of normally investing at least 65% of its total
assets in income-producing securities. Zero coupon Municipal Obligations
generally are liquid, although such liquidity may be reduced from time to time
due to interest rate volatility and other factors.
Federal tax law requires the Fund to distribute at least 90% of its tax-
exempt income, plus its investment company taxable income, including non-cash
income, each year in order to qualify for pass-through federal income tax
treatment as a regulated investment company. Accordingly, although the Fund
will receive no payments on its zero coupon Municipal Obligations prior to
their maturity or disposition, it will have income attributable to such
securities, and it might be required, in order to maintain its desired tax
treatment, to include in its dividends the income attributable to its zero
coupon securities. The Fund might be required to liquidate portfolio
securities at a time that it otherwise would not have done so in order to make
such dividends. The Fund will not be able to purchase additional income-
producing securities with cash used to make such distributions, and as a
result, its current income ultimately may be reduced. See "Taxes" and "Other
Investment Practices" in this Prospectus and "Taxes" in the SAI.
FLOATING AND VARIABLE RATE OBLIGATIONS
The Fund also may purchase floating and variable rate municipal notes and
bonds, which frequently permit the holder to demand payment of principal at
any time, or at specified intervals, and permit the issuer to prepay
principal, plus accrued interest, at its discretion after a specified notice
period. The issuer's obligations under the demand feature of such notes and
bonds generally are secured by bank letters of credit or other credit support
arrangements. There may be no secondary market for variable and floating rate
obligations held by the Fund, although the Fund may be able to obtain payment
of principal at face value by exercising the demand feature of the obligation.
MUNICIPAL DERIVATIVES
The Fund may invest in derivative securities that are Municipal Obligations,
or components thereof, that have been specially structured to reflect
investment characteristics ordinarily associated with other securities or to
have other special rights desired by investors. Generally, such securities are
designed to allow investors to take advantage of expected interest rate trends
or to hedge interest rate or other risks. The Fund does not expect to invest
more than 5% of its net assets in any particular form of municipal derivative
during the coming year other than detachable call options and Municipal
Obligations with embedded caps. Detachable call options are sold by issuers of
Municipal Obligations separately from the Municipal Obligations to which the
call options relate and permit the purchasers of the call options to acquire
the Municipal Obligations at the call price(s) and call date(s). In the event
that interest rates drop, the purchaser could exercise the call option to
acquire Municipal Obligations that yield above-market rates. The Fund expects
during the coming year only to acquire detachable call options relating to
Municipal Obligations that the Fund already owns or will acquire in the
immediate future and thereby, in effect, make such Municipal Obligations non-
callable so long as the Fund continues to hold the
A-2
<PAGE>
detachable call option. Municipal Obligations with embedded caps provide for
additional tax-free payments for a stated period (generally a period that is
shorter than the bond's maturity) above the fixed rate of interest payable on
the Municipal Obligations to the extent that the average level of a particular
index exceeds a specified base level. As long as the APS are outstanding, the
Fund would use Municipal Obligations with embedded caps in order to attempt to
offset the risk of increases in short-term interest rates while continuing to
earn tax-exempt income. Investments in municipal derivatives may be subject to
the same risks as floating rate Municipal Obligations, risks of adverse tax
determinations or, in the case of municipal derivatives used for hedging
purposes, risks similar to those for other hedging strategies. See "Hedging
and Related Income Strategies" in the SAI. The Fund will only invest in those
municipal derivatives that Mitchell Hutchins believes will facilitate the
Fund's ability to achieve its investment objective.
OTHER MUNICIPAL OBLIGATIONS
The Fund also may invest in participations that are issued by banks or other
financial institutions and that represent ownership interests in municipal
bonds, IDBs or PABs, custodial receipts representing ownership interests in
future interest or principal payments on such obligations, inverse floaters,
put bonds and tender option bonds. The Fund currently does not intend to
invest more than 5% of its net assets in any one of these types of Municipal
Obligations during the coming year. The following categories of instruments
will not be treated as satisfying the 80% test (in the Fund's policy of
normally investing at least 80% of its net assets in Municipal Obligations
that pay interest that is not a Tax Preference Item): participation interests,
custodial receipts, inverse floaters and municipal derivatives that are issued
by a third party or anyone other than a municipality.
A-3
<PAGE>
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NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY REPRE-
SENTATIONS NOT CONTAINED IN THIS PROSPECTUS IN CONNECTION WITH THE OFFERING
MADE BY THIS PROSPECTUS AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTA-
TIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE FUND OR
PAINEWEBBER. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFERING BY THE FUND OR BY
PAINEWEBBER IN ANY JURISDICTION IN WHICH SUCH OFFERING MAY NOT LAWFULLY BE
MADE.
---------------
TABLE OF CONTENTS
<TABLE>
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<S> <C>
Fund Expenses.............................................................. 2
Prospectus Summary......................................................... 3
Financial Highlights....................................................... 9
The Fund................................................................... 11
The Offering............................................................... 11
Use Of Proceeds............................................................ 11
Trading History............................................................ 11
Investment Objective And Policies.......................................... 12
Other Investment Practices................................................. 13
Special Leverage Considerations............................................ 15
Special Considerations and Risk Factors.................................... 17
Management of the Fund..................................................... 18
Dividends and Other Distributions; Dividend Reinvestment Plan.............. 19
Taxes...................................................................... 21
Description of Capital Stock............................................... 22
Custodian, Transfer And Dividend Disbursing Agent and Registrar............ 26
Further Information........................................................ 26
Table of Contents of Statement of Additional Information................... 27
Appendix A--Types Of Municipal Obligations................................. A-1
</TABLE>
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INVESTMENT GRADE
MUNICIPAL INCOME FUND INC.
COMMON STOCK
---------------
PROSPECTUS
---------------
PAINEWEBBER INCORPORATED
---------------
JANUARY 31, 1997
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
(C) 1997 PaineWebber Incorporated
<PAGE>
INVESTMENT GRADE MUNICIPAL INCOME FUND INC.
1285 AVENUE OF THE AMERICAS
NEW YORK, NEW YORK 10019
STATEMENT OF ADDITIONAL INFORMATION
Investment Grade Municipal Income Fund Inc. ("Fund") is a diversified
closed-end management investment company. The Fund's investment objective is
to achieve a high level of current income that is exempt from federal income
tax, consistent with the preservation of capital. There is no assurance that
the Fund will achieve its investment objective.
Prior to January 19, 1996, the name of the Fund was "PaineWebber Premier
Tax-Free Income Fund Inc." The Fund began doing business under the name
"Investment Grade Municipal Income Fund" in August 1995 and the shareholders
of the Fund approved a formal change of the Fund's name to Investment Grade
Municipal Income Fund Inc. on January 18, 1996.
Shares of the Fund's common stock ("Common Stock") may be offered from time
to time in order to effect over-the-counter ("OTC") secondary market sales by
PaineWebber Incorporated ("PaineWebber") in its capacity as a dealer and
secondary market-maker. PaineWebber may (but is not obligated to) make such a
secondary market.
Mitchell Hutchins Asset Management Inc. ("Mitchell Hutchins"), a wholly
owned subsidiary of PaineWebber, serves as investment adviser and
administrator of the Fund. This Statement of Additional Information ("SAI") is
not a prospectus and should be read only in conjunction with the Fund's
current Prospectus, dated January 31, 1997 Capitalized terms not otherwise
defined herein have the same meanings as in the Prospectus. Certain terms
relating to the Fund's auction preferred shares ("APS") are defined in the
Fund's Articles Supplementary, which are on file with the U.S. Securities and
Exchange Commission ("SEC"), Washington, D.C., as an exhibit to the
registration statement of which this SAI forms a part and may be obtained from
the SEC upon payment of the fee prescribed or inspected at the SEC's office at
no charge. A copy of the Prospectus may be obtained by contacting PaineWebber
at 1285 Avenue of the Americas, New York, New York 10019, or calling toll free
1-800-852-4750. This SAI is dated January 31, 1997.
INVESTMENT POLICIES AND RESTRICTIONS
The following supplements the information contained in the Prospectus
concerning the Fund's investment policies and limitations.
APS RATING AGENCY GUIDELINES
The Fund intends that, so long as the APS are outstanding, the composition
of its portfolio will reflect guidelines established by Moody's Investors
Service, Inc. ("Moody's") and Standard & Poor's, a division of The McGraw-Hill
Companies, Inc. ("S&P"), in connection with their respective ratings of the
APS. See Appendix B.
<PAGE>
MUNICIPAL OBLIGATIONS
Under normal circumstances, the Fund does not invest 25% or more of its
total assets in any one industry. Governmental issuers of Municipal
Obligations are not considered part of any industry and, therefore, are not
subject to this limitation. Municipal Obligations backed only by the assets
and revenues of non-governmental entities, however, are considered to be
issued by such non-governmental entities and would be subject to this
limitation. The Fund reserves the right to invest more than 25% of its assets
in industrial development bonds or in issuers located in the same state. If
the Fund were to invest more than 25% of its total assets in issuers located
in the same state, it would be more susceptible to adverse economic, business
or regulatory conditions in that state.
The Fund is authorized to invest in the following types of Municipal
Obligations but does not currently intend to invest more than 5% of its net
assets in any one such type of Municipal Obligation during the coming year:
Participation Interests. The Fund may invest in participation interests in
municipal bonds, including industrial development bonds ("IDBs"), private
activity bonds ("PABs") and floating and variable rate securities. A
participation interest gives the Fund an undivided interest in a municipal
bond owned by a bank. The Fund has the right to sell the instrument back to
the bank. Such right is generally backed by the bank's irrevocable letter of
credit or guarantee and permits the Fund to draw on the letter of credit on
demand, after specified notice, for all or any part of the principal amount of
the Fund's participation interest plus accrued interest. Generally, the Fund
intends to exercise the demand under the letters of credit or other guarantees
only upon a default under the terms of the underlying bond, or to maintain the
Fund's portfolio in accordance with its investment objective and policies. The
ability of a bank to fulfill its obligations under a letter of credit or
guarantee might be affected by possible financial difficulties of its
borrowers, adverse interest rate or economic conditions, regulatory
limitations or other factors. Mitchell Hutchins will monitor the pricing,
quality and liquidity of the participation interests held by the Fund, and the
credit standing of banks issuing letters of credit or guarantees supporting
such participation interests held by the Fund on the basis of published
financial information reports of rating services and bank analytical services.
Custodial Receipts. The Fund may acquire custodial receipts or certificates
underwritten by securities dealers or banks that evidence ownership of future
interest payments, principal payments or both on certain Municipal
Obligations. The underwriter of these certificates or receipts typically
purchases Municipal Obligations and deposits the obligations in an irrevocable
trust or custodial account with a custodial bank, which then issues receipts
or certificates that evidence ownership of the periodic unmatured coupon
payments and the final principal payment on the obligations. Custodial
receipts evidencing specific coupon or principal payments have the same
economic attributes as zero coupon Municipal Obligations described herein.
Although under the terms of a custodial receipt the Fund would be typically
authorized to assert its rights directly against the issuer of the underlying
obligation, the Fund could be required to assert through the custodian bank
those rights that may exist against the underlying issuer. Thus, in the event
the underlying issuer fails to pay principal or interest when due, the Fund
may be subject to delays, expenses and risks that are greater than those that
would have been involved if the Fund had purchased a direct obligation of the
issuer. In addition, in the event that the trust or custodial account in which
the underlying security has been deposited is determined to be an association
taxable as a corporation, instead of a non-taxable entity, the yield on the
underlying security would be reduced in recognition of any taxes paid.
Inverse Floaters. The Fund may invest in Municipal Obligations on which the
rate of interest varies inversely with interest rates on other Municipal
Obligations or an index. Such obligations include components of
2
<PAGE>
securities on which interest is paid in two separate parts--an auction
component, which pays interest at a rate that is set periodically through an
auction process or other method, and a residual component, which pays interest
at a rate equal to the difference between the rate that the issuer would have
paid on a fixed-rate obligation at the time of issuance and the rate paid on
the auction component. The market value of an inverse floater will be more
volatile than that of a fixed-rate obligation and, like most debt obligations,
will vary inversely with changes in interest rates.
Because the interest rate paid to holders of residual components is
generally determined by subtracting the interest rate paid to the holders of
auction components from a fixed amount, the interest rate paid or residual
component holders will decrease as the auction component's rate increases and
increase as the auction component's rate decreases. Moreover, the extent of
the increases and decreases in market value of residual components may be
larger than comparable changes in the market value of an equal principal
amount of a fixed rate Municipal Obligation having similar credit quality,
redemption provisions and maturity.
Put Bonds. Put bonds are municipal bonds which give the holder an
unconditional right to sell the bond back to the issuer or a remarketing agent
at a specified price and exercise date, which is typically well in advance of
the bond's maturity date. If the put is a "one time only" put, the Fund
ordinarily will sell the bond or put the bond, depending on the more favorable
price. If the bond has a series of puts after the first put, the bond will be
held as long as, in Mitchell Hutchins' opinion, it is in the best interests of
the Fund to do so. The obligation to purchase the bond on the exercise date of
the put may be supported by a letter of credit or other credit support
agreement from a bank, insurance company or other financial institution, the
credit standing of which affects the credit standing of the obligation. There
is no assurance that an issuer or remarketing agent for a put bond will be
able to repurchase the bond on the put exercise date if the Fund chooses to
exercise its right to put the bond back to the issuer or remarketing agent.
Tender Option Bonds. Tender option bonds are long-term municipal securities
sold by a bank subject to a "tender option" that gives the purchaser the right
to tender them to the bank at par plus accrued interest at designated times
(the "tender option"). The tender option may be exercisable at intervals
ranging from bi-weekly to semi-annually, and the interest rate on the bonds is
typically reset at the end of the applicable interval in order to cause the
bonds to have a market value that approximates their par value. The tender
option generally would not be exercisable in the event of a default on, or
significant downgrading of, the underlying municipal securities. Therefore, a
Fund's ability to exercise the tender option will be affected by the credit
standing of both the bank involved and the issuer of the underlying
securities.
WHEN-ISSUED AND DELAYED DELIVERY SECURITIES
A security purchased on a when-issued or delayed delivery basis is recorded
as an asset on the commitment date and is subject to changes in market value,
generally based upon changes in the level of interest rates. Thus, fluctuation
in the value of the security from the time of the commitment date will affect
the Fund's net asset value. When the Fund commits to purchase securities on a
when-issued or delayed delivery basis, its custodian will set aside in a
segregated account cash or liquid securities, marked to market daily, with a
market value equal to the amount of the commitment. If necessary, additional
assets will be placed in the account daily so that the value of the account
will equal or exceed the amount of the Fund's purchase commitment. Placing
securities rather than cash in the segregated account may have a leveraging
effect on the Fund's net asset value per share; that is, to the extent that
the Fund remains substantially fully invested in securities at the same time
that it has committed to purchase securities on a when-issued or delayed
delivery basis, greater fluctuations in its net asset value per share may
occur than if it had set aside cash to satisfy its purchase commitments.
3
<PAGE>
STAND-BY COMMITMENTS
The Fund may acquire "stand-by commitments" with respect to Municipal
Obligations it purchases or holds. Under a stand-by commitment, which
resembles a put option, a broker, dealer or bank is obligated to repurchase at
the Fund's option specified securities at a specified price. The Fund's
ability to exercise a stand-by commitment is subject to the ability of the
seller to make payment on demand. The Fund will acquire stand-by commitments
solely to facilitate liquidity and does not intend to exercise the rights
afforded by the commitments for trading purposes. The Fund anticipates that
stand-by commitments will be available from brokers, dealers, and banks
without the payment of any direct or indirect consideration. The Fund may pay
for stand-by commitments if payment is deemed necessary, thus increasing to a
degree the cost of the underlying Municipal Obligation and similarly
decreasing the obligation's yield.
