<PAGE>
2002 TARGET TERM TRUST INC.
COMMON STOCK
------------------------
2002 Target Term Trust Inc. ('Trust') is a diversified, closed-end
management investment company. The Trust's investment objective is to manage a
portfolio of high quality fixed-income and adjustable-rate securities in order
to return $15 per Share (the initial public offering price) to investors on or
about November 30, 2002, while providing high monthly income. The Trust normally
invests substantially all of its total assets in a diversified portfolio of: (1)
Mortgage-Backed Securities issued or guaranteed by the U.S. government, its
agencies or instrumentalities; and (2) Mortgage-Backed and Asset-Backed
Securities that, at the time of investment, are rated AAA by Standard & Poor's
Ratings Service ('S&P') or Aaa by Moody's Investors Service, Inc. ('Moody's') or
are comparably rated by another nationally recognized statistical rating
organization ('NRSRO') or, with respect to up to 20% of the Trust's total
assets, that are unrated but that, at the time of investment, have been
determined by the Trust's Sub-Adviser to be of comparable quality to those that
are rated AAA or Aaa. The Trust also may invest in Zero Coupon Municipal
Securities that are rated AAA by S&P or Aaa by Moody's and in certain Strategic
Transactions, such as options, futures and interest rate protection
transactions. No assurance can be given that the Trust will achieve its
investment objective.
The Trust seeks to return $15 per Share to investors on or about November
30, 2002 by: (1) preserving capital through active management of the Trust's
portfolio; (2) reducing, over time, the price sensitivity of the Trust's
portfolio to changes in interest rates; and (3) retaining a portion of the
income from its investments. The Trust seeks to achieve high monthly income by
actively managing its assets in relation to market conditions, interest rate
changes and the remaining term of the Trust. The Trust may engage in leverage
through mortgage dollar rolls and reverse repurchase agreements. The use of
leverage will create the opportunity for increased net income but, at the same
time, will involve special risks. SEE 'RISK FACTORS AND OTHER INVESTMENT
POLICIES--LEVERAGE.'
It is uncertain that the Trust will be able to return a full $15 per share
to investors on or about November 30, 2002. However, the Sub-Adviser intends to
manage the Trust so that the amount available to distribute to shareholders at
that date will be as much as possible while still providing investors with high
monthly income. SEE 'RISK FACTORS AND OTHER INVESTMENT POLICIES--RETURN OF $15
PER SHARE.'
The Shares are listed and traded on the New York Stock Exchange, Inc.
('NYSE') under the symbol 'TTR.' NO ADDITIONAL SHARES WILL BE ISSUED IN
CONNECTION WITH THIS OFFERING. The Shares 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 for
the Shares on the NYSE on March 19, 1997 was $12.625. See 'Trading History.' The
Trust will not receive any proceeds from the sale of any Shares offered pursuant
to this Prospectus.
Mitchell Hutchins Asset Management Inc. ('Mitchell Hutchins') serves as
investment adviser and administrator of the Trust and Goldman Sachs Funds
Management, L.P. ('Sub-Adviser') serves as the Trust's sub-adviser. 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 April 1, 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 Trust, 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 April 1, 1997.
<PAGE>
TRUST EXPENSES
The following tables are intended to assist investors in understanding the
various direct or indirect costs and expenses associated with investing in the
Trust.
<TABLE>
<S> <C>
SHAREHOLDER TRANSACTION EXPENSES
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......................................... 0.70%
Interest Payments on Borrowed Funds................................................. 1.93%
Other Expenses...................................................................... 0.50%
----
Total Annual Expenses................................................................. 3.13%
----
----
</TABLE>
- ------------------
(1) Prices for Shares traded in the OTC secondary market will reflect ordinary
dealer mark ups.
(2) See 'Management of the Trust' for additional information. 'Other Expenses'
have been estimated based upon expenses actually incurred for the last
fiscal year.
EXAMPLE
An investor would directly or indirectly pay the following expenses on a
$1,000 investment in the Trust, 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>
$32 $96 $162 $340
</TABLE>
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 Shares. In addition, while this Example
assumes reinvestment of all dividends and other distributions at net asset
value, participants in the Trust's Dividend Reinvestment Plan will receive
Shares purchased by the Plan's 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 FUTURE EXPENSES,
AND THE TRUST'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.'
<TABLE>
<S> <C>
The Trust................................. 2002 Target Term Trust Inc. ('Trust') is a diversified, closed-end
management investment company. See 'The Trust.'
The Offering.............................. No additional shares of the Trust's common stock ('Shares') will be
issued in connection with this offering. The Shares 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 Shares are listed and traded on the NYSE under the
symbol 'TTR.' See 'The Offering' and 'Trading History.'
Investment Objective and Policies......... The Trust's investment objective is to manage a portfolio of high
quality fixed-income and adjustable-rate securities in order to
return $15 per Share (the initial public offering price) to investors
on or about November 30, 2002, while providing high monthly income.
No assurance can be given that the Trust will achieve its investment
objective.
The Trust seeks to return $15 per Share to investors on or about
November 30, 2002 by: (1) preserving capital through active
management of the Trust's portfolio; (2) reducing, over time, the
price sensitivity of the Trust's portfolio to changes in interest
rates; and (3) retaining a portion of the income from its
investments. The Trust seeks to achieve high monthly income by
actively managing its assets in relation to market conditions,
interest rate changes and the remaining term of the Trust.
The Trust normally invests substantially all of its total assets in a
diversified portfolio of: (1) Mortgage-Backed Securities issued or
guaranteed by the U.S. government, its agencies or instrumentalities;
and (2) Mortgage-Backed and Asset-Backed Securities that, at the time
of investment, are rated AAA by Standard & Poor's Ratings Service, a
division of The McGraw-Hill Companies, Inc. ('S&P'), or Aaa by
Moody's Investors Service, Inc. ('Moody's') or are comparably rated
by another nationally recognized statistical rating organization
('NRSRO') or, with respect to up to 20% of the Trust's total assets,
that are unrated but that, at the time of investment, have been
determined by the Sub-Adviser to be of comparable quality to those
that are rated
</TABLE>
3
<PAGE>
<TABLE>
<S> <C>
AAA or Aaa. The Trust also may invest in Zero Coupon Municipal
Securities that are rated AAA by S&P or Aaa by Moody's.
In order to seek to reduce the Trust's exposure to certain risks that
generally are inherent in Mortgage-Backed Securities, a substantial
portion of the Mortgage-Backed Securities held by the Trust normally
are Planned Amortization Class Mortgage-Backed Securities ('PAC
Bonds') and ARM and Floating Rate Mortgage-Backed Securities (as
defined below). The Sub-Adviser expects that, in the later years of
the term of the Trust, an increased proportion of the Trust's total
assets may be invested in Asset-Backed Securities, which generally
have shorter effective terms to maturity than Mortgage-Backed
Securities. The Trust does not invest in collateralized mortgage
obligation residuals and may invest no more than an aggregate of 10%
of its total assets in Specified Mortgage-Backed Securities.
'Specified Mortgage-Backed Securities' are interest-only ('IO') and
principal-only ('PO') classes of Mortgage-Backed Securities (other
than IOs and POs that are PAC Bonds), inverse floating rate
obligations and other types of Mortgage-Backed Securities that may be
developed in the future and that are determined by the Sub-Adviser to
present types and levels of risk that are comparable to such IOs, POs
and inverse floating rate obligations. Under normal circumstances,
the Trust concentrates at least 25% of its total assets in Mortgage-
and Asset-Backed Securities issued or guaranteed by Private Mortgage
Lenders or by agencies or instrumentalities of the U.S. government.
In order to invest cash reserves or, on a temporary basis, during
defensive periods or when, in the opinion of the Sub-Adviser, no
suitable Mortgage- or Asset-Backed Securities or Zero Coupon
Municipal Securities are available, the Trust may invest in money
market instruments and in certain types of longer term, high quality
debt securities.
Under current market conditions, the Trust intends to borrow through
mortgage dollar rolls or reverse repurchase agreements. Borrowing
constitutes leverage, a speculative technique. The Trust is
authorized to borrow money for investment purposes in an amount up to
33 1/3% of its total assets (including the amount of the borrowing
and any other indebtedness representing 'senior securities' under the
Investment Company Act of 1940 ('1940 Act') but reduced by any
liabilities and indebtedness other than senior securities).
The Trust may engage in when-issued and delayed delivery
transactions, purchase restricted or illiquid securities, enter into
repurchase agreements, lend portfolio securities and enter into
certain Strategic Transactions, such as options, futures and interest
rate protection transactions. The Trust may enter into Strategic
</TABLE>
4
<PAGE>
<TABLE>
<S> <C>
Transactions under which up to 100% of the Trust's portfolio assets
are at risk.
See 'Investment Objective and Policies,' 'Risk Factors and Other
Investment Policies,' and 'Description of the Shares.'
Mortgage-Backed Securities................ Mortgage-Backed Securities represent direct or indirect
participations in, or are secured by and payable from, mortgage loans
secured by real property. Mortgage-Backed Securities (including PAC
Bonds) include single- and multi-class mortgage pass-through
securities and collateralized mortgage obligations ('CMOs') and are:
(1) issued or guaranteed by U.S. government agencies or
instrumentalities, such as the Government National Mortgage
Association ('Ginnie Mae'), the Federal National Mortgage Association
('Fannie Mae') or the Federal Home Loan Mortgage Corporation
('Freddie Mac'); (2) issued by private issuers (generally originators
of and investors in mortgage loans, including savings associations,
mortgage bankers, commercial banks, investment bankers and special
purpose entities (collectively, 'Private Mortgage Lenders') but
supported by pools of mortgage loans or other Mortgage-Backed
Securities that are guaranteed, directly or indirectly, by the U.S.
government or one of its agencies or instrumentalities; or (3) issued
by Private Mortgage Lenders without any government guarantee of the
underlying mortgage assets, but usually with some form of non-
governmental credit enhancement.
PAC Bonds are a particular type of Mortgage-Backed Security designed
to provide relatively predictable payments of principal provided
that, among other things, the actual prepayment experience on the
underlying mortgage loans falls within a contemplated range. If the
actual prepayment experience on the underlying mortgage loans is at a
rate faster or slower than the contemplated range, or if deviations
from other assumptions occur, principal payments on a PAC Bond may be
greater or smaller than predicted. The magnitude of the contemplated
range varies from one PAC Bond to another; a narrower range increases
the risk that prepayments will be greater or smaller than
contemplated. Due to the planned amortization feature of PAC Bonds,
the Sub-Adviser believes that investment in PAC Bonds normally
reduces the prepayment risks that are inherent in Mortgage-Backed
Securities unless, among other things, the actual prepayment
experience on the underlying mortgage loans fails to fall within the
range contemplated when the PAC Bonds were created. ARM
Mortgage-Backed Securities are Mortgage-Backed Securities that
represent a right to receive interest payments at a rate that is
adjusted to reflect the interest earned on a pool of mortgage loans
bearing variable or adjustable rates of interest
</TABLE>
5
<PAGE>
<TABLE>
<S> <C>
(such mortgage loans are referred to as 'ARMs'). Floating Rate
Mortgage-Backed Securities are classes of Mortgage-Backed Securities
that have been structured to represent the right to receive interest
payments at rates that fluctuate in accordance with an index but that
generally are supported by pools comprised of fixed-rate mortgage
loans. Because the interest rates on ARM and Floating Rate
Mortgage-Backed Securities are reset in response to changes in a
specified market index, the values of such securities tend to be less
sensitive to interest rate fluctuations than the values of fixed-rate
securities.
See 'Investment Objective and Policies' and 'Appendix A.'
Zero Coupon Municipal Securities;
Retention of Income..................... The Trust may invest in zero coupon securities that are issued for
various public purposes by or on behalf of municipal issuers or that
are created by investment banks or other private parties that
separate the interest and principal components of an interest-paying
security that has been previously issued by or on behalf of a
municipal issuer (collectively, 'Zero Coupon Municipal Securities').
While Zero Coupon Municipal Securities do not contribute to the cash
available to the Trust for purposes of paying dividends to
shareholders, the income retained by the Trust from the accrual of
the original issue discount on such securities, together with any
other income that is retained by the Trust, can be used to increase
the amount available to be distributed to investors on or about
November 30, 2002. See 'Investment Objective and Policies.'
Asset-Backed Securities................... Asset-Backed Securities have structural characteristics similar to
Mortgage-Backed Securities but relate to assets other than mortgage
assets. Under current conditions the Sub-Adviser does not intend to
invest a significant portion of the Trust's assets in Asset-Backed
Securities until the later years of the Trust's term. The Sub-Adviser
anticipates that a substantial portion of the Asset-Backed Securities
that it acquires for the Trust would be structured in a manner
similar to PAC Bonds. New types of Asset-Backed Securities are
developed and marketed from time to time by a variety of new and
existing issuers, and consistent with its investment limitations, the
Trust expects to invest in those new types of Asset-Backed Securities
that the Sub-Adviser believes may assist the Trust in achieving its
investment objective. See 'Investment Objective and Policies.'
Investment Adviser and
Administrator........................... Mitchell Hutchins Asset Management Inc. ('Mitchell Hutchins'), a
wholly owned subsidiary of PaineWebber, serves as the Trust's
investment adviser and administrator. Mitchell Hutchins provides
investment advisory and portfolio management services to
</TABLE>
6
<PAGE>
<TABLE>
<S> <C>
investment companies, pension funds and other institutional,
corporate and individual clients. The Trust pays Mitchell Hutchins,
as investment adviser and administrator, an investment advisory fee
in an amount equal to an annual fee of 0.50% of the Trust's average
weekly net assets, and an administration fee in an amount equal to an
annual fee of 0.20% of the Trust's average weekly net assets. Each
such fee is computed weekly and payable monthly. Mitchell Hutchins
(not the Trust) pays the Sub-Adviser a fee, computed weekly and
payable monthly, in an amount equal to one-half of the investment
advisory fee received by Mitchell Hutchins from the Trust.
Sub-Adviser............................... Goldman Sachs Funds Management, L.P. ('Sub-Adviser') serves as the
Trust's sub-adviser under a Sub-Investment Advisory Contract with
Mitchell Hutchins. The Sub-Adviser makes investment decisions and
places orders to buy, sell or hold particular securities for the
Trust. The Sub-Adviser is able to draw on the substantial research
and market expertise of its affiliate, Goldman, Sachs & Co., which is
among the oldest and largest investment banking firms in the United
States. The Sub-Adviser, together with its affiliates, provide
investment advisory and portfolio management services to pension
funds, investment companies and other institutional, corporate and
individual clients. See 'Management of the Trust.'
Dividends and Other Distributions......... The Trust declares and pays monthly dividends from its net investment
income. The Trust has retained, and currently intends to continue to
retain, until its final liquidating distribution, a portion of the
income on its investments. The Trust expects to pay Excise Tax (as
defined below) on a portion of any taxable income that it retains.
The Trust expects to distribute annually all or a portion of any net
capital gain (the excess of net long-term capital gain over net
short-term capital loss) it realizes in excess of available capital
loss carryforwards. Various factors may affect the level of the
Trust's income, including the asset mix, interest rates, the
remaining term of the Trust, the amount of leverage utilized by the
Trust and the Trust's use of Strategic Transactions. See 'Dividends
and Other Distributions; Dividend Reinvestment Plan' and 'Taxation.'
Dividend Reinvestment Plan................ The Trust has established a Dividend Reinvestment Plan ('Plan') under
which all shareholders whose Shares are registered in their own
names, or in the name of PaineWebber (or its nominee), have all
dividends and other distributions automatically reinvested in
additional Shares, unless such shareholders elect to receive cash.
Shareholders who hold their Shares in the name of a broker or nominee
other than PaineWebber (or its nominee) should contact such other
broker or nominee to determine whether, or how, they
</TABLE>
7
<PAGE>
<TABLE>
<S> <C>
may participate in the Plan. Shares 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 at the
time of the purchase. The Trust will not issue any new Shares in
connection with the Plan. See 'Dividends and Other Distributions;
Dividend Reinvestment Plan.'
Share Repurchases and Tender Offers....... The Trust's board of directors, in consultation with Mitchell
Hutchins, considers at least annually whether to make open market
Share repurchases or tender offers at net asset value. In July 1995,
the Trust commenced a program of repurchasing Trust Shares in the
open market. As of March 31, 1997, the Trust had repurchased
approximately 3.0 million of its Shares under that program.
Additional shares may be repurchased under this program, but there is
no assurance that they will be. Similarly, there can be no assurance
that the board of directors will decide to undertake any tender
offers or that any such actions will result in the Shares trading at
a price that is equal or close to net asset value per Share. The
Trust may borrow to finance such repurchases and tender offers. See
'Description of the Shares--Share Repurchases and Tender Offers.'
Custodian, Transfer and Dividend
Disbursing Agent and Registrar.......... State Street Bank and Trust Company serves as custodian of the
Trust's assets. PNC Bank, National Association, serves as transfer
and dividend disbursing agent and as registrar of the Trust. See
'Custodian, Transfer and Dividend Disbursing Agent and Registrar.'
Special Considerations and Risk Factors... Return of $15 Per Share. To the extent capital losses realized by
the Trust on dispositions of securities are not offset by capital
gains realized in the same or in subsequent years (subject to the
eight-year limit on capital loss carryforwards under the federal tax
law) and by income retained on its investments, the Trust may be
unable to distribute $15 per Share to its shareholders at the end of
the Trust's term. Also, in order to avoid the imposition of a 4%
federal excise tax on certain undistributed income and gains ('Excise
Tax'), the Trust would need to distribute all or a substantial
portion of any taxable income and net capital gains (in excess of any
available capital loss carryforwards) in the year in which they are
earned or realized. By retaining a portion of the income on its
investments, the Trust expects to incur some Excise Tax liability.
Moreover, the Trust would need to distribute all of its taxable
income and net capital gain (in excess of any available capital loss
carryforwards) in the year in which they are earned or realized, or
within 12 months thereafter, in order to avoid the imposition of
federal income tax. In order to return $15 per Share
</TABLE>
8
<PAGE>
<TABLE>
<S> <C>
to its shareholders at the end of its term, the Trust also must
recoup amounts paid by the Trust in connection with its organization
and its initial public offering. It is uncertain that the Trust will
be able to return a full $15 per Share to investors on or about
November 30, 2002. However, the Sub-Adviser intends to manage the
Trust so that the amount available to distribute to shareholders at
that date will be as much as possible while still providing investors
with high monthly income.
