MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND OF MERR, 497, 1998-12-31

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND OF MERR
497, 1998-12-31

Previous: COCENSYS INC, DEFS14A, 1998-12-31

Next: INSURED MUNICIPALS INCOME TRUST 132ND INSURED MULTI SERIES, 24F-2NT, 1998-12-31

<PAGE> 1
PROSPECTUS

[MERRILL LYNCH LOGO]

Merrill Lynch California Insured Municipal Bond Fund
of Merrill Lynch California Municipal Series Trust

[MERRILL LYNCH ARTWORK]

December 29, 1998

THIS PROSPECTUS CONTAINS INFORMATION YOU SHOULD KNOW BEFORE
INVESTING, INCLUDING INFORMATION ABOUT RISKS. PLEASE READ
IT BEFORE YOU INVEST AND KEEP IT FOR FUTURE REFERENCE.

THE SECURITIES AND EXCHANGE COMMISSION HAS NOT APPROVED OR
DISAPPROVED THESE SECURITIES OR PASSED UPON THE ADEQUACY OF
THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.

<PAGE> 2
Table of Contents

<TABLE>
<CAPTION>
PAGE
<S> <C>
[KEY FACTS ICON]
KEY FACTS
- -----------------------------------------------------------------
The Merrill Lynch California Insured Municipal Bond Fund at
a Glance.................................................... 3
Risk/Return Bar Chart....................................... 5
Fees and Expenses........................................... 6

[DETAILS ABOUT THE FUND ICON]
DETAILS ABOUT THE FUND
- -----------------------------------------------------------------
How the Fund Invests........................................ 8
Investment Risks............................................ 10

[YOUR ACCOUNT ICON]
YOUR ACCOUNT
- -----------------------------------------------------------------
Merrill Lynch Select Pricing(SM) System..................... 15
How to Buy, Sell, Transfer and Exchange Shares.............. 20
Participation in Merrill Lynch Fee-Based Programs........... 24

[MANAGEMENT OF THE FUND ICON]
MANAGEMENT OF THE FUND
- -----------------------------------------------------------------
Fund Asset Management....................................... 27
Financial Highlights........................................ 28

[FOR MORE INFORMATION ICON]
FOR MORE INFORMATION
- -----------------------------------------------------------------
Shareholder Reports....................................Back Cover
Statement of Additional Information....................Back Cover
</TABLE>

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND

<PAGE> 3
Key Facts [KEY FACTS ICON]

IN AN EFFORT TO HELP YOU BETTER UNDERSTAND THE MANY CONCEPTS INVOLVED IN MAKING
AN INVESTMENT DECISION, WE HAVE DEFINED THE HIGHLIGHTED TERMS IN THIS PROSPECTUS
IN THE SIDEBAR.

INVESTMENT GRADE -- any of the four highest debt obligation ratings by
recognized rating agencies, including Moody's Investors Service, Inc., Standard
& Poor's or Fitch IBCA, Inc.

CALIFORNIA MUNICIPAL BOND -- a debt obligation issued by or on behalf of a
governmental entity in California or other qualifying issuer that pays interest
exempt from California income taxes as well as from Federal income tax.

THE MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL
BOND FUND AT A GLANCE
- --------------------------------------------------------------------------------

WHAT ARE THE FUND'S OBJECTIVE AND GOALS?

WHAT ARE THE FUND'S MAIN INVESTMENT STRATEGIES?

The Fund invests primarily in a portfolio of long term INVESTMENT GRADE
CALIFORNIA MUNICIPAL BONDS. These may be obligations of a variety of issuers
including governmental entities in California and issuers located in Puerto
Rico, the U.S. Virgin Islands and Guam. Generally, the Fund will invest at least
80% of its total assets in insured municipal bonds, with at least 65% of its
assets in insured California municipal bonds. However, the Fund may invest up to
20% of its assets in high yield or "junk" bonds. The Fund also may invest in
certain types of "derivative" securities. When choosing investments, Fund
management considers various factors, including the credit quality of issuers,
yield analysis, maturity analysis and call features of the obligations.

An insured municipal bond is either (i) insured under an insurance policy
purchased by the Fund or (ii) insured under an insurance policy obtained by the
issuer of the municipal bonds or any other party. The Fund's portfolio insurance
relates only to timely payment of principal at maturity and interest on the
municipal bonds held by the Fund and not to the value of the municipal bonds or
Fund shares.

WHAT ARE THE MAIN RISKS OF INVESTING IN THE FUND?

As with any mutual fund, the value of the Fund's investments -- and therefore
the value of Fund shares -- may go up or down. These changes may occur in
response to interest rate changes or other factors that may affect a particular
issuer or obligation. Generally, when interest rates go up, the value of debt
instruments like municipal bonds goes down. If the value of the Fund's
investments goes down, you may lose money.

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 3

<PAGE> 4

[KEY FACTS ICON] Key Facts

In addition, since the Fund invests at least 65% of its assets in California
municipal bonds, it is more susceptible to negative political or economic
factors in California than a fund that invests more widely. Derivatives and high
yield or "junk" bonds may be volatile and subject to liquidity, leverage, credit
and other types of risks.

WHO SHOULD INVEST?

The Fund may be an appropriate investment for you if you:

- Are looking for income that is exempt from Federal and
California income taxes;

- Want a professionally managed portfolio without the
administrative burdens of direct investments in municipal bonds;

- Are looking for liquidity;

- Can tolerate the risk of loss caused by negative political or
economic developments in California, changes in interest rates
or adverse changes in the price of bonds in general.

4 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 5

RISK/RETURN BAR CHART
- --------------------------------------------------------------------------------

The bar chart and table shown below provide an indication of the risks of
investing in the Fund. The bar chart shows changes in the Fund's performance for
Class B shares from year to year for each complete calendar year since the
Fund's inception. Sales charges are not reflected in the bar chart. If these
amounts were reflected, returns would be less than those shown. The table
compares the average annual total returns for each class of the Fund's shares
for the years shown with those of the Lehman Brothers Municipal Bond Index. How
the Fund performed in the past is not necessarily an indication of how the Fund
will perform in the future.

During the period shown in the bar chart, the highest return for a quarter was
7.36% (quarter ended March 31, 1995) and the lowest return for a quarter was
- -7.58% (quarter ended March 31, 1994). The year-to-date return as of September
30, 1998 was 5.53%.

<TABLE>
<CAPTION>
AVERAGE ANNUAL TOTAL RETURNS (AS OF THE PAST SINCE
CALENDAR YEAR ENDED DECEMBER 31, 1997) ONE YEAR INCEPTION
- -------------------------------------------------------------------
<S> <C> <C>
Merrill Lynch California
Insured Municipal Bond Fund* A 4.15% 5.38%+
- -------------------------------------------------------------------
B 3.84% 5.74%+
- -------------------------------------------------------------------
C 6.84% 8.87%++
- -------------------------------------------------------------------
D 4.05% 8.07%++
- -------------------------------------------------------------------
Lehman Brothers Municipal Bond Index** 9.19% 6.57% / 9.78%#
- -------------------------------------------------------------------
</TABLE>

* Includes sales charge.

** This unmanaged Index consists of long-term revenue bonds, prerefunded bonds,
general obligation bonds and insured bonds. Past performance is not
predictive of future performance.

+ Inception date is February 26, 1993.

++ Inception date is October 21, 1994.

# Represents total returns as of December 31, 1997 for the periods since
February 28, 1993 and October 31, 1994, respectively.

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 5
<PAGE> 6

[KEY FACTS ICON] Key Facts

UNDERSTANDING EXPENSES

Fund investors pay various fees and expenses, either directly or indirectly.
Listed below are some of the main types of expenses, which all mutual funds may
charge:

EXPENSES PAID DIRECTLY BY THE SHAREHOLDER:

SHAREHOLDER FEES -- these include sales charges which you may pay when you buy
or sell shares of the Fund.

EXPENSES PAID INDIRECTLY BY THE SHAREHOLDER:

ANNUAL FUND OPERATING EXPENSES -- expenses that cover the costs of operating the
Fund.

MANAGEMENT FEE -- a fee paid to the Manager for managing the Fund.

DISTRIBUTION FEES -- fees used to support the Fund's marketing and distribution
efforts, such as compensating Financial Consultants, advertising and promotion.

SERVICE (ACCOUNT MAINTENANCE) FEES -- fees used to compensate securities
dealers for account maintenance activities.

FEES AND EXPENSES
- --------------------------------------------------------------------------------

The Fund offers four different classes of shares. Although your money will be
invested the same way no matter which class of shares you buy, there are
differences among the fees and expenses associated with each class. Not everyone
is eligible to buy every class. After determining which classes you are eligible
to buy, decide which class best suits your needs. Your Merrill Lynch Financial
Consultant can help you with this decision.

This table shows the different fees and expenses that you may pay if you buy and
hold the different classes of shares of the Fund. Future expenses may be greater
or less than those indicated below.

<TABLE>
<CAPTION>
SHAREHOLDER FEES (FEES PAID DIRECTLY FROM YOUR
INVESTMENT) CLASS A CLASS B(a) CLASS C CLASS D
- ----------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Maximum Sales Charge (Load) imposed on purchases
(as a percentage of offering price) 4.00%(b) None None 4.00%(b)
- ----------------------------------------------------------------------------------------------------
Maximum Deferred Sales Charge (Load) (as a
percentage of original purchase price or
redemption proceeds, whichever is lower) None(c) 4.0%(b) 1.0%(b) None(c)
- ----------------------------------------------------------------------------------------------------
Maximum Sales Charge (Load) imposed on Dividend
Reinvestments None None None None
- ----------------------------------------------------------------------------------------------------
Redemption Fee None None None None
- ----------------------------------------------------------------------------------------------------
Exchange Fee None None None None
- ----------------------------------------------------------------------------------------------------
Maximum Account Fee None None None None
- ----------------------------------------------------------------------------------------------------
ANNUAL FUND OPERATING EXPENSES (EXPENSES THAT ARE
DEDUCTED FROM FUND ASSETS)
- ----------------------------------------------------------------------------------------------------
MANAGEMENT FEE(D) 0.55% 0.55% 0.55% 0.55%
- ----------------------------------------------------------------------------------------------------
DISTRIBUTION AND/OR SERVICE (12b-1) FEES(e) None 0.50% 0.60% 0.10%
- ----------------------------------------------------------------------------------------------------
Other Expenses (including transfer agency
fees)(f) 0.27% 0.27% 0.27% 0.27%
- ----------------------------------------------------------------------------------------------------
TOTAL ANNUAL FUND OPERATING EXPENSES(g) 0.82% 1.32% 1.42% 0.92%
- ----------------------------------------------------------------------------------------------------
</TABLE>

(a) Class B shares automatically convert to Class D shares about ten years after
you buy them. Then they will no longer be subject to distribution fees and
will pay lower account maintenance fees.

(b) Some investors may qualify for reductions in the sales charge (load).

(d) The Fund pays the Manager a fee at the annual rate of 0.55% of the average
daily net assets of the Fund for the first $500 million; 0.525% of the
average daily net assets from $500 million to $1 billion; and 0.50% of the
average daily net assets above $1 billion. For the fiscal year ended August
31, 1998, the fee payable to the Manager from the Fund was equal to 0.55% of
the Fund's average daily net assets, but the Manager voluntarily waived
$6,357 of the management fee due. Total Fund Operating Expenses in the fee
table have been restated to assume the absence of the waiver because it may
be discontinued or reduced by the Manager at any time without notice. For
the fiscal year ended August 31, 1998, the Manager waived management fees
totaling .01% for Class A shares, .01% for Class B shares, less than .01%
for Class C shares and .01% for Class D shares, after which the Fund's total
expense ratio was 0.81% for Class A shares, 1.31% for Class B shares, 1.42%
for Class C shares and 0.91% for Class D shares.

(e) The Fund calls the "Service Fee" an "Account Maintenance Fee." Account
Maintenance Fee is the term used in this Prospectus and all other Fund
materials. If you hold Class B or Class C shares for a long time, it may
cost you more in distribution (12b-1) fees than the maximum sales charge
that you would have paid if you had bought one of the other classes.

(f) The Fund pays the Transfer Agent $11.00 for each Class A and Class D
shareholder account and $14.00 for each Class B and Class C shareholder
account and reimburses the Transfer Agent's out-of-pocket expenses. The Fund
pays a 0.10% fee for certain accounts that participate in the Merrill Lynch
Mutual Fund Advisor program. The Fund also pays a $0.20 monthly closed
account charge, which is assessed upon all accounts that

6 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 7

(footnotes continued from previous page)
close during the year. This fee begins the month following the month the
account is closed and ends at the end of the calendar year. For the fiscal
year ended August 31, 1998, the Fund paid the Transfer Agent fees totaling
$27,202. The Manager provides accounting services to the Fund at its cost.
For the fiscal year ended August 31, 1998, the Fund reimbursed the Manager
$68,135 for these services.

(g) In addition, Merrill Lynch may charge clients a processing fee (currently
$5.35) when a client buys or redeems shares.

EXAMPLES:

These examples are intended to help you compare the cost of investing in the
Fund with the cost of investing in other mutual funds.

These examples assume that you invest $10,000 in the Fund for the time periods
indicated, that your investment has a 5% return each year, that you pay the
sales charges, if any, that apply to the particular class and that the Fund's
operating expenses remain the same. This assumption is not meant to indicate you
will receive a 5% annual rate of return. Your annual return may be more or less
than the 5% used in this example. Although your actual costs may be higher or
lower, based on these assumptions your costs would be:

EXPENSES IF YOU DID REDEEM YOUR SHARES:

<TABLE>
<CAPTION>
1 YEAR 3 YEARS 5 YEARS 10 YEARS
- --------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Class A $480 $651 $837 $1,373
- --------------------------------------------------------------------------------------
Class B $534 $618 $724 $1,590
- --------------------------------------------------------------------------------------
Class C $245 $449 $776 $1,702
- --------------------------------------------------------------------------------------
Class D $490 $682 $889 $1,486
- --------------------------------------------------------------------------------------
</TABLE>

EXPENSES IF YOU DID NOT REDEEM YOUR SHARES:

<TABLE>
<CAPTION>
1 YEAR 3 YEARS 5 YEARS 10 YEARS
- --------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Class A $480 $651 $837 $1,373
- --------------------------------------------------------------------------------------
Class B $134 $418 $724 $1,590
- --------------------------------------------------------------------------------------
Class C $145 $449 $776 $1,702
- --------------------------------------------------------------------------------------
Class D $490 $682 $889 $1,486
- --------------------------------------------------------------------------------------
</TABLE>

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 7
<PAGE> 8

Details About the Fund [DETAILS ABOUT THE FUND ICON]

ABOUT THE PORTFOLIO MANAGER

Walter O'Connor is the portfolio manager of the Fund. Mr. O'Connor has been a
Director of Merrill Lynch Asset Management since 1997, a Vice President from
1993 to 1997 and an Assistant Vice President from 1991 to 1993.

ABOUT THE MANAGER

The Fund is managed by Fund Asset Management.

HOW THE FUND INVESTS
- --------------------------------------------------------------------------------

The Fund's main goal is to seek a high level of income that is exempt from
Federal and California income taxes. The Fund invests primarily in long term,
investment grade California municipal bonds. Issuers may be located in
California or in other qualifying jurisdictions such as Puerto Rico, the U.S.
Virgin Islands and Guam.

The Fund may invest in either fixed rate or variable rate obligations. At least
80% of the Fund's total assets will be invested in investment grade securities.
The Fund will limit its investments in high yield or junk bonds to no more than
20% of its total assets. These bonds are generally more speculative and involve
greater price fluctuations than investment grade securities.

The Fund generally will invest at least 80% of its total assets in municipal
bonds that are covered by insurance and at least 65% of its total assets in
California municipal bonds that are covered by insurance. Insurance may be
provided either under (i) an insurance policy purchased by the Fund or (ii) an
insurance policy obtained by the issuer of the municipal bonds or any other
party. The insurance policies on the municipal bonds will not guarantee the
market value of the insured municipal bonds or the value of the shares of the
Fund. The insurance policies reduce the possibility that the owners of the
insured municipal bonds will not receive timely scheduled payments of principal
or interest, but have no effect on the risk caused by fluctuations in market
value as a result of changes in prevailing interest rates. For temporary periods
the Fund may invest up to 35% of its total assets in short term tax exempt or
taxable money market obligations. No more than 20% of the Fund's net assets will
be invested in taxable money market obligations. However, as a temporary measure
for defensive purposes, the Fund may invest without limitation in short term
obligations. Short term investments may limit the potential for tax exempt
income on your shares.

Insurance guarantees that interest payments on the bond will be made on time and
the principal will be repaid when the bond matures. Either the issuer of the
security or the Fund itself purchases the insurance. Insurance is expected to
protect the Fund against losses caused by a bond issuer's failure to make
interest or principal payments. However, it does not protect the Fund or its
shareholders against losses because of declines in a bond's market value. Also,
the Fund cannot be certain that an insurance company

8 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 9

will make the payments it guarantees. The Fund may lose money on its investment
if the insurance company does not make these payments. If the Fund purchases the
insurance, it must pay the premiums, which payments will reduce the Fund's
yield. The Fund intends to use only insurance companies that have an AAA/Aaa
credit rating. However, if insurance with these ratings is not available, the
Fund may use insurance carriers with lower ratings or stop purchasing insurance
or insured bonds.

The Fund may use derivatives including futures, options, indexed securities and
inverse securities. Derivatives are financial instruments whose value is derived
from another security or an index such as the Lehman Brothers Municipal Bond
Index.

The Fund's investments may include private activity bonds that may subject
certain shareholders to an alternative minimum tax.

Economic conditions in California are influenced by numerous factors including
technology business services (such as computer software), construction,
computers and electronic components as well as the economies of Canada and Latin
America, California's largest trading partners. The Manager believes that
current economic conditions in California will enable the Fund to continue to
invest in high quality California municipal bonds. Moody's, Standard & Poor's
and Fitch currently rate the State of California's general obligation bonds,
Aa3, A+ and AA-, respectively.

Fund management considers a variety of factors when choosing investments, such
as:

- CREDIT QUALITY OF ISSUERS -- based on bond ratings and other
factors including economic and financial conditions.

- YIELD ANALYSIS -- takes into account factors such as the
different yields available on different types of obligations and
the shape of the yield curve (longer term obligations typically
have higher yields).

- MATURITY ANALYSIS -- the average maturity of the portfolio will
be maintained within a desirable range as determined from time
to time. Factors considered include portfolio activity, maturity
of the supply of available bonds and the shape of the yield
curve.

In addition, Fund management considers the availability of features that protect
against an early call of a bond by the issuer.

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 9
<PAGE> 10
[DETAILS ABOUT THE FUND ICON] Details About the Fund

INVESTMENT RISKS
- --------------------------------------------------------------------------------
This section contains a summary discussion of the general risks of investing
in the Fund. As with any mutual fund, there can be no guarantee that the Fund
will meet its goals or that the Fund's performance will be positive for any
period of time.

BOND MARKET AND SELECTION RISK

Bond market risk is the risk that the bond markets will go down in value,
including the possibility that the market will go down sharply and
unpredictably. Selection risk is the risk that the investments that Fund
management selects will underperform the market or other funds with similar
investment objectives and investment strategies.

CREDIT RISK

Credit risk is the risk that the issuer will be unable to pay the interest or
principal when due. The degree of credit risk depends on both the financial
condition of the issuer and the terms of the obligation.

INTEREST RATE RISK

Interest rate risk is the risk that prices of municipal bonds generally increase
when interest rates decline and decrease when interest rates increase. Prices of
longer term securities generally change more in response to interest rate
changes than prices of shorter term securities.

STATE SPECIFIC RISK

The Fund will invest primarily in California municipal bonds. Therefore, an
investment in the Fund may be riskier than an investment in a fund that does not
concentrate in municipal bonds of one state.

CALL AND REDEMPTION RISK

A bond's issuer may call a bond for redemption before it matures. If this
happens to a bond the Fund holds, the Fund may lose income and may have to
invest the proceeds in bonds with lower yields.

Risks associated with certain types of obligations in which the Fund may invest
include:

GENERAL OBLIGATION BONDS -- The faith, credit and taxing power of the
municipality that issues a general obligation bond secures payment of interest
and repayment of principal. Timely payments depend on the issuer's credit
quality, ability to raise tax revenues and ability to maintain an adequate tax
base.

10 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 11

REVENUE BONDS -- Payments of interest and principal on revenue bonds are made
only from the revenues generated by a particular facility, class of facilities
or the proceeds of a special tax or other revenue source. These payments depend
on the money earned by the particular facility or class of facilities.
Industrial development bonds are one type of revenue bond.

INDUSTRIAL DEVELOPMENT BONDS -- Municipalities and other public authorities
issue industrial development bonds to finance development of industrial
facilities for use by a private enterprise. The private enterprise pays the
principal and interest on the bond, and the issuer does not pledge its faith,
credit and taxing power for repayment. If the private enterprise defaults on its
payments, the Fund may not receive any income or get its money back from the
investment.

MORAL OBLIGATION BONDS -- Moral obligation bonds are generally issued by special
purpose public authorities of a state or municipality. If the issuer is unable
to meet its obligations, repayment of these bonds becomes a moral commitment,
but not a legal obligation, of the state or municipality.

MUNICIPAL NOTES -- Municipal notes are shorter term municipal debt obligations.
They may provide interim financing in anticipation of tax collection, bond sales
or revenue receipts. If there is a shortfall in the anticipated proceeds, the
notes may not be fully repaid and the Fund may lose money.

MUNICIPAL LEASE OBLIGATIONS -- In a municipal lease obligation, the issuer
agrees to budget for and appropriate municipal funds to make payments due on the
lease obligation. However, this does not ensure that funds will actually be
appropriated in future years. The issuer does not pledge its unlimited taxing
power for payment of the lease obligation, but the leased property secures the
obligation. In addition, the proceeds of a sale may not cover the Fund's loss.

INSURED MUNICIPAL BONDS -- Insurance covering bonds purchased by the Fund
guarantees timely interest payments and repayment of principal on maturity. If a
bond's insurer fails to fulfill its obligations or loses its credit rating, the
value of the bond could drop.

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 11
<PAGE> 12
Details About The Fund [DETAILS ABOUT THE FUND ICON]

JUNK BONDS -- Junk bonds are debt securities that are rated below investment
grade by the major rating agencies or are unrated securities that Fund
management believes are of comparable quality. Although junk bonds generally pay
higher rates of interest than investment grade bonds, they are high risk
investments that may cause income and principal losses for the Fund. Junk bonds
generally are less liquid and experience more price volatility than higher rated
debt securities. The issuers of junk bonds may have a larger amount of
outstanding debt relative to their assets than issuers of investment grade
bonds. In the event of an issuer's bankruptcy, claims of other creditors may
have priority over the claims of junk bond holders, leaving few or no assets
available to repay junk bond holders. Junk bonds may be subject to greater call
and redemption risk than higher rated debt securities.

WHEN ISSUED SECURITIES, DELAYED DELIVERY SECURITIES AND FORWARD
COMMITMENTS -- When issued and delayed delivery securities and forward
commitments involve the risk that the security the Fund buys will lose value
prior to its delivery to the Fund. There also is the risk that the security will
not be issued or that the other party will not meet its obligation, in which
case the Fund loses the investment opportunity for the assets it has set aside
to pay for the security and any gain in the security's price.

VARIABLE RATE DEMAND OBLIGATIONS -- Variable rate demand obligations (VRDOs) are
floating rate securities that combine an interest in a long term municipal bond
with a right to demand payment before maturity from a bank or other financial
institution. If the bank or financial institution is unable to pay, the Fund may
lose money.

ILLIQUID INVESTMENTS -- The Fund may invest up to 15% of its assets in illiquid
securities that it cannot easily resell within seven days at current value or
that have contractual or legal restrictions on resale. If the Fund buys illiquid
securities it may be unable to quickly resell them or may be able to sell them
only at a price below current value.

12 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 13

DERIVATIVES -- Derivatives allow the Fund to increase or decrease its risk
exposure more quickly and efficiently than other types of instruments.
Derivatives are volatile and involve significant risks, including:

CREDIT RISK -- the risk that the counterparty (the party on the
other side of the transaction) on a derivative transaction will be
unable to honor its financial obligation to the Fund.

LEVERAGE RISK -- the risk associated with certain types of
investments or trading strategies (such as borrowing money to
increase the amount of investments) that relatively small market
movements may result in large changes in the value of an
investment. Certain investments or trading strategies that involve
leverage can result in losses that greatly exceed the amount
originally invested.

LIQUIDITY RISK -- the risk that certain securities may be
difficult or impossible to sell at the time that the seller would
like or at the price that the seller believes the security is
currently worth.

The Fund may use derivatives for hedging purposes including anticipatory hedges.
Hedging is a strategy in which the Fund uses a derivative to offset the risk
that other Fund holdings may decrease in value. While hedging can reduce losses,
it can also reduce or eliminate gains if the market moves in a different manner
than anticipated by the Fund or if the cost of the derivative outweighs the
benefit of the hedge. Hedging also involves the risk that changes in the value
of the derivative will not match those of the holdings being hedged as expected
by the Fund, in which case any losses on the holdings being hedged may not be
reduced. There can be no assurance that the Fund's hedging strategy will reduce
risk or that hedging transactions will be either available or cost effective.
The Fund is not required to use hedging and may choose not to do so.

INDEXED AND INVERSE FLOATING RATE SECURITIES -- The Fund may invest in
securities whose potential returns are directly related to changes in an
underlying index or interest rate, known as indexed securities. The return on
indexed securities will rise when the underlying index or interest rate rises
and fall when the index or interest rate falls. The Fund may also invest in

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 13
<PAGE> 14
[DETAILS ABOUT THE FUND ICON] Details About the Fund

securities whose return is inversely related to changes in an interest rate
(inverse floaters). In general, income on inverse floaters will decrease when
short term interest rates increase and increase when short term interest rates
decrease. Investments in inverse floaters may subject the Fund to the risks of
reduced or eliminated interest payments and losses of principal. In addition,
certain indexed securities and inverse floaters may increase or decrease in
value at a greater rate than the underlying interest rate, which effectively
leverages the Fund's investment. As a result, the market value of such
securities will generally be more volatile than that of fixed rate, tax exempt
securities. Both indexed securities and inverse floaters are derivative
securities and can be considered speculative.

BORROWING AND LEVERAGE -- The Fund may borrow for temporary emergency purposes
including to meet redemptions. Borrowing may exaggerate changes in the net asset
value of Fund shares and in the yield on the Fund's portfolio. Borrowing will
cost the Fund interest expense and other fees. The costs of borrowing may reduce
the Fund's return. Certain securities that the Fund buys may create leverage
including, for example, when issued securities, forward commitments and options.

STATEMENT OF ADDITIONAL INFORMATION
- --------------------------------------------------------------------------------

If you would like further information about the Fund, including how it invests,
please see the Statement of Additional Information.

14 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 15
Your Account [YOUR ACCOUNT ICON]

MERRILL LYNCH SELECT PRICING(SM) SYSTEM
- --------------------------------------------------------------------------------

The Fund offers four share classes, each with its own sales charge and expense
structure, allowing you to invest in the way that best suits your needs. Each
share class represents an ownership interest in the same investment portfolio.
When you choose your class of shares you should consider the size of your
investment and how long you plan to hold your shares. Your Merrill Lynch
Financial Consultant can help you determine which share class is best suited to
your personal financial goals.

For example, if you select Class A or D shares, you generally pay a sales charge
at the time of purchase. If you buy Class D shares, you also pay an ongoing
account maintenance fee of 0.10%. You may be eligible for a sales charge waiver.

If you select Class B or C shares, you will invest the full amount of your
purchase price, but you will be subject to a distribution fee of 0.25% on Class
B shares or 0.35% on Class C shares and an account maintenance fee of 0.25% on
both classes. Because these fees are paid out of the Fund's assets on an ongoing
basis, over time these fees increase the cost of your investment and may cost
you more than paying an initial sales charge. In addition, you may be subject to
a deferred sales charge when you sell Class B or C shares.

The Fund's shares are distributed by Merrill Lynch Funds Distributor, a division
of Princeton Funds Distributor, Inc., an affiliate of Merrill Lynch. The Fund is
a series of the Merrill Lynch California Municipal Series Trust.

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 15

<PAGE> 16

[YOUR ACCOUNT ICON] Your Account

The table below summarizes key features of the Merrill Lynch Select Pricing(SM)
System.
<TABLE>
<CAPTION>
CLASS A CLASS B CLASS C
- ---------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Availability Limited to certain Generally available Generally available
investors including: through Merrill Lynch. through Merrill Lynch.
- Current Class A Limited availability Limited availability
shareholders through other securities through other securities
- Participants in dealers. dealers.
certain Merrill Lynch
sponsored programs
- Certain affiliates of
Merrill Lynch.
- ---------------------------------------------------------------------------------------------------------------
Initial Sales Yes. Payable at time of No. Entire purchase No. Entire purchase
Charge? purchase. Lower sales price is invested in price is invested in
charges available for shares of the Fund. shares of the Fund.
larger investments.
- ---------------------------------------------------------------------------------------------------------------
Deferred Sales No. (May be charged for Yes. Payable if you Yes. Payable if you
Charge? purchases over $1 redeem within four years redeem within one year
million that are of purchase. of purchase.
redeemed within one
year.)
- ---------------------------------------------------------------------------------------------------------------
Account Maintenance No. 0.25% Account 0.25% Account
and Distribution Maintenance Fee 0.25% Maintenance Fee 0.35%
Fees? Distribution Fee. Distribution Fee.
- ---------------------------------------------------------------------------------------------------------------
Conversion to Class No. Yes, automatically after No.
D shares? approximately ten years.
- ---------------------------------------------------------------------------------------------------------------

<CAPTION>
CLASS D
<S> <C>
Availability Generally available
through Merrill Lynch.
Limited availability
through other securities
dealers.
- ----------------------------------------------------
Initial Sales Yes. Payable at time of
Charge? purchase. Lower sales
charges available for
larger investments.
- ----------------------------------------------------
Deferred Sales No. (May be charged for
Charge? purchases over $1
million that are
redeemed within one
year.)
- ----------------------------------------------------
Account Maintenance 0.10% Account
and Distribution Maintenance Fee No
Fees? Distribution Fee.
- ----------------------------------------------------
Conversion to Class No.
D shares?
- ----------------------------------------------------
</TABLE>

16 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 17
RIGHT OF ACCUMULATION -- permits you to pay the sales charge that would apply to
the cost or value (whichever is higher) of all shares you own in the Merrill
Lynch mutual funds that offer Select Pricing options.

LETTER OF INTENT -- permits you to pay the sales charge that would be applicable
if you add up all shares of Merrill Lynch Select Pricing System funds that you
agree to buy within a 13 month period. Certain restrictions apply.

CLASS A AND CLASS D SHARES -- INITIAL SALES CHARGE OPTIONS

If you select Class A or Class D shares, you will pay a sales charge at the time
of purchase.

<TABLE>
<CAPTION>
DEALER
COMPENSATION
AS A % OF AS A % OF AS A % OF
YOUR INVESTMENT OFFERING PRICE YOUR INVESTMENT* OFFERING PRICE
- -------------------------------------------------------------------------------------
<S> <C> <C> <C>
Less than $25,000 4.00% 4.17% 3.75%
- -------------------------------------------------------------------------------------
$25,000 but less than
$50,000 3.75% 3.90% 3.50%
- -------------------------------------------------------------------------------------
$50,000 but less than
$100,000 3.25% 3.36% 3.00%
- -------------------------------------------------------------------------------------
$100,000 but less than
$250,000 2.50% 2.56% 2.25%
- -------------------------------------------------------------------------------------
$250,000 but less than
$1,000,000 1.50% 1.52% 1.25%
- -------------------------------------------------------------------------------------
$1,000,000 and over** 0.00% 0.00% 0.00%
- -------------------------------------------------------------------------------------
</TABLE>

* Rounded to the nearest one-hundredth percent.

** If you invest $1,000,000 or more in Class A or Class D shares, you may not
pay an initial sales charge. However, if you redeem your shares within one
year after purchase, you may be charged a deferred sales charge. This charge
is 1% of the lesser of the original cost of the shares being redeemed or your
redemption proceeds.

No initial sales charge applies to Class A or Class D shares that you buy
through reinvestment of dividends or distributions.
A reduced or waived sales charge on a purchase of Class A or Class D shares may
apply for:

- Purchases under a RIGHT OF ACCUMULATION or LETTER OF INTENT.

- TMA(SM) Managed Trusts.

- Certain Merrill Lynch investment or central asset accounts.

- Purchases using proceeds from the sale of certain Merrill Lynch
closed-end funds under certain circumstances.

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 17
<PAGE> 18
[YOUR ACCOUNT ICON] Your Account

- Certain investors, including directors or trustees of Merrill
Lynch mutual funds and Merrill Lynch employees.

- Certain Merrill Lynch fee-based programs.

Only certain investors are eligible to buy Class A shares. Your Merrill Lynch
Financial Consultant can help you determine whether you are eligible to buy
Class A shares or to participate in any of these programs.

If you decide to buy shares under the initial sales charge alternative and you
are eligible to buy both Class A and Class D shares, you should buy Class A
since Class D shares are subject to a 0.10% account maintenance fee, while Class
A shares are not.

If you redeem Class A or Class D shares and within 30 days buy new shares of the
same class, you will not pay a sales charge on the new purchase amount. The
amount eligible for this "Reinstatement Privilege" may not exceed the amount of
your redemption proceeds. To exercise the privilege, contact your Merrill Lynch
Financial Consultant or the Fund's Transfer Agent at 1-800-MER-FUND.

CLASS B AND CLASS C SHARES -- DEFERRED SALES CHARGE OPTIONS

If you select Class B or Class C shares, you do not pay an initial sales charge
at the time of purchase. However, if you redeem your Class B shares within four
years after purchase, or your Class C shares within one year after purchase, you
may be required to pay a deferred sales charge. You will also pay distribution
fees of 0.25% for Class B shares and 0.35% for Class C shares and account
maintenance fees of 0.25% for Class B and Class C shares each year under
distribution plans that the Fund has adopted under Rule 12b-1. Because these
fees are paid out of the Fund's assets on an ongoing basis, over time these fees
increase the cost of your investment and may cost you more than paying an
initial sales charge. The Distributor uses the money that it receives from the
deferred sales charges and the distribution fees to cover the costs of
marketing, advertising and compensating the Merrill Lynch Financial Consultant
or other securities dealer who assists you in purchasing Fund shares.

18 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 19

Class B Shares

If you redeem Class B shares within four years after purchase, you may be
charged a deferred sales charge. The amount of the charge gradually decreases as
you hold your shares over time, according to the following schedule:

<TABLE>
<CAPTION>
YEARS SINCE PURCHASE SALES CHARGE*
- -------------------------------------------
<S> <C>
0 - 1 4.00%
- -------------------------------------------
1 - 2 3.00%
- -------------------------------------------
2 - 3 2.00%
- -------------------------------------------
3 - 4 1.00%
- -------------------------------------------
4 AND THEREAFTER 0.00%
- -------------------------------------------
</TABLE>

* The percentage charge will apply to the lesser of the original cost of the
shares being redeemed or the proceeds of your redemption. Shares acquired
through reinvestment of dividends or distributions are not subject to a
deferred sales charge. Not all Merrill Lynch funds have identical deferred
sales charge schedules. If you exchange your shares for shares of another
fund, the higher charge will apply.

The deferred sales charge relating to Class B shares may be reduced or waived in
certain circumstances, such as:

- Redemption in connection with participation in certain Merrill
Lynch fee-based programs.

- Withdrawals resulting from shareholder death or disability as
long as the waiver request is made within one year of death or
disability or if later, reasonably promptly following completion
of probate or in connection with involuntary termination of an
account in which Fund shares are held.

- Withdrawal through the Merrill Lynch Systematic Withdrawal Plan
of up to 10% per year of your Class B account value at the time
the plan is established.

Your Class B shares convert automatically into Class D shares approximately ten
years after purchase. Any Class B shares received through reinvestment of
dividends or distributions paid on converting shares will also convert at that
time. Class D shares are subject to lower annual expenses than Class B

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 19
<PAGE> 20
[YOUR ACCOUNT ICON] Your Account

shares. The conversion of Class B to Class D shares is not a taxable event for
Federal income tax purposes.

Different conversion schedules apply to Class B shares of different Merrill
Lynch mutual funds. For example, Class B shares of a fixed-income fund convert
approximately ten years after purchase compared to approximately eight years for
equity funds. If you acquire your Class B shares in an exchange from another
fund with a shorter conversion schedule, the Fund's ten year conversion schedule
will apply. If you exchange your Class B shares in the Fund for Class B shares
of a fund with a shorter conversion schedule, the other fund's conversion
schedule will apply. The length of time that you hold both the original and
exchanged Class B shares in both funds will count toward the conversion
schedule. The conversion schedule may be modified in certain other cases as
well.

Class C Shares

If you redeem Class C shares within one year after purchase, you may be charged
a deferred sales charge of 1.00%. The charge will apply to the lesser of the
original cost of the shares being redeemed or the proceeds of your redemption.
You will not be charged a deferred sales charge when you redeem shares that you
acquire through reinvestment of Fund dividends or distributions. The deferred
sales charge relating to Class C shares may be reduced or waived in connection
with participation in certain Merrill Lynch fee-based programs, involuntary
termination of an account in which Fund shares are held and withdrawals through
the Merrill Lynch Systematic Withdrawal Plan.