The Fund would enter into stand-by commitments only with those brokers,
banks or dealers that, in the opinion of Mitchell Hutchins, present minimal
credit risks. The Fund's right to exercise stand-by commitments would be
unconditional and unqualified. A stand-by commitment would not be transferable
by the Fund, although the Fund could sell the underlying securities to a third
party at any time. The acquisition of a stand-by commitment would not
ordinarily affect the valuation or maturity of the underlying Municipal
Obligations.
ILLIQUID SECURITIES
As noted in the Prospectus, the Fund may invest up to 20% of its total
assets in illiquid securities. The board of directors has delegated the
function of making day-to-day determinations of liquidity to Mitchell
Hutchins, pursuant to guidelines approved by the board. Mitchell Hutchins
takes into account a number of factors in reaching liquidity decisions,
including: (1) the frequency of trades for the security; (2) the number of
dealers that make quotes for the security; (3) the number of dealers that have
undertaken to make a market in the security; (4) the number of other potential
purchasers; and (5) the nature of the security and how trading is effected
(e.g., the time needed to sell the security, how offers are solicited and the
mechanics of transfer). Mitchell Hutchins monitors the liquidity of securities
in the Fund's portfolio and reports periodically on liquidity decisions to the
board of directors.
In making determinations as to the liquidity of municipal lease obligations,
Mitchell Hutchins will distinguish between direct investments in municipal
lease obligations (or participations therein) and investments in securities
that may be supported by municipal lease obligations or certificates of
participation therein. Since these municipal lease obligation-backed
securities are based on a well-established means of securitization, Mitchell
Hutchins does not believe that investing in such securities presents the same
liquidity issues as direct investments in municipal lease obligations. The
assets used as cover for any OTC options written by the Fund would be
considered illiquid unless the OTC options are sold to qualified dealers who
agree that the Fund may repurchase any OTC option it writes at a maximum price
to be calculated by a formula set forth in the option agreement. The cover for
an OTC option written subject to this procedure will be considered illiquid
only to the extent that the maximum repurchase price under the formula exceeds
the intrinsic value of the option.
INVESTMENT LIMITATIONS
The following fundamental investment limitations cannot be changed without
the affirmative vote of the lesser of (a) more than 50% of the outstanding
shares of the Fund or (b) 67% or more of such shares present at a
stockholders' meeting if more than 50% of the outstanding shares are
represented at the meeting in person or by proxy. If a percentage restriction
is adhered to at the time of an investment or transaction, a later increase or
4
<PAGE>
decrease in percentage resulting from a change in values of portfolio
securities or the amount of total assets will not be considered a violation of
any of the following limitations or of any of the Fund's investment policies.
The Fund may not:
(1) purchase securities of any one issuer if, as a result, more than 5% of the
Fund's total assets would be invested in securities of that issuer or the
Fund would own or hold more than 10% of the outstanding voting securities
of that issuer, except that up to 25% of the Fund's total assets may be
invested without regard to this limitation, and except that this
limitation does not apply to securities issued or guaranteed by the U.S.
government, its agencies and instrumentalities or to securities issued by
other investment companies.
The following interpretation applies to, but is not a part of, this
fundamental limitation: Each state (including the District of Columbia and
Puerto Rico), territory and possession of the United States, each political
subdivision, agency, instrumentality and authority thereof, and each multi-
state agency of which a state is a member is a separate "issuer." When the
assets and revenues of an agency, authority, instrumentality or other
political subdivision are separate from the government creating the
subdivision and the security is backed only by the assets and revenues of
the subdivision, such subdivision would be deemed to be the sole issuer.
Similarly, in the case of an IDB or PAB, if that bond is backed only by the
assets and revenues of the non-governmental user, then that non-
governmental user would be deemed to be the sole issuer. However, if the
creating government or another entity guarantees a security, then to the
extent that the value of all securities issued or guaranteed by that
government or entity and owned by the Fund exceeds 10% of the Fund's total
assets, the guarantee would be considered a separate security and would be
treated as issued by that government or entity.
(2) purchase any security if, as a result of that purchase, 25% or more of the
Fund's total assets would be invested in securities of issuers having
their principal business activities in the same industry, except that this
limitation does not apply to securities issued or guaranteed by the U.S.
government, its agencies or instrumentalities or to municipal securities.
(3) issue senior securities (including borrowing money from banks and other
entities through reverse repurchase agreements), except (a) the Fund may
borrow in an amount not in excess of 33 1/3% of total assets (including
the amount of the senior securities issued, but reduced by any liabilities
and indebtedness not constituting senior securities), (b) the Fund may
issue preferred stock having a liquidation preference in an amount which,
combined with the amount of any liabilities or indebtedness constituting
senior securities, is not in excess of 50% of its total assets (computed
as provided in clause (a) above) and (c) the Fund may borrow up to an
additional 5% of its total assets (not including the amount borrowed) for
temporary or emergency purposes.
(4) make loans, except through loans of portfolio securities or through
repurchase agreements, provided that for purposes of this restriction, the
acquisition of bonds, debentures or other debt securities or instruments,
or participations or other interests therein and investments in government
obligations, commercial paper, certificates of deposit, bankers'
acceptances or similar instruments will not be considered the making of a
loan.
(5) engage in the business of underwriting securities of other issuers, except
to the extent that the Fund might be considered an underwriter under the
federal securities laws in connection with its disposition of portfolio
securities.
(6) purchase or sell real estate, except that investments in securities of
issuers that invest in real estate and investments in mortgage-backed
securities, mortgage participations or other instruments supported by
5
<PAGE>
interests in real estate are not subject to this limitation, and except
that the Fund may exercise rights under agreements relating to such
securities, including the right to enforce security interests and to hold
real estate acquired by reason of such enforcement until that real estate
can be liquidated in an orderly manner.
(7) purchase or sell physical commodities unless acquired as a result of
owning securities or other instruments, but the Fund may purchase, sell or
enter into financial options and futures, forward and spot currency
contracts, swap transactions and other financial contracts or derivative
instruments.
The following investment restrictions are not fundamental and may be changed
by the Fund's board of directors without shareholder approval.
The Fund will not:
(1) purchase securities on margin, except for short-term credit necessary for
clearance of portfolio transactions and except that the Fund may make
margin deposits in connection with its use of financial options and
futures, forward and spot currency contracts, swap transactions and other
financial contracts or derivative instruments.
(2) engage in short sales of securities or maintain a short position, except
that the Fund may (a) sell short "against the box" and (b) maintain short
positions in connection with its use of financial options and futures,
forward and spot currency contracts, swap transactions and other financial
contracts or derivative instruments.
6
<PAGE>
HEDGING AND RELATED INCOME STRATEGIES
As discussed in the Prospectus, Mitchell Hutchins may use a variety of
financial instruments ("Hedging Instruments"), including certain options,
futures contracts (sometimes referred to as "futures"), options on futures
contracts and interest rate protection transactions, to attempt to hedge the
Fund's portfolio and may use options to attempt to enhance the Fund's income.
Since any income realized from the use of options and futures would be taxable
to stockholders, the Fund currently does not intend to engage in hedging or
related income strategies and would do so only under unusual market
conditions. In addition, rating agency guidelines impose restrictions on the
Fund's ability to invest in Hedging Instruments. For as long as shares of any
series of APS are rated by Moody's, the Fund may engage in transactions in
options on securities, futures contracts based on the Municipal Index or
Treasury Bonds and options on such futures contracts (collectively "Moody's
Hedging Transactions") only when consistent with the provisions set forth
under "Appendix B--Rating Agency Guidelines," unless it receives written
confirmation from Moody's that engaging in such transactions will not impair
the ratings then assigned to the APS by Moody's. For as long as shares of any
series of APS are rated by S&P, the Fund will not buy or sell futures
contracts or options thereon or write put options or call options on portfolio
securities or enter into interest rate caps, collars or floors unless it
receives written confirmation from S&P that engaging in such transactions will
not impair the ratings then assigned to the APS by S&P, except that the Fund
may buy or sell futures contracts based on the Municipal Index or Treasury
Bonds, may purchase put and call options on such contracts and may write
covered call options and secured put options on portfolio securities
(collectively "S&P Hedging Transactions") subject to the limitations described
under "Appendix B--Rating Agency Guidelines."
Hedging strategies can be broadly categorized as "short hedges" and "long
hedges." A short hedge is a purchase or sale of a Hedging Instrument intended
to partially or fully offset potential declines in the value of one or more
investments held in the Fund's portfolio. Thus, in a short hedge the Fund
takes a position in a Hedging Instrument the price of which is expected to
move in the opposite direction of the price of the investment being hedged.
For example, the Fund might purchase a put option on a security to hedge
against a potential decline in the value of that security. If the price of the
security declined below the exercise price of the put, the Fund could exercise
the put and thus limit its loss below the exercise price to the premium paid
plus transaction costs. In the alternative, because the value of the put
option can be expected to increase as the value of the underlying security
declines, the Fund might be able to close out the put option and realize a
gain to offset the decline in the value of the security.
Conversely, a long hedge is a purchase or sale of a Hedging Instrument
intended partially or fully to offset potential increases in the acquisition
cost of one or more investments that the Fund intends to acquire. Thus, in a
long hedge the Fund takes a position in a Hedging Instrument the price of
which is expected to move in the same direction as the price of the
prospective investment being hedged. For example, the Fund might purchase a
call option on a security it intends to purchase in order to hedge against an
increase in the cost of the security. If the price of the security increased
above the exercise price of the call, the Fund could exercise the call and
thus limit its acquisition cost to the exercise price plus the premium paid
and transaction costs. Alternatively, the Fund might be able to offset the
price increase by closing out an appreciated call option and realizing a gain.
Hedging Instruments on securities generally are used to hedge against price
movements in one or more particular securities positions that the Fund owns or
intends to acquire. Hedging Instruments on debt securities may be used to
hedge either individual securities or broad fixed income market sectors.
7
<PAGE>
The use of Hedging Instruments is subject to applicable regulations of the
SEC, the several options and futures exchanges upon which they are traded and
the Commodity Futures Trading Commission ("CFTC"). In addition, the Fund's
ability to use Hedging Instruments will be limited by tax considerations. See
"Taxes."
In addition to the products, strategies and risks described below, Mitchell
Hutchins expects additional opportunities to develop in connection with
options, futures contracts and other hedging techniques. These new
opportunities may become available as Mitchell Hutchins develops new
techniques, as regulatory authorities broaden the range of permitted
transactions and as new options, futures contracts or other techniques are
developed. Mitchell Hutchins may utilize these opportunities to the extent
that they are consistent with the Fund's investment objective and permitted by
the Fund's investment limitations and applicable regulatory authorities.
SPECIAL RISKS OF HEDGING STRATEGIES
The use of Hedging Instruments involves special considerations and risks, as
described below. Risks pertaining to particular Hedging Instruments are
described in the sections that follow.
(1) Successful use of most Hedging Instruments depends upon Mitchell
Hutchins' ability to predict movements of the overall securities and
interest rate markets, which requires different skills than predicting
changes in the prices of individual securities. While Mitchell Hutchins is
experienced in the use of Hedging Instruments, there can be no assurance
that any particular hedging strategy adopted will succeed.
(2) There might be imperfect correlation, or even no correlation, between
price movements of a Hedging Instrument and price movements of the
investments being hedged. For example, if the value of a Hedging Instrument
used in a short hedge increased by less than the decline in value of the
hedged investment, the hedge would not be fully successful. Such a lack of
correlation might occur due to factors unrelated to the value of the
investments being hedged, such as speculative or other pressures on the
markets in which Hedging Instruments are traded. The effectiveness of
hedges using Hedging Instruments on indexes will depend on the degree of
correlation between price movements in the index and price movements in the
securities being hedged.
(3) Hedging strategies, if successful, can reduce risk of loss by wholly
or partially offsetting the negative effect of unfavorable price movements
in the investments being hedged. However, hedging strategies can also
reduce opportunity for gain by offsetting the positive effect of favorable
price movements in the hedged investments. For example, if the Fund entered
into a short hedge because Mitchell Hutchins projected a decline in the
price of a security in the Fund's portfolio, and the price of that security
increased instead, the gain from that increase might be wholly or partially
offset by a decline in the price of the Hedging Instrument. Moreover, if
the price of the Hedging Instrument declined by more than the increase in
the price of the security, the Fund could suffer a loss. In either such
case, the Fund would have been in a better position had it not hedged at
all.
(4) As described below, the Fund might be required to maintain assets as
"cover," maintain segregated accounts or make margin payments when it takes
positions in Hedging Instruments involving obligations to third parties
(i.e., Hedging Instruments other than purchased options). If the Fund were
unable to close out its positions in such Hedging Instruments, it might be
required to continue to maintain such assets or accounts or make such
payments until the position expired or matured. These requirements might
impair the Fund's ability to sell a portfolio security or make an
investment at a time when it would otherwise be favorable to do so, or
require that the Fund sell a portfolio security at a disadvantageous time.
The Fund's ability to close out a position in a Hedging Instrument prior to
expiration or maturity depends on the
8
<PAGE>
existence of a liquid secondary market or, in the absence of such a market,
the ability and willingness of a contra party to enter into a transaction
closing out the position. Therefore, there is no assurance that any hedging
position can be closed out at a time and price that is favorable to the
Fund.
COVER FOR HEDGING STRATEGIES
Transactions using Hedging Instruments, other than purchased options, expose
the Fund to an obligation to another party. The Fund will not enter into any
such transactions unless it owns either (1) an offsetting ("covered") position
in securities or other options or futures contracts or (2) cash or liquid
securities, with a value sufficient at all times to cover its potential
obligations to the extent not covered as provided in (1) above. The Fund will
comply with SEC guidelines regarding cover for hedging transactions and will,
if the guidelines so require, set aside cash or liquid securities, marked to
market daily, in a segregated account with its custodian in the prescribed
amount.
Assets used as cover or held in a segregated account cannot be sold while
the position in the corresponding Hedging Instrument is open, unless they are
replaced with similar assets. As a result, the commitment of a large portion
of the Fund's assets to cover or segregated accounts could impede portfolio
management or the Fund's ability to meet redemption requests or other current
obligations.
OPTIONS
The Fund may purchase put and call options, and write (sell) covered call
options and covered put options, on debt securities. The purchase of call
options serves as a long hedge, and the purchase of put options serves as a
short hedge. Writing covered put or call options can enable the Fund to
enhance income by reason of the premiums paid by the purchasers of such
options. However, if the market price of the security underlying a covered put
option declines to less than the exercise price on the option, minus the
premium received, the Fund would expect to suffer a loss. Writing covered call
options serves as a limited short hedge, because declines in the value of the
hedged investment would be offset to the extent of the premium received for
writing the option. However, if the security appreciates to a price higher
than the exercise price of the call option, it can be expected that the option
will be exercised and the Fund will be obligated to sell the security at less
than its market value. If the covered call option is an OTC option, the
securities or other assets used as cover would be considered illiquid to the
extent described under "Investment Policies and Restrictions--Illiquid
Securities."