Interest Rate Sensitivity. The yield on debt securities, including
Mortgage-Backed and Asset-Backed Securities and Zero Coupon Municipal
Securities, depends on a variety of factors, including general market
conditions for such securities, the financial condition of the
issuer, the size of the particular offering, the maturity, credit
quality and rating of the security and, in the case of securities of
municipal issuers, expectations regarding changes in income tax
rates. Generally, the longer the maturity of such a security, the
higher its yield and the greater its volatility. The market value of
debt securities, and accordingly the Trust's net asset value,
normally will vary inversely with changes in interest rates. Such
changes in the values of the securities held by the Trust will affect
the net asset value of Shares. Neither the issuance by, nor the
guarantee of a U.S. government agency, nor a AAA or equivalent rating
for a security, constitutes assurance that the security will not
fluctuate in value or that the Trust will receive the originally
anticipated yield on the security. A significant decline in market
rates of interest may have an adverse effect on the income earned and
dividends paid by the Trust. In addition, the Trust's income and
dividends may decline in the later years of the Trust.
Certain types of Mortgage-Backed Securities, commonly known as CMOs,
may be specifically structured in a manner that provides any of a
wide variety of investment characteristics, such as yield, effective
maturity and interest rate sensitivity. As market conditions change,
however, and particularly during periods of rapid or unanticipated
changes in market interest rates, the attractiveness of the CMO
classes and the ability of the structure to provide the anticipated
investment characteristics may be significantly reduced. These
changes can result in volatility in the market value, and in some
instances reduced liquidity, of the CMO class.
The yields on Specified Mortgage-Backed Securities (as defined in
'Appendix A'), in which the Trust may invest up to 10% of its total
assets, on IOs and POs that are PAC Bonds and on Zero Coupon
Municipal Securities generally are more sensitive to changes in
interest rates than most Mortgage-Backed Securities. The Trust is not
limited in its ability to invest in IOs and POs that are PAC
</TABLE>
9
<PAGE>
<TABLE>
<S> <C>
Bonds. The yields on most IOs and POs are extremely sensitive to the
rate of principal payments (including prepayments), which can result
in price volatility and, in the case of IOs, can result in the Trust
failing to recoup fully its initial investment in such securities
even though the securities may be issued or guaranteed by a U.S.
government agency or be rated in the highest rating category. While
the Sub-Adviser seeks to limit the impact of these factors on the
Trust, no assurance can be given that it will achieve this result.
ARM and Floating Rate Mortgage-Backed Securities. ARMs underlying
ARM Mortgage-Backed Securities generally provide that the borrower's
mortgage interest rate may not be adjusted over a specified lifetime
maximum rate. ARMs also may provide for limitations on the maximum
amount by which the mortgage interest rate may adjust for any single
adjustment period or by which the borrower's monthly payment may
adjust for any single adjustment period. Similarly, interest rate
changes on Floating Rate Mortgage-Backed Securities are subject to
lifetime interest rate caps. Interest rates on ARMs generally are
reset only at monthly or longer intervals. Moreover, interest rate
changes on ARM and Floating Rate Mortgage-Backed Securities may be
based on indices that tend to lag behind changes in market rates.
Accordingly, the coupon rate on such Mortgage-Backed Securities often
lags behind changes in short-term interest rates, which may
negatively affect the market value in periods of increasing interest
rates. The market value of ARM and Floating Rate Mortgage-Backed
Securities may be affected adversely if interest rates increase
beyond the applicable limits on interest rate or interest payment
adjustments. In periods of declining interest rates, the market
values of ARM and Floating Rate Mortgage-Backed Securities generally
will increase to a lesser extent, if at all, than the values of
fixed-rate Mortgage-Backed Securities.
Special Leverage Risks. The use of leverage is a speculative
technique that provides the opportunity for increased net income but,
at the same time, involves special risks. The Trust only uses
leverage when the Sub-Adviser believes that such leverage benefits
the Trust after taking such risks into consideration. For example,
leveraging exaggerates changes in the net asset value of the Shares
and in the yield on the Trust's portfolio which may, in turn, result
in increased volatility of the market price of the Shares. To the
extent the income derived from leverage exceeds the interest and
other expenses that the Trust will have to pay in connection with
such leverage, the Trust's net income will be greater than if
leverage were not used. Conversely, if the income obtained is not
sufficient to cover the cost of the leverage, the net income of the
Trust will be less than if leverage were not used, and
</TABLE>
10
<PAGE>
<TABLE>
<S> <C>
therefore the amount available for distribution to shareholders will
be reduced.
Other Investment Risks. Certain investment practices in which the
Trust may engage would expose the Trust to additional risks. These
practices include investing in illiquid securities, entering into
securities transactions on a when-issued or delayed delivery basis,
entering into repurchase agreements, lending portfolio securities and
engaging in Strategic Transactions.
Market Price of Shares. Shares of the Trust and of other closed-end
investment companies frequently trade at a discount from net asset
value. This market risk is separate and distinct from the risk that
the Trust's net asset value may decrease. Accordingly, the Shares are
designed primarily for long-term investors and should not be viewed
as a vehicle for trading purposes.
Anti-Takeover Provisions. The Trust's Articles of Incorporation
contain provisions limiting: (1) the ability of other entities or
persons to acquire control of the Trust; (2) the Trust's freedom to
engage in certain transactions; and (3) the ability of the Trust's
directors or shareholders to amend the Articles of Incorporation.
These provisions of the Articles of Incorporation may be regarded as
'anti-takeover' provisions.
See 'Trading History,' 'Risk Factors and Other Investment Policies,'
'Description of the Shares' and 'Appendix A.'
</TABLE>
11
<PAGE>
FINANCIAL HIGHLIGHTS
The table below provides selected per share data and ratios for one Share
for the periods shown. This information is supplemented by the financial
statements and accompanying notes appearing in the Trust's Annual Report to
Shareholders for the fiscal year ended November 30, 1996, which are incorporated
by reference into the Trust's SAI and can be obtained by shareholders upon
request. The financial statements and notes, as well as the information in the
table below, have been audited by Ernst & Young LLP, independent auditors, whose
report thereon is included in the Annual Report to Shareholders.
<TABLE>
<CAPTION>
FOR THE
PERIOD
DECEMBER 31,
FOR THE YEARS ENDED NOVEMBER 30, 1992(2) TO
-------------------------------- NOVEMBER 30,
1996 1995 1994 1993
-------- -------- -------- ------------
<S> <C> <C> <C> <C>
Net asset value, beginning of period..................... $ 14.37 $ 12.70 $ 14.68 $ 14.10
-------- -------- -------- ------------
Net investment income.................................... 1.13* 1.02* 0.93 0.89
Net realized and unrealized gains (losses) on
investments............................................ (0.05)* 1.36* (1.90) 0.68
-------- -------- -------- ------------
Net increase (decrease) in net asset value resulting from
operations............................................. 1.08 2.38 (0.97) 1.57
-------- -------- -------- ------------
Dividends from net investment income..................... (0.86) (0.90) (0.96) (0.84)
Dividends from short-term capital gains.................. -- -- (0.05) (0.11)
-------- -------- -------- ------------
Total dividends and distributions to shareholders........ (0.86) (0.90) (1.01) (0.95)
Net increase in net asset value resulting from repurchase
of common stock........................................ 0.29 0.19 -- --
-------- -------- -------- ------------
Offering costs charged to capital........................ -- -- -- (0.04)
-------- -------- -------- ------------
Net asset value, end of period........................... $ 14.88 $ 14.37 $ 12.70 $ 14.68
-------- -------- -------- ------------
-------- -------- -------- ------------
Per share market value, end of period.................... $ 12.63 $ 12.50 $ 11.25 $ 14.00
-------- -------- -------- ------------
-------- -------- -------- ------------
Total investment return(1)............................... 8.07% 19.85% (12.79)% 5.94%
-------- -------- -------- ------------
-------- -------- -------- ------------
Ratios/Supplemental Data:
Net assets, end of period (000 omitted).................. $117,276 $136,754 $136,562 $157,888
Expenses to average net assets+.......................... 3.13% 3.42% 2.72% 1.79%**
Net investment income to average net assets.............. 7.74% 7.44% 6.82% 6.67%**
Portfolio turnover rate.................................. 127% 103% 108% 355%
Asset coverage++......................................... $ 3,261 $ 4,013 $ 3,023 $ 3,110
</TABLE>
- ------------------
* Calculated using average daily shares outstanding for the year
** Annualized
+ These ratios include 1.93%, 2.50%, 1.82% and 0.91% related to interest
expense for the periods ended November 30, 1996, 1995, 1994 and 1993,
respectively, which represents a cost of leverage to the Trust.
++ Per $1,000 of reverse repurchase and dollar roll transactions outstanding.
(Footnotes continued on next page)
12
<PAGE>
(Footnotes continued from previous page)
(1) Total investment return is calculated assuming a purchase of common
stock at the current market price on the first day of each period reported
and a sale at the current market price on the last day of each period
reported, and assuming reinvestment of dividends and distributions to
common stockholders at prices obtained under the Fund's Dividend
Reinvestment Plan. Investment returns do not reflect brokerage commissions
and have not been annualized for periods of less than one year.
(2) Commencement of operations
The following information relates to the Trust's 'senior securities,' as
defined under the 1940 Act.
<TABLE>
<CAPTION>
TOTAL ASSET
AMOUNT COVERAGE AVERAGE
OUTSTANDING PER $1,000 OF MARKET
AS OF END INDEBTEDNESS VALUE
PERIOD OF AS OF END OF PER $1,000 OF
SENIOR SECURITES ENDED PERIOD PERIOD INDEBTEDNESS*
- ----------------------------------------- ------------------ ----------- ------------- -------------
<S> <C> <C> <C> <C>
Mortgage dollar rolls and reverse
repurchase agreements.................. +November 30, 1993 $74,831,000 $ 3,110 $ 3,142
November 30, 1994 $67,516,000 $ 3,023 $ 2,227
November 30, 1995 $45,383,000 $ 4,013 $ 2,177
November 30, 1996 $49,843,242 $ 3,261 $ 2,275
-------------
</TABLE>
- ------------------
+ Data reflects period from December 31, 1992 (commencement of operations)
to November 30, 1993.
* Calculated by multiplying $1,000 by the result obtained by dividing:
(a) the average market value of the Shares on the last day of each month
during the period indicated, in which the Trust had outstanding
indebtedness; by (b) the average amount of indebtedness outstanding on the
last day of each such month.
13
<PAGE>
THE TRUST
The Trust is a diversified, closed-end management investment company and
has registered as such under the 1940 Act. The Trust was incorporated under the
laws of the State of Maryland on October 16, 1992 and commenced operations on
December 31, 1992. The Trust will terminate and distribute substantially all of
its net assets on or about November 30, 2002. The Trust'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 will be issued in connection with this offering. The
Shares 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 Trust will not receive any proceeds from the sale of any Shares offered
pursuant to this Prospectus. Proceeds received by PaineWebber as a result of its
OTC secondary market sales of the Shares will be utilized by PaineWebber in
connection with its secondary market operations and for general corporate
purposes.
TRADING HISTORY
The Shares are listed and traded on the NYSE under the symbol 'TTR.' The
following table sets forth for the Shares for each fiscal quarter 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 Trust's computation
as of 4:00 p.m. Eastern time, on the second to 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 Shares during the periods shown may
be broader than is shown in this table. On March 19, 1997, the closing price per
Share on the NYSE was $12.625, the Trust's net asset value per Share was $14.59
and the discount to net asset value per Share was (13.47)%.
<TABLE>
<CAPTION>
(DISCOUNT) OR
PREMIUM TO NET
SALES PRICES NET ASSET VALUES ASSET VALUE
------------------ ---------------- ------------------
PERIOD ENDED HIGH LOW HIGH LOW HIGH LOW
- ------------------------------------------ ------- ------- ------ ------ ------- -------
<S> <C> <C> <C> <C> <C> <C>
02/28/95.................................. $11.500 $10.625 $13.11 $12.78 (12.28)% (16.86)%
05/31/95.................................. 12.000 11.250 13.81 13.49 (13.11) (16.60)
08/31/95.................................. 12.250 11.625 13.94 13.85 (12.12) (16.06)
11/30/95.................................. 12.750 12.125 14.37 13.98 (11.27) (13.27)
02/29/96.................................. 13.625 12.375 14.50 14.42 (6.03) (14.18)
05/31/96.................................. 12.875 12.250 14.07 14.18 (8.49) (13.61)
08/31/96.................................. 12.875 12.125 14.37 13.99 (10.40) (13.33)
11/30/96.................................. 13.000 12.500 14.79 14.55 (12.10) (14.09)
02/28/97.................................. 13.000 12.500 14.78 14.53 (12.04) (13.97)
</TABLE>
See 'Description of Shares--Share Repurchases and Tender Offers' as to
methods that may be undertaken by the Trust to reduce any discount.
14
<PAGE>
INVESTMENT OBJECTIVE AND POLICIES
The Trust's investment objective is to manage a portfolio of high quality
fixed-income and adjustable-rate securities in order to return $15 per Share
(the initial public offering price) to investors on or about November 30, 2002,
while providing high monthly income. No assurance can be given that the Trust
will achieve its investment objective.
The Trust seeks to return $15 per Share to investors on or about November
30, 2002 by: (1) preserving capital through active management of the Trust's
portfolio; (2) reducing, over time, the price sensitivity of the Trust's
portfolio to changes in interest rates; and (3) retaining a portion of the
income from its investments. The Trust seeks to achieve high monthly income by
actively managing its assets in relation to market conditions, interest rate
changes and the remaining term of the Trust.
The Trust normally invests substantially all of its total assets in a
diversified portfolio of: (1) Mortgage-Backed Securities issued or guaranteed by
the U.S. government, its agencies or instrumentalities; and (2) Mortgage-Backed
and Asset-Backed Securities that, at the time of investment, are rated AAA by
S&P or Aaa by Moody's or are comparably rated by another NRSRO or, with respect
to up to 20% of the Trust's total assets, that are unrated but that, at the time
of investment, have been determined by the Sub-Adviser to be of comparable
quality to those that are AAA or Aaa. Under normal circumstances, the Trust
concentrates at least 25% of its total assets in Mortgage-Backed and
Asset-Backed Securities issued or guaranteed by Private Mortgage Lenders or by
agencies or instrumentalities of the U.S. government. This concentration policy
may not be changed without the approval of the Trust's shareholders.
In order to seek to reduce the Trust's exposure to certain risks that
generally are inherent in Mortgage-Backed Securities, a substantial portion of
the Mortgage-Backed Securities held by the Trust normally are PAC Bonds and ARM
and Floating Rate Mortgage-Backed Securities. The Sub-Adviser expects that, in
the later years of the term of the Trust, an increased proportion of the Trust's
total assets may be invested in Asset-Backed Securities, which generally have
shorter effective terms to maturity than Mortgage-Backed Securities.
Mortgage-Backed Securities represent direct or indirect participations in,
or are secured by and payable from, mortgage loans secured by real property.
Mortgage-Backed Securities (including PAC Bonds) include single- and multi-class
mortgage pass-through securities and CMOs and will be: (1) issued or guaranteed
by U.S. government agencies or instrumentalities, such as Ginnie Mae, Fannie Mae
or Freddie Mac; (2) issued by Private Mortgage Lenders but supported by pools of
mortgage loans or other Mortgage-Backed Securities that are guaranteed, directly
or indirectly, by the U.S. government or one of its agencies or
instrumentalities; or (3) issued by Private Mortgage Lenders without any
government guarantee of the underlying mortgage assets, but usually with some
form of non-governmental credit enhancement. The types of Mortgage-Backed
Securities in which the Trust may invest are described in Appendix A to this
Prospectus and in the SAI.
Mortgage-Backed and Asset-Backed Securities differ from investments in
traditional debt securities in that, among other things, principal may be
prepaid at any time due to prepayments by the obligors on the underlying loans
or other obligations. Such prepayments may reduce the yield to the Trust on
Mortgage-Backed and Asset-Backed Securities held in its portfolio and may result
in reinvestment of the proceeds of such prepayments at interest rates that are
lower than on the prepaid securities. Prepayments are influenced by a variety of
economic, geographic, social and other factors. Generally, however, prepayments
will increase during periods of declining interest rates and decrease during
periods of rising interest rates. The Trust's policy of investing primarily in
Mortgage-Backed and Asset-Backed Securities has the effect of increasing the
Trust's exposure to these and other risks related to such securities and might
cause the value of the Trust's
15
<PAGE>
portfolio securities to fluctuate more than otherwise would be the case. The
Sub-Adviser believes that investment by the Trust in PAC Bonds and in ARM and
Floating Rate Mortgage-Backed Securities normally reduces the Trust's exposure
to the risks of prepayments. See 'Special Characteristics of Mortgage-Backed and
Asset-Backed Securities' in the SAI.
Certain types of mortgage-backed securities, commonly known as CMOs, may be
specially structured in a manner that provides any of a wide variety of
investment characteristics, such as yield, effective maturity and interest rate
sensitivity. As market conditions change, however, and particularly during
periods of rapid or unanticipated changes in market interest rates, the
attractiveness of the CMO classes and the ability of the structure to provide
the anticipated investment characteristics may be significantly reduced. These
changes can result in volatility in the market value, and in some instances
reduced liquidity, of the CMO class.
The Trust does not invest in CMO residuals. The Trust may invest no more
than an aggregate of 10% of its total assets in Mortgage-Backed Securities
constituting IOs, POs (other than IOs and POs that are PAC Bonds) or inverse
floating rate obligations or other types of Mortgage-Backed Securities that may
be developed in the future and that are determined by the Sub-Adviser to present
types and levels of risk that are comparable to such IOs, POs and inverse
floating rate obligations. The Trust invests in Specified Mortgage-Backed
Securities only when the Sub-Adviser believes that such securities, when
combined with the Trust's other investments, would enable the Trust to achieve
its investment objective. The yields on Specified Mortgage-Backed Securities
generally are more sensitive to changes in interest rates than other Mortgage-
Backed Securities. While the Sub-Adviser will seek to limit the impact of these
factors on the Trust, no assurance can be given that it will achieve this
result.
The Trust also may invest in Zero Coupon Municipal Securities that are
rated AAA by S&P or Aaa by Moody's. While Zero Coupon Municipal Securities do
not contribute to the cash available to the Trust for purposes of paying
dividends to shareholders, the income retained by the Trust from the accrual of
the original issue discount on such securities, together with any other income
that is retained by the Trust, can be used to increase the amount available to
be distributed to investors on or about November 30, 2002.
Because accrued original issue discount on Zero Coupon Municipal Securities
is generally not taxable to holders, Zero Coupon Municipal Securities have lower
yields than other zero coupon securities. The accrued discount on Zero Coupon
Municipal Securities in which the Trust invests is generally not taxable to the
Trust; however, when distributed to shareholders, that accrued discount will be
treated for tax purposes in the same manner as other dividend distributions
(that is, as a taxable dividend to the extent of the Trust's earnings and
profits). Any accrued discount from Zero Coupon Municipal Securities that is not
distributed will increase the net asset value of the Shares. See 'Dividends and
Other Distributions; Dividend Reinvestment Plan' and 'Taxation.'
Asset-Backed Securities have structural characteristics similar to
Mortgage-Backed Securities but relate to assets other than Mortgage Assets.