Class C shares do not offer a conversion privilege.

HOW TO BUY, SELL, TRANSFER AND EXCHANGE SHARES
- --------------------------------------------------------------------------------

The chart below summarizes how to buy, sell, transfer and exchange shares
through Merrill Lynch or other securities dealers. You may also buy shares
through the Transfer Agent. To learn more about buying shares through the
Transfer Agent, call 1-800-MER-FUND. Because the selection of a mutual fund
involves many considerations, your Merrill Lynch Financial Consultant may help
you with this decision.

20 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 21

(The minimums for initial investments may be waived under
certain circumstances.)
-------------------------------------------------------------------------------------------------------
Have your Merrill Lynch Financial The price of your shares is based on the next calculation of
Consultant or securities dealer sub- net asset value after your order placed. Any purchase orders
mit your purchase order placed within fifteen minutes after the close of business on
the New York Stock Exchange will be priced at the net asset
value determined that day.

Purchase orders placed after that time will be priced at the
net asset value determined on the next business day. The
Fund may reject any order to buy shares and may suspend the
sale of shares at any time. Merrill Lynch may charge a
processing fee to confirm a purchase. This fee is currently
$5.35.
-------------------------------------------------------------------------------------------------------
Or contact the Transfer Agent To purchase shares directly, call the Transfer Agent at
1-800-MER-FUND and request a purchase order. Mail the
completed purchase order to the Transfer Agent at the
address on the inside back cover of this Prospectus.
- --------------------------------------------------------------------------------------------------------------------------------
ADD TO YOUR Purchase additional shares The minimum investment for additional purchases is $50.
INVESTMENT
(The minimum for additional purchases may be waived under
certain circumstances.)
-------------------------------------------------------------------------------------------------------
Acquire additional shares through the All dividends and capital gains distributions are
automatic dividend reinvestment plan automatically reinvested without a sales charge.
-------------------------------------------------------------------------------------------------------
Participate in the automatic invest- You may invest a specific amount on a periodic basis through
ment plan certain Merrill Lynch investment or central asset accounts.
- --------------------------------------------------------------------------------------------------------------------------------
TRANSFER SHARES TO Transfer to a participating You may transfer your Fund shares only to another securities
ANOTHER SECURITIES securities dealer dealer that has entered into an agreement with Merrill
DEALER Lynch. All shareholder services will be available for the
transferred shares. You may only purchase additional shares
of funds previously owned before the transfer. All future
trading of these assets must be coordinated by the receiving
firm.
- --------------------------------------------------------------------------------------------------------------------------------
</TABLE>

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 21
<PAGE> 22

[YOUR ACCOUNT ICON] Your Account

<TABLE>
<CAPTION>
IF YOU WANT TO YOUR CHOICES INFORMATION IMPORTANT FOR YOU TO KNOW
- --------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
TRANSFER SHARES TO Transfer to a non-participating You must either:
ANOTHER SECURITIES securities dealer - Transfer your shares to an account with the Transfer
DEALER (CONTINUED) Agent; or
- Sell your shares.
- --------------------------------------------------------------------------------------------------------------------------------
SELL YOUR SHARES Have your Merrill Lynch Financial The price of your shares is based on the next calculation of
Consultant or securities dealer net asset value after your order is placed. For your
submit your sales order redemption request to be priced at the net asset value on
the day of your request, you must submit your request to
your dealer within fifteen minutes after that day's close of
business on the New York Stock Exchange (generally 4:00 p.m.
Eastern time). Any redemption request placed after that time
will be priced at the net asset value at the close of
business on the next business day. Dealers must submit
redemption requests to the Fund not more than thirty minutes
after the close of business on the New York Stock Exchange
on the day the request was received.

Securities dealers, including Merrill Lynch, may charge a
fee to process a redemption of shares. Merrill Lynch
currently charges a fee of $5.35. No processing fee is
charged if you redeem shares directly through the Transfer
Agent.

The Fund may reject an order to sell shares under certain
circumstances.
-------------------------------------------------------------------------------------------------------
Sell through the Transfer Agent You may sell shares held at the Transfer Agent by writing to
the Transfer Agent at the address on the inside back cover
of this prospectus. All shareholders on the account must
sign the letter and signatures must be guaranteed. If you
hold stock certificates, return the certificates with the
letter. The Transfer Agent will normally mail redemption
proceeds within seven days following receipt of a properly
completed request. If you make a redemption request before
the Fund has collected payment for the purchase of shares,
the Fund or the Transfer Agent may delay mailing your
proceeds. This delay will usually not exceed ten days.

If you hold share certificates, they must be delivered to
the Transfer Agent before they can be converted. Check with
the Transfer Agent or your Merrill Lynch Financial
Consultant for details.
- --------------------------------------------------------------------------------------------------------------------------------
</TABLE>

22 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 23

<TABLE>
<CAPTION>
IF YOU WANT TO YOUR CHOICES INFORMATION IMPORTANT FOR YOU TO KNOW
- --------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
SELL SHARES Participate in the Fund's Systematic You can choose to receive systematic payments from your Fund
SYSTEMATICALLY Withdrawal Plan account either by check or through direct deposit to your
bank account on a monthly or quarterly basis. If you have a
Merrill Lynch CMA(R), CBA(R) or Retirement Account you can
arrange for systematic redemptions of a fixed dollar amount
on a monthly, bi-monthly, quarterly, semi-annual or annual
basis, subject to certain conditions. Under either method
you must have dividends and other distributions
automatically reinvested. For Class B and C shares your
total annual withdrawals cannot be more than 10% per year of
the value of your shares at the time your plan is
established. The deferred sales charge is waived for
systematic redemptions. Ask your Merrill Lynch Financial
Consultant for details.
- --------------------------------------------------------------------------------------------------------------------------------
EXCHANGE YOUR Select the fund into which you want You can exchange your shares of the Fund for shares of many
SHARES to exchange. Be sure to read that other Merrill Lynch mutual funds. You must have held the
fund's prospectus shares used in the exchange for at least 15 calendar days
before you can exchange to another fund.

Each class of Fund shares is generally exchangeable for
shares of the same class of another fund. If you own Class A
shares and wish to exchange into a fund in which you have no
Class A shares, you will exchange into Class D shares.

Some of the Merrill Lynch mutual funds impose a different
initial or deferred sales charge schedule. If you exchange
Class A or D shares for shares of a fund with a higher
initial sales charge than you originally paid, you will be
charged the difference at the time of exchange. If you
exchange Class B shares for shares of a fund with a
different deferred sales charge schedule, the higher
schedule will apply. The time you hold Class B or C shares
in both funds will count when determining your holding
period for calculating a deferred sales charge at
redemption. If you exchange Class A or D shares for money
market fund shares, you will receive Class A shares of
Summit Cash Reserves Fund. Class B or C shares of the Fund
will be exchanged for Class B shares of Summit.

Although there is currently no limit on the number of
exchanges that you can make, the exchange privilege may be
modified or terminated at any time in the future.
- --------------------------------------------------------------------------------------------------------------------------------
</TABLE>

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 23
<PAGE> 24

[YOUR ACCOUNT ICON] Your Account

NET ASSET VALUE -- the market value of the Fund's total assets after deducting
liabilities, divided by the number of shares outstanding.

HOW SHARES ARE PRICED
- --------------------------------------------------------------------------------

When you buy shares, you pay the NET ASSET VALUE, plus any applicable sales
charge. This is the offering price. Shares are also redeemed at their net asset
value, minus any applicable deferred sales charge. The Fund calculates its net
asset value (generally by using market quotations) each day the New York Stock
Exchange is open, fifteen minutes after the close of business on the Exchange
(the Exchange generally closes at 4:00 p.m. Eastern time). The net asset value
used in determining your price is the next one calculated after your purchase or
redemption order is placed.

Generally, Class A shares will have the highest net asset value because that
class has the lowest expenses, and Class D shares will have a higher net asset
value than Class B or Class C shares. Also dividends paid on Class A and Class D
shares will generally be higher than dividends paid on Class B and Class C
shares because Class A and Class D shares have lower expenses.

PARTICIPATION IN MERRILL LYNCH FEE-BASED PROGRAMS
- --------------------------------------------------------------------------------

If you participate in certain fee-based programs offered by Merrill Lynch, you
may be able to buy Class A shares at net asset value, including by exchanges
from other share classes. Sales charges on the shares being exchanged may be
reduced or waived under certain circumstances.

You generally cannot transfer shares held through a fee-based program into
another account. Instead, you will have to redeem your shares held through the
program and purchase shares of another class, which may be subject to
distribution and account maintenance fees. This may be a taxable event and you
will pay any applicable sales charges.

If you leave one of these programs, your shares may be redeemed or automatically
exchanged into another class of Fund shares or into a money market fund. The
class you receive may be the class you originally owned when you entered the
program, or in certain cases, a different class. If the exchange is into Class B
shares, the period before conversion to Class D shares may be modified. Any
redemption or exchange will be at net asset value. However, if you participate
in the program for less than a specified period, you may be charged a fee in
accordance with the terms of the program.

24 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 25
DIVIDENDS -- income paid to shareholders. Dividends may be reinvested in
additional Fund shares as they are paid.

DISTRIBUTIONS -- capital gains paid to shareholders. Distributions may be
reinvested in additional Fund shares as they are paid.

Details about these features and the relevant charges are included in the client
agreement for each fee-based program and are available from your Merrill Lynch
Financial Consultant.

DIVIDENDS, CAPITAL GAINS AND TAXES
- --------------------------------------------------------------------------------

The Fund will distribute any net investment income monthly and any net realized
long or short term capital gains at least annually. The Fund may also pay a
special distribution at the end of the calendar year to comply with Federal tax
requirements. If your account is with Merrill Lynch and you would like to
receive DIVIDENDS and DISTRIBUTIONS in cash, contact your Merrill Lynch
Financial Consultant. If your account is with the Transfer Agent and you would
like to receive dividends and distributions in cash, contact the Transfer Agent.

TAXES

To the extent that the dividends distributed by the Fund are from municipal bond
interest income, they are exempt from Federal income tax. However, certain
investors may be subject to alternative minimum tax on dividends received from
the Fund. To the extent that the dividends distributed by the Fund are derived
from California municipal bond interest income, they are also exempt from
California income tax. Interest income from other investments may produce
taxable distributions. If you are subject to income tax in a state other than
California, the dividends derived from California municipal bonds will not be
exempt from income tax in that state. Capital gain dividends are taxed at the
same rates as ordinary income for California income tax purposes.

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 25
<PAGE> 26

[YOUR ACCOUNT ICON] Your Account

"BUYING A DIVIDEND"

You may want to avoid buying shares shortly before the Fund pays a dividend or
distribution, although the impact on you will be significantly less than if you
were invested in a fund paying fully taxable dividends. The reason? If you buy
shares when a fund has realized but not yet distributed taxable income (if any)
or capital gains, you will pay the full price for the shares and then receive a
portion of the price back in the form of a distribution all or, more likely,
part of which could be taxable. Before investing you may want to consult your
tax adviser.

Generally, within 60 days after the end of the Fund's taxable year, the Trust
will tell you the amount of exempt interest dividends, ordinary income dividends
or capital gain dividends you received that year. Capital gain dividends are
taxable as long term capital gains to you regardless of how long you have held
your shares. The tax treatment of distributions from the Fund is the same
whether you choose to receive distributions in cash or to have them reinvested
in shares of the Fund.

By law, the Fund must withhold 31% of your distributions and proceeds if you
have not provided a taxpayer identification number or social security number.

If you redeem Fund shares or exchange them for shares of another fund, any gain
on the transaction may be subject to Federal income tax.

This section summarizes some of the consequences of an investment in the Fund
under current Federal and California income tax laws. It is not a substitute for
personal tax advice. Consult your personal tax adviser about the potential tax
consequences to you of an investment in the Fund under all applicable tax laws.

26 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND

<PAGE> 27
Management of the Fund [MANAGEMENT OF THE FUND ICON]

FUND ASSET MANAGEMENT
- --------------------------------------------------------------------------------

Fund Asset Management, the Fund's Manager, manages the Fund's investments and
its business operations under the overall supervision of the Trust's Board of
Trustees. The Manager has the responsibility for making all investment
decisions for the Fund. The Fund pays the Manager a fee at the annual rate of
0.55% of the average daily net assets of the Fund for the first $500 million;
0.525% of the average daily net assets from $500 million to $1 billion; and
0.50% of the average daily net assets above $1 billion. For the fiscal year
ended August 31, 1998, the fee payable to the Manager from the Fund was equal
to 0.55% of the Fund's average daily net assets, but the Manager voluntarily
waived a portion of the management fee due for the fiscal year. The Manager may
discontinue or reduce this waiver of fees at any time without notice. See the
Fees and Expenses table on page 6.

Fund Asset Management is a part of the Merrill Lynch Asset Management Group. The
Asset Management Group had approximately $499 billion in investment company and
other portfolio assets under management as of November 1998. This amount
includes assets managed for Merrill Lynch affiliates.

A NOTE ABOUT YEAR 2000

Many computer systems were designed using only two digits to designate years.
These systems may not be able to distinguish the Year 2000 from the Year 1900
(commonly known as the "Year 2000 Problem"). The Fund could be adversely
affected if the computer systems used by the Fund's management or other Fund
service providers do not properly address this problem before January 1, 2000.
The Fund's management expects to have addressed this problem before then, and
does not anticipate that the services it provides will be adversely affected.
The Fund's other service providers have told the Fund management that they also
expect to resolve the Year 2000 Problem, and the Fund management will continue
to monitor the situation as the Year 2000 approaches. However, if the problem
has not been fully addressed, the Fund could be negatively affected. The Year
2000 Problem could also have a negative impact on the issuers of securities in
which the Fund invests, and this could hurt the Fund's investment returns.

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 27

<PAGE> 28
[MANAGEMENT OF THE FUND ICON] Management of the Fund

FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------

The Financial Highlights table is intended to help you understand the Fund's
financial performance for the past five years. Certain information reflects
financial results for a single Fund share. The total returns in the table
represent the rate an investor would have earned on an investment in the Fund
(assuming reinvestment of all dividends and distributions). This information has
been audited by Deloitte & Touche LLP, whose report, along with the Fund's
financial statements are included in the Fund's annual report to shareholders,
which is available upon request.
<TABLE>
<CAPTION>
CLASS A
----------------------------------------------------------------
FOR THE YEAR ENDED AUGUST 31,
INCREASE (DECREASE) IN ----------------------------------------------------------------
NET ASSET VALUE: 1998 1997 1996 1995 1994
- -----------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE:
- -----------------------------------------------------------------------------------------------------
Net asset value, beginning of
year $ 10.25 $ 9.84 $ 9.65 $ 9.54 $ 10.23
- -----------------------------------------------------------------------------------------------------
Investment income -- net .49 .50 .52 .52 .51
- -----------------------------------------------------------------------------------------------------
Realized and unrealized gain
(loss) on investments -- net .29 .41 .19 .11 (.65)
- -----------------------------------------------------------------------------------------------------
Total from investment
operations .78 .91 .71 .63 (.14)
- -----------------------------------------------------------------------------------------------------
Less dividends and
distributions:
Investment income -- net (.49) (.50) (.52) (.52) (.51)
In excess of realized gain
on investments -- net -- -- -- -- (.04)
- -----------------------------------------------------------------------------------------------------
Total dividends and
distributions (.49) (.50) (.52) (.52) (.55)
- -----------------------------------------------------------------------------------------------------
Net asset value, end of year $ 10.54 $ 10.25 $ 9.84 $ 9.65 $ 9.54
- -----------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
- -----------------------------------------------------------------------------------------------------
Based on net asset value per
share 7.79% 9.50% 7.44% 6.94% (1.44)%
- -----------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
- -----------------------------------------------------------------------------------------------------
Expenses, net of reimbursement .81% .63% .49% .47% .33%
- -----------------------------------------------------------------------------------------------------
Expenses .82% .89% .85% .87% .96%
- -----------------------------------------------------------------------------------------------------
Investment income -- net 4.74% 5.03% 5.20% 5.53% 5.16%
- -----------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
- -----------------------------------------------------------------------------------------------------
Net assets, end of year (in
thousands) $ 12,520 $ 12,438 $ 14,183 $ 14,204 $ 15,946
- -----------------------------------------------------------------------------------------------------
Portfolio turnover 82.91% 67.28% 87.77% 61.53% 93.04%
- -----------------------------------------------------------------------------------------------------

<CAPTION>
CLASS B
----------------------------------------------------------------
FOR THE YEAR ENDED AUGUST 31,
INCREASE (DECREASE) IN ----------------------------------------------------------------
NET ASSET VALUE: 1998 1997 1996 1995 1994
- -----------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE
- -----------------------------------------------------------------------------------------------------
Net asset value, beginning of
year $ 10.25 $ 9.84 $ 9.65 $ 9.54 $ 10.23
- -----------------------------------------------------------------------------------------------------
Investment income -- net .44 .45 .47 .48 .46
- -----------------------------------------------------------------------------------------------------
Realized and unrealized gain
(loss) on investments -- net .30 .41 .19 .11 (.65)
- -----------------------------------------------------------------------------------------------------
Total from investment
operations .74 .86 .66 .59 (.19)
- -----------------------------------------------------------------------------------------------------
Less dividends and
distributions:
Investment income -- net (.44) (.45) (.47) (.48) (.46)
In excess of realized gain
on investments -- net -- -- -- -- (.04)
- -----------------------------------------------------------------------------------------------------
Total dividends and
distributions (.44) (.45) (.47) (.48) (.50)
- -----------------------------------------------------------------------------------------------------
Net asset value, end of year $ 10.55 $ 10.25 $ 9.84 $ 9.65 $ 9.54
- -----------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:*
- -----------------------------------------------------------------------------------------------------
Based on net asset value per
share 7.35% 8.95% 6.89% 6.38% (1.93)%
- -----------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
- -----------------------------------------------------------------------------------------------------
Expenses, net of reimbursement 1.31% 1.14% .99% .97% .83%
- -----------------------------------------------------------------------------------------------------
Expenses 1.32% 1.39% 1.36% 1.38% 1.48%
- -----------------------------------------------------------------------------------------------------
Investment income -- net 4.24% 4.52% 4.69% 5.02% 4.67%
- -----------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
- -----------------------------------------------------------------------------------------------------
Net assets, end of year (in
thousands) $ 66,805 $ 69,320 $ 73,292 $ 71,670 $ 74,982
- -----------------------------------------------------------------------------------------------------
Portfolio turnover 82.91% 67.28% 87.77% 61.53% 93.04%
- -----------------------------------------------------------------------------------------------------
</TABLE>

* Total investment returns exclude the effects of sales loads.

28 MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 29

FINANCIAL HIGHLIGHTS (CONCLUDED)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
CLASS C
-------------------------------------------------
FOR THE PERIOD
FOR THE YEAR ENDED OCT. 21,
AUGUST 31, 1994+
INCREASE (DECREASE) IN ------------------------------ TO AUGUST 31,
NET ASSET VALUE: 1998 1997 1996 1995
- -------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE:
- -------------------------------------------------------------------------------------------------------------
Net asset value, beginning of period $ 10.24 $ 9.84 $ 9.64 $ 9.19
- -------------------------------------------------------------------------------------------------------------
Investment income -- net .43 .44 .46 .39
- -------------------------------------------------------------------------------------------------------------
Realized and unrealized gain on investments -- net .30 .40 .20 .45
- -------------------------------------------------------------------------------------------------------------
Total from investment operations .73 .84 .66 .84
- -------------------------------------------------------------------------------------------------------------
Less dividends from investment income -- net (.43) (.44) (.46) (.39)
- -------------------------------------------------------------------------------------------------------------
Net asset value, end of period $ 10.54 $ 10.24 $ 9.84 $ 9.64
- -------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:**
- -------------------------------------------------------------------------------------------------------------
Based on net asset value per share 7.25% 8.74% 6.90% 9.38%#
- -------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
- -------------------------------------------------------------------------------------------------------------
Expenses, net of reimbursement 1.42% 1.24% 1.10% 1.09%*
- -------------------------------------------------------------------------------------------------------------
Expenses 1.42% 1.49% 1.46% 1.49%*
- -------------------------------------------------------------------------------------------------------------
Investment income -- net 4.13% 4.42% 4.59% 4.76%*
- -------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
- -------------------------------------------------------------------------------------------------------------
Net assets, end of period (in thousands) $ 4,537 $ 5,361 $ 4,901 $ 1,778
- -------------------------------------------------------------------------------------------------------------
Portfolio turnover 82.91% 67.28% 87.77% 61.53%
- -------------------------------------------------------------------------------------------------------------

<CAPTION>
CLASS D
-------------------------------------------------
FOR THE PERIOD
FOR THE YEAR ENDED OCT. 21,
AUGUST 31, 1994+
INCREASE (DECREASE) IN ------------------------------ TO AUGUST 31,
NET ASSET VALUE: 1998 1997 1996 1995
<S> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE:
- -------------------------------------------------------------------------------------------------------------
Net asset value, beginning of period $ 10.26 $ 9.85 $ 9.65 $ 9.19
- -------------------------------------------------------------------------------------------------------------
Investment income -- net .48 .49 .51 .44
- -------------------------------------------------------------------------------------------------------------
Realized and unrealized gain on investments -- net .29 .41 .20 .46
- -------------------------------------------------------------------------------------------------------------
Total from investment operations .77 .90 .71 .90
- -------------------------------------------------------------------------------------------------------------
Less dividends from investment income -- net (.48) (.49) (.51) (.44)
- -------------------------------------------------------------------------------------------------------------
Net asset value, end of period $ 10.55 $ 10.26 $ 9.85 $ 9.65
- -------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:**
- -------------------------------------------------------------------------------------------------------------
Based on net asset value per share 7.68% 9.39% 7.44% 9.99%#
- -------------------------------------------------------------------------------------------------------------
RATIOS TO AVERAGE NET ASSETS:
- -------------------------------------------------------------------------------------------------------------
Expenses, net of reimbursement .91% .74% .59% .57%*
- -------------------------------------------------------------------------------------------------------------
Expenses .92% .98% .95% .97%*
- -------------------------------------------------------------------------------------------------------------
Investment income -- net 4.63% 4.92% 5.09% 5.33%*
- -------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DATA:
- -------------------------------------------------------------------------------------------------------------
Net assets, end of period (in thousands) $ 10,124 $ 4,939 $ 4,304 $ 1,845
- -------------------------------------------------------------------------------------------------------------
Portfolio turnover 82.91% 67.28% 87.77% 61.53%
- -------------------------------------------------------------------------------------------------------------
</TABLE>

<TABLE>
<C> <S>
* Annualized.
** Total investment returns exclude the effects of sales loads.
+ Commencement of operations.
# Aggregate total investment return.
</TABLE>

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND 29
<PAGE> 30

(This page intentionally left blank)

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 31

[ML POTENTIAL INVESTORS CHART]

<TABLE>
<S> <C>
POTENTIAL
INVESTORS
Open an account (two options).
1 2

MERRILL LYNCH TRANSFER AGENT
FINANCIAL CONSULTANT
OR SECURITIES DEALER FINANCIAL DATA SERVICES, INC.
P.O. Box 45289
Advises shareholders on their Fund investments. Jacksonville, Florida 32232-5289
Performs recordkeeping and reporting services.

DISTRIBUTOR

MERRILL LYNCH FUNDS DISTRIBUTOR,
A DIVISION OF PRINCETON FUNDS DISTRIBUTOR, INC.
P.O. Box 9081
Princeton, New Jersey 08543-9081

Arranges for the sale of Fund shares.

COUNSEL THE FUND CUSTODIAN

BROWN & WOOD LLP The Board of Trustees THE BANK OF NEW YORK
One World Trade Center oversees the Fund. 90 Washington Street,
New York, New York 10048-0557 12th Floor
New York, New York 10286
Provides legal advice to the Fund.
Holds the Fund's assets for safekeeping.

INDEPENDENT AUDITORS INVESTMENT ADVISER

DELOITTE & TOUCHE LLP FUND ASSET MANAGEMENT, L.P.
117 Campus Drive
Princeton, New Jersey 08540-6400 ADMINISTRATIVE OFFICES
800 Scudders Mill Road
Audits the financial Plainsboro, New Jersey 08536
statements of the Fund on behalf of
the shareholders. MAILING ADDRESS
P.O. Box 9011
Princeton, New Jersey 08543-9011

TELEPHONE NUMBER
1-800-MER-FUND

Manages the Fund's day-to-day activities.

</TABLE>

MERRILL LYNCH CALIFORNIA INSURED MUNICIPAL BOND FUND
<PAGE> 32
For More Information [FOR MORE INFORMATION ICON]

SHAREHOLDER REPORTS

Additional information about the Fund's investments is available in the Fund's
annual and semi-annual reports to shareholders. In the Fund's annual report you
will find a discussion of the market conditions and investment strategies that
significantly affected the Fund's performance during its last fiscal year. You
may obtain these reports at no cost by calling 1-800-MER-FUND.

The Fund will send you one copy of each shareholder report and certain other
mailings, regardless of the number of Fund accounts you have. To receive
separate shareholder reports for each account, call your Merrill Lynch Financial
Consultant or write to the Transfer Agent at its mailing address. Include your
name, address, tax identification number and Merrill Lynch brokerage or mutual
fund account number. If you have any questions, please call your Merrill Lynch
Financial Consultant or the Transfer Agent at 1-800-MER-FUND.

STATEMENT OF ADDITIONAL INFORMATION

The Fund's Statement of Additional Information contains further information
about the Fund and is incorporated by reference (legally considered to be part
of this prospectus). You may request a free copy by writing the Fund at
Financial Data Services, Inc., P.O. Box 45289, Jacksonville, Florida 32232-5289
or by calling 1-800-MER-FUND.

Contact your Merrill Lynch Financial Consultant or the Fund at the telephone
number or address indicated above, if you have any questions.

Information about the Fund (including the Statement of Additional Information)
can be reviewed and copied at the SEC's Public Reference Room in Washington,
D.C. Call 1-800-SEC-0330 for information on the operation of the public
reference room. This information is also available on the SEC's Internet site at
http://www.sec.gov and copies may be obtained upon payment of a duplicating fee
by writing the Public Reference Section of the SEC, Washington, D.C. 20549-6009.

YOU SHOULD RELY ONLY ON THE INFORMATION CONTAINED IN THIS PROSPECTUS. NO ONE IS
AUTHORIZED TO PROVIDE YOU WITH INFORMATION THAT IS DIFFERENT FROM INFORMATION
CONTAINED IN THIS PROSPECTUS.

Investment Company Act file #811-4264
Code #16574-12-98
(C) Fund Asset Management, L.P.

PROSPECTUS

[MERRILL LYNCH LOGO]

Merrill Lynch
California Insured
Municipal Bond Fund
of Merrill Lynch California
Municipal Series Trust

[MERRILL LYNCH ARTWORK]

December 29, 1998

<PAGE> 33

STATEMENT OF ADDITIONAL INFORMATION

MERRILL LYNCH CALIFORNIA INSURED
MUNICIPAL BOND FUND
OF MERRILL LYNCH CALIFORNIA MUNICIPAL SERIES TRUST

P.O. Box 9011, Princeton, New Jersey 08543-9011 - Phone No. (609) 282-2800
------------------------
Merrill Lynch California Insured Municipal Bond Fund (the "Fund"), is a
series of Merrill Lynch California Municipal Series Trust (the "Trust"), a
non-diversified, open-end investment company organized as a Massachusetts
business trust. The investment objective of the Fund is to provide shareholders
with as high a level of income exempt from Federal and California income taxes
as is consistent with prudent investment management. The Fund seeks to achieve
its objective while providing investors with the opportunity to invest primarily
in a diversified portfolio of long-term obligations issued by or on behalf of
California, its political subdivisions, agencies and instrumentalities and
obligations of other qualifying issuers, such as issuers located in Puerto Rico,
the U.S. Virgin Islands and Guam, which pay interest exempt, in the opinion of
bond counsel to the issuer, from Federal and California income taxes. Under
normal circumstances, at least 80% of the Fund's total assets will be invested
in long-term municipal bonds that are covered by insurance and at least 65% of
the Fund's assets will be invested in insured California municipal bonds. The
Fund may invest in certain tax-exempt securities classified as "private activity
bonds" that may subject certain investors in the Fund to an alternative minimum
tax. At times, the Fund may seek to hedge its portfolio through the use of
futures transactions and options. There can be no assurance that the investment
objective of the Fund will be realized. For more information on the Fund's
investment objective and policies, see "Investment Objective and Policies."

Pursuant to the Merrill Lynch Select PricingSM System, the Fund offers four
classes of shares, each with a different combination of sales charges, ongoing
fees and other features. The Merrill Lynch Select PricingSM System permits an
investor to choose the method of purchasing shares that the investor believes is
most beneficial given the amount of the purchase, the length of time the
investor expects to hold the shares and other relevant circumstances. See
"Purchase of Shares."
------------------------
This Statement of Additional Information of the Fund is not a prospectus
and should be read in conjunction with the Prospectus of the Fund, dated
December 29, 1998 (the "Prospectus"), which has been filed with the Securities
and Exchange Commission (the "Commission") and can be obtained, without charge,
by calling (800) 637-3863 or by writing the Fund at the above address. The
Prospectus is incorporated by reference into this Statement of Additional
Information, and this Statement of Additional Information is incorporated by
reference into the Prospectus. The Fund's audited financial statements are
incorporated in this Statement of Additional Information by reference to its
1998 annual report to shareholders. You may request a copy of the annual report
at no charge by calling (800) 456-4587 ext. 789 between 8:00 a.m. and 8:00 p.m.
on any business day.
------------------------

FUND ASSET MANAGEMENT -- MANAGER
MERRILL LYNCH FUNDS DISTRIBUTOR -- DISTRIBUTOR
------------------------
The date of this Statement of Additional Information is December 29, 1998.
<PAGE> 34

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Investment Objective and Policies........................... 2
General................................................... 2
Portfolio Insurance....................................... 3
Risk Factors and Special Considerations Relating to
Municipal Bonds........................................ 5
Description of Municipal Bonds............................ 6
Financial Futures Transactions and Options................ 10
Description of Temporary Investments...................... 14
Investment Restrictions................................... 15
Portfolio Turnover........................................ 17
Management of the Trust..................................... 17
Trustees and Officers..................................... 17
Compensation of Trustees.................................. 19
Management and Advisory Arrangements...................... 19
Code of Ethics............................................ 21
Purchase of Shares.......................................... 21
Initial Sales Charge Alternatives -- Class A and Class D
Shares................................................. 22
Deferred Sales Charge Alternatives -- Class B and Class C
Shares................................................. 26
Distribution Plans........................................ 29
Limitations on the Payment of Deferred Sales Charges...... 30
Redemption of Shares........................................ 31
Redemption................................................ 32
Repurchase................................................ 32
Reinstatement Privilege -- Class A and Class D Shares..... 32
Pricing of Shares........................................... 33
Determination of Net Asset Value.......................... 33
Computation of Offering Price Per Share................... 34
Portfolio Transactions...................................... 34
Transactions in Portfolio Securities...................... 34
Shareholder Services........................................ 36
Investment Account........................................ 36
Exchange Privilege........................................ 36
Fee-Based Programs........................................ 38
Automatic Investment Plans................................ 39
Automatic Dividend Program................................ 39
Systematic Withdrawal Plans............................... 39
Distributions and Taxes..................................... 40
Dividends and Distributions............................... 40
Taxes..................................................... 41
Tax Treatment of Options and Futures Transactions......... 43
Performance Data............................................ 44
General Information......................................... 46
Description of Shares..................................... 46
Independent Auditors...................................... 47
Custodian................................................. 47
Transfer Agent............................................ 47
Legal Counsel............................................. 47
Reports to Shareholders................................... 48
Shareholder Inquiries..................................... 48
Additional Information.................................... 48
Financial Statements........................................ 48
Appendix I -- Economic and Financial Conditions in
California................................................ I-1
Appendix II -- Ratings of Municipal Bonds................... II-1
</TABLE>
<PAGE> 35

INVESTMENT OBJECTIVE AND POLICIES

The investment objective of the Fund is to provide shareholders with as
high a level of income exempt from Federal and California income taxes as is
consistent with prudent investment management. The Fund seeks to achieve its
objective by investing primarily in a portfolio of long-term obligations issued
by or on behalf of the State of California, its political subdivisions, agencies
and instrumentalities and obligations of other qualifying issuers, such as
issuers located in Puerto Rico, the U.S. Virgin Islands and Guam, which pay
interest exempt, in the opinion of bond counsel to the issuer, from Federal and
California income taxes. Obligations exempt from Federal income taxes are
referred to herein as "Municipal Bonds," and obligations exempt from Federal and
California income taxes are referred to as "California Municipal Bonds." Unless
otherwise indicated, references to Municipal Bonds shall be deemed to include
California Municipal Bonds. Under normal circumstances, at least 80% of the
Fund's total assets will be invested in Municipal Bonds which are covered by
insurance guaranteeing the timely payment of principal at maturity and interest
and at least 65% of the Fund's total assets will be invested in insured
California Municipal Bonds. The investment objective as set forth in the first
sentence of this paragraph is a fundamental policy and may not be changed
without a vote of a majority of the outstanding shares of the Fund. See "How the
Fund Invests" in the Prospectus for a general discussion of the Fund's goals,
main investment strategies and main risks.

GENERAL

Under normal circumstances, except when acceptable securities are
unavailable as determined by Fund Asset Management, L.P. (the "Manager" or
"FAM"), the Fund's manager, the Fund will invest at least 80% of its total
assets in Municipal Bonds that are covered by insurance guaranteeing the timely
payment of principal at maturity and interest and at least 65% of its total
assets in California Municipal Bonds that are covered by insurance. The value of
bonds and other fixed-income obligations may fall when interest rates rise and
rise when interest rates fall. In general, bonds and other fixed-income
obligations with longer maturities will be subject to greater volatility
resulting from interest rate fluctuations than will similar obligations with
shorter maturities. Under normal conditions, it is generally anticipated that
the Fund's average weighted maturity will be in excess of ten years. For
temporary periods or to provide liquidity, the Fund has the authority to invest
as much as 35% of its total assets in tax-exempt or taxable money market
obligations with a maturity of one year or less (such short-term obligations
being referred to herein as "Temporary Investments"), except that taxable
Temporary Investments shall not exceed 20% of the Fund's net assets.

The Fund may also invest in variable rate demand obligations ("VRDOs") and
VRDOs in the form of participation interests ("Participating VRDOs") in variable
rate tax-exempt obligations held by a financial institution. See "Description of
Temporary Investments." The Fund's hedging strategies, which are described in
more detail under "Financial Futures Transactions and Options," are not
fundamental policies and may be modified by the Trustees of the Trust without
the approval of the Fund's shareholders.

At least 80% of the Municipal Bonds purchased by the Fund will be what are
commonly referred to as "investment grade" securities, which are obligations
rated at the time of purchase within the four highest quality ratings as
determined by either Moody's Investors Service, Inc. ("Moody's") (currently Aaa,
Aa, A and Baa), Standard & Poor's ("S&P") (currently AAA, AA, A and BBB) or
Fitch IBCA, Inc. ("Fitch") (currently AAA, AA, A and BBB). If unrated, such
securities will possess creditworthiness comparable, in the opinion of the
Manager, to other obligations in which the Fund may invest.

The Fund may invest up to 20% of its total assets in Municipal Bonds that
are rated below Baa by Moody's or below BBB by S&P or Fitch or which, in the
Manager's judgment, possess similar credit characteristics. Such securities,
sometimes referred to as "high yield" or "junk" bonds, are predominantly
speculative with respect to the capacity to pay interest and repay principal in
accordance with the terms of the security and generally involve a greater
volatility of price than securities in higher rating categories. See
"Description of Municipal Bonds -- 'High Yield' or 'Junk' Bonds." The Fund does
not intend to purchase debt securities that are in default or which the Manager
believes will be in default.

2
<PAGE> 36

Certain Municipal Bonds may be entitled to the benefits of letters of
credit or similar credit enhancements issued by financial institutions. In such
instances, the Trustees and the Manager will take into account in assessing the
quality of such bonds not only the creditworthiness of the issuer of such bonds
but also the creditworthiness of the financial institution that provides the
credit enhancement.

The Fund ordinarily does not intend to realize investment income not exempt
from Federal income tax and California income taxes. However, to the extent that
suitable California Municipal Bonds are not available for investment by the
Fund, the Fund may purchase Municipal Bonds issued by other states, their
agencies and instrumentalities, the interest income on which is exempt, in the
opinion of bond counsel to the issuer, from Federal income tax, but not
California income tax. The Fund also may invest in securities not issued by or
on behalf of a state or territory or by an agency or instrumentality thereof, if
the Fund nevertheless believes such securities to be exempt from Federal income
taxation ("Non-Municipal Tax-Exempt Securities"). Non-Municipal Tax-Exempt
Securities could include trust certificates or other instruments evidencing
interest in one or more long-term municipal securities. Non-Municipal Tax-Exempt
Securities also may include securities issued by other investment companies that
invest in municipal bonds, to the extent such investments are permitted by
applicable law. Non-Municipal Tax-Exempt Securities will be considered
"Municipal Bonds" for purposes of the Fund's investment objective and policies.
The Fund at all times will have at least 80% of its net assets invested in
securities the interest on which is exempt from Federal taxation. However,
interest received on certain otherwise tax-exempt securities that are classified
as "private activity bonds" (in general, bonds that benefit non-governmental
entities) may be subject to Federal alternative minimum tax. The percentage of
the Fund's total assets invested in "private activity bonds" will vary during
the year. Federal tax legislation has limited the types and volume of bonds the
interest on which qualifies for a Federal income tax exemption. As a result,
this legislation and legislation that may be enacted in the future may affect
the availability of Municipal Bonds for investment by the Fund. See
"Distributions and Taxes -- Taxes."

