<PAGE>
INSURED MUNICIPAL INCOME FUND INC.
COMMON STOCK
------------------------
Insured Municipal Income Fund Inc. ('Fund') is a diversified, closed-end
management investment company. The Fund's investment objective is to achieve a
high level of current income that is exempt from federal income tax, consistent
with the preservation of capital. To achieve this objective, the Fund normally
invests substantially all of its assets in a diversified portfolio of long-term
Municipal Obligations that are insured as to timely payment of both principal
and interest by an entity with claims-paying ability rated Aaa by Moody's
Investors Service, Inc. ('Moody's'), AAA by Standard & Poor's ('S&P'), or an
equivalent rating from another nationally recognized statistical rating
organization ('NRSRO') or (with respect to 20% of the Fund's total assets) that
are (i) backed by an escrow or trust account containing sufficient U.S.
government or U.S. government agency securities to ensure the timely payment of
principal and interest, (ii) guaranteed as to the timely payment of principal
and interest by an entity which has a credit rating of Aaa by Moody's, AAA by
S&P or an equivalent rating by another NRSRO or (iii) rated Aaa by Moody's, AAA
by S&P or an equivalent rating by another NRSRO. No assurance can be given that
the Fund will achieve its investment objective. All or a portion of the Fund's
dividends may be attributable to interest income that is an item of tax
preference for purposes of the federal alternative minimum tax.
The Fund's common stock ('Common Stock') is listed and traded on the New
York Stock Exchange, Inc. ('NYSE') under the symbol 'PIF.' NO ADDITIONAL SHARES
OF COMMON STOCK WILL BE ISSUED IN CONNECTION WITH THIS OFFERING. Shares of the
Common Stock may be offered pursuant to this Prospectus from time to time in
order to effect over-the-counter ('OTC') secondary market sales by PaineWebber
Incorporated ('PaineWebber') in its capacity as a dealer and secondary
market-maker at negotiated prices related to the prevailing market prices on the
NYSE at the time of sale. The closing price of the Common Stock on the NYSE on
July 26, 1996 was $11.75 per share. See 'Trading History.' The Fund will not
receive any proceeds from the sale of any Common Stock offered pursuant to this
Prospectus.
The Fund has outstanding auction preferred shares ('APS') having a
liquidation preference of $150,000,000. The APS have resulted in financial
leverage for the Fund, which involves special risks. The Fund may utilize
additional leverage through the issuance of additional preferred stock or
through borrowings. See 'SPECIAL LEVERAGE CONSIDERATIONS' and 'DESCRIPTION OF
CAPITAL STOCK.'
Mitchell Hutchins Asset Management Inc. ('Mitchell Hutchins') serves as
investment adviser and administrator of the Fund. This Prospectus concisely sets
forth certain information an investor should know before investing and should be
retained for future reference. A Statement of Additional Information ('SAI')
dated August 1, 1996 has been filed with the Securities and Exchange Commission
and is incorporated by reference in its entirety into this Prospectus. A table
of contents for the SAI is set forth as the last section of this Prospectus. A
copy of the SAI can be obtained without charge by writing to the Fund, by
contacting your PaineWebber investment executive or PaineWebber's correspondent
firms or by calling toll-free 1-800-852-4750.
------------------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE
SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION
PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
------------------
PAINEWEBBER INCORPORATED
------------------
The date of this Prospectus is August 1, 1996.
<PAGE>
FUND EXPENSES
The following tables are intended to assist investors in understanding the
various direct or indirect costs and expenses associated with investing in the
Fund.
<TABLE>
<S> <C>
SHAREHOLDER TRANSACTION EXPENSES
Sales Load (as a percentage of offering price).............. None(1)
Dividend Reinvestment Fees.................................. None
ANNUAL EXPENSES (AS A PERCENTAGE OF NET ASSETS ATTRIBUTABLE TO
COMMON STOCK)(2)
Investment Advisory and Administration Fees (after fee
waiver).................................................... 1.04%
Interest Payments on Borrowed Funds(3)...................... 0.00%
Other Expenses.............................................. 0.29%
------
Total Annual Expenses.................................. 1.33%
</TABLE>
- ------------------
(1) Prices for the Common Stock traded in the OTC secondary market will reflect
ordinary dealer mark-ups.
(2) The percentages shown reflect all expenses expected to be incurred by the
Fund as a percentage of only those net assets attributable to the Common
Stock. If expressed as a percentage of all of the Fund's net assets
(regardless of whether such assets are attributable to the Common Stock or
to the APS), such percentages would be lower. Investment advisory and
administration fees are payable to Mitchell Hutchins at an annual rate of
0.90% of the Fund's average weekly net assets (attributable to Common Stock
and the APS). Effective June 1, 1995, Mitchell Hutchins began waiving 0.25%
of its 0.90% investment advisory and administration fees. Mitchell Hutchins
may discontinue this fee waiver at any time. If the fee waiver were not in
effect, the Fund's Investment Advisory and Administration Fees and Total
Annual Expenses (each expressed as a percentage of net assets attributable
to Common Stock) would have been 1.36% and 1.65%, respectively. See
'Management of the Fund' for additional information. The investment advisory
and administration fees payable to Mitchell Hutchins are higher than that
paid by most funds. 'Other Expenses' have been estimated based upon expenses
actually incurred for the fiscal year ended March 31, 1996.
(3) The Fund may borrow money. See 'Special Leverage
Considerations--Borrowings.'
EXAMPLE
An investor would directly or indirectly pay the following expenses on a
$1,000 investment in the Fund, assuming (i) a 5% annual return and (ii)
reinvestment of all dividends and other distributions at net asset value*:
<TABLE>
<CAPTION>
ONE YEAR THREE YEARS FIVE YEARS TEN YEARS
- -------- ----------- ---------- ---------
<S> <C> <C> <C>
$14 $ 42 $ 73 $ 160
</TABLE>
- ------------------
* After fee waivers. If fee waivers were not in effect, the amounts that would
be paid by an investor during the one-year, three-year, five-year and ten-year
periods reflected in the table would be $17, $52, $90 and $195, respectively.
This Example assumes that the percentage amounts listed under Annual
Expenses remain the same in the years shown (except that Annual Expenses have
been reduced to reflect the completion of organization expense amortization
after five years from the commencement of investment operations). The above
tables and the assumptions in the Example of a 5% annual return and reinvestment
at net asset value are required by regulation of the Securities and Exchange
Commission ('SEC') applicable to all closed-end investment companies; the
assumed 5% annual return is not a prediction of, and does not represent, the
projected or actual performance of the Fund's Common Stock. In addition, while
this Example assumes reinvestment of all dividends and other distributions at
net asset value, participants in the Fund's Dividend Reinvestment Plan ('Plan')
will receive shares of the Fund's Common Stock purchased by the Plan agent at
the market price in effect at that time, which may be at, above, or below net
asset value.
THIS EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF FUTURE EXPENSES,
AND THE FUND'S ACTUAL EXPENSES MAY BE MORE OR LESS THAN THOSE SHOWN.
2
<PAGE>
PROSPECTUS SUMMARY
The following summary is qualified in its entirety by reference to the more
detailed information included elsewhere in this Prospectus, and in the Statement
of Additional Information ('SAI'). Investors should carefully consider
information set forth under the heading 'Special Risk Considerations' and
'Special Leverage Considerations.'
<TABLE>
<S> <C>
The Fund................. Insured Municipal Income Fund Inc. (the 'Fund') is a
diversified, closed-end management investment
company. See 'The Fund.'
The Offering............. No additional shares of the Fund's common stock
('Common Stock') will be issued in connection with
this offering. Shares of Common Stock may be offered
pursuant to this Prospectus from time to time in
order to effect over-the-counter ('OTC') secondary
market sales by PaineWebber Incorporated
('PaineWebber') in its capacity as a dealer and
secondary market-maker at negotiated prices related
to prevailing market prices on the New York Stock
Exchange, Inc. ('NYSE') at the time of sale.