Under current conditions the Sub-Adviser does not intend to invest a significant
portion of the Trust's assets in Asset-Backed Securities until the later years
of the Trust's term. The Sub-Adviser anticipates that a substantial portion of
any Asset-Backed Securities that it acquires for the Trust would be structured
in a manner similar to PAC Bonds. New types of Asset-Backed Securities are
developed and marketed from time to time by a variety of new and existing
issuers, and consistent with its investment limitations, the Trust expects to
invest in those new types of Asset-Backed Securities that the Sub-Adviser
believes may assist the Trust in achieving its investment objective.
In order to invest cash reserves or, on a temporary basis, during defensive
periods or when, in the opinion of the Sub-Adviser, no suitable Mortgage-Backed
or Asset-Backed Securities or Zero Coupon Municipal Securities are available,
the Trust may invest in money market instruments and longer-term debt securities
of
16
<PAGE>
various types, including: (1) U.S. government securities; (2) high quality
corporate bonds, debentures, notes and commercial paper that are rated AAA or
A-1+ by S&P or Aaa or Prime-1 by Moody's or that have a comparable rating from
another NRSRO or that are unrated but that, at the time of investment, have been
determined by the Sub-Adviser to be of comparable quality to those that are so
rated; (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.
The U.S. government securities in which the Trust may invest include
securities that are backed by the full faith and credit of the U.S. government,
securities that are supported primarily or solely by the creditworthiness of a
U.S. government agency or instrumentality as issuer or guarantor, and securities
that are supported primarily or solely by specific pools of assets and the
creditworthiness of a government related issuer.
Repurchase agreements are transactions in which the Trust purchases
securities from a bank or recognized securities dealer and simultaneously
commits to resell the 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 Trust maintains custody
of the underlying securities prior to their repurchase; thus, the obligation of
the bank or dealer to pay the repurchase price on the date agreed to is, in
effect, secured by such securities. If the value of such securities becomes less
than the repurchase price, plus any agreed-upon additional amount, the other
party to the agreement is 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
Trust upon acquisition is accrued as interest and included in the Trust'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 Trust if the
other party to a repurchase agreement becomes bankrupt. The Trust intends to
enter into repurchase agreements only with banks and dealers in transactions
believed by the Sub-Adviser to present minimal credit risks in accordance with
guidelines established by the Trust's board of directors. Mitchell Hutchins will
review and monitor the creditworthiness of such institutions under the board's
general supervision.
17
<PAGE>
RISK FACTORS AND OTHER INVESTMENT POLICIES
RETURN OF $15 PER SHARE
To the extent capital losses realized by the Trust on dispositions of
securities are not offset by capital gains realized in the same or in subsequent
years (subject to the eight-year limit on capital loss carryforwards under the
federal tax law) and by income retained on its investments, the Trust may be
unable to distribute $15 per Share to its shareholders at the end of the Trust's
term. Also, in order to avoid the imposition of the Excise Tax, the Trust would
need to distribute all or a substantial portion of any taxable income and net
capital gain (in excess of any available capital loss carryforwards) in the year
in which they are earned or realized. By retaining a portion of the income on
its investments, the Trust expects to incur some Excise Tax liability. Moreover,
the Trust would need to distribute all of its taxable income and net capital
gain (in excess of any available capital loss carryforwards) in the year in
which they are earned or realized, or within 12 months thereafter, in order to
avoid the imposition of federal income tax. In order to return $15 per Share to
its shareholders at the end of its term, the Trust also must recoup amounts paid
by the Trust in connection with its organization and its initial public
offering.
Due to the adverse conditions that affected the Mortgage-Backed Securities
markets during 1994, the Trust sustained realized and unrealized capital losses
aggregating approximately $20.5 million. It is uncertain that the Trust will be
able to return a full $15 per Share to investors on or about November 30, 2002.
The Sub-Adviser intends to manage the Trust so that the amount available to
distribute to shareholders at that date will be as much as possible while still
providing high monthly income.
The Trust expects to continue to retain a portion of the accrued income on
the investments in its portfolio, provided that such retention is consistent
with maintenance of its status as a regulated investment company ('RIC') for
federal income tax purposes. Such retained income is intended to increase the
net asset value of the Trust. See 'Investment Objective and Policies.' No
assurance can be given that such results will be achieved.
INTEREST RATE SENSITIVITY
The yield on debt securities, including Mortgage-Backed and Asset-Backed
Securities and Zero Coupon Municipal Securities, depends on a variety of
factors, including general market conditions for such securities, the financial
condition of the issuer, the size of the particular offering, the maturity,
credit quality and rating of the security and, in the case of securities of
municipal issuers, expectations regarding changes in income tax rates.
Generally, the longer the maturity of such a security, the higher its yield and
the greater its volatility. The market value of debt securities, and accordingly
the Trust's net asset value, normally will vary inversely with changes in
interest rates. Such changes in the values of the securities held by the Trust
will affect the net asset value of Shares. Neither the issuance by, nor the
guarantee of a U.S. government agency, nor a AAA or equivalent rating for a
security constitutes assurance that the security will not fluctuate in value or
that the Trust will receive the originally anticipated yield on the security.
The yields on Specified Mortgage-Backed Securities (including IOs, POs
(other than IOs and POs that are PAC Bonds) and inverse floating rate
obligations), in which the Trust may invest up to 10% of its total assets, on
IOs and POs that are PAC Bonds, and on Zero Coupon Municipal Securities
generally are more sensitive to changes in interest rates than most
Mortgage-Backed Securities. The Trust is not limited in its ability to invest in
IOs and POs that are PAC Bonds. The yields on most IOs and POs are extremely
sensitive to the rate of principal payments (including prepayments), which can
result in price volatility and, in the case of IOs, can result in the Trust
failing to recoup fully its initial investment in such securities even though
the securities may be issued or guaranteed by a U.S. government agency or be
rated in the highest rating category
18
<PAGE>
by a NRSRO. Due to their planned amortization structure, yields on IOs and POs
that are PAC Bonds generally do not have the same sensitivity to prepayments as
other IOs and POs unless, among other things, the actual prepayment experience
on the underlying mortgage loans fails to fall within the range contemplated
when the PAC Bonds were created. While the Sub-Adviser will seek to limit the
impact of these factors on the Trust, no assurance can be given that it will
achieve this result.
The market value of an inverse floating rate obligation will be more
volatile than that of a fixed-rate obligation and, like most debt obligations,
will vary inversely with changes in interest rates. Some inverse floating rate
obligations have coupon rates that adjust to changes in market interest rates to
a greater degree than the change in the market rate and, accordingly, have
investment characteristics similar to investment leverage. As a result, the
market value of such inverse floating rate obligations are subject to greater
risk of fluctuation than other Mortgage-Backed Securities, and such fluctuations
could adversely affect the ability of the Trust to achieve its investment
objective.
LEVERAGE
The Trust may engage in leverage through the use of mortgage dollar rolls
and reverse repurchase agreements. Leveraging exaggerates changes in the net
asset value of the Shares and in the yield on the Trust's portfolio, which may,
in turn, result in increased volatility of the market price of the Shares.
Leverage also creates interest expenses for the Trust, which can exceed the
income from the assets obtained with the proceeds. To the extent the income
derived from securities purchased with funds obtained through leverage exceeds
the interest and other expenses that the Trust will have to pay in connection
with such leverage, the Trust's net income will be greater than if leverage were
not used. Conversely, if the income from the assets obtained through leverage is
not sufficient to cover the cost of leverage, the net income of the Trust will
be less than if leverage were not used, and therefore the amount available for
distribution to shareholders will be reduced. Because of the short-term nature
of the funding available in the dollar roll and reverse repurchase markets,
relatively low transactions costs, wide availability of funds at favorable terms
and the ability to increase or decrease the amount of outstanding borrowing in a
relatively short period of time, the Trust expects that substantially all of its
leverage will be in the form of mortgage dollar rolls and reverse repurchase
agreements.
The Trust is authorized to borrow money for investment purposes in an
amount up to 33 1/3% of its total assets (including the amount of the borrowing
and any other indebtedness representing 'senior securities' under the 1940 Act
but reduced by any liabilities and indebtedness other than senior securities).
The Trust is also authorized to borrow an additional 5% of its total assets
without regard to the foregoing limitation for temporary purposes such as
clearance of portfolio transactions, the payment of dividends and Share
repurchases. Borrowing constitutes leverage, a speculative technique. The use of
leverage provides the opportunity for increased net income but, at the same
time, involves special risks. The Trust will only use leverage when the
Sub-Adviser believes that such leverage will benefit the Trust after taking such
risks into consideration.
Mortgage Dollar Rolls. Mortgage dollar rolls are transactions in which the
Trust sells Mortgage-Backed Securities for delivery in the current month and
simultaneously contracts to purchase substantially similar (same type, coupon
and maturity) securities on a specified future date. During the roll period, the
Trust forgoes principal and interest paid on the Mortgage-Backed Securities. The
Trust is compensated by the difference between the current sales price and the
lower forward price for the future purchase (often referred to as the 'drop') as
well as by the interest earned on the cash proceeds of the initial sale. The
Trust also may be compensated through the receipt of fee income equivalent to a
lower forward price. Unless such benefits exceed the income, capital
appreciation and gain or loss due to mortgage prepayments that would have been
19
<PAGE>
realized on the securities sold as part of the mortgage dollar roll, the use of
this technique will diminish the investment performance of the Trust compared
with what such performance would have been without the use of mortgage dollar
rolls. At the time the Trust enters into a mortgage dollar roll, the Trust's
custodian segregates cash or liquid securities having a value not less than the
forward purchase price. Mortgage dollar rolls will be considered borrowings and,
accordingly, will be subject to the Trust's 33 1/3% limitation on borrowings.
Mortgage dollar rolls involve certain risks including the risk that the
broker-dealer to whom the Trust sells the security becomes insolvent, the
Trust's right to purchase or repurchase the mortgage-related securities subject
to the mortgage dollar roll may be restricted, and the instrument which the
Trust is required to repurchase may be worth less than an instrument which the
Trust originally held. Successful use of Trust mortgage dollar rolls will depend
upon the Sub-Adviser's ability to predict correctly interest rates and mortgage
prepayments. For these reasons, there is no assurance that mortgage dollar rolls
can be successfully employed.
Reverse Repurchase Agreements. The Trust also has engaged in leverage by
entering into reverse repurchase agreements with the same parties with whom it
may enter into repurchase agreements. Under a reverse repurchase agreement, the
Trust sells securities and agrees to repurchase them at a mutually agreed date
or upon demand and at a price reflecting a market rate of interest. At the time
the Trust enters into a reverse repurchase agreement, an approved custodian
segregates cash or liquid securities 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 Trust invests those
proceeds. Thus, reverse repurchase agreements involve the risk that the buyer of
the securities sold by the Trust might be unable to deliver them when the Trust
seeks to repurchase. In the event the buyer of securities under a reverse
repurchase agreement files for bankruptcy or becomes insolvent, such buyer or
its trustee or receiver may receive an extension of time to determine whether to
enforce the Trust's obligation to repurchase the securities and the Trust's use
of the proceeds of the reverse repurchase agreement may effectively be
restricted pending such decision. Reverse repurchase agreements will be
considered borrowings and, accordingly, will be subject to the Trust's 33 1/3%
limitation on borrowings.
Effect of Leverage. The Trust's portfolio must experience an annual return
of 1.30% in order to cover the 5.51% annualized rate of interest on reverse
repurchase agreements outstanding as of November 30, 1996. Such percentages are
not necessarily indicative of the annualized rate of interest on the Trust's
outstanding senior securities, or of the annual return necessary to cover such
rate of interest, as of other dates. The following table may assist the investor
in understanding the effects of leverage by illustrating the effect of leverage
on return to a shareholder. 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> <C>
Assumed Return on Portfolio (Net
of Expenses)................... -10% -5% 0% 1.30% 5% 10%
Corresponding Return to
Shareholder.................... -17.52% -9.76% -2.01% 0% 5.74% 13.50%
</TABLE>
LENDING OF PORTFOLIO SECURITIES
The Trust is authorized to lend portfolio securities with a value of up to
33 1/3% of its total assets to broker-dealers or institutional investors that
Mitchell Hutchins or the Sub-Adviser deems qualified, but only when the borrower
maintains acceptable collateral, with the Trust's custodian in amount, marked to
market daily, at least equal to the market value of the securities loaned, plus
accrued interest and dividends. Acceptable
20
<PAGE>
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 Trust will retain authority to terminate
any loans at any time. The Trust may pay reasonable administrative and custodial
fees in connection 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
Trust 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 Trust 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
Trust's interest.
WHEN-ISSUED AND DELAYED DELIVERY SECURITIES
The Trust may purchase debt securities on a when-issued basis or may
purchase or sell debt securities for delayed delivery. In when-issued or delayed
delivery transactions, delivery of the securities occurs beyond normal
settlement periods, but no payment or delivery is made by the Trust prior to the
actual delivery or payment by the other party to the transaction. The Trust does
not accrue income with respect to a when-issued or delayed delivery security
prior to its stated delivery date. 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, fluctuations in the value of the security from the time of
the commitment date will affect the Trust's net asset value. When the Trust
commits to purchase securities on a when-issued or delayed delivery basis, its
custodian sets aside in a segregated account cash or liquid securities with a
market value equal to the amount of the commitment. If necessary, additional
assets are placed in the account daily so that the value of the account equals
or exceeds the amount of the Trust's purchase commitment. Placing securities
rather than cash in the segregated account may have a leveraging effect on the
Trust's net asset value per share; that is, to the extent that the Trust 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.
STRATEGIC TRANSACTIONS
The Trust may use the investment strategies described below to hedge
various market risks (such as the risk of changes in interest rates), to manage
the effective maturity or interest rate sensitivity of its portfolio or to
enhance income or realize gains. New financial products and risk management
techniques continue to be developed, and the Trust may use these products and
techniques to the extent consistent with its investment objective and regulatory
and tax considerations.
In pursuing these investment strategies, the Trust may purchase and sell
exchange-listed and OTC put and call options (including straddles and spreads)
on securities, financial futures, interest rate indices and other financial
instruments, purchase and sell financial futures contracts and enter into
interest rate protection transactions, including interest rate swaps, caps,
collars and floors (all of the foregoing transactions are referred to
collectively as 'Strategic Transactions'). Strategic Transactions may be used to
attempt to protect against possible changes in the market value of securities
held in or to be purchased for the Trust's portfolio, to protect the Trust's
unrealized gains in the value of its portfolio securities, to facilitate the
sale of such securities, to manage the effective maturity or interest rate
sensitivity of the Trust's portfolio or to establish a position as a temporary
substitute for purchasing or selling particular securities. Some Strategic
Transactions
21
<PAGE>
may also be used to enhance income or realize gains. The Trust may enter into
Strategic Transactions under which up to 100% of the Trust's portfolio assets is
at risk.
The Trust might not employ any Strategic Transactions, and there can be no
assurance that any Strategic Transactions used will succeed. The use of
Strategic Transactions involves certain risks, including: (1) the fact that
skills needed to use Strategic Transactions are different from those needed to
select the Trust's securities; (2) possible imperfect correlation, or even no
correlation, between price movements of Strategic Transactions and price
movements of related portfolio positions; (3) the fact that, while Strategic
Transactions can reduce risk of loss, they can also reduce the opportunity for
gain, or even result in losses, by offsetting favorable price movements in
related portfolio positions; and (4) the possible inability of the Trust to
purchase or sell a portfolio security at a time that otherwise would be
favorable for it to do so, or the possible need for the Trust to sell a
portfolio position at a disadvantageous time, due to the need for the Trust to
maintain 'cover' or segregate assets in connection with Strategic Transactions
and the possible inability of the Trust to close out or to liquidate its related
portfolio position. Strategic Transactions also are subject to the risk that, if
the Sub-Adviser is incorrect in its forecast of interest rates, market values or
other economic factors affecting such a transaction, the Trust would have been
better off if it had not entered into the Strategic Transaction. See the SAI for
additional information on Strategic Transactions.
ILLIQUID SECURITIES
The Trust may invest up to 20% of its total assets (determined at the time
of investment) in illiquid securities. 'Illiquid securities' for this purpose
are securities that cannot be disposed of within seven days at approximately the
amount at which the Trust has valued the securities and includes, among other
things, certain Zero Coupon Municipal Securities, purchased OTC options,
repurchase agreements maturing in more than seven days and restricted securities
other than Rule 144A securities and commercial paper that the Sub-Adviser has
determined to be liquid pursuant to guidelines established by the Trust's board
of directors. The Trust may not be able to sell illiquid securities when the
Sub-Adviser considers it desirable to do so or may have to sell such securities
at a price lower than could be obtained if they were more liquid. Also, the sale
of illiquid securities may require more time and result in higher dealer
discounts, brokerage commissions and other selling expenses than does the sale
of securities that are not illiquid. The lack of a liquid secondary market for
illiquid securities may make it more difficult for the Trust to assign a value
to those securities for purposes of valuing the Trust's portfolio and
calculating its net asset value. Under current guidelines of the staff of the
SEC, IOs and POs are considered illiquid. However, IO and PO classes of
fixed-rate Mortgage-Backed Securities issued by the U.S. government or one of
its agencies or instrumentalities will not be considered illiquid if the
Sub-Adviser has determined that they are liquid pursuant to guidelines
established by the Trust's board of directors. All or a portion of the assets
used as cover for OTC options also may be considered illiquid.
PORTFOLIO TURNOVER
Portfolio turnover may vary from year to year and will not be a limiting
factor when the Sub-Adviser deems portfolio changes appropriate. Higher
portfolio turnover will result in higher Trust expenses, including brokerage
commissions, dealer mark-ups and other transaction costs on the sale of
securities and on reinvestment in other securities. The portfolio turnover rate
is calculated by dividing the lesser of the Trust'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 securities in the portfolio during the year. The Trust's
portfolio turnover rates for the last two fiscal years were 127% and 103%,
respectively.
22
<PAGE>
MARKET PRICE OF SHARES
Shares of the Trust and of other closed-end investment companies frequently
trade at a discount from net asset value. See 'Trading History.' Whether
investors will realize gains or losses upon the sale of Shares will not depend
directly upon changes in the Trust's net asset value, but will depend upon
whether the market price of the Shares at the time of sale is above or below the
original purchase price for the Shares. The market price of the Shares is
determined by such factors as relative demand for and supply of such shares in
the market, general market and economic conditions, changes in the Trust's net
asset value and other factors beyond the control of the Trust. There is a risk
that, for example, a shareholder who sells Shares of the Trust at a time when
they are trading at a discount could incur a loss of capital even if the Trust's
net asset value has not declined since the shareholder purchased the Shares.
This market risk is separate and distinct from the risk that the Trust's net
asset value may decrease. Accordingly, the Shares are designed primarily for
long-term investors and should not be viewed as a vehicle for trading purposes.
OTHER INFORMATION
The Trust'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
Trust's board of directors without shareholder approval.