PORTFOLIO INSURANCE

Under normal circumstances, at least 80% of the Fund's total assets will be
invested in Municipal Bonds and at least 65% of the Fund's total assets will be
invested in California Municipal Bonds which are either (i) insured under an
insurance policy purchased by the Fund or (ii) insured under an insurance policy
obtained by the issuer thereof or any other party. The Fund will seek to limit
its investments to Municipal Bonds insured under insurance policies issued by
insurance carriers that have total admitted assets (unaudited) of at least
$75,000,000 and capital and surplus (unaudited) of at least $50,000,000 and
insurance claims-paying ability ratings of AAA from S&P or Fitch or Aaa from
Moody's.

There can be no assurance that insurance from carriers meeting these
criteria will be at all times available. Currently, it is anticipated that a
majority of the insured California Municipal Bonds and Municipal Bonds in the
Fund's portfolio will be insured by the following insurance companies that
satisfy the foregoing criteria: AMBAC Indemnity Corporation, Financial Guaranty
Insurance Company, Financial Security Assurance and Municipal Bond Investors
Assurance Corporation. The Fund also may purchase California Municipal Bonds and
Municipal Bonds covered by insurance issued by any other insurance company that
satisfies the foregoing criteria. It is anticipated that initially a majority of
insured California Municipal Bonds and Municipal Bonds held by the Fund will be
insured under policies obtained by parties other than the Fund.

The Fund may purchase, but has no obligation to purchase, separate mutual
fund insurance policies (the "Policies") from insurance companies meeting the
requirements set forth above which guarantee the payment of principal and
interest on specified eligible California Municipal Bonds and Municipal Bonds
purchased by the Fund. A California Municipal Bond and a Municipal Bond will be
eligible for coverage if it meets certain requirements of the insurance company
set forth in a Policy. In the event interest or principal on an insured
California Municipal Bond and a Municipal Bond is not paid when due, the insurer
will be obligated under its Policy to make such payment not later than 30 days
after it has been notified by, and provided with documentation from, the Fund
that such nonpayment has occurred.

3
<PAGE> 37

The Policies will be effective only as to insured California Municipal
Bonds and Municipal Bonds beneficially owned by the Fund. In the event of a sale
of any California Municipal Bonds and Municipal Bonds held by the Fund, the
issuer of the relevant Policy will be liable only for those payments of interest
and principal which are then due and owing. The Policies will not guarantee the
market value of the insured California Municipal Bonds and Municipal Bonds or
the value of the shares of the Fund.

The insurer will not have the right to withdraw coverage on securities
insured by their Policies and held by the Fund so long as such securities remain
in the Fund's portfolio. In addition, the insurer may not cancel its Policies
for any reason except failure to pay premiums when due. The Trustees of the
Trust will reserve the right to terminate any of the Policies if they determine
that the benefits to the Fund of having its portfolio insured under such
Policies are not justified by the expense involved.

The premiums for the Policies are paid by the Fund, and the yield on the
Fund's portfolio is reduced thereby. The Manager estimates that the cost of the
annual premiums for the Policies currently ranges from approximately .20 of 1%
to .25 of 1% of the principal amount of the California Municipal Bonds and
Municipal Bonds covered by such Policies. The estimate is based on the expected
composition of the Fund's portfolio of California Municipal Bonds and Municipal
Bonds. In instances in which the Fund purchases California Municipal Bonds and
Municipal Bonds insured under Policies obtained by parties other than the Fund,
the Fund does not pay the premiums for such Policies; rather, the cost of such
Policies may be reflected in the purchase price of the California Municipal
Bonds and Municipal Bonds.

It is the intention of the Manager to retain any insured securities that
are in default or in significant risk of default and to place a value on the
insurance, which ordinarily will be the difference between the market value of
the defaulted security and the market value of similar securities which are not
in default. In certain circumstances, however, the Manager may determine that an
alternative value for the insurance, such as the difference between the market
value of the defaulted security and its par value, is more appropriate. The
Manager's ability to manage the portfolio may be limited to the extent it holds
defaulted securities, which may limit its ability in certain circumstances to
purchase other California Municipal Bonds and Municipal Bonds. See "Pricing of
Shares -- Determination of Net Asset Value" below for a more complete
description of the Fund's method of valuing defaulted securities and securities
that have a significant risk of default.

There can be no assurance that insurance with the terms and issued by
insurance carriers meeting the criteria described above will continue to be
available to the Fund. In the event the Board of Trustees determines that such
insurance is unavailable or that the cost of such insurance outweighs the
benefits to the Fund, the Fund may modify the criteria for insurance carriers or
the terms of the insurance, or discontinue its policy of maintaining insurance
for all or any of the California Municipal Bonds and Municipal Bonds held in the
Fund's portfolio. Although the Manager periodically reviews the financial
condition of each insurer, there can be no assurance that the insurers will
honor their obligations under all circumstances.

The portfolio insurance reduces financial or credit risk (i.e., the
possibility that the owners of the insured California Municipal Bonds or
Municipal Bonds will not receive timely scheduled payments of principal or
interest). However, the insured California Municipal Bonds or Municipal Bonds
are subject to market risk (i.e., fluctuations in market value as a result of
changes in prevailing interest rates).

In determining eligibility for insurance, insurance companies will apply
their own standards. These standards correspond generally to the standards such
companies normally use in establishing the insurability of new issues of
California Municipal Bonds and Municipal Bonds and are not necessarily the
criteria that would be used in regard to the purchase of such bonds by the Fund.
The Policies do not insure (i) municipal securities ineligible for insurance and
(ii) municipal securities no longer owned by the Fund.

The Policies do not guarantee the market value of the insured California
Municipal Bonds and Municipal Bonds or the value of the shares of the Fund. In
addition, if the provider of an original issuance policy is unable to meet its
obligations under such policy or if the rating assigned to the insurance
claims-paying ability of any such insurer deteriorates, the insurance company
will not have any obligation to insure any issue held by the Fund that is
adversely affected by either of the above described events. In addition to the
payment of premiums, the Policies may require that the Fund notify the insurance
company as to all California Municipal

4
<PAGE> 38

Bonds and Municipal Bonds in the Fund's portfolio and permit the insurance
company to audit their records. The insurance premiums will be payable monthly
by the Fund in accordance with a premium schedule to be furnished by the
insurance company at the time the Policies are issued. Premiums are based upon
the amounts covered and the composition of the portfolio.

As noted above, the insurance companies used by the Fund will have
insurance claims-paying ability ratings of AAA from S&P or Fitch or Aaa from
Moody's. An S&P insurance claims-paying ability rating is an assessment of an
operating insurance company's financial capacity to meet obligations under an
insurance policy in accordance with the terms. An insurer with an insurance
claims-paying ability rating of AAA has the highest rating assigned by S&P or
Fitch. Capacity to honor insurance contracts is considered by S&P and Fitch to
be extremely strong and highly likely to remain so over a long period of time. A
Moody's insurance claims-paying ability rating is an opinion of the ability of
an insurance company to repay punctually senior policyholder obligations and
claims. An insurer with an insurance claims-paying ability rating of Aaa is
considered by Moody's to be of the best quality. In the opinion of Moody's, the
policy obligations of an insurance company with an insurance claims-paying
ability rating of Aaa carry the smallest degree of credit risk and, while the
financial strength of these companies is likely to change, such changes as can
be visualized are most unlikely to impair the company's fundamentally strong
position. A Fitch insurance claims-paying ability rating provides an assessment
of an insurance company's financial strength and, therefore, its ability to pay
policy and contract claims under the terms indicated. An insurer with an
insurance claims-paying ability rating of AAA has the highest rating assigned by
Fitch. The ability to pay claims is adjudged by Fitch to be extremely strong for
insurance companies with this highest rating. In the opinion of Fitch,
foreseeable business and economic risk factors should not have any material
adverse impact on the ability of these insurers to pay claims. In Fitch's
opinion, profitability, overall balance sheet strength, capitalization and
liquidity are all at very secure levels and are unlikely to be affected by
potential adverse underwriting, investment or cyclical events.

An insurance claims-paying ability rating of S&P, Fitch or Moody's does not
constitute an opinion on any specific contract in that such an opinion can only
be rendered upon the review of the specific insurance contract. Furthermore, an
insurance claims-paying ability rating does not take into account deductibles,
surrender or cancellation penalties or the timeliness of payment; nor does it
address the ability of a company to meet nonpolicy obligations (i.e., debt
contracts).

The assignment of ratings by S&P, Fitch or Moody's to debt issues that are
fully or partially supported by insurance policies, contracts or guarantees is a
separate process from the determination of claims-paying ability ratings. The
likelihood of a timely flow of funds from the insurer to the trustee for the
bondholders is a key element in the rating determination for such debt issues.

RISK FACTORS AND SPECIAL CONSIDERATIONS RELATING TO MUNICIPAL BONDS

The risks and special considerations involved in investment in Municipal
Bonds vary with the types of instruments being acquired. Investments in
Non-Municipal Tax-Exempt Securities may present similar risks, depending on the
particular product. Certain instruments in which the Fund may invest may be
characterized as derivative instruments. See "Investment Objective and
Policies -- Description of Municipal Bonds" and "-- Financial Futures
Transactions and Options."

The Fund ordinarily will invest at least 65% of its assets in California
Municipal Bonds, and therefore it is more susceptible to factors adversely
affecting issuers of California Municipal Bonds than is a municipal bond mutual
fund that is not concentrated in issuers of California Municipal Bonds to this
degree. While at least 80% of the Fund's assets will be held in Municipal Bonds
(and at least 65% of the Fund's assets in California Municipal Bonds) that are
insured, the shares of the Fund are not insured by any government entity and the
value of the shares may fluctuate daily. From 1990-1993, the State suffered
through a severe recession, the worst since the 1930's, heavily influenced by
large cutbacks in defense/aerospace industries and military base closures and by
a major drop in real estate construction. California's economy has been
recovering and growing steadily since the start of 1994. The current economic
expansion is marked by growth in high technology manufacturing and services,
including computer software, electronic manufacturing and motion

5
<PAGE> 39

picture/television production; growth is also occurring in other business
services, both nonresidential and residential construction and local education.
However the soaring trade deficit, continuing weakness in Asia, initial signs of
economic weakness in Canada and Latin America, which have been California's
largest trading partners, and the fall in stock prices worldwide are expected to
have a negative effect. Other impacts of the international situation may help
California, such as the reduction in long-term interest rates. Currently,
California's general obligation bonds are rated A+, Aa3 and AA- by S&P, Moody's
and Fitch, respectively. See Appendix I, "Economic and Financial Conditions in
California."

The value of Municipal Bonds generally may be affected by uncertainties in
the municipal markets as a result of legislation or litigation changing the
taxation of Municipal Bonds or the rights of Municipal Bond holders in the event
of bankruptcy. Municipal bankruptcies are rare, and certain provisions of the
U.S. Bankruptcy Code governing such bankruptcies are unclear. Further, the
application of state law to Municipal Bond issuers could produce varying results
among the states or among Municipal Bond issuers within a state. These
uncertainties could have a significant impact on the prices of the California
Municipal Bonds or Municipal Bonds in which the Fund invests.

The Manager does not believe that the current economic conditions in
California or other factors described above will have a significant adverse
effect on the Fund's ability to invest in high quality California Municipal
Bonds. Because the Fund's portfolio will be comprised primarily of investment
grade securities, the Fund is expected to be less subject to market and credit
risks than a fund that invests primarily in lower quality California Municipal
Bonds. For a discussion of economic and other conditions in California, see
Appendix I -- "Economic and Financial Conditions in California."

The suitability for any particular investor of a purchase of shares of the
Fund will depend upon, among other things, such investor's investment objectives
and such investor's ability to accept the risks of investing in such markets,
including the loss of principal.

DESCRIPTION OF MUNICIPAL BONDS

Set forth below is a detailed description of the Municipal Bonds and
Temporary Investments in which the Fund may invest. Information with respect to
ratings assigned to tax-exempt obligations that the Fund may purchase is set
forth in Appendix II to this Statement of Additional Information. See "How the
Fund Invests" in the Prospectus.

Municipal Bonds include debt obligations issued to obtain funds for various
public purposes, including the construction of a wide range of public
facilities, refunding of outstanding obligations and obtaining funds for general
operating expenses and loans to other public institutions and facilities. In
addition, certain types of bonds are issued by or on behalf of public
authorities to finance various privately owned or operated facilities, including
certain facilities for the local furnishing of electric energy or gas, sewage
facilities, solid waste disposal facilities and other specialized facilities.
Such obligations are included within the term Municipal Bonds if the interest
paid thereon is excluded from gross income for Federal income tax purposes and,
in the case of California Municipal Bonds, exempt from California income taxes.
Other types of industrial development bonds or private activity bonds, the
proceeds of which are used for the construction, equipment or improvement of
privately operated industrial or commercial facilities, may constitute Municipal
Bonds, although the current Federal tax laws place substantial limitations on
the size of such issues. In the case of certain community facilities district
special tax ("Mello-Roos" in the case of California Municipal Bonds), tax
increment (or tax allocation) and assessment bonds, the payment of the special
tax, tax increment and assessments may be secured solely by remedies against the
land (such as by foreclosure) and not against the individual property owner,
which could be time-consuming and costly. The interest on Municipal Bonds may
bear a fixed rate or be payable at a variable or floating rate. The two
principal classifications of Municipal Bonds are "general obligation" and
"revenue" bonds, which latter category includes industrial development bonds
("IDBs") and, for bonds issued after August 15, 1986, private activity bonds.

6
<PAGE> 40

General Obligation Bonds. General obligation bonds are secured by the
issuer's pledge of its faith, credit and taxing power for the payment of
principal and interest. The taxing power of any governmental entity may be
limited, however, by provisions of its state constitution or laws, and an
entity's creditworthiness will depend on many factors, including potential
erosion of its tax base due to population declines, natural disasters, declines
in the state's industrial base or inability to attract new industries, economic
limits on the ability to tax without eroding the tax base, state legislative
proposals or voter initiatives to limit ad valorem real property taxes and the
extent to which the entity relies on Federal or state aid, access to capital
markets or other factors beyond the state's or entity's control. Accordingly,
the capacity of the issuer of a general obligation bond as to the timely payment
of interest and the repayment of principal when due is affected by the issuer's
maintenance of its tax base.

Revenue Bonds. Revenue bonds are payable only from the revenues derived
from a particular facility or class of facilities or, in some cases, from the
proceeds of a special excise tax or other specific revenue source such as
payments from the user of the facility being financed; accordingly the timely
payment of interest and the repayment of principal in accordance with the terms
of the revenue or special obligation bond is a function of the economic
viability of such facility or such revenue source.

IDBs and Private Activity Bonds. The Fund may purchase IDBs and private
activity bonds. IDBs and private activity bonds are, in most cases, tax-exempt
securities issued by states, municipalities or public authorities to provide
funds, usually through a loan or lease arrangement, to a private entity for the
purpose of financing construction or improvement of a facility to be used by the
entity. Such bonds are secured primarily by revenues derived from loan
repayments or lease payments due from the entity which may or may not be
guaranteed by a parent company or otherwise secured. IDBs and private activity
bonds generally are not secured by a pledge of the taxing power of the issuer of
such bonds. Therefore, an investor should be aware that repayment of such bonds
generally depends on the revenues of a private entity and be aware of the risks
that such an investment may entail. Continued ability of an entity to generate
sufficient revenues for the payment of principal and interest on such bonds will
be affected by many factors including the size of the entity, capital structure,
demand for its products or services, competition, general economic conditions,
government regulation and the entity's dependence on revenues for the operation
of the particular facility being financed. The Fund may invest more than 25% of
its total assets in IDBs or private activity bonds.

Lease Obligations. Also included within the general category of Municipal
Bonds are participation certificates issued by government authorities or
entities to finance the acquisition or construction of equipment, land and/or
facilities. The certificates represent participations in a lease, an installment
purchase contract or a conditional sales contract (hereinafter collectively
called "lease obligations") relating to such equipment, land or facilities.
Although lease obligations do not constitute general obligations of the issuer
for which the issuer's unlimited taxing power is pledged, a lease obligation is
frequently backed by the issuer's covenant to budget for, appropriate and make
the payments due under the lease obligation. However, certain lease obligations
contain "non-appropriation" clauses which provide that the issuer has no
obligation to make lease or installment purchase payments in future years unless
money is appropriated for such purpose on a yearly basis. Although
"non-appropriation" lease obligations are secured by the leased property,
disposition of the property in the event of foreclosure might prove difficult.
These securities represent a type of financing that has not yet developed the
depth of marketability associated with more conventional securities. Certain
investments in lease obligations may be illiquid. The Fund may not invest in
illiquid lease obligations if such investments, together with all other illiquid
investments, would exceed 15% of the Fund's total assets. The Fund may, however,
invest without regard to such limitation in lease obligations which the Manager,
pursuant to guidelines which have been adopted by the Board of Trustees and
subject to the supervision of the Board, determines to be liquid. The Manager
will deem lease obligations to be liquid if they are publicly offered and have
received an investment grade rating of Baa or better by Moody's, or BBB or
better by S&P or Fitch. Unrated lease obligations, or those rated below
investment grade, will be considered liquid if the obligations come to the
market through an underwritten public offering and at least two dealers are
willing to give competitive bids. In reference to the latter, the Manager must,
among other things, also review the creditworthiness of the entity obligated to
make payment under the lease obligation and make certain specified
determinations based on such factors as the existence of a rating or credit
enhancement such as insurance, the

7
<PAGE> 41

frequency of trades or quotes for the obligation and the willingness of dealers
to make a market in the obligation.

"Moral Obligation" Bonds. The Fund also may invest in "moral obligation"
bonds, which are normally issued by special purpose public authorities. If an
issuer of moral obligation bonds is unable to meet its obligations, the
repayment of such bonds becomes a moral commitment but not a legal obligation of
the state or municipality in question.

Indexed and Inverse Floating Obligations. The Fund may invest in Municipal
Bonds (and Non-Municipal Tax-Exempt Securities) the return on which is based on
a particular index of value or interest rates. For example, the Fund may invest
in Municipal Bonds that pay interest based on an index of Municipal Bond
interest rates. The principal amount payable upon maturity of certain Municipal
Bonds also may be based on the value of the index. To the extent the Fund
invests in these types of Municipal Bonds, the Fund's return on such Municipal
Bonds will be subject to risk with respect to the value of the particular index.
Interest and principal payable on the Municipal Bonds may also be based on
relative changes among particular indices. Also, the Fund may invest in
so-called "inverse floating obligations" or "residual interest bonds" on which
the variable long-term interest rates typically decline as short-term market
rates increase and increase as short-term market rates decline. The Fund's
return on such Municipal Bonds (and Non-Municipal Tax-Exempt Securities) will be
subject to risk with respect to the value of the particular index, which may
include reduced or limited interest payments and losses of invested principal.
Such securities have the effect of providing a degree of investment leverage,
since they may increase or decrease in value in response to changes, as an
illustration, in market interest rates at a rate which is a multiple (typically
two) of the rate at which fixed-rate long-term tax-exempt securities increase or
decrease in response to such changes. As a result, the market values of such
securities will generally be more volatile than the market values of fixed-rate
tax-exempt securities. To seek to limit the volatility of these securities, the
Fund may purchase inverse floating obligations with shorter-term maturities or
which contain limitations on the extent to which the interest rate may vary.
Certain investments in such obligations may be illiquid. The Fund may not invest
in such illiquid obligations if such investments, together with other illiquid
investments, would exceed 15% of the Fund's total assets. The Manager, however,
believes that indexed and inverse floating obligations represent flexible
portfolio management instruments for the Fund which allow the Fund to seek
potential investment rewards, hedge other portfolio positions or vary the degree
of investment leverage relatively efficiently under different market conditions.

When Issued Securities and Delayed Delivery Transactions. Municipal Bonds
may at times be purchased or sold on a delayed delivery basis or a when issued
basis. These transactions arise when securities are purchased or sold by the
Fund with payment and delivery taking place in the future, often a month or more
after the purchase. The purchase will be recorded on the date the Fund enters
into the commitment and the value of the obligation will thereafter be reflected
in the calculation of the Fund's net asset value. The value of the obligation on
the delivery date may be more or less than its purchase price. The payment
obligation and the interest rate are each fixed at the time the buyer enters
into the commitment. The Fund will make only commitments to purchase such
securities with the intention of actually acquiring the securities, but the Fund
may sell these securities prior to the settlement date if it is deemed
advisable. Purchasing Municipal Bonds on a when issued basis involves the risk
that the yields available in the market when the delivery takes place may
actually be higher than those obtained in the transaction itself; if yields so
increase, the value of the when issued obligation generally will decrease. The
Fund will maintain a separate account at its custodian bank consisting of cash,
cash equivalents or liquid securities (valued on a daily basis) equal at all
times to the amount of the when issued commitment.

Call Rights. The Fund may purchase a Municipal Bond issuer's right to call
all or a portion of such Municipal Bond for mandatory tender for purchase (a
"Call Right"). A holder of a Call Right may exercise such right to require a
mandatory tender for the purchase of related Municipal Bonds, subject to certain
conditions. A Call Right that is not exercised prior to maturity of the related
Municipal Bond will expire without value. The economic effect of holding both
the Call Right and the related Municipal Bond is identical to holding a
Municipal Bond as a non-callable security. Certain investments in such
obligations may be

8
<PAGE> 42

illiquid. The Fund may not invest in such illiquid obligations if such
investments, together with other illiquid investments, would exceed 15% of the
Fund's total assets.

"High Yield" or "Junk" Bonds. The Fund may invest up to 20% of its total
assets in Municipal Bonds that are rated below Baa by Moody's or below BBB by
S&P or Fitch or which, in the Manager's judgment, possess similar credit
characteristics. See Appendix II -- "Ratings of Municipal Bonds" for additional
information regarding ratings of debt securities. In purchasing such securities,
the Fund will rely on the Manager's judgment, analysis and experience in
evaluating the creditworthiness of the issuer of such securities. The Manager
will take into consideration, among other things, the ratings assigned by S&P,
Moody's or Fitch, the issuer's financial resources, its sensitivity to economic
conditions and trends, its operating history, the quality of its management and
regulatory matters.

High yield securities are considered by S&P, Moody's and Fitch to have
varying degrees of speculative characteristics. Consequently, although high
yield securities can be expected to provide higher yields, such securities may
be subject to greater market price fluctuations and risk of loss of principal
than lower yielding, higher-rated debt securities. The market prices of
high-yielding, lower-rated securities may fluctuate more than higher-rated
securities and may decline significantly in periods of general economic
difficulty, which may follow periods of rising interest rates. Investments in
high yield securities will be made only when, in the judgment of the Manager,
such securities provide attractive total return potential relative to the risk
of such securities, as compared to higher quality debt securities. The Fund
generally will not invest in debt securities in the lowest rating categories
(those rated CC or lower by S&P or Fitch or Ca or lower by Moody's) unless the
Manager believes that the financial condition of the issuer or the protection
afforded the particular securities is stronger than would otherwise be indicated
by such low ratings. The Fund does not intend to purchase debt securities that
are in default or which the Manager believes will be in default.

Issuers or obligors of high yield securities may be highly leveraged and
may not have available to them more traditional methods of financing. Therefore,
the risks associated with acquiring the securities of such issuers generally are
greater than is the case with higher rated securities. For example, during an
economic downturn or a sustained period of rising interest rates, issuers or
obligors of high yield securities may be more likely to experience financial
stress, especially if such issuers or obligors are highly leveraged. During such
periods, such issuers may not have sufficient revenues to meet their interest
payment obligations. The issuer's ability to service its debt obligations also
may be adversely affected by specific issuer developments, or the issuer's
inability to meet specific projected business forecasts, or the unavailability
of additional financing. The risk of loss due to default by the issuer is
significantly greater for the holders of high yield securities because such
securities may be unsecured and may be subordinated to other creditors of the
issuer.

High yield securities frequently have call or redemption features that
would permit an issuer to repurchase the security from the Fund. If a call were
exercised by the issuer during a period of declining interest rates, the Fund
likely would have to replace such called security with a lower yielding
security, thus decreasing the net investment income to the Fund and dividends to
shareholders.

The Fund may have difficulty disposing of certain high yield securities
because there may be a thin trading market for such securities. Because not all
dealers maintain markets in all high yield securities, there is no established
secondary market for many of these securities, and the Fund anticipates that
such securities could be sold only to a limited number of dealers or
institutional investors. To the extent that a secondary trading market for high
yield securities does exist, it generally is not as liquid as the secondary
market for higher rated securities. Reduced secondary market liquidity may have
an adverse impact on market price and the Fund's ability to dispose of
particular issues when necessary to meet the Fund's liquidity needs or in
response to a specific economic event such as a deterioration in the
creditworthiness of the issuer. Reduced secondary market liquidity for certain
securities also may make it more difficult for the Fund to obtain accurate
market quotations for purposes of valuing the Fund's portfolio. Market
quotations are generally available on many high yield securities only from a
limited number of dealers and may not necessarily represent firm bids of such
dealers or prices for actual sales.

9
<PAGE> 43

It is expected that a significant portion of the high yield securities
acquired by the Fund will be purchased upon issuance, which may involve special
risks because the securities so acquired are new issues. In such instances the
Fund may be a substantial purchaser of the issue and therefore have the
opportunity to participate in structuring the terms of the offering. Although
this may enable the Fund to seek to protect itself against certain of such
risks, the considerations discussed herein would nevertheless remain applicable.

Adverse publicity and investor perceptions, which may not be based on
fundamental analysis, also may decrease the value and liquidity of high yield
securities, particularly in a thinly traded market. Factors adversely affecting
the market value of high yield securities are likely to adversely affect the
Fund's net asset value. In addition, the Fund may incur additional expenses to
the extent that it is required to seek recovery upon a default on a portfolio
holding or participate in the restructuring of the obligation.

Yields. Yields on Municipal Bonds are dependent on a variety of factors,
including the general condition of the money market and of the municipal bond
market, the size of a particular offering, the financial condition of the
issuer, the maturity of the obligation and the rating of the issue. The ability
of the Fund to achieve its investment objective is also dependent on the
continuing ability of the issuers of the securities in which the Fund invests to
meet their obligations for the payment of interest and principal when due. There
are variations in the risks involved in holding Municipal Bonds, both within a
particular classification and between classifications, depending on numerous
factors. Furthermore, the rights of owners of Municipal Bonds and the
obligations of the issuer of such Municipal Bonds may be subject to applicable
bankruptcy, insolvency and similar laws and court decisions affecting the rights
of creditors generally and to general equitable principles, which may limit the
enforcement of certain remedies.

FINANCIAL FUTURES TRANSACTIONS AND OPTIONS

Reference is made to "How the Fund Invests" in the Prospectus. Set forth
below is additional information concerning these transactions.

The Fund is authorized to purchase and sell certain exchange traded
financial futures contracts ("financial futures contracts") solely for the
purpose of hedging its investments in Municipal Bonds against declines in value
and to hedge against increases in the cost of securities it intends to purchase.
However, any transactions involving financial futures or options (including puts
and calls associated therewith) will be in accordance with the Fund's investment
policies and limitations. A financial futures contract obligates the seller of a
contract to deliver and the purchaser of a contract to take delivery of the type
of financial instrument covered by the contract, or in the case of index-based
futures contracts to make and accept a cash settlement, at a specific future
time for a specified price. To hedge its portfolio, the Fund may take an
investment position in a futures contract which will move in the opposite
direction from the portfolio position being hedged. A sale of financial futures
contracts may provide a hedge against a decline in the value of portfolio
securities because such depreciation may be offset, in whole or in part, by an
increase in the value of the position in the financial futures contracts. A
purchase of financial futures contracts may provide a hedge against an increase
in the cost of securities intended to be purchased because such appreciation may
be offset, in whole or in part, by an increase in the value of the position in
the futures contracts. While the Fund's use of hedging strategies is intended to
moderate capital changes in portfolio holdings and thereby reduce the volatility
of the net asset value of Fund shares, the Fund anticipates that its net asset
value will fluctuate. Distributions, if any, of net long-term capital gains from
certain transactions in futures or options are taxable at long-term capital
gains rates for Federal income tax purposes, regardless of the length of time
the shareholder has owned Fund shares. See "Distributions and Taxes -- Taxes."

Description of Futures Contracts. A futures contract is an agreement
between two parties to buy and sell a security or, in the case of an index-based
futures contract, to make and accept a cash settlement for a set price on a
future date. A majority of transactions in futures contracts, however, do not
result in the actual delivery of the underlying instrument or cash settlement,
but are settled through liquidation, i.e., by entering into an offsetting
transaction. Futures contracts have been designed by boards of trade which have
been designated "contracts markets" by the Commodity Futures Trading Commission
("CFTC").

10
<PAGE> 44

The purchase or sale of a futures contract differs from the purchase or
sale of a security in that no price or premium is paid or received. Instead, an
amount of cash or securities acceptable to the broker and the relevant contract
market, which varies, but is generally about 5% of the contract amount, must be
deposited with the broker. This amount is known as "initial margin" and
represents a "good faith" deposit assuring the performance of both the purchaser
and seller under the futures contract. Subsequent payments to and from the
broker, called "variation margin," are required to be made on a daily basis as
the price of the futures contract fluctuates making the long and short positions
in the futures contract more or less valuable, a process known as "marking to
the market." At any time prior to the settlement date of the futures contract,
the position may be closed out by taking an opposite position that will operate
to terminate the position in the futures contract. A final determination of
variation margin is then made, additional cash is required to be paid to or
released by the broker and the purchaser realizes a loss or gain. In addition, a
nominal commission is paid on each completed sale transaction.

The Fund deals in financial futures contracts based on a long-term
municipal bond index developed by the Chicago Board of Trade ("CBT") and The
Bond Buyer (the "Municipal Bond Index"). The Municipal Bond Index is comprised
of 40 tax-exempt municipal revenue and general obligation bonds. Each bond
included in the Municipal Bond Index must be rated A or higher by Moody's or S&P
and must have a remaining maturity of 19 years or more. Twice a month new issues
satisfying the eligibility requirements are added to, and an equal number of old
issues are deleted from, the Municipal Bond Index. The value of the Municipal
Bond Index is computed daily according to a formula based on the price of each
bond in the Municipal Bond Index, as evaluated by six dealer-to-dealer brokers.

The Municipal Bond Index futures contract is traded only on the CBT. Like
other contract markets, the CBT assures performance under futures contracts
through a clearing corporation, a nonprofit organization managed by the exchange
membership which is also responsible for handling daily accounting of deposits
or withdrawals of margin.

The Fund may purchase and sell financial futures contracts on U.S.
Government securities as a hedge against adverse changes in interest rates as
described below. With respect to U.S. Government securities, currently there are
financial futures contracts based on long-term U.S. Treasury bonds, Treasury
notes, Government National Mortgage Association ("GNMA") Certificates and
three-month U.S. Treasury bills. The Fund may purchase and write call and put
options on futures contracts on U.S. Government securities and purchase and sell
Municipal Bond Index futures contracts in connection with its hedging
strategies.

Subject to policies adopted by the Trustees, the Fund also may engage in
other futures contracts transactions such as futures contracts on other
municipal bond indices that may become available if the Manager and the Trustees
of the Trust should determine that there is normally a sufficient correlation
between the prices of such futures contracts and the Municipal Bonds in which
the Fund invests to make such hedging appropriate.

Futures Strategies. The Fund may sell a financial futures contract (i.e.,
assume a short position) in anticipation of a decline in the value of its
investments in Municipal Bonds resulting from an increase in interest rates or
otherwise. The risk of decline could be reduced without employing futures as a
hedge by selling such Municipal Bonds and either reinvesting the proceeds in
securities with shorter maturities or by holding assets in cash. This strategy,
however, entails increased transaction costs in the form of dealer spreads and
typically would reduce the average yield of the Fund's portfolio securities as a
result of the shortening of maturities. The sale of futures contracts provides
an alternative means of hedging against declines in the value of its investments
in Municipal Bonds. As such values decline, the value of the Fund's positions in
the futures contracts will tend to increase, thus offsetting all or a portion of
the depreciation in the market value of the Fund's Municipal Bond investments
that are being hedged. While the Fund will incur commission expenses in selling
and closing out futures positions, commissions on futures transactions are lower
than transaction costs incurred in the purchase and sale of Municipal Bonds. In
addition, the ability of the Fund to trade in the standardized contracts
available in the futures markets may offer a more effective defensive position
than a program to reduce the average maturity of the portfolio securities due to
the unique and varied credit and technical characteristics of the municipal debt
instruments available to the Fund. Employing futures as a

11
<PAGE> 45

hedge also may permit the Fund to assume a defensive posture without reducing
the yield on its investments beyond any amounts required to engage in futures
trading.

When the Fund intends to purchase Municipal Bonds, the Fund may purchase
futures contracts as a hedge against any increase in the cost of such Municipal
Bonds resulting from a decrease in interest rates or otherwise, that may occur
before such purchases can be effected. Subject to the degree correlation between
the Municipal Bonds and the futures contracts, subsequent increases in the cost
of Municipal Bonds should be reflected in the value of the futures held by the
Fund. As such purchases are made, an equivalent amount of futures contracts will
be closed out. Due to changing market conditions and interest rate forecasts,
however, a futures position may be terminated without a corresponding purchase
of portfolio securities.

Call Options on Futures Contracts. The Fund may also purchase and sell
exchange traded call and put options on financial futures contracts on U.S.
Government securities. The purchase of a call option on a futures contract is
analogous to the purchase of a call option on an individual security. Depending
on the pricing of the option compared to either the futures contract upon which
it is based or the price of the underlying debt securities, it may or may not be
less risky than ownership of the futures contract or underlying debt securities.
Like the purchase of a futures contract, the Fund will purchase a call option on
a futures contract to hedge against a market advance when the Fund is not fully
invested.

The writing of a call option on a futures contract constitutes a partial
hedge against declining prices of the securities which are deliverable upon
exercise of the futures contract. If the futures price at expiration is below
the exercise price, the Fund will retain the full amount of the option premium
which provides a partial hedge against any decline that may have occurred in the
Fund's portfolio holdings.

Put Options on Futures Contracts. The purchase of a put option on a
futures contract is analogous to the purchase of a protective put option on
portfolio securities. The Fund will purchase a put option on a futures contract
to hedge the Fund's portfolio against the risk of rising interest rates.

The writing of a put option on a futures contract constitutes a partial
hedge against increasing prices of the securities which are deliverable upon
exercise of the futures contract. If the futures price at expiration is higher
than the exercise price, the Fund will retain the full amount of the option
premium which provides a partial hedge against any increase in the price of
Municipal Bonds which the Fund intends to purchase.

The writer of an option on a futures contract is required to deposit
initial and variation margin pursuant to requirements similar to those
applicable to futures contracts. Premiums received from the writing of an option
will be included in initial margin. The writing of an option on a futures
contract involves risks similar to those relating to futures contracts.

The Trust has received an order from the Commission exempting it from the
provisions of Section 17(f) and Section 18(f) of the Investment Company Act of
1940, as amended (the "Investment Company Act"), in connection with its strategy
of investing in futures contracts. Section 17(f) relates to the custody of
securities and other assets of an investment company and may be deemed to
prohibit certain arrangements between the Fund and commodities brokers with
respect to initial and variation margin. Section 18(f) of the Investment Company
Act prohibits an open-end investment company such as the Trust from issuing a
"senior security" other than a borrowing from a bank. The staff of the
Commission has in the past indicated that a futures contract may be a "senior
security" under the Investment Company Act.

Restrictions on Use of Futures Transactions. Regulations of the CFTC
applicable to the Fund require that all of the Fund's futures transactions
constitute bona fide hedging transactions and that the Fund purchase and sell
futures contracts and options thereon (i) for bona fide hedging purposes, and
(ii) for non-hedging purposes, if the aggregate initial margin and premiums
required to establish positions in such contracts and options does not exceed 5%
of the liquidation value of the Fund's portfolio assets after taking into
account unrealized profits and unrealized losses on any such contracts and
options. (However, the Fund intends to engage in options and futures
transactions only for hedging purposes.) Margin deposits may consist of cash or
securities acceptable to the broker and the relevant contract market.

12
<PAGE> 46

When the Fund purchases a futures contract, or writes a put option or
purchases a call option thereon, it will maintain an amount of cash, cash
equivalents (e.g., high grade commercial paper and daily tender adjustable
notes) or liquid securities in a segregated account with the Fund's custodian,
so that the amount so segregated plus the amount of initial and variation margin
held in the account of its broker equals the market value of the futures
contracts, thereby ensuring that the use of such futures contract is
unleveraged. It is not anticipated that transactions in futures contracts will
have the effect of increasing portfolio turnover.