PaineWebber is not obligated to conduct any such
market-making activities and may discontinue such
activities at any time without notice, at its sole
discretion. No assurance can be given as to the
liquidity of, or the trading market for, the Common
Stock as a result of any market-making activities
undertaken by PaineWebber. The Common Stock is
listed and traded on the NYSE under the symbol
'PIF.' See 'The Offering' and 'Trading History.'
Investment Objective and
Policies............... The Fund's investment objective is to achieve a high
level of current income that is exempt from federal
income tax, consistent with the preservation of
capital. To achieve this objective, the Fund
normally invests substantially all of its assets in
a diversified portfolio of long-term Municipal
Obligations that are insured as to the timely
payment of both principal and interest by an entity
that, at the time of investment, has a claims-paying
ability rated Aaa by Moody's Investors Service, Inc.
('Moody's'), AAA by Standard & Poor's, a division of
The McGraw Hill Companies, Inc. ('S&P'), or has an
equivalent rating from another nationally recognized
statistical rating organization ('NRSRO') or (with
respect to 20% of the Fund's total assets) that are,
at the time of investment, (1) backed by an escrow
or trust account containing sufficient U.S.
government or U.S. government agency securities to
ensure the timely payment of principal and interest;
(2) guaranteed as to the timely payment of principal
and interest by an entity which has a credit rating
of Aaa by Moody's, AAA by S&P or an equivalent
rating by another NRSRO; or (3) not insured,
guaranteed or backed by escrows but rated Aaa by
Moody's, AAA by S&P or have an equivalent rating by
another NRSRO. All or a portion of the Fund's assets
may be invested in Municipal Obligations the
interest on which is an item of tax
</TABLE>
3
<PAGE>
<TABLE>
<S> <C>
preference ('Tax Preference Item') for purposes of
the federal alternative minimum tax ('AMT'). No
assurance can be given that the Fund will achieve
its investment objective.
See 'Investment Objective and Policies,' 'Insurance,'
'Other Investment Practices,' 'Taxes' and Appendix
A.
Municipal Obligations.... Municipal Obligations are debt obligations or similar
securities issued by or on behalf of states
(including the District of Columbia), territories or
possessions of the United States or their respective
political subdivisions, agencies or
instrumentalities, or by multistate agencies or
authorities, the interest on which is, in the
opinion of bond counsel, exempt from federal income
tax. Municipal Obligations are issued for various
public purposes, including construction of public
facilities, refinancing outstanding obligations and
obtaining funds for general operating expenses and
for loans to other public institutions and
facilities. Municipal Obligations include 'public
purpose' obligations, which generate interest that
is exempt from federal income tax and is not a Tax
Preference Item, and qualified 'private activity'
obligations, which generate interest that is exempt
from federal income tax but may be a Tax Preference
Item. The Municipal Obligations in which the Fund
may invest include municipal bonds, industrial
development and private activity bonds, municipal
lease obligations, zero coupon obligations, floating
and variable rate obligations, participation
interests and custodial receipts for any of the
foregoing, inverse floaters, put bonds, tender
option bonds and certain municipal derivatives, such
as detachable call options and Municipal Obligations
with embedded caps. The market prices of inverse
floaters and zero coupon obligations will be more
volatile than those of other types of municipal
obligations and certain Municipal Obligations, such
as many forms of municipal lease obligations, may be
illiquid.
See 'Investment Objective and Policies,' 'Other
Investment Practices' and 'Appendix A.'
Insurance................ Insurance for Municipal Obligations in which the Fund
invests will be obtained from insurance companies
having claims-paying ability ratings of Aaa from
Moody's or AAA from S&P or having an equivalent
rating from another NRSRO. Such insurance may be
purchased by the issuer of the Municipal Obligation
or by a third party at the time of issuance of the
Municipal Obligation ('Original Issue Insurance') or
by the Fund or a third party subsequent to the
original issuance of the Municipal Obligation
('Secondary Market Insurance'). The Fund also may
purchase insurance covering certain Municipal
Obligations which it intends to purchase for its
portfolio or which it already owns ('Portfolio
Insurance'). See 'Insurance.'
Auction Preferred
Shares................. The Fund has outstanding 800 shares of Auction
Preferred Shares ('APS') Series A, 800 shares of APS
Series B, 800 shares of APS
</TABLE>
4
<PAGE>
<TABLE>
<S> <C>
Series C and 600 shares of APS Series D, having an
aggregate liquidation value of $150,000,000. The APS
have resulted in the financial leveraging of the
Common Stock. The APS pay dividends at rates that
are adjusted over relatively short periods of time
and that reflect prevailing short-term, tax-exempt
interest rates. Through this leveraging technique,
the Fund seeks to obtain a higher yield for Common
Stockholders than would be available if the APS had
not been issued. The APS have received ratings of
aaa from Moody's and AAA from S&P. The Fund may
utilize additional leverage through the issuance of
additional preferred stock or through borrowings.
There are special risks associated with leveraging,
including the possibility that changes in the
relationship of short- and long-term interest rates
might cause the yield on, and the net asset value
of, the Common Stock to be lower than would be the
case without leveraging.
See 'Special Leverage Considerations' and 'Description
of Capital Stock.'
Investment Adviser and
Administrator.......... Mitchell Hutchins Asset Management Inc. ('Mitchell
Hutchins'), a wholly owned asset management
subsidiary of PaineWebber, serves as the Fund's
investment adviser and administrator. Mitchell
Hutchins provides investment advisory and portfolio
management services to investment companies, pension
funds and other institutional, corporate and
individual clients. As investment adviser and
administrator, Mitchell Hutchins is entitled to
receive a fee from the Fund, computed weekly and
payable monthly, in an amount equal to an annual
rate of 0.90% of the Fund's average weekly net
assets. This fee is higher than the advisory and
administration fees paid by most funds. Since June
1, 1995, Mitchell Hutchins has been waiving 0.25% of
its 0.90% investment advisory and administration
fees. Mitchell Hutchins may discontinue this fee
waiver at any time. See 'Management of the Fund.'
Dividends and Other
Distributions.......... The Fund declares and pays monthly cash dividends to
Common Stockholders at a level rate that, on an
annual basis and after payment of dividends on any
preferred stock, results in the distribution of all
of the Fund's net investment income. The dividend
rate on the Common Stock is adjusted by the Fund's
board of directors as necessary to reflect the
performance of the Fund. The Fund intends to
distribute annually to Common Stockholders
substantially all of the net capital gains realized
by the Fund to the extent that such net capital
gains are not necessary to satisfy dividend,
redemption or liquidation preferences of the APS or
any other preferred stock.
For federal tax purposes, the Fund is required to
allocate net realized capital gains and any taxable
income (along with tax-exempt income) between Common
Stockholders and any preferred stockholders in
</TABLE>
5
<PAGE>
<TABLE>
<S> <C>
proportion to total distributions paid to each class
of stockholders for the relevant year. If a portion
of the dividends paid on the preferred stock is
taxable because of such allocations, the Fund may be
required to make an additional dividend payment to
the preferred stockholders so that the net after-tax
return on the preferred stock is the same after the
additional dividend as the net after-tax return that
would have been derived if the initial dividends had
qualified in their entirety as tax-exempt income.
Common Stockholders are not entitled to comparable
additional dividends and any such payments to the
preferred stockholders would reduce the net
investment income, capital gains or other income
available for distribution to the Common
Stockholders.
Dividends paid to Common Stockholders are exempt from
federal income tax to the extent such dividends are
properly designated by the Fund as being derived
from interest on tax-exempt securities. All or a
portion of such dividends may be attributable to
interest income that is a Tax Preference Item.
See 'Dividends and Other Distributions; Dividend
Reinvestment Plan' and 'Taxes.'
Dividend Reinvestment
Plan................... The Fund has established a Dividend Reinvestment Plan
('Plan') under which all Common Stockholders whose
shares are registered in their own names, or in the
name of PaineWebber or its nominee, have all
dividends and other distributions on their shares of
Common Stock automatically reinvested in additional
shares of Common Stock, unless such Common
Stockholders elect to receive cash. Common
Stockholders who elect to hold their shares in the
name of another broker or nominee should contact
such broker or nominee to determine whether, or how,
they may participate in the Plan. Additional shares
of Common Stock acquired under the Plan will be
purchased in the open market, on the NYSE or
otherwise, at prices that may be higher or lower
than the net asset value per share of the Common
Stock at the time of the purchase. The Fund will not
issue any new shares of Common Stock in connection
with the Plan. See 'Dividends and Other
Distributions; Dividend Reinvestment Plan.'