MANAGEMENT OF THE TRUST
INVESTMENT ADVISORY AND ADMINISTRATION ARRANGEMENTS
Subject to the supervision of the Trust's board of directors, investment
advisory and administration services are provided to the Trust by Mitchell
Hutchins pursuant to an Investment Advisory and Administration Contract dated as
of December 18, 1992 ('Mitchell Hutchins 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 February 28, 1997,
Mitchell Hutchins served as investment adviser or sub-adviser to 30 registered
investment companies with 65 separate portfolios having aggregate assets of
approximately $33.3 billion.
Goldman Sachs Funds Management, L.P. serves as the Sub-Adviser under a
Sub-Investment Advisory Contract with Mitchell Hutchins dated as of December 18,
1992. The Sub-Adviser makes investment decisions and places orders to buy, sell
or hold particular securities for the Trust. The Sub-Adviser's principal
business address is One New York Plaza, New York, New York 10004. The
Sub-Adviser is a limited partnership that is indirectly controlled by Goldman
Sachs Group, L.P. through Goldman Sachs Funds Management, Inc. The Sub-Adviser
is able to draw on the substantial research and market expertise of its
affiliate, Goldman, Sachs & Co., which is among the oldest and largest
investment banking firms in the United States. The Sub-Adviser and its
affiliates provide investment advisory and portfolio management services to
pension funds, investment companies and other institutional, corporate and
individual clients. As of February 24, 1997, total assets under the management
of the Sub-Adviser and its affiliates were approximately $106.6 billion. Of this
amount, approximately $23.7 billion represented assets invested in fixed-income
securities.
23
<PAGE>
Pursuant to the Mitchell Hutchins Contract, Mitchell Hutchins provides a
continuous investment program for the Trust and makes investment decisions and
places orders to buy, sell or hold particular securities; Mitchell Hutchins has
delegated these responsibilities to the Sub-Adviser subject to the supervision
of Mitchell Hutchins. As administrator, Mitchell Hutchins supervises all matters
relating to the operation of the Trust and provides for it corporate,
administrative and clerical personnel, office space, equipment and services,
including arranging for the periodic preparation, updating, filing and
dissemination of proxy materials, tax returns and reports to the Trust's board
of directors, shareholders and regulatory authorities. The Trust pays Mitchell
Hutchins, as investment adviser and administrator, an investment advisory fee in
an amount equal to an annual fee of 0.50% of the Trust's average weekly net
assets, and an administration fee in an amount equal to an annual fee of 0.20%
of the Trust's average weekly net assets; each such fee is computed weekly and
payable monthly. Mitchell Hutchins (not the Trust) pays the Sub-Adviser a fee,
computed weekly and payable monthly, in an amount equal to one-half of the
investment advisory fee received by Mitchell Hutchins from the Trust.
The Trust incurs various other expenses in its operations, such as custody
and transfer agency fees, brokerage commissions, professional fees, expenses of
board and shareholder meetings, fees and expenses relating to registration of
its Shares, taxes and governmental fees, fees and expenses of the directors,
costs of obtaining insurance, expenses of printing and distributing shareholder
materials, organizational expenses, including costs or losses to any litigation.
For the fiscal years ended November 30, 1996, November 30, 1995 and November 30,
1994, the Trust's total expenses, stated as a percentage of average net assets,
were 3.13%, 3.42% and 2.72%, respectively.
Since March 1993, Ms. Sharmin Mossavar-Rahmani has been responsible for the
management of the Trust's portfolio and, subject to Ms. Mossavar-Rahmani's
supervision, Jonathan A. Beinner has provided day-to-day portfolio management
for the Trust. Ms. Mossavar-Rahmani is the Chief Investment Officer of Goldman
Sachs Asset Management and a Director of the Sub-Adviser responsible for
fixed-income investments. For six years prior to joining the Sub-Adviser in
1993, Ms. Mossavar-Rahmani was employed by Fidelity Management Trust Company,
where most recently she was Chief Investment Officer responsible for all
separate and commingled fixed income accounts. Mr. Beinner joined the
Sub-Adviser in 1990 after working in the trading and arbitrage group of Franklin
Savings Association and is currently a Vice President of the Sub-Adviser and
co-head of the fixed income group.
Mitchell Hutchins and Sub-Adviser investment personnel may engage in
securities transactions for their own accounts pursuant to separate codes of
ethics that establish procedures for personal investing and restrict certain
transactions.
DIVIDENDS AND OTHER DISTRIBUTIONS; DIVIDEND REINVESTMENT PLAN
DIVIDENDS AND OTHER DISTRIBUTIONS
The Trust declares and pays monthly dividends from its net investment
income. 'Net investment income,' as used herein, includes all interest
(including any accrued tax-exempt original issue discount on Zero Coupon
Municipal Securities) and other ordinary income earned by the Trust on its
portfolio holdings and net short-term capital gains, net of the Trust's
expenses. The Trust has retained, and currently intends to continue to retain,
until its final liquidating distribution, a portion of its income from
investments. The Trust expects that all or a portion of its net capital gain, if
any, in excess of available capital loss carryforwards will be distributed at
least once annually. If the Trust realizes any capital losses on dispositions of
securities that are not offset by capital gains realized on dispositions of
other securities and by retained income on its
24
<PAGE>
investments, the Trust may be unable to distribute to its shareholders at the
end of its term $15 per Share then outstanding. In addition, the timing of the
realization of any such capital gains or capital losses, and the possibility
that the Trust may be required to distribute all or a portion of any such gains
prior to its termination date, as well as the level of income earned by the
Trust, may adversely affect its ability to distribute $15 per Share at the end
of its term. See 'Investment Objective and Policies' and 'Risk Factors and Other
Investment Policies.'
Various factors may affect the level of the Trust's income, including the
asset mix, interest rates, the remaining term of the Trust, the amount of
leverage utilized by the Trust and the Trust's use of Strategic Transactions. A
significant decline in market rates of interest may have an adverse effect on
the income earned and dividends paid by the Trust. In addition, the Trust's
income and dividends may decline in later years. The Trust expects that a final
liquidating distribution to shareholders of its net assets will be made on or
about the termination of the Trust.
The Trust may not declare any dividend (other than a dividend payable in
Shares) or any other distribution on the Shares, and may not purchase any
Shares, unless at the time of such declaration or purchase the amount of the
Trust's obligations constituting senior securities does not exceed 33 1/3% of
its total assets (computed as specified in the 1940 Act) after deducting the
amount of such dividend, other distribution or purchase. See 'Description of the
Shares--Share Repurchases and Tender Offers.'
DIVIDEND REINVESTMENT PLAN
Under the Plan, all shareholders whose Shares are registered in their own
names, or in the name of PaineWebber (or its nominee), have all dividends and
other distributions payable to them automatically reinvested in additional
Shares, unless such shareholders elect to receive cash. Shareholders may
affirmatively elect to receive all dividends and other distributions in cash
paid by check mailed directly to them by PNC Bank, National Association
('Transfer Agent'), as dividend disbursing agent. Shareholders who hold their
Shares in the name of a broker or nominee other than PaineWebber (or its
nominee) should contact such broker or nominee to determine whether, or how,
they may participate in the Plan. The ability of such shareholders to
participate in the Plan may change if their Shares are transferred into the name
of another broker or nominee.
The Transfer Agent serves as agent for the shareholders in administering
the Plan. After the Trust declares a dividend or determines to make another
distribution, the Transfer Agent, as agent for the participants, receives the
cash payment and uses it to buy Shares 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 at the time
of purchase. The number of Shares purchased with each distribution to a
particular shareholder equals the result obtained by dividing the amount of the
distribution payable to that shareholder by the average price per Share
(including applicable brokerage commissions) that the Transfer Agent was able to
obtain in the open market. The Trust will not issue any new Shares in connection
with the Plan. The Transfer Agent maintains all shareholder accounts in the Plan
and furnishes written confirmations of all transactions in the accounts,
including information needed by shareholders for personal and tax records.
Shares in the account of each Plan participant are held by the Transfer Agent in
non-certificated form in the name of the participant, and each shareholder's
proxy will include the Shares 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 are paid by the Trust. However, each participant pays a pro rata
share of brokerage commissions incurred with respect to the Transfer Agent's
open market purchases of Shares in connection with the reinvestment of
distributions. The automatic reinvestment of dividends and
25
<PAGE>
other distributions does not relieve participants of any income tax that may be
payable on such distributions. See 'Taxation.'
A shareholder who has elected to participate in the Plan may terminate
participation in the Plan at any time without penalty, and shareholders 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 shareholder'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, is deemed to be an
election by a shareholder 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.
Experience under the Plan may indicate that changes are desirable.
Accordingly, the Trust 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.
TAXATION
The Trust intends to continue to qualify for treatment as a RIC under the
Internal Revenue Code. For each taxable year that the Trust so qualifies, it
(but not its shareholders) 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 transactions) and net capital gain that is distributed to its
shareholders. To continue to qualify for treatment as a RIC, the Trust must,
among other things, distribute to its shareholders for each taxable year at
least 90% of its investment company taxable income and net tax-exempt income
(including original issue discount on Zero Coupon Municipal Securities)
('Distribution Requirement'). The Trust's distributions for any taxable year,
for purposes of determining both its income tax liability and whether it
satisfies the Distribution Requirement (but not its liability for the Excise
Tax), include not only distributions made during the year but also
distributions, made within 12 months after the end of the year that satisfy
certain specific requirements (known as 'spillover distributions'). Spillover
distributions will be taxable to each shareholder for his taxable year in which
they are received, not the Trust's taxable year to which they relate. The Trust
intends to utilize spillover distributions to avoid income tax liability and
maintain its qualification for treatment as a RIC.
Dividends from the Trust's net investment income (including dividends
attributable to any tax-exempt interest income or original issue discount and
net short-term capital gains, if any) are taxable to its shareholders as
ordinary income to the extent of its earnings and profits, whether received in
cash or reinvested in additional Shares. It is not expected that any portion of
the Trust's distributions will be eligible for the dividends-received deduction
available for corporations.
Distributions of the Trust's net capital gain, if any, are taxable to its
shareholders as long-term capital gain, regardless of the length of time they
have held their Shares. (The Trust's distributable net capital gain for any
taxable year equals its net capital gain realized during the year less any
available capital loss carryforwards. At November 30, 1996, the Trust had net
capital loss carryforwards of approximately $6.2 million.) The Trust may decide
to retain for reinvestment all or a portion of its net capital gain and to pay
tax on the undistributed portion. If the Trust did so, it would designate that
portion as undistributed capital gains by notice to its shareholders. In that
event, each person who was a shareholder of record on the last day of the
Trust's taxable year would be required to include his proportionate share of the
designated gains in calculating his own long-
26
<PAGE>
term capital gains. Each such shareholder would be allowed, however, to credit
against his federal income tax liability his proportionate share of the income
tax imposed on the Trust with respect to the undistributed capital gains and to
increase the basis of his Shares by 65% of his proportionate share of those
gains.
Although the Trust intends to distribute a sufficient amount of its net
investment income each year (either during the year or by spillover
distributions applicable to the year) so as to satisfy the Distribution
Requirement, it expects to retain enough of the income on its investments to
incur some Excise Tax Liability. The Trust may decide to retain for reinvestment
all or a portion of its net investment income and net capital gain. If it did
so, the net investment income and undistributed gain would be taxed to the Trust
at corporate income tax rates, in addition to possibly being subject to the
Excise Tax.
A participant in the Plan is treated as having received a distribution in
the amount of cash used to purchase Shares on his behalf, including a pro rata
portion of the brokerage fees incurred by the Transfer Agent. An investor should
be aware that if Shares are purchased shortly before the record date for any
dividend or other distribution, the investor will pay full price for the Shares
and could receive some portion of the price back as a taxable distribution.
Shareholders who are not liable for tax on their income and whose Shares are not
debt-financed are not required to pay tax on dividends or other distributions
they receive from the Trust.
Dividends and other distributions declared by the Trust in October,
November or December of any year and payable to shareholders of record on a date
in any of those months will be deemed to have been paid by the Trust and
received by the shareholders on December 31 of that year if the distributions
are paid by the Trust during the following January. Accordingly, those
distributions will be taxed to shareholders for the year in which that December
31 falls. The Trust notifies its shareholders following the end of each calendar
year of the amounts of dividends and capital gain distributions paid (or deemed
paid) that year.
Upon a sale or exchange of Shares (including a sale pursuant to a Share
repurchase or tender offer by the Trust) or upon receiving a distribution in
liquidation of the Trust, a shareholder 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 shareholder'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 (1) will be treated as a long-term, rather than as a
short-term, capital loss to the extent of the sum of any capital gain
distributions received thereon plus any undistributed capital gains designated
with respect thereto, 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
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 Plan), in which event, the replacement Shares' basis
would be adjusted to reflect the disallowed loss.
The Trust is required to withhold 31% of all dividends, capital gain
distributions and repurchase proceeds payable to any individuals and certain
other non-corporate shareholders who do not provide the Trust with a correct
taxpayer identification number. Withholding at that rate also is required from
dividends and capital gain distributions payable to such shareholders who
otherwise are subject to backup withholding.
The Trust is not intended to be an investment for non-U.S. persons.
The foregoing is only a summary of some of the important federal tax
considerations affecting the Trust and its shareholders; see the SAI for a
further discussion. There may be other federal, state or local tax
considerations applicable to a particular investor. Prospective shareholders are
therefore urged to consult their tax advisers.
27
<PAGE>
DESCRIPTION OF THE SHARES
The Trust is authorized to issue 200 million shares of common stock, $0.001
par value. The information contained under this heading is subject to the
provisions contained in the Trust's Articles of Incorporation ('Articles') and
By-Laws.
THE SHARES
Shares of the Trust have no preemptive, conversion, exchange or redemption
rights. Each Share has equal voting, dividend, distribution and liquidation
rights. The Shares are fully paid and nonassessable. Shareholders are entitled
to one vote per Share. 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.
The Articles provide that the Trust will terminate on or about November 30,
2002, without shareholder approval. In connection with such termination, the
Trust will liquidate all of its assets and distribute to shareholders the net
proceeds therefrom after making appropriate provision for any liabilities of the
Trust. Prior to such termination, however, the board of directors of the Trust
will consider whether it is in the best interests of the shareholders to
terminate and liquidate the Trust without shareholder approval notwithstanding
the provision of the Articles. In considering the matter, the board of directors
will take into account, among other factors, the adverse effect which capital
losses realized upon disposition of securities in connection with liquidation
(if any such losses are anticipated) would have on the Trust and its
shareholders. In the event that the board of directors determines that under the
circumstances, termination and liquidation of the Trust on or about November 30,
2002 without a shareholder vote would not be in the best interests of
shareholders, the board of directors will call a special meeting of shareholders
to consider an appropriate amendment to the Articles. The Articles require the
affirmative vote of the holders of at least 66 2/3% outstanding Shares to
approve such an amendment. The foregoing provisions of the Articles are
goverened by the laws of the State of Maryland and not the 1940 Act. Under the
rules of the NYSE applicable to listed companies, the Trust normally will be
required to hold an annual meeting of shareholders in each year. If for any
reason the Shares are no longer listed on the NYSE (or any other national
securities exchange the rules of which require annual meetings of shareholders),
the Trust may decide not to hold annual meetings of shareholders.
Any additional offerings of the Shares, if made, will require approval of
the Trust'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 shareholders or with the
consent of the holders of at least a majority of the Trust's outstanding voting
securities. The Trust has no present intention of issuing any additional Shares.
The following chart indicates the Shares outstanding as of March 19, 1997.
<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..................... 200,000,000 7,335 7,795,532
</TABLE>
28
<PAGE>
SHARE REPURCHASES AND TENDER OFFERS
In recognition of the possibility that the Shares may trade at a discount
to net asset value and that any such discount may not be in the best interests
of shareholders, the Trust's board of directors has determined that it will
consider taking action to attempt to reduce or eliminate any discount. To that
end, the board at least annually considers, in consultation with Mitchell
Hutchins, whether to take action either to repurchase Shares in the open market
or to make a tender offer for the Shares at their net asset value. At such times
the board may consider such factors as the market price of the Shares, the net
asset value of the Shares, the liquidity of the assets of the Trust, whether
such transactions would impair the Trust's status as a RIC, general economic
conditions and such other events or conditions that the board believes may have
a material effect of the Trust's ability to consummate such transactions. Under
certain circumstances, it is possible that open market repurchases or tender
offers may constitute a distribution under the Internal Revenue Code to the
remaining shareholders of the Trust. The Trust may borrow to finance repurchases
and tender offers. Interest on any such borrowings will reduce the Trust's net
income.
In July 1995, the Trust commenced a program of repurchasing Shares in the
open market. As of March 31, 1997, the Trust had repurchased approximately 3.0
million Shares under that program. Additional Shares may be repurchased under
this program, but there is no assurance that they will be. Similarly, there can
be no assurance that the board of directors will decide to undertake any tender
offers or that any such acts will result in the Shares trading at a price that
is equal or close to net asset value per Share. The market price of Shares will
be determined by, among other things, the relative demand for and supply of
Shares in the market, the Trust's investment performance, the Trust's dividends
and yield and investor perception of the Trust's overall attractiveness as an
investment as compared with other investment alternatives. Nevertheless, the
fact that the Shares may be the subject of tender offers at net asset value from
time to time may reduce the spread that might otherwise exist between the market
price of the Shares and net asset value per Share. In the opinion of Mitchell
Hutchins, sellers may be less inclined to accept a significant discount if they
have a reasonable expectation of being able to recover net asset value in
conjunction with a possible tender offer.
Although the board of directors believes that Share repurchases and tender
offers generally would have a favorable effect on the market price of the
Shares, it should be recognized that the Trust's acquisition of Shares would
decrease the Trust's total assets and therefore have the effect of increasing
the Trust's expense ratio and decreasing the asset coverage with respect to any
outstanding borrowings. Because of the nature of the Trust'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 Trust's investment performance and that
the Sub-Adviser 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.
Any tender offer made by the Trust for its Shares generally would be at a
price equal to the net asset value of the Shares on a date subsequent to the
Trust's receipt of all tenders. Each offer would be made, and the shareholders
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 offering document would contain such information as is prescribed by such
laws and the rules and regulations promulgated thereunder. Each person tendering
Shares would pay to the Trust's Transfer Agent a service charge to help defray
certain costs, including the processing of tender forms, effecting payment,
postage and handling. Any such service charge would be paid directly by the
tendering shareholder and would not be deducted from the proceeds of the
purchase. The Transfer Agent would receive the fee as an offset to these costs.
The Trust 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.
29
<PAGE>
Tendered Shares that have been accepted and purchased by the Trust will be
held in the Trust's treasury until retired by the board. If treasury Shares are
retired, Shares issued and outstanding and capital in excess of par will be
reduced. If tendered Shares are not retired, the Trust may hold, sell or
otherwise dispose of the Shares for any lawful corporate purpose as determined
by the board of directors.