The value of an option position will reflect, among other things, the
current market value of the underlying investment, the time remaining until
expiration, the relationship of the exercise price to the market price of the
underlying investment, the historical price volatility of the underlying
investment and general market conditions. Options normally have expiration
dates of up to nine months. Options that expire unexercised have no value.
The Fund may effectively terminate its right or obligation under an option
by entering into a closing transaction. For example, the Fund may terminate
its obligation under a call option that it had written by purchasing an
identical call option; this is known as a closing purchase transaction.
Conversely, the Fund may terminate a position in a put or call option it had
purchased by writing an identical put or call option; this is known as a
closing sale transaction. Closing transactions permit the Fund to realize
profits or limit losses on an option position prior to its exercise or
expiration.
The Fund may purchase or write both exchange-traded and OTC options.
However, exchange-traded or liquid OTC options on Municipal Obligations are
not currently available. Exchange-traded options in the United States are
issued by a clearing organization affiliated with the exchange on which the
option is listed which, in
9
<PAGE>
effect, guarantees completion of every exchange-traded option transaction. In
contrast, OTC options are contracts between the Fund and its contra party
(usually a securities dealer or a bank) with no clearing organization
guarantee. Thus, when the Fund purchases or writes an OTC option, it relies on
the contra party to make or take delivery of the underlying investment upon
exercise of the option. Failure by the contra party to do so would result in
the loss of any premium paid by the Fund as well as the loss of any expected
benefit of the transaction.
Generally, OTC options on debt securities are European style options. This
means that the option is only exercisable immediately prior to its expiration.
This is in contrast to American-style options, which are exercisable at any
time prior to the expiration date of the option.
The Fund's ability to establish and close out positions in exchange-listed
options depends on the existence of a liquid market. The Fund intends to
purchase or write only those exchange-traded options for which there appears
to be a liquid secondary market. However, there can be no assurance that such
a market will exist at any particular time. Closing transactions can be made
for OTC options only by negotiating directly with the contra party, or by a
transaction in the secondary market if any such market exists. Although the
Fund will enter into OTC options only with contra parties that are expected to
be capable of entering into closing transactions with the Fund, there is no
assurance that the Fund will in fact be able to close out an OTC option
position at a favorable price prior to expiration. In the event of insolvency
of the contra party, the Fund might be unable to close out an OTC option
position at any time prior to its expiration.
If the Fund were unable to effect a closing transaction for an option it had
purchased, it would have to exercise the option to realize any profit. The
inability to enter into a closing purchase transaction for a covered call
option written by the Fund could cause material losses because the Fund would
be unable to sell the investment used as cover for the written option until
the option expires or is exercised.
In the event that options on indexes of municipal and non-municipal debt
securities become available, the Fund may purchase and write put and call
options on such indexes in much the same manner as the more traditional
options discussed above, except that index options may serve as a hedge
against overall fluctuations in the debt securities market (or market sectors)
rather than anticipated increases or decreases in the value of a particular
security.
FUTURES
The Fund may purchase and sell municipal bond index futures, other interest
rate futures and options thereon. The purchase of futures or call options
thereon can serve as a long hedge, and the sale of futures or the purchase of
put options thereon can serve as a short hedge. Writing covered call options
on futures contracts can serve as a limited short hedge, using a strategy
similar to that used for writing covered call options on securities or
indexes. Similarly, writing covered put options on futures contracts can serve
as a limited long hedge.
Futures strategies also can be used to manage the average duration of the
Fund's portfolio. If Mitchell Hutchins wishes to shorten the average duration
of the Fund's portfolio, the Fund may sell a futures contract or a call option
thereon, or purchase a put option on that futures contract. If Mitchell
Hutchins wishes to lengthen the average duration of the Fund's portfolio, the
Fund may buy a futures contract or a call option thereon, or sell a put option
thereon.
No price is paid upon entering into a futures contract. Instead, at the
inception of a futures contract the Fund is required to deposit in a
segregated account with its custodian, in the name of the futures broker
through whom the transaction was effected, "initial margin" consisting of
cash, obligations of the United States or obligations that are fully
guaranteed as to principal and interest by the United States, in an amount
generally
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<PAGE>
equal to 10% or less of the contract value. Margin must also be deposited when
writing a call option on a futures contract, in accordance with applicable
exchange rules. Unlike margin in securities transactions, initial margin on
futures contracts does not represent a borrowing, but rather is in the nature
of a performance bond or good-faith deposit that is returned to the Fund at
the termination of the transaction if all contractual obligations have been
satisfied. Under certain circumstances, such as periods of high volatility,
the Fund may be required by an exchange to increase the level of its initial
margin payment, and initial margin requirements might be increased generally
in the future by regulatory action.
Subsequent "variation margin" payments are made to and from the futures
broker daily as the value of the futures position varies, a process known as
"marking to market." Variation margin does not involve borrowing, but rather
represents a daily settlement of the Fund's obligations with respect to an
open futures position. When the Fund purchases an option on a future, the
premium paid plus transaction costs is all that is at risk. In contrast, when
the Fund purchases or sells a futures contract or writes a call option
thereon, it is subject to daily variation margin calls that could be
substantial in the event of adverse price movements. If the Fund has
insufficient cash to meet daily variation margin requirements, it might need
to sell securities at a time when such sales are disadvantageous.
Holders and writers of futures positions and options on futures can enter
into offsetting closing transactions, similar to closing transactions on
options, by selling or purchasing, respectively, an instrument identical to
the instrument held or written. Positions in futures and options on futures
may be closed only on an exchange or board of trade that provides a secondary
market. The Fund intends to enter into futures transactions only on exchanges
or boards of trade where there appears to be a liquid secondary market.
However, there can be no assurance that such a market will exist for a
particular contract at a particular time. Secondary markets for options on
futures are currently in the development stage, and the Fund will not trade
options on futures on any exchange or board of trade unless, in Mitchell
Hutchins' opinion, the markets for such options have developed sufficiently
that the liquidity risks for such options are not greater than the
corresponding risks for futures.
Under certain circumstances, futures exchanges may establish daily limits on
the amount that the price of a future or related option can vary from the
previous day's settlement price; once that limit is reached, no trades may be
made that day at a price beyond the limit. Daily price limits do not limit
potential losses because prices could move to the daily limit for several
consecutive days with little or no trading, thereby preventing liquidation of
unfavorable positions.
If the Fund were unable to liquidate a futures or related options position
due to the absence of a liquid secondary market or the imposition of price
limits, it could incur substantial losses. The Fund would continue to be
subject to market risk with respect to the position. In addition, except in
the case of purchased options, the Fund would continue to be required to make
daily variation margin payments and might be required to maintain the position
being hedged by the future or option or to maintain cash or liquid securities
in a segregated account.
Certain characteristics of the futures market might increase the risk that
movements in the prices of futures contracts or related options might not
correlate perfectly with movements in the prices of the investments being
hedged. For example, all participants in the futures and related options
markets are subject to daily variation margin calls and might be compelled to
liquidate futures or related options positions whose prices are moving
unfavorably to avoid being subject to further calls. These liquidations could
increase price volatility of the instruments and distort the normal price
relationship between the futures or options and the investments being hedged.
Also, because initial margin deposit requirements in the futures market are
less onerous than margin requirements in the securities markets, there might
be increased participation by speculators in the futures markets. This
participation also might cause temporary price distortions. In addition,
activities of large traders in
11
<PAGE>
both the futures and securities markets involving arbitrage, "program trading"
and other investment strategies might result in temporary price distortions.
GUIDELINE FOR FUTURES AND RELATED OPTIONS
To the extent that the Fund enters into futures contracts and options on
futures positions that are not for bona fide hedging purposes (as defined by
the CFTC), the aggregate initial margin and premiums on these positions
(excluding the amount by which options are "in-the-money") may not exceed 5%
of the Fund's net assets. This guideline may be modified by the Fund's board
of directors without a stockholder vote. Adoption of this guideline cannot be
guaranteed to limit the percentage of the Fund's assets at risk to 5%.
The Fund may use the following Hedging Instruments:
OPTIONS ON DEBT SECURITIES--A call option is a contract pursuant to which
the purchaser of the option, in return for a premium, has the right to buy the
security underlying the option at a specified price at any time during the
term, or upon the expiration, of the option. The writer of the call option,
who receives the premium, has the obligation, upon exercise of the option, to
deliver the underlying security against payment of the exercise price. A put
option is a similar contract which gives its purchaser, in return for a
premium, the right to sell the underlying security at a specified price during
the option term or upon expiration. The writer of the put option, who receives
the premium, has the obligation, upon exercise, to buy the underlying security
at the exercise price. Options on debt securities are traded primarily in the
OTC market rather than on any of the several options exchanges.
OPTIONS ON INDEXES OF DEBT SECURITIES--An index assigns relative values to
the securities included in the index and fluctuates with changes in the market
values of such securities. Index options operate in the same way as more
traditional options except that exercises of index options are effected with
cash payments and do not involve delivery of securities. Thus, upon exercise
of an index option, the purchaser will realize and the writer will pay, an
amount based on the difference between the exercise price and the closing
price of the index.
MUNICIPAL BOND INDEX FUTURES CONTRACTS--A municipal bond index futures
contract is a bilateral agreement pursuant to which one party agrees to accept
and the other party agrees to make delivery of an amount of cash equal to a
specified dollar amount times the difference between the index value at the
close of trading of the contract and the price at which the futures contract
is originally struck. No physical delivery of the bonds comprising the index
is made; generally contracts are closed out prior to the expiration date of
the contract.
MUNICIPAL DEBT FUTURES CONTRACTS--A municipal debt futures contract is a
bilateral agreement pursuant to which one party agrees to accept and the other
party agrees to make delivery of the specific type of municipal debt security
called for in the contract at a specified future time and at a specified
price.
OPTIONS ON FUTURES CONTRACTS--Options on futures contracts are similar to
options on securities except that an option on a futures contract gives the
purchaser the right, in return for the premium, to assume a position in a
futures contract (a long position if the option is a call and a short position
if the option is a put), rather than to purchase or sell a security, at a
specified price at any time during the option term. Upon exercise of the
option, the delivery of the futures position to the holder of the option will
be accompanied by delivery of the accumulated balance, which represents the
amount by which the market price of the futures contract exceeds, in
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<PAGE>
the case of a call, or is less than, in the case of a put, the exercise price
of the option on the future. The writer of an option, upon exercise, will
assume a short position in the case of a call, and a long position in the case
of put.
INTEREST RATE PROTECTION TRANSACTIONS--The Fund may enter into interest rate
protection transactions, including interest rate swaps and interest rate caps,
collars and floors. Interest rate swap transactions involve an agreement
between two parties to exchange payments that are based, for example, on
variable and fixed rates of interest and that are calculated on the basis of a
specified amount of principal (the "notional principal amount") for a
specified period of time. Interest rate cap and floor transactions involve an
agreement between two parties in which the first party agrees to make payments
to the counterparty when a designated market interest rate goes above (in the
case of a cap) or below (in the case of a floor) a designated level on
predetermined dates or during a specified time period. Interest rate collar
transactions involve an agreement between two parties in which payments are
made when a designated market interest rate either goes above a designated
level or goes below a designated floor level on predetermined dates or during
a specified time period.
The Fund would enter into interest rate protection transactions to preserve
a return or spread on a particular investment or portion of its portfolio, to
protect against any increase in the price of securities the Fund anticipates
purchasing at a later date or to effectively fix the rate of interest that it
pays on one or more borrowings or series of borrowings. The Fund would use
these transactions as a hedge and not as a speculative investment. Interest
rate protection transactions are subject to risks comparable to those
described above with respect to other hedging strategies.
The Fund may enter into interest rate swaps, caps, collars and floors on
either an asset-based or liability-based basis, depending on whether it is
hedging its assets or its liabilities, and will usually enter into interest
rate swaps on a net basis, i.e., the two payment streams are netted out, with
the Fund receiving or paying, as the case may be, only the net amount of the
two payments. Inasmuch as these interest rate protection transactions are
entered into for good faith hedging purposes, and inasmuch as segregated
accounts will be established with respect to such transactions, Mitchell
Hutchins and the Fund believe such obligations do not constitute senior
securities and, accordingly, will not treat them as being subject to its
borrowing restrictions. The net amount of the excess, if any, of the Fund's
obligations over its entitlements with respect to each interest rate swap will
be accrued on a daily basis and an amount of cash or liquid securities, marked
to market daily, having an aggregate net asset value at least equal to the
accrued excess will be maintained in a segregated account by a custodian that
satisfies the requirements of the Investment Company Act of 1940 ("1940 Act").
The Fund also will establish and maintain such segregated accounts with
respect to its total obligations under any interest rate swaps that are not
entered into on a net basis and with respect to any interest rate caps,
collars and floors that are written by the Fund.
The Fund will enter into interest rate protection transactions only with
banks and recognized securities dealers or their affiliates believed by
Mitchell Hutchins to present minimal credit risks in accordance with
guidelines established by the Fund's board of directors. If there is a default
by the other party to such a transaction, the Fund will have to rely on its
contractual remedies (which may be limited by bankruptcy, insolvency or
similar laws) pursuant to the agreements related to the transaction.
The swap market has grown substantially in recent years with a large number
of banks and investment banking firms acting both as principals and as agents
utilizing standardized swap documentation. Caps, collars and floors are more
recent innovations for which documentation is less standardized, and
accordingly, they are less liquid than swaps.
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<PAGE>
DIRECTORS AND OFFICERS
The overall management of the business and affairs of the Fund is vested
with its board of directors. The board of directors approves all significant
agreements between the Fund and persons or companies furnishing services to
it, including the Fund's agreements with its investment adviser and
administrator, custodian and transfer and dividend disbursing agent and
registrar. The day-to-day operations of the Fund are delegated to its officers
and to Mitchell Hutchins, subject always to the investment objective and
policies of the Fund and to general supervision by the Fund's board of
directors.
The business addresses and principal occupations during the past five years
of the directors and executive officers of the Fund are:
NAME, AGE AND ADDRESS* POSITION BUSINESS EXPERIENCE;
WITH THE FUND OTHER DIRECTORSHIPS
Margo N. Alexander; 49** Director and Mrs. Alexander is president,
President chief executive officer and a
director of Mitchell Hutchins
(since January 1995) and an ex-
ecutive vice president and di-
rector of PaineWebber. Mrs. Al-
exander is president and a di-
rector or trustee of 29 invest-
ment companies for which Mitch-
ell Hutchins or PaineWebber
serves as investment adviser.
Richard Q. Armstrong; 61 Director Mr. Armstrong is chairman and
78 West Brother Drive principal of RQA Enterprises
Greenwich, CT 06830 (management consulting firm)
(since April 1991 and principal
occupation since March 1995).
Mr. Armstrong is also a director
of Hi Lo Automotive, Inc. He was
chairman of the board, chief ex-
ecutive officer and co-owner of
Adirondack Beverages (producer
and distributor of soft drinks
and sparkling/still waters) (Oc-
tober 1993-March 1995). Mr. Arm-
strong was a partner of The New
England Consulting Group (man-
agement consulting firm) (Decem-
ber 1992-September 1993). He was
managing director of LVMH U.S.
Corporation (U.S. subsidiary of
the French luxury goods conglom-
erate, Luis Vuitton Moet
Hennessey Corporation) (1987-
1991) and chairman of its wine
and spirits subsidiary,
Schieffelin & Somerset Company
(1987-1991). Mr. Armstrong is
also a director or trustee of 28
investment companies for which
Mitchell Hutchins or PaineWebber
serves as investment adviser.