Special Risk
Considerations......... Insurance. There can be no assurance that the insurers
whose policies insure Municipal Obligations held by
the Fund will be able to maintain their Aaa, AAA or
equivalent claims-paying ability ratings or to honor
their obligations under all circumstances. The loss
of such ratings or an inability to honor such
obligations would be likely to have an adverse
effect on the market value of the Municipal
Obligations covered by policies issued by such
insurers to the extent the Fund is not able to or
does not obtain alternative insurance. Mitchell
Hutchins will engage in an orderly disposition of
downgraded Municipal Obligations to the extent
necessary to ensure that the Fund's holdings of
Municipal Obligations rated below Baa by Moody's,
BBB by S&P or an
</TABLE>
6
<PAGE>
<TABLE>
<S> <C>
equivalent rating by another NRSRO do not exceed 5%
of the Fund's net assets.
Alternative Minimum Tax; State and Local Taxation. The
Fund may invest all or a portion of its assets in
Municipal Obligations the interest on which is a Tax
Preference Item. Accordingly, the Fund may not be an
appropriate investment for investors who are subject
to AMT liability or who would become subject to AMT
liability by reason of an investment in the Fund.
All or a portion of the Fund's dividends also may be
subject to state and local taxation.
Market Risk of Insured Municipal Obligations. Although
insurance or guarantees on, or escrows of U.S.
government securities with respect to, Municipal
Obligations reduce financial or credit risk, such
Municipal Obligations remain subject to market risk
(i.e., the risk of fluctuations in market value as a
result of changes in prevailing interest rates).
Illiquid Securities. The Fund may invest up to 20% of
its net assets in illiquid securities. The Fund may
not be able readily to dispose of such securities at
an amount that approximates that at which the Fund
has valued them and would have to sell other
investments if necessary to raise cash to meet its
obligations. Illiquid securities include, among
other things, municipal lease obligations (including
certificates of participation) other than those that
Mitchell Hutchins has determined to be liquid
pursuant to guidelines established by the Fund's
board of directors.
Rights of Preferred Stockholders. In the event that
dividends payable on any preferred stock remain
unpaid for a period of two years, the preferred
stockholders will, for so long as the dividends
remain unpaid, be entitled to elect a majority of
the Fund's board of directors. In the event of any
voluntary or involuntary liquidation, dissolution or
winding up of the Fund, the preferred stockholders
will be entitled to receive a preferential
liquidating distribution equal to the purchase price
of the preferred stock plus any accrued and unpaid
dividends before any distribution of assets is made
to the Common Stockholders.
Other Investment Risks. Certain investment practices
in which the Fund may engage would expose the Fund
to additional risks. These practices include
entering into securities transactions on a
when-issued or delayed delivery basis, lending
portfolio securities and engaging in hedging
transactions.
Anti-Takeover Provisions. The Fund's Articles of
Incorporation contain provisions limiting (1) the
ability of other entities or persons to acquire
control of the Fund, (2) the Fund's freedom to
engage in certain transactions and (3) the ability
of the Fund's directors or stockholders to amend the
Articles of Incorporation. These provisions of the
Articles of
</TABLE>
7
<PAGE>
<TABLE>
<S> <C>
Incorporation may be regarded as 'anti-takeover'
provisions. These provisions could have the effect
of depriving the Common Stockholders of
opportunities to sell their shares at a premium over
prevailing market prices by discouraging a third
party from seeking to obtain control of the Fund in
a tender offer or similar transaction. The overall
effect of these provisions is to render more
difficult the accomplishment of a merger or the
assumption of control by a stockholder who owns
beneficially more than 5% of the Fund's shares. They
provide, however, the advantage of potentially
requiring persons seeking control of the Fund to
negotiate with its management regarding the price to
be paid and facilitating the continuity of the
Fund's management, investment objective and
policies.
See 'Investment Objective and Policies,' 'Insurance,'
'Other Investment Practices,' 'Taxes' and
'Description of Capital Stock.'
Market Price and Net
Asset Value of
Shares................. Shares of closed-end investment companies, including
the Fund, frequently trade at a discount to their
net asset values. Whether investors will realize
gains or losses upon the sale of Common Stock will
not depend directly upon the Fund's net asset
value, but will depend upon whether the market
price of the Common Stock at the time of sale is
above or below the original purchase price for the
shares. This market risk is separate and distinct
from the risk that the Fund's net asset value may
decrease. Accordingly, the Common Stock is
designed primarily for long-term investors, and
investors in the Common Stock should not view the
Fund as a vehicle for short-term trading purposes.
See 'Trading History,' 'Investment Objective and
Policies,' 'Special Leverage Considerations' and
'Description of Capital Stock.'
Special Leverage
Considerations......... The APS have resulted in leverage, which poses special
risks for Common Stockholders, including the
possibility of higher volatility of both the net
asset value and the market value of the Common
Stock. Fluctuations in the dividend rates on the
preferred stock will affect the dividends on the
Common Stock. There can be no assurance that the
Fund will be able to realize a higher return on its
investment portfolio than the then current dividend
rate on any preferred stock. If the then current
dividend rate on any preferred stock were to exceed
the rate of return on the Fund's portfolio, the
Fund's leveraged capital structure would result in a
lower yield to Common Stockholders than if the Fund
were not leveraged. Moreover, any decline in the
value of the Fund's assets will be borne entirely by
Common Stockholders. Accordingly, the effect of
leverage in a declining market would be a greater
decrease in the net asset value of the Common Stock
than if the Fund were not leveraged, which may be
reflected in a greater decline in the market price
of the Common Stock.
See 'Special Leverage Considerations,' 'Taxes' and
'Description of Capital Stock.'
</TABLE>
8
<PAGE>
FINANCIAL HIGHLIGHTS
The table below provides selected per share data and ratios for one share
of Common Stock for each of the periods shown. This information is supplemented
by the financial statements and the accompanying notes appearing in the Fund's
Annual Report to Shareholders for the fiscal year ended March 31, 1996, which
are incorporated by reference into the Fund's SAI, which can be obtained by
shareholders upon request. The financial statements and notes and the financial
information in the table below have been audited by Ernst & Young LLP,
independent auditors, whose report thereon is included in the Annual Report to
Shareholders, which may be obtained without charge.
<TABLE>
<CAPTION>
FOR THE YEARS FOR THE PERIOD
ENDED MARCH 31, JUNE 8, 1993+
------------------------------- TO
1996 1995 MARCH 31, 1994
-------------- -------------- --------------
<S> <C> <C> <C>
Net asset value, beginning of period.... $ 13.42 $ 13.42 $ 15.00
-------------- -------------- --------------
Net investment income................... 1.06 1.02** 0.73
Net realized and unrealized gains
(losses) from investments............. 0.67 0.04 (1.44)
-------------- -------------- --------------
Net increase (decrease) in net asset
value from operations................. 1.73 1.06 (0.71)
-------------- -------------- --------------
Dividends and distributions:
From net investment income--common
stockholders....................... (0.76) (0.79) (0.60)
From net investment income--preferred
stockholders....................... (0.28) (0.25) (0.13)
In excess of net investment
income--common stockholders........ -- (0.02) --
In excess of net investment
income--preferred stockholders..... -- --++ --
-------------- -------------- --------------
Total dividends and distributions to
shareholders.......................... (1.04) (1.06) (0.73)
-------------- -------------- --------------
Underwriting and offering costs incurred
with the preferred stock offering
charged to common stock............... -- -- (0.14)
-------------- -------------- --------------
Net asset value, end of period.......... $ 14.11 $ 13.42 $ 13.42
-------------- -------------- --------------
-------------- -------------- --------------
Per share market value, end of period... $ 12.13 $ 11.13 $ 13.00
-------------- -------------- --------------
-------------- -------------- --------------
Total investment return (1)............. 16.13% (8.17)% (9.74)%
-------------- -------------- --------------
-------------- -------------- --------------
Ratios to average net assets
attributable to common shares:
Total expenses, net of waivers from
adviser............................ 1.33% 1.74% 1.57%*
Total expenses, before waivers from
adviser............................ 1.65% 1.74% 1.57%*
Net investment income before
preferred stock dividends.......... 7.45% 7.94% 5.92%*
Preferred stock dividends............ 1.97% 2.02% 0.98%*
Net investment income available to
common stockholders................ 5.48% 5.92% 4.94%*
Supplemental data:
Net assets, end of period (000's).... $ 441,040 $ 426,795 $ 333,825
Portfolio turnover rate.............. 4% 4% 8%
Asset coverage per share of preferred
stock, end of period............... $ 147,013 $ 142,265 $ 139,094
</TABLE>
- ------------------
<TABLE>
<S> <C>
+ Commencement of operations
++ Actual amount calculates to $0.00499 per common share.