CERTAIN ANTI-TAKEOVER PROVISIONS OF THE ARTICLES OF INCORPORATION
The Trust's Articles contain provisions that have the effect of limiting:
(1) the ability of other entities or persons to acquire control of the Trust;
(2) the Trust's freedom to engage in certain transactions; and (3) the ability
of the Trust's directors or shareholders to amend the Articles. These provisions
of the Articles may be regarded as 'anti-takeover' provisions. Under Maryland
law and the Trust's Articles, 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 Trust with another corporation, a merger of the Trust with or into another
corporation (except for certain mergers in which the Trust is the successor), a
statutory share exchange in which the Trust is not the successor, a sale or
transfer of all or substantially all of the Trust's assets, the dissolution of
the Trust and any amendment to the Trust's Articles of Incorporation. In
addition, the affirmative vote 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
Trust's capital stock is required generally to authorize any of the following
transactions or to amend the provisions of the Articles relating to such
transactions:
(1) merger, consolidation or statutory share exchange of the Trust with or
into any other corporation;
(2) issuance of any securities of the Trust to any person or entity for
cash;
(3) sale, lease or exchange of all or any substantial part of the assets of
the Trust to any entity or person (except assets having an aggregate
fair market value of less than $1,000,000); or
(4) sale, lease or exchange to the Trust, in exchange for securities of the
Trust, 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 (a
'Principal Shareholder'). A similar vote would also be required for any
amendment of the Articles to convert the Trust to an open-end investment company
by making any class of the Trust'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 Trust's assets or the conversion of the Trust to an
open-end investment company, the affirmative vote of a majority of the
outstanding Shares would nevertheless be required. Reference is made to the
Articles, on file with the SEC, for the full text of these provisions.
The provisions of the Articles described above and the Trust's right to
repurchase or make a tender offer for its Shares could have the effect of
depriving the shareholders 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 Trust in a tender offer or similar transaction. See
'Description of the Shares--Share Repurchases and Tender Offers.' 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
Trust to negotiate with its management regarding the price to be paid and
facilitating the continuity of the Trust's management, investment objective and
policies. The board of
30
<PAGE>
directors of the Trust has considered the foregoing anti-takeover provisions and
concluded that they are in the best interests of the Trust and its shareholders.
CUSTODIAN, TRANSFER AND DIVIDEND DISBURSING AGENT AND REGISTRAR
State Street Bank and Trust Company, One Heritage Drive, North Quincy,
Massachusett 02171, serves as custodian of the Trust's assets. PNC Bank,
National Association, whose principal business address is Broad and Chestnut
Streets, Philadelphia, Pennsylvania 19110, is the Trust's transfer and dividend
disbursing agent and registrar.
FURTHER INFORMATION
Further information concerning these securities and the Trust may be found
in the Registration Statement of which this Prospectus and the Trust's SAI
constitute a part, on file with the SEC.
TABLE OF CONTENTS OF
STATEMENT OF ADDITIONAL INFORMATION
The Table of Contents for the SAI is as follows:
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Investment Policies and Restrictions............................................................. 1
Investment Limitations........................................................................... 4
Strategic Transactions........................................................................... 7
Directors and Officers........................................................................... 14
Control Persons and Principal Holders of Securities.............................................. 20
Investment Advisory Arrangements................................................................. 20
Portfolio Transactions........................................................................... 22
Valuation of Shares.............................................................................. 23
Taxes............................................................................................ 24
Additional Information........................................................................... 26
Financial Statements............................................................................. 26
Appendix A....................................................................................... A-1
</TABLE>
31
<PAGE>
APPENDIX A
TYPES OF MORTGAGE-BACKED SECURITIES
The Trust may invest in the following types of Mortgage-Backed Securities.
New types of Mortgage-Backed Securities are developed and marketed from time to
time and, consistent with its investment limitations, the Trust expects to
invest in those new types of Mortgage-Backed Securities that the Sub-Adviser
believes may assist the Trust in achieving its investment objective. Similarly,
the Trust may invest in Mortgage-Backed Securities issued by new or existing
governmental or private issuers other than those identified in Appendix A to
this Prospectus and in the Statement of Additional Information.
GINNIE MAE CERTIFICATES
Ginnie Mae guarantees certain mortgage pass-through certificates ('Ginnie
Mae certificates') that are issued by Private Mortgage Lenders and that
represent ownership interests in individual pools of residential mortgage loans.
These securities are designed to provide monthly payments of interest and
principal to the investor. Timely payment of interest and principal is backed by
the full faith and credit of the United States government. Each mortgagor's
monthly payments to his lending institution on his residential mortgage are
'passed through' to certificateholders such as the Trust. Mortgage pools consist
of whole mortgage loans or participations in loans. The terms and
characteristics of the mortgage instruments are generally uniform within a pool
but may vary among pools. Lending institutions that originate mortgages for the
pools are subject to certain standards, including credit and other underwriting
criteria for individual mortgages included in the pools.
FANNIE MAE CERTIFICATES
Fannie Mae facilitates a national secondary market in residential mortgage
loans insured or guaranteed by U.S. government agencies and in privately insured
or uninsured residential mortgage loans (sometimes referred to as 'conventional
mortgage loans' or 'conventional loans') through its mortgage purchase and
Mortgage-Backed Securities sales activities. Fannie Mae issues guaranteed
mortgage pass-through certificates ('Fannie Mae certificates'), which represent
pro rata shares of all interest and principal payments made and owed on the
underlying pools. Fannie Mae guarantees timely payment of interest and principal
on Fannie Mae certificates. The Fannie Mae guarantee is not backed by the full
faith and credit of the United States government.
FREDDIE MAC CERTIFICATES
Freddie Mac also facilitates a national secondary market for conventional
residential and U.S. government-insured mortgage loans through its mortgage
purchase and Mortgage-Backed Securities sales activities. Freddie Mac issues two
types of mortgage pass-through securities: mortgage participation certificates
('PCs') and guaranteed mortgage certificates ('GMCs'). Each PC represents a pro
rata share of all interest and principal payments made and owed on the
underlying pool. Freddie Mac generally guarantees timely monthly payment of
interest on PCs and the ultimate payment of principal, but it also has a PC
program under which it guarantees timely payment of both principal and interest.
GMCs also represent a pro rata interest in a pool of mortgages. These
instruments, however, pay interest semi-annually and return principal once a
year in guaranteed minimum payments. The Freddie Mac guarantee is not backed by
the full faith and credit of the United States government.
A-1
<PAGE>
PRIVATE, RTC AND SIMILAR MORTGAGE-BACKED SECURITIES
Mortgage-Backed Securities issued by Private Mortgage Lenders are
structured similarly to the pass-through certificates and CMOs issued or
guaranteed by Ginnie Mae, Fannie Mae and Freddie Mac. Such Mortgage-Backed
Securities may be supported by pools of U.S. government or agency insured or
guaranteed mortgage loans or by other Mortgage-Backed Securities issued by a
government agency or instrumentality, but they generally are supported by pools
of conventional (i.e., non-government guaranteed or insured) mortgage loans.
Since such Mortgage-Backed Securities normally are not guaranteed by an entity
having the credit standing of Ginnie Mae, Fannie Mae or Freddie Mac, they
normally are structured with one or more types of credit enhancement. See
'--Types of Credit Enhancement.'
The Resolution Trust Corporation ('RTC'), which was organized by the U.S.
government in connection with the savings and loan crisis, held assets of failed
savings associations as either a conservator or receiver for such associations,
or it acquired such assets in its corporate capacity. These assets included,
among other things, single family and multifamily mortgage loans, as well as
commercial mortgage loans. In order to dispose of such assets in an orderly
manner, RTC established a vehicle registered with the SEC through which it sold
Mortgage-Backed Securities. RTC Mortgage-Backed Securities represent pro rata
interests in pools of mortgage loans that RTC acquired, as described above, and
are supported by one or more of the types of private credit enhancements used by
Private Mortgage Lenders.
COLLATERALIZED MORTGAGE OBLIGATIONS AND MULTI-CLASS MORTGAGE PASS-THROUGHS
CMOs are debt obligations that are collateralized either by mortgage loans
or mortgage pass-through securities (such collateral collectively being called
'Mortgage Assets'). CMOs may be issued by Private Mortgage Lenders or by
government entities such as Fannie Mae or Freddie Mac. Multi-class mortgage
pass-through securities are interests in trusts that are comprised of Mortgage
Assets and that have multiple classes similar to those in CMOs. Unless the
context indicates otherwise, references herein to CMOs include multi-class
mortgage pass-through securities. Payments of principal and interest on the
Mortgage Assets (and, in the case of CMOs, any reinvestment income thereon)
provide the funds to pay debt service on the CMOs or to make scheduled
distributions on the multi-class mortgage pass-through securities.
In a CMO, a series of bonds or certificates is issued in multiple classes.
Each class of CMO, also referred to as a 'tranche,' is issued at a specific
fixed or floating coupon rate and has a stated maturity or final distribution
date. Principal prepayments on the Mortgage Assets may cause CMOs to be retired
substantially earlier than their stated maturities or final distribution dates.
Interest is paid or accrues on all classes of a CMO (other than any PO class) on
a monthly, quarterly or semiannual basis. The principal and interest on the
Mortgage Assets may be allocated among the several classes of a CMO in many
ways. In one structure, payments of principal, including any principal
prepayments, on the Mortgage Assets are applied to the classes of a CMO in the
order of their respective stated maturities or final distribution dates so that
no payment of principal will be made on any class of the CMO until all other
classes having an earlier stated maturity or final distribution date have been
paid in full. In some CMO structures, all or a portion of the interest
attributable to one or more of the CMO classes may be added to the principal
amounts attributable to such classes, rather than passed through to
certificateholders on a current basis, until other classes of the CMO are paid
in full.
Parallel pay CMOs are structured to provide payments of principal on each
payment date to more than one class. These simultaneous payments are taken into
account in calculating the stated maturity date or final distribution date of
each class, which, as with other CMO structures, must be retired by its stated
maturity date or final distribution date but may be retired earlier. The
Sub-Adviser anticipates that a substantial portion of the Mortgage-Backed
Securities that it acquires for the Trust normally will be PAC Bonds, which are
a form
A-2
<PAGE>
of parallel pay CMO. PAC Bonds are designed to provide relatively predictable
payments of principal provided that, among other things, the actual prepayment
experience on the underlying mortgage loans falls within a contemplated range.
If the actual prepayment experience on the underlying mortgage loans is at a
rate faster or slower than the contemplated range, or if deviations from other
assumptions occur, principal payments on a PAC Bond may be greater or smaller
than predicted. The magnitude of the contemplated range varies from one PAC Bond
to another; a narrower range increases the risk that prepayments will be greater
or smaller than contemplated.
ARM AND FLOATING RATE MORTGAGE-BACKED SECURITIES
The Sub-Adviser anticipates that a substantial portion of the
Mortgage-Backed Securities that it acquires for the Trust normally will be ARM
and Floating Rate Mortgage-Backed Securities. Because the interest rates on ARM
and Floating Rate Mortgage-Backed Securities are reset in response to changes in
a specified market index, the values of such securities tend to be less
sensitive to interest rate fluctuations than the values of fixed-rate
securities. ARM Mortgage-Backed Securities represent a right to receive interest
payments at a rate that is adjusted to reflect the interest earned on a pool of
ARMs. ARMs generally provide that the borrower's mortgage interest rate may not
be adjusted above a specified lifetime maximum rate or, in some cases, below a
minimum lifetime rate. In addition, certain ARMs provide for limitations on the
maximum amount by which the mortgage interest rate may adjust for any single
adjustment period. ARMs also may provide for limitations on changes in the
maximum amount by which the borrower's monthly payment may adjust for any single
adjustment period. In the event that a monthly payment is not sufficient to pay
the interest accruing on the ARM, any such excess interest is added to the
mortgage loan ('negative amortization'), which is repaid through future monthly
payments. If the monthly payment exceeds the sum of the interest accrued at the
applicable mortgage interest rate and the principal payment that would have been
necessary to amortize the outstanding principal balance over the remaining term
of the loan, the excess reduces the principal balance of the ARM. Borrowers
under ARMs experiencing negative amortization may take longer to build up their
equity in the underlying property and may be more likely to default.
The rates of interest payable on certain ARMs, and therefore on certain ARM
Mortgage-Backed Securities, are based on indices, such as the one-year constant
maturity Treasury rate, that reflect changes in market interest rates. Others
are based on indices, such as the 11th District Federal Home Loan Bank Cost of
Funds index, that tend to lag behind changes in market interest rates. The
values of ARM Mortgage-Backed Securities supported by ARMs that adjust based on
lagging indices tend to be more sensitive to interest rate fluctuations than
those reflecting current interest rate levels, although the values of such ARM
Mortgage-Backed Securities still tend to be less sensitive to interest rate
fluctuations than fixed-rate securities.
Floating Rate Mortgage-Backed Securities are classes of Mortgage-Backed
Securities that have been structured to represent the right to receive interest
payments at rates that fluctuate in accordance with an index but that generally
are supported by pools comprised of fixed-rate mortgage loans. As with ARM
Mortgage-Backed Securities, interest rate adjustments on Floating Rate
Mortgage-Backed Securities may be based on indices that lag behind market
interest rates. Interest rates on Floating Rate Mortgage-Backed Securities
generally are adjusted monthly. Floating Rate Mortgage-Backed Securities are
subject to lifetime interest rate caps, but they generally are not subject to
limitations on monthly or other periodic changes in interest rates or monthly
payments.
A-3
<PAGE>
TYPES OF CREDIT ENHANCEMENT
To lessen the effect of failures by obligors on Mortgage Assets to make
payments, Mortgage-Backed Securities may contain elements of credit enhancement.
Such credit enhancement falls into two categories: (1) liquidity protection; and
(2) protection against losses resulting after default by an obligor on the
underlying assets and collection of all amounts recoverable directly from the
obligor and through liquidation of the collateral. Liquidity protection refers
to the provisions of advances, generally by the entity administering the pool of
assets (usually the bank, savings association or mortgage banker that
transferred the underlying loans to the issuer of the security), to ensure that
the receipt of payments on the underlying pool occurs in a timely fashion.
Protection against losses resulting after default and liquidation ensures
ultimate payment of the obligations on at least a portion of the assets in the
pool. Such protection may be provided through guarantees, insurance policies or
letters of credit obtained by the issuer or sponsor from third parties, through
various means of structuring the transaction or through a combination of such
approaches. The Trust will not pay any additional fees for such credit
enhancement, although the existence of credit enhancement may increase the price
of a security.
Examples of credit enhancement arising out of the structure of the
transaction include 'senior-subordinated securities' (multiple class securities
with one or more classes subordinate to other classes as to the payment of
principal thereof and interest thereon, with the result that defaults on the
underlying assets are borne first by the holders of the subordinated class),
creation of 'spread accounts' or 'reserve funds' (where cash or investments,
sometimes funded from a portion of the payments on the underlying assets, are
held in reserve against future losses) and 'over-collateralization' (where the
scheduled payments on, or the principal amount of, the underlying assets exceeds
that required to make payment of the securities and pay any servicing or other
fees). The degree of credit enhancement provided for each issue generally is
based on historical information regarding the level of credit risk associated
with the underlying assets. Delinquency or loss in excess of that anticipated
could adversely affect the return on an investment in such a security.
SPECIFIED MORTGAGE-BACKED SECURITIES
Specified Mortgage-Backed Securities include IOs, POs (other than IOs and
POs that are PAC Bonds) or inverse floating rate obligations or other types of
Mortgage-Backed Securities that may be developed in the future and that are
determined by the Sub-Adviser to present types and levels of risk that are
comparable to such IOs, POs and inverse floating rate obligations. An IO is a
class of Morgage-Backed Security that is entitled to receive all or a portion of
the interest, but none of the principal payments, on the underlying Mortgage
Assets; a PO is a class of Mortgage-Backed Security that is entitled to receive
all or a portion of the principal payments, but none of the interest payments,
on the underlying Mortgage Assets.
Mortgage-Backed Securities that constitute inverse floating rate
obligations are Mortgage-Backed Securities on which the interest rates adjust or
vary inversely to changes in market interest rates. Typically, an inverse
floating rate Mortgage-Backed Security is one of two components created from a
pool of fixed rate mortgage loans. The other component is a variable rate
Mortgage-Backed Security, on which the amount of interest payable is adjusted
directly in accordance with market interest rates. The inverse floating rate
obligation receives the portion of the interest on the underlying fixed-rate
mortgages that is allocable to the two components and that remains after
subtracting the amount of interest payable on the variable rate component.
A-4
<PAGE>
================================================================================
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR MAKE ANY
REPRESENTATIONS NOT CONTAINED IN THIS PROSPECTUS IN CONNECTION WITH THE OFFERING
MADE BY THIS PROSPECTUS AND, IF GIVEN OR MADE, SUCH INFORMATION OR
REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE TRUST
OR PAINEWEBBER. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFERING BY THE TRUST OR
BY PAINEWEBBER IN ANY JURISDICTION IN WHICH SUCH OFFERING MAY NOT LAWFULLY BE
MADE.
------------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Trust Expenses................................. 2
Prospectus Summary............................. 3
Financial Highlights........................... 12
The Trust...................................... 14
The Offering................................... 14
Use of Proceeds................................ 14
Trading History................................ 14
Investment Objective and Policies.............. 15
Risk Factors and Other Investment Policies..... 18
Management of the Trust........................ 23
Dividends and Other Distributions; Dividend
Reinvestment Plan............................ 24
Taxation....................................... 26
Description of the Shares...................... 28
Custodian, Transfer and Dividend Disbursing
Agent and Registrar.......................... 31
Further Information............................ 31
Table of Contents of Statement of Additional
Information.................................. 31
Appendix A..................................... A-1
</TABLE>
================================================================================
(copyright) 1997 PaineWebber Incorporated
================================================================================
2002 TARGET
TERM TRUST INC.
COMMON STOCK
------------------------
PROSPECTUS
------------------------
PAINEWEBBER INCORPORATED
------------------------
APRIL 1, 1997
================================================================================
<PAGE>
2002 TARGET TERM TRUST INC.
1285 AVENUE OF THE AMERICAS
NEW YORK, NEW YORK 10019
STATEMENT OF ADDITIONAL INFORMATION
2002 Target Term Trust Inc. ('Trust') is a diversified closed-end
management investment company. The Trust's investment objective is to manage a
portfolio of high quality fixed-income and adjustable-rate securities in order
to return $15 per Share (the initial public offering price) to investors on or
about November 30, 2002, while providing high monthly income. No assurance can
be given that the Trust will be able to achieve its investment objective.
Shares of the Trust's common stock ('Shares') 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 Trust and Goldman Sachs Funds Management, L.P. ('Sub-Adviser') serves as
the Trust's sub-adviser. This Statement of Additional Information is not a
prospectus and should be read only in conjunction with the Trust's current
Prospectus, dated April 1, 1997. Capitalized terms not otherwise defined herein
have the same meanings as in the Prospectus. A copy of the Prospectus may be
obtained by contacting PaineWebber at 1285 Avenue of the Americas, New York, New
York 10019, or calling 1-800-852-4750. This Statement of Additional Information
is dated April 1, 1997.