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<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME, AGE AND ADDRESS* WITH THE FUND OTHER DIRECTORSHIPS
---------------------- ------------- --------------------
<C> <C> <S>
E. Garrett Bewkes, Jr.; 70** Director and Mr. Bewkes is a director of Paine
Chairman of the Webber Group Inc. ("PW Group")
Board of Directors (holding company of Mitchell
Hutchins and PaineWebber). Prior
to December 1995, he was a con-
sultant to PW Group. Prior to
1988, he was chairman of the
board, president and chief exec-
utive officer of American Baker-
ies Company. Mr. Bewkes is a di-
rector of Interstate Bakeries
Corporation and Na Pro Bio-Ther-
apeutics, Inc. Mr. Bewkes is a
director or trustee of 29 in-
vestment companies for which
Mitchell Hutchins or PaineWebber
serves as investment adviser.
Richard R. Burt; 49 Director Mr. Burt is chairman of Interna-
1101 Connecticut Avenue, N.W. tional Equity Partners (interna-
Washington, D.C. 20036 tional investments and consult-
ing firm) (since March 1994) and
a partner of McKinsey & Company
(management consulting firm)
(since 1991). He is also a di-
rector of American Publishing
Company and Archer-Daniels-Mid-
land Co. (agricultural commodi-
ties). He was the chief negotia-
tor in the Strategic Arms Reduc-
tion Talks with the former So-
viet Union (1989-1991) and the
U.S. Ambassador to the Federal
Republic of Germany (1985-1989).
Mr. Burt is a director or
trustee of 28 investment compa-
nies for which Mitchell Hutchins
or PaineWebber serves as invest-
ment adviser.
Mary C. Farrell; 46** Director Ms. Farrell is a managing direc-
tor, senior investment strate-
gist and member of the Invest-
ment Policy Committee of
PaineWebber. Ms. Farrell joined
PaineWebber in 1982. She is a
member of the Financial Women's
Association and Women's Economic
Roundtable and is employed as a
regular panelist on Wall Street
Week with Louis Rukeyser. She
also serves on the Board of
Overseers of New York
University's Stern School of
Business. Ms. Farrell is a di-
rector or trustee of 28 invest-
ment companies for which Mitch-
ell Hutchins or PaineWebber
serves as investment adviser.
</TABLE>
15
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME, AGE AND ADDRESS* WITH THE FUND OTHER DIRECTORSHIPS
---------------------- ------------- --------------------
<C> <C> <S>
Meyer Feldberg; 54 Director Dean Feldberg is Dean and Profes-
Columbia University sor of Management of the Gradu-
101 Uris Hall ate School of Business, Columbia
New York, NY 10027 University. Prior to 1989, he
was president of the Illinois
Institute of Technology. Dean
Feldberg is also a director of
AMSCO International Inc., Feder-
ated Department Stores Inc., and
New World Communications Group
Incorporated. Dean Feldberg is a
director or trustee of 28 in-
vestment companies for which
Mitchell Hutchins or PaineWebber
serves as investment adviser.
George W. Gowen; 67 Director Mr. Gowen is a partner in the law
666 Third Avenue firm of Dunnington, Bartholow &
New York, New York 10017 Miller. Prior to May 1994, he
was a partner in the law firm of
Fryer, Ross & Gowen. Mr. Gowen
is a director of Columbia Real
Estate Investments, Inc. Mr.
Gowen is a director or trustee
of 28 investment companies for
which Mitchell Hutchins or
PaineWebber serves as investment
adviser.
Frederic V. Malek; 59 Director Mr. Malek is chairman of Thayer
1455 Pennsylvania Avenue, N.W. Capital Partners (investment
Suite 350 Washington, bank) and a co-chairman and di-
D.C. 20004 rector of CB Commercial Group
Inc. (real estate). From January
1992 to November 1992, he was
campaign manager of Bush-Quayle
'92. From 1990 to 1992, he was
vice chairman and, from 1989 to
1990, he was president of North-
west Airlines Inc., NWA Inc.
(holding company of Northwest
Airlines Inc.) and Wings Hold-
ings Inc. (holding company of
NWA Inc.). Prior to 1989, he was
employed by the Marriott Corpo-
ration (hotels, restaurants,
airline catering and contract
feeding), where he most recently
was an executive vice president
and president of Marriott Hotels
and Resorts. Mr. Malek is also a
director of American Management
Systems, Inc. (management con-
sulting and computer related
services), Automatic Data
Processing, Inc., Avis, Inc.
(passenger car rental), FPL
Group, Inc. (electric services),
and National Education Corpora-
tion and Northwest Airlines Inc.
Mr. Malek is a director or
trustee of 28 investment compa-
nies for which Mitchell Hutchins
or PaineWebber serves as invest-
ment adviser.
</TABLE>
16
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME, AGE AND ADDRESS* WITH THE FUND OTHER DIRECTORSHIPS
---------------------- ------------- --------------------
<C> <C> <S>
Carl W. Schafer; 60 Director Mr. Schafer is president of the
P.O. Box 1164 Atlantic Foundation (charitable
Princeton, NJ 08542 foundation supporting mainly
oceanographic exploration and
research). He also is a director
of Roadway Express, Inc. (truck-
ing). The Guardian Group of Mu-
tual Funds, Evans Systems, Inc.
(a motor fuels, convenience
store and diversified company),
Hidden Lake Gold Mines Ltd,
Electronic Clearing House, Inc.,
(financial transactions process-
ing), Wainoco Oil Corporation
and Nutraceutiz, Inc. (biotech-
nology). Prior to January 1993,
he was chairman of the Invest-
ment Advisory Committee of the
Howard Hughes Medical Institute.
Mr. Schafer is a director or
trustee of 28 investment compa-
nies for which Mitchell Hutchins
or PaineWebber serves as an in-
vestment adviser.
John R. Torell III; 57 Director Mr. Torell is chairman of Torell
767 Fifth Avenue Management, Inc. (financial ad-
Suite 4605 visory firm) (since 1989),
New York, NY 10153 chairman of Telesphere Corpora-
tion (electronic provider of
private financial information)
and a partner of Zilkha and Com-
pany (merchant banking and pri-
vate investment company). He is
the former chairman and chief
executive officer of Fortune
Bancorp (1990-1991 and 1990-
1994, respectively). He is the
former chairman, president and
chief executive officer of
CalFed, Inc. (savings associa-
tion) (1988 to 1989) and former
president of Manufacturers Hano-
ver Corp. (bank) (prior to
1988). Mr. Torell is also a di-
rector of American Home Products
Corp., New Colt Inc. (armament
manufacturer) and Volt Informa-
tion Sciences Inc. Mr. Torell is
a director or trustee of 28 in-
vestment companies for which
Mitchell Hutchins or PaineWebber
serves as investment adviser.
</TABLE>
17
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME, AGE AND ADDRESS* WITH THE FUND OTHER DIRECTORSHIPS
---------------------- ------------- --------------------
<C> <C> <S>
Cynthia N. Bow; 38 Vice President Ms. Bow is a vice presi-
dent and a portfolio
manager of Mitchell
Hutchins. Ms. Bow has
been with Mitchell
Hutchins since 1982.
Ms. Bow is a vice pres-
ident of four invest-
ment companies for
which Mitchell Hutchins
or PaineWebber serves
as investment adviser.
Teresa M. Boyle; 38 Vice President Ms. Boyle is a first
vice president of
Mitchell Hutchins.
Prior to November 1993,
she was compliance man-
ager of Hyperion Capi-
tal Management, Inc.,
an investment advisory
firm. Prior to April
1993, Ms. Boyle was a
vice president and man-
ager--legal administra-
tion of Mitchell
Hutchins. Ms. Boyle is
also a vice president
of 29 investment compa-
nies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Elbridge T. Gerry III; 39 Vice President Mr. Gerry is a senior
vice president and a
portfolio manager of
Mitchell Hutchins.
Prior to January 1996,
he was with J.P. Morgan
Private Banking where
he was responsible for
managing municipal as-
sets, including several
municipal bond funds.
Mr. Gerry is a vice
president of five in-
vestment companies for
which Mitchell Hutchins
or PaineWebber serves
as investment adviser.
C. William Maher; 35 Vice President and Mr. Maher is a first
Assistant Treasurer vice president and a
senior manager of the
mutual fund finance di-
vision of Mitchell
Hutchins. Mr. Maher is
also a vice president
and assistant treasurer
of 29 investment compa-
nies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Dennis McCauley; 50 Vice President Mr. McCauley is a manag-
ing director and chief
investment officer--
fixed income of Mitch-
ell Hutchins. Prior to
December 1994, he was
director of fixed in-
come investments of IBM
Corporation. Mr.
McCauley is also a vice
president of 19 invest-
ment companies for
which Mitchell Hutchins
or PaineWebber serves
as investment adviser.
Ann E. Moran; 39 Vice President and Ms. Moran is a vice
Assistant Treasurer president of Mitchell
Hutchins. Ms. Moran is
a vice president and
assistant treasurer of
29 investment companies
for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
</TABLE>
18
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME, AGE AND ADDRESS* WITH THE FUND OTHER DIRECTORSHIPS
---------------------- ------------- --------------------
<C> <C> <S>
Dianne E. O'Donnell; 44 Vice President Ms. O'Donnell is a se-
and Secretary nior vice president and
deputy general counsel
of Mitchell Hutchins.
Ms. O'Donnell is also a
vice president and sec-
retary of 28 investment
companies for which
Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Emil Polito; 36 Vice President Mr. Polito is a senior
vice president and di-
rector of operations
and control for Mitch-
ell Hutchins. From
March 1991 to September
1993 he was director of
the Mutual Funds Sales
Support and Service
Center for Mitchell
Hutchins and
PaineWebber. Mr. Polito
is also vice president
of 29 investment compa-
nies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Victoria E. Schonfeld; 46 Vice President Ms. Schonfeld is a man-
aging director and gen-
eral counsel of Mitch-
ell Hutchins. Prior to
May 1994, she was a
partner in the law firm
of Arnold & Porter. Ms.
Schonfeld is also a
vice president of 29
investment companies
for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Paul H. Schubert; 34 Vice President and Mr. Schubert is a first
Assistant Treasurer vice president and a
senior manager of the
mutual fund finance di-
vision of Mitchell
Hutchins. From August
1992 to August 1994, he
was a vice president of
Black Rock Financial
Management, Inc. Prior
to August 1992, he was
an audit manager with
Ernst & Young LLP. Mr.
Schubert is also a vice
president and assistant
treasurer of 29 invest-
ment companies for
which Mitchell Hutchins
or PaineWebber serves
as investment adviser.
Julian F. Sluyters; 36 Vice President and Mr. Sluyters is a senior
Treasurer vice president and the
director of the mutual
fund finance division
of Mitchell Hutchins.
Prior to 1991, he was
an audit senior manager
with Ernst & Young LLP.
Mr. Sluyters is also a
vice president and
treasurer of 29 invest-
ment companies for
which Mitchell Hutchins
or PaineWebber serves
as investment adviser.
</TABLE>
19
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME, AGE AND ADDRESS* WITH THE FUND OTHER DIRECTORSHIPS
---------------------- ------------- --------------------
<C> <C> <S>
Gregory K. Todd; 40 Vice President and Mr. Todd is a first vice
Assistant Secretary president and senior
associate general coun-
sel of Mitchell
Hutchins. Prior to
1993, he was a partner
in the firm of Shereff,
Friedman, Hoffman &
Goodman. Mr. Todd is a
vice president and as-
sistant secretary of
nine investment compa-
nies and vice president
and secretary of one
investment company for
which Mitchell Hutchins
or PaineWebber serves
as investment adviser.
Keith A. Weller; 35 Vice President and Mr. Weller is a first
Assistant Secretary vice president and as-
sociate general counsel
of Mitchell Hutchins.
Prior to May 1995, he
was an attorney in pri-
vate practice. Mr.
Weller is a vice presi-
dent and assistant sec-
retary of 28 investment
companies for which
Mitchell Hutchins or
PaineWebber serves as
investment adviser.
</TABLE>
- --------
* Unless otherwise indicated, the business address of each listed person is
1285 Avenue of the Americas, New York, New York 10019.
** Mrs. Alexander, Ms. Farrell and Mr. Bewkes are "interested persons" of the
Fund, as defined in the 1940 Act, by reason of their positions with
Mitchell Hutchins, PaineWebber and/or PW Group.
The Fund pays directors who are not "interested persons" of the Fund $1,000
annually and $150 for each board meeting and each separate meeting of a board
committee. Messrs. Feldberg and Torrell serve as chairmen of the audit and
contract review committees of individual funds within the PaineWebber fund
complex and receive additional compensation aggregating $15,000 annually each
from the relevant funds. All directors are reimbursed for any expenses
incurred in attending meetings. Because PaineWebber and Mitchell Hutchins
perform substantially all the services necessary for the operation of the
Fund, the Fund requires no employees. No officer, director or employee of
Mitchell Hutchins or PaineWebber presently receives any compensation from the
Fund for acting as a director or officer.
The table below includes certain information relating to the compensation of
the Fund's current directors who held office with the Fund or with other
PaineWebber funds during the Fund's last fiscal year.
20
<PAGE>
COMPENSATION TABLE
<TABLE>
<CAPTION>
TOTAL
COMPENSATION
FROM THE
AGGREGATE FUND AND THE
COMPENSATION FUND COMPLEX
NAME OF FROM THE PAID TO
PERSON, POSITION FUND* DIRECTORS**
---------------- ------------ ------------
<S> <C> <C>
Margo N. Alexander,
Director....................................... -- --
Richard Q. Armstrong,
Director....................................... $2,914 $59,873
E. Garrett Bewkes, Jr.,
Director and chairman of the board of direc-
tors........................................... -- --
Richard R. Burt,
Director....................................... $2,414 $51,173
Mary C. Farrell,***
Director....................................... -- --
Meyer Feldberg,
Director....................................... $3,248 $96,181
George W. Gowen,***
Director....................................... $ 373 $92,431
Frederic V. Malek,***
Director....................................... $ 373 $92,431
Carl W. Schafer,***
Director....................................... $ 373 $62,307
John R. Torell III,
Director....................................... $3,289 $60,123
</TABLE>
- --------
*Represents fees paid to each director during the fiscal year ended
September 30, 1996.
**Represents total compensation paid to each director during the calendar
year ended December 31, 1996; no fund within the fund complex has a pension
or retirement plan.
***Elected as a director at a Shareholder meeting held on April 11, 1996.
Because Mitchell Hutchins performs substantially all of the services
necessary for the operation of the Fund, the Fund requires no employees. No
officer, director or employee of PaineWebber or Mitchell Hutchins presently
receives any compensation from the Fund for acting as a director or officer.
The 1940 Act requires that the holders of the outstanding shares of Preferred
Stock, including the APS, voting as a separate class, have the right to select
at least two of the Fund's directors at all times. For purposes of this
condition, Mr. Feldberg and Mrs. Alexander (who were elected by a majority of
the holders of the APS at the annual meeting of shareholders of the Fund held
on January 18, 1996) will stand for re-election as directors by the holders of
the APS at the Fund's next annual meeting of shareholders.
CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES
As of January 28, 1997, Cede & Co. (the nominee of The Depository Trust
Company, a securities depository) owned of record 9,740,517 shares of the
Fund's Common Stock or 94% of the outstanding shares of Common Stock. To the
knowledge of the Fund, no person is the beneficial owner of 5% or more of its
shares of Common Stock.