* Annualized
</TABLE>
(Footnotes continued on next page)
9
<PAGE>
(Footnotes continued from previous page)
<TABLE>
<S> <C>
** Calculated using the average share method.
(1) Total investment return is calculated assuming a purchase of one share
of common stock at the current market price on the first day of the
period reported and the sale at the current market price on the last
day of the period reported, and assuming reinvestment of dividends and
distributions to common shareholders at prices obtained under the
Fund's Dividend Reinvestment Plan. Total investment returns for
periods less than a year have not been annualized. Total investment
returns do not reflect brokerage commissions.
</TABLE>
The following information relates to the APS outstanding as of the end of
the periods indicated. See 'Special Leverage Considerations.'
<TABLE>
<CAPTION>
ASSET INVOLUNTARY
COVERAGE LIQUIDATING AVERAGE
FISCAL TOTAL AMOUNT PER PERFORMANCE MARKET VALUE
YEAR SENIOR SECURITIES OUTSTANDING* UNIT** PER UNIT*** PER UNIT****
- ------------------- --------------------------------------------- ------------ -------- ----------- ------------
<S> <C> <C> <C> <C> <C>
1994+ APS Series A, B and C........................ $120,000,000 $139,094 $50,000 $ 96,654
1995++ APS Series A, B, C and D..................... $150,000,000 $142,265 $50,000 $ 76,554
1996 APS Series A, B, C and D..................... $150,000,000 $147,013 $50,000 $ 81,726
</TABLE>
- ---------------
<TABLE>
<S> <C>
* Based on liquidation value of $50,000 per share. The number of
outstanding shares of each Series of APS has not changed since the
Series was issued and is as follows: Series A, B and C (each issued
August 12, 1993)--800 shares of each Series; APS Series D (issued
November 28, 1994)--600 shares.
** Asset Coverage Per Unit is the same for each APS Series.
*** Plus any accrued but unpaid dividends.
**** Average Market Value Per Unit is the same for each APS Series and is
calculated by multiplying $50,000 by the result obtained by dividing:
(a) the average monthly market value of the Common Stock during the
fiscal year; by (b) the average of the amount of APS outstanding at
the end of such month.
+ Reflects the period from August 12, 1993 (date of issuance of APS
Series A, B and C) to March 31, 1994.
++ Reflects the full fiscal year for APS Series A, B and C and the period
from November 28, 1994 (date of issuance) to March 31, 1995 for APS
Series D.
</TABLE>
10
<PAGE>
THE FUND
The Fund is a diversified, closed-end management investment company and has
registered as such under the Investment Company Act of 1940 ('1940 Act'). The
Fund was incorporated under the laws of the State of Maryland on February 18,
1993, as 'PaineWebber Premier Insured Municipal Income Fund Inc.' The Fund began
doing business under the name 'Insured Municipal Income Fund' in August 1995,
and shareholders approved a change of the Fund's name to 'Insured Municipal
Income Fund Inc.' on April 11, 1996. The Fund's principal office is located at
1285 Avenue of the Americas, New York, New York 10019, and its telephone number
is (212) 713-2000.
THE OFFERING
No additional shares of Common Stock will be issued in connection with this
offering. Shares of the Common Stock may be offered pursuant to this Prospectus
from time to time in order to effect OTC secondary market sales by PaineWebber
in its capacity as a dealer and secondary market-maker at negotiated prices
related to prevailing market prices on the NYSE at the time of sale. Costs
incurred in connection with this offering will be paid by PaineWebber.
PaineWebber's principal offices are located at 1285 Avenue of the Americas, New
York, New York 10019. Mitchell Hutchins is a wholly owned subsidiary of
PaineWebber.
USE OF PROCEEDS
The Fund will not receive any proceeds from the sale of any Common Stock
offered pursuant to this Prospectus. Proceeds received by PaineWebber as a
result of its OTC secondary market sales of the Common Stock will be utilized by
PaineWebber in connection with its secondary market operations and for general
corporate purposes.
TRADING HISTORY
Shares of the Common Stock, par value $.001 per share are listed and traded
on the NYSE under the symbol 'PIF.' The following table sets forth for the
Common Stock for each fiscal quarter within the two most recent fiscal years and
each fiscal quarter since the beginning of the current fiscal year: (a) the per
share high and low sales prices as reported by the NYSE; (b) the per share net
asset values, based on the Fund's computation as of 4:00 p.m. on the last NYSE
business day for the week corresponding to the dates on which the respective
high and low sales prices were recorded; and (c) the discount or premium to net
asset value represented by the high and low sales prices shown. THE RANGE OF NET
ASSET VALUES AND/OR PREMIUMS AND DISCOUNTS FOR THE COMMON STOCK DURING THE
PERIODS SHOWN MAY BE BROADER THAN IS SHOWN ON THIS TABLE. On July 26, 1996, the
closing price per share of Common Stock on the NYSE was $11.75, the Fund's net
asset value per share was $14.19 and the discount to net asset value per share
was (17.20)%.
<TABLE>
<CAPTION>
(DISCOUNT) OR
PREMIUM TO NET
SALES PRICES NET ASSET VALUES ASSET VALUE
------------------ ---------------- -----------------
QUARTER ENDED HIGH LOW HIGH LOW HIGH LOW
- ------------- ------- ------- ------ ------ ------ ------
<S> <C> <C> <C> <C> <C> <C>
6/30/94...... $ 13.38 $ 12.00 $13.37 $13.37 0.07% (10.25)%
9/30/94...... 12.13 10.63 13.66 12.81 (11.20) (17.02)
12/31/94..... 10.88 9.38 12.75 11.13 (14.67) (15.72)
3/31/95...... 11.63 10.13 12.92 11.99 (9.98) (15.51)
6/30/95...... 12.00 10.88 14.32 13.25 (16.20) (17.89)
9/30/95...... 11.88 11.13 14.08 13.35 (15.63) (16.63)
12/31/95..... 12.63 11.50 14.87 14.10 (15.06) (18.44)
3/31/96...... 12.88 11.88 15.10 14.23 (14.70) (16.51)
6/30/96...... 12.13 11.25 14.11 13.61 (14.03) (17.34)
</TABLE>
The Common Stock has historically traded in the market at prices below net
asset value. See 'Description of Capital Stock--Common Stock Repurchases and
Tender Offers' and '--Conversion to Open-End Investment Company' as to methods
that may be undertaken by the Fund to reduce any discount.