Risk Factors in Futures Transactions and Options. Investment in futures
contracts involves the risk of imperfect correlation between movements in the
price of the futures contract and the price of the security being hedged. The
hedge will not be fully effective when there is imperfect correlation between
the movements in the prices of two financial instruments. For example, if the
price of the futures contract moves more than the price of the hedged security,
the Fund will experience either a loss or gain on the futures contract which is
not completely offset by movements in the price of the hedged securities. To
compensate for imperfect correlations, the Fund may purchase or sell futures
contracts in a greater dollar amount than the hedged securities if the
volatility of the hedged securities is historically greater than the volatility
of the futures contracts. Conversely, the Fund may purchase or sell fewer
futures contracts if the volatility of the price of the hedged securities is
historically less than that of the futures contracts.

The particular municipal bonds comprising the index underlying the
Municipal Bond Index financial futures contract may vary from the bonds held by
the Fund. As a result, the Fund's ability to hedge effectively all or a portion
of the value of its Municipal Bonds through the use of such financial futures
contracts will depend in part on the degree to which price movements in the
index underlying the financial futures contract correlate with the price
movements of the Municipal Bonds held by the Fund. The correlation may be
affected by disparities in the average maturity, ratings, geographical mix or
structure of the Fund's investments as compared to those comprising the
Municipal Bond Index and general economic or political factors. In addition, the
correlation between movements in the value of the Municipal Bond Index may be
subject to change over time as additions to and deletions from the Municipal
Bond Index alter its structure. The correlation between futures contracts on
U.S. Government securities and the Municipal Bonds held by the Fund may be
adversely affected by similar factors and the risk of imperfect correlation
between movements in the prices of such futures contracts and the prices of
Municipal Bonds held by the Fund may be greater. Municipal Bond Index futures
contracts were approved for trading in 1986. Trading in such futures contracts
may tend to be less liquid than trading in other futures contracts. The trading
of futures contracts also is subject to certain market risks, such as inadequate
trading activity, which could at times make it difficult or impossible to
liquidate existing positions.

The Fund expects to liquidate a majority of the futures contracts it enters
into through offsetting transactions on the applicable contract market. There
can be no assurance, however, that a liquid secondary market will exist for any
particular futures contract at any specific time. Thus, it may not be possible
to close out a futures position. In the event of adverse price movements, the
Fund would continue to be required to make daily cash payments of variation
margin. In such situations, if the Fund has insufficient cash, it may be
required to sell portfolio securities to meet daily variation margin
requirements at a time when it may be disadvantageous to do so. The inability to
close out futures positions also could have an adverse impact on the Fund's
ability to hedge effectively its investments in Municipal Bonds. The liquidity
of a secondary market in a futures contract may be adversely affected by "daily
price fluctuation limits" established by commodity exchanges which limit the
amount of fluctuation in a futures contract price during a single trading day.
Once the daily limit has been reached in the contract, no trades may be entered
into at a price beyond the limit, thus preventing the liquidation of open
futures positions. Prices have in the past moved beyond the daily limit on a
number of consecutive trading days. The Fund will enter into a futures position
only if, in the judgment of the Manager, there appears to be an actively traded
secondary market for such futures contracts.

The successful use of transactions in futures and related options also
depends on the ability of the Manager to forecast correctly the direction and
extent of interest rate movements within a given time frame. To the extent
interest rates remain stable during the period in which a futures contract or
option is held by the Fund or such rates move in a direction opposite to that
anticipated, the Fund may realize a loss on the hedging

13
<PAGE> 47

transaction which is not fully or partially offset by an increase in the value
of portfolio securities. As a result, the Fund's total return for such period
may be less than if it had not engaged in the hedging transaction.

Because of low initial margin deposits made upon the opening of a futures
position, futures transactions involve substantial leverage. As a result,
relatively small movements in the price of the futures contracts can result in
substantial unrealized gains or losses. There is also the risk of loss by the
Fund of margin deposits in the event of bankruptcy of a broker with whom the
Fund has an open position in a financial futures contract. Because the Fund will
engage in the purchase and sale of futures contracts solely for hedging
purposes, however, any losses incurred in connection therewith should, if the
hedging strategy is successful, be offset in whole or in part by increases in
the value of securities held by the Fund or decreases in the price of securities
the Fund intends to acquire.

The amount of risk the Fund assumes when it purchases an option on a
futures contract is the premium paid for the option plus related transaction
costs. In addition to the correlation risks discussed above, the purchase of an
option on a futures contract also entails the risk that changes in the value of
the underlying futures contract will not be fully reflected in the value of the
option purchased.

DESCRIPTION OF TEMPORARY INVESTMENTS

The Fund may invest in short-term tax-free and taxable securities subject
to the limitations set forth above and in the Prospectus under "How the Fund
Invests." The tax-exempt money market securities may include municipal notes,
municipal commercial paper, municipal bonds with a remaining maturity of less
than one year, variable rate demand notes and participations therein. Municipal
notes include tax anticipation notes, bond anticipation notes and grant
anticipation notes. Anticipation notes are sold as interim financing in
anticipation of tax collection, bond sales, government grants or revenue
receipts. Municipal commercial paper refers to short-term unsecured promissory
notes generally issued to finance short-term credit needs. The taxable money
market securities in which the Fund may invest as Temporary Investments consist
of U.S. Government securities, U.S. Government agency securities, domestic bank
or savings institution certificates of deposit and bankers' acceptances,
short-term corporate debt securities such as commercial paper and repurchase
agreements. These Temporary Investments must have a stated maturity not in
excess of one year from the date of purchase. The Fund may not invest in any
security issued by a commercial bank or a savings institution unless the bank or
institution is organized and operating in the United States, has total assets of
at least one billion dollars and is a member of the Federal Deposit Insurance
Corporation ("FDIC"), except that up to 10% of total assets may be invested in
certificates of deposit of smaller institutions if such certificates are fully
insured by the FDIC.

VRDOs and Participating VRDOs. VRDOs are tax-exempt obligations which
contain a floating or variable interest rate adjustment formula and a right of
demand on the part of the holder thereof to receive payment of the unpaid
principal balance plus accrued interest upon a short notice period not to exceed
seven days. There is, however, the possibility that because of default or
insolvency the demand feature of VRDOs and Participating VRDOs may not be
honored. The interest rates are adjustable at intervals (ranging from daily to
up to one year) to some prevailing market rate for similar investments, such
adjustment formula being calculated to maintain the market value of the VRDOs,
at approximately the par value of the VRDOs on the adjustment date. The
adjustments typically are based upon the Public Securities Association Index or
some other appropriate interest rate adjustment index. The Fund may invest in
all types of tax-exempt instruments currently outstanding or to be issued in the
future which satisfy the short-term maturity and quality standards of the Fund.

Participating VRDOs provide the Fund with a specified undivided interest
(up to 100%) of the underlying obligation and the right to demand payment of the
unpaid principal balance plus accrued interest on the Participating VRDOs from
the financial institution upon a specified number of days notice, not to exceed
seven days. In addition, the Participating VRDO is backed by an irrevocable
letter of credit or guaranty of the financial institution. The Fund would have
an undivided interest in the underlying obligation and thus participate on the
same basis as the financial institution in such obligation except that the
financial institution typically retains fees out of the interest paid on the
obligation for servicing the obligation, providing

14
<PAGE> 48

the letter of credit and issuing the repurchase commitment. The Fund has been
advised by its counsel that the Fund should be entitled to treat the income
received on Participating VRDOs as interest from tax-exempt obligations.

VRDOs that contain a right of demand to receive payment of the unpaid
principal balance plus accrued interest on a notice period exceeding seven days
may be deemed to be illiquid securities. A VRDO with a demand notice period
exceeding seven days will therefore be subject to the Fund's restriction on
illiquid investments unless, in the judgment of the Trustees, such VRDO is
liquid. The Trustees may adopt guidelines and delegate to the Manager the daily
function of determining and monitoring liquidity of such VRDOs. The Trustees,
however, will retain sufficient oversight and will be ultimately responsible for
such determinations.

The Temporary Investments, VRDOs and Participating VRDOs in which the Fund
may invest will be in the following rating categories at the time of purchase:
MIG-1/VMIG-1 through MIG-3/VMIG-3 for notes and VRDOs and Prime-1 through
Prime-3 for commercial paper (as determined by Moody's), SP-1 through SP-2 for
notes and A-1 through A-3 for VRDOs and commercial paper (as determined by S&P),
or F-1 through F-3 for notes, VRDOs and commercial paper (as determined by
Fitch). Temporary Investments, if not rated, must be of comparable quality in
the opinion of the Manager. In addition, the Fund reserves the right to invest
temporarily a greater portion of its assets in Temporary Investments for
defensive purposes, when, in the judgment of the Manager, market conditions
warrant.

Repurchase Agreements. The Fund may invest in securities pursuant to
repurchase agreements. Repurchase agreements may be entered into only with a
member bank of the Federal Reserve System or primary dealer or an affiliate
thereof, in U.S. Government securities. Under such agreements, the bank or
primary dealer or an affiliate thereof agrees, upon entering into the contract,
to repurchase the security at a mutually agreed upon time and price, thereby
determining the yield during the term of the agreement. This results in a fixed
rate of return insulated from market fluctuations during such period. In
repurchase agreements, the prices at which the trades are conducted do not
reflect accrued interest on the underlying obligations. Such agreements usually
cover short periods, such as under one week. Repurchase agreements may be
construed to be collateralized loans by the purchaser to the seller secured by
the securities transferred to the purchaser. In a repurchase agreement, the Fund
will require the seller to provide additional collateral if the market value of
the securities falls below the repurchase price at any time during the term of
the repurchase agreement. In the event of default by the seller under a
repurchase agreement construed to be a collateralized loan, the underlying
securities are not owned by the Fund but only constitute collateral for the
seller's obligation to pay the repurchase price. Therefore, the Fund may suffer
time delays and incur costs or possible losses in connection with the
disposition of the collateral. In the event of a default under such a repurchase
agreement, instead of the contractual fixed rate of return, the rate of return
to the Fund shall be dependent upon intervening fluctuations of the market value
of such security and the accrued interest on the security. In such event, the
Fund would have rights against the seller for breach of contract with respect to
any losses arising from market fluctuations following the failure of the seller
to perform. The Fund may not invest in repurchase agreements maturing in more
than seven days if such investments, together with all other illiquid
investments, would exceed 15% of the Fund's net assets.

In general, for Federal income tax purposes, repurchase agreements are
treated as collateralized loans secured by the securities "sold." Therefore,
amounts earned under such agreements will not be considered tax-exempt interest.
The treatment of purchase and sales contracts is less certain.

INVESTMENT RESTRICTIONS

The Fund has adopted a number of fundamental and non-fundamental investment
restrictions and policies relating to the investment of its assets and its
activities. The fundamental policies set forth below may not be changed without
the approval of the holders of a majority of the Fund's outstanding voting
securities as defined in the Investment Company Act means the lesser of (i) 67%
of the Fund's shares present at a meeting

15
<PAGE> 49

at which more than 50% of the outstanding shares of the Fund are represented or
(ii) more than 50% of the Fund's outstanding shares. The Fund may not:

(1) Invest more than 25% of its assets, taken at market value, in the
securities of issuers in any particular industry (excluding the U.S.
Government and its agencies and instrumentalities). For the purposes of
this restriction, states, municipalities and their political subdivisions
are not considered to be part of any industry.

(2) Make investments for the purpose of exercising control or
management.

(3) Purchase or sell real estate, except that, to the extent permitted
by applicable law, the Fund may invest in securities directly or indirectly
secured by real estate or interests therein or issued by companies that
invest in real estate or interests therein.

(4) Make loans to other persons, except that the acquisition of bonds,
debentures or other corporate debt securities and investment in government
obligations, commercial paper, pass-through instruments, certificates of
deposit, bankers acceptances, repurchase agreements or any similar
instruments shall not be deemed to be the making of a loan, and except
further that the Fund may lend its portfolio securities, provided that the
lending of portfolio securities may be made only in accordance with
applicable law and the guidelines set forth in the Fund's Prospectus and
Statement of Additional Information, as they may be amended from time to
time.

(5) Issue senior securities to the extent such issuance would violate
applicable law.

(6) Borrow money, except that (i) the Fund may borrow from banks (as
defined in the Investment Company Act) in amounts up to 33 1/3% of its
total assets (including the amount borrowed), (ii) the Fund may, to the
extent permitted by applicable law, borrow up to an additional 5% of its
total assets for temporary purposes, (iii) the Fund may obtain such
short-term credit as may be necessary for the clearance of purchases and
sales of portfolio securities and (iv) the Fund may purchase securities on
margin to the extent permitted by applicable law. The Fund may not pledge
its assets other than to secure such borrowings or, to the extent permitted
by the Fund's investment policies as set forth in its Prospectus and
Statement of Additional Information, as they may be amended from time to
time, in connection with hedging transactions, short sales, when-issued and
forward commitment transactions and similar investment strategies.

(7) Underwrite securities of other issuers except insofar as the Fund
technically may be deemed an underwriter under the Securities Act in
selling portfolio securities.

(8) Purchase or sell commodities or contracts on commodities, except
to the extent that the Fund may do so in accordance with applicable law and
the Fund's Prospectus and Statement of Additional Information, as they may
be amended from time to time, and without registering as a commodity pool
operator under the Commodity Exchange Act.

In addition, the Fund has adopted non-fundamental investment restrictions
that may be changed by the Board of Trustees without a vote of the Fund's
shareholders. Under the non-fundamental investment restrictions, the Fund may
not:

(a) Purchase securities of other investment companies, except to the
extent permitted by applicable law. As a matter of policy, however, the
Fund will not purchase shares of any registered open-end investment company
or registered unit investment trust, in reliance on Section 12(d)(1)(F) or
(G) (the "fund of funds" provisions) of the Investment Company Act at any
time the Fund's shares are owned by another investment company that is part
of the same group of investment companies as the Fund.

(b) Make short sales of securities or maintain a short position,
except to the extent permitted by applicable law. The Fund currently does
not intend to engage in short sales, except short sales "against the box."

16
<PAGE> 50

(c) Invest in securities that cannot be readily resold because of
legal or contractual restrictions or that cannot otherwise be marketed,
redeemed or put to the issuer or a third party, if at the time of
acquisition more than 15% of its total assets would be invested in such
securities. This restriction shall not apply to securities that mature
within seven days or securities, that the Board of Trustees of the Trust
has otherwise determined to be liquid pursuant to applicable law.

(d) Notwithstanding fundamental investment restriction (6) above,
borrow amounts in excess of 20% of its total assets taken at market value
including the amount borrowed, and then only from banks as a temporary
measure for extraordinary or emergency purposes.

In addition, to comply with tax requirements for qualification as a
"regulated investment company," the Fund's investments will be limited in a
manner such that, at the close of each quarter of each fiscal year, (a) no more
than 25% of the Fund's total assets are invested in the securities of a single
issuer, and (b) with regard to at least 50% of the Fund's total assets, no more
than 5% of its total assets are invested in the securities of a single issuer.
For purposes of this restriction, the Fund will regard each state and each
political subdivision, agency or instrumentality of such state and each
multi-state agency of which such state is a member and each public authority
which issues securities on behalf of a private entity as a separate issuer,
except that if the security is backed only by the assets and revenues of a
non-government entity then the entity with the ultimate responsibility for the
payment of interest and principal may be regarded as the sole issuer. These
tax-related limitations may be changed by the Board of Trustees of the Trust to
the extent necessary to comply with changes to the Federal tax requirements.

Because of the affiliation of Merrill Lynch with the Manager, the Fund is
prohibited from engaging in certain transactions involving Merrill Lynch or its
affiliates except pursuant to an exemptive order under the Investment Company
Act. See "Portfolio Transactions." Without such an exemptive order the Fund
would be prohibited from engaging in portfolio transactions with Merrill Lynch
or any of its affiliates acting as principal.

PORTFOLIO TURNOVER

Generally, the Fund does not purchase securities for short-term trading
profits. However, the Fund may dispose of securities without regard to the time
they have been held when such action, for defensive or other reasons, appears
advisable to the Manager. As a result of the investment policies described
herein, the Fund's portfolio turnover rate may be higher than that of other
investment companies; however, it is extremely difficult to predict portfolio
turnover rates with any degree of accuracy. Higher portfolio turnover may
contribute to higher transaction costs in the form of dealer spreads and
brokerage commissions which are borne directly by the Fund. High portfolio
turnover may also result in negative tax consequences, such as an increase in
capital gains dividends or in ordinary income dividends of accrued market
discount. See "Distributions and Taxes -- Taxes." The portfolio turnover rate is
calculated by dividing the lesser of purchases or sales of portfolio securities
for the particular fiscal year by the monthly average of the value of the
portfolio securities owned by the Fund during the particular fiscal year. For
purposes of determining this rate, all securities whose maturities at the time
of acquisition are one year or less are excluded.

MANAGEMENT OF THE TRUST

TRUSTEES AND OFFICERS

The Trustees of the Trust consist of six individuals, five of whom are not
"interested persons" of the Trust as defined in the Investment Company Act (the
"non-interested Trustees"). The Trustees are responsible for the overall
supervision of the operations of the Trust and perform the various duties
imposed on the directors or trustees of investment companies by the Investment
Company Act.

Information about the Trustees, executive officers of the Trust and the
portfolio manager of the Fund, including their ages and their principal
occupations for at least the last five years, is set forth below. Unless
otherwise noted, the address of each Trustee, executive officer and the
portfolio manager is P.O. Box 9011, Princeton, New Jersey 08543-9011.

17
<PAGE> 51

ARTHUR ZEIKEL (66) -- President and Trustee(1)(2) -- Chairman of the
Manager and of Merrill Lynch Asset Management, L.P. ("MLAM") (which terms as
used herein include their corporate predecessors) since 1997; President of the
Manager and MLAM from 1977 to 1997; Chairman of Princeton Services, Inc.
("Princeton Services") since 1997 and Director thereof since 1993; President of
Princeton Services from 1993 to 1997; Executive Vice President of Merrill Lynch
& Co., Inc. ("ML & Co.") since 1990.

JAMES H. BODURTHA (54) -- Trustee(2)(3) -- 36 Popponesset Road, Cotuit,
Massachusetts 02635. Director and Executive Vice President, The China Business
Group, Inc. since 1996; Chairman and Chief Executive Officer, China Enterprise
Management Corporation from 1993 to 1996; Chairman, Berkshire Corporation since
1980; Partner, Squire, Sanders & Dempsey from 1980 to 1993.

HERBERT I. LONDON (59) -- Trustee(2)(3) -- 113-115 University Place, New
York, New York 10003. John M. Olin Professor of Humanities, New York University
since 1993 and Professor thereof since 1980; President, Hudson Institute since
1997 and Trustee thereof since 1980; Dean, Gallatin Division of New York
University from 1976 to 1993; Distinguished Fellow, Herman Kahn Chair, Hudson
Institute from 1984 to 1985; Director, Damon Corporation from 1991 to 1995;
Overseer, Center for Naval Analyses from 1983 to 1993; Limited Partner,
Hypertech LP since 1996.

ROBERT R. MARTIN (71) -- Trustee(2)(3) -- 513 Grand Hill, St. Paul,
Minnesota 55102. Chairman and Chief Executive Officer, Kinnard Investments, Inc.
from 1990 to 1993; Executive Vice President, Dain Bosworth from 1974 to 1989;
Director, Carnegie Capital Management from 1977 to 1985 and Chairman thereof in
1979; Director, Securities Industry Association from 1981 to 1982 and Public
Securities Association from 1979 to 1980; Chairman of the Board, WTC Industries,
Inc. in 1994; Trustee, Northland College since 1992.

JOSEPH L. MAY (69) -- Trustee(2)(3) -- 424 Church Street, Suite 2000,
Nashville, Tennessee 37219. Attorney in private practice since 1984; President,
May and Athens Hosiery Mills Division, Wayne-Gossard Corporation from 1954 to
1983; Vice President, Wayne-Gossard Corporation from 1972 to 1983; Chairman, The
May Corporation (personal holding company) from 1972 to 1983; Director, Signal
Apparel Co. from 1972 to 1989.

ANDRE F. PEROLD (46) -- Trustee(2)(3) -- Morgan Hall, Soldiers Field,
Boston, Massachusetts 02163. Professor, Harvard Business School since 1989 and
Associate Professor from 1983 to 1989; Trustee, The Common Fund since 1989;
Director, Quantec Limited since 1991 and TIBCO from 1994 to 1996.

TERRY K. GLENN (58) -- Executive Vice President(1)(2) -- Executive Vice
President of the Manager and MLAM since 1983; Executive Vice President and
Director of Princeton Services since 1993; President of Princeton Funds
Distributor, Inc. ("PFD") since 1986 and Director thereof since 1991; President
of Princeton Administrators, L.P. since 1988.

VINCENT R. GIORDANO (54) -- Senior Vice President(1)(2) -- Senior Vice
President of the Manager and MLAM since 1984; Senior Vice President of Princeton
Services since 1993.

KENNETH A. JACOB (47) -- Vice President(1)(2) -- First Vice President of
MLAM since 1997; Vice President of MLAM from 1984 to 1997; Vice President of the
Manager since 1984.

WALTER O'CONNOR (37) -- Portfolio Manager and Vice President of the
Fund(1)(2) -- Director (Municipal Tax-Exempt) of MLAM since 1997; Vice President
of MLAM from 1993 to 1997; Assistant Vice President of MLAM from 1991 to 1993.

DONALD C. BURKE (38) -- Vice President(1)(2) -- First Vice President of
MLAM since 1997; Vice President of MLAM from 1990 to 1997; Director of Taxation
of MLAM since 1990.

GERALD M. RICHARD (49) -- Treasurer(1)(2) -- Senior Vice President and
Treasurer of the Manager and MLAM since 1984; Senior Vice President and
Treasurer of Princeton Services since 1993; Treasurer of PFD since 1984 and Vice
President thereof since 1981.

18
<PAGE> 52

ROBERT E. PUTNEY, III (38) -- Secretary(1)(2) -- Director (Legal Advisory)
of MLAM and Princeton Administrators, L.P. since 1997; Vice President of MLAM
from 1994 to 1997; Vice President of Princeton Administrators, L.P. from 1996 to
1997; Attorney with MLAM from 1991 to 1994.
- ---------------
(1) Interested person, as defined in the Investment Company Act, of the Trust.
(2) Such Trustee or officer is a director, trustee or officer of certain other
investment companies for which FAM or MLAM acts as the investment adviser or
manager.
(3) Member of the Trust's Audit and Nominating Committee, which is responsible
for the selection of the independent auditors and the selection and
nomination of non-interested Trustees.

As of December 1, 1998, the Trustees, officers of the Trust and officers of
the Fund as a group (13 persons) owned an aggregate of less than 1% of the
outstanding shares of the Fund. At such date, Mr. Zeikel, a Trustee and officer
of the Trust, the other officers of the Trust and officers of the Fund owned an
aggregate of less than 1% of the outstanding shares of common stock of ML & Co.

COMPENSATION OF TRUSTEES

The Trust pays each non-interested Trustee a fee of $5,000 per year plus
$500 per meeting attended. The Trust also compensates members of its Audit and
Nominating Committee (the "Committee"), which consists of all the non-interested
Trustees, a fee of $1,000 per year plus $250 per Committee meeting attended. The
Trust reimburses each non-interested Trustee for his out-of-pocket expenses
relating to attendance at Board and Committee meetings. The fees and expenses of
the Trustees are allocated to the respective series of the Trust on the basis of
asset size.

The following table shows the compensation earned by the non-interested
Trustees from the Fund for the fiscal year ended August 31, 1998 and the
aggregate compensation paid to non-interested Trustees from all registered
investment companies advised by the Manager and its affiliate, MLAM
("MLAM/FAM-advised funds"), for the calendar year ended December 31, 1997.

<TABLE>
<CAPTION>
AGGREGATE
PENSION OR ESTIMATED COMPENSATION FROM
RETIREMENT BENEFITS ANNUAL TRUST AND OTHER
POSITION WITH COMPENSATION ACCRUED AS PART OF BENEFITS UPON MLAM/FAM-
NAME TRUST FROM FUND FUND EXPENSE RETIREMENT ADVISED FUNDS(1)
- ---- ------------- ------------ ------------------- ------------- -----------------
<S> <C> <C> <C> <C> <C>
James H. Bodurtha..... Trustee $1,196 None None $148,500
Herbert I. London..... Trustee $1,196 None None $148,500
Robert R. Martin...... Trustee $1,196 None None $148,500
Joseph L. May......... Trustee $1,196 None None $148,500
Andre F. Perold....... Trustee $1,196 None None $148,500
</TABLE>

- ---------------
(1) The Trustees serve on the boards of MLAM/FAM-advised funds as follows: Mr.
Bodurtha (25 registered investment companies consisting of 43 portfolios);
Mr. London (25 registered investment companies consisting of 43 portfolios);
Mr. Martin (25 registered investment companies consisting of 43 portfolios);
Mr. May (25 registered investment companies consisting of 43 portfolios);
and Mr. Perold (25 registered investment companies consisting of 43
portfolios).

Trustees of the Trust, members of the Boards of other MLAM-advised
investment companies, ML & Co. and its subsidiaries (the term "subsidiaries,"
when used herein with respect to ML & Co., includes MLAM, the Manager and
certain other entities directly or indirectly wholly owned and controlled by ML
& Co.) and their directors and employees, and any trust, pension, profit-sharing
or other benefit plan for such persons, may purchase Class A shares of the Fund
at net asset value.

MANAGEMENT AND ADVISORY ARRANGEMENTS

Management Services. The Manager provides the Fund with investment
advisory and management services. Subject to the supervision of the Trustees,
the Manager is responsible for the actual management of the Fund's portfolio and
constantly reviews the Fund's holdings in light of its own research analysis and
that from other relevant sources. The responsibility for making decisions to
buy, sell or hold a particular security rests with the Manager. The Manager
performs certain of the other administrative services and provides all the
office space, facilities, equipment and necessary personnel for management of
the Trust and the Fund.

19
<PAGE> 53

Management Fee. The Trust has entered into a management agreement on
behalf of the Fund with the Manager (the "Management Agreement"), pursuant to
which the Manager receives for its services to the Fund monthly compensation at
the following annual rates: 0.55% of the average daily net assets not exceeding
$500 million; 0.525% of the average daily net assets exceeding $500 million but
not exceeding $1.0 billion and 0.50% of the average daily net assets exceeding
$1.0 billion. The table below sets forth information about the total management
fees paid by the Fund to the Manager for the periods indicated.

<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31, MANAGEMENT FEE
---------------------------- --------------
<S> <C>
1998.......................................... $502,296*
1997.......................................... $525,625
1996.......................................... $517,728
</TABLE>

- ---------------
* For the fiscal year ended August 31, 1998, $16,537 of the total management
fees was voluntarily waived.

Payment of Fund Expenses. The Management Agreement obligates the Manager
to provide investment advisory services and to pay all compensation of and
furnish office space for officers and employees of the Trust connected with
investment and economic research, trading and investment management of the
Trust, as well as the fees of all Trustees of the Trust who are affiliated
persons of ML & Co. or any of its affiliates. The Fund pays all other expenses
incurred in its operation and a portion of the Trust's general administrative
expenses allocated on the basis of the asset size of the respective series of
the Trust ("Series"). Expenses that will be borne directly by the Series include
redemption expenses, expenses of portfolio transactions, expenses of registering
the shares under federal and state securities laws, pricing costs (including the
daily calculation of net asset value), expenses of printing shareholder reports,
prospectuses and statements of additional information, except to the extent paid
by Merrill Lynch Funds Distributor, a division of PFD (the "Distributor") as
described below, fees for legal and auditing services, Commission fees,
interest, certain taxes and other expenses attributable to a particular Series.
Expenses that will be allocated on the basis of asset size of the respective
Series include fees and expenses of non-interested Trustees, state franchise
taxes, costs of printing proxies and other expenses relating to shareholder
meetings and other expenses properly payable by the Trust. The organizational
expenses of the Trust were paid by the Trust, and if additional Series are added
to the Trust, the organizational expenses will be allocated among the Series in
a manner deemed equitable by the Trustees. Depending upon the nature of a
lawsuit, litigation costs may be assessed to the specific Series to which the
lawsuit relates or allocated on the basis of the asset size of the respective
Series. The Trustees have determined that this is an appropriate method of
allocation of expenses. Accounting services are provided to the Trust by the
Manager and the Trust reimburses the Manager for its costs in connection with
such services. As required by the Fund's distribution agreements, the
Distributor will pay the promotional expenses of the Fund incurred in connection
with the offering of shares of the Fund. Certain expenses in connection with the
account maintenance and distribution of Class B and Class C shares will be
financed by the Trust pursuant to the Distribution Plans in compliance with Rule
12b-1 under the Investment Company Act. See "Purchase of Shares -- Distribution
Plans." Reference is made to "Management of the Fund" in the Prospectus for
certain information concerning the management and advisory arrangements of the
Trust.

Organization of the Manager. The Manager is a limited partnership, the
partners of which are ML & Co., a financial services holding company and the
parent of Merrill Lynch, and Princeton Services. ML & Co. and Princeton Services
are "controlling persons" of the Manager as defined under the Investment Company
Act because of their ownership of its voting securities or their power to
exercise a controlling influence over its management or policies.

Duration and Termination. Unless earlier terminated as described herein,
the Management Agreement will remain in effect from year to year if approved
annually (a) by the Trustees of the Trust or by a majority of the outstanding
shares of the Fund and (b) by a majority of the Trustees who are not parties to
such contract or interested persons (as defined in the Investment Company Act)
of any such party. Such contracts are not assignable and may be terminated
without penalty on 60 days' written notice at the option of either party or by
vote of the shareholders of the Fund.

20
<PAGE> 54

Transfer Agency Services. Financial Data Services, Inc. (the "Transfer
Agent"), a subsidiary of ML & Co., acts as the Trust's Transfer Agent pursuant
to a Transfer Agency, Dividend Disbursing Agency and Shareholder Servicing
Agency Agreement (the "Transfer Agency Agreement"). Pursuant to the Transfer
Agency Agreement, the Transfer Agent is responsible for the issuance, transfer
and redemption of shares and the opening and maintenance of shareholder
accounts. Pursuant to the Transfer Agency Agreement, the Transfer Agent receives
a fee of $11.00 per Class A or Class D account and $14.00 per Class B or Class C
account and is entitled to reimbursement for certain transaction charges and
out-of-pocket expenses incurred by the Transfer Agent under the Transfer Agency
Agreement. Additionally, a $.20 monthly closed account charge will be assessed
on all accounts which close during the calendar year. Application of this fee
will commence the month following the month the account is closed. At the end of
the calendar year, no further fees will be due. For purposes of the Transfer
Agency Agreement, the term "account" includes a shareholder account maintained
directly by the Transfer Agent and any other account representing the beneficial
interest of a person in the relevant share class on a recordkeeping system,
provided the recordkeeping system is maintained by a subsidiary of ML & Co.

Distribution Expenses. The Fund has entered into four separate
distribution agreements with the Distributor in connection with the continuous
offering of each class of shares of the Fund (the "Distribution Agreements").
The Distribution Agreements obligate the Distributor to pay certain expenses in
connection with the offering of each class of shares of the Fund. After the
prospectuses, statements of additional information and periodic reports have
been prepared, set in type and mailed to shareholders, the Distributor pays for
the printing and distribution of copies thereof used in connection with the
offering to dealers and investors. The Distributor also pays for other
supplementary sales literature and advertising costs. The Distribution
Agreements are subject to the same renewal requirements and termination
provisions as the Management Agreement described above.

CODE OF ETHICS

The Board of Trustees of the Trust has adopted a Code of Ethics under Rule
17j-1 of the Investment Company Act which incorporates the Code of Ethics of the
Manager (together, the "Codes"). The Codes significantly restrict the personal
investing activities of all employees of the Manager and, as described below,
impose additional, more onerous, restrictions on fund investment personnel.

The Codes require that all employees of the Manager pre-clear any personal
securities investment (with limited exceptions, such as government securities).
The pre-clearance requirement and associated procedures are designed to identify
any substantive prohibition or limitation applicable to the proposed investment.
The substantive restrictions applicable to all employees of the Manager include
a ban on acquiring any securities in a "hot" initial public offering and a
prohibition from profiting on short-term trading in securities. In addition, no
employee may purchase or sell any security that at the time is being purchased
or sold (as the case may be), or to the knowledge of the employee is being
considered for purchase or sale, by any fund advised by the Manager.
Furthermore, the Codes provide for trading "blackout periods" which prohibit
trading by investment personnel of the Fund within periods of trading by the
Fund in the same (or equivalent) security (15 or 30 days depending upon the
transaction).

PURCHASE OF SHARES

Reference is made to "How to Buy, Sell, Transfer and Exchange Shares" in
the Prospectus.

The Fund offers four classes of shares under the Merrill Lynch Select
Pricing(SM) System: shares of Class A and Class D are sold to investors choosing
the initial sales charge alternatives and shares of Class B and Class C are sold
to investors choosing the deferred sales charge alternatives. Each Class A,
Class B, Class C or Class D share of the Fund represents an identical interest
in the investment portfolio of the Fund and has the same rights, except that
Class B, Class C and Class D shares bear the expenses of the ongoing account
maintenance fees (also known as service fees) and Class B and Class C shares
bear the expenses of the ongoing distribution fees and the additional
incremental transfer agency costs resulting from the deferred sales charge
arrangements. The contingent deferred sales charges ("CDSCs"), distribution fees
and account

21
<PAGE> 55

maintenance fees that are imposed on Class B and Class C shares, as well as the
account maintenance fees that are imposed on Class D shares, are imposed
directly against those classes and not against all assets of the Fund and,
accordingly, such charges do not affect the net asset value of any other class
or have any impact on investors choosing another sales charge option. Dividends
paid by the Fund for each class of shares are calculated in the same manner at
the same time and differ only to the extent that account maintenance and
distribution fees and any incremental transfer agency costs relating to a
particular class are borne exclusively by that class. Each class has different
exchange privileges. See "Shareholder Services -- Exchange Privilege."

Investors should understand that the purpose and function of the initial
sales charges with respect to the Class A and Class D shares are the same as
those of the CDSCs and distribution fees with respect to the Class B and Class C
shares in that the sales charges and distribution fees applicable to each class
provide for the financing of the distribution of the shares of the Fund. The
distribution-related revenues paid with respect to a class will not be used to
finance the distribution expenditures of another class. Sales personnel may
receive different compensation for selling different classes of shares.

The Merrill Lynch Select Pricing(SM) System is used by more than 50
registered investment companies advised by MLAM or FAM. Funds advised by MLAM or
FAM that utilize the Merrill Lynch Select Pricing(SM) System are referred to
herein as "Select Pricing Funds."

The Fund or the Distributor may suspend the continuous offering of the
Fund's shares of any class at any time in response to conditions in the
securities markets or otherwise and may thereafter resume such offering from
time to time. Neither the Distributor nor the dealers are permitted to withhold
placing orders to benefit themselves by a price change. Merrill Lynch may charge
its customers a processing fee (presently $5.35) to confirm a sale of shares to
such customers. Purchases made directly through the Transfer Agent are not
subject to the processing fee.

INITIAL SALES CHARGE ALTERNATIVES -- CLASS A AND CLASS D SHARES

Investors who prefer an initial sales charge alternative may elect to
purchase Class D shares or, if an eligible investor, Class A shares. Investors
choosing the initial sales charge alternative who are eligible to purchase Class
A shares should purchase Class A shares rather than Class D shares because there
is an account maintenance fee imposed on Class D shares. Investors qualifying
for significantly reduced initial sales charges may find the initial sales
charge alternative particularly attractive because similar sales charge
reductions are not available with respect to the deferred sales charges imposed
in connection with purchases of Class B or Class C shares. Investors not
qualifying for reduced initial sales charges who expect to maintain their
investment for an extended period of time also may elect to purchase Class A or
Class D shares, because over time the accumulated ongoing account maintenance
and distribution fees on Class B or Class C shares may exceed the initial sales
charges and, in the case of Class D shares, the account maintenance fee.
Although some investors who previously purchased Class A shares may no longer be
eligible to purchase Class A shares of other Select Pricing Funds, those
previously purchased Class A shares, together with Class B, Class C and Class D
share holdings, will count toward a right of accumulation which may qualify the
investor for a reduced initial sales charge on new initial sales charge
purchases. In addition, the ongoing Class B and Class C account maintenance and
distribution fees will cause Class B and Class C shares to have higher expense
ratios, pay lower dividends and have lower total returns than the initial sales
charge shares. The ongoing Class D account maintenance fees will cause Class D
shares to have a higher expense ratio, pay lower dividends and have a lower
total return than Class A shares.

The term "purchase," as used in the Prospectus and this Statement of
Additional Information in connection with an investment in Class A and Class D
shares of the Fund, refers to a single purchase by an individual or to
concurrent purchases, which in the aggregate are at least equal to the
prescribed amounts, by an individual, his or her spouse and their children under
the age of 21 years purchasing shares for his, her or their own account and to
single purchases by a trustee or other fiduciary purchasing shares for a single
trust estate or single fiduciary account although more than one beneficiary is
involved. The term "purchase" also includes purchases by any "company," as that
term is defined in the Investment Company Act, but does not include purchases by
any such company that has not been in existence for at least six months or which
has no

22
<PAGE> 56

purpose other than the purchase of shares of the Fund or shares of other
registered investment companies at a discount; provided, however, that it shall
not include purchases by any group of individuals whose sole organizational
nexus is that the participants therein are credit cardholders of a company,
policyholders of an insurance company, customers of either a bank or
broker-dealer or clients of an investment adviser.