INVESTMENT POLICIES AND RESTRICTIONS
The following supplements the information contained in the Prospectus
concerning the Trust's investment policies and limitations.
RATINGS
Standard & Poor's Ratings Service, a division of The McGraw-Hill Companies,
Inc., ('S&P'), Moody's Investors Service, Inc. ('Moody's') and other nationally
recognized statistical rating organizations ('NRSROs') are private services that
provide ratings of the credit quality of Mortgage-Backed and Asset-Backed
Securities and other debt obligations. S&P's highest rating category is AAA.
Moody's highest rating category is Aaa. Publications of S&P indicate that it
assigns such ratings to securities for which the obligor's 'capacity to pay
interest and repay principal is extremely strong.' Publications of Moody's
indicate that it assigns such ratings to securities that 'are judged to be of
the best quality' and 'carry the smallest degree of investment risk,' that
interest payments on such securities 'are protected by a large or by an
exceptionally stable margin and principal is secure' and that 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.' The
process by which S&P and Moody's determine ratings for Mortgage-Backed and
Asset-Backed Securities includes consideration of the likelihood of the receipt
by security holders of all distributions, the nature of the underlying
securities, the credit quality of the guarantor, if any, and the structural,
legal and tax aspects associated with such securities. Neither of such ratings
represents an assessment of the likelihood that principal prepayments will be
made by mortgagors or the degree to which such prepayments may differ from that
originally anticipated, nor do such ratings address the possibility that
investors may suffer a lower than anticipated yield or that investors in such
securities may fail to recoup fully their initial investment due to
<PAGE>
prepayments. It should be emphasized that ratings are general and not absolute
standards of quality. Consequently, debt obligations with the same maturity,
interest rate and rating may have different market prices.
SPECIAL CHARACTERISTICS OF MORTGAGE-BACKED AND ASSET-BACKED SECURITIES
The yield characteristics of Mortgage-Backed and Asset-Backed Securities
differ from those of traditional debt securities. Among the major differences
are that interest and principal payments are made more frequently, usually
monthly, and that principal may be prepaid at any time because the underlying
mortgage loans or other obligations generally may be prepaid at any time. As a
result, if the securities are purchased at a premium, a prepayment rate that is
faster than expected will reduce yield to maturity, while a prepayment rate that
is slower than expected will have the opposite effect of increasing yield to
maturity. Conversely, if the securities are purchased at a discount, faster than
expected prepayments will increase, while slower than expected prepayments will
reduce, yield to maturity. Amounts available for reinvestment are likely to be
greater during a period of decreasing interest rates and are likely to be
reinvested at lower interest rates than during a period of rising interest
rates. Accelerated prepayments on securities purchased at a premium also impose
a risk of loss of principal because the premium may not have been fully
amortized at the time the principal is repaid in full.
Prepayments on a pool of mortgage loans are influenced by a variety of
economic, geographic, social and other factors, including changes in mortgagors'
housing needs, job transfers, unemployment, mortgagors' net equity in the
mortgaged properties and servicing decisions. Generally, however, prepayments on
fixed-rate mortgage loans will increase during a period of falling interest
rates and decrease during a period of rising interest rates. Similar factors
apply to prepayments on Asset-Backed Securities but the receivables underlying
Asset-Backed Securities generally are of a shorter maturity and thus are less
likely to experience substantial prepayments. Such securities, however, often
provide that for a specified time period the issuers will replace receivables in
the pool that are repaid with comparable obligations. If the issuer is unable to
do so, repayment of principal on the Asset-Backed Securities may commence at an
earlier date. Mortgage-Backed and Asset-Backed Securities may decrease in value
as a result of increases in interest rates and may benefit less than other
fixed-income securities from declining interest rates because of the risk of
prepayment.
ARMs also may be subject to a greater rate of prepayments in a declining
interest rate environment. For example, during a period of declining interest
rates, prepayments on ARMs could increase because the availability of fixed
mortgage loans at competitive interest rates may encourage mortgagors to
'lock-in' at a lower interest rate. Conversely, during a period of rising
interest rates, prepayments on ARMs might decrease. The rate of prepayments with
respect to ARMs has fluctuated in recent years.
ARMs underlying ARM Mortgage-Backed Securities generally provide that the
borrower's mortgage interest rate may not be adjusted over a specified lifetime
maximum rate. ARMs also may provide for limitations on the maximum amount by
which the borrower's mortgage interest rate may adjust for any single adjustment
period or by which the borrower's required monthly payment may adjust for any
single adjustment period. Similarly, interest rate changes on Floating Rate
Mortgage-Backed Securities are subject to lifetime interest rate caps. Interest
rates on ARMs generally are reset only at monthly or longer intervals. Interest
rate changes on ARM and Floating Rate Mortgage-Backed Securities may be based on
indices that tend to lag behind changes in market rates. Accordingly, the coupon
rate on such Mortgage-Backed Securities often lags behind changes in short-term
interest rates, which may negatively affect the market value in periods of
increasing interest rates. The market value of ARM and Floating Rate
Mortgage-Backed Securities may be affected adversely if prevailing interest
rates increase beyond the applicable limits on interest rate or interest payment
adjustments. Since the indices applicable to certain ARMs are at times affected
by factors unrelated
2
<PAGE>
to changes in prevailing interest rates, the coupon rate on ARM Mortgage-Backed
Securities could, under some circumstances, be adjusted at a rate or in a
direction that does not reflect prevailing interest rates, which could adversely
affect the market value of the securities. In periods of declining interest
rates, the market values of ARM and Floating Rate Mortgage-Backed Securities
generally will increase to a lesser extent, if at all, than the values of
fixed-rate Mortgage-Backed Securities.
The rate of interest on Mortgage-Backed Securities is lower than the
interest rates paid on the mortgages included in the underlying pool due to the
annual fees paid to the servicer of the mortgage pool for passing through
monthly payments to certificateholders and to any guarantor, such as Ginnie Mae,
and due to any yield retained by the issuer. Actual yield to the holder may vary
from the coupon rate, even if adjustable, if the Mortgage-Backed Securities are
purchased or traded in the secondary market at a premium or discount. In
addition, there is normally some delay between the time the issuer receives
mortgage payments from the servicer and the time the issuer makes the payments
on the Mortgage-Backed Securities and this delay reduces the effective yield to
the holder of such securities.
The size of the primary issuance market, and active participation in the
secondary market by securities dealers and many types of investors, makes
government and government-related pass-through pools highly liquid. Yields on
pass-through securities are typically quoted by investment dealers and vendors
based on the maturity of the underlying instruments and the associated average
life assumption. The average life of pass-through pools varies with the
maturities of the underlying mortgage loans. A pool's term may be shortened by
unscheduled or early payments of principal on the underlying mortgages. Because
prepayment rates of individual pools vary widely, it is not possible to predict
accurately the average life of a particular pool. In the past, a common industry
practice has been to assume that prepayments on pools of fixed rate 30-year
mortgages would result in a 12-year average life for the pool. At present,
mortgage pools, particularly those with loans with other maturities or different
characteristics, are priced on an assumption of average life determined for each
pool. In periods of declining interest rates, the rate of prepayment tends to
increase, thereby shortening the actual average life of a pool of
mortgage-related securities. Conversely, in periods of rising rates the rate of
prepayment tends to decrease thereby lengthening the actual average life of the
pool. However, these effects may not be present, or may differ in degree, if the
mortgage loans in the pools have adjustable interest rates or other special
payment terms, such as a prepayment charge. Actual prepayment experience may
cause the yield of mortgage-backed securities to differ from the assumed average
life yield. Reinvestment of prepayments may occur at lower interest rates than
the original investment, thus adversely affecting the yield of the Trust.
ZERO COUPON MUNICIPAL SECURITIES
As indicated in the Prospectus, the Trust may invest in zero coupon
securities that are issued for various public purposes by or on behalf of
municipal issuers or that are created by investment banks or other private
parties that separate the interest and principal components of an
interest-paying security that has been previously issued by or on behalf of a
municipal issuer (collectively, 'Zero Coupon Municipal Securities').
The two principal classifications of the debt obligations of municipal
issuers are (i) 'general obligation' bonds and (ii) '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
facility or project or, in a few cases, from the proceeds of a special excise or
other tax, but are not supported by the issuer's power to levy taxes. There are
variations in the security and credit quality of municipal obligations, both
within a particular classification and between classifications, depending on
numerous factors. The yields and market values of municipal obligations are
dependent on a variety of factors, including general economic and monetary
conditions, money market factors,
3
<PAGE>
the condition of the municipal obligation market, prevailing income tax rates,
the size of a particular offering, the maturity of the obligation and the rating
of the issue.
Zero Coupon Municipal Securities do not entitle the holder to periodic
payments prior to maturity and therefore are issued and traded at a discount
from their face or par value. In the absence of financial difficulties of the
issuer, the discount generally decreases as the maturity of the security
approaches. Zero Coupon Municipal Securities can be sold prior to their maturity
dates in the secondary market at the then prevailing market value, which depends
primarily on the time remaining to maturity, prevailing levels of interest rates
and the perceived credit quality of the issuer.
The market prices of Zero Coupon Municipal Securities are more volatile
than the market prices of securities of comparable quality and similar maturity
that pay interest periodically and may respond to a greater degree to
fluctuations in interest rates than do such other securities. Many of the types
of Zero Coupon Municipal Securities in which the Trust may invest are currently
categorized as illiquid under guidelines of the staff of the SEC. See 'Risk
Factors and Other Investment Policies--Illiquid Securities' in the Prospectus.
ASSET-BACKED SECURITIES
Asset-Backed Securities represent participations in, or are secured by and
payable from, assets such as motor vehicle installment sales contracts, other
installment loan contracts, leases of various types of real and personal
property and receivables from revolving credit (credit card) agreements. Such
assets are securitized through the use of trusts and special purpose
corporations. Payments or distributions of principal and interest may be
guaranteed up to certain amounts and for a certain time period by a letter of
credit or a pool insurance policy issued by a financial institution unaffiliated
with the issuer or other credit enhancements may be present. In general, the
collateral supporting Asset-Backed Securities has a shorter effective term to
maturity than Mortgage Assets and, accordingly, such securities may be less
likely to experience substantial prepayments.
Asset-Backed Securities present certain risks that are not presented by
Mortgage-Backed Securities or other securities in which the Trust may invest.
Primarily, these securities do not have the benefit of a security interest in
collateral that is comparable to first lien mortgage loans. Credit card
receivables are generally unsecured, and the debtors on such receivables are
entitled to the protection of a number of state and federal consumer credit
laws, many of which give such debtors the right to set-off certain amounts owed
on the credit cards, thereby reducing the balance due. Automobile receivables
generally are secured, by automobiles rather than residential real property.
Most issuers of automobile receivables permit the loan servicers to retain
possession of the underlying obligations. If the servicer were to sell these
obligations to another party, there is a risk that the purchaser would acquire
an interest superior to that of the holders of the Asset-Backed Securities. In
addition, because of the large number of vehicles involved in a typical issuance
and technical requirements under state laws, the trustee for the holders of the
automobile receivables may not have a proper security interest in the underlying
automobiles. Therefore, there is the possibility that, in some cases, recoveries
on repossessed collateral may not be available to support payments on these
securities.
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 Trust or (b) 67% or more of such Shares present at a shareholders'
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
4
<PAGE>
increase or 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 Trust's
investment policies.
(1) The Trust will not purchase securities of any one issuer if, as a
result, more than 5% of the Trust's total assets would be invested in
securities of that issuer or the Trust would own or hold more than 10% of
the outstanding voting securities of that issuer, except that up to 25% of
the Trust'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 interpretations apply to, but are not a part of,
fundamental limitation (1):
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 industrial Development Bond or Private Activity Bond, 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 Trust exceeds 10%
of the Trust's total assets, the guarantee would be considered a separate
security and would be treated as issued by that government or entity.
Mortgage-Backed and Asset-Backed Securities will not be considered to
have been issued by the same issuer by reason of the securities having the
same sponsor, and Mortgage-Backed and Asset-Backed Securities issued by a
finance or other special purpose subsidiary that are not guaranteed by the
parent company will be considered to be issued by a separate issuer from
the parent company.
(2) The Trust will not purchase any security if, as a result of that
purchase, 25% or more of the Trust'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, and except that the Trust,
under normal circumstances, will invest 25% or more of its total assets in
Mortgage-Backed and Asset-Backed Securities, which (whether or not issued
or guaranteed by an agency or instrumentality of the U.S. government) shall
be considered a single industry for purposes of this limitation.
(3) The Trust will not issue senior securities or borrow money, except
as permitted under the 1940 Act and then not in excess of 33 1/3% of the
Trust's total assets (including the amount of the senior securities issued
but reduced by any liabilities not constituting senior securities) at the
time of the issuance or borrowing, except that the Trust may borrow up to
an additional 5% of its total assets (not including the amount borrowed)
for temporary or emergency purposes.
(4) The Trust will not make loans, except through loans of portfolio
securities or through repurchase agreements, provided that for purposes of
this restriction, the acquisition of bonds, debentures, 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
<PAGE>
(5) The Trust will not engage in the business of underwriting
securities of other issuers, except to the extent that the Trust might be
considered an underwriter under the federal securities laws in connection
with its disposition of portfolio securities.
(6) The Trust will not 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 interests in real estate are not subject to this
limitation, and except that the Trust 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) The Trust will not purchase or sell physical commodities unless
acquired as a result of owning securities or other instruments, but the
Trust 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 Trust's board of directors without shareholder approval.
The Trust will not:
(1) purchase securities on margin, except for short-term credit necessary
for clearance of portfolio transactions and except that the Trust 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 Trust 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>
STRATEGIC TRANSACTIONS
As discussed in the Prospectus, the Trust may purchase and sell a variety
of financial instruments ('Strategic Transactions'), including certain options,
futures contracts (sometimes referred to as 'futures'), options on futures
contracts and interest rate protection transactions, for the purposes described
in the Prospectus under 'Risk Factors and Other Investment Policies--Strategic
Transactions.'
Strategic Transactions that are entered into for hedging or other risk
management purposes can be broadly categorized as 'short hedges' and 'long
hedges.' A short hedge is a Strategic Transaction intended partially or fully
offset potential declines in the value of one or more investments held in the
Trust's portfolio. Thus, in a short hedge the Trust takes a position in a
Strategic Transaction the price of which is expected to move in the opposite
direction of the price of the investment being hedged. For example, the Trust
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 Trust 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 Trust 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 Strategic Transaction intended partially or
fully to offset potential increases in the acquisition cost of one or more
investments that the Trust intends to acquire. Thus, in a long hedge the Trust
takes a position in a Strategic Transaction the price of which is expected to
move in the same direction as the price of the prospective investment being
hedged. For example, the Trust 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 Trust could exercise the call and thus limit its acquisition cost to
the exercise price plus the premium paid and transaction costs. Alternatively,
the Trust might be able to offset the price increase by closing out an
appreciated call option and realizing a gain.
The use of Strategic Transactions 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 Trust's
ability to use Strategic Transactions will be limited by tax considerations. See
'Taxes.'
In addition to the products, strategies and risks described below, the
Sub-Adviser expects additional opportunities to develop in connection with
options, futures contracts and other hedging techniques. These new opportunities
may become available as the Sub-Adviser develops new techniques, as regulatory
authorities broaden the range of permitted transactions and as new options,
futures contracts, or other techniques are developed. The Sub-Adviser may
utilize these opportunities to the extent that they are consistent with the
Trust's investment objectives and permitted by the Trust's investment
limitations and applicable regulatory authorities.
SPECIAL RISKS OF STRATEGIC TRANSACTIONS
The use of Strategic Transactions involves special considerations and
risks, as described below. Risks pertaining to particular Strategic Transactions
are described in the sections that follow.
(1) Successful use of most Strategic Transactions depends upon the
Sub-Adviser's 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 the Sub-Adviser is
experienced in the use of Strategic Transactions, there can be no assurance
that any particular strategy adopted will succeed.
7
<PAGE>
(2) There might be imperfect correlation, or even no correlation,
between price movements of Strategic Transactions and price movements of
the related portfolio positions. For example, if the value of Strategic
Transactions used to hedge related portfolio positions against market
decline increased by less than the decline in value of the related
portfolio positions, the strategy would not be fully successful. Such a
lack of correlation might occur due to factors unrelated to the value of
the related portfolio positions, such as speculative or other pressures on
the markets in which Strategic Transactions are traded. The effectiveness
of Strategic Transactions involving indices will depend on the degree of
correlation between price movements in the indices and price movements in
the related portfolio positions.
(3) Strategic Transactions, if successful, can reduce risk of loss by
wholly or partially offsetting the negative effect of unfavorable price
movements in the related portfolio positions. However, Strategic
Transactions can also reduce opportunity for gain by offsetting the
positive effect of favorable price movements in the positions. For example,
if the Trust entered into a Strategic Transaction to hedge a related
portfolio position because the Sub-Adviser projected a decline in the price
of that position, and the price of that position increased instead, the
gain from that increase might be wholly or partially offset by a decline in
the price of the Strategic Transaction. Moreover, if the price of the
Strategic Transaction declined by more than the increase in the price of
the position, the Trust could suffer a loss. In either such case, the Trust
would have been in a better position had it not entered into the Strategic
Transaction at all.
(4) As described below, the Trust might be required to maintain assets
as 'cover,' maintain segregated accounts or make margin payments when it
takes positions in Strategic Transactions involving obligations to third
parties (i.e., Strategic Transactions other than purchased options). If the
Trust were unable to close out its positions in such Strategic
Transactions, 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 Trust'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 Trust sell a portfolio security at a
disadvantageous time. The Trust's ability to close out a position in a
Strategic Transaction prior to expiration or maturity depends on the
existence of a liquid secondary market or, in the absence of such a market,
the ability and willingness of the other party to the transaction (the
'counterparty') 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 Trust.
COVER FOR STRATEGIC TRANSACTIONS
Strategic Transactions other than purchased options, expose the Trust to an
obligation to another party. The Trust 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 and 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 Trust will comply with SEC guidelines
regarding cover and will, if the guidelines so require, set aside cash or liquid
securities 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 Strategic Transaction is open, unless they are
replaced with similar assets. As a result, the commitment of a large portion of
the Trust's assets to cover or segregated accounts could impede portfolio
management or the Trust's ability to meet current obligations.
8
<PAGE>
OPTIONS
The Trust may purchase and write (sell) put and call options on U.S.
government securities, Mortgage-Backed Securities and corporate debt securities.
The Trust also may purchase and sell put and call options on securities indices
and other financial indices. The purchase of call options can serve as a long
hedge, and the purchase of put options can serve as a short hedge. Writing put
or call options can enable the Trust 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 put option declines to less than the exercise price on the
option, minus the premium received, the Trust would expect to suffer a loss.