11
<PAGE>
INVESTMENT OBJECTIVE AND POLICIES
The Fund's investment objective is to achieve a high level of current
income that is exempt from federal income tax, consistent with the preservation
of capital. To achieve this objective, the Fund normally invests substantially
all of its assets in a diversified portfolio of long-term Municipal Obligations
that are insured as to the timely payment of both principal and interest by an
entity that, at the time of investment, has a claims-paying ability rated Aaa by
Moody's, AAA by S&P or an equivalent rating by another NRSRO or (with respect to
20% of the Fund's total assets) that are, at the time of investment, (1) backed
by an escrow or trust account containing sufficient U.S. government or U.S.
government agency securities to ensure the timely payment of principal and
interest; (2) guaranteed as to timely payment of principal and interest by an
entity which has a credit rating of Aaa by Moody's, AAA by S&P or an equivalent
rating by another NRSRO; or (3) not insured, guaranteed or backed by escrows but
rated Aaa by Moody's, AAA by S&P or an equivalent rating by another NRSRO. All
the Municipal Obligations described above will have, at the time of investment,
ratings of Aaa from Moody's, AAA from S&P or equivalent ratings from another
NRSRO or (with respect to the Municipal Obligations described in (1) above), if
unrated, will have been determined by Mitchell Hutchins to be of comparable
quality to Municipal Obligations that have received such ratings. In addition,
the Fund under normal circumstances invests at least 65% of its total assets in
income-producing securities. 'Long-term' as used in this Prospectus means
Municipal Obligations with maturities in excess of 10 years. No assurance can be
given that the Fund will achieve its investment objective.
Municipal Obligations are obligations issued by or on behalf of states
(including the District of Columbia), territories or possessions of the United
States or their respective political subdivisions, agencies or
instrumentalities, or by multistate agencies or authorities, the interest on
which is, in the opinion of bond counsel, exempt from regular federal income
tax. Municipal Obligations are issued for various public purposes, including
construction of public facilities, such as airports, bridges, hospitals,
housing, mass transportation, schools, streets and water and sewer works. Other
public purposes for which Municipal Obligations may be issued include
refinancing outstanding obligations and obtaining funds for general operating
expenses and for loans to other public institutions and facilities. Municipal
Obligations include 'public purpose' obligations, which generate interest that
is exempt from federal income tax and is not a Tax Preference Item, and
qualified 'private activity' obligations, which generate interest that is exempt
from federal income tax but that, if the obligations were issued after August 7,
1986, is a Tax Preference Item. The types of Municipal Obligations in which the
Fund may invest are described in Appendix A to this Prospectus and in the SAI.
The Fund may invest more than 25% of its total assets in a particular
segment of the Municipal Obligations market, such as hospital, housing or
airport revenue bonds, or in securities the interest on which is paid from
revenues on similar types of projects, if Mitchell Hutchins determines that the
yields available from obligations in that market segment justify the potential
increase in risk resulting from a large investment in that market segment.
Although such obligations might be supported by the credit of governmental
entities or by non-governmental entities from a number of different industries,
an economic, business, political or other change affecting one such obligation
might also affect other obligations in the same market segment.
The yield on a Municipal Obligation depends on a variety of factors,
including general municipal and fixed-income security market conditions, the
financial condition of the issuer, the size of the particular offering, the
maturity, credit quality and rating of the issue and expectations regarding
changes in income tax rates. Generally, the longer the maturity of a Municipal
Obligation, the higher the yield and the greater the volatility. The market
value of Municipal Obligations, and accordingly the Fund's net asset value,
normally varies inversely with changes in interest rates. Such changes in the
values of Municipal Obligations held by the Fund will not affect the interest
income derived from them but will affect the net asset value of shares of the
Common Stock.
12
<PAGE>
Certain Municipal Obligations held by the Fund may permit the issuer to
call or redeem the obligations, in whole or in part, at its option. If an issuer
were to redeem Municipal Obligations held by the Fund during a time of declining
interest rates, the Fund might realize capital gains or losses at a time that it
would not otherwise do so, and the Fund might not be able to reinvest the
proceeds of the redemption in Municipal Obligations providing as high a level of
income as the obligations that were redeemed.
Opinions relating to the validity of Municipal Obligations and to the
exemption of interest thereon from federal income tax (and also, when
applicable, from treatment as a Tax Preference Item) are rendered by bond
counsel to the issuer at the time of issuance. Neither the Fund nor Mitchell
Hutchins will review the proceedings relating to the issuance of Municipal
Obligations or the basis for such opinions. Further, federal, state and local
laws may be enacted that adversely affect the tax-exempt status of interest on
Municipal Obligations or of the exempt-interest dividends received by the Fund's
stockholders or that impose other constraints upon enforcement of such
obligations. It is also possible that, as a result of litigation or other
conditions, the power or ability of issuers to meet their obligations for the
payment of principal of and interest on their Municipal Obligations may be
materially and adversely affected.
The Fund may invest all or a portion of its assets in Municipal Obligations
the interest on which is a Tax Preference Item. Accordingly, stockholders may be
required to include a portion of the Fund's dividends in calculating their AMT
liability. Corporations that hold Common Stock must include the entire amount of
any exempt-interest dividends (including any portion that is not a Tax
Preference Item) in calculating their adjusted current earnings for purposes of
the AMT. The Fund may not be an appropriate investment for investors who are
subject to AMT liability or who would become subject to AMT liability by reason
of an investment in the Fund. All or a portion of the Fund's dividends also may
be subject to state and local taxation. See 'Taxes.'
Generally, Municipal Obligations which are covered by insurance or a
guarantee would not be rated Aaa or AAA, and might not be considered to be of
investment grade credit quality in the absence of such insurance or guarantee.
Although insurance or guarantees on, or escrows of U.S. government securities
with respect to, Municipal Obligations reduce financial or credit risk with
respect to those Municipal Obligations (i.e., the possibility that owners of the
insured Municipal Obligations will not receive timely scheduled payments of
principal or interest), insured, guaranteed and escrow backed Municipal
Obligations remain subject to market risk (i.e., fluctuations in market value as
a result of changes in prevailing interest rates). Accordingly, insurance or
guarantees on, or escrow backing with respect to, Municipal Obligations do not
ensure the market value of the Fund's assets or the net asset value or the
market price for the Common Stock.
The Fund's investment objective and certain investment limitations
described in the SAI are fundamental policies that may not be changed without
shareholder approval. In addition, the Fund's policy of normally investing at
least 80% of its total assets in insured Municipal Obligations may not be
changed without shareholder approval. All other investment policies may be
changed by the Fund's board of directors without shareholder approval. The Fund
does not consider custodial receipts to be Municipal Obligations in connection
with the foregoing 80% policy, unless such custodial receipts are of the type
utilized in order to provide Secondary Market Insurance for Municipal
Obligations.
INSURANCE
Each insured Municipal Obligation in which the Fund invests will be covered
by Original Issue Insurance, Secondary Market Insurance or Portfolio Insurance.
Original Issue Insurance is purchased with respect to a particular issue of
Municipal Obligations by the issuer thereof or a third party in conjunction with
the original issue of such Municipal Obligations. Secondary Market Insurance is
purchased by the Fund or a third party subsequent to the time of original
issuance of a Municipal Obligation. Both Original Issue Insurance and Secondary
Market Insurance remain in effect as long as the Municipal Obligations covered
thereby remain outstanding and the insurer remains in business, regardless of
whether the Fund ultimately disposes of such
13
<PAGE>
Municipal Obligations. Portfolio Insurance may be purchased by the Fund with
respect to Municipal Obligations which the Fund intends to purchase or already
owns and would generally terminate when the Municipal Obligation is sold by the
Fund or redeemed. The Fund currently intends to emphasize investments in
Municipal Obligations with Original Issue Insurance or Secondary Market
Insurance. There is no limitation on the percentage of the Fund's assets that
may be invested in Municipal Obligations insured by any given insurer.
Original Issue Insurance, Secondary Market Insurance and Portfolio
Insurance generally do not insure payment on an accelerated basis, the payment
of any redemption premium (except with respect to certain premium payments in
the case of certain small issue industrial development and pollution control
Municipal Obligations), the value of the Common Stock or the market value of
Municipal Obligations, or payments of any tender purchase price upon the tender
of the Municipal Obligations. Such insurance also does not insure against
nonpayment of principal of or interest on Municipal Obligations resulting from
the insolvency, negligence or any other act or omission of the trustee or other
paying agent for such obligations.