Eligible Class A Investors

Class A shares are offered to a limited group of investors and also will be
issued upon reinvestment of dividends on outstanding Class A shares. Investors
who currently own Class A shares are entitled to purchase additional Class A
shares of the Fund in that account. Class A shares are available at net asset
value to corporate warranty insurance reserve fund programs provided that the
program has $3 million or more initially invested in Select Pricing Funds. Also
eligible to purchase Class A shares at net asset value are participants in
certain investment programs including TMA(SM) Managed Trusts to which Merrill
Lynch Trust Company provides discretionary trustee services, collective
investment trusts for which Merrill Lynch Trust Company serves as trustee and
certain purchases made in connection with certain fee-based programs. In
addition, Class A shares are offered at net asset value to ML & Co. and its
subsidiaries and their directors and employees and to members of the Boards of
MLAM-advised investment companies. Certain persons who acquired shares of
certain MLAM-advised closed-end funds in their initial offerings who wish to
reinvest the net proceeds from a sale of their closed-end fund shares of common
stock in shares of the Fund also may purchase Class A shares of the Fund if
certain conditions are met. In addition, Class A shares of the Fund and certain
other Select Pricing Funds are offered at net asset value to shareholders of
Merrill Lynch Senior Floating Rate Fund, Inc. and, if certain conditions are
met, to shareholders of Merrill Lynch Municipal Strategy Fund, Inc. and Merrill
Lynch High Income Municipal Bond Fund, Inc. who wish to reinvest the net
proceeds from a sale of certain of their shares of common stock pursuant to a
tender offer conducted by such funds in shares of the Fund and certain other
Select Pricing Funds.

Investors are advised that only Class A and Class D shares may be available
for purchase through securities dealers, other than Merrill Lynch, that are
eligible to sell shares.

Class A and Class D Sales Charge Information

CLASS A SHARES

<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------
For the Fiscal Year Gross Sales Sales Charges Sales Charges CDSCs Received on
Ended Charges Retained by Paid to Redemption of
August 31, Collected Distributor Merrill Lynch Load-Waived Shares
- ---------------------- ------------- --------------- --------------- --------------------
<S> <C> <C> <C> <C>
1998 $ 613 $ 46 $ 567 0
1997 $1,485 $ 150 $1,335 0
1996 $9,669 $1,410 $8,259 0
</TABLE>

CLASS D SHARES

<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------
For the Fiscal Year Gross Sales Sales Charges Sales Charges CDSCs Received on
Ended Charges Retained by Paid to Redemption of
August 31, Collected Distributor Merrill Lynch Load-Waived Shares
- ---------------------- ------------- --------------- --------------- --------------------
<S> <C> <C> <C> <C>
1998 $ 9,801 $1,083 $ 8,718 0
1997 $ 3,599 $ 503 $ 3,096 0
1996 $11,008 $ 912 $10,096 0
</TABLE>

The Distributor may reallow discounts to selected dealers and retain the
balance over such discounts. At times the Distributor may reallow the entire
sales charge to such dealers. Since securities dealers selling Class A and
Class D shares of the Fund will receive a concession equal to most of the sales
charge, they may be deemed to be underwriters under the Securities Act.

23
<PAGE> 57

Reduced Initial Sales Charges

Reinvested Dividends and Capital Gains. No initial sales charges are
imposed upon Class A and Class D shares issued as a result of the automatic
reinvestment of dividends or capital gains distributions.

Right of Accumulation. Reduced sales charges are applicable through a
right of accumulation under which eligible investors are permitted to purchase
shares of the Fund subject to an initial sales charge at the offering price
applicable to the total of (a) the public offering price of the shares then
being purchased plus (b) an amount equal to the then current net asset value or
cost, whichever is higher, of the purchaser's combined holdings of all classes
of shares of the Fund and of any other Select Pricing Funds. For any such right
of accumulation to be made available, the Distributor must be provided at the
time of purchase, by the purchaser or the purchaser's securities dealer, with
sufficient information to permit confirmation of qualification. Acceptance of
the purchase order is subject to such confirmation. The right of accumulation
may be amended or terminated at any time. Shares held in the name of a nominee
or custodian under pension, profit-sharing or other employee benefit plans may
not be combined with other shares to qualify for the right of accumulation.

Letter of Intent. Reduced sales charges are applicable to purchases
aggregating $25,000 or more of the Class A or Class D shares of the Fund or any
Select Pricing Funds made within a 13-month period starting with the first
purchase pursuant to a Letter of Intent. The Letter of Intent is available only
to investors whose accounts are established and maintained at the Fund's
Transfer Agent. The Letter of Intent is not available to employee benefit plans
for which Merrill Lynch provides plan participant recordkeeping services. The
Letter of Intent is not a binding obligation to purchase any amount of Class A
or Class D shares; however, its execution will result in the purchaser paying a
lower sales charge at the appropriate quantity purchase level. A purchase not
originally made pursuant to a Letter of Intent may be included under a
subsequent Letter of Intent executed within 90 days of such purchase if the
Distributor is informed in writing of this intent within such 90-day period. The
value of Class A and Class D shares of the Fund and of other Select Pricing
Funds presently held, at cost or maximum offering price (whichever is higher),
on the date of the first purchase under the Letter of Intent, may be included as
a credit toward the completion of such Letter, but the reduced sales charge
applicable to the amount covered by such Letter will be applied only to new
purchases. If the total amount of shares does not equal the amount stated in the
Letter of Intent (minimum of $25,000), the investor will be notified and must
pay, within 20 days of the expiration of such Letter, the difference between the
sales charge on the Class A or Class D shares purchased at the reduced rate and
the sales charge applicable to the shares actually purchased through the Letter.
Class A or Class D shares equal to at least 5.0% of the intended amount will be
held in escrow during the 13-month period (while remaining registered in the
name of the purchaser) for this purpose. The first purchase under the Letter of
Intent must be at least 5.0% of the dollar amount of such Letter. If a purchase
during the term of such Letter would otherwise be subject to a further reduced
sales charge based on the right of accumulation, the purchaser will be entitled
on that purchase and subsequent purchases to the further reduced percentage
sales charge that would be applicable to a single purchase equal to the total
dollar value of the Class A or Class D shares then being purchased under such
Letter, but there will be no retroactive reduction of the sales charge on any
previous purchase.

The value of any shares redeemed or otherwise disposed of by the purchaser
prior to termination or completion of the Letter of Intent will be deducted from
the total purchases made under such Letter. An exchange from the Summit Cash
Reserves Fund into the Fund that creates a sales charge will count toward
completing a new or existing Letter of Intent from the Fund.

TMA(SM) Managed Trusts. Class A shares are offered at net asset value to
TMA(SM) Managed Trusts to which Merrill Lynch Trust Company provides
discretionary trustee services.

Employee Access(SM)Accounts. Provided applicable threshold requirements
are met, either Class A or Class D shares are offered at net asset value to
Employee Access(SM) Accounts available through authorized employers. The
initial minimum investment for such accounts is $500, except that the initial
minimum investment for shares purchased for such accounts pursuant to the
Automatic Investment Program is $50.

24
<PAGE> 58

Purchase Privilege of Certain Persons. Trustees of the Trust, members of
the Boards of other MLAM-advised funds, ML & Co. and its subsidiaries (the term
"subsidiaries," when used herein with respect to ML & Co., includes MLAM, FAM
and certain other entities directly or indirectly wholly owned and controlled by
ML & Co.) and their directors and employees, and any trust, pension,
profit-sharing or other benefit plan for such persons, may purchase Class A
shares of the Fund at net asset value.

Class D shares of the Fund are offered at net asset value, without a sales
charge, to an investor that has a business relationship with a Financial
Consultant who joined Merrill Lynch from another investment firm within six
months prior to the date of purchase by such investor, if the following
conditions are satisfied: first, the investor must advise Merrill Lynch that it
will purchase Class D shares of the Fund with proceeds from a redemption of
shares of a mutual fund that was sponsored by the Financial Consultant's
previous firm and was subject to a sales charge either at the time of purchase
or on a deferred basis; and, second, the investor must establish that such
redemption had been made within 60 days prior to the investment in the Fund and
the proceeds from the redemption had been maintained in the interim in cash or a
money market fund.

Class D shares of the Fund are also offered at net asset value, without a
sales charge, to an investor that has a business relationship with a Merrill
Lynch Financial Consultant and that has invested in a mutual fund sponsored by a
non-Merrill Lynch company for which Merrill Lynch has served as a selected
dealer and where Merrill Lynch has either received or given notice that such
arrangement will be terminated ("notice") if the following conditions are
satisfied: first, the investor must purchase Class D shares of the Fund with
proceeds from a redemption of shares of such other mutual fund and the shares of
such other fund were subject to a sales charge either at the time of purchase or
on a deferred basis; and, second, such purchase of Class D shares must be made
within 90 days after such notice.

Class D shares of the Fund are offered at net asset value, without a sales
charge, to an investor that has a business relationship with a Merrill Lynch
Financial Consultant and that has invested in a mutual fund for which Merrill
Lynch has not served as a selected dealer if the following conditions are
satisfied: first, the investor must advise Merrill Lynch that it will purchase
Class D shares of the Fund with proceeds from the redemption of shares of such
other mutual fund and that such shares have been outstanding for a period of no
less than six months; and, second, such purchase of Class D shares must be made
within 60 days after the redemption and the proceeds from the redemption must be
maintained in the interim in cash or a money market fund.

Closed-End Fund Investment Option. Class A shares of the Fund and certain
other Select Pricing Funds ("Eligible Class A Shares") are offered at net asset
value to shareholders of certain closed-end funds advised by FAM or MLAM who
purchased such closed-end fund shares prior to October 21, 1994 (the date the
Merrill Lynch Select Pricing(SM) System commenced operations) and wish to
reinvest the net proceeds from a sale of their closed-end fund shares of common
stock in Eligible Class A Shares, if the conditions set forth below are
satisfied. Alternatively, closed-end fund shareholders who purchased such
shares on or after October 21, 1994 and wish to reinvest the net proceeds from
a sale of their closed-end fund shares are offered Class A shares (if eligible
to buy Class A shares) or Class D shares of the Fund and other Select Pricing
Funds ("Eligible Class D Shares"), if the following conditions are met. First,
the sale of closed-end fund shares must be made through Merrill Lynch, and the
net proceeds therefrom must be immediately reinvested in Eligible Class A or
Eligible Class D Shares. Second, the closed-end fund shares must either have
been acquired in the initial public offering or be shares representing
dividends from shares of common stock acquired in such offering. Third, the
closed-end fund shares must have been continuously maintained in a Merrill
Lynch securities account. Fourth, there must be a minimum purchase of $250 to
be eligible for the investment option.

Shareholders of certain MLAM-advised continuously offered closed-end funds
may reinvest at net asset value the net proceeds from a sale of certain shares
of common stock of such funds in shares of the Fund. Upon exercise of this
investment option, shareholders of Merrill Lynch Senior Floating Rate Fund, Inc.
will receive Class A shares of the Fund and shareholders of Merrill Lynch
Municipal Strategy Fund, Inc. and Merrill Lynch High Income Municipal Bond Fund,
Inc. will receive Class D shares of the Fund, except that shareholders already
owning Class A shares of the Fund will be eligible to purchase additional Class
A shares

25
<PAGE> 59

pursuant to this option, if such additional Class A shares will be held in the
same account as the existing Class A shares and the other requirements
pertaining to the reinvestment privilege are met. In order to exercise this
investment option, a shareholder of one of the above-referenced continuously
offered closed-end funds (an "eligible fund") must sell his or her shares of
common stock of the eligible fund (the "eligible shares") back to the eligible
fund in connection with a tender offer conducted by the eligible fund and
reinvest the proceeds immediately in the designated class of shares of the Fund.
This investment option is available only with respect to eligible shares as to
which no Early Withdrawal Charge or CDSC (each as defined in the eligible fund's
prospectus) is applicable. Purchase orders from eligible fund shareholders
wishing to exercise this investment option will be accepted only on the day that
the related tender offer terminates and will be effected at the net asset value
of the designated class of the Fund on such day.

Acquisition of Certain Investment Companies. The public offering price of
Class D shares may be reduced to the net asset value per Class D share in
connection with the acquisition of the assets of or merger or consolidation with
a personal holding company or a public or private investment company. The value
of the assets or company acquired in a tax-free transaction may be adjusted in
appropriate cases to reduce possible adverse tax consequences to the Fund that
might result from an acquisition of assets having net unrealized appreciation
that is disproportionately higher at the time of acquisition than the realized
or unrealized appreciation of the Fund. The issuance of Class D shares for
consideration other than cash is limited to bona fide reorganizations, statutory
mergers or other acquisitions of portfolio securities that (i) meet the
investment objectives and policies of the Fund; (ii) are acquired for investment
and not for resale (subject to the understanding that the disposition of the
Fund's portfolio securities shall at all times remain within its control); and
(iii) are liquid securities, the value of which is readily ascertainable, which
are not restricted as to transfer either by law or liquidity of market (except
that the Fund may acquire through such transactions restricted or illiquid
securities to the extent the Fund does not exceed the applicable limits on
acquisition of such securities set forth under "Investment Objective and
Policies" herein).

Reductions in or exemptions from the imposition of a sales load are due to
the nature of the investors and/or the reduced sales efforts that will be needed
in obtaining such investments.

DEFERRED SALES CHARGE ALTERNATIVES -- CLASS B AND CLASS C SHARES

Investors choosing the deferred sales charge alternatives should consider
Class B shares if they intend to hold their shares for an extended period of
time and Class C shares if they are uncertain as to the length of time they
intend to hold their assets in Select Pricing Funds.

Because no initial sales charges are deducted at the time of the purchase,
Class B and Class C shares provide the benefit of putting all of the investor's
dollars to work from the time the investment is made. The deferred sales charge
alternatives may be particularly appealing to investors that do not qualify for
the reduction in initial sales charges. Both Class B and Class C shares are
subject to ongoing account maintenance fees and distribution fees; however, the
ongoing account maintenance and distribution fees potentially may be offset to
the extent any return is realized on the additional funds initially invested in
Class B or Class C shares. In addition, Class B shares will be converted into
Class D shares of the Fund after a conversion period of approximately ten years,
and thereafter investors will be subject to lower ongoing fees.

The public offering price of Class B and Class C shares for investors
choosing the deferred sales charge alternatives is the next determined net asset
value per share without the imposition of a sales charge at the time of
purchase. See "Pricing of Shares -- Determination of Net Asset Value" below.

Contingent Deferred Sales Charges -- Class B Shares

Class B shares that are redeemed within four years of purchase may be
subject to a CDSC at the rates set forth below charged as a percentage of the
dollar amount subject thereto. In determining whether a CDSC is applicable to a
redemption, the calculation will be determined in the manner that results in the
lowest applicable rate being charged. The charge will be assessed on an amount
equal to the lesser of the proceeds of redemption or the cost of the shares
being redeemed. Accordingly, no CDSC will be imposed on increases in net asset
value above the initial purchase price. In addition, no CDSC will be assessed on
shares derived from

26
<PAGE> 60

reinvestment of dividends or capital gains distributions. It will be assumed
that the redemption is first of shares held for over four years or shares
acquired pursuant to reinvestment of dividends or distributions and then of
shares held longest during the four-year period. A transfer of shares from a
shareholder's account to another account will be assumed to be made in the same
order as a redemption.

The following table sets forth the Class B CDSC:

<TABLE>
<CAPTION>
CDSC AS A PERCENTAGE
OF DOLLAR AMOUNT
YEAR SINCE PURCHASE PAYMENT MADE SUBJECT TO CHARGE
-------------------------------- --------------------
<S> <C>
0-1............................................... 4.0%
1-2............................................... 3.0%
2-3............................................... 2.0%
3-4............................................... 1.0%
4 and thereafter.................................. None
</TABLE>

To provide an example, assume an investor purchased 100 shares at $10 per
share (at a cost of $1,000) and in the third year after purchase, the net asset
value per share is $12 and, during such time, the investor has acquired 10
additional shares upon dividend reinvestment. If at such time the investor makes
his or her first redemption of 50 shares (proceeds of $600), 10 shares will not
be subject to a CDSC because of dividend reinvestment. With respect to the
remaining 40 shares, the charge is applied only to the original cost of $10 per
share and not to the increase in net asset value of $2 per share. Therefore,
$400 of the $600 redemption proceeds will be charged at a rate of 2.0% (the
applicable rate in the third year after purchase).

The Class B CDSC is waived on redemptions of shares in certain
circumstances, including any partial or complete redemption following the death
or disability (as defined in the Internal Revenue Code of 1986, as amended (the
"Code")) of a Class B shareholder (including one who owns the Class B shares as
joint tenant with his or her spouse), provided the redemption is requested
within one year of the death or initial determination of disability. The Class B
CDSC also is waived for any Class B shares that are purchased within qualifying
Employee Access(SM) Accounts. The terms of the CDSC may be modified in
connection with certain fee-based programs. See "Shareholder Services --
Fee-Based Programs."

Conversion of Class B Shares to Class D Shares. After approximately ten
years (the "Conversion Period"), Class B shares will be converted automatically
into Class D shares of the Fund. Class D shares are subject to an ongoing
account maintenance fee of 0.10% of net assets but are not subject to the
distribution fee that is borne by Class B shares. Automatic conversion of Class
B shares into Class D shares will occur at least once each month (on the
"Conversion Date") on the basis of the relative net asset value of the shares of
the two classes on the Conversion Date, without the imposition of any sales
load, fee or other charge. Conversion of Class B shares to Class D shares will
not be deemed a purchase or sale of the shares for Federal income tax purposes.

In addition, shares purchased through reinvestment of dividends on Class B
shares also will convert automatically to Class D shares. The Conversion Date
for dividend reinvestment shares will be calculated taking into account the
length of time the shares underlying such dividend reinvestment shares were
outstanding. If at the Conversion Date the conversion of Class B shares to Class
D shares of the Fund in a single account will result in less than $50 worth of
Class B shares being left in the account, all of the Class B shares of the Fund
held in the account on the Conversion Date will be converted to Class D shares
of the Fund.

In general, Class B shares of equity Select Pricing Funds will convert
approximately eight years after initial purchase and Class B shares of taxable
and tax-exempt fixed income Select Pricing Funds will convert approximately ten
years after initial purchase. If, during the Conversion Period, a shareholder
exchanges Class B shares with an eight-year Conversion Period for Class B shares
with a ten-year Conversion Period, or vice versa, the Conversion Period
applicable to the Class B shares acquired in the exchange will apply and the
holding period for the shares exchanged will be tacked on to the holding period
for the shares acquired. The

27
<PAGE> 61

conversion period also may be modified for investors that participate in certain
fee-based programs. See "Shareholder Services -- Fee-Based Programs."

Class B shareholders of the Fund exercising the exchange privilege
described under "Shareholder Services -- Exchange Privilege" will continue to be
subject to the Fund's CDSC schedule if such schedule is higher than the CDSC
schedule relating to the Class B shares acquired as a result of the exchange.

Share certificates for Class B shares of the Fund to be converted must be
delivered to the Transfer Agent at least one week prior to the Conversion Date
applicable to those shares. In the event such certificates are not received by
the Transfer Agent at least one week prior to the Conversion Date, the related
Class B shares will convert to Class D shares on the next scheduled Conversion
Date after such certificates are delivered.

Contingent Deferred Sales Charges -- Class C Shares

Class C shares that are redeemed within one year of purchase may be subject
to a 1.0% CDSC charged as a percentage of the dollar amount subject thereto. In
determining whether a Class C CDSC is applicable to a redemption, the
calculation will be determined in the manner that results in the lowest possible
rate being charged. The charge will be assessed on an amount equal to the lesser
of the proceeds of redemption or the cost of the shares being redeemed.
Accordingly, no Class C CDSC will be imposed on increases in net asset value
above the initial purchase price. In addition, no Class C CDSC will be assessed
on shares derived from reinvestment of dividends or capital gains distributions.
It will be assumed that the redemption is first of shares held for over one year
or shares acquired pursuant to reinvestment of dividends or distributions and
then of shares held longest during the one-year period. The charge will not be
applied to dollar amounts representing an increase in the net asset value since
the time of purchase. A transfer of shares from a shareholder's account to
another account will be assumed to be made in the same order as a redemption.
The Class C CDSC may be waived in connection with certain fee-based programs,
involuntary termination of an account in which Fund shares are held and
withdrawals through the Merrill Lynch Systematic Withdrawal Plan. See
"Shareholder Services -- Fee-Based Programs."

Class B and Class C Sales Charge Information

<TABLE>
<CAPTION>
CLASS B SHARES*
- ----------------------------------------------------------------------------
For the Fiscal Year CDSCs Received CDSCs Paid to
Ended August 31, by Distributor Merrill Lynch
- ------------------------ ------------------------ ------------------------
<S> <C> <C>
1998 $ 93,829 $ 93,829
1997 $129,315 $129,315
1996 $157,396 $157,396
</TABLE>

* Additional Class B CDSCs payable to the Distributor
with respect to the fiscal years ended August 31,
1997 and 1998 may have been waived or converted to a
contingent obligation in connection with a
shareholder's participation in certain fee-based
programs.

<TABLE>
<CAPTION>
CLASS C SHARES
- ----------------------------------------------------------------------------
For the Fiscal Year CDSCs Received CDSCs Paid to
Ended August 31, by Distributor Merrill Lynch
- ------------------------ ------------------------ ------------------------
<S> <C> <C>
1998 $ 8,328 $ 8,328
1997 $ 1,735 $ 1,735
1996 $ 2,319 $ 2,319
</TABLE>

Merrill Lynch compensates its Financial Consultants for selling Class B and
Class C shares at the time of purchase from its own funds. Proceeds from the
CDSC and the distribution fee are paid to the Distributor and are used in whole
or in part by the Distributor to defray the expenses of dealers (including
Merrill Lynch) related to providing distribution-related services to the Fund in
connection with the sale of the Class B and Class C shares, such as the payment
of compensation to financial consultants for selling Class B and Class C shares
from the dealer's own funds. The combination of the CDSC and the ongoing
distribution fee facilitates
28
<PAGE> 62

the ability of the Fund to sell the Class B and Class C shares without a sales
charge being deducted at the time of purchase. See "Distribution Plans" below.
Imposition of the CDSC and the distribution fee on Class B and Class C shares is
limited by the NASD asset-based sales charge rule. See "Limitations on the
Payment of Deferred Sales Charges" below.

DISTRIBUTION PLANS

Reference is made to "Fees and Expenses" in the Prospectus for certain
information with respect to the separate distribution plans for Class B, Class C
and Class D shares pursuant to Rule 12b-1 under the Investment Company Act (each
a "Distribution Plan") with respect to the account maintenance and/or
distribution fees paid by the Fund to the Distributor with respect to such
classes.

The Distribution Plans for Class B, Class C and Class D shares each
provides that the Fund pays the Distributor an account maintenance fee relating
to the shares of the relevant class, accrued daily and paid monthly, at the
annual rates of 0.25%, 0.25% and 0.10%, respectively, of the average daily net
assets of the Fund attributable to shares of the relevant class in order to
compensate the Distributor and Merrill Lynch (pursuant to a sub-agreement) in
connection with account maintenance activities with respect to Class B, Class C
and Class D shares. Each of those classes has exclusive voting rights with
respect to the Distribution Plan adopted with respect to such class pursuant to
which account maintenance and/or distribution fees are paid (except that Class B
shareholders may vote upon any material changes to expenses charged under the
Class D Distribution Plan).

The Distribution Plans for Class B and Class C shares each provides that
the Fund also pays the Distributor a distribution fee relating to the shares of
the relevant class, accrued daily and paid monthly, at the annual rates of 0.25%
and 0.35%, respectively, of the average daily net assets of the Fund
attributable to the shares of the relevant class in order to compensate the
Distributor and Merrill Lynch (pursuant to a sub-agreement) for providing
shareholder and distribution services and bearing certain distribution-related
expenses of the Fund, including payments to financial consultants for selling
Class B and Class C shares of the Fund. The Distribution Plans relating to Class
B and Class C shares are designed to permit an investor to purchase Class B and
Class C shares through dealers without the assessment of an initial sales charge
and at the same time permit the dealer to compensate its financial consultants
in connection with the sale of the Class B and Class C shares.

The Fund's Distribution Plans are subject to the provisions of Rule 12b-1
under the Investment Company Act. In their consideration of each Distribution
Plan, the Trustees must consider all factors they deem relevant, including
information as to the benefits of the Distribution Plan to the Fund and each
related class of shareholders. Each Distribution Plan further provides that, so
long as the Distribution Plan remains in effect, the selection and nomination of
non-interested Trustees shall be committed to the discretion of the non-
interested Trustees then in office. In approving each Distribution Plan in
accordance with Rule 12b-1, the non-interested Trustees concluded that there is
reasonable likelihood that each Distribution Plan will benefit the Fund and its
related class of shareholders. Each Distribution Plan can be terminated at any
time, without penalty, by the vote of a majority of the non-interested Trustees
or by the vote of the holders of a majority of the outstanding related class of
voting securities of the Fund. A Distribution Plan cannot be amended to increase
materially the amount to be spent by the Fund without the approval of the
related class of shareholders and all material amendments are required to be
approved by the vote of Trustees, including a majority of the non-interested
Trustees who have no direct or indirect financial interest in the Distribution
Plan, cast in person at a meeting called for that purpose. Rule 12b-1 further
requires that the Fund preserve copies of the Distribution Plan and any report
made pursuant to such plan for a period of not less than six years from the date
of the Distribution Plan or such report, the first two years in an easily
accessible place.

Among other things, each Distribution Plan provides that the Distributor
shall provide and the Trustees shall review quarterly reports of the
disbursement of the account maintenance and/or distribution fees paid to the
Distributor. Payments under the Distribution Plans are based on a percentage of
average daily net assets attributable to the shares regardless of the amount of
expenses incurred and, accordingly, distribution-related revenues from the
Distribution Plans may be more or less than distribution-related expenses.
Information with

29
<PAGE> 63

respect to the distribution-related revenues and expenses is presented to the
Trustees for their consideration in connection with their deliberations as to
the continuance of the Class B and Class C Distribution Plans annually, as of
December 31 of each year, on a "fully allocated accrual" basis and quarterly on
a "direct expense and revenue/cash" basis. On the fully allocated accrual basis,
revenues consist of the account maintenance fees, distribution fees, the CDSCs
and certain other related revenues, and expenses consist of financial consultant
compensation, branch office and regional operation center selling and
transaction processing expenses, advertising, sales promotion and marketing
expenses, corporate overhead and interest expense. On the direct expense and
revenue/cash basis, revenues consist of the account maintenance fees,
distribution fees and CDSCs and the expenses consist of financial consultant
compensation.

As of December 31, 1997, the last date for which fully allocated accrual
data is available, the fully allocated accrual expenses of the Distributor and
Merrill Lynch for the period since the commencement of operations of Class B
shares exceeded the fully allocated accrual revenues by approximately $1,495,000
(2.19% of Class B net assets at that date). As of August 31, 1998, direct cash
revenues for the period since the commencement of operations of Class B shares
exceeded direct cash expenses by $885,421 (1.33% of Class B net assets at that
date). As of December 31, 1997, the fully allocated accrual revenues incurred by
the Distributor and Merrill Lynch for the period since the commencement of
operations of Class C shares exceeded the fully allocated accrual expenses by
approximately $4,000 (0.08% of Class C net assets at that date). As of August
31, 1998, direct cash revenues for the period since the commencement of
operations of Class C shares exceeded direct cash expenses by $65,177 (1.44% of
Class C net assets at that date).

For the fiscal year ended August 31, 1998, the Fund paid the Distributor
$336,037 pursuant to the Class B Distribution Plan (based on average daily net
assets subject to such Class B Distribution Plan of approximately $67.4
million), all of which was paid to Merrill Lynch for providing account
maintenance and distribution-related activities and services in connection with
Class B shares. For the fiscal year ended August 31, 1998, the Fund paid the
Distributor $29,896 pursuant to the Class C Distribution Plan (based on average
daily net assets subject to such Class C Distribution Plan of approximately $5.0
million), all of which was paid to Merrill Lynch for providing account
maintenance and distribution-related activities and services in connection with
Class C shares. For the fiscal year ended August 31, 1998, the Fund paid the
Distributor $7,024 pursuant to the Class D Distribution Plan (based on average
daily net assets subject to such Class D Distribution Plan of approximately $7.0
million), all of which was paid to Merrill Lynch for providing account
maintenance activities in connection with Class D shares.

LIMITATIONS ON THE PAYMENT OF DEFERRED SALES CHARGES

The maximum sales charge rule in the Conduct Rules of the NASD imposes a
limitation on certain asset-based sales charges such as the distribution fee and
the CDSC borne by the Class B and Class C shares but not the account maintenance
fee. The maximum sales charge rule is applied separately to each class. As
applicable to the Fund, the maximum sales charge rule limits the aggregate of
distribution fee payments and CDSCs payable by the Fund to (1) 6.25% of eligible
gross sales of Class B shares and Class C shares, computed separately (defined
to exclude shares issued pursuant to dividend reinvestments and exchanges), plus
(2) interest on the unpaid balance for the respective class, computed
separately, at the prime rate plus 1% (the unpaid balance being the maximum
amount payable minus amounts received from the payment of the distribution fee
and the CDSC). In connection with the Class B shares, the Distributor has
voluntarily agreed to waive interest charges on the unpaid balance in excess of
0.50% of eligible gross sales. Consequently, the maximum amount payable to the
Distributor (referred to as the "voluntary maximum") in connection with the
Class B shares is 6.75% of eligible gross sales. The Distributor retains the
right to stop waiving the interest charges at any time. To the extent payments
would exceed the voluntary maximum, the Fund will not make further payments of
the distribution fee with respect to Class B shares and any CDSCs will be paid
to the Fund rather than to the Distributor; however, the Fund will continue to
make payments of the account maintenance fee. In certain circumstances the
amount payable pursuant to the voluntary maximum may exceed the amount payable
under the NASD formula. In such circumstances payment in excess of the amount
payable under the NASD formula will not be made.

30
<PAGE> 64

The following table sets forth comparative information as of August 31,
1998 with respect to the Class B and Class C shares of the Fund indicating the
maximum allowable payments that can be made under the NASD maximum sales charge
rule and, with respect to the Class B shares, the Distributor's voluntary
maximum.

<TABLE>
<CAPTION>
DATA CALCULATED AS OF AUGUST 31, 1998
-------------------------------------------------------------------------------------------
(IN THOUSANDS)
ANNUAL
DISTRIBUTION
ALLOWABLE AMOUNTS FEE AT
ELIGIBLE ALLOWABLE INTEREST ON MAXIMUM PREVIOUSLY AGGREGATE CURRENT NET
GROSS AGGREGATE UNPAID AMOUNT PAID TO UNPAID ASSET
SALES(1) SALES CHARGE BALANCE(2) PAYABLE DISTRIBUTOR(3) BALANCE LEVEL(4)
-------- ------------ ----------- ------- -------------- --------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
CLASS B SHARES FOR THE PERIOD
FEBRUARY 26, 1993 (COMMENCEMENT
OF OPERATIONS) TO AUGUST 31,
1998
Under NASD Rule as Adopted....... $118,878 $7,430 $3,039 $10,469 $1,908 $8,561 $167
Under Distributor's Voluntary
Waiver......................... $118,878 $7,430 $ 595 $ 8,025 $1,908 $6,117 $167

CLASS C SHARES, FOR THE PERIOD
OCTOBER 21, 1994 (COMMENCEMENT
OF OPERATIONS) TO AUGUST 31,
1998
Under NASD Rule as Adopted....... $ 9,809 $ 613 $ 125 $ 738 $ 63 $ 675 $ 16
</TABLE>

- ---------------
(1) Purchase price of all eligible Class B or Class C shares sold during the
periods indicated other than shares acquired through dividend reinvestment
and the exchange privilege.
(2) Interest is computed on a monthly basis based upon the prime rate, as
reported in The Wall Street Journal, plus 1.0%, as permitted under the NASD
Rule.
(3) Consists of CDSC payments, distribution fee payments and accruals. See "What
are the Fund's fees and expenses?" in the Prospectus. This figure may
include CDSCs that were deferred when a shareholder redeemed shares prior to
the expiration of the applicable CDSC period and invested the proceeds,
without the imposition of a sales charge, in Class A shares in conjunction
with the shareholder's participation in the Merrill Lynch Mutual Fund
Advisor (Merrill Lynch MFASM) Program (the "MFA Program"). The CDSC is
booked as a contingent obligation that may be payable if the shareholder
terminates participation in the MFA Program.
(4) Provided to illustrate the extent to which the current level of distribution
fee payments (not including any CDSC payments) is amortizing the unpaid
balance. No assurance can be given that payments of the distribution fee
will reach either the voluntary maximum (with respect to Class B shares) or
the NASD maximum (with respect to Class B and Class C shares).

REDEMPTION OF SHARES

Reference is made to "How to Buy, Sell, Transfer and Exchange Shares" in
the Prospectus.

The Fund is required to redeem for cash all shares of the Fund upon receipt
of a written request in proper form. The redemption price is the net asset value
per share next determined after the initial receipt of proper notice of
redemption. Except for any CDSC that may be applicable, there will be no charge
for redemption if the redemption request is sent directly to the Transfer Agent.
Shareholders liquidating their holdings will receive upon redemption all
dividends reinvested through the date of redemption.

The right to redeem shares or to receive payment with respect to any such
redemption may be suspended for more than seven days only for any period during
which trading on the NYSE is restricted as determined by the Commission or the
NYSE is closed (other than customary weekend and holiday closings), for any
period during which an emergency exists as defined by the Commission as a result
of which disposal of portfolio securities or determination of the net asset
value of the Fund is not reasonably practicable, and for such other periods as
the Commission may by order permit for the protection of shareholders of the
Fund.

The value of shares at the time of redemption may be more or less than the
shareholder's cost, depending in part on the market value of the securities held
by the Fund at such time.

31
<PAGE> 65

REDEMPTION

A shareholder wishing to redeem shares held with the Transfer Agent may do
so without charge by tendering the shares directly to the Transfer Agent at
Financial Data Services, Inc., P.O. Box 45289, Jacksonville, Florida 32232-5289.
Redemption requests delivered other than by mail should be delivered to
Financial Data Services, Inc., 4800 Deer Lake Drive East, Jacksonville, Florida
32246-6484. Proper notice of redemption in the case of shares deposited with the
Transfer Agent may be accomplished by a written letter requesting redemption.
Proper notice of redemption in the case of shares for which certificates have
been issued may be accomplished by a written letter as noted above accompanied
by certificates for the shares to be redeemed. Redemption requests should not be
sent to the Fund. The redemption request in either event requires the
signature(s) of all persons in whose name(s) the shares are registered, signed
exactly as such name(s) appear(s) on the Transfer Agent's register. The
signature(s) on the redemption requests must be guaranteed by an "eligible
guarantor institution" as such is defined in Rule 17Ad-15 under the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), the existence and
validity of which may be verified by the Transfer Agent through the use of
industry publications. Notarized signatures are not sufficient. In certain
instances, the Transfer Agent may require additional documents such as, but not
limited to, trust instruments, death certificates, appointments as executor or
administrator, or certificates of corporate authority. For shareholders
redeeming directly with the Transfer Agent, payments will be mailed within seven
days of receipt of a proper notice of redemption.

At various times the Fund may be requested to redeem shares for which it
has not yet received good payment (e.g., cash, Federal funds or certified check
drawn on a United States bank). The Fund may delay or cause to be delayed the
mailing of a redemption check until such time as it has assured itself that good
payment (e.g., cash, Federal funds or certified check drawn on a United States
bank) has been collected for the purchase of such Fund shares, which will not
exceed 10 days.

REPURCHASE

The Fund also will repurchase Fund shares through a shareholder's listed
securities dealer. The Fund normally will accept orders to repurchase Fund
shares by wire or telephone from dealers for their customers at the net asset
value next computed after the order is placed. Shares will be priced at the net
asset value calculated on the day the request is received, provided that the
request for repurchase is submitted to the dealer prior to fifteen minutes after
the regular close of business on the NYSE (generally, the NYSE closes at 4:00
p.m., Eastern time) on the day received, and such request is received by the
Fund from such dealer not later than 30 minutes after the close of business on
the NYSE on the same day. Dealers have the responsibility of submitting such
repurchase requests to the Fund not later than 30 minutes after the close of
business on the NYSE, in order to obtain that day's closing price.

The foregoing repurchase arrangements are for the convenience of
shareholders and do not involve a charge by the Fund (other than any applicable
CDSC). Securities firms that do not have selected dealer agreements with the
Distributor, however, may impose a transaction charge on the shareholder for
transmitting the notice of repurchase to the Fund. Merrill Lynch may charge its
customers a processing fee (presently $5.35) to confirm a repurchase of shares
to such customers. Repurchases made directly through the Transfer Agent on
accounts held at the Transfer Agent are not subject to the processing fee. The
Fund reserves the right to reject any order for repurchase, which right of
rejection might adversely affect shareholders seeking redemption through the
repurchase procedure. However, a shareholder whose order for repurchase is
rejected by the Fund may redeem Fund shares as set forth above.

REINSTATEMENT PRIVILEGE -- CLASS A AND CLASS D SHARES

Shareholders who have redeemed their Class A or Class D shares of the Fund
have a privilege to reinstate their accounts by purchasing Class A or Class D
shares, as the case may be, of the Fund at net asset value without a sales
charge up to the dollar amount redeemed. The reinstatement privilege may be
exercised by sending a notice of exercise along with a check for the amount to
be reinstated to the Transfer Agent within 30 days after the date the request
for redemption was accepted by the Transfer Agent or the Distributor.