Writing covered call options can serve 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 Trust will be obligated to
sell the security at less than its market value. If the covered call option is
an OTC option, all or a portion of the securities or other assets used as cover
would be considered illiquid. See 'Risk Factors and Other Investment
Policies--Illiquid Securities' in the Prospectus.
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 that expire unexercised have
no value.
The Trust may effectively terminate its right or obligation under an option
by entering into a closing transaction. For example, the Trust 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
Trust 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 Trust to realize profits or limit
losses on an option position prior to its exercise or expiration.
The Trust may purchase or write both exchange-traded and OTC options.
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 effect, guarantees completion of every exchange-traded option transaction. In
contrast, OTC options are contracts between the Trust and its counterparty
(usually a securities dealer or a bank) with no clearing organization guarantee.
Thus, when the Trust purchases or writes an OTC option, it relies on its
counterparty to make or take delivery of the underlying investment upon exercise
of the option. Failure by the counterparty to do so would result in the loss of
any premium paid by the Trust 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 the contrast to American-style options, which are exercisable at any
time prior to the expiration date of the option.
The Trust's ability to establish and close out positions in exchange-listed
options depends on the existence of a liquid market. The Trust 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 counterparty, or by a
transaction in the secondary market if any such market exists. Although the
Trust will enter into OTC options only with counterparties that are expected to
be capable of entering into closing transactions with the Trust, there is no
assurance that the Trust 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 counterparty, the Trust might be unable to close out an OTC option position
at any time prior to its expiration.
9
<PAGE>
If the Trust 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 Trust would result in the Trust being unable to sell the
investment used as cover for the written option until the option expires or is
exercised.
Options on indices are similar to options on a security or other instrument
except that, rather than settling by physical delivery of the underlying
instrument, they settle by cash settlement, i.e., an option on an index gives
the holder the right to receive, upon exercise of the option, an amount of cash
if the closing level of the index upon which the option is based exceeds, in the
case of a call, or is less than, in the case of a put, the exercise price of the
option (except if, in the case of an OTC option, physical delivery is
specified). This amount of cash is equal to the excess of the closing price of
the index over the exercise price of the option, which also may be multiplied by
a formula value. The seller of the option is obligated, in return for the
premium received, to make delivery of this amount. The gain or loss on an option
on an index depends on price movements in the instruments making up the market,
market segment, industry or other composite on which the underlying index is
based, rather than price movements in individual securities, as is the case with
respect to options on securities.
FUTURES
The Trust may purchase and sell financial 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 indices.
Similarly, writing 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
Trust's portfolio. If the Sub-Adviser wishes to shorten the average duration of
the Trust's portfolio, the Trust may sell a futures contract or a call option
thereon, or purchase a put option on that futures contract. If the Sub-Adviser
wishes to lengthen the average duration of the Trust's portfolio, the Trust 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 Trust 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 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 Trust at the termination of the
transaction if all contractual obligations have been satisfied. Under certain
circumstances, such as periods of high volatility, the Trust 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 Trust's obligations with respect to an open
futures position. When the Trust purchases an option on a future, the premium
paid plus transaction costs is all that is at risk. In contrast, when the Trust
purchases or sells a futures contract or writes an option thereon, it is subject
to daily variation margin calls that could be substantial in the event of
adverse price movements. If the
10
<PAGE>
Trust 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 Trust 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 Trust will not trade options or futures on any
exchange or board of trade unless, in the Sub-Adviser's opinion, 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 Trust 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 Trust would continue to be
subject to market risk with respect to the position. In addition, except in the
case of purchased options, the Trust 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 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 both
the futures and securities markets involving arbitrage, 'program trading' and
other investment strategies might result in temporary price distortions.
GUIDELINES FOR FUTURES AND RELATED OPTIONS
In view of the risks involved in using the futures and options strategies
that are described above, the Trust will not purchase or sell futures contracts
or related options if, immediately thereafter, the sum of the amount of initial
margin deposits on the Trust's existing futures positions and initial margin
deposits and premiums paid for related options would exceed 5% of the Trust's
total assets; however, in the case of an option that is in-the-money at the time
of purchase, the in-the-money amount may be excluded in calculating the 5%
limitation. This guideline may be modified by the Trust without shareholder
vote. For purposes of this guideline, options on futures contracts traded on a
commodities exchange are considered 'related options.' Adoption of this
guideline will not limit the percentage of the Trust's assets at risk to 5%.
11
<PAGE>
COMBINED TRANSACTIONS
The Trust may enter into multiple transactions, including multiple options
transactions, multiple futures transactions and any combination of futures and
options transactions ('component' transactions), instead of a single Strategic
Transaction, as part of a single or combined strategy when, in the opinion of
the Sub-Adviser, it is in the best interests of the Trust to do so. A combined
transaction will usually contain elements of risk that are present in each of
its component transactions. Although combined transactions are normally entered
into based on the Sub-Adviser's judgment that the combined strategies will
reduce risk or otherwise more effectively achieve the desired portfolio
management goal, it is possible that the combination will instead increase such
risks or hinder achievement of the portfolio management objective.
TYPES OF INSTRUMENTS
The instruments used by the Trust in effecting Strategic Transactions
include the following:
OPTIONS ON 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 on the OTC
market rather than on any of the several options exchanges.
OPTIONS ON INDICES OF 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.
FINANCIAL INDEX FUTURES CONTRACTS--An 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 securities comprising the index is made; generally
contracts are closed out prior to the expiration date of the contract.
INTEREST RATE FUTURES CONTRACTS--An interest rate 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 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 the case of a
call, or is less than, in the case of a put, the exercise price of the option on
the
12
<PAGE>
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 Trust 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 the first party makes payments to the
counterparty when a designated market interest rate goes above a designated
level on predetermined dates or during a specified time period, and the
counterparty makes payments to the first party when a designated market interest
rate goes below a designated level on predetermined dates or during a specified
time period.
The Trust 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 Trust
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
Trust 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 Trust 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
Trust 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, the Sub-Adviser and the Trust
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 Trust'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 1940
Act. The Trust 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 Trust.
The Trust will enter into interest rate protection transactions only with
banks and recognized securities dealers or their affiliates believed by the
Sub-Adviser to present minimal credit risks in accordance with guidelines
established by the Trust's board of directors. If there is a default by the
other party to such a transaction, the Trust 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.
13
<PAGE>
DIRECTORS AND OFFICERS
The overall management of the business and affairs of the Trust is vested
with its board of directors. The board of directors approves all significant
agreements between the Trust and persons or companies furnishing services to it,
including the Trust's agreements with its investment adviser and administrator,
custodian and transfer and dividend disbursing agent and registrar. The
day-to-day operations of the Trust are delegated to its officers and to Mitchell
Hutchins and the Sub-Adviser, subject always to the investment objective and
policies of the Trust and to general supervision by the Trust's board of
directors.
The business addresses and principal occupations during the past five years
of the directors and executive officers of the Trust are:
<TABLE>
<CAPTION>
Position Business Experience;
NAME AND ADDRESS* with the Trust Other Directorships
- -------------------------------------- --------------- ------------------------------------------------------
<S> <C> <C>
Margo N. Alexander**; 50 Director and Mrs. Alexander is president, chief executive officer
President and a director of Mitchell Hutchins (since January
1995) and an executive vice president and director
of PaineWebber. Mrs. Alexander is president and a
director or trustee of 29 investment companies for
which Mitchell Hutchins or PaineWebber serves as
investment adviser.
Richard Q. Armstrong; 61 Director Mr. Armstrong is chairman and principal of RQA
78 West Brother Drive Enterprises (management consulting firm) (since
Greenwich, CT 06830 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
executive officer and co-owner of Adirondack
Beverages (producer and distributor of soft drinks
and sparkling/still waters) (October 1993-March
1995). Mr. Armstrong was a partner of the New
England Consulting Group (management consulting
firm) (December 1992-September 1993). He was
managing director of LMVH U.S. Corporation (U.S.
subsidiary of the French luxury goods conglomerate,
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.
</TABLE>
14
<PAGE>
<TABLE>
<CAPTION>
Position Business Experience;
NAME AND ADDRESS* with the Trust Other Directorships
- -------------------------------------- --------------- ------------------------------------------------------
<S> <C> <C>
E. Garrett Bewkes, Jr.**; 70 Director and Mr. Bewkes is a director of Paine Webber Group Inc.
Chairman of ('PW Group') (holding company of PaineWebber and
the Board of Mitchell Hutchins). Prior to December 1995, he was a
Directors consultant to PW Group. Prior to 1988, he was
chairman of the board, president and chief executive
officer of American Bakeries Company. Mr. Bewkes is
also a director of Interstate Bakeries Corporation
and NaPro Bio Therapeutics, Inc. Mr. Bewkes is a
director or trustee of 29 investment companies for
which Mitchell Hutchins or PaineWebber serves as
investment adviser.
Richard R. Burt; 50 Director Mr. Burt is chairman of International Equity Partners
1101 Connecticut Avenue, N.W (international investments and consulting firm)
Washington, D.C. 20036 (since March 1994) and a partner of McKinsey &
Company (management consulting firm) (since 1991).
He is also a director of American Publishing Company
and Archer-Daniels-Midland Co. (agricultural
commodities). He was the chief negotiator in the
Strategic Arms Reduction Talks with the former
Soviet 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
companies for which Mitchell Hutchins or PaineWebber
serves as investment adviser.
Mary C. Farrell**; 47 Director Ms. Farrell is a managing director, senior investment
strategist and member of the Investment 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 $treet 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 director or trustee of 28 investment companies
for which Mitchell Hutchins or PaineWebber serves as
an investment adviser.
Meyer Feldberg; 55 Director Mr. Feldberg is Dean and Professor of Manage- ment of
Columbia University the Graduate School of Business, Co- lumbia
101 Uris Hall University. Prior to 1989, he was pres- ident of the
New York, New York 10027 Illinois Institute of Technology. Dean
</TABLE>
15
<PAGE>
<TABLE>
<CAPTION>
Position Business Experience;
NAME AND ADDRESS* with the Trust Other Directorships
- -------------------------------------- --------------- ------------------------------------------------------
<S> <C> <C>
Feldberg is also a director of K-III Communications
Corporation, Federated Department Stores, Inc., and
Revlon, Inc. Dean Feldberg is a director or trustee
of 28 investment companies for which Mitchell
Hutchins or PaineWebber serves as an investment
adviser.
George W. Gowen; 67 Director Mr. Gowen is a partner in the law firm of Dun-
666 Third Avenue nington, Bartholow & Miller. Prior to May 1994, he
New York, New York 10017 was a partner in the law firm of Fryer, Ross &
Gowen. Mr. Gowen is also 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; 60 Director Mr. Malek is chairman of Thayer Capital Partners
1455 Pennsylvania Avenue, N.W. (merchant bank). From January 1992 to November 1992,
Suite 350 he was campaign manager of Bush-Quayle '92. From
Washington, D.C. 20004 1990 to 1992, he was vice chairman and, from 1989 to
1990, he was president of Northwest Airlines Inc.,
NWA Inc. (holding company of Northwest Airlines
Inc.) and Wings Holdings Inc. (holding company of
NWA Inc.) Prior to 1989, he was employed by the
Marriott Corporation (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 consulting and computer related
services), Automatic Data Processing, Inc., CB
Commercial Group, Inc. (real estate services),
Choice Hotels International (hotel and hotel
franchising), FPL Group, Inc. (electric services),
Integra, Inc. (bio-medical), Manor Care, Inc.
(healthcare), National Education Corporation and
Northwest Airlines Inc. Mr. Malek is a director or
trustee of 28 investment companies for which
Mitchell Hutchins or PaineWebber serves as
investment adviser.
</TABLE>
16
<PAGE>
<TABLE>
<CAPTION>
Position Business Experience;
NAME AND ADDRESS* with the Trust Other Directorships
- -------------------------------------- --------------- ------------------------------------------------------
<S> <C> <C>
Carl W. Schafer; 61 Director Mr. Schafer is president of the Atlantic Founda-
c/o Atlantic Foundation tion (charitable foundation supporting mainly
16 Farber Road oceanographic exploration and research). He is a
Princeton, NJ 08542 director of Roadway Express, Inc. (trucking), The
Guardian Group of Mutual Funds, Evans Systems, Inc.
(motor fuels, convenience store and diversified
company), Electronic Clearing House, Inc., (a
financial transactions processing company), Wainoco
Oil Corporation and Nutraceutix, Inc. (biotechnology
company). Prior to January 1993, he was chairman of
the Investment Advisory Committee of the Howard
Hughes Medical Institute. Mr. Schafer is a director
or trustee of 28 investment companies for which
Mitchell Hutchins or PaineWebber serves as an
investment adviser.
T. Kirkham Barneby; 50 Vice President Mr. Barneby is a managing director and chief
investment officer--quantitative investment of
Mitchell Hutchins. Prior to September 1994, he was a
senior vice president at Vantage Global Management.
Prior to June 1993, he was a senior vice president
at Mitchell Hutchins. Mr. Barneby is a vice
president of five investment companies for which
Mitchell Hutchins or PaineWebber serves as
investment adviser.
C. William Maher; 35 Vice President Mr. Maher is a first vice president and a senior
and Assistant manager of the mutual fund finance division of
Secretary Mitchell Hutchins. Mr. Maher is also a vice
president and assistant treasurer of 29 investment
companies for which Mitchell Hutchins or PaineWebber
serves as investment adviser.
Ann E. Moran; 39 Vice President Ms. Moran is a vice president of Mitchell Hutchins.
and Assistant Ms. Moran is also a vice president and assistant
Treasurer treasurer of 29 investment companies for which
Mitchell Hutchins or PaineWebber serves as
investment adviser.
Dianne E. O'Donnell; 44 Vice President Ms. O'Donnell is a senior vice president and deputy
and Secretary general counsel of Mitchell Hutchins. Ms. O'Donnell
is also a vice president and secretary of 28
investment companies for which Mitchell Hutchins or
PaineWebber serves as investment adviser.
</TABLE>
17
<PAGE>
<TABLE>
<CAPTION>
Position Business Experience;
NAME AND ADDRESS* with the Trust Other Directorships
- -------------------------------------- --------------- ------------------------------------------------------
<S> <C> <C>
Emil Polito; 36 Vice President Mr. Polito is a senior vice president and director of
operations and control for Mitchell 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 a vice president of 29 investment companies for
which Mitchell Hutchins or PaineWebber serves as
investment adviser.
Victoria E. Schonfeld; 46 Vice President Ms. Schonfeld is a managing director and general
counsel of Mitchell 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 Mr. Schubert is a first vice president and a senior
and Assistant manager of the mutual fund finance division of
Treasurer Mitchell Hutchins. From August 1992 to August 1994,
he was a vice president of BlackRock 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 investment companies for which Mitchell Hutchins
or PaineWebber serves as investment adviser.
Julian F. Sluyters; 36 Vice President Mr. Sluyters is a senior vice president and the
and Treasurer director of the mutual fund finance division of
Mitchell Hutchins. Mr. Sluyters is also a vice
president and treasurer of 29 investment companies
for which Mitchell Hutchins or PaineWebber serves as
investment adviser.
Gregory K. Todd; 40 Vice President Mr. Todd is a first vice president and senior
and Assistant associate general counsel of Mitchell Hutchins.
Secretary Prior to 1993, he was a partner in the law firm of
Shereff, Friedman, Hoffman & Goodman. Mr. Todd is
also a vice president and assistant secretary of
nine investment companies and vice president and
secretary of one investment company for which
Mitchell Hutchins or PaineWebber serves as
investment adviser.
</TABLE>
18
<PAGE>
<TABLE>
<CAPTION>
Position Business Experience;
NAME AND ADDRESS* with the Trust Other Directorships
- -------------------------------------- --------------- ------------------------------------------------------
<S> <C> <C>
Keith A. Weller; 35 Vice President Mr. Weller is a first vice president and associate
and Assistant general counsel of Mitchell Hutchins. Prior to May
Secretary 1995, he was an attorney in private practice. Mr.
Weller is also a vice president and assistant
secretary of 28 investment companies for which
Mitchell Hutchins or PaineWebber serves as
investment adviser.
Teresa M. West; 38 Vice President Ms. West is a first vice president of Mitchell
Hutchins. Prior to November 1993, she was Compliance
Manager of Hyperion Capital Management, Inc., an
investment advisory firm. Prior to April 1993, Ms.
West was a vice president and manager--legal
administration of Mitchell Hutchins. Ms. West is
also a vice president of 29 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, Mr. Bewkes and Ms. Farrell are 'interested persons' of the
Trust, as defined in the 1940 Act, by reason of their position with Mitchell
Hutchins and PW Group, the parent company of PaineWebber and Mitchell Hutchins.
The Trust pays directors who are not 'interested persons' of the Trust
$1,000 annually and $150 for each board meeting and each separate meeting of a
board committee. Mr. Feldberg and another independent director to be elected by
the board 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 Mitchell Hutchins and the Sub-Adviser perform substantially all the
services necessary for the operation of the Trust, the Trust requires no
employees. No officer, director or employee of Mitchell Hutchins or PaineWebber
presently receives any compensation from the Trust for acting as a director or
officer.
19
<PAGE>
The table below includes certain information relating to the compensation
of the Trust's current directors who held office with the Trust or other
PaineWebber funds during the Trust's last fiscal year.
COMPENSATION TABLE
<TABLE>
<CAPTION>
TOTAL
COMPENSATION
AGGREGATE FROM THE TRUST
COMPENSATION AND THE FUND
NAME OF PERSON, POSITION FROM THE TRUST* COMPLEX**
- ------------------------ --------------- --------------
<S> <C> <C>
Richard Q. Armstrong, Director.................................................. $ 3,006 $ 59,873
Richard R. Burt, Director....................................................... 2,606 51,173
Meyer Feldberg***, Director..................................................... 839 96,181
George W. Gowen***, Director.................................................... 839 92,431
Frederic V. Malek***, Director.................................................. 839 92,431
Carl W. Schafer***, Director.................................................... 839 62,307
</TABLE>
- ------------------
Only independent members of the board are compensated by the Trust and
identified above; board members who are 'interested persons,' as defined by the
1940 Act, do not receive compensation.
* Represents fees paid to each director during the fiscal year ended November
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.
CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES
As of March 19, 1997, Cede & Co. (the nominee of The Depository Trust
Company, a securities depository) owned of record 7,433,409 of the Trust's
Shares or 95% of the outstanding Shares. To the knowledge of the Trust, no
person is the beneficial owner of 5% or more of its Shares. As of March 19,
1997, the directors and officers of the Trust as a group beneficially owned less
than 1% of the Trust's outstanding Shares.