As of January 28, 1997, the directors and officers of the Fund as a group
beneficially owned less than 1% of the Fund's outstanding shares of Common
Stock.
21
<PAGE>
INVESTMENT ADVISORY ARRANGEMENTS
Mitchell Hutchins is the Fund's investment adviser and administrator
pursuant to a contract dated October 15, 1992 with the Fund ("Advisory
Contract"). Pursuant to the Advisory Contract, Mitchell Hutchins provides a
continuous investment program for the Fund and makes investment decisions and
places orders to buy, sell or hold particular securities. As administrator,
Mitchell Hutchins supervises all matters relating to the operation of the Fund
and provides for it corporate, administrative and clerical personnel, office
space, equipment and services. For the fiscal years ended September 30, 1994,
September 30, 1995 and September 30, 1996, the Fund paid or accrued to
Mitchell Hutchins $2,207,447, $1,914,328 and $1,594,803 respectively, in
investment advisory and administration fees (net of waivers).
In addition to the payments to Mitchell Hutchins under the Advisory Contract
described in the Prospectus, the Fund pays certain other costs including: (1)
the costs (including brokerage commissions) of securities purchased or sold by
the Fund and any losses incurred in connection therewith; (2) expenses
incurred on behalf of the Fund by Mitchell Hutchins; (3) organizational
expenses of the Fund, whether or not advanced by Mitchell Hutchins; (4) filing
fees and expenses relating to the registration and qualification of the Common
Stock under federal and state securities laws; (5) fees and salaries payable
to directors who are not interested persons of the Fund or Mitchell Hutchins;
(6) all expenses incurred in connection with the directors' services,
including travel expenses; (7) taxes (including any income or franchise taxes)
and governmental fees; (8) costs of any liability, uncollectible items of
deposit and any other insurance or fidelity bonds; (9) any costs, expenses or
losses arising out of a liability of or claims for damages or other relief
asserted against the Fund for violation of any law; (10) legal, accounting and
auditing expenses, including legal fees of special counsel for the independent
directors; (11) charges of custodians, transfer agents and other agents; (12)
costs of preparing share certificates; (13) expenses of printing and
distributing reports to stockholders; (14) any extraordinary expenses
(including fees and disbursements of counsel) incurred by the Fund; (15) fees,
voluntary assessments and other expenses incurred in connection with
membership in investment company organizations; (16) costs of mailing and
tabulating proxies and costs of meetings of stockholders, the board and any
committees thereof; (17) the costs of investment company literature and other
publications provided to directors and officers; (18) costs of mailing,
stationery and communications equipment; (19) interest charges on borrowings;
(20) fees and expenses of listing and maintaining any listing of the Fund's
shares on the New York Stock Exchange, Inc. ("NYSE") or any other national
securities exchange; and (21) costs and expenses (including rating agency
fees) associated with the issuance of preferred stock.
The Advisory Contract was approved by the Fund's board of directors and by a
majority of the directors who neither are interested persons of the Fund nor
have any direct or indirect financial interest in the Advisory Contract
("Independent Directors"), on September 16, 1992 and by its initial
stockholder on October 15, 1992. Unless sooner terminated, the Advisory
Contract will continue in effect automatically for successive annual periods,
provided that such continuance is specifically approved at least annually: (1)
by a majority vote of the Independent Directors cast in person at a meeting
called for the purpose of voting on such approval; and (2) by the board of
directors or by vote of a majority of the outstanding voting securities (i.e.,
the Common Stockholders and holders of the APS, voting as a single class) of
the Fund.
Under the Advisory Contract, Mitchell Hutchins will not be liable for any
error of judgment or mistake of law or for any loss suffered by the Fund in
connection with the Advisory Contract, except a loss resulting from willful
misfeasance, bad faith or gross negligence on the part of Mitchell Hutchins in
the performance of its
22
<PAGE>
duties or from reckless disregard of its duties and obligations under the
Advisory Contract. The Advisory Contract is terminable by vote of the board of
directors or by the holders of a majority of the outstanding voting securities
of the Fund, at any time without penalty, on 60 days' written notice to
Mitchell Hutchins. The Advisory Contract may also be terminated by Mitchell
Hutchins on 60 days' written notice to the Fund. The Advisory Contract
terminates automatically upon its assignment.
Mitchell Hutchins personnel may invest in securities for their own accounts
pursuant to a code of ethics that describes the fiduciary duty owed to
shareholders of the PaineWebber funds, and other Mitchell Hutchins' advisory
accounts by all Mitchell Hutchins' directors, officers and employees,
establishes procedures for personal investing and restricts certain
transactions. For example, employee accounts generally must be maintained at
PaineWebber, personal trades in most securities require pre-clearance and
short-term trading and participation in initial public offerings generally are
prohibited. In addition, the code of ethics puts restrictions on the timing of
personal investing in relation to trades by PaineWebber funds and other
Mitchell Hutchins advisory clients.
PORTFOLIO TRANSACTIONS
Subject to policies established by the board of directors, Mitchell Hutchins
is responsible for the execution of the Fund's portfolio transactions and the
allocation of brokerage transactions. In executing portfolio transactions,
Mitchell Hutchins seeks to obtain the best net results for the Fund, taking
into account such factors as the price (including the applicable dealer spread
or brokerage commission), size of order, difficulty of execution and
operational facilities of the firm involved. Municipal Obligations in which
the Fund invests generally are traded on the OTC market on a "net" basis
without a stated commission through dealers acting for their own account and
not as brokers. Prices paid to dealers in principal transactions generally
include a "spread," which is the difference between the prices at which the
dealer is willing to purchase and sell a specific security at that time. For
the fiscal years ended September 30, 1994, September 30, 1995 and September
30, 1996, the Fund paid no brokerage commissions.
In placing orders with dealers, Mitchell Hutchins attempts to obtain the
best net price and the most favorable execution of its orders. Mitchell
Hutchins may purchase and sell portfolio securities from and to dealers who
provide the Fund with research, analysis, statistical or pricing advice or
similar services. Portfolio transactions will not be directed by the Fund to
dealers solely on the basis of research and advice provided. Research services
furnished by the dealers through which or with which the Fund effects
securities transactions may be used by Mitchell Hutchins in advising other
funds or accounts they advise and, conversely, research services furnished to
Mitchell Hutchins in connection with other funds or accounts that Mitchell
Hutchins advises may be used in advising the Fund.
Investment decisions for the Fund and for other investment accounts managed
by Mitchell Hutchins are made independently of each other in light of
differing considerations for the various accounts. However, the same
investment decision may occasionally be made for the Fund and one or more such
accounts. In such cases, simultaneous transactions are inevitable. Purchases
or sales then are then averaged as to price and allocated between the Fund and
such other account(s) as to amount according to a formula deemed equitable to
the Fund and such account(s). While in some cases this practice could have a
detrimental effect upon the price or value of
23
<PAGE>
the security as far as the Fund is concerned, or upon its ability to complete
its entire order, in other cases it is believed that coordination and the
ability to participate in volume transactions will be beneficial to the Fund.
The Fund will not purchase securities that are offered in underwritings in
which PaineWebber, Mitchell Hutchins or any of their affiliates is a member of
the underwriting or selling group, except pursuant to procedures adopted by
the board of directors pursuant to Rule 10f-3 under the 1940 Act. Among other
things, these procedures require that the commission or spread paid in
connection with such a purchase be reasonable and fair, that the purchase be
at not more than the public offering price prior to the end of the first
business day after the date of the public offering and that PaineWebber,
Mitchell Hutchins and their affiliates not participate in or benefit from the
sale to the Fund.
PORTFOLIO TURNOVER
For the fiscal year ended September 30, 1995 and for the fiscal year ended
September 30, 1996, the Fund's portfolio turnover rates were 7% and 0%,
respectively. Portfolio turnover may vary from year to year and will not be a
limiting factor when Mitchell Hutchins deems portfolio changes appropriate.
The portfolio turnover rate is calculated by dividing the lesser of the Fund's
annual sales or purchases of portfolio securities (exclusive of purchases or
sales of securities whose maturities at the time of acquisition were one year
or less) by the monthly average value of the long-term securities in the
portfolio during the year.
VALUATION OF COMMON STOCK
The net asset value of the Common Stock is determined weekly as of the close
of regular trading on the NYSE (currently 4:00 p.m., Eastern time) on the last
day of the week on which the NYSE is open for trading. The net asset value per
share of the Common Stock also is determined monthly as of the close of
regular trading on the NYSE on the last day of the month on which the NYSE is
open for trading. The net asset value per share of Common Stock is computed by
dividing the value of the securities held by the Fund plus any cash or other
assets (including interest and dividends accrued but not yet received and
earned discount) minus all liabilities (including accrued expenses) and the
liquidation preference of any outstanding preferred stock by the total number
of shares of Common Stock outstanding at such time.
When market quotations are readily available, the Fund's debt securities are
valued based upon those quotations. When market quotations for options and
futures positions held by the Fund are readily available, those positions are
valued based upon such quotations. Market quotations generally are not
available for options traded in the OTC market. When market quotations for
options and futures positions or any other securities and assets of the Fund
are not readily available, they are valued at fair value as determined in good
faith by or under the direction of the board of directors. When market
quotations are not readily available for any of the Fund's debt securities,
such securities are valued based upon appraisals received from a pricing
service using a computerized matrix system, or based upon appraisals derived
from information concerning the security or similar securities received from
recognized dealers in those securities. Notwithstanding the above, debt
securities with maturities of 60 days or less generally are valued at
amortized cost if their original term to maturity was 60 days or less, or by
amortizing the difference between their fair value as of the 61st day prior to
maturity and their maturity value if their original term to maturity exceeded
60 days, unless in either case the board of directors or its delegate
determines that this does not represent fair value.
24
<PAGE>
TAXES
TAXATION OF THE FUND
General. In order to continue to qualify for treatment as a regulated
investment company ("RIC") under the Internal Revenue Code, the Fund must
distribute to its stockholders for each taxable year at least 90% of the sum
of its net interest income excludable from gross income under section 103(a)
of the Internal Revenue Code ("tax-exempt income") plus its investment company
taxable income (consisting generally of taxable net investment income, net
short-term capital gain and net realized gains from certain hedging
transactions) ("Distribution Requirement") and must meet several additional
requirements. Among these requirements are the following: (1) the Fund must
derive at least 90% of its gross income each taxable year from dividends,
interest, payments with respect to securities loans and gains from the sale or
other disposition of securities, or other income (including gains from options
or futures contracts) derived with respect to its business of investing in
securities ("Income Requirement"); (2) the Fund must derive less than 30% of
its gross income each taxable year from the sale or other disposition of
securities, options or futures contracts held for less than three months
("Short-Short Limitation"); (3) at the close of each quarter of the Fund's
taxable year, at least 50% of the value of its total assets must be
represented by cash and cash items, U.S. government securities, securities of
other RICs and other securities, with those other securities limited, in
respect of any one issuer, to an amount that does not exceed 5% of the value
of the Fund's total assets; and (4) at the close of each quarter of the Fund's
taxable year, not more than 25% of the value of its total assets may be
invested in securities (other than U.S. government securities or the
securities of other RICs) of any one issuer. If the Fund failed to qualify for
treatment as a RIC for any taxable year, it would be taxed as an ordinary
corporation on its taxable income for that year (even if that income was
distributed to its stockholders) and all distributions out of its earnings and
profits, including those attributable to tax-exempt income would be taxable to
its stockholders as dividends (that is, ordinary income).
The Fund will be subject to a nondeductible 4% excise tax ("Excise Tax") to
the extent it fails to distribute by the end of any calendar year at least 98%
of the sum of its ordinary income (not including tax-exempt income) for that
year and its capital gain net income for the one-year period ending on October
31 of that year, plus certain other amounts. For these purposes, any such
taxable income retained by the Fund, and on which it pays federal income tax,
will be treated as having been distributed.
While any shares of the APS are outstanding, the Fund may not declare any
cash dividend or other distribution on the Common Stock unless, at the time of
the declaration, the Fund satisfies certain dividend payment and asset
coverage requirements. See "Special Leverage Considerations" in the
Prospectus. Any such suspension of distributions on the Common Stock could
prevent the Fund from satisfying the Distribution Requirement and avoiding
imposition of the Excise Tax. For so long as the Fund has outstanding
preferred stock, it will be required to allocate each particular type of its
income for each taxable year (such as tax-exempt income, net realized capital
gains and other taxable income) between the two classes of shares, Common
Stock and preferred stock, in proportion to the total distributions paid to
each such class for that year. It is not expected that any portion of the
Fund's distributions will be eligible for the dividends-received deduction
available for corporations.
The Fund may acquire zero coupon Municipal Obligations issued with original
issue discount. As the holder of such a security, the Fund would have to
include in its gross income for purposes of the Distribution and
25
<PAGE>
Income Requirements and the Short-Short Limitation the original issue discount
that accrues on the security for the taxable year, even if it receives no
payment on the security during the year. Because the Fund annually must
distribute at least 90% of its tax-exempt income, including any accrued
original issue discount, to satisfy the Distribution Requirement, it may be
required in a particular year to distribute as a dividend an amount that is
greater than the total amount of cash it actually receives. Those
distributions will be made from the Fund's cash assets or from the proceeds of
sales of portfolio securities or from borrowings, if necessary. The Fund may
realize taxable capital gains or losses from those sales, which would increase
or decrease its investment company taxable income or net capital gain (the
excess of net long-term capital gain over net short-term capital loss). In
addition, any such gains may be realized on the disposition of securities held
for less than three months. Because of the Short-Short Limitation, any such
gains would reduce the Fund's ability to sell other securities, or options or
futures, held for less than three months that it might wish to sell in the
ordinary course of its portfolio management.
Hedging Strategies. The use of hedging strategies, such as writing (selling)
and purchasing options and futures, involves complex rules that will determine
for income tax purposes the character and timing of recognition of the gains
and losses the Fund realizes in connection therewith. These rules also may
require the Fund to "mark to market" (that is, treat as sold for their fair
market value) at the end of each taxable year certain positions in its
portfolio, which may cause the Fund to recognize taxable income without
receiving cash with which to make distributions necessary to satisfy the
Distribution Requirement and to avoid imposition of the Excise Tax. In that
event, the Fund might have to liquidate securities to enable it to make the
required distributions, which would cause the Fund to recognize gains or
losses and might affect its ability to satisfy the Short-Short Limitation.
Income from transactions in options and futures derived by the Fund with
respect to its business of investing in securities will qualify as permissible
income under the Income Requirement. However, income from the disposition of
options and futures will be subject to the Short-Short Limitation if they are
held for less than three months.
If the Fund satisfies certain requirements, any increase in value of a
position that is part of a "designated hedge" will be offset by any decrease
in value (whether realized or not) of the offsetting hedging position during
the period of the hedge for purposes of determining whether the Fund satisfies
the Short-Short Limitation. Thus, only the net gain (if any) from the
designated hedge will be included in gross income for purposes of that
limitation. The Fund will consider whether it should seek to qualify for this
treatment for its hedging transactions. To the extent the Fund does not
qualify for this treatment, it may be forced to defer the closing out of
certain options and futures beyond the time when it otherwise would be
advantageous to do so, in order for the Fund to continue to qualify as a RIC.