32
<PAGE> 66

Alternatively, the reinstatement privilege may be exercised through the
investor's Merrill Lynch Financial Consultant within 30 days after the date the
request for redemption was accepted by the Transfer Agent or the Distributor.
The reinstatement will be made at the net asset value per share next determined
after the notice of reinstatement is received and cannot exceed the amount of
the redemption proceeds.

PRICING OF SHARES

DETERMINATION OF NET ASSET VALUE

Reference is made to "How Shares are Priced" in the Prospectus.

The net asset value of the shares of all classes of the Fund is determined
by the Manager once daily Monday through Friday as of 15 minutes after the close
of business on the NYSE on each day the NYSE is open for trading. The NYSE
generally closes at 4:00 p.m., Eastern time. The NYSE is not open for trading on
New Year's Day, Martin Luther King, Jr. Day, Presidents' Day, Good Friday,
Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day.

Net asset value is computed by dividing the value of the securities held by
the Fund plus any cash or other assets (including interest and dividends accrued
but not yet received) minus all liabilities (including accrued expenses) by the
total number of shares outstanding at such time, rounded to the nearest cent.
Expenses, including the fees payable to the Manager and Distributor, are accrued
daily.

The per share net asset value of Class B, Class C and Class D shares
generally will be lower than the per share net asset value of Class A shares,
reflecting the daily expense accruals of the account maintenance, distribution
and higher transfer agency fees applicable with respect to Class B and Class C
shares, and the daily expense accruals of the account maintenance fees
applicable with respect to the Class D shares; moreover, the per share net asset
value of the Class B and Class C shares generally will be lower than the per
share net asset value of Class D shares reflecting the daily expense accruals of
the distribution fees and higher transfer agency fees applicable with respect to
Class B and Class C shares of the Fund. It is expected, however, that the per
share net asset value of the four classes will tend to converge (although not
necessarily meet) immediately after the payment of dividends or distributions,
which will differ by approximately the amount of the expense accrual
differentials between the classes.

The Municipal Bonds and other portfolio securities in which the Fund
invests are traded primarily in over-the-counter ("OTC") municipal bond and
money markets and are valued at the last available bid price for long positions
and at the last available ask price for short positions in the OTC market or on
the basis of yield equivalents as obtained from one or more dealers that make
markets in the securities. One bond is the "yield equivalent" of another bond
when, taking into account market price, maturity, coupon rate, credit rating and
ultimate return of principal, both bonds will theoretically produce an
equivalent return to the bondholder. Financial futures contracts and options
thereon, which are traded on exchanges, are valued at their settlement prices as
of the close of such exchanges. Short-term investments with a remaining maturity
of 60 days or less are valued on an amortized cost basis which approximates
market value. Securities and assets for which market quotations are not readily
available are valued at fair value as determined in good faith by or under the
direction of the Trustees of the Trust, including valuations furnished by a
pricing service retained by the Trust, which may utilize a matrix system for
valuations. The procedures of the pricing service and its valuations are
reviewed by the officers of the Trust under the general supervision of the
Trustees.

33
<PAGE> 67

COMPUTATION OF OFFERING PRICE PER SHARE

An illustration of the computation of the offering price for Class A, Class
B, Class C and Class D shares of the Fund based on the value of the Fund's net
assets and number of shares outstanding on August 31, 1998 is set forth below.

<TABLE>
<CAPTION>
CLASS A CLASS B CLASS C CLASS D
----------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
Net Assets............................. $12,520,426 $66,804,025 $4,536,704 $10,124,412
=========== =========== ========== ===========
Number of Shares Outstanding........... 1,187,422 6,334,960 430,419 959,525
=========== =========== ========== ===========
Net Asset Value Per Share (net assets
divided by number of shares
outstanding)......................... $ 10.54 $ 10.55 $ 10.54 $ 10.55
Sales Charge (for Class A and Class D
shares: 4.00% of offering price;
4.17% of net asset value per
share)*.............................. 0.44 ** ** 0.44
----------- ----------- ---------- -----------
Offering Price......................... $ 10.98 $ 10.55 $ 10.54 $ 10.99
=========== =========== ========== ===========
</TABLE>

- ---------------
* Rounded to the nearest one-hundredth percent; assumes maximum sales charge is
applicable.
** Class B and Class C shares are not subject to an initial sales charge but may
be subject to a CDSC on redemption of shares. See "Purchase of
Shares -- Deferred Sales Charge Alternatives -- Class B and Class C
Shares -- Contingent Deferred Sales Charges -- Class B Shares" and
"-- Contingent Deferred Sales Charges -- Class C Shares" herein.

PORTFOLIO TRANSACTIONS

TRANSACTIONS IN PORTFOLIO SECURITIES

Subject to policies established by the Trustees, the Manager is primarily
responsible for the execution of the Fund's portfolio transactions. The Trust
has no obligation to deal with any dealer or group of dealers in the execution
of transactions in portfolio securities of the Fund. Where possible, the Trust
deals directly with the dealers who make a market in the securities involved
except in those circumstances where better prices and execution are available
elsewhere. It is the policy of the Trust to obtain the best results in
conducting portfolio transactions for the Fund, taking into account such factors
as price (including the applicable dealer spread or commission), the size, type
and difficulty of the transaction involved, the firm's general execution and
operations facilities and the firm's risk in positioning the securities
involved. The portfolio securities of the Fund generally are traded on a
principal basis and normally do not involve either brokerage commissions or
transfer taxes. The cost of portfolio securities transactions of the Fund
primarily consists of dealer or underwriter spreads. While reasonable
competitive spreads or commissions are sought, the Fund will not necessarily be
paying the lowest spread or commission available. Transactions with respect to
the securities of small and emerging growth companies in which the Fund may
invest may involve specialized services on the part of the broker or dealer and
thereby entail higher commissions or spreads than would be the case with
transactions involving more widely traded securities.

Subject to obtaining the best net results, dealers who provide supplemental
investment research (such as information concerning tax-exempt securities,
economic data and market forecasts) to the Manager may receive orders for
transactions by the Fund. Information so received will be in addition to and not
in lieu of the services required to be performed by the Manager under its
Management Agreement and the expense of the Manager will not necessarily be
reduced as a result of the receipt of such supplemental information.
Supplemental investment research obtained from such dealers might be used by the
Manager in servicing all of its accounts and all such research might not be used
by the Manager in connection with the Fund. Consistent with the Conduct Rules of
the NASD and policies established by the Trustees of the Trust, the Manager may
consider sales of shares of the Fund as a factor in the selection of brokers or
dealers to execute portfolio transactions for the Fund.

34
<PAGE> 68

Because of the affiliation of Merrill Lynch with the Manager, the Fund is
prohibited from engaging in certain transactions involving such firm or its
affiliates except pursuant to an exemptive order under the Investment Company
Act. Included among such restricted transactions are purchases from or sales to
Merrill Lynch of securities in transactions in which it acts as principal. Under
an exemptive order, the Trust may effect principal transactions with Merrill
Lynch in high quality, short-term, tax-exempt securities subject to conditions
set forth in such order. Information regarding transactions executed pursuant to
the exemptive order is set forth in the following table:

<TABLE>
<CAPTION>
APPROXIMATE AGGREGATE
FOR THE FISCAL YEAR NUMBER OF MARKET VALUE OF
ENDED AUGUST 31, TRANSACTIONS TRANSACTIONS
------------------- ------------ ---------------------
<S> <C> <C>
1998............................ 0 --
1997............................ 0 --
1996............................ 1 $2,300,000
</TABLE>

An affiliated person of the Trust may serve as broker for the Fund in OTC
transactions conducted on an agency basis. Certain court decisions have raised
questions as to the extent to which investment companies should seek exemptions
under the Investment Company Act in order to seek to recapture underwriting and
dealer spreads from affiliated entities. The Trustees have considered all
factors deemed relevant and have made a determination not to seek such recapture
at this time. The Trustees will reconsider this matter from time to time.

The Fund may not purchase securities, including Municipal Bonds, during the
existence of any underwriting syndicate of which Merrill Lynch is a member or in
a private placement in which Merrill Lynch serves as placement agent except
pursuant to procedures approved by the Trustees of the Trust which either comply
with rules adopted by the Commission or with interpretations of the Commission
staff. Rule 10f-3 under the Investment Company Act sets forth conditions under
which the Fund may purchase Municipal Bonds from an underwriting syndicate of
which Merrill Lynch is a member. The rule sets forth requirements relating to,
among other things, the terms of an issue of Municipal Bonds purchased by the
Fund, the amount of Municipal Bonds that may be purchased in any one issue and
the assets of the Fund that may be invested in a particular issue.

Section 11(a) of the Exchange Act generally prohibits members of the U.S.
national securities exchanges from executing exchange transactions for their
affiliates and institutional accounts that they manage unless the member (i) has
obtained prior express authorization from the account to effect such
transactions, (ii) at least annually furnishes the account with a statement
setting forth the aggregate compensation received by the member in effecting
such transactions, and (iii) complies with any rules the Commission has
prescribed with respect to the requirements of clauses (i) and (ii). To the
extent Section 11(a) would apply to Merrill Lynch acting as a broker for the
Fund in any of its portfolio transactions executed on any such securities
exchange of which it is a member, appropriate consents have been obtained from
the Fund and annual statements as to aggregate compensation will be provided to
the Fund. Securities may be held by, or be appropriate investments for, the Fund
as well as other funds or investment advisory clients of the Manager or MLAM.

Because of different objectives or other factors, a particular security may
be bought for one or more clients of the Manager or an affiliate when one or
more clients of the Manager or an affiliate are selling the same security. If
purchases or sales of securities arise for consideration at or about the same
time that would involve the Fund or other clients or funds for which the Manager
or an affiliate acts as manager, transactions in such securities will be made,
insofar as feasible, for the respective funds and clients in a manner deemed
equitable to all. To the extent that transactions on behalf of more than one
client of the Manager or an affiliate during the same period may increase the
demand for securities being purchased or the supply of securities being sold,
there may be an adverse effect on price.

35
<PAGE> 69

SHAREHOLDER SERVICES

The Fund offers a number of shareholder services and investment plans
described below that are designed to facilitate investment in shares of the
Fund. Full details as to each of such services, copies of the various plans and
instructions as to how to participate in the various services or plans, or how
to change options with respect thereto, can be obtained from the Fund, by
calling the telephone number on the cover page hereof, or from the Distributor
or Merrill Lynch.

INVESTMENT ACCOUNT

Each shareholder whose account is maintained at the Transfer Agent has an
Investment Account and will receive statements, at least quarterly, from the
Transfer Agent. These statements will serve as transaction confirmations for
automatic investment purchases and the reinvestment of ordinary income dividends
and capital gain distributions. The statements will also show any other activity
in the account since the preceding statement. Shareholders will also receive
separate confirmations for each purchase or sale transaction other than
automatic investment purchases and the reinvestment of ordinary income dividends
and capital gains distributions. A shareholder with an account held at the
Transfer Agent may make additions to his or her Investment Account at any time
by mailing a check directly to the Transfer Agent. A shareholder may also
maintain an account through Merrill Lynch. Upon the transfer of shares out of a
Merrill Lynch brokerage account, an Investment Account in the transferring
shareholder's name may be opened automatically at the Transfer Agent.

Share certificates are issued only for full shares and only upon the
specific request of a shareholder who has an Investment Account. Issuance of
certificates representing all or only part of the full shares in an Investment
Account may be requested by a shareholder directly from the Transfer Agent.

Shareholders considering transferring their Class A or Class D shares from
Merrill Lynch to another brokerage firm or financial institution should be aware
that, if the firm to which the Class A or Class D shares are to be transferred
will not take delivery of shares of the Fund, a shareholder either must redeem
the Class A or Class D shares (paying any applicable CDSC) so that the cash
proceeds can be transferred to the account at the new firm or continue to
maintain an Investment Account at the Transfer Agent for those Class A or Class
D shares. Shareholders interested in transferring their Class B or Class C
shares from Merrill Lynch who do not wish to have an Investment Account
maintained for such shares at the Transfer Agent may request their new brokerage
firm to maintain such shares in an account registered in the name of the
brokerage firm for the benefit of the shareholder at the Transfer Agent. If the
new brokerage firm is willing to accommodate the shareholder in this manner, the
shareholder must request that he or she be issued certificates for his or her
shares and then must turn the certificates over to the new firm for
re-registration in the new brokerage firm's name.

EXCHANGE PRIVILEGE

U.S. shareholders of each class of shares of the Fund have an exchange
privilege with certain other Select Pricing Funds and Summit Cash Reserves Fund
("Summit"), a series of Financial Institutions Series Trust, which is a Merrill
Lynch-sponsored money market fund specifically designated for exchange by
holders of Class A, Class B, Class C and Class D shares of Select Pricing Funds.
Shares with a net asset value of at least $100 are required to qualify for the
exchange privilege and any shares utilized in an exchange must have been held by
the shareholder for at least 15 days. Before effecting an exchange, shareholders
should obtain a currently effective prospectus of the fund into which the
exchange is to be made. Exercise of the exchange privilege is treated as a sale
of the exchanged shares and a purchase of the acquired shares for Federal income
tax purposes.

Exchanges of Class A and Class D Shares. Class A shareholders may exchange
Class A shares of the Fund for Class A shares of a second Select Pricing Fund if
the shareholder holds any Class A shares of the second fund in his or her
account in which the exchange is made at the time of the exchange or is
otherwise eligible to purchase Class A shares of the second fund. If the Class A
shareholder wants to exchange Class A shares for shares of a second Select
Pricing Fund, but does not hold Class A shares of the second fund in his or

36
<PAGE> 70

her account at the time of the exchange and is not otherwise eligible to acquire
Class A shares of the second fund, the shareholder will receive Class D shares
of the second fund as a result of the exchange. Class D shares also may be
exchanged for Class A shares of a second Select Pricing Fund at any time as long
as, at the time of the exchange, the shareholder holds Class A shares of the
second fund in the account in which the exchange is made or is otherwise
eligible to purchase Class A shares of the second fund. Class D shares are
exchangeable with shares of the same class of other Select Pricing Funds.

Exchanges of Class A or Class D shares outstanding ("outstanding Class A or
Class D shares") for Class A or Class D shares of other Select Pricing Funds or
Class A shares of Summit ("new Class A or Class D shares"), are transacted on
the basis of relative net asset value per Class A or Class D share,
respectively, plus an amount equal to the difference, if any, between the sales
charge previously paid on the outstanding Class A or Class D shares and the
sales charge payable at the time of the exchange on the new Class A or Class D
shares. With respect to outstanding Class A or Class D shares as to which
previous exchanges have taken place, the "sales charge previously paid" shall
include the aggregate of the sales charges paid with respect to such Class A or
Class D shares in the initial purchase and any subsequent exchange. Class A or
Class D shares issued pursuant to dividend reinvestment are sold on a no-load
basis in each of the funds offering Class A or Class D shares. For purposes of
the exchange privilege, Class A or Class D shares acquired through dividend
reinvestment shall be deemed to have been sold with a sales charge equal to the
sales charge previously paid on the Class A or Class D shares on which the
dividend was paid. Based on this formula, Class A and Class D shares generally
may be exchanged into the Class A or Class D shares, respectively, of the other
funds with a reduced sales charge or without a sales charge.

Exchanges of Class B and Class C Shares. Each Select Pricing Fund with
Class B or Class C shares outstanding ("outstanding Class B or Class C shares")
offers to exchange its Class B or Class C shares for Class B or Class C shares,
respectively, of another Select Pricing Fund or for Class B shares of Summit
("new Class B or Class C shares") on the basis of relative net asset value per
Class B or Class C share, without the payment of any CDSC that might otherwise
be due on redemption of the outstanding shares. Class B shareholders of the Fund
exercising the exchange privilege will continue to be subject to the Fund's CDSC
schedule if such schedule is higher than the CDSC schedule relating to the new
Class B shares acquired through use of the exchange privilege. In addition,
Class B shares of the Fund acquired through use of the exchange privilege will
be subject to the Fund's CDSC schedule if such schedule is higher than the CDSC
schedule relating to the Class B shares of the fund from which the exchange has
been made. For purposes of computing the CDSC that may be payable on a
disposition of the new Class B or Class C shares, the holding period for the
outstanding Class B or Class C shares is "tacked" to the holding period of the
new Class B or Class C shares. For example, an investor may exchange Class B or
Class C shares of the Fund for those of Merrill Lynch Special Value Fund, Inc.
("Special Value Fund") after having held the Fund's Class B shares for two and a
half years. The 2% CDSC that generally would apply to a redemption would not
apply to the exchange. Three years later the investor may decide to redeem the
Class B shares of Special Value Fund and receive cash. There will be no CDSC due
on this redemption, since by "tacking" the two and a half year holding period of
Fund Class B shares to the three-year holding period for the Special Value Fund
Class B shares, the investor will be deemed to have held the Special Value Fund
Class B shares for more than five years.

Exchanges for Shares of a Money Market Fund. Class A and Class D shares
are exchangeable for Class A shares of Summit and Class B and Class C shares are
exchangeable for Class B shares of Summit. Class A shares of Summit have an
exchange privilege back into Class A or Class D shares of Select Pricing Funds;
Class B shares of Summit have an exchange privilege back into Class B or Class C
shares of Select Pricing Funds and, in the event of such an exchange, the period
of time that Class B shares of Summit are held will count toward satisfaction of
the holding period requirement for purposes of reducing any CDSC and toward
satisfaction of any Conversion Period with respect to Class B shares. Class B
shares of Summit will be subject to a distribution fee at an annual rate of
0.75% of average daily net assets of such Class B shares. This exchange
privilege does not apply with respect to certain Merrill Lynch fee-based
programs for which alternative exchange arrangements may exist. Please see your
Merrill Lynch Financial Consultant for further information.

37
<PAGE> 71

Prior to October 12, 1998, exchanges from the Fund and other Select Pricing
Funds into a money market Fund were directed to certain Merrill Lynch-sponsored
money market funds other than Summit. Shareholders who have exchanged Select
Pricing Fund shares for shares of such other money market funds and subsequently
wish to exchange those money market fund shares for shares of the Fund will be
subject to the CDSC schedule applicable to such Fund shares, if any. The holding
period for those money market fund shares will not count toward satisfaction of
the holding period requirement for reduction of the CDSC imposed on such shares,
if any, and, with respect to Class B shares, toward satisfaction of the
Conversion Period. However, the holding period for Class B or Class C shares
received in exchange for such money market fund shares will be aggregated with
the holding period for the original Select Pricing Fund shares for purposes of
reducing the CDSC or satisfying the Conversion Period.

Exchanges by Participants in the MFA Program. The Fund's exchange
privilege is also modified with respect to purchases of Class A and Class D
shares by investors under the MFA Program. First, the initial allocation of
assets is made under the MFA Program. Then any subsequent exchange under the MFA
Program of Class A or Class D shares of a Select Pricing Fund for Class A or
Class D shares of the Fund will be made solely on the basis of the relative net
asset values of the shares being exchanged. Therefore, there will not be a
charge for any difference between the sales charge previously paid on the shares
of the other Select Pricing Fund and the sales charge payable on the shares of
the Fund being acquired in the exchange under the MFA Program.

Exercise of the Exchange Privilege. To exercise the exchange privilege, a
shareholder should contact his or her Merrill Lynch Financial Consultant, who
will advise the Fund of the exchange. Shareholders of the Fund, and shareholders
of the other Select Pricing Funds with shares for which certificates have not
been issued, may exercise the exchange privilege by wire through their
securities dealers. The Fund reserves the right to require a properly completed
Exchange Application. This exchange privilege may be modified or terminated in
accordance with the rules of the Commission. The Fund reserves the right to
limit the number of times an investor may exercise the exchange privilege.
Certain funds may suspend the continuous offering of their shares to the general
public at any time and may thereafter resume such offering from time to time.
The exchange privilege is available only to U.S. shareholders in states where
the exchange legally may be made. It is contemplated that the exchange privilege
may be applicable to other new mutual funds whose shares may be distributed by
the Distributor.

FEE-BASED PROGRAMS

Certain Merrill Lynch fee-based programs, including pricing alternatives
for securities transactions (each referred to in this paragraph as a "Program"),
may permit the purchase of Class A shares at net asset value. Under specified
circumstances, participants in certain Programs may deposit other classes of
shares which will be exchanged for Class A shares. Initial or deferred sales
charges otherwise due in connection with such exchanges may be waived or
modified, as may the Conversion Period applicable to the deposited shares.
Termination of participation in a Program may result in the redemption of shares
held therein or the automatic exchange thereof to another class at net asset
value, which may be shares of a money market fund. In addition, upon termination
of participation in a Program, shares that have been held for less than
specified periods within such Program may be subject to a fee based upon the
current value of such shares. These Programs also generally prohibit such shares
from being transferred to another account at Merrill Lynch, to another
broker-dealer or to the Transfer Agent. Except in limited circumstances (which
may also involve an exchange as described above), such shares must be redeemed
and another class of shares purchased (which may involve the imposition of
initial or deferred sales charges and distribution and account maintenance fees)
in order for the investment not to be subject to Program fees. Additional
information regarding a specific Program (including charges and limitations on
transferability applicable to shares that may be held in such Program) is
available in such Program's client agreement and from the Transfer Agent at
1-800-MER-FUND or 1-800-637-3863.

38
<PAGE> 72

AUTOMATIC INVESTMENT PLANS

A shareholder may make additions to an Investment Account at any time by
purchasing Class A shares (if he or she is an eligible Class A investor) or
Class B, Class C or Class D shares at the applicable public offering price.
These purchases may be made either through the shareholder's securities dealer,
or by mail directly to the Transfer Agent, acting as agent for such securities
dealer. Voluntary accumulation also can be made through a service known as the
Fund's Automatic Investment Plan. The Fund would be authorized, on a regular
basis, to provide systematic additions to the Investment Account of such
shareholder through charges of $50 or more to the regular bank account of the
shareholder by either pre-authorized checks or automated clearing house debits.
An investor whose shares of the Fund are held within a CMA(R) or CBA(R) account
may arrange to have periodic investments made in the Fund in amounts of $100 or
more through the CMA(R) or CBA(R) Automated Investment Program.

AUTOMATIC DIVIDEND PROGRAM

Unless specific instructions are given as to the method of payment,
dividends and capital gains distributions will be automatically reinvested,
without sales charge, in additional full and fractional shares of the Fund. Such
reinvestment will be at the net asset value of shares of the Fund as of the
close of business on the NYSE on the monthly payment date for such dividends and
distributions. No CDSC will be imposed upon redemption of shares issued as a
result of the automatic reinvestment of dividends or capital gains
distributions.

Shareholders may, at any time, by written notification to Merrill Lynch if
their account is maintained with Merrill Lynch, or by written notification or by
telephone (1-800-MER-FUND) to the Transfer Agent, if their account is maintained
with the Transfer Agent elect to have subsequent dividends or both dividends and
capital gains distributions, paid in cash, rather than reinvested in shares of
the Fund or vice versa (provided that, in the event that a payment on an account
maintained at the Transfer Agent would amount to $10.00 or less, a shareholder
will not receive such payment in cash and such payment will automatically be
reinvested in additional shares). Commencing ten days after the receipt by the
Transfer Agent of such notice, those instructions will be effected. The Fund is
not responsible for any failure of delivery to the shareholder's address of
record and no interest will accrue on amounts represented by uncashed
distribution checks. Cash payments can also be directly deposited to the
shareholder's bank account.

SYSTEMATIC WITHDRAWAL PLANS

A shareholder may elect to receive systematic withdrawals from his or her
Investment Account by check or through automatic payment by direct deposit to
his or her bank account on either a monthly or quarterly basis as provided
below. Quarterly withdrawals are available for shareholders that have acquired
shares of the Fund having a value, based on cost or the current offering price,
of $5,000 or more, and monthly withdrawals are available for shareholders with
shares having a value of $10,000 or more.

At the time of each withdrawal payment, sufficient Class A, Class B, Class
C or Class D shares are redeemed from those on deposit in the shareholder's
account to provide the withdrawal payment specified by the shareholder. The
shareholder may specify the dollar amount and the class of shares to be
redeemed. Redemptions will be made at net asset value as determined as of 15
minutes after the close of business on the NYSE (generally, the NYSE closes at
4:00 p.m., Eastern time) on the 24th day of each month or the 24th day of the
last month of each quarter, whichever is applicable. If the NYSE is not open for
business on such date, the shares will be redeemed at the net asset value
determined 15 minutes after the close of business on the NYSE on the following
business day. The check for the withdrawal payment will be mailed, or the direct
deposit of the withdrawal payment will be made, on the next business day
following redemption. When a shareholder is making systematic withdrawals,
dividends and distributions on all shares in the Investment Account are
automatically reinvested in shares of the Fund. A shareholder's Systematic
Withdrawal Plan may be terminated at any time, without charge or penalty, by the
shareholder, the Fund, the Transfer Agent or the Distributor.

39
<PAGE> 73

With respect to redemptions of Class B or Class C shares pursuant to a
systematic withdrawal plan, the maximum number of Class B or Class C shares that
can be redeemed from an account annually shall not exceed 10% of the value of
shares of such class in that account at the time the election to join the
systematic withdrawal plan was made. Any CDSC that otherwise might be due on
such redemption of Class B or Class C shares will be waived. Shares redeemed
pursuant to a systematic withdrawal plan will be redeemed in the same order as
Class B or Class C shares are otherwise redeemed. See "Purchase of
Shares -- Deferred Sales Charge Alternatives -- Class B and Class C Shares."
Where the systematic withdrawal plan is applied to Class B shares, upon
conversion of the last Class B shares in an account to Class D shares, the
systematic withdrawal plan will be applied thereafter to Class D shares if the
shareholder so elects. If an investor wishes to change the amount being
withdrawn in a systematic withdrawal plan the investor should contact his or her
Financial Consultant.

Withdrawal payments should not be considered as dividends. Each withdrawal
is a taxable event. If periodic withdrawals continuously exceed reinvested
dividends, the shareholder's original investment may be reduced correspondingly.
Purchases of additional shares concurrent with withdrawals are ordinarily
disadvantageous to the shareholder because of sales charges and tax liabilities.
The Fund will not knowingly accept purchase orders for shares of the Fund from
investors that maintain a Systematic Withdrawal Plan unless such purchase is
equal to at least one year's scheduled withdrawals or $1,200, whichever is
greater. Automatic investments may not be made into an Investment Account in
which the shareholder has elected to make systematic withdrawals.

Alternatively, a shareholder whose shares are held within a CMA(R) or
CBA(R) Account may elect to have shares redeemed on a monthly, bimonthly,
quarterly, semiannual or annual basis through the CMA(R) or CBA(R) Systematic
Redemption Program. The minimum fixed dollar amount redeemable is $50. The
proceeds of systematic redemptions will be posted to the shareholder's account
three business days after the date the shares are redeemed. All redemptions are
made at net asset value. A shareholder may elect to have his or her shares
redeemed on the first, second, third or fourth Monday of each month, in the case
of monthly redemptions, or of every other month, in the case of bimonthly
redemptions. For quarterly, semiannual or annual redemptions, the shareholder
may select the month in which the shares are to be redeemed and may designate
whether the redemption is to be made on the first, second, third or fourth
Monday of the month. If the Monday selected is not a business day, the
redemption will be processed at net asset value on the next business day. The
CMA(R) or CBA(R) Systematic Redemption Program is not available if Fund shares
are being purchased within the account pursuant to the Automated Investment
Program. For more information on the CMA(R) or CBA(R) Systematic Redemption
Program, eligible shareholders should contact their Financial Consultant.

DISTRIBUTIONS AND TAXES

DIVIDENDS AND DISTRIBUTIONS

The net investment income of the Fund is declared as dividends daily prior
to the determination of the net asset value which is calculated 15 minutes after
the close of business on the NYSE (generally, the NYSE closes at 4:00 p.m.,
Eastern time) on that day. The net investment income of the Fund for dividend
purposes consists of interest earned on portfolio securities, less expenses, in
each case computed since the most recent determination of net asset value.
Expenses of the Fund, including the management fees and the account maintenance
and distribution fees, are accrued daily. Dividends of net investment income are
declared daily and reinvested monthly in the form of additional full and
fractional shares of the Fund at net asset value as of the close of business on
the "payment date" unless the shareholder elects to receive such dividends in
cash. Shares will accrue dividends as long as they are issued and outstanding.
Shares are issued and outstanding from the settlement date of a purchase order
to the day prior to the settlement date of a redemption order.

All net realized capital gains, if any, are declared and distributed to the
Fund's shareholders at least annually. Capital gains distributions will be
reinvested automatically in shares of the Fund unless the shareholder elects to
receive such distributions in cash.

40
<PAGE> 74

The per share dividends and distributions on each class of shares will be
reduced as a result of any account maintenance, distribution and transfer agency
fees applicable to that class. See "Pricing of Shares -- Determination of Net
Asset Value."

See "Shareholder Services" for information as to how to elect either
dividend reinvestment or cash payments. Portions of dividends and distributions
which are taxable to shareholders as described below are subject to income tax
whether they are reinvested in shares of the Fund or received in cash.

TAXES

The Trust intends to continue to qualify the Fund for the special tax
treatment afforded regulated investment companies ("RICs") under the Code. As
long as it so qualifies, the Fund (but not its shareholders) will not be subject
to Federal income tax to the extent that it distributes its net investment
income and net realized capital gains. The Trust intends to cause the Fund to
distribute substantially all of such income.

As discussed in "General Information -- Description of Shares," the Trust
has established other series in addition to the Fund (together with the Fund,
the "Series"). Each Series of the Trust is treated as a separate corporation for
Federal income tax purposes. Each Series, therefore, is considered to be a
separate entity in determining its treatment under the rules for RICs. Losses in
one Series do not offset gains in another Series, and the requirements (other
than certain organizational requirements) for qualifying for RIC status will be
determined at the Series level rather than at the Trust level.

The Code requires a RIC to pay a nondeductible 4% excise tax to the extent
the RIC does not distribute, during each calendar year, 98% of its ordinary
income, determined on a calendar year basis, and 98% of its capital gains,
determined, in general, on an October 31 year end, plus certain undistributed
amounts from previous years. The required distributions, however, are based only
on the taxable income of a RIC. The excise tax, therefore, generally will not
apply to the tax-exempt income of a RIC, such as the Fund, that pays
exempt-interest dividends.

The Trust intends to qualify the Fund to pay "exempt-interest dividends" as
defined in Section 852(b)(5) of the Code. Under such section if, at the close of
each quarter of the Fund's taxable year, at least 50% of the value of the Fund's
total assets consists of obligations exempt from Federal income tax ("tax-
exempt obligations") under Section 103(a) of the Code (relating generally to
obligations of a state or local governmental unit), the Fund shall be qualified
to pay exempt-interest dividends to its Class A, Class B, Class C and Class D
shareholders (together, the "shareholders"). Exempt-interest dividends are
dividends or any part thereof paid by the Fund that are attributable to interest
on tax-exempt obligations and designated by the Trust as exempt-interest
dividends in a written notice mailed to the Fund's shareholders within 60 days
after the close of the Fund's taxable year. The Fund will allocate interest from
tax-exempt obligations (as well as ordinary income, capital gains and tax
preference items discussed below) among the Class A, Class B, Class C and Class
D shareholders according to a method (which it believes is consistent with the
Commission rule permitting the issuance and sale of multiple classes of shares)
that is based upon the gross income that is allocable to the Class A, Class B,
Class C and Class D shareholders during the taxable year, or such other method
as the Internal Revenue Service may prescribe.

Exempt-interest dividends will be excludable from a shareholder's gross
income for Federal income tax purposes. Exempt-interest dividends are included,
however, in determining the portion, if any, of a person's social security and
railroad retirement benefits subject to Federal income taxes. Interest on
indebtedness incurred or continued to purchase or carry shares of a RIC paying
exempt-interest dividends, such as the Fund, will not be deductible by the
investor for Federal income tax purposes or for California income tax purposes
to the extent attributable to exempt-interest dividends. Shareholders are
advised to consult their tax advisors with respect to whether exempt-interest
dividends retain the exclusion under Code Section 103(a) if a shareholder would
be treated as a "substantial user" or "related person" under Code Section 147(a)
with respect to property financed with the proceeds of an issue of "industrial
development bonds" or "private activity bonds," if any, held by the Fund.

41
<PAGE> 75

The portion of the Fund's exempt-interest dividends paid from interest
received by the Fund from California Municipal Bonds also will be exempt from
California income taxes if, at the close of each quarter of the Fund's taxable
year, at least 50% of the value of the Fund's total assets consists of
California Municipal Bonds. The Fund intends to invest at least 50% of its
assets in California Municipal Bonds at all times. Shareholders subject to
income taxation by states other than California will realize a lower after-tax
rate of return than California shareholders since the dividends distributed by
the Fund generally will not be exempt, to any significant degree, from income
taxation by such other states. The Trust will inform shareholders annually
regarding the portion of the Fund's distributions that constitutes
exempt-interest dividends and the portion that is exempt from California income
taxes. The Trust will allocate exempt-interest dividends among Class A, Class B,
Class C and Class D shareholders for California income tax purposes based on a
method similar to that described above for Federal income tax purposes.

Distributions from investment income and capital gains, including
exempt-interest dividends, will be subject to California franchise tax if
received by a corporate shareholder subject to such tax and may also be subject
to state taxes in states other than California and to local taxes imposed by
certain cities within and outside of California. Accordingly, investors in the
Fund including, in particular, corporate investors which may be subject to the
California corporate franchise tax should consult their tax advisors with
respect to the application of such taxes to an investment in the Fund, to the
receipt of Fund dividends and as to their California tax situation in general.

To the extent the Fund's distributions are derived from interest on its
taxable investments or from an excess of net short-term capital gains over net
long-term capital losses ("ordinary income dividends"), such distributions are
considered ordinary income for Federal income tax purposes and California income
tax purposes. Distributions, if any, from an excess of net long-term capital
gains over net short-term capital losses derived from the sale of securities or
from certain transactions in futures or options ("capital gain dividends") are
taxable as long-term capital gains for Federal income tax purposes, regardless
of the length of time the shareholder has owned Fund shares, and for California
income tax purposes, are treated as capital gains which are taxed at ordinary
income tax rates. Certain categories of capital gains are taxable at different
rates. Generally not later than 60 days after the close of the Fund's taxable
year, the Trust will provide its shareholders with a written notice designating
the amounts of any exempt-interest dividends, ordinary income dividends or
capital gain dividends, as well as any amount of capital gain dividends in the
different categories of capital gain referred to above. Distributions by the
Fund, whether from exempt-interest income, ordinary income or capital gains,
will not be eligible for the dividends received deduction allowed to
corporations under the Code.

All or a portion of the Fund's gains from the sale or redemption of
tax-exempt obligations purchased at a market discount will be treated as
ordinary income rather than capital gain. This rule may increase the amount of
ordinary income dividends received by shareholders. Distributions in excess of
the Fund's earnings and profits will first reduce the adjusted tax basis of a
holder's shares and, after such adjusted tax basis is reduced to zero, will
constitute capital gains to such holder (assuming the shares are held as a
capital asset). Any loss upon the sale or exchange of Fund shares held for six
months or less will be disallowed to the extent of any exempt-interest dividends
received by the shareholder. In addition, any such loss that is not disallowed
under the rule stated above will be treated as long-term capital loss to the
extent of any capital gain dividends received by the shareholder. If the Fund
pays a dividend in January which was declared in the previous October, November
or December to shareholders of record on a specified date in one of such months,
then such dividend will be treated for tax purposes as being paid by the Fund
and received by its shareholders on December 31 of the year in which such
dividend was declared.

The Code subjects interest received on certain otherwise tax-exempt
securities to an alternative minimum tax. The alternative minimum tax applies to
interest received on certain "private activity bonds" issued after August 7,
1986. Private activity bonds are bonds which, although tax-exempt, are used for
purposes other than those generally performed by governmental units and which
benefit non-governmental entities (e.g., bonds used for industrial development
or housing purposes). Income received on such bonds is classified as an item of
"tax preference," which could subject certain investors in such bonds, including
shareholders of the Fund, to an alternative minimum tax. The Fund will purchase
such "private activity bonds," and the Trust will report

42
<PAGE> 76

to shareholders within 60 days after calendar year-end the portion of the Fund's
dividends declared during the year which constitute an item of tax preference
for alternative minimum tax purposes. The Code further provides that
corporations are subject to an alternative minimum tax based, in part, on
certain differences between taxable income as adjusted for other tax preferences
and the corporation's "adjusted current earnings," which more closely reflect a
corporation's economic income. Because an exempt-interest dividend paid by the
Fund will be included in adjusted current earnings, a corporate shareholder may
be required to pay alternative minimum tax on exempt-interest dividends paid by
the Fund.

The Fund may invest in high yield securities, as described herein.
Furthermore, the Fund may also invest in instruments the return on which
includes non-traditional features such as indexed principal or interest payments
("non-traditional instruments"). These instruments may be subject to special tax
rules under which the Fund may be required to accrue and distribute income
before amounts due under the obligations are paid. In addition, it is possible
that all or a portion of the interest payments on such high yield securities
and/or non-traditional instruments could be recharacterized as taxable ordinary
income.

No gain or loss will be recognized by Class B shareholders on the
conversion of their Class B shares into Class D shares. A shareholder's basis in
the Class D shares acquired will be the same as such shareholder's basis in the
Class B shares converted and the holding period of the acquired Class D shares
will include the holding period for the converted Class B shares.