The Fund's policy of investing in Municipal Obligations insured by insurers
whose claims-paying ability is rated Aaa by Moody's, AAA by S&P or the
equivalent by another NRSRO applies only at the time of the Fund's investment in
a Municipal Obligation. A subsequent downgrade by Moody's, S&P or another NRSRO
of an insurer's claims-paying ability would result in a downgrade of the rating
assigned to the Municipal Obligations insured by such insurer, although the
Municipal Obligations may have an independent rating that is higher than the new
rating assigned to the insurer's claims-paying ability. The securities could
experience a decrease in market price as a result of such a downgrade. In the
event the ratings assigned to such Municipal Obligations decline to below
investment grade, such Municipal Obligations would probably become less liquid
or even illiquid. Mitchell Hutchins will consider a downgrade by Moody's, S&P or
another NRSRO of the claims-paying ability of an insurer or the credit
characteristics of a particular issuer in determining whether the Fund should
continue to hold a Municipal Obligation. In making such a determination,
Mitchell Hutchins also will consider such factors as the rating assigned to the
Municipal Obligation independent of the insurance, its assessment of the credit
quality of the issuer of the Municipal Obligation and the price at which the
Municipal Obligation could be sold. Mitchell Hutchins will engage in an orderly
disposition of downgraded Municipal Obligations to the extent necessary to
ensure that the Fund's holdings of Municipal Obligations rated below Baa by
Moody's, BBB by S&P or an equivalent rating by another NRSRO do not exceed 5% of
the Fund's net assets. Municipal Obligations rated Baa by Moody's are investment
grade but Moody's considers them to have speculative characteristics. Changes in
economic conditions or other circumstances are more likely to lead to a weakened
capacity for Municipal Obligations that are rated Baa or BBB (or equivalent
ratings) to make principal and interest payments than is the case for higher
grade Municipal Obligations.
Although Mitchell Hutchins periodically reviews the financial condition of
each insurer, there can be no assurance that the insurers will be able to honor
their obligations in all circumstances. In the event of a default by an insurer
on its obligations with respect to any Municipal Obligations in the Fund's
portfolio, the Fund would look to the issuer or guarantor of the relevant
Municipal Obligations for payments of principal and interest and such issuer or
any guarantor may not be rated Aaa, AAA or the equivalent. Accordingly, the Fund
could be exposed to greater risk of non-payment in such circumstances which
could adversely affect the Fund's net asset value and the market price per share
of the Common Stock. Alternatively, the Fund could elect to dispose of such
Municipal Obligations; however, the market prices for such Municipal Obligations
may be lower than the Fund's purchase price for them and the Fund could sustain
a capital loss as a result.
14
<PAGE>
OTHER INVESTMENT PRACTICES
Certain of the other investment practices in which the Fund may engage and
that are described below may give rise to federal income tax. Under normal
circumstances, the Fund does not intend to engage in those practices to a
significant extent. The Fund's ability to engage in certain of these investment
practices is also limited by the rating agency guidelines applicable to the APS.
See 'Special Leverage Considerations' below and Appendix B to the SAI.
WHEN-ISSUED AND DELAYED DELIVERY SECURITIES
The Fund may purchase Municipal Obligations on a when-issued basis, or may
purchase or sell Municipal Obligations for delayed delivery. In when-issued or
delayed delivery transactions, delivery of the securities occurs beyond normal
settlement periods, but no payment or delivery will be made by the Fund prior to
the actual delivery or payment by the other party to the transaction. The Fund
will not accrue income with respect to a when-issued or delayed delivery
security prior to its stated delivery date. When the Fund purchases securities
on a when-issued or delayed delivery basis, however, it immediately assumes the
risks of ownership, including the risk of price fluctuation. Depending on market
conditions, the Fund's when-issued and delayed delivery purchase commitments
could cause its net asset value per share (and thus its market value per share)
to be more volatile, because such securities may increase the amount by which
the Fund's total assets, including the value of when-issued and delayed delivery
securities held by the Fund, exceed its net assets. Failure by the issuer to
deliver a security purchased on a when-issued or delayed delivery basis may
result in a loss or missed opportunity to make an alternative investment.
SHORT-TERM TAX-EXEMPT AND TAXABLE INVESTMENTS
The Fund normally invests substantially all of its assets in long-term
Municipal Obligations. However, in order to invest cash reserves or when, in the
opinion of Mitchell Hutchins, no suitable long-term Municipal Obligations are
available, the Fund may invest up to 20% of its total assets in high quality
short-term Municipal Obligations that are rated, at the time of investment, no
lower than MIG-2 by Moody's, SP-2 by S&P or the equivalent by another NRSRO or,
if unrated, that are determined by Mitchell Hutchins to be of comparable quality
to Municipal Obligations that are rated at least MIG-2 or SP-2. These short-term
Municipal Obligations may include variable or floating rate demand notes and
similar instruments that trade as short-term obligations. For temporary
defensive purposes, the Fund may invest without limit in such short-term
Municipal Obligations.
In addition, if in the opinion of Mitchell Hutchins no suitable short-term
Municipal Obligations are available, the Fund temporarily may hold cash and,
with respect to up to 20% of its total assets, invest in taxable money market
instruments, including: (1) U.S. government securities; (2) high quality
commercial paper that is rated, at the time of purchase, no lower than Prime-2
by Moody's or A-2 by S&P or, if unrated, that is determined by Mitchell Hutchins
to be of comparable quality to commercial paper that is rated at least Prime-2
or A-2; (3) bank obligations (including certificates of deposit, time deposits
and bankers' acceptances of domestic banks); and (4) repurchase agreements with
respect to any of the foregoing. Interest earned from such taxable investments
will be taxable to stockholders as ordinary income when distributed. If the Fund
were to hold cash, the cash would not earn interest, and the Fund's yield would
be lower than if the cash had been invested. For temporary defensive purposes,
the Fund may invest without limit in such taxable money market instruments.
HEDGING AND RELATED INCOME STRATEGIES
The Fund may use options (both exchange-traded and over-the-counter) and
futures contracts to attempt to enhance income and to reduce the overall risk of
its investments (hedge). These strategies may generate taxable income. In
addition, new financial products and risk management techniques continue to be
developed and may be used if consistent with the Fund's investment objective and
policies. The Fund's ability to use these strategies may be limited by market
conditions, regulatory limits and tax considerations and is limited by the
rating agency guidelines applicable to the APS. The Fund would only engage in
these strategies if doing so would not adversely
15
<PAGE>
affect the rating of the APS by Moody's and S&P. The use of options and futures
solely to enhance income may be considered a form of speculation. The Statement
of Additional Information for the Fund contains further information on these
strategies.
The Fund might not use any hedging strategies, and there can be no
assurance that any strategy used will succeed. If Mitchell Hutchins is incorrect
in its judgment on market values, interest rates or other economic factors in
using a hedging strategy, the Fund may have lower net income and a net loss on
the investment. Each of these strategies involves certain risks, which include:
o the fact that the skills needed to use hedging instruments are
different from those needed to select securities for the Fund;
o the possibility of imperfect correlation, or even no correlation,
between price movements of hedging instruments and price movements
of the securities being hedged;
o possible constraints placed on the Fund's ability to purchase or
sell portfolio investments at advantageous times due to the need for
the Fund to maintain 'cover' or to segregate securities; and
o the possibility that the Fund is unable to close out or liquidate
its hedged position.
LENDING OF PORTFOLIO SECURITIES
To attempt to enhance income (which would be taxable income), the Fund is
authorized to lend portfolio securities with a value of up to 33 1/3% of its
total assets to broker-dealers or institutional investors that Mitchell Hutchins
deems qualified, but only if doing so would not adversely affect the rating of
the APS by Moody's and S&P and only when the borrower maintains with the Fund's
custodian collateral, either in cash or money market instruments, in an amount
at least equal to the market value of the securities loaned, plus accrued
interest and dividends, determined on a daily basis and adjusted accordingly. In
determining whether to lend securities to a particular broker-dealer or
institutional investor, Mitchell Hutchins will consider, and during the period
of the loan will monitor, all relevant facts and circumstances, including the
creditworthiness of the borrower. The Fund will retain authority to terminate
any loans at any time. The Fund may pay reasonable administrative and custodial
fees in connection with a loan and may pay a negotiated portion of the interest
earned on the cash or money market instruments held as collateral to the
borrower or placing broker. The Fund will receive reasonable interest on the
loan or a flat fee from the borrower, and the Fund will receive amounts
equivalent to any dividends, interest or other distributions on the securities
loaned. The Fund will regain record ownership of loaned securities to exercise
beneficial rights, such as voting and subscription rights and rights to
dividends, interest and other distributions, when regaining such rights is
considered by Mitchell Hutchins to be in the Fund's interest.