TAXATION OF THE STOCKHOLDERS
Up to 85% of social security and railroad retirement benefits may be
included in taxable income for recipients whose modified adjusted gross income
(including income from tax-exempt sources such as the Fund) plus 50% of their
net benefits exceeds certain base amounts. Exempt-interest dividends are still
tax-exempt to the extent described in the Prospectus; they are only included
in the calculation of whether a recipient's income exceeds the established
amounts.
26
<PAGE>
Distributions of the Fund's net capital gain, if any, will be taxable to its
stockholders as long-term capital gains, regardless of the length of time they
held their Fund shares.
Entities or other persons who are "substantial users" (or persons related to
"substantial users") of facilities financed by IDBs or PABs should consult
their tax advisers before purchasing shares of Common Stock because, for users
of certain of these facilities, the interest on such bonds is not exempt from
federal income tax. For these purposes, the term "substantial user" is defined
generally to include a "non-exempt person" who regularly uses in trade or
business a part of a facility financed from the proceeds of IDBs or PABs.
A participant in the Fund's Dividend Reinvestment Plan is treated as having
received a distribution in the amount of the cash used to purchase shares of
Common Stock on his behalf, including a pro rata portion of the brokerage fees
incurred by the Transfer Agent. See "Dividends and Other Distributions;
Dividend Reinvestment Plan" in the Prospectus.
The Fund is required to withhold 31% of all taxable dividends, capital gain
distributions and repurchase proceeds payable to any individuals and certain
other noncorporate stockholders who do not provide the Fund with a correct
taxpayer identification number. Withholding at that rate also is required from
taxable dividends and capital gain distributions payable to such stockholders
who otherwise are subject to backup withholding.
ADDITIONAL INFORMATION
COMMON STOCK REPURCHASES AND TENDERS
As discussed in the Prospectus, the Fund's board of directors may tender for
its shares to reduce or eliminate the discount to net asset value at which the
Fund's shares might trade. Even if a tender offer has been made, it will be
the board's announced policy, which may be changed by the board, not to accept
tenders or effect repurchases (or, if a tender offer has not been made, not to
initiate a tender offer) if: (1) such transactions, if consummated, would (a)
result in the delisting of the Common Stock from the NYSE (the NYSE having
advised the Fund that it would consider delisting if the aggregate market
value of the outstanding shares is less than $5,000,000, the number of
publicly held shares falls below 600,000 or the number of round-lot holders
falls below 1,200), (b) impair the Fund's status as a RIC (which would
eliminate the Fund's eligibility to deduct dividends paid to its stockholders,
thus causing the Fund's income to be fully taxed at the corporate level in
addition to the taxation of stockholders upon dividends received from the
Fund) or (c) cause the Fund to violate applicable asset coverage or similar
requirements on outstanding preferred stock or borrowings; (2) the Fund would
not be able to liquidate portfolio securities in an orderly manner and
consistent with the Fund's investment objective and policies in order to
repurchase its shares; or (3) there is, in the board's judgment, any (a)
material legal action or proceeding instituted or threatened challenging such
transactions or otherwise materially adversely affecting the Fund, (b)
suspension of trading or limitation on prices of securities generally on the
NYSE or any other exchange on which portfolio securities of the Fund are
traded, (c) declaration of a banking moratorium by federal or state
authorities or any suspension of payment by banks in the United States, New
York State or any state in which the Fund invests, (d) limitation affecting
the Fund or the issuers of its portfolio securities imposed by federal or
state authorities on the extension of credit by lending institutions, (e)
commencement of war, armed hostilities or other international or national
calamity directly or indirectly involving the United States or (f) other event
or condition that would have a material adverse effect on the Fund or its
stockholders if shares were repurchased. The board of directors may modify
these conditions in light of experience.
27
<PAGE>
COUNSEL
The law firm of Kirkpatrick & Lockhart LLP, 1800 Massachusetts Avenue N.W.,
Washington, D.C. 20036-1200, counsel to the Fund, has passed upon the legality
of the shares offered by the Fund's Prospectus. Kirkpatrick & Lockhart LLP
also acts as counsel to Mitchell Hutchins and PaineWebber in connection with
other matters.
INDEPENDENT ACCOUNTANTS
Price Waterhouse LLP, 1177 Avenue of the Americas, New York, New York 10036,
serves as the Fund's independent accountants.
FINANCIAL STATEMENTS
The Fund's Annual Report to Shareholders for the fiscal year ended September
30, 1996 is a separate document supplied with this SAI, and the financial
statements, accompanying notes and report of independent accountants therein
are incorporated by reference in this SAI.
28
<PAGE>
APPENDIX A
RATINGS
Municipal bonds are rated by Moody's and S&P. Moody's also publishes
separate ratings for municipal notes. Descriptions of these ratings, together
with the ratings assigned by Moody's and S&P to commercial paper, are set
forth below.
DESCRIPTION OF MOODY'S FOUR HIGHEST MUNICIPAL BOND RATINGS
AAA. Bonds which are rated Aaa are judged to be of the best quality and
carry the smallest degree of investment risk. Interest payments are protected
by a large or by an exceptionally stable margin and principal is secure. While
the various protective elements are likely to change, such changes as can be
visualized are most unlikely to impair the fundamentally strong position of
such issues.
AA. Bonds which are rated Aa are judged to be of high quality by all
standards. They are rated lower than the Aaa bonds because margins of
protection may not be as large as in Aaa securities, or fluctuation of
protective elements may be of greater amplitude, or there may be other
elements present which make the long-term risks appear somewhat larger than in
Aaa securities.
A. Bonds which are rated A possess many favorable investment attributes and
are considered to be upper medium grade obligations. Factors giving security
to principal and interest are considered adequate, but elements may be present
which suggest a susceptibility to impairment sometime in the future.
BAA. Bonds which are rated Baa are considered as medium grade obligations,
i.e., they are neither highly protected nor poorly secured. Interest payments
and principal security appear adequate for the present but certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
Note: Those bonds in the Aa, A and Baa groups which Moody's believes possess
the strongest investment attributes are designated by the symbols Aa1, A1 and
Baa1.
DESCRIPTION OF S&P'S FOUR HIGHEST MUNICIPAL BOND RATINGS
AAA. Debt rated AAA has the highest rating assigned by S&P. Capacity to pay
interest and repay principal is extremely strong.
AA. Debt rated AA has a very strong capacity to pay interest and repay
principal and differs from the highest rated issues only in small degree.
A. Debt rated A has a strong capacity to pay interest and repay principal
although it is somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than debt in higher rated categories.
BBB. Debt rated BBB is regarded as having adequate capacity to pay interest
and repay principal. Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher rated categories.
A-1
<PAGE>
Note: Plus (+) or Minus (-): The ratings from "AA" to "BBB" may be modified
by the addition of a plus or minus sign to show relative standing within the
major categories.
DESCRIPTION OF MOODY'S HIGHEST RATINGS OF STATE AND MUNICIPAL NOTES AND OTHER
SHORT-TERM LOANS
Moody's ratings for state and municipal notes and other short-term loans are
designated "Moody's Investment Grade" ("MIG" or, for variable or floating rate
obligations, "VMIG"). Such ratings recognize the differences between short-
term credit risk and long-term risk. Factors affecting the liquidity of the
borrower and short-term cyclical elements are critical in short-term ratings.
Symbols used will be as follows:
MIG-1/VMIG-1. This designation denotes best quality. There is present strong
protection by established cash flows, superior liquidity support or
demonstrated broad based access to the market for refinancing or both.
MIG-2/VMIG-2. This designation denotes high quality. Margins of protection
are ample although not so large as in the preceding group.
DESCRIPTION OF S&P'S RATINGS OF STATE AND MUNICIPAL NOTES AND OTHER SHORT-TERM
LOANS
S&P's tax exempt note ratings are generally given to such notes that mature
in three years or less. The two higher rating categories are as follows:
SP-1. Very strong or strong capacity to pay principal and interest. Those
issues determined to possess overwhelming safety characteristics will be given
a plus (+) designation.
SP-2. Satisfactory capacity to pay principal and interest.
DESCRIPTION OF COMMERCIAL PAPER RATINGS
Issuers assigned Prime-1 by Moody's have a superior capacity for repayment
of short-term promissory obligations. Prime-1 repayment capacity will often be
evidenced by the following characteristics: leading market positions in well-
established industries; high rates of return on funds employed; conservative
capitalization structures with moderate reliance on debt and ample asset
protection; broad margins in earning coverage of fixed financial charges and
high internal cash generation; well established access to a range of financial
markets and assured sources of alternate liquidity. Issuers assigned Prime-2
have a strong capacity for repayment of senior short-term promissory
obligations. This will normally be evidenced by many of the characteristics
cited above but to a lesser degree. Earnings trends and coverage ratios, while
sound, will be more subject to variation. Capitalization characteristics,
while still appropriate, may be more affected by external conditions. Ample
alternate liquidity is maintained.
Issues assigned A by S&P, the highest rating category, are regarded as
having the greatest capacity for timely repayment. Issues in this category are
delineated with the numbers 1, 2 and 3 to indicate the relative degree of
safety. The A-1 designation indicates that the degree of safety regarding
timely payment is strong. Those issues determined to possess extremely strong
safety characteristics are denoted with a plus sign (+) designation. The A-2
designation indicates that the capacity for timely payment is satisfactory.
However, the relative degree of safety is not as high as for issues designated
A-1.
A-2
<PAGE>
APPENDIX B
RATING AGENCY GUIDELINES
GENERAL
The guidelines described below have been developed by Moody's and S&P in
connection with other issuances of asset-backed and similar securities,
including debt obligations and adjustable rate preferred stock, generally on a
case-by-case basis through discussions with the issuers of these securities.
The guidelines are designed to ensure that assets underlying outstanding debt
or preferred stock will be sufficiently varied and will be of sufficient
quality and amount to justify investment grade ratings. The guidelines do not
have the force of law, but they have been adopted by the Fund in order to
satisfy current requirements necessary for Moody's and S&P to issue the above-
described ratings for shares of each series of APS, which ratings are
generally relied upon by institutional investors in purchasing such
securities. In the context of a closed-end investment company such as the
Fund, therefore, the guidelines provide a set of tests for portfolio
composition and asset coverage that supplement (and in some cases are more
restrictive than) the applicable requirements under the 1940 Act. A rating
agency's guidelines will apply to shares of any series of APS only so long as
such rating agency is rating such shares.
The Fund intends to maintain a Discounted Value for its portfolio at least
equal to the APS Basic Maintenance Amount and, in addition, so long as S&P is
rating the shares of any series of APS, the Fund intends to maintain a Minimum
Liquidity Level. Moody's and S&P have each established separate guidelines for
determining Discounted Value. To the extent any particular portfolio holding
does not satisfy the applicable rating agency's guidelines, all or a portion
of such holding's value will not be included in the calculation of Discounted
Value (as defined by such rating agency). The Moody's and S&P guidelines do
not impose any limitations on the percentage of Fund assets that may be
invested in holdings not eligible for inclusion in the calculation of the
Discounted Value of the Fund's portfolio. The amount of such assets included
in the portfolio at any time may vary depending upon the rating,
diversification and other characteristics of the Eligible Assets included in
the portfolio, although it is not anticipated that in the normal course of
business the value of such assets would exceed 20% of the Fund's total assets.
In managing the Fund's portfolio, Mitchell Hutchins will not alter the
composition of the Fund's portfolio if, in the reasonable belief of Mitchell
Hutchins, the effect of any such alteration would be to cause the Fund to have
Eligible Assets with an aggregate Discounted Value, as of the immediately
preceding Valuation Date, less than the APS Basic Maintenance Amount of such
Valuation Date; provided, however, that in the event that, as of the
immediately preceding Valuation Date, the aggregate Discounted Value of the
Fund's Eligible Assets exceeded the APS Basic Maintenance Amount by five
percent or less, Mitchell Hutchins will not alter the composition of the
Fund's portfolio in a manner reasonably expected to reduce the aggregate
Discounted Value of the Fund's Eligible Assets unless the Fund shall have
confirmed that, after giving effect to such alteration, the aggregate
Discounted Value of the Fund's Eligible Assets would exceed the APS Basic
Maintenance Amount.
Upon any failure to maintain the required Discounted Value, the Fund will
seek to alter the composition of its portfolio to reattain the APS Basic
Maintenance Amount on or prior to the APS Basic Maintenance Cure Date, thereby
incurring additional transaction costs and possible losses and/or gains on
dispositions of portfolio securities. To the extent any such failure is not
cured in a timely manner, shares of each series of APS will be subject to
redemption if either Moody's or S&P is rating such shares. The APS Basic
Maintenance Amount includes the sum of (i) the aggregate liquidation value of
each series of APS then Outstanding and (ii) certain accrued and projected
payment obligations of the Fund. See "Asset Maintenance."
B-1
<PAGE>
The Fund may, but is not required to, adopt any modifications to these
guidelines that may hereafter be established by Moody's and S&P. Failure to
adopt any such modifications, however, may result in a change in the ratings
described above or a withdrawal of ratings altogether. In addition, any rating
agency providing a rating for the shares of any series of APS may, at any
time, change or withdraw any such rating. As set forth in the APS Provisions,
the Board of Directors may, without Stockholder approval, modify certain
definitions or policies which have been adopted by the Fund pursuant to the
rating agency guidelines, provided the Board of Directors has obtained written
confirmation from Moody's and S&P, as appropriate, that any such change would
not impair the ratings then assigned by Moody's and S&P to any series of APS.
As described by Moody's and S&P, a preferred stock rating is an assessment
of the capacity and willingness of an issuer to pay preferred stock
obligations. The ratings on any series of the APS are not recommendations to
purchase, hold or sell shares of such series of APS, inasmuch as the ratings
do not comment as to market price or suitability for a particular investor nor
do the rating agency guidelines described above address the likelihood that a
holder of shares of any series of APS will be able to sell such shares in an
Auction. The ratings are based on current information furnished to Moody's and
S&P by the Fund and Mitchell Hutchins, and information obtained from other
sources. The ratings may be changed, suspended or withdrawn as a result of
changes in, or the unavailability of, such information. The Fund's Common
Stock has not been rated by a nationally recognized statistical rating
organization.