If a shareholder exercises an exchange privilege within 90 days of
acquiring the shares, then the loss the shareholder can recognize on the
exchange will be reduced (or the gain increased) to the extent any sales charge
paid to the Fund reduces any sales charge the shareholder would have owed upon
purchase of the new shares in the absence of the exchange privilege. Instead,
such sales charge will be treated as an amount paid for the new shares.

A loss realized on a sale or exchange of shares of the Fund will be
disallowed if other Fund shares are acquired (whether through the automatic
reinvestment of dividends or otherwise) within a 61-day period beginning 30 days
before and ending 30 days after the date that the shares are disposed of. In
such a case, the basis of the shares acquired will be adjusted to reflect the
disallowed loss.

Ordinary income dividends paid to shareholders that are nonresident aliens
or foreign entities will be subject to a 30% United States withholding tax under
existing provisions of the Code applicable to foreign individuals and entities
unless a reduced rate of withholding or a withholding exemption is provided
under applicable treaty law. Nonresident shareholders are urged to consult their
own tax advisors concerning the applicability of the United States withholding
tax.

Under certain provisions of the Code, some shareholders may be subject to a
31% withholding tax on certain ordinary income dividends and on capital gain
dividends and redemption payments ("backup withholding"). Generally,
shareholders subject to backup withholding will be those for whom no certified
taxpayer identification number is on file with the Trust or who, to the Trust's
knowledge, have furnished an incorrect number. When establishing an account, an
investor must certify under penalty of perjury that such number is correct and
that such shareholder is not otherwise subject to backup withholding.

The Code provides that every person required to file a tax return must
include for information purposes on such return the amount of exempt-interest
dividends received from all sources (including the Fund) during the taxable
year.

TAX TREATMENT OF OPTIONS AND FUTURES TRANSACTIONS

The Fund may purchase and sell municipal bond index futures contracts and
interest rate futures contracts on U.S. Government securities ("financial
futures contracts"). The Fund may also purchase and write call and put options
on such financial futures contracts. In general, unless an election is available
to the Fund or an exception applies, such options and futures contracts that are
"Section 1256 contracts" will be "marked to market" for Federal income tax
purposes at the end of each taxable year, i.e., each such option or financial
futures contract will be treated as sold for its fair market value on the last
day of the taxable year, and any gain or loss attributable to Section 1256
contracts will be 60% long-term and 40% short-term capital gain

43
<PAGE> 77

or loss. Application of these rules to Section 1256 contracts held by the Fund
may alter the timing and character of distributions to shareholders. The
mark-to-market rules outlined above, however, will not apply to certain
transactions entered into by the Fund solely to reduce the risk of changes in
price or interest rates with respect to its investments.

Code Section 1092, which applies to certain "straddles," may affect the
taxation of the Fund's sales of securities and transactions in financial futures
contracts and related options. Under Section 1092, the Fund may be required to
postpone recognition for tax purposes of losses incurred in certain sales of
securities and certain closing transactions in financial futures contracts or
the related options.

The foregoing is a general and abbreviated summary of the applicable
provisions of the Code, Treasury regulations and California tax laws presently
in effect. For the complete provisions, reference should be made to the
pertinent Code sections, the Treasury regulations promulgated thereunder and
California tax laws. The Code and the Treasury regulations, as well as the
California tax laws, are subject to change by legislative, judicial or
administrative action either prospectively or retroactively.

Shareholders are urged to consult their tax advisors regarding the
availability of any exemptions from state or local taxes and with specific
questions as to Federal, foreign, state or local taxes.

PERFORMANCE DATA

From time to time the Fund may include its average annual total return and
other total return data, as well as yield and tax-equivalent yield, in
advertisements or information furnished to present or prospective shareholders.
Total return, yield and tax-equivalent yield figures are based on the Fund's
historical performance and are not intended to indicate future performance.
Average annual total return, yield and tax-equivalent yield are determined
separately for Class A, Class B, Class C and Class D shares in accordance with
formulas specified by the Commission.

Average annual total return quotations for the specified periods are
computed by finding the average annual compounded rates of return (based on net
investment income and any realized and unrealized capital gains or losses on
portfolio investments over such periods) that would equate the initial amount
invested to the redeemable value of such investment at the end of each period.
Average annual total return is computed assuming all dividends and distributions
are reinvested and taking into account all applicable recurring and nonrecurring
expenses, including the maximum sales charge in the case of Class A and Class D
shares and the CDSC that would be applicable to a complete redemption of the
investment at the end of the specified period in the case of Class B and Class C
shares.

Yield quotations will be computed based on a 30-day period by dividing (a)
the net income based on the yield of each security earned during the period by
(b) the average daily number of shares outstanding during the period that were
entitled to receive dividends multiplied by the maximum offering price per share
on the last day of the period. Tax equivalent yield quotations will be computed
by dividing (a) the part of the Fund's yield that is tax-exempt by (b) one minus
a stated tax rate and (c) adding the result to that part, if any, of the Fund's
yield that is not tax-exempt.

The Fund also may quote annual, average annual and annualized total return
and aggregate total return performance data, both as a percentage and as a
dollar amount based on a hypothetical $1,000 investment, for various periods
other than those noted below. Such data will be computed as described above,
except that (1) as required by the periods of the quotations, actual annual,
annualized or aggregate data, rather than average annual data, may be quoted and
(2) the maximum applicable sales charges will not be included with respect to
annual or annualized rates of return calculations. Aside from the impact on the
performance data calculations of including or excluding the maximum applicable
sales charges, actual annual or annualized total return data generally will be
lower than average annual total return data since the average rates of return
reflect compounding of return; aggregate total return data generally will be
higher than average annual total return data since the aggregate rates of return
reflect compounding over a longer period of time.

44
<PAGE> 78

Set forth below is the total return, yield and tax-equivalent yield
information for Class A, Class B, Class C and Class D shares of the Fund for the
periods indicated.
<TABLE>
<CAPTION>
CLASS A SHARES CLASS B SHARES
---------------------------- ----------------------------
REDEEMABLE REDEEMABLE
EXPRESSED AS VALUE OF A EXPRESSED AS VALUE OF A
A PERCENTAGE HYPOTHETICAL A PERCENTAGE HYPOTHETICAL
BASED ON A $1,000 BASED ON A $1,000
HYPOTHETICAL INVESTMENT HYPOTHETICAL INVESTMENT
$1,000 AT THE END OF $1,000 AT THE END OF
INVESTMENT THE PERIOD INVESTMENT THE PERIOD
------------ ------------- ------------ -------------
AVERAGE ANNUAL TOTAL RETURN
(INCLUDING MAXIMUM APPLICABLE SALES CHARGE)
<S> <C>
One year ended August 31, 1998............... 3.48% $1,034.80 3.35% $1,033.50
Five years ended August 31, 1998............. 5.11% $1,283.10 5.46% $1,304.30
Inception (February 26, 1993) to August 31,
1998....................................... 5.52% $1,344.80 5.79% $1,368.80
Inception (October 21, 1994) to August 31,
1998....................................... -- -- -- --
ANNUAL TOTAL RETURN
(EXCLUDING MAXIMUM APPLICABLE SALES CHARGE)
Year Ended August 31,
1998....................................... 7.79% $1,077.90 7.35% $1,073.50
1997....................................... 9.50% $1,095.00 8.95% $1,089.50
1996....................................... 7.44% $1,074.40 6.89% $1,068.90
1995....................................... 6.94% $1,069.40 6.38% $1,063.80
1994....................................... (1.44)% $ 985.60 (1.93)% $ 980.70
Inception (February 26, 1993) to August 31,
1993....................................... 4.81% $1,048.10 4.56% $1,045.60
Inception (October 21, 1994) to August 31,
1995....................................... -- -- -- --
AGGREGATE TOTAL RETURN
(INCLUDING MAXIMUM APPLICABLE SALES CHARGE)
Inception (February 26, 1993) to August 31,
1998....................................... 34.48% $1,344.80 36.38% $1,363.80
Inception (October 21, 1994) to August 31,
1998....................................... -- -- -- --
YIELD
30 days ended August 31, 1998................ 3.83% -- 3.49% --
TAX EQUIVALENT YIELD*
30 days ended August 31, 1998................ 5.32% -- 4.85% --

<CAPTION>
CLASS C SHARES CLASS D SHARES
---------------------------- ----------------------------
REDEEMABLE REDEEMABLE
EXPRESSED AS VALUE OF A EXPRESSED AS VALUE OF A
A PERCENTAGE HYPOTHETICAL A PERCENTAGE HYPOTHETICAL
BASED ON A $1,000 BASED ON A $1,000
HYPOTHETICAL INVESTMENT HYPOTHETICAL INVESTMENT
$1,000 AT THE END OF $1,000 AT THE END OF
INVESTMENT THE PERIOD INVESTMENT THE PERIOD
------------ ------------- ------------ -------------
AVERAGE ANNUAL TOTAL RETURN
(INCLUDING MAXIMUM APPLICABLE SALES CHARGE)
<S> <C>
One year ended August 31, 1998............... 6.25% $1,062.50 3.37% $1,033.70
Five years ended August 31, 1998............. -- -- -- --
Inception (February 26, 1993) to August 31,
1998....................................... -- -- -- --
Inception (October 21, 1994) to August 31,
1998....................................... 8.36% $1,363.60 7.80% $1,336.20
ANNUAL TOTAL RETURN
(EXCLUDING MAXIMUM APPLICABLE SALES CHARGE)
Year Ended August 31,
1998....................................... 7.25% $1,072.50 7.68% $1,076.80
1997....................................... 8.74% $1,087.40 9.39% $1,093.90
1996....................................... 6.90% $1,069.00 7.44% $1,074.40
1995....................................... -- -- -- --
1994....................................... -- -- -- --
Inception (February 26, 1993) to August 31,
1993....................................... -- -- -- --
Inception (October 21, 1994) to August 31,
1995....................................... 9.38% $1,093.80 9.99% $1,099.90
AGGREGATE TOTAL RETURN
(INCLUDING MAXIMUM APPLICABLE SALES CHARGE)
Inception (February 26, 1993) to August 31,
1998....................................... -- -- -- --
Inception (October 21, 1994) to August 31,
1998....................................... 36.36% $1,363.60 33.62% $1,336.20
YIELD
30 days ended August 31, 1998................ 3.39% -- 3.74% --
TAX EQUIVALENT YIELD*
30 days ended August 31, 1998................ 4.71% -- 5.19% --
</TABLE>

- ---------------
* Based on a Federal income tax rate of 28%.

45
<PAGE> 79

In order to reflect the reduced sales charges in the case of Class A or
Class D shares, or the waiver of the CDSC in the case of Class B or Class C
shares applicable to certain investors, as described under "Purchase of Shares"
the total return data quoted by the Fund in advertisements directed to such
investors may take into account the reduced, and not the maximum, sales charge
or may not take into account the CDSC, and, therefore, may reflect greater total
return since, due to the reduced sales charges or the waiver of CDSCs, a lower
amount of expenses may be deducted.

On occasion, the Fund may compare its performance to the Lehman Brothers
Municipal Bond Index or other market indices or to performance data published by
Lipper Analytical Services, Inc., Morningstar Publications Inc. ("Morningstar"),
CDA Investment Technology, Inc., Money Magazine, U.S. News & World Report,
Business Week, Forbes Magazine, Fortune Magazine or other industry publications.
When comparing its performance to a market index, the Fund may refer to various
statistical measures derived from the historic performance of the Fund and the
index such as standard deviation and beta. In addition, from time to time the
Fund may include the Fund's Morningstar risk-adjusted performance ratings in
advertisements or supplemental sales literature. As with other performance data,
performance comparisons should not be considered indicative of the Fund's
relative performance for any future period.

The Fund's total return, yield and tax-equivalent yield will vary depending
on market conditions, the securities comprising the Fund's portfolio, the Fund's
operating expenses and the amount of realized and unrealized net capital gains
or losses during the period. The value of an investment in the Fund will
fluctuate and an investor's shares, when redeemed, may be worth more or less
than their original cost.

GENERAL INFORMATION

DESCRIPTION OF SHARES

The Trust is a business trust organized on March 20, 1985 under the laws of
Massachusetts. The Trust is an open-end management investment company comprised
of separate series ("Series"), each of which is a separate portfolio offering
shares to selected groups of purchasers. The Trust is presently comprised of the
Fund and Merrill Lynch California Municipal Bond Fund. The Trustees are
authorized to create an unlimited number of Series and, with respect to each
Series, to issue an unlimited number of full and fractional shares of beneficial
interest, par value $.10 per share, of different classes and to divide or
combine the shares into a greater or lesser number of shares without thereby
changing the proportionate beneficial interests in the Series. Shareholder
approval is not necessary for the authorization of additional Series or classes
of a Series of the Trust. At the date of this Statement of Additional
Information, the shares of the Fund are divided into Class A, Class B, Class C
and Class D shares. Class A, Class B, Class C and Class D shares represent
interests in the same assets of the Fund and are identical in all respects
except that Class B, Class C and Class D shares bear certain expenses related to
the account maintenance and/or distribution of such shares and have exclusive
voting rights with respect to matters relating to such account maintenance
and/or distribution expenditures. The Board of Trustees of the Trust may
classify and reclassify the shares of any Series into additional or other
classes at a future date.

All shares of the Trust have equal voting rights, except that only shares
of the respective Series are entitled to vote on matters concerning only that
Series and, as noted above, Class B, Class C and Class D shares have exclusive
voting rights with respect to matters relating to the account maintenance and/or
distribution expenses, as appropriate, being borne solely by such class. Each
issued and outstanding share of a Series is entitled to one vote and to
participate equally in dividends and distributions with respect to that Series
and, upon liquidation or dissolution of the Series, in the net assets of such
Series remaining after satisfaction of outstanding liabilities, except that, as
noted above, expenses relating to distribution and/or account maintenance of the
Class B, Class C and Class D shares are borne solely by the respective class.
There normally will be no meeting of shareholders for the purposes of electing
Trustees unless and until such time as less than a majority of the Trustees
holding office have been elected by shareholders, at which time the Trustees
then in office will call a shareholders' meeting for the election of Trustees.
Shareholders may, in accordance with the terms of the Declaration of Trust,
cause a meeting of shareholders to be held for the

46
<PAGE> 80

purpose of voting on the removal of Trustees. Also, the Trust will be required
to call a special meeting of shareholders in accordance with the requirements of
the Investment Company Act to seek approval of new management and advisory
arrangements, of a material increase in distribution fees or of a change in the
fundamental policies, objectives or restrictions of a Series.

The obligations and liabilities of a particular Series are restricted to
the assets of that Series and do not extend to the assets of the Trust
generally. The shares of each Series, when issued, will be fully paid and
nonassessable, have no preference, preemptive, conversion, exchange or similar
rights and will be freely transferable. Holders of shares of any Series are
entitled to redeem their shares as set forth elsewhere herein and in the
Prospectus. Shares do not have cumulative voting rights and the holders of more
than 50% of the shares of the Trust voting for the election of Trustees can
elect all of the Trustees if they choose to do so and in such event the holders
of the remaining shares would not be able to elect any Trustees. No amendments
may be made to the Declaration of Trust, other than amendments necessary to
conform the Declaration to certain laws or regulations, to change the name of
the Trust, or to make certain non-material changes, without the affirmative vote
of a majority of the outstanding shares of the Trust, or of the affected Series
or class, as applicable.

Under Massachusetts law, shareholders of a business trust may, under
certain circumstances, be held personally liable as partners for the trust's
obligations. However, the risk of a shareholder incurring financial loss on
account of shareholder liability is limited to circumstances in which both
inadequate insurance existed and the trust itself was unable to meet its
obligations.

The Manager provided the initial capital for the Fund by purchasing 10,000
shares of the Fund for $100,000. Such shares were acquired for investment and
can only be disposed of by redemption. If additional Series are added to the
Trust, the organizational expenses will be allocated among the Series in a
manner deemed equitable by the Trustees.

INDEPENDENT AUDITORS

Deloitte & Touche LLP, 117 Campus Drive, Princeton, New Jersey 08540-6400,
has been selected as the independent auditors of the Trust. The selection of
independent auditors is subject to approval by the non-interested Trustees of
the Trust. The independent auditors are responsible for auditing the annual
financial statements of the Fund.

CUSTODIAN

The Bank of New York, 90 Washington Street, 12th Floor, New York, New York
10286, acts as the Custodian of the Fund's assets. The Custodian is responsible
for safeguarding and controlling the Fund's cash and securities, handling the
receipt and delivery of securities and collecting interest on the Fund's
investments.

TRANSFER AGENT

Financial Data Services, Inc., 4800 Deer Lake Drive East, Jacksonville,
Florida 32246-6484, acts as the Trust's Transfer Agent. The Transfer Agent is
responsible for the issuance, transfer and redemption of shares and the opening,
maintenance and servicing of shareholder accounts. See "How to Buy, Sell,
Transfer and Exchange Shares -- Through the Transfer Agent" in the Prospectus.

LEGAL COUNSEL

Brown & Wood LLP, One World Trade Center, New York, New York 10048-0557, is
counsel for the Trust.

47
<PAGE> 81

REPORTS TO SHAREHOLDERS

The fiscal year of the Fund ends on August 31 of each year. The Trust sends
to the Fund's shareholders, at least semi-annually, reports showing the Fund's
portfolio and other information. An annual report, containing financial
statements audited by independent auditors, is sent to shareholders each year.
After the end of each year, shareholders will receive Federal income tax
information regarding dividends and capital gains distributions.

SHAREHOLDER INQUIRIES

Shareholder inquiries may be addressed to the Fund at the address or
telephone number set forth on the cover page of this Statement of Additional
Information.

ADDITIONAL INFORMATION

The Prospectus and this Statement of Additional Information do not contain
all the information set forth in the Registration Statement and the exhibits
relating thereto, which the Trust has filed with the Securities and Exchange
Commission, Washington, D.C., under the Securities Act and the Investment
Company Act, to which reference is hereby made.

The Declaration of Trust establishing the Trust dated March 20, 1985, a
copy of which, together with all amendments thereto (the "Declaration") is on
file in the office of the Secretary of the Commonwealth of Massachusetts
provides that the name "Merrill Lynch California Municipal Series Trust" refers
to the Trustees under the Declaration collectively as the Trustees, but not as
individuals or personally; and no Trustee, shareholder, officer, employee or
agent of the Trust shall be held to any personal liability; nor shall resort be
had to any such person's private property for the satisfaction of any obligation
or claim of the Trust but the "Trust Property" (as defined in the Declaration)
only shall be liable.

To the knowledge of the Trust, no person or entity owned beneficially 5% or
more of the Fund's shares as of December 1, 1998.

FINANCIAL STATEMENTS

The Fund's audited financial statements are incorporated in this Statement
of Additional Information by reference to its 1998 annual report to
shareholders. You may request a copy of the annual report at no charge by
calling (800) 456-4587 ext. 789 between 8:00 a.m. and 8:00 p.m. on any business
day.

48
<PAGE> 82

APPENDIX I

ECONOMIC AND FINANCIAL CONDITIONS IN CALIFORNIA

The following information is a brief summary of factors affecting the
economy of the State of California and does not purport to be a complete
description of such factors. Other factors will affect issuers. The summary is
based primarily upon one or more of the most recent publicly available offering
statements relating to debt offerings of California issuers, however, it has not
been updated. The Trust has not independently verified the information.

GENERAL ECONOMIC CONDITIONS

The economy of the State of California (sometimes referred to herein as the
"State" or "California") is the largest among the 50 states and one of the
largest in the world. This diversified economy has major components in
agriculture, manufacturing, high technology, trade, entertainment, tourism,
construction and services.

California's July 1, 1997 population of over 32.9 million represented over
12% of the total United States population. As of July 1, 1990, the population of
29,944,000 represented an increase of over 6 million persons, or 26%, during the
decade of the 1980's.

California's population is concentrated in metropolitan areas. As of the
April 1, 1990 census, 96% of the State's population resided in the 23
Metropolitan Statistical Areas in the State. As of July 1, 1997, the 5-county
Los Angeles area accounted for 49%, with 16.0 million residents. The 10-county
San Francisco Bay Area represented 21%, with a population of 6.9 million.

From 1990-1993, the State suffered through a severe recession, the worst
since the 1930's, heavily influenced by large cutbacks in defense/aerospace
industries and military base closures and by a major drop in real estate
construction. California's economy has been recovering and growing steadily
since the start of 1994. The current economic expansion is marked by strong
growth in high technology manufacturing and services, including computer
software, electronic manufacturing and motion picture/television production;
growth is also strong in other business services, both nonresidential and
residential construction and local education.

In May 1998, the State Department of Finance projected that the California
economy will continue to show robust growth through 1998, although at a slightly
slower pace than in 1997. The Asian economic crisis which began in late 1997 was
expected to have some dampening effects on the State's economy. However, during
the summer of 1998, the soaring trade deficit, continuing weakness in Asia,
initial signs of economic weakness in Canada and Latin America, which have been
California's largest trading partners, and the fall in stock prices worldwide
all suggest that the May forecasts may be too optimistic, particularly for 1999.
Other impacts of the international situation may help California, such as the
reduction in long-term interest rates.

THE STATE

Fiscal Years Prior to 1995-1996. The State's budget problems in the early
1990's were caused by a combination of external economic conditions and a
structural imbalance in that the largest general fund programs -- K-14
education, health, welfare and corrections -- were increasing faster than the
revenue base, driven by the State's rapid population growth. These pressures are
expected to continue as population trends maintain strong demand for health and
welfare services, as the school age population continues to grow, and as the
State's corrections program responds to a "Three Strikes" law enacted in 1994,
which requires mandatory life prison terms for certain third-time felony
offenders. In addition, the State's health and welfare programs are in a
transition period as a result of recent federal and state welfare reform
initiatives.

As a result of these factors and others, and especially because a severe
recession between 1990-1994 reduced revenues and increased expenditures for
social welfare programs, from the late 1980's until 1992-93, the State had a
period of budget imbalance. During this period, expenditures exceeded revenues
in four out of six years, and the State accumulated and sustained a budget
deficit in its budget reserve, the Special Fund for Economic Uncertainties
("SFEU") approaching $2.8 billion at its peak at June 30, 1993. Starting in the
1990-91 Fiscal Year and for each fiscal year thereafter, each budget required
multibillion dollar actions to

I-1
<PAGE> 83

bring projected revenues and expenditures into balance. The State Legislature
and Governor agreed on the following principal steps to produce Budget Acts in
the years 1991-92 to 1994-95, although not all these actions were taken in each
year.

1. significant cuts in health and welfare program expenditures;

2. transfers of program responsibilities and funding from the State to
local governments (referred to as "realignment"), coupled with some
reduction in mandates on local government;

3. transfer of about $3.6 billion in local property tax revenues from
cities, counties, redevelopment agencies and some other districts to
local school districts, thereby reducing State funding for schools under
Proposition 98 (discussed below);

4. reduction in growth of support for higher education programs, coupled
with increases in student fees, through the 1994-95 Fiscal Year;

5. maintenance of the minimum Proposition 98 funding guarantee for K-14
schools, and the disbursement of additional funds to keep a constant
level of about $4,200 per K-12 pupil (also called "per ADA" or "Average
Daily Attendance") through the 1993-94 Fiscal Year;

6. revenue increases (particularly in the 1991-92 Fiscal Year budget), most
of which were for a short duration;

7. increased reliance on aid from the federal government to offset the
costs of incarcerating, educating and providing health and welfare
services to illegal immigrants, although during this time frame, most of
the additional aid requested by the Administration was not received; and

8. various one-time adjustments and accounting changes.

Despite these budget actions, as noted, the effects of the recession led to
large, unanticipated deficits in the budget reserve, the SFEU, as compared to
projected positive balances. By the 1993-94 Fiscal Year, the accumulated deficit
was so large that it was impractical to budget to retire it in one year, so a
two-year program was implemented, using the issuance of revenue anticipation
warrants to carry a portion of the deficit over the end of the fiscal year. When
the economy failed to recover sufficiently in 1993-94, a second two-year plan
was implemented in 1994-95, again using cross-fiscal year revenue anticipation
warrants to partly finance the deficit into the 1995-96 fiscal year.

Another consequence of the accumulated budget deficits, together with other
factors such as disbursement of funds to local school districts "borrowed" from
future fiscal years and hence not shown in the annual budget, was to
significantly reduce the State's cash resources available to pay its ongoing
obligations. When the Legislature and the Governor failed to adopt a budget for
the 1992-93 Fiscal Year by July 1, 1992, which would have allowed the State to
carry out its normal annual cash flow borrowing to replenish its cash reserves,
the State Controller issued registered warrants to pay a variety of obligations
representing prior years' or continuing appropriations, and mandates from court
order. Available funds were used to make constitutionally-mandated payments,
such as debt service on bonds and warrants. Between July 1 and September 4,
1992, when the budget was adopted, the State Controller issued a total of
approximately $3.8 billion of registered warrants.

For several years during the recession, the State was forced to rely
increasingly on external debt markets to meet its cash needs, as a succession of
notes and revenue anticipation warrants were issued in the period from June 1992
to July 1994, often needed to pay previously maturing notes or warrants. These
borrowings were used also in part to spread out the repayment of the accumulated
budget deficit over the end of a fiscal year, as noted earlier. The last and
largest of these borrowings was $4.0 billion of revenue anticipation warrants
which were issued in July 1994 and matured on April 25, 1996.

1995-96 Fiscal Year. The 1995-96 Budget Act was signed by the Governor on
August 3, 1995, 34 days after the start of the fiscal year. The Budget Act
projected general fund revenues and transfers of $44.1 billion, a 3.5% increase
from the prior year. Expenditures were budgeted at $43.4 billion, a 4% increase.
The Budget

I-2
<PAGE> 84

Act also projected Special Fund revenues of $12.7 billion and appropriated
Special Fund expenditures of $13.0 billion.

Final data for the 1995-96 Fiscal Year showed revenues and transfers of
$46.1 billion, some $2 billion over the original fiscal year estimate, which was
attributed to the strong economic recovery. Expenditures also increased, to an
estimated $45.4 billion, as a result of the requirement to expend revenues for
schools under Proposition 98, and among other things, failure of the federal
government to enact welfare reform during the fiscal year and to budget new aid
for illegal immigrant costs, both of which had been counted on to allow
reductions in State costs. SFEU had a small negative balance of about $87
million at June 30, 1996, all but eliminating the accumulated budget deficit
from the early 1990's. Available internal borrowable resources (available cash,
after payment of all obligations due) on June 30, 1996 was about $3.8 billion,
representing a significant improvement in the State's cash position, and ending
the need for deficit borrowing over the end of the fiscal year. The State's
improved cash position allowed it to repay the $4.0 billion Revenue Anticipation
Warrant issue on April 25, 1996, and to issue only $2.0 billion of revenue
anticipation notes during the fiscal year, which matured on June 28, 1996.

The 1995-96 Budget Act included substantial additional funding under
Proposition 98 for schools and community colleges (about $1.0 billion general
fund and $1.2 billion total above 1994-95 levels). Because of higher than
projected revenues in 1994-95, an additional $561 million ($92 per K-12 ADA) was
appropriated to the 1994-95 Proposition 98 entitlement. A large part of this was
a block grant of about $50 per pupil for any one-time purpose. For the first
time in several years, a full 2.7 percent cost of living allowance was funded.
The budget was based on the settlement of the CTA v. Gould litigation. Cuts in
health and welfare costs totaled about $220 million, almost $700 million less
than had been anticipated, because of the failure by the federal government to
approve certain of these actions in a timely manner. The federal government also
failed to appropriate all but $31 million of an anticipated $500 million in new
federal aid for incarceration and health care costs of illegal immigrants.
Funding from the general fund for the University of California was increased by
$106 million and for the California State University system by $97 million, with
no increases in student fees.

1996-97 Fiscal Year. The 1996-97 Budget Act was signed by the Governor on
July 15, 1996, along with various implementing bills. The Governor vetoed about
$82 million of appropriations (both general fund and Special Fund). With the
signing of the Budget Act, the State implemented its regular cash flow borrowing
program with the issuance of $3.0 billion of Revenue Anticipation Notes to
mature on June 30, 1997. The Budget Act appropriated a modest budget reserve in
the SFEU of $305 million, as of June 30, 1997. The Department of Finance
projected that, on June 30, 1997, the State's available internal borrowing
(cash) resources would be $2.9 billion, after payment of all obligations due by
that date, so that no cross-fiscal year borrowing will be needed.

Revenues. The Legislature rejected the Governor's proposed 15% cut in
personal income taxes (to be phased in over three years), but did approve a 5%
cut in bank and corporation taxes, to be effective for income years starting in
January 1, 1997. As a result, revenues for the Fiscal Year were estimated to
total $47.643 billion, a 3.3% increase over the final estimated 1995-96
revenues. Special Fund revenues were estimated to be $13.3 billion.

Expenditures. The Budget Act contained general fund appropriations
totaling $47.251 billion, a 4.0% increase over the final estimated 1995-96
expenditures. Special Fund expenditures were budgeted at $12.6 billion.

The following are principal features of the 1996-97 Budget Act:

1. Proposition 98 funding for schools and community college districts
increased by almost $1.6 billion (general fund) and $1.65 billion total
above revised 1995-96 levels. Almost half of this money was budgeted to
fund class-size reductions in kindergarten and grades 1-3. Also, for the
second year in a row, the full cost of living allowance (3.2%) was funded.
The Proposition 98 increases have brought K-12 expenditures to almost
$4,800 per ADA, an almost 15% increase over the level prevailing during the

I-3
<PAGE> 85

recession years. Community colleges will receive an increase in funding of
$157 million for 1996-97 out of this $1.6 billion total.

Because of the higher than projected revenues in 1995-96, an
additional $1.1 billion ($190 per K-12 ADA and $145 million for community
colleges) was appropriated and retroactively applied towards the 1995-96
Fiscal Year Proposition 98 guarantee, bringing K-12 expenditures in that
year to over $4,600 per ADA. These new funds were appropriated for a
variety of purposes, including block grants, allocations for each school
site, facilities for class size reduction, and a reading initiative.
Similar retroactive increases totaling $230 million, based on final figures
on revenues and State population growth, were made to the 1991-92 Fiscal
Year and the 1994-95 Fiscal Year Proposition 98 guarantees, most of which
was allocated to each school site.

2. The Budget Act assumed savings of approximately $660 million in
health and welfare costs which required changes in federal law, including
federal welfare reform. The Budget Act further assumed federal law changes
in August 1996 which would allow welfare cash grant levels to be reduced by
October 1, 1996. These cuts totaled approximately $163 million of the
anticipated $660 million savings.

3. The Budget Act includes a 4.9% increase in funding for the
University of California ($130 million general fund) and the California
State University system ($101 million general fund), with no increases in
student fees, maintaining the second year of the Governor's four-year
"Compact" with the State's higher education units.

4. The Budget Act assumed the federal government will provide
approximately $700 million in new aid for incarceration and health care
costs of illegal immigrants. These funds reduce appropriations in these
categories that would otherwise have to be paid from the general fund. (For
purposes of cash flow projections, the State Department of Finance expects
$540 million of this amount to be received during the 1996-97 Fiscal Year.)

5. General fund support for the State Department of Corrections was
increased by about 7% over the prior year, reflecting estimates of
increased prison population.

6. With respect to aid to local governments, the principal new
programs included in the Budget Act are $100 million in grants to cities
and counties for law enforcement purposes, and budgeted $50 million for
competitive grants to local governments for programs to combat juvenile
crime.

1997-98 Fiscal Year. Once the pension payment eliminated essentially all
the "increased" revenue in the budget, final agreement was reached within a few
weeks on the welfare package and the remainder of the budget. The Legislature
passed the 1997-98 Budget Bill on August 11, 1997, along with numerous related
bills to implement its provisions. Agreement was not finally reached, however,
on one aspect of the budget plan, concerning the Governor's proposal for a
comprehensive educational testing program.

On August 18, 1997, the Governor signed the Budget Act, but vetoed about
$314 million of specific spending items, primarily in health and welfare and
education areas from both the General Fund and Special Funds. The Governor
announced that he was prepared to restore about $200 million of education
spending upon satisfactory completion of legislation on the education testing
program.

The Budget Act anticipated General Fund revenues and transfers of $52.5
billion (a 6.8 percent increase over the final 1996-97 amount), and expenditures
of $52.8 billion (an 8.0 percent increase from the 1996-97 levels). On a
budgetary basis, the budget reserve (SFEU) was projected to decrease from $408
million at June 30, 1997 to $112 million at June 30, 1998. As of January 9,
1998, the State Director of Finance estimated a reserve of $329 million at June
30, 1998. (The expenditure figure assumes restoration of $200 million in vetoed
funding.) The Budget Act also included Special Fund expenditures of $14.4
billion (as against estimated Special Fund revenues of $14.0 billion), and $2.1
billion of expenditures from various bond funds. The State has implemented its
normal annual cash flow borrowing program, issuing $3 billion of notes which
matured on June 30, 1998.

I-4
<PAGE> 86

The following were major features of the 1997-98 Budget Act:

1. The Budget contained a large increase in funding for K-14 education
under Proposition 98, reflecting strong revenues which exceeded initial
budgeted amounts. Part of the nearly $1.75 billion in increased spending
was allocated to prior fiscal years. Funds were provided to fully pay for
the cost-of-living increase component of Proposition 98, and to extend
class size reduction and reading initiatives.

2. The Budget Act reflected the $1.235 billion pension case judgment
payment, and brought funding of the State's pension contribution back to
the quarterly basis which existed prior to the deferral actions which were
invalidated by the courts. There was no provision for any additional
payments relating to this court case.

3. Continuing the third year of a four-year "compact" which the
Administration made with higher education units, funding from the General
Fund for the University of California and California State University has
increased by about 6 percent ($121 million and $107 million, respectively),
and there was no increase in student fees.

4. Because of the effect of the pension payment, most other State
programs were continued at 1996-97 levels.

5. Health and welfare costs were contained, continuing generally the
grant levels from prior years, as part of the initial implementation of the
new CalWORKs program.

6. Unlike prior years, this Budget Act does not depend on federal
budget actions. About $300 million in federal funds, already included in
the federal FY 1997 and 1998 budgets, were included in the Budget Act, to
offset incarceration costs for illegal aliens.

7. The Budget Act contained no tax increases, and no tax reductions.
The Renters Tax Credit was suspended for another year, saving approximately
$500 million.

Federal Welfare Reform. Congress passed and the President signed (on
August 22, 1996) the Personal Responsibility and Work Opportunity Act of 1996
(the "Law") making a fundamental reform of the current welfare system. Among
many provisions, the Law includes: (i) conversion of Aid to Families with
Dependent Children from an entitlement program to a block grant titled Temporary
Assistance for Needy Families ("TANF"), with lifetime time limits on TANF
recipients, work requirements and other changes; (ii) provisions denying certain
federal welfare and public benefits to legal noncitizens, allowing states to
elect to deny additional benefits (including TANF) to legal noncitizens, and
generally denying almost all benefits to illegal immigrants; and (iii) changes
in the Food Stamp program, including reducing maximum benefits and imposing work
requirements.

As part of the 1997-98 Budget Act legislative package, the State
Legislature and Governor agreed on a comprehensive reform of the State's public
assistance programs to implement the new federal Law. The new basic State
welfare program is called California Work Opportunity and Responsibility to Kids
Act ("CalWORKs"), which replaces the former Aid to Families with Dependent
Children (AFDC) and Greater Avenues to Independence (GAIN) programs effective
January 1, 1998. Consistent with the federal Law, CalWORKs contains new time
limits on receipt of welfare aid, both lifetime as well as for any current time
on aid. Administration of the new Welfare-to-Work programs will be largely at
the county level, and counties are given financial incentives for success in
this program.

Although the longer-term impact of the new federal Law and CalWORKs cannot
be determined until there has been some experience, the State does not presently
anticipate that these new programs will have any adverse financial impact on its
general fund. Overall TANF grants from the federal government are expected to
equal or exceed the amounts the State would have received under the old AFDC
program.

1998-99 Fiscal Year Budget. When the Governor released his proposed
1998-99 Fiscal Year Budget on January 9, 1998, he projected general fund
revenues for the 1998-99 Fiscal Year of $55.4 billion, and proposed expenditures
in the same amount. By the time the Governor released the May Revision to the
1998-99 Budget ("May Revision") on May 14, 1998, the Administration projected
that revenues for the 1997-98 and 1998-

I-5
<PAGE> 87

99 Fiscal Years combined would be more than $4.2 billion higher than was
projected in January. The Governor proposed that most of this increased revenue
be dedicated to fund a 75% cut in the Vehicle License Fee ("VLF").

Pursuant to Article IV, Section 13(c) of the Constitution of the State of
California, the State Legislature is required to adopt its budget for the
upcoming fiscal year (July 1-June 30) by midnight of June 15th, and in the
absence of which, the Legislature may not send to the Governor for consideration
any bill appropriating funds for expenditure during the fiscal year for which
the budget bill is to be enacted, except emergency bills or appropriations for
the salaries and expenses of the Legislature. For the current fiscal year, as
has been true since the late 1980's, the State Legislature did not adhere to
this deadline. Due to the Legislature's failure to comply with this
constitutional requirement, the Howard Jarvis Taxpayers Association sought an
injunction in a Los Angeles Superior Court to prohibit the State from making
certain types of payments in the absence of an adopted budget. On July 21, 1998,
a preliminary injunction was issued. Under the terms of the injunction order,
until such time as the budget has been adopted, the State may not make any
payments from the State treasury for Fiscal Year 1998-99 except for certain
enumerated expenditures.