OTHER PRACTICES
The Fund may invest up to 20% of its net assets in illiquid securities. The
term 'illiquid securities' for this purpose means securities that cannot be
disposed of within seven days in the ordinary course of business at
approximately the amount at which the Fund has valued the securities and
includes, among other things, securities subject to contractual restrictions on
resale, repurchase agreements maturing in more than seven days and municipal
lease obligations (including certificates of participation) other than those
that Mitchell Hutchins has determined are liquid pursuant to guidelines
established by the board of directors. To the extent the Fund invests in
illiquid securities, the Fund may not be able to readily liquidate such
investments, and would have to sell other investments if necessary to raise cash
to meet its obligations. The lack of a liquid secondary market for illiquid
securities may make it more difficult for the Fund to assign a value to those
securities for purposes of valuing the Fund's portfolio and calculating its net
asset value. The Fund also may invest in stand-by commitments with respect to
Municipal Obligations it purchases or holds. The Fund may engage in short-sales
'against the box.'
16
<PAGE>
SPECIAL LEVERAGE CONSIDERATIONS
PREFERRED STOCK
On August 12, 1993, the Fund issued 800 shares of APS Series A, 800 shares
of APS Series B and 800 shares of APS Series C, having an aggregate liquidation
preference of $120,000,000. The net proceeds to the Fund of the sale of the APS,
after deduction of underwriting discounts and offering expenses, was
$117,667,500. On November 28, 1994, in connection with the acquisition by the
Fund of the assets and liabilities of PaineWebber Premier Intermediate Tax-Free
Income Fund Inc., the Fund issued 600 shares of APS Series D, having an
aggregate liquidation preference of $30,000,000. The Fund has the right to issue
addditional APS or other preferred stock to the maximum extent permitted under
the 1940 Act.
The APS have resulted (and any issuance of other preferred stock would
result) in the financial leveraging of the Common Stock. The use of leverage is
a speculative investment technique and involves special risks to the Common
Stockholders. These include the possibility of higher volatility of both the net
asset value and the market value of the Common Stock. Also, fluctuations in the
dividend rate on the APS will affect the dividends on the Common Stock. So long
as the Fund is able to realize a higher net rate of return on its investment
portfolio than the then current dividend rate on the APS (or on any other
preferred stock issued by the Fund) together with other related expenses, the
effect of the leverage will be to cause Common Stockholders to realize higher
current net investment income than if the Fund were not leveraged. There can be
no assurance, however, that the Fund will be able to realize a higher net
return. To the extent that the then current dividend rate on the APS approaches
the net return on the Fund's investment portfolio, the benefit of leverage to
Common Stockholders will be reduced, and if the then current dividend rate on
the APS were to exceed the net return on the Fund's portfolio, the Fund's
leveraged capital structure would result in a lower yield to Common Stockholders
than if the Fund were not leveraged.
Each Series of APS pays dividends at rates that normally are tax-exempt and
that are adjusted to market based on an auction process. Rates normally are
adjusted every 7 days on APS Series A, every 28 days on APS Series B, every
three months on APS Series C and every 7 days on APS Series D. As of March 31,
1996, the dividend rate payable on APS Series A was 3.800%, the dividend rate
payable on APS Series B was 3.438%, the dividend rate payable on APS Series C
was 3.299%, and the dividend rate payable on APS Series D was 3.490%. Based on
those dividend rates, the Fund must experience a net annual return of
approximately 1.19% in order to cover the annual dividend payments on the APS.
There can be no assurance that the Fund will continue to realize a higher net
rate of return on its investment portfolio than the dividend rate that must be
paid on the APS. The following table may assist the investor in understanding
the effects of leverage by illustrating the effect of leverage on return to a
Common Stockholder. The figures appearing in the table are hypothetical and
actual returns may be greater or less than those appearing in the table.
<TABLE>
<S> <C> <C> <C> <C> <C>
Assumed Return on
Portfolio (Net of
Expenses).............. -10% -5% 0% 5% 10%
Corresponding Return to
Common Stockholder..... -16.98% -9.39% -1.81% 5.78% 13.37%
</TABLE>
Any decline in the net asset value of the Fund's investments will be borne
entirely by Common Stockholders. Accordingly, the effect of leverage in a
declining market would be a greater decrease in the net asset value of the
Common Stock than if the Fund were not leveraged and could adversely affect the
Fund's ability to make dividend payments on its Common Stock. Any such decrease
may be reflected in a greater decline in the market price of the Common Stock.
If the Fund's current investment income were not sufficient to meet dividend
requirements on the APS, it could become necessary for the Fund to liquidate
certain of its investments, thereby reducing net assets and, therefore, the net
asset value of the Common Stock. Such liquidations would cause the Fund to incur
transaction costs and might also cause the Fund to realize gains on securities
held for less than three months. Because, under current tax laws, the Fund must
derive less than 30% of its annual gross
17
<PAGE>
income from the sale or other disposition of stocks or other securities held for
less than three months to maintain its status as a regulated investment company
('RIC'), such securities gains would limit the ability of the Fund to sell other
securities held for less than three months that it might wish to sell in the
ordinary course of its portfolio management and thus might adversely affect its
yield. Moreover, while dividends on the APS, which are cumulative, are unpaid,
no dividends or other distributions would be permitted to be paid on Common
Stock until the Fund resumed its payments of dividends on the APS as required.
Under the 1940 Act, the value of the Fund's total assets, less all
liabilities and indebtedness not deemed to be senior securities under the 1940
Act, must be at least equal to 200% of the aggregate liquidation value of the
preferred stock (plus any outstanding indebtedness deemed to be senior
securities) at any time that the Fund pays a dividend or makes any other
distribution on Common Stock (other than a distribution payable in Common Stock)
or any time the Fund repurchases Common Stock, in each case after giving effect
to such dividend, distribution or repurchase. This requirement could impair the
ability of the Fund to maintain its qualification as a RIC for federal tax
purposes. To the extent necessary, the Fund intends to purchase or redeem
preferred stock in order to maintain asset coverage at the required 200% level.
In such circumstances, the Fund may have to liquidate portfolio securities in
order to meet redemption requirements. This could have the effect of reducing
the Fund's future net income. Such liquidations would cause the Fund to incur
related transaction costs. In addition, such liquidations might require the Fund
to realize capital gains or losses at a time that it would not otherwise and
might limit the ability of the Fund to dispose of other securities that it might
wish to sell in the ordinary course of portfolio management, and thus might
adversely affect the Fund's yield. Such redemptions could also require the Fund
to pay redemption premiums, which would adversely affect the Common
Stockholders.
The APS have received ratings of aaa from Moody's and AAA from S&P. The
rating agencies have established guidelines and other requirements with which
the Fund has agreed to comply for so long as the APS are outstanding and are
rated by Moody's and S&P. The rating agencies' portfolio guidelines establish a
set of tests for portfolio composition and asset coverage that supplement (and
in some cases are more restrictive than) the applicable requirements under the
1940 Act and the Fund's investment policies. These guidelines include asset
coverage requirements which are more restrictive than those under the 1940 Act,
restrictions on certain portfolio investments and investment practices,
requirements that the Fund maintain a portion of its assets in short-term high
quality fixed-income securities and certain mandatory redemption requirements.
The rating agency requirements also impose certain minimum issue size,
geographic diversification and other requirements for determining portfolio
assets that are eligible for computing compliance with their asset coverage
requirements. The ability of the Fund to comply with such asset coverage
maintenance ratios may be subject to circumstances which are beyond the control
of the Fund, such as market conditions for its portfolio securities. The terms
of the APS prohibit the payment of dividends or distributions on the Common
Stock in the event the Fund fails to meet such asset coverage maintenance ratios
and, in such circumstances, also provide for mandatory redemption of the APS,
with the potential adverse effects discussed above. For additional information
concerning rating agency guidelines and restrictions, see Appendix B to the SAI.