S&P AAA Rating Guidelines. For purposes of calculating the Discounted Value
of the Fund's portfolio under current S&P guidelines, the fair market value of
Municipal Obligations eligible for consideration under such guidelines ("S&P
Eligible Assets") must be discounted by certain discount factors set forth in
the table below ("S&P Discount Factors"). The Discounted Value of a Municipal
Obligation under S&P guidelines is the fair market value thereof divided by
the S&P Discount Factor. The S&P Discount Factor used to discount a particular
Municipal Obligation will be determined by reference to the "S&P Exposure
Period" as determined by S&P (currently, 3 Business Days) and the S&P rating
on such Municipal Obligation. S&P Discount Factors for a range of exposure
periods are set forth below:
<TABLE>
<CAPTION>
S&P DISCOUNT
FACTORS
RATING CATEGORY
------------------
S&P EXPOSURE PERIOD AAA AA A BBB
------------------- --- --- --- ---
<S> <C> <C> <C> <C>
40 Business Days...................................... 190% 195% 210% 250%
22 Business Days...................................... 170 175 190 230
10 Business Days...................................... 155 160 175 215
7 Business Days...................................... 150 155 170 210
3 Business Days...................................... 130 135 150 190
</TABLE>
Since the S&P Exposure Period currently applicable to the Fund is three
Business Days, the S&P Discount Factors currently applicable to S&P Eligible
Assets will be determined by reference to the factors set forth opposite the
line entitled "3 Business Days." Notwithstanding the foregoing, (i) the S&P
Discount Factor for short-term Municipal Obligations will be 115%, so long as
such Municipal Obligations are rated A-1+ or SP-1+ by S&P and mature or have a
demand feature exercisable within 30 days or less, or 125% if such Municipal
Obligations are not rated by S&P but are rated VMIG-1, P-1 or MIG-1 by
Moody's; provided, however, that any such Moody's-rated short-term Municipal
Obligations which have demand features exercisable within 30 days or less must
be backed by a letter of credit, liquidity facility or guarantee from a bank
or other financial institution with a short-term rating of at least A-1+ from
S&P; and further provided that such Moody's-rated short-term Municipal
Obligations may comprise no more than 50% of short-term Municipal Obligations
that qualify as S&P
B-2
<PAGE>
Eligible Assets and (ii) no S&P Discount Factor will be applied to cash or to
Receivables for Municipal Obligations Sold. For purposes of the foregoing,
Anticipation Notes rated SP-1+ or, if not rated by S&P, rated MIG-1 or VMIG-1
by Moody's, which do not mature or have a demand feature at par exercisable in
30 days and which do not have a long-term rating, will be considered to be
short-term Municipal Obligations. "Receivables for Municipal Obligations
Sold," for purposes of calculating S&P Eligible Assets as of any Valuation
Date, means the book value of receivables for Municipal Obligations sold as of
or prior to such Valuation Date if such receivables are due within five
business days of such Valuation Date.
The S&P guidelines impose certain minimum issue size, issuer, geographical
diversification and other requirements for purposes of determining S&P
Eligible Assets:
(1) In order to be considered S&P Eligible Assets, Municipal Obligations
owned by the Fund must:
(a) Be interest bearing and pay interest at least semi-annually;
(b) Be payable with respect to principal and interest in U.S.
dollars;
(c) Be publicly rated BBB or higher by S&P or, if not rated by S&P
but rated by Moody's, be rated at least A by Moody's; provided that
such Moody's-rated Municipal Obligations will be included in S&P
Eligible Assets only to the extent the fair market value of such
Municipal Obligations does not exceed 50% of the aggregate fair market
value of S&P Eligible Assets. For purposes of determining the S&P
Discount Factors applicable to such Moody's-rated Municipal
Obligations, any such Municipal Obligation will be deemed to have an
S&P rating which is one full rating category lower than its Moody's
rating;
(d) Not be private placements; and
(e) Be part of an issue with an original issue size of at least $20
million or, if of an issue with an original issue size below $20
million (but in no event lower than $10 million), be issued by an
issuer with a total of at least $50 million of securities outstanding.
(2) Municipal Obligations of any one issuer or guarantor (excluding bond
insurers) will be considered S&P Eligible Assets only to the extent the
fair market value of such Municipal Obligations does not exceed 10% of the
aggregate fair market value of S&P Eligible Assets, provided that 2% is
added to the applicable S&P Discount Factor for every 1% by which the fair
market value of such Municipal Obligations exceeds 5% of the aggregate fair
market value of S&P Eligible Assets,
(3) Municipal Obligations guaranteed or insured by any one bond insurer
will be considered S&P Eligible Assets only to the extent the fair market
value of such Municipal Obligations does not exceed 25% of the aggregate
fair market value of S&P Eligible Assets.
(4) Municipal Obligations issued by issuers in any one state (including
the District of Columbia), territory or possession of the United States
will be considered S&P Eligible Assets only to the extent the fair market
value of such Municipal Obligations does not exceed 20% of the aggregate
fair market value of S&P Eligible Assets.
For so long as shares of any series of APS are Outstanding and S&P is rating
such APS, the Fund will not, unless the Fund has received written confirmation
from S&P that any such action would not impair the rating then assigned by S&P
to the APS, engage in any one or more of the following transactions: engage in
reverse repurchase agreement transactions; borrow money, except that the Fund
may, without obtaining the written confirmation described above, borrow money
for the purposes of clearing securities transactions if the APS Basic
Maintenance Amount would continue to be satisfied after giving effect to such
borrowing; issue any class or
B-3
<PAGE>
series of shares ranking prior to or on a parity with the APS with respect to
the payment of dividends or the distribution of assets upon dissolution,
liquidation or winding up of the Fund, or reissue any APS previously purchased
or redeemed by the Fund; lend portfolio securities; merge or consolidate with
any corporation; engage in repurchase agreement transactions in which the term
of such repurchase obligation is longer than 90 days, in which the underlying
security is a security other than United States Treasury securities (not
inclusive of zero coupon securities), demand deposits, certificates of
deposit, or bankers acceptances in which the counter-party or its affiliates
have securities rated A-1+ by S&P with respect to such underlying security; or
engage in short sale transactions. In addition, as long as shares of APS are
so rated or unless such confirmation has been received, the Fund will not
enter into interest rate caps, collars or floors, purchase or sell futures
contracts or options thereon or write uncovered put or uncovered call options
on portfolio securities except that (i) the Fund may engage in any S&P Hedging
Transactions based on the Municipal Index, provided that the Fund shall not
engage in any S&P Hedging Transaction based on the Municipal Index (other than
Closing Transactions) which would cause the Fund at the time of such
transaction to own or have sold the least of (1) more than 1,000 outstanding
futures contracts based on the Municipal Index, (2) outstanding futures
contracts based on the Municipal Index and on the Treasury Bonds exceeding in
number 25% of the quotient of the fair market value of the Fund's total assets
divided by 100,000 or (3) outstanding futures contracts based on the Municipal
Index exceeding in number 10% of the average number of daily traded futures
contracts based on the Municipal Index in the month prior to the time of
effecting such transaction as reported by The Wall Street Journal and (ii) the
Fund may engage in S&P Hedging Transactions based on Treasury Bonds, provided
that the Fund shall not engage in any S&P Hedging Transaction based on
Treasury Bonds (other than Closing Transactions) which would cause the Fund at
the time of such transaction to own or have sold the lesser of (1) outstanding
futures contracts based on Treasury Bonds and on the Municipal Index exceeding
in number 25% of the quotient of the fair market value of the Fund's total
assets divided by 100,000 or (2) outstanding futures contracts based on
Treasury Bonds exceeding in number 10% of the average number of daily traded
futures contracts based on Treasury Bonds in the month prior to the time of
effecting such transaction as reported by The Wall Street Journal.
For so long as shares of any series of APS are rated by S&P, the Fund will
engage in Closing Transactions to close out any outstanding futures contract
which the Fund owns or has sold or any outstanding option thereon owned by the
Fund in the event (i) the Fund does not have S&P Eligible Assets with an
aggregate Discounted Value equal to or greater than the APS Basic Maintenance
Amount on two consecutive Valuation Dates and (ii) the Fund is required to pay
Variation Margin on the second such Valuation Date. For so long as shares of
any series of APS are rated by S&P, the Fund will engage in a Closing
Transaction to close out any outstanding futures contract or option thereon in
the month prior to the delivery month under the terms of such futures contract
or option thereon unless the Fund holds securities deliverable under such
terms. For purposes of determining S&P Eligible Assets to determine compliance
with the APS Basic Maintenance Amount, no amounts on deposit with the Fund's
custodian or broker representing Initial Margin or Variation Margin shall
constitute S&P Eligible Assets. For so long as shares of any series of APS are
rated by S&P, when the Fund writes a futures contract or option thereon, it
will maintain an amount of cash, cash equivalents or short-term, money market
securities in a segregated account with the Fund's custodian, so that the
amount so segregated plus the amount of Initial Margin and Variation Margin
held in the account of the Fund's broker equals the fair market value of the
futures contract, except that in the event the Fund writes a futures contract
or option thereon which requires delivery of an underlying security, the Fund
shall hold such underlying security.
Moody's "aaa" Rating Guidelines. For purposes of calculating the Discounted
Value of the Fund's portfolio under current Moody's guidelines, the fair
market value of Municipal Obligations eligible for consideration under such
guidelines ("Moody's Eligible Assets") must be discounted by certain discount
factors set forth in the table below ("Moody's Discount Factors"). The
Discounted Value of a Municipal Obligation
B-4
<PAGE>
under Moody's guidelines is the fair market value thereof divided by the
Moody's Discount Factor. The Moody's Discount Factor used to discount a
particular Municipal Obligation will be determined by reference to the
"Moody's Exposure Period" as determined by Moody's (currently, the period
commencing on a given Valuation Date and ending 47 days thereafter) and the
Moody's rating on such Municipal Obligation. Moody's Discount Factors for a
range of exposure periods are set forth below:
<TABLE>
<CAPTION>
MOODY'S DISCOUNT FACTORS RATING CATEGORY
---------------------------------------------------
VMIG-1 SP-1+
MOODY'S EXPOSURE PERIOD AAA(1) AA(1) A(1) BAA(1) OTHER(2) (1)(3)(4) (3)(4)
----------------------- ------ ----- ---- ------ -------- --------- ------
<S> <C> <C> <C> <C> <C> <C> <C>
7 weeks................. 151% 159% 168% 202% 229% 136% 148%
8 weeks or less but
greater than 7 weeks... 154 164 173 205 235 137 149
9 weeks or less but
greater than 8 weeks... 158 169 179 209 242 138 150
</TABLE>
- --------
(1) Moody's rating.
(2) Municipal Obligations not rated by Moody's but rated BBB-, BBB or BBB+ by
S&P.
(3) Municipal Obligations rated MIG-1, VMIG-1 or Prime-1 or, if not rated by
Moody's, rated SP-1+ by S&P which do not mature or have a demand feature
at par exercisable within the Moody's Exposure Period and which do not
have a long-term rating.
(4) For the purposes of the definition of Moody's Eligible Assets, these
securities will have an assumed rating of "A" by Moody's.
Since the Moody's Exposure Period currently applicable to the Fund is 47
days, the Moody's Discount Factors currently applicable to Moody's Eligible
Assets will be determined by reference to the factors set forth opposite the
line entitled "7 weeks." Notwithstanding the foregoing, (i) no Moody's
Discount Factor will be applied to short-term Municipal Obligations so long as
such Municipal Obligations are rated at least MIG-1, VMIG-1 or P-1 by Moody's
and mature or have a demand feature at par exercisable within the Moody's
Exposure Period, and the Moody's Discount Factor for such Municipal
Obligations will be 125% as long as such Municipal Obligations are rated A-1-
/M or SP-1+/M by S&P and mature or have a demand feature at par exercisable
within the Moody's Exposure Period and (ii) no Moody's Discount Factor will be
applied to cash or to Receivables for Municipal Obligations Sold. "Receivables
for Municipal Obligations Sold," for purposes of calculating Moody's Eligible
Assets as of any Valuation Date, means no more than the aggregate of the
following: (i) the book value of receivables for Municipal Obligations sold as
of or prior to such Valuation Date if such receivables are due within five
business days of such Valuation Date, and if the trades which generated such
receivables are (x) settled through clearinghouse firms with respect to which
the Fund has received prior written authorization from Moody's or (y) with
counterparties having a Moody's long-term debt rating of at least Baa3; and
(ii) the Moody's Discounted Value of Municipal Obligations sold as of or prior
to such Valuation Date which generated receivables, if such receivables are
due within the Moody's Exposure Period but do not comply with either of
conditions (x) or (y).
The Moody's guidelines impose certain minimum issue size, issuer,
geographical diversification and other requirements for purposes of
determining Moody's Eligible Assets, as set forth in the table below:
<TABLE>
<CAPTION>
MINIMUM MAXIMUM MAXIMUM STATE OR
ISSUE SIZE UNDERLYING TERRITORY
RATING (MILLIONS) OBLIGOR** CONCENTRATION**
------ ---------- ---------- ----------------
<S> <C> <C> <C>
Aaa................................... $10 100% 100%
Aa.................................... 10 20 60
A..................................... 10 10 40
Baa................................... 10 6 20
Other*................................ 10 4 12
</TABLE>
B-5
<PAGE>
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* Municipal Obligations not rated by Moody's but rated at least BBB- by S&P.
** The referenced percentages represent maximum cumulative totals for the
related rating category and each lower rating category.
Current Moody's guidelines also require that Municipal Obligations
constituting Moody's Eligible Assets pay interest in cash, be publicly rated
Baa or higher by Moody's or, if not rated by Moody's but rated by S&P that
they be rated at least BBB by S&P, and that they not have suspended ratings.
For purposes of determining the Moody's Discount Factors applicable to such
S&P-rated Municipal Obligations, any such Municipal Obligations (excluding
short-term Municipal Obligations) will be deemed to have a Moody's rating
which is one full rating category lower than its S&P rating. For purposes of
calculation of Minimum Issue Size, Maximum Underlying Obligor and Maximum
State or Territory Concentration, Moody's Eligible Assets shall be calculated
without including cash and Municipal Obligations rated MIG-1, VMIG-1 or Prime-
1 or, if not rated by Moody's, rated SP-1+ by S&P, which either mature or have
a demand feature at par exercisable within the Moody's Exposure Period. Where
the Fund sells an asset and agrees to repurchase such asset in the future, the
Discounted Value of such asset will constitute a Moody's Eligible Asset and
the amount the Fund is required to pay upon repurchase of such asset will
count as a liability for the purposes of the APS Basic Maintenance Amount.
Where the Fund purchases an asset and agrees to sell it to a third party in
the future, cash receivable by the Fund thereby will constitute a Moody's
Eligible Asset if the long-term debt of such other party is rated at least A2
by Moody's and such agreement has a term of 30 days or less; otherwise the
Discounted Value of such asset will constitute a Moody's Eligible Asset.
Notwithstanding the foregoing, an asset will not be considered a Moody's
Eligible Asset to the extent that it has been irrevocably deposited for the
payment of (A)(i) through (A)(vii) under the definition of APS Basic
Maintenance Amount or it is subject to any material lien, mortgage, pledge,
security interest or security agreement of any kind (collectively, "Liens"),
except for (a) Liens which are being contested in good faith by appropriate
proceedings and which Moody's has indicated to the Fund will not affect the
status of such asset as a Moody's Eligible Asset, (b) Liens for taxes that are
not then due and payable or that can be paid thereafter without penalty, (c)
Liens to secure payment for services rendered or cash advanced to the Fund by
Mitchell Hutchins, State Street Bank and Trust Company or the Auction Agent
and (d) Liens by virtue of any repurchase agreement.