On July 22, 1998, the Legislature unanimously passed an $18.9 billion
emergency-spending bill to cover the costs of, among others, bond payments,
paychecks for state workers, retirement pensions, prisons, school and welfare
payments from July 1st through August 5th. However, before a final resolution of
the legal issues raised by the plaintiff, a budget for fiscal year 1998-99 was
passed by the Legislature on August 11, 1998, and the Governor signed it on
August 21, 1998.

In signing the Budget Bill, the Governor used his line-item veto power to
reduce expenditures by $1.360 billion from the General Fund, and $160 million
from Special Funds. Of this total, the Governor indicated that about $250
million of vetoed funds were "set aside" to fund programs for education. Vetoed
items included education funds, salary increases and many individual resources
and capital projects.

The 1998-99 Budget Act is based on projected general fund revenues and
transfers of $57.0 billion (after giving effect to various tax reductions
enacted in 1997 and 1998), a 4.2% increase from the revised 1997-98 figures.
Special Fund revenues were estimated at $14.3 billion. The revenue projections
were based on the May Revision. Economic problems overseas since that time may
affect the May Revision projections.

After giving effect to the Governor's vetoes, the Budget Act provides
authority for expenditures of $57.3 billion from the general fund (a 7.3%
increase from 1997-98), $14.7 billion from Special Funds, and $3.4 billion from
bond funds. The Budget Act projects a balance in the SFEU at June 30, 1999 (but
without including the "set aside" veto amount) of $1.255 billion, a little more
than 2% of general fund revenues. The Budget Act assumes the State will carry
out its normal intra-year cash flow borrowing in the amount of $1.7 billion of
revenue anticipation notes, which are expected to be issued by early October.

The most significant feature of the 1998-99 budget was agreement on a total
of $1.4 billion of tax cuts. The central element is a bill which provides for a
phased-in reduction of the motor vehicle license fee (the "VLF"). Since the VLF
is currently transferred to cities and counties, the bill provides for the
general fund to replace the lost revenues. Starting on January 1, 1999, the VLF
will be reduced by 25%, at a cost to the general fund of approximately $500
million in the 1998-99 Fiscal Year and about $1 billion annually thereafter.

In addition to the cut in VLF, the 1998-99 budget includes both temporary
and permanent increases in the personal income tax dependent credit ($612
million General Fund cost in 1998-99, but less in future years), a nonrefundable
renters tax credit ($133 million), and various targeted business tax credits
($106 million). About half of the business tax credits will only become
effective if Proposition 7, an initiative measure which includes various tax
credits, is rejected by the voters on the November 3, 1998 ballot.

Other significant elements of the 1998-99 Budget Act are as follows:

1. Proposition 98 funding for K-12 schools is increased by $1.7
billion in General Fund moneys over revised 1997-98 levels, about $300
million higher than the minimum Proposition 98 guaranty. An additional $600
million was appropriated to "settle up" prior years' Proposition 98
entitlements, and was

I-6
<PAGE> 88

primarily devoted to one-time uses such as block grants, deferred
maintenance, and computer and laboratory equipment.

2. Funding for higher education increased substantially above the
level called for in the Governor's four-year compact. General Fund support
was increased by $340 million (15.6%) for the University of California and
$267 million (14.1%) for the California State University system. In
addition, Community Colleges received a $300 million (6.6%) increase under
Proposition 98.

3. The Budget includes increased funding for health, welfare and
social services programs. A 4.9% grant increase was included in the basic
welfare grants, the first increase in those grants in 9 years. Future
increases will depend on sufficient general fund revenue to trigger the
phased cuts in VLF described above.

4. Funding for the judiciary and criminal justice programs increased
by about 11% over 1997-98, primarily to reflect increased State support for
local trial courts and rising prison population.

5. Various other highlights of the Budget included new funding for
resources projects, dedication of $376 million of general fund moneys for
capital outlay projects, funding of a 3% State employee salary increase,
funding of 2,000 new Department of Transportation positions to accelerate
transportation construction projects, and funding of the Infrastructure and
Economic Development Bank ($50 million).

6. The State of California received approximately $167 million of
federal reimbursements to offset costs related to the incarceration of
undocumented alien felons for federal fiscal year 1997. The State
anticipates receiving approximately $195 million in federal reimbursements
for federal fiscal year 1998.

LOCAL GOVERNMENTS

The primary units of local government in California are the counties,
ranging in population from 1,300 (Alpine) to over 9,000,000 (Los Angeles).
Counties are responsible for the provision of many basic services, including
indigent healthcare, welfare, courts, jails and public safety in unincorporated
areas. There are also about 480 incorporated cities and thousands of other
special districts formed for education, utility and other services. The fiscal
condition of local governments has been constrained since the enactment of
"Proposition 13" in 1978, which reduced and limited the future growth of
property taxes and limited the ability of local governments to impose "special
taxes" (those devoted to a specific purpose) without two-thirds voter approval.
Counties, in particular, have had fewer options to raise revenues than many
other local governmental entities, and have been required to maintain many
services.

The entire statewide welfare system has been changed in response to the
change in federal welfare law enacted in 1996 (see "Federal Welfare Reform"
above). Under the CalWORKs program, counties are given flexibility to develop
their own plans, consistent with State law, to implement Welfare-to-Work and to
administer many of its elements and their costs for administrative and support
services are capped at 1996-97 levels. Counties are also given financial
incentives if, at the individual county level or statewide, the CalWORKs program
produces savings associated with specified Welfare-to-Work outcomes; counties
may also suffer penalties for failing to meet federal standards. Under CalWORKs,
counties will still be required to provide "general assistance" aid to certain
persons who cannot obtain welfare from other programs.

Historically, funding for the State's trial court system was divided
between the State and the counties. However, Chapter 850, Statutes of 1997,
implements a restructuring of the State's trial court funding system. Funding
for the courts, with the exception of costs for facilities, local judicial
benefits, and revenue collection, was consolidated at the State level. County
contribution for both their general fund and fine and penalty amounts is capped
at the 1994-95 level and becomes part of the Trial Court Trust Fund, which
supports all trial court operations. The State assumed responsibility for future
growth in trial court funding. The consolidation of funding is intended to
streamline the operation of the courts, provide a dedicated revenue source, and
relieve fiscal pressure on the counties. Beginning in 1998-99, county general
fund contribution for court operations is reduced by $300 million, including
$10.7 million to buy out the contribution of the 20 smallest counties, and
cities will retain $62 million in fine and penalty revenue previously remitted
to the State; the State's general fund backfilled the $362 million revenue loss
to the Trial Court Trust Fund. In
I-7
<PAGE> 89

addition to this general fund backfill, a $50 million augmentation is included
in the 1998 Budget Act for the trial courts to fund workload increases and high
priority issues such as court security. In 1999-2000, county general fund
contributions will be further reduced by an additional $92 million to buy out
the next 17 smallest counties and reduce by ten percent the general fund
contribution of the remaining 21 counties.

In the aftermath of Proposition 13, the State provided aid from the general
fund to make up some of the loss of property tax moneys, including taking over
the principal responsibility for funding local K-12 schools and community
colleges. Under the pressure of the recent recession, the Legislature has
eliminated remnants of this post-Proposition 13 aid to entities other than K-14
education districts, although it has also provided additional funding sources
(such as sales taxes) and reduced mandates for local services. Many counties
continue to be under severe fiscal stress. While such stress has in recent years
most often been experienced by smaller, rural counties, larger urban counties,
such as Los Angeles, have also been affected. Orange County implemented
significant reductions in services and personnel, and continues to face fiscal
constraints in the aftermath of its bankruptcy, which has been caused by large
investment losses in its pooled investment funds.

On November 5, 1996, voters approved Proposition 218, entitled the "Right
to Vote on Taxes Act," which incorporates new Articles XIIIC and XIIID into the
California Constitution. These new provisions enact limitations on the ability
of local government agencies to impose or raise various taxes, fees, charges and
assessments without voter approval. Certain "general taxes" imposed after
January 1, 1995 must be approved by voters in order to remain in effect. In
addition, Article XIIIC clarifies the right of local voters to reduce taxes,
fees, assessments to changes through local initiatives. There are a number of
ambiguities concerning the Proposition and its impact on local governments and
their bonded debt which will require interpretation by the courts or the State
Legislature. The State Legislature Analyst estimated that enactment of
Proposition 218 would reduce local government revenues statewide by over $100
million a year, and that over time revenues to local government would be reduced
by several hundred million dollars. Proposition 218 does not affect the State or
its ability to levy or collect taxes.

On December 23, 1997, a consortium of California counties filed a test
claim with the Commission on State Mandates (the "Commission") asking the
Commission to determine whether the property tax shift from counties to the
Educational Revenue Augmentation Fund, which is a funding source for schools, is
a reimbursable state mandated cost. On August 11, 1998, the State Department of
Justice, on behalf of the State Department of Finance, filed a rebuttal in
opposition to the counties' claim. The issue is currently scheduled to be heard
by the Commission on October 22, 1998. The fiscal impact to the State general
fund if the Commission determines that the property tax shifts created a
reimbursable state mandate could total approximately $8 billion for the 1996-97
($2.5 billion), 1997-98 ($2.6 billion) and 1998-99 ($2.7 billion) property tax
shifts. Ongoing costs to the State general fund would be approximately $2.7
billion annually.

CONSTITUTIONAL AND STATUTORY LIMITATIONS; RECENT AND PENDING INITIATIVES;
PENDING LEGISLATION

Constitutional and Statutory Limitations. Article XIIIA of the California
Constitution (which resulted from the voter-approved Proposition 13 in 1978)
limits the taxing powers of California public agencies, Article XIIIA, provides
that the maximum ad valorem tax on real property cannot exceed 1% of the "full
cash value" of the property and effectively prohibits the levying of any other
ad valorem tax on real property for general purposes. However, on May 3, 1986,
Proposition 46, an amendment to Article XIIIA, was approved by the voters of the
State of California, creating a new exemption under Article XIIIA permitting an
increase in ad valorem taxes on real property in excess of 1% for bonded
indebtedness approved by two-thirds of the voters voting on the proposed
indebtedness, "Full cash value" is defined as "the County Assessor's valuation
of real property as shown on the 1975-76 Fiscal Year tax bill under 'full cash
value' or, thereafter, the appraised value of real property when purchased,
newly constructed, or a change in ownership has occurred after the 1975
assessment." The "full cash value" is subject to annual adjustment to reflect
increases (not to exceed 2%) or decreases in the consumer price index or
comparable local data, or to reflect reductions in property value caused by
damage, destruction or other factors.

I-8
<PAGE> 90

Article XIIIB of the California Constitution limits the amount of
appropriations of the State and of the local governments to the amount of
appropriations of the entity for the prior year, adjusted for changes in the
cost of living, population and the services that local government has financial
responsibility for providing. To the extent that the revenues of the State
and/or local government exceed its appropriations, the excess revenues must be
rebated to the public either directly or through a tax decrease. Expenditures
for voter-approved debt services are not included in the appropriations limit.

At the November 9, 1988 general election, California voters approved an
initiative known as Proposition 98. This initiative amends Article XIIIB to
require that (i) the California Legislature establish a prudent state reserve
fund in an amount it shall deem reasonable and necessary and (ii) revenues in
excess of amounts permitted to be spent and which would otherwise be returned
pursuant to Article XIIIB by revision of tax rates or fee schedules be
transferred and allocated (up to a maximum of 40%) to the State School Fund and
be expended solely for purposes of instructional improvement and accountability.
Proposition 98 also amends Article XVI to require that the State of California
provide a minimum level of funding for public schools and community colleges.
Commencing with the 1988-89 Fiscal Year, money to be applied by the State for
the support of school districts and community college districts shall not be
less than the greater of: (i) the amount which, as a percentage of the State
general fund revenues which may be appropriated pursuant to Article XIIIB,
equals the percentage of such State general fund revenues appropriated for
school districts and community college districts, respectively, in the 1986-87
Fiscal Year or (ii) the amount required to ensure that the total allocations to
school districts and community college districts from the State general fund
proceeds of taxes appropriated pursuant to Article XIIIB and allocated local
proceeds of taxes shall not be less than the total amount from these sources in
the prior year, adjusted for increases in enrollment and adjusted for changes in
the cost of living pursuant to the provisions of Article XIIIB. The initiative
permits the enactment of legislation, by a two-thirds vote, to suspend the
minimum funding requirements for one year. As a result of Proposition 98, funds
that the State might otherwise make available to its political subdivisions may
be allocated instead to satisfy such minimum funding level.

During the recent recession, general fund revenues for several years were
less than originally projected, so that the original Proposition 98
appropriations turned out to be higher than the minimum percentage provided in
the law. The Legislation responded to these developments by designating the
"extra" Proposition 98 payments in one year as a "loan" from future years'
Proposition 98 entitlements and also intended that the "extra" payments would
not be included in the Proposition 98 "base" for calculating future years'
entitlements. By implementing these actions, per-pupil funding from Proposition
98 sources stayed almost constant at approximately $4,220 from the 1991-92
Fiscal Year to the 1993-94 Fiscal Year.

In 1992, a lawsuit was filed, called California Teachers' Association v.
Gould, which challenged the validity of these off-budget loans. The settlement
of this case, finalized in July 1996, provides, among other things, that both
the State and K-14 schools share in the repayment of prior years' emergency
loans to schools. Of the total $1.76 billion in loans, the State will repay $935
million by forgiveness of the amount owned, while schools will repay $825
million. The State share of the repayment will be reflected as an appropriation
above the current Proposition 98 base calculation. The schools' share of the
repayment will count either as appropriations that count toward satisfying the
Proposition 98 guarantee, or as appropriations from "below" the current base.
Repayments are spread over the eight-year period of the 1994-95 Fiscal Year
through the 2001-02 Fiscal Year to mitigate any adverse fiscal impact.

Substantially increased general fund revenues, above initial budget
projections, in the 1994-95, 1995-96 and 1996-97 fiscal years have resulted or
will result in retroactive increases in Proposition 98 appropriations from
subsequent fiscal years' budgets.

On November 8, 1994, the voters approved Proposition 187, an initiative
statute ("Proposition 187"), Proposition 187 specifically prohibits funding by
the State of social services, health care services and public school education
for the benefit of any person not verified as either a United States citizen or
a person legally admitted to the United States. Among the provisions in
Proposition 187 pertaining to public school education, the measure requires,
commencing January 1, 1995, that every school district in the State verify the
legal status of every child enrolling in the district for the first time. By
January 1, 1996, each school district must

I-9
<PAGE> 91

also verify the legal status of children already enrolled in the district and of
all parents or guardians of all students. If the district "reasonably suspects"
that a student, parent or guardian is not legally in the United States, that
district must report the student to the United States Immigration and
Naturalization Service and certain other parties. The measure also prohibits a
school district from providing education to a student it does not verify as
either a United States citizen or a person legally admitted to the United
States. The State Legislative Analyst estimates that verification costs could be
in the tens of millions of dollars on a statewide level (including verification
costs incurred by other local governments), with first-year costs potentially in
excess of $100 million.

The reporting requirements may violate the Family Educational Rights and
Privacy Act ("FERPA"), which generally prohibits schools that receive federal
funds from disclosing information in student records without parental consent.
Compliance with FERPA is a condition of receiving federal education funds, which
total $2.3 billion annually to California school districts. The Secretary of the
United States Department of Education has indicated that the reporting
requirements in Proposition 187 could jeopardize the ability of school districts
to receive these funds.

Opponents of Proposition 187 have filed at least eight lawsuits challenging
the constitutionality and validity of the measure. On November 2, 1995, a
District Court judge struck down the central provisions of Proposition 187 by
ruling that parts of Propositions 187 conflict with federal power over
immigration. The ruling concluded that states may not enact their own schemes to
"regulate immigration or devise immigration regulations which can parallel or
purport to supplement Federal immigration law." As a consequence of the ruling,
students may not be denied public education and may not be asked about their
immigration status when enrolling in public schools. Further, the ruling struck
down the requirements of Proposition 187 that teachers and district employees
report information on the immigrant status of students, parents and guardians.
An appeal has been filed.

Article XIIIA, Article XIIIB and a number of other propositions were
adopted pursuant to California's constitutional initiative process. From time to
time, other initiative measures could be adopted by California voters. The
adoption of any such initiatives may cause California issuers to receive reduced
revenues, or to increase expenditures, or both.

Pending Litigation. The State is a party to numerous legal proceedings,
many of which normally occur in governmental operations. Some of the more
significant lawsuits pending against the State are described herein.

The State is involved in a lawsuit, Thomas Hayes v. Commission on State
Mandates, related to the state-mandated costs. The action involves an appeal by
the Director of Finance from a 1984 decision by the State Board of Control (now
succeeded by the Commission on State Mandates). The Board of Control decided in
favor of local school districts' claims for reimbursement for special education
programs for handicapped students. The case was then brought to the trial court
by the State and later remanded to the Commission on State Mandates for
redetermination. The Commission on State Mandates has since expanded the claim
to include supplemental claims filed by seven other educational institutions;
the issuance of a final consolidated decision is anticipated some time in late
1998. To date, the Legislature has not appropriated funds. The liability to the
State, if all potentially eligible school districts pursue timely claims, has
been estimated by the Department of Finance at more than $1 billion.

The State is involved in a lawsuit related to contamination at the
Stringfellow toxic waste site. In United States, People of the State of
California v. J.B. Stringfellow, Jr., et. al., the State is seeking recovery for
past costs of cleanup of the site, a declaration that the defendants are jointly
and severally liable for future costs, and an injunction ordering completion of
the cleanup. However, the defendants have filed a counterclaim against the State
for alleged negligent acts. Because the State is the present owner of the site,
the State may be found liable. Present estimates of the cleanup range from $300
million to $800 million.

I-10
<PAGE> 92

The State is a defendant in a coordinated action involving 3,000 plaintiffs
seeking recovery for damages caused by the Yuba River flood of February 1986.
The appellate court affirmed the trial court finding of liability in inverse
condemnation and awarded damages of $500,000 to 12 sample plaintiffs. Potential
liability to the remaining 300 plaintiffs, from claims filed, ranges from $800
million to $1.5 billion. An appeal has been filed.

The State is a defendant in Just Say No To Tobacco Dough Campaign v. State
of California, where the petitioners challenge the appropriation of
approximately $166 million of Proposition 99 funds in the Cigarette and Tobacco
Products Surtax Fund for years ended June 30, 1990, through June 30, 1995 for
programs which were allegedly not health education or tobacco-related disease
research. If the State loses, the general fund and funds from other sources
would be used to reimburse the Cigarette and Tobacco Products Surtax Fund for
approximately $166 million.

The State is a defendant in the case of Kurt Hathaway, et al. v. Wilson, et
al., where the plaintiffs are challenging the legality of various budget action
transfers and appropriations from particular special funds for years ended June
30, 1995, and June 30, 1996. The plaintiffs allege that the transfers and
appropriations are contrary to the substantive law establishing the funds and
providing for interest accruals to the funds, violate the single subject
requirement of the State Constitution, and is an invalid "special law." Pursuant
to a settlement, judgment was entered in August 1998, requiring the State to
return $19,427,000 from the general fund to one special fund.

The State is a defendant in two related cases, Beno vs. Sullivan (Beno) and
Welch v. Anderson (Welch), concerning reductions in Aid to Families with
Dependent Children ("AFDC") grant payments. In the Beno case, plaintiffs seek to
invalidate AFDC grant reductions and in the Welch case, plaintiffs contend that
AFDC grant reductions are not authorized by state law. The Beno case concerns
the total grant reductions while the Welch case concerns the period of time the
State did not have a waiver for those reductions. Pursuant to a settlement, the
State has agreed to pay $42 million in return for plaintiff's agreement to
dismiss both actions.

In the case of Board of Administration, California Public Employees'
Retirement System, et al. v. Pete Wilson, Governor, et al., plaintiffs
challenged the constitutionality of legislation which deferred payment of the
State's employer contribution to the Public Employees' Retirement System
("PERS") beginning in the 1992-93 Fiscal Year. On January 11, 1995, the
Sacramento County Superior Court entered a judgment finding that the legislation
unconstitutionally impaired the vested contract rights of PERS members. The
judgment provides for issuance of a writ of mandate directing State defendants
to disregard the provisions of the legislation, to implement the statute
governing employer contributions that existed before the changes in the
legislation were found to be unconstitutional and to transfer to PERS the
contributions that are unpaid to date. On February 19, 1997, the State Court of
Appeals affirmed the decision of the Superior Court, and the Supreme Court
subsequently refused to hear the case, making the Court of Appeals' ruling
final. On July 30, 1997, the Controller transferred $1.235 billion from the
General Fund to PERS in repayment of the principal amount determined to have
been improperly deferred. Subsequent State payments to PERS will be made on a
quarterly basis. No prejudgment interest has been paid in accordance with the
trial court ruling that there was insufficient evidence that money for that
purpose had been appropriated and was available. No post-judgment interest was
ordered. PERS has filed a claim with the State Board of Control in the amount of
$308 million for the accrued interest on the judgment. PERS also seeks interest
on the unpaid accrued interest amount. The State Board of Control approved this
claim in March 1998.

I-11
<PAGE> 93

(This page intentionally left blank.)
<PAGE> 94

APPENDIX II

RATINGS OF MUNICIPAL BONDS

DESCRIPTION OF MOODY'S INVESTORS SERVICE, INC.'S ("MOODY'S") LONG-TERM DEBT
RATINGS

<TABLE>
<S> <C>
Aaa Bonds which are rated Aaa are judged to be of the best
quality. They carry the smallest degree of investment risk
and are generally referred to as "gilt-edged." Interest
payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various
protective elements are likely to change, such changes as
can be visualized are most unlikely to impair the
fundamentally strong position of such issues.

Aa Bonds which are rated Aa are judged to be of high quality by
all standards. Together with the Aaa group they comprise
what are generally known as high grade bonds. They are rated
lower than the best bonds because margins of protection may
not be as large as in Aaa securities or fluctuation of
protective elements may be of greater amplitude or there may
be other elements present which make the long-term risk
appear somewhat larger than in Aaa securities.

A Bonds which are rated A possess many favorable investment
attributes and are to be considered as upper-medium-grade
obligations. Factors giving security to principal and
interest are considered adequate, but elements may be
present which suggest a susceptibility to impairment
sometime in the future.

Baa Bonds which are rated Baa are considered as medium-grade
obligations, i.e., they are neither highly protected nor
poorly secured. Interest payment and principal security
appear adequate for the present but certain protective
elements may be lacking or may be characteristically
unreliable over any great length of time. Such bonds lack
outstanding investment characteristics and in fact have
speculative characteristics as well.

Ba Bonds which are rated Ba are judged to have speculative
elements; their future cannot be considered as well-assured.
Often the protection of interest and principal payments may
be very moderate and thereby not well safeguarded during
both good and bad times over the future. Uncertainty of
position characterizes bonds in this class.

B Bonds which are rated B generally lack characteristics of
the desirable investment. Assurance of interest and
principal payments or of maintenance of other terms of the
contract over any long period of time may be small.

Caa Bonds which are rated Caa are of poor standing. Such issues
may be in default or there may be present elements of danger
with respect to principal or interest.

Ca Bonds which are rated Ca represent obligations which are
speculative in a high degree. Such issues are often in
default or have other marked shortcomings.

C Bond which are rated C are the lowest rated class of bonds,
and issues so rated can be regarded as having extremely poor
prospects of ever attaining any real investment standing.
</TABLE>

Note: Those bonds in the Aa, A, Baa, Ba and B groups which Moody's
believes possess the strongest investment attributes are designated by the
symbols Aa1, A1, Baa1, Ba1 and B1.

Short-term Notes: The three ratings of Moody's for short-term notes are
MIG1/VMIG1, MIG2/VMIG2 and MIG3/VMIG3; MIG1/VMIG1 denotes "best quality . . .
strong protection by established cash flows"; MIG2/VMIG2 denotes "high quality"
with ample margins of protection; MIG3/VMIG3 notes are of "favorable quality
. . . but . . . lacking the undeniable strength of the preceding grades."

II-1
<PAGE> 95

DESCRIPTION OF MOODY'S SHORT-TERM DEBT RATINGS

Moody's employs the following three designations, all judged to be
investment grade, to indicate the relative repayment ability of rated issuers:

Issuers rated Prime-1 (or supporting institutions) have a superior ability
for repayment of senior short-term debt obligations. Prime-1 repayment ability
will often be evidenced by the many following characteristics: leading market
positions in well established industries; high rates of return on funds
employed; conservative capitalization structure with moderate reliance on debt
and ample asset protection; broad margins in earnings coverage of fixed
financial charges and high internal cash generation; and well established access
to a range of financial markets and assured sources of alternate liquidity.

Issuers rated Prime-2 (or supporting institutions) have a strong ability
for repayment of senior short-term debt obligations. This will normally be
evidenced by many of the characteristics cited above but to a lesser degree.
Earnings trends and coverage ratios, while sound, may be more subject to
variation. Capitalization characteristics, while still appropriate, may be more
affected by external conditions. Ample alternate liquidity is maintained.

Issuers rated Prime-3 (or supporting institutions) have an acceptable
ability for repayment of senior short-term debt obligations. The effect of
industry characteristics and market composition may be more pronounced.
Variability in earnings and profitability may result in changes in the level of
debt protection measurements and may require relatively high financial leverage.
Adequate alternate liquidity is maintained.

Issuers rated Not Prime do not fall within any of the Prime rating
categories.

DESCRIPTION OF STANDARD & POOR'S ("STANDARD & POOR'S") ISSUE CREDIT RATING
DEFINITIONS

A Standard & Poor's issue credit rating is a current opinion of the
creditworthiness of an obligor with respect to a specific financial obligation,
a specific class of financial obligations, or a specific financial program
(including ratings on medium term note programs and commercial paper programs).
It takes into consideration the creditworthiness of guarantors, insurers, or
other forms of credit enhancement on the obligation and takes into account the
currency in which the obligation is denominated.

The issue credit rating is not a recommendation to purchase, sell, or hold
a financial obligation, inasmuch as it does not comment as to market price or
suitability for a particular investor.

Issue credit ratings are based on current information furnished by the
obligors or obtained by Standard & Poor's from other sources it considers
reliable. Standard & Poor's does not perform an audit in connection with any
credit rating and may, on occasion, rely on unaudited financial information.
Credit ratings may be changed, suspended, or withdrawn as a result of changes
in, or unavailability of, such information, or based on other circumstances.

The ratings are based, in varying degrees, on the following considerations:

I. Likelihood of payment capacity and willingness of the obligor to
meet its financial commitment on an obligation in accordance with the terms
of obligation;

II. Nature of and provisions of the obligation; and

III. Protection afforded by, and relative position of, the obligation
in the event of bankruptcy, reorganization, or other arrangement under the
laws of bankruptcy and other laws affecting creditors' rights.

II-2
<PAGE> 96

LONG-TERM ISSUE CREDIT RATINGS

<TABLE>
<C> <S>
AAA An obligation rated "AAA" has the highest rating assigned by
Standard & Poor's. The obligor's capacity to meet its
financial commitment on the obligation is extremely strong.

AA An obligation rated "AA" differs from the highest rated
obligations only in small degree. The obligor's capacity to
meet its financial commitment on the obligation is very
strong.

A An obligation rated "A" is somewhat more susceptible to the
adverse effects of changes in circumstances and economic
conditions than obligations in higher-rated categories.
However, the obligor's capacity to meet its financial
commitment on the obligation is still strong.

BBB An obligation rated "BBB" exhibits adequate protection
parameters. However, adverse economic conditions or changing
circumstances are more likely to lead to a weakened capacity
of the obligor to meet its financial commitment on the
obligation.

BB An obligation rated "BB," "B," "CCC," "CC" and "C" is

B regarded as having significant speculative characteristics.

CCC "BB" indicates the least degree of speculation and "C" the

CC highest degree of speculation. While such bonds will likely

C have some quality and protective characteristics, these may
be outweighed by large uncertainties or major exposures to
adverse conditions.

D An obligation rated "D" is in payment default. The "D"
rating category is used when payments on an obligation are
not made on the date due even if the applicable grace period
has not expired, unless Standard & Poor's believes that such
payments will be made during such grace period. The "D"
rating also will be used upon the filing of a bankruptcy
petition or the taking of a similar action if payments on an
obligation are jeopardized.
</TABLE>

Plus (+) or Minus (-): The ratings from "AA" to "CCC" may be modified by
the addition of a plus or minus sign to show relative standing within the major
rating categories.

SHORT-TERM ISSUE CREDIT RATINGS

<TABLE>
<C> <S>
A-1 A short-term obligation rated "A-1" is rated in the highest
category by Standard & Poor's. The obligor's capacity to
meet its financial commitment on the obligation is strong.
Within this category, certain obligations are designated
with a plus sign (+). This indicates that the obligor's
capacity to meet its financial commitment on these
obligations is extremely strong.

A-2 A short-term obligation rated "A-2" is somewhat more
susceptible to the adverse effects of changes in
circumstances and economic conditions than obligations in
higher rating categories. However, the obligor's capacity to
meet its financial commitment on the obligation is
satisfactory.

A-3 A short-term obligation rated "A-3" exhibits adequate
protection parameters. However, adverse economic conditions
or changing circumstances are more likely to lead to a
weakened capacity of the obligor to meet its financial
commitment on the obligation.

B A short-term obligation rated "B" is regarded as having
significant speculative characteristics. The obligor
currently has the capacity to meet its financial commitment
on the obligation; however, it faces major ongoing
uncertainties which could lead to the obligor's inadequate
capacity to meet its financial commitment on the obligation.

C A short-term obligation rated "C" is currently vulnerable to
nonpayment and is dependent upon favorable business,
financial, and economic conditions for the obligor to meet
its financial commitment on the obligation.

D A short-term obligation rated "D" is in payment default. The
"D" rating category is used when payments on an obligation
are not made on the date due even if the applicable grace
period has not expired, unless Standard & Poor's believes
that such payments will be made during such grace period.
The "D" rating also will be used upon the filing of a
bankruptcy petition or the taking of a similar action if
payments on an obligation are jeopardized.
</TABLE>

II-3
<PAGE> 97

DESCRIPTION OF FITCH IBCA, INC. ("FITCH") RATINGS

Fitch credit ratings are an opinion on the ability of an entity or of a
securities issue to meet financial commitments, such as interest, preferred
dividends, or repayment of principal, on a timely basis.

Credit ratings are used by investors as indications of the likelihood of
getting their money back in accordance with the terms on which they invested.
Thus, the use of credit ratings defines their function: "investment-grade"
ratings (international long-term "AAA" -- "BBB" categories; short-term
"F1" -- "F3") indicate a relatively low probability of default, while those in
the "speculative" or "non-investment grade" categories (international long-term
"BB" -- "D") either signal a higher probability of default or that a default has
already occurred. Ratings imply no specific prediction of default probability.

Entities or issues carrying the same rating are of similar but not
necessarily identical credit quality since the rating categories do not fully
reflect small differences in the degrees of credit risk.

Fitch credit and other ratings are not recommendations to buy, sell, or
hold any security. Ratings do not comment on the adequacy of market price, the
suitability of any security for a particular investor, or the tax-exempt nature
or taxability of any payments of any security. The ratings are based on
information obtained from issuers, other obligors, underwriters, their experts,
and other sources Fitch believes to be reliable. Fitch does not audit or verify
the truth or accuracy of such information. Ratings may be changed or withdrawn
as a result of changes in, or the unavailability of, information or for other
reasons.

INTERNATIONAL CREDIT RATINGS

Fitch's international credit ratings are applied to the spectrum of
corporate, structured, and public finance. They cover sovereign (including
supranational and subnational), financial, bank, insurance, and other corporate
entities and the securities they issue, as well as municipal and other public
finance entities, and securities backed by receivables or other financial
assets, and counterparties. When applied to an entity, these long- and
short-term ratings assess its general creditworthiness on a senior basis. When
applied to specific issues and programs, these ratings take into account the
relative preferential position of the holder of the security and reflect the
terms, conditions, and covenants attaching to that security.

ANALYTICAL CONSIDERATIONS

When assigning ratings, Fitch considers the historical and prospective
financial condition, quality of management, and operating performance of the
issuer and of any guarantor, any special features of a specific issue or
guarantee, the issue's relationship to other obligations of the issuer, as well
as developments in the economic and political environment that might affect the
issuer's financial strength and credit quality.

Investment-grade ratings reflect expectations of timeliness of payment.
However, ratings of different classes of obligations of the same issuer may vary
based on expectations of recoveries in the event of a default or liquidation.
Recovery expectations, which are the amounts expected to be received by
investors after a security defaults, are a relatively minor consideration in
investment-grade ratings, but Fitch does use "notching" of particular issues to
reflect their degree of preference in a winding up, liquidation, or
reorganization as well as other factors. Recoveries do, however, gain in
importance at lower rating levels, because of the greater likelihood of default,
and become the major consideration at the "DDD" category. Factors that affect
recovery expectations include collateral and seniority relative to other
obligations in the capital structure.

Variable rate demand obligations and other securities which contain a
demand feature will have a dual rating, such as "AAA/F1+." The first rating
denotes long-term ability to make principal and interest payments. The second
rating denotes ability to meet a demand feature in full and on time.

II-4
<PAGE> 98

International Long-Term Credit Ratings

Investment Grade

AAA Highest credit quality. "AAA" ratings denote the lowest expectation of
credit risk. They are assigned only in case of exceptionally strong capacity
for timely payment of financial commitments. This capacity is highly
unlikely to be adversely affected by foreseeable events.

AA Very high credit quality. "AA" ratings denote a very low expectation of
credit risk. They indicate strong capacity for timely payment of financial
commitments. This capacity is not significantly vulnerable to foreseeable
events.

A High credit quality. "A" ratings denote a low expectation of credit risk.
The capacity for timely payment of financial commitments is considered
strong. This capacity may, nevertheless, be more vulnerable to changes in
circumstances or in economic conditions than is the case for higher
ratings.

BBB Good credit quality. "BBB" ratings indicate that there is currently a low
expectation of credit risk. The capacity for timely payment of financial
commitments is considered adequate, but adverse changes in circumstances
and in economic conditions are more likely to impair this capacity. This is
the lowest investment grade category.

Speculative Grade

BB Speculative. "BB" ratings indicate that there is a possibility of credit
risk developing, particularly as the result of adverse economic change
over time; however, business or financial alternatives may be available to
allow financial commitments to be met. Securities rated in this category
are not investment grade.

B Highly speculative. "B" ratings indicate that significant credit risk is
present, but a limited margin of safety remains. Financial commitments
are currently being met; however, capacity for continued payment is
contingent upon a sustained, favorable business and economic environment.

<TABLE>
<S> <C>
CCC High default risk. Default is a real possibility. Capacity
CC for meeting financial commitments is solely reliant upon
C sustained, favorable business or economic developments. A
"CC" rating indicated that default of some kind appears
probable. "C" ratings signal imminent default.
</TABLE>

<TABLE>
<S> <C>
DDD Default. Securities are not meeting current obligations and
DD are extremely speculative. "DDD" designates the highest
D potential for recovery of amounts outstanding on any
securities involved. For U.S. corporates, for example, "DD"
indicates expected recovery of 50%-90% of such outstandings,
and "D," the lowest recovery potential, i.e. below 50%.
</TABLE>

International Short-Term Credit Ratings.

A short-term rating has a time horizon of less than 12 months for most
obligations, or up to three years for U.S. public finance securities, and thus
places greater emphasis on the liquidity necessary to meet financial commitments
in a timely manner.

F1 Highest credit quality. Indicates the strongest capacity for timely
payment of financial commitments; may have an added "+" to denote any
exceptionally strong credit feature.

F2 Good credit quality. A satisfactory capacity for timely payment of
financial commitments, but the margin of safety is not as great as in the
case of the higher ratings.

F3 Fair credit quality. The capacity for timely payment of financial
commitments is adequate; however, near-term adverse changes could result in
a reduction to non-investment grade.

B Speculative. Minimal capacity for timely payment of financial commitments,
plus vulnerability to near-term adverse changes in financial and economic
conditions.

II-5
<PAGE> 99

C High default risk. Default is a real possibility. Capacity for meeting
financial commitments is solely reliant upon a sustained, favorable
business and economic environment.

D Default. Denotes actual or imminent payment default.
- ---------------
Notes:

"+" or "-" may be appended to a rating to denote relative status within
major rating categories. Such suffixes are not added to the "AAA" long-term
rating category, to categories below "CCC," or to short-term ratings other than
"F1."

"NR" indicates that Fitch does not rate the issuer or issue in question.

"Withdrawn": A rating is withdrawn when Fitch deems the amount of
information available to be inadequate for rating purposes, or when an
obligation matures, is called, or refinanced.

RatingAlert: Ratings are placed on RatingAlert to notify investors that
there is a reasonable probability of a rating change and the likely direction of
such change. These are designated as "Positive," indicating a potential upgrade,
"Negative," for a potential downgrade, or "Evolving," if ratings may be raised,
lowered or maintained. RatingAlert is typically resolved over a relatively short
period.

II-6
<PAGE> 100

(This page intentionally left blank.)
<PAGE> 101

(This page intentionally left blank.)
<PAGE> 102

CODE # 16576-12-98