INVESTMENT ADVISORY ARRANGEMENTS
Pursuant to the Investment Advisory and Administration Contract dated as of
December 18, 1992 ('Mitchell Hutchins Contract'), Mitchell Hutchins provides a
continuous investment program for the Trust and makes investment decisions and
places orders to buy, sell or hold particular securities; Mitchell Hutchins has
delegated these responsibilities to the Sub-Adviser subject to the supervision
of Mitchell Hutchins. As administrator, Mitchell Hutchins supervises all matters
relating to the operation of the Trust and provides for its corporate,
administrative and clerical personnel, office space, equipment and services,
including arranging for the periodic preparation, updating, filing and
dissemination of proxy materials, tax returns and reports to the Trust's board
of directors, shareholders and regulatory authorities. Pursuant to a separate
contract with Mitchell Hutchins, dated as of December 18, 1992 ('Sub-Advisory
Contract'), the Sub-Adviser serves as the Trust's sub-adviser.
In addition to the payments to Mitchell Hutchins under the Mitchell
Hutchins Contract described above, the Trust pays certain other costs including:
(1) the costs (including brokerage commissions) of securities purchased or sold
by the Trust and any losses incurred in connection therewith; (2) expenses
incurred on behalf of the Trust by Mitchell Hutchins; (3) organizational
expenses of the Trust, whether or not advanced by Mitchell Hutchins;
20
<PAGE>
(4) filing fees and expenses relating to the registration and qualification of
the Shares under federal and state securities laws; (5) fees and salaries
payable to directors who are not interested persons of the Trust 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 Trust 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 shareholders; (14) any extraordinary expenses (including
fees and disbursements of counsel) incurred by the Trust; (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 shareholders, 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; and (20) fees and expenses of
listing and maintaining any listing of the Shares on the NYSE or any other
national securities exchange.
Under the Mitchell Hutchins Contract, Mitchell Hutchins is not liable for
any error of judgment or mistake of law or for any loss suffered by the Trust or
its shareholders in connection with the Mitchell Hutchins Contract, except a
loss resulting from willful misfeasance, bad faith or gross negligence on the
part of Mitchell Hutchins in the performance of its duties or from reckless
disregard of its duties and obligations under the Mitchell Hutchins Contract.
Under the Sub-Advisory Contract, the Sub-Adviser is not liable for any error of
judgment or mistake of law or for any loss suffered by the Trust, its
shareholders or Mitchell Hutchins in connection with the Sub-Advisory Contract,
except any liability to the Trust, its shareholders or Mitchell Hutchins to
which the Sub-Adviser would otherwise be subject by reason of willful
misfeasance, bad faith or gross negligence on its part in the performance of its
duties or from reckless disregard by it of its obligations and duties under the
Sub-Advisory Contract. The Mitchell Hutchins Contract terminates automatically
upon assignment and is terminable by vote of the board of directors or by the
holders of a majority of the outstanding voting securities of the Trust, at any
time without penalty, on 60 days' written notice to Mitchell Hutchins. The
Mitchell Hutchins Contract may also be terminated by Mitchell Hutchins on 60
days' written notice to the Trust.
The Sub-Advisory Contract terminates automatically upon assignment or upon
termination of the Mitchell Hutchins Contract and is terminable by vote of the
Trust's board of directors, or by the holders of a majority of the outstanding
voting securities of the Trust, at any time without penalty, on 60 days' written
notice to the Sub-Adviser. The Sub-Advisory Contract may be terminated by
Mitchell Hutchins: (1) on 20 days' notice to the Sub-Adviser upon material
breach by the Sub-Adviser of its representations and warranties, which breach
shall not have been cured within such 20-day notice period; (2) if the
Sub-Adviser becomes unable to discharge its duties and obligations under the
Sub-Advisory Contract; or (3) on 120 days' notice to the Sub-Adviser. The
Sub-Adviser may terminate the Sub-Advisory Contract at any time on 120 days'
notice to Mitchell Hutchins.
For the fiscal years ended November 30, 1996, November 30, 1995 and
November 30, 1994, the Trust paid or accrued to Mitchell Hutchins $853,256,
$998,135 and $1,031,048, respectively, in investment advisory and administration
fees, and Mitchell Hutchins (not the Trust) paid or accrued to the Sub-Adviser
$304,734, $356,567 and $368,231, respectively, in investment sub-advisory fees.
21
<PAGE>
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 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 the PaineWebber funds and other Mitchell Hutchins advisory
clients. Sub-Adviser personnel may also invest in securities for their own
accounts pursuant to a comparable code of ethics.
PORTFOLIO TRANSACTIONS
Subject to policies established by the board of directors and oversight by
Mitchell Hutchins, the Sub-Adviser is responsible for the execution of the
Trust's portfolio transactions and the allocation of brokerage transactions. In
executing portfolio transactions, the Sub-Adviser seeks to obtain the best net
results for the Trust, 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. The securities in
which the Trust will invest 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.
In placing orders with dealers, the Sub-Adviser attempts to obtain the best
net price and the most favorable execution of its orders. The Sub-Adviser may
purchase and sell portfolio securities from and to dealers who provide the Trust
with research, analysis, statistical or pricing advice or similar services.
Portfolio transactions are not directed by the Trust to dealers solely on the
basis of research and advice provided. Research services furnished by the
dealers through which or with which the Trust effects securities transactions
may be used by the Sub-Adviser and in advising other funds or accounts they
advise and, conversely, research services furnished to Mitchell Hutchins or the
Sub-Adviser in connection with other funds or accounts that either of them
advises may be used in advising the Trust.
The Trust will have no obligation to deal with any broker or group of
brokers in the execution of portfolio transactions. The Trust contemplates that,
consistent with obtaining the best net results, brokerage transactions may be
conducted through Mitchell Hutchins or the Sub-Adviser or any of their
affiliates, including PaineWebber. The Trust's board of directors has adopted
procedures in conformity with Rule 17e-1 under the 1940 Act to ensure that all
brokerage commissions paid to Mitchell Hutchins or the Sub-Adviser or any of
their affiliates are reasonable and fair. Specific provisions in the Mitchell
Hutchins Contract authorize Mitchell Hutchins or the Sub-Adviser and any
affiliate thereof that is a member of a national securities exchange to effect
portfolio transactions for the Trust on such exchange and to retain compensation
in connection with such transactions. Any such transactions will be effected and
related compensation paid only in accordance with applicable SEC regulations.
Goldman, Sachs & Co., an affiliate of the Sub-Adviser, is an active
participant in the securities markets, including the markets for Mortgage-Backed
Securities and other securities and instruments in which the Trust invests.
Goldman, Sachs & Co. and its affiliates have proprietary interests in, and
manage accounts trading in, such markets which have investment objectives
similar to those of the Trust, as well as accounts with investment objectives
different from those of the Trust but trading in the same types of securities
and instruments as those traded on behalf of the Trust. Such activities could
affect the prices of securities and instruments to be purchased or sold by the
Trust, and such accounts may compete with the Trust for investments in
securities and other instruments. Transactions for the proprietary and other
accounts managed
22
<PAGE>
by Goldman, Sachs & Co. (other than accounts managed by the Sub-Adviser or its
advisory affiliates) are executed separately from the Sub-Adviser's execution of
trades, including trades for the Trust.
Investment decisions for the Trust and for other investment accounts
managed by the Sub-Adviser 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 Trust and one or more such accounts.
In such cases, simultaneous transactions are inevitable. Purchases and sales
then are averaged as to price and allocated between the Trust and such other
account(s) as to amount in a manner determined by the Sub-Adviser in good faith
to be fair and equitable in light of the Sub-Adviser's fiduciary obligations to
the Trust and the other account(s) involved. While in some cases this practice
could have a detrimental effect upon the price or value of the security as far
as the Trust 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 Trust.
Transactions in futures contracts are executed through futures commission
merchants ('FCMs') who receive brokerage commissions for their services. The
Trust's procedures in selecting FCMs to execute the Trust's transactions in
futures contracts, including procedures permitting the use of the Sub-Adviser
and its affiliates are similar to those in effect with respect to brokerage
transactions in securities. For the fiscal year ended November 30, 1996 the
Trust paid $664 in commissions to FCMs. For the fiscal years ended November 30,
1995 and November 30, 1994, the Trust paid no commissions to FCMs.
The Trust does not purchase securities that are offered in underwritings in
which Mitchell Hutchins, the Sub-Adviser 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 Mitchell Hutchins, the
Sub-Adviser and their affiliates not participate in or benefit from the sale to
the Trust.
For the fiscal years ended November 30, 1996, November 30, 1995 and
November 30, 1994, the Sub-Adviser did not direct any portfolio transactions to
brokers chosen because they provide research and analysis. For the fiscal years
ended November 30, 1996, November 30, 1995 and November 30, 1994, the Trust
paid no brokerage commissions other than to FCMs.
VALUATION OF SHARES
The net asset value of the Shares is determined weekly on the second to
last day in each week on which the NYSE is open (or on such other day as may be
determined by the Trust's board of directors) and 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 is computed by
dividing the value of the securities held by the Trust plus any cash or other
assets (including interest and dividends accrued but not yet received and earned
discount) minus all liabilities (including accrued expenses) by the total number
of Shares outstanding at such time.
The Trust's mortgage-backed and U.S. Treasury obligations are valued by the
Sub-Adviser in good faith and under the supervision of the Trust's board of
directors based on yield equivalents, a pricing matrix or other sources. Other
portfolio securities for which accurate market quotations are readily available
are valued on the basis of quotations furnished by a pricing service or provided
by dealers in those securities. When market quotations for securities held by
the Trust are not readily available, they are valued at fair value by or under
the direction of the board of directors utilizing quotations and other
information concerning similar securities derived from recognized dealers in
those securities or information regarding the trading spreads
23
<PAGE>
quoted by recognized dealers between such securities and U.S. Treasury
securities whose maturities are determined by the Sub-Adviser to be most closely
matched to the average life of the Trust's securities. When market quotations
for positions in Strategic Transactions held by the Trust are readily available,
those positions will be valued based upon such quotations. Market quotations
generally will not be available for options traded on the OTC market. When
market quotations for positions in Strategic Transactions are not readily
available, they will be valued at fair value as determined in good faith by or
under the direction of the board of directors. 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.
TAXES
General. In order to continue to qualify for treatment as a regulated
investment company ('RIC') under the Internal Revenue Code, the Trust must
distribute to its shareholders for each taxable year at least 90% of the sum of
its investment company taxable income (consisting generally of taxable net
investment income, net short-term capital gains and net realized gains from
certain transactions) plus its net interest income excludable from gross income
under section 103(a) of the Internal Revenue Code ('tax-exempt income')
('Distribution Requirement') and must meet several additional requirements.
Among these requirements are the following: (1) the Trust 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 Trust 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 Trust'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 Trust's total assets; and (4) at the close of
each quarter of the Trust'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 Trust
fails 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 shareholders) and all distributions out of its
earnings and profits would be taxable to its shareholders as dividends (that is,
ordinary income).
The Trust 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 November
30 of that year, plus certain other amounts. For these purposes, any such
taxable income retained by the Trust, and on which it pays federal income tax,
will be treated as having been distributed.
Any capital losses that the Trust may realize can be used only to offset
capital gains and cannot be used to reduce the Trust's ordinary income. Thus, if
the Trust realized a net capital loss in any taxable year, the amount the Trust
would be required to distribute to satisfy the Distribution Requirement and to
avoid imposition of the Excise Tax would not be decreased. Net capital losses
that the Trust cannot use in one taxable year may be carried forward by it for
eight years. If any capital losses have not been used by the time the Trust
terminates, the potential benefits of those capital losses will be lost.
24
<PAGE>
While any obligations constituting senior securities are outstanding, the
Trust may not declare any cash dividend or other distribution on its Shares
unless, at the time of the declaration, the Trust satisfies certain dividend
payment and asset coverage requirements. See 'Dividends and Other Distributions;
Dividend Reinvestment Plan' in the Prospectus. Any such suspension of
distributions on the Shares could prevent the Trust from satisfying the
Distribution Requirement and avoiding imposition of the Excise Tax.
Original Issue Discount. The Trust may acquire Zero Coupon Municipal
Securities (or other securities, such as PO classes of Mortgage-Backed
Securities) that are issued with original issue discount. As a holder of such a
security, the Trust would have to take into account each taxable year the
original issue discount that accrues on the security for the year, even if it
receives no payment on the security during the year. Because the Trust annually
must distribute (1) at least 90% of its investment company taxable income,
including any accrued original issue discount (whether taxable or not), to
satisfy the Distribution Requirement and (2) substantially all of its
non-tax-exempt income to avoid imposition of the Excise Tax, 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 Trust's cash assets or from the proceeds of sales of portfolio
securities or from borrowings, if necessary. The Trust may realize capital gains
or losses from those sales, which would increase or decrease its investment
company taxable income or net capital gain. 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 Trust's
ability to sell other securities, options or futures held for less than three
months that it might wish to sell in the ordinary course of its portfolio
management. The Trust will not invest in Zero Coupon Municipal Securities the
interest on which is a tax preference item for purposes of the federal
alternative minimum tax.
Strategic Transactions. The use of Strategic Transactions, 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 Trust realizes in connection therewith. These rules also
may require the Trust 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 Trust to recognize 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 Trust
might have to liquidate securities to enable it to make the required
distributions, which would cause it to recognize gains or losses and might
affect its ability to satisfy the Short-Short Limitation.
Gains from options and futures derived by the Trust 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 Trust 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 Trust 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
Trust will consider whether it should seek to qualify for this treatment for its
hedging transactions. To the extent the Trust 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 Trust to continue to qualify as a RIC.
Other Securities. As a result of investing in certain securities and also
as a result of leveraging to purchase or hold certain other securities, the
Trust may be required to report taxable income in excess of the economic income
derived therefrom. The timing and character of any deduction attributable to the
Trust's failure to fully recoup its initial investment in certain
Mortgage-Backed Securities as a result of greater than anticipated prepayments
of principal on the underlying mortgage assets are unclear. The tax treatment of
25
<PAGE>
certain securities in which the Trust may invest is not free from doubt, and it
is possible that an Internal Revenue Service examination of the issuers of those
securities or of the Trust could result in adjustments to the Trust's taxable
income.
ADDITIONAL INFORMATION
COMMON STOCK REPURCHASES AND TENDER OFFERS
As discussed in the Prospectus, the Trust's board of directors may make a
tender offer for its Shares to reduce or eliminate the discount to net asset
value at which the Trust's Shares might trade. Even if such 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 Share 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 Shares from the NYSE (the
NYSE having advised the Trust 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) or (b) impair the Trust's status as a RIC (which would
eliminate the Trust's eligibility to deduct distributions paid to its
shareholders, thus causing the Trust's income to be fully taxed at the corporate
level in addition to the taxation of shareholders on distributions received from
the Trust); (2) the Trust would not be able to liquidate portfolio securities in
an orderly manner and consistent with the Trust'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
Trust, (b) suspension of trading or limitation on prices of securities generally
on the NYSE or any other exchange on which portfolio securities of the Trust 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 Trust invests, (d) limitation affecting the Trust 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 Trust or its shareholders if Shares were
repurchased. The board of directors may modify these conditions in light of
experience.
COUNSEL
The law firm of Kirkpatrick & Lockhart LLP, 1800 Massachusetts Avenue,
N.W., Washington, D.C. 20036-1800, counsel to the Trust, has passed upon the
legality of the shares offered by the Trust's Prospectus. Kirkpatrick & Lockhart
LLP also acts as counsel to Mitchell Hutchins and PaineWebber in connection with
other matters.
INDEPENDENT AUDITORS
Ernst & Young LLP, 787 Seventh Avenue, New York, New York 10019, serves as
the Trust's independent auditors.
FINANCIAL STATEMENTS
The Trust's Annual Report to Shareholders for the fiscal year ended
November 30, 1996 is a separate document supplied with this Statement of
Additional Information and the financial statements, accompanying notes and
report of independent auditors appearing therein are incorporated by reference
in this Statement of Additional Information.
26
<PAGE>
APPENDIX A
PERFORMANCE COMPARISONS AND ECONOMIC INFORMATION
The Trust may, in advertisements, reports to shareholders and other
publicly-distributed documents, compare its performance with or otherwise
discuss the investment returns of various securities, such as 6-month Treasury
bills, 1-year Treasury notes, and 10-year and 30-year Treasury bonds. Such
comparisons or discussions also may include economic data and statistics
published by the United States Bureau of Labor Statistics, such as the cost of
living index, information and statistics on the residential mortgage market or
the market for Mortgage-Backed Securities such as those published by the Federal
Reserve Bank, the Office of Thrift Supervision, Ginnie Mae, Fannie Mae and
Freddie Mac and the Lehman Mortgage-Backed Securities Index. The Trust also may
compare its performance with or otherwise discuss data (including average 30-day
money market fund yields) published by Lipper Analytical Services, Inc.,
IBC/Donoghue's Money Market Fund Report, Wiesenberger Investment Service or
Investment Company Data Inc. In comparing the Trust or its performance to money
market funds, investors should keep in mind that money market funds seek to
maintain a constant net asset value per share of $1.00, while the net asset
value of the Shares will fluctuate. The securities held by the Trust generally
have longer maturities than those held by money market funds and may reflect
interest rate fluctuations for longer term securities.
The Trust also may compare its performance with or otherwise discuss the
performance of bank certificates of deposit ('CDs') as measured by the CDA
Investment Technologies Certificate of Deposit Index and the Bank Rate Monitor
Index and the averages of yields of CDs of major banks published by Banxquote
(R) Money Markets. In comparing the Trust or its performance to CD performance,
investors should keep in mind that bank CDs are insured in whole or in part by
an agency of the U.S. government and offer fixed principal and fixed or variable
rates of interest, and that bank CD yields may vary depending on the financial
institution offering the CD and prevailing interest rates. The Shares are not
insured or guaranteed by the U.S. government; returns and net asset value will
fluctuate. The securities held by the Trust generally have longer maturities
than most CDs and may reflect interest rate fluctuations for longer term
securities.
The Trust may include discussions or illustrations of the effects of
compounding in advertisements. 'Compounding' refers to the fact that, if
dividends and other distributions are reinvested in additional Shares, any
future income or capital appreciation would increase the net asset value, not
only of the original Trust investment, but also of the additional Shares
received through reinvestment. As a result, the net asset value of an investment
in the Trust would increase more rapidly than if dividends and other
distributions had been paid in cash.
A-1
<PAGE>
================================================================================
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 TRUST OR PAINEWEBBER. THE PROSPECTUS AND
THIS STATEMENT OF ADDITIONAL INFORMATION DO NOT CONSTITUTE AN OFFERING BY THE
TRUST 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
Investment Limitations......................... 4
Strategic Transactions......................... 7
Directors and Officers......................... 14
Control Persons and Principal Holders of
Securities................................... 20
Investment Advisory Arrangements............... 20
Portfolio Transactions......................... 22
Valuation of Shares............................ 23
Taxes.......................................... 24
Additional Information......................... 26
Financial Statements........................... 26
Appendix A..................................... A-1
</TABLE>
================================================================================
================================================================================
2002 TARGET
TERM TRUST INC.
COMMON STOCK
------------------------
STATEMENT OF ADDITIONAL
INFORMATION
------------------------
PAINEWEBBER INCORPORATED
------------------------
APRIL 1, 1997
================================================================================