For so long as the shares of any series of APS are Outstanding and the APS
are rated by Moody's, the Fund will not, unless it has received written
confirmation from Moody's that any such action would not impair the ratings
then assigned by Moody's to the APS engage in any one or more of the following
transactions: (1) incur any indebtedness, except that the Fund may, without
obtaining the prior written approval described above, incur indebtedness for
the purpose of clearing securities transactions if the Discounted Value of
Moody's Eligible Assets would equal or exceed the APS Basic Maintenance Amount
after giving effect to such indebtedness; (2) issue any class or series of
shares ranking prior to or on a parity with the APS with respect to the
payment of dividends or the distribution of assets upon dissolution,
liquidation or winding up of the Fund, or reissue any APS previously purchased
or redeemed by the Fund; (3) engage in short sale transactions; or (4) except
as necessary to effect Closing Transactions, engage in transactions in options
on securities, futures contracts or options on futures contracts, except that
in connection with Moody's Hedging Transactions: (A) the Fund may buy call or
put options on securities; (B) the Fund may write covered call options on
securities; (C) the Fund may write put options on securities; (D) the Fund may
enter into positions in futures contracts based on the Municipal Index
provided that the Fund shall not engage in any such transaction which would
cause the Fund at the time of such transaction to own or have sold (1)
outstanding futures contracts based on the Municipal Index
B-6
<PAGE>
exceeding in number 10% of the rolling average number of daily traded futures
contracts based on the Municipal Index in the 30 calendar days prior to the
time of effecting such transaction as reported by The Wall Street Journal or
(2) outstanding futures contracts based on the Municipal Index and options on
such futures contracts having an aggregate fair market value (taking into
account the fair market value of futures contracts based on Treasury Bonds)
exceeding the fair market value of Moody's Eligible Assets owned by the Fund;
(E) the Fund may enter into futures contracts on Treasury Bonds provided that
the Fund shall not engage in any such transaction which would cause the Fund
at the time of such transaction to own or have sold (1) outstanding futures
contracts based on Treasury Bonds and options on such futures contracts having
an aggregate fair market value (taking into account the fair market value of
futures contracts based on the Municipal Index) exceeding 40% of the aggregate
fair market value of Moody's Eligible Assets owned by the Fund and rated Aa by
Moody's (or, if not rated by Moody's but rated by S&P, rated AAA by S&P) or
(2) outstanding futures contracts based on Treasury Bonds and options on such
futures contracts having an aggregate fair market value (taking into account
the fair market value of futures contracts based on the Municipal Index)
exceeding 80% of the aggregate fair market value of Moody's Eligible Assets
owned by the Fund and rated Baa or A by Moody's (or, if not rated by Moody's
but rated by S&P, rated A or AA by S&P); for purposes of the foregoing clauses
(D) and (E), the Fund shall be deemed to own the number of futures contracts
that underlie any outstanding option written by the Fund; and (F) the Fund may
buy call or put options on futures contracts on the Municipal Index or
Treasury Bonds, may write put options on such futures contracts (provided,
that if the contract would require delivery of a security, that security must
be held by the Fund) and may write call options on such futures if it owns the
futures contract subject to the option.
For so long as shares of any series of APS are rated by Moody's, the Fund
will engage in Closing Transactions to close out any outstanding futures
contract based on the Municipal Index if the open interest with respect to
such futures contracts based on the Municipal Index as reported by The Wall
Street Journal is less than 5,000. For so long as shares of APS are rated by
Moody's, the Fund will engage in a Closing Transaction to close out any
outstanding futures contract by no later than the fifth Business Day of the
month in which such contract expires and will engage in a Closing Transaction
to close out any outstanding option on a futures contract by no later than the
first Business Day of the month in which such option expires. For so long as
shares of APS are rated by Moody's, the Fund will engage in transactions with
respect to futures contracts or options thereon having only the next
settlement date or the settlement date immediately thereafter.
For purposes of valuation of Moody's Eligible Assets (i) if the Fund writes
a call option, the underlying asset will be valued as follows: (A) if the
option is exchange-traded and may be offset readily or if the option expires
before the earliest possible redemption of the APS, at the lower of the
Discounted Value of the underlying security of the option and the exercise
price of the option or (B) otherwise, it has no value; (ii) if the Fund writes
a put option, the underlying asset will be valued as follows: the lesser of
(A) exercise price and (B) the Discounted Value of the underlying security;
(iii) if the Fund is a seller under a futures contract, the underlying
security will be valued at the lower of (A) settlement price and (B)
Discounted Value of the underlying security; provided that, if a contract
matures within the Moody's Exposure Period, the security may be valued at the
settlement price; (iv) if the Fund is the buyer under a futures contract, the
underlying security will be valued at the lower of (A) the settlement price
and (B) Discounted Value of the underlying security; provided that, if the
contract matures within the Moody's Exposure Period, the security may be
valued at Discounted Value of the underlying security; and (v) call or put
option contracts which the Fund buys have no value. For so long as shares of
any series of APS are rated by Moody's: (1) the Fund will not engage in
options and futures transactions for leveraging or speculative purposes; (2)
the Fund will not write any anticipatory call options or sell any anticipatory
contracts pursuant to which the Fund hedges the anticipated purchase of an
asset
B-7
<PAGE>
prior to completion of such purchase; (3) the Fund will not enter into an
option or futures transaction unless, after giving effect thereto, the Fund
would continue to have Moody's Eligible Assets with an aggregate Discounted
Value equal to or greater than the APS Basic Maintenance Amount; (4) for
purposes of the APS Basic Maintenance Amount (i) assets in margin accounts are
not Moody's Eligible Assets, (ii) 10% of the settlement price of assets sold
under a futures contract, the settlement price of assets purchased under a
futures contract and the settlement price of an underlying futures contract if
the Fund writes put options on futures contracts will constitute liabilities
of the Fund and (iii) if the Fund writes call options on futures contracts and
does not own the underlying futures contract, 105% of the fair market value of
the underlying futures contract will constitute a liability of the Fund; (5)
the Fund shall enter into only exchange-traded futures and shall write only
exchange-traded options on exchanges approved by Moody's; (6) where delivery
may be made to the Fund with any of a class of securities, the Fund shall
assume for purposes of the APS Basic Maintenance Amount that it takes delivery
of that security which yields it the least value; (7) the Fund will not engage
in forward contracts; (8) the Fund will enter into futures contracts as seller
only if it owns the underlying security; and (9) there shall be a quarterly
audit made of the Fund's futures and options transactions by the Fund's
independent accountants to confirm that the Fund is in compliance with these
standards.
ASSET MAINTENANCE
1940 ACT APS ASSET COVERAGE
The Fund is required under the APS Provisions to maintain, with respect to
the APS, as of the last Business Day of each month in which any APS are
outstanding, asset coverage of at least 200% with respect to senior securities
which are stock, including APS (or such other asset coverage as may in the
future be specified in or under the 1940 Act as the minimum asset coverage for
senior securities which are stock of a closed-end investment company as a
condition of declaring dividends on its common stock). If the Fund fails to
maintain such asset coverage in accordance with the requirements of the rating
agency or agencies then rating the APS ("1940 Act APS Asset Coverage") and
such failure is not cured as of the last Business Day of the following month
("1940 Act Cure Date"), the Fund will be required in certain circumstances to
redeem certain of the APS.
APS BASIC MAINTENANCE AMOUNT
So long as any APS are Outstanding, the Fund is required under the APS
Provisions to maintain as of each Business Day (a "Valuation Date") assets
having in the aggregate a Discounted Value at least equal to the APS Basic
Maintenance Amount established by the rating agency or agencies then rating
the APS. If the Fund fails to meet such requirement on any Valuation Date and
such failure is not cured on or before the third Business Day after such
Valuation Date ("APS Basic Maintenance Cure Date"), the Fund will be required
in certain circumstances to redeem certain of the shares of APS.
The "APS Basic Maintenance Amount" as of any Valuation Date is defined as
the dollar amount equal to the sum of:
(A)(i) the product of the number of APS outstanding on such date
multiplied by $50,000;
(ii) the aggregate amount of dividends that will have accumulated at
the Applicable Rate (whether or not earned or declared) to (but not
including) the respective first Dividend Payment Dates for each of the
APS outstanding that follow such Valuation Date (or to the 47th day
after such Valuation Date, if such 47th day is earlier than the first
following Dividend Payment Date);
B-8
<PAGE>
(iii) the amount equal to the Projected Dividend Amount (based on the
number of APS outstanding on such date);
(iv) the amount of anticipated Fund expenses for the 90 days
subsequent to such Valuation Date;
(v) the amount of the Fund's Maximum Potential Additional Dividends
Liability as of such Valuation Date;
(vi) the amount of any premium payable pursuant to a Premium Call
Period; and
(vii) any current liabilities as of such Valuation Date to the extent
not reflected in any of (A)(i) through (A)(vi) (including, without
limitation, any amounts described below as required to be treated as
liabilities in connection with the Fund's transactions in futures and
options and including any payables for Municipal Obligations purchased
as of such Valuation Date) less
(B) either (i) the face value of any Fund assets irrevocably deposited by
the Fund for the payment of any of (A)(i) through (A)(vii) if such assets
mature prior to or on the date of payment of the liability for which such
assets are deposited and are either securities issued or guaranteed by the
United States Government or have a rating assigned by Moody's of P-1, VMIG-
1, or MIG-1, (or, with respect to S&P, SP-1+ or A-1+) or (ii) the
Discounted Value of such assets.
For purposes of the foregoing, "Maximum Potential Additional Dividends
Liability," as of any Valuation Date, means the aggregate amount of Additional
Dividends that would be due if the Fund were to make Retroactive Taxable
Allocations, with respect to any taxable year, estimated based upon dividends
paid and the amount of undistributed realized net capital gains and other
taxable income earned by the Fund, as of the end of the calendar month
immediately preceding such Validation Date, and assuming such Additional
Dividends are fully taxable.
For purposes of the APS Basic Maintenance Amount in connection with S&P's
ratings of the APS, with respect to any transactions by the Fund in futures
contracts, the Fund shall include as liabilities (i) 30% of the aggregate
settlement value, as marked to market, of any outstanding futures contracts
based on the Municipal Index which are owned by the Fund plus (ii) 25% of the
aggregate settlement value, as marked to market, of any outstanding futures
contracts based on Treasury Bonds which contracts are owned by the Fund. For
purposes of the APS Basic Maintenance Amount in connection with Moody's rating
of the APS, with respect to any transactions by the Fund in securities
operations, the Fund shall include as liabilities (i) 10% of the exercise
price of a call option written by the Fund and (ii) the exercise price of any
written put option.
The Discount Factors and guidelines for determining the market value of the
Fund's portfolio holdings, described above under the heading "Rating Agency
Guidelines--General," have been based on criteria established in connection
with rating each series of APS. These factors include, but are not limited to,
the sensitivity of the market value of the relevant asset to changes in
interest rates, the liquidity and depth of the market for the relevant asset,
the credit quality of the relevant asset (for example, the lower the rating of
a debt obligation, the higher the related discount factor) and the frequency
with which the relevant asset is marked to market. In no event shall the
Discounted Value of any asset of the Fund exceed its unpaid principal balance
or face amount as of the date of calculation. The Discount Factors relating to
any asset of the Fund and the APS Basic Maintenance Amount, the assets
eligible for inclusion in the calculation of the Discounted Value of the
Fund's portfolio and certain definitions and methods of calculation relating
thereto may be changed from time to time by the Fund without approval of the
holders of the APS, but only in the event the Fund receives written
confirmation from the appropriate rating agency that any such change would not
impair the rating then assigned to the APS by such rating agency. A rating
agency's Discount Factors and guidelines will apply to the APS so long as such
rating agency is rating the APS.
B-9
<PAGE>
On or before 5:00 P.M., New York City time, on the third Business Day after
a Valuation Date on which the Fund fails to maintain a Discounted Value of
Moody's Eligible Assets or S&P Eligible Assets in an amount greater than or
equal to the APS Basic Maintenance Amount, and the third Business Day after
the APS Basic Maintenance Cure Date with respect to such Valuation Date, the
Fund is required to deliver to the Auction Agent (so long as either Moody's or
S&P is rating the APS) a report with respect to the calculation of the APS
Basic Maintenance Amount and the value of its portfolio holdings as of the
date of such failure or such cure date, as the case may be ("APS Basic
Maintenance Report"). The Fund will also deliver an APS Basic Maintenance
Report to S&P (if S&P is then rating the APS) and Moody's (if Moody's is then
rating the APS) on a bi-weekly or quarterly basis and: (i) on any Valuation
Date on which the Discounted Value of Moody's Eligible Assets or S&P Eligible
Assets, as the case may be, is greater than the APS Basic Maintenance Amount
by 5% or less or (ii) on any date on which the Fund redeems Common Stock.
Within ten Business Days after delivery of such report relating to the last
Business Day of each fiscal quarter of the Fund, commencing March 31, 1993,
the Fund will deliver a letter prepared by the Fund's independent accountants
regarding the accuracy of the calculations made by the Fund in its most recent
APS Basic Maintenance Report. If any such letter prepared by the Fund's
independent accountants shows that an error was made in the most recent APS
Basic Maintenance Report, the calculation or determination made by the Fund's
independent accountants will be conclusive and binding on the Fund.
MINIMUM LIQUIDITY LEVEL
Pursuant to S&P guidelines, so long as S&P is rating the APS, the Fund is
required under the APS Provisions to have, as of each Valuation Date and with
respect to shares of each series of APS, Deposit Securities with maturity or
tender dates not later than the day preceding the first Dividend Payment Date
for such series that follows such Valuation Date (collectively "Dividend
Coverage Assets") for each share of each series of APS Outstanding that follow
such Valuation Date and having a value not less than the Dividend Coverage
Amount (the "Minimum Liquidity Level"). So long as S&P is rating the APS, if,
as of each Valuation Date, the Fund does not have the required Dividend
Coverage Assets, the Fund will, as soon as practicable, adjust its portfolio
in order to meet the Minimum Liquidity Level. The "Dividend Coverage Amount,"
as of any Valuation Date, means with respect to each series of APS, (A) the
aggregate amount of dividends that will accumulate on each share of APS to
(but not including) the first Dividend Payment Date for each share of APS
Outstanding that follows such Valuation Date plus any liabilities that will
become payable prior to or on such payment date; less (B) the combined value
of Deposit Securities irrevocably deposited for the payment of dividends on
the APS and Receivables for Municipal Obligations Sold which become due prior
to the Dividend Payment Date and interest with respect to Municipal
Obligations which is payable to the Fund prior to the Dividend Payment Date.
"Deposit Securities" generally means cash and Municipal Obligations rated at
least A-1+ or SP-1+ by S&P. The definitions of "Deposit Securities," "Dividend
Coverage Assets" and "Dividend Coverage Amount" may be changed from time to
time by the Fund without approval of the holders of the APS, but only in the
event the Fund receives written confirmation from S&P that any such change
would not impair the rating then assigned by S&P to the APS.
B-10
<PAGE>
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NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS NOT CONTAINED IN THE PROSPECTUS OR IN THIS STATEMENT OF
ADDITIONAL INFORMATION IN CONNECTION WITH THE OFFERING MADE BY THE PROSPECTUS
AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED
UPON AS HAVING BEEN AUTHORIZED BY THE FUND OR PAINEWEBBER. THE PROSPECTUS AND
THIS STATEMENT OF ADDITIONAL INFORMATION DO NOT CONSTITUTE AN OFFERING BY THE
FUND OR BY PAINEWEBBER IN ANY JURISDICTION IN WHICH SUCH OFFERING MAY NOT
LAWFULLY BE MADE.
----------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Investment Policies and Restrictions....................................... 1
Hedging and Related Income Strategies...................................... 7
Directors and Officers..................................................... 14
Control Persons and Principal Holders of Securities........................ 21
Investment Advisory Arrangements........................................... 22
Portfolio Transactions..................................................... 23
Valuation of Common Stock.................................................. 24
Taxes...................................................................... 25
Additional Information..................................................... 27
Financial Statements....................................................... 28
Appendix A................................................................. A-1
Appendix B................................................................. B-1
</TABLE>
(C) 1997 PaineWebber Incorporated
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INVESTMENT GRADE
MUNICIPAL INCOME FUND INC.
COMMON STOCK
----------------
STATEMENT OF ADDITIONAL
INFORMATION
----------------
PAINEWEBBER INCORPORATED
----------------
JANUARY 31, 1997
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