In accordance with the 1940 Act, the holders of the APS have special voting
rights, including the right to elect at least two directors at all times. See
'Description of Capital Stock--Auction Preferred Shares--Voting Rights.'
The issuance of the APS has entailed certain costs and expenses, such as
underwriting discounts, fees associated with the registration of the APS with
the SEC, filings under state securities laws, rating agency fees, legal and
accounting fees, printing costs, and will entail certain other ongoing expenses,
such as administrative and accounting fees. These costs and expenses have been
or will be borne by the Fund. The initial costs and expenses of the APS have
been reflected as a reduction in the net asset value of the Common Stock.
Ongoing expenses associated with the APS will be reflected as a reduction in the
investment income that otherwise would be available for distribution to Common
Stockholders.
18
<PAGE>
The Fund does not expect to realize significant taxable income. For federal
tax purposes, however, net realized capital gains and other taxable income, if
any, will be allocated (along with tax-exempt income) between Common
Stockholders and the holders of the APS in proportion to total distributions
paid to each class of stockholders for the year in which such capital gains or
other taxable income is realized or earned. The holders of the APS are entitled
to receive dividends on a cumulative basis before any dividend or other
distribution may be paid to Common Stockholders. Moreover, the terms of the APS
require that, if any portion of a dividend or other distribution to the holders
of the APS is taxable, the Fund must pay an additional dividend on the APS in an
amount such that the net after-tax return on the APS will be the same as the net
after-tax return that would have been derived if the initial dividends paid to
the holders of the APS had qualified in their entirety as tax-exempt income. Any
such additional dividends paid to holders of the APS will reduce the net
investment income of the Fund available for distribution to Common Stockholders.
BORROWINGS
The Fund is permitted to borrow money to finance Common Stock repurchases
and tender offers or for investment purposes from banks and other entities or
through reverse repurchase agreements in an amount not in excess of 33 1/3% of
total assets (including the amount of the borrowing and any other senior
securities representing indebtedness issued, but reduced by any liabilities and
indebtedness not constituting senior securities). Borrowing by the Fund would
create leverage and would entail speculative factors similar to those applicable
to the issuance of preferred stock. If borrowings are made on a secured basis,
the custodian will segregate the pledged assets for the benefit of the lender or
arrangements will be made with a suitable subcustodian, which may include the
lender. The Fund has no current intention of borrowing money for investment
purposes during the coming year. See 'Description of Capital Stock--Common Stock
Repurchases and Tender Offers.'
MANAGEMENT OF THE FUND
Subject to the supervision of the Fund's board of directors, investment
advisory and administration services will be provided to the Fund by Mitchell
Hutchins pursuant to an Investment Advisory and Administration Contract dated
May 26, 1993 ('Advisory Contract'). Mitchell Hutchins' principal business
address is 1285 Avenue of the Americas, New York, New York 10019. Mitchell
Hutchins is a wholly owned subsidiary of PaineWebber, which is a wholly owned
subsidiary of Paine Webber Group Inc., a publicly held financial services
holding company. Mitchell Hutchins provides investment advisory and portfolio
management services to investment companies, pension funds and other
institutional, corporate and individual clients. As of June 30, 1996, total
assets under Mitchell Hutchins' management exceeded $43.8 billion. As of that
date, Mitchell Hutchins served as investment adviser or sub-adviser to 31
registered investment companies with 65 separate portfolios having aggregate
assets of approximately $30 billion.
Pursuant to the Advisory Contract, Mitchell Hutchins provides a continuous
investment program for the Fund and makes investment decisions and place orders
to buy, sell or hold particular securities; Mitchell Hutchins also supervises
all matters relating to the operation of the Fund and obtains for it corporate
officers, clerical staff, office space, equipment and services. As compensation
for its services, Mitchell Hutchins is entitled to receive a fee, computed
weekly and paid monthly, in an amount equal to the annual rate of 0.90% of the
Fund's average weekly net assets. This fee is higher than the advisory and
administration fees paid by most funds. Since June 1, 1995, Mitchell Hutchins
has been waiving 0.25% of its investment advisory and administration fees.
Mitchell Hutchins may discontinue this fee waiver at any time.
19
<PAGE>
The Fund incurs various other expenses in its operations, such as custody
and transfer agency fees, brokerage commissions, professional fees, expenses of
board and shareholder meetings, fees and expenses relating to registration of
its Common Stock, taxes and governmental fees, fees and expenses of the
directors, costs of obtaining insurance, expenses of printing and distributing
shareholder materials, organizational expenses, including costs or losses to any
litigation. For the fiscal years ended March 31, 1996, March 31, 1995, and for
the fiscal period June 8, 1993 (commencement of operations) through March 31,
1994, the Fund's total expenses, stated as a percentage of average net assets
attributable to Common Stock, were 1.65% (1.33% after fee waivers), 1.74% and
1.57%, respectively.
Elbridge (Ebby) T. Gerry III, a senior vice president and a portfolio
manager of Mitchell Hutchins, has been responsible for the day-to-day management
of the Fund's portfolio since January 1996. Mr. Gerry has portfolio management
responsibility for over $4 billion in municipal assets at Mitchell Hutchins,
including municipal bond and money funds and private accounts. Prior to joining
Mitchell Hutchins in January 1996, he had been associated with J.P. Morgan
Private Banking since 1981 where he was responsible for managing municipal
assets, including several municipal bond funds. Other members of Mitchell
Hutchins' tax-exempt investments group provide input on market outlook, interest
rate forecasts, and other considerations pertaining to tax-exempt investments.
Mitchell Hutchins investment personnel may engage in securities
transactions for their own accounts pursuant to a code of ethics that
establishes procedures for personal investing and restricts certain
transactions.
DIVIDENDS AND OTHER DISTRIBUTIONS; DIVIDEND REINVESTMENT PLAN
DIVIDENDS AND OTHER DISTRIBUTIONS
The Fund declares and pays monthly cash dividends to Common Stockholders at
a level rate that, on an annual basis and after the payment of dividends on any
outstanding preferred stock, results in the distribution of all of the Fund's
net investment income. The dividend rate is adjusted by the Fund's board of
directors as necessary to reflect the performance of the Fund. Dividend levels
are determined by the Fund's board of directors after giving consideration to a
number of factors, including the Fund's undistributed net investment income,
historical and projected net investment income, expenses and projected payments
to preferred stockholders. The Fund's policy to pay dividends on the Common
Stock on this basis may be changed by its board of directors without notice to
stockholders.
The Fund intends to distribute annually to Common Stockholders
substantially all of its realized net capital gain (the excess of net long-term
capital gain over net short-term capital loss) and its realized net short-term
capital gain to the extent that such capital gains are not necessary to satisfy
the dividend, redemption or liquidation preferences of the APS or any other
preferred stock. Substantially all of the Fund's net investment income for any
fiscal year will be distributed to stockholders during or after the end of that
year.
To enable the Fund to maintain level monthly dividends, the Fund
anticipates that its monthly dividends may from time to time represent less or
more than the entire amount of net investment income earned by the Fund in the
period to which the dividend relates. Undistributed net investment income would
be available to supplement future distributions which might otherwise have been
reduced by reason of a decrease in the Fund's monthly net income due to
fluctuations or expenses or due to an increase in the dividend rate on the
Fund's outstanding preferred stock. As a result, dividends paid by the Fund for
any particular monthly period may be more or less than the amount of net
investment income earned by the Fund during the related period. Undistributed
net investment income will be reflected in the Fund's net asset value, and
correspondingly, distributions from undistributed net investment income will
reduce the Fund's net asset value.
20
<PAGE>
For federal tax purposes, the Fund is required to allocate tax-exempt
income, net realized capital gains and any other taxable income between shares
of Common Stock and shares of any preferred stock in proportion to the total
dividends and other distributions paid to each class for the year in which such
tax-exempt income, net realized capital gains or other taxable income is earned
or realized. See 'Taxes.'
While any shares of the APS are outstanding, the Fund may not declare any
cash dividend or other distribution on its Common Stock unless at the time of
such declaration: (1) all accrued dividends on the APS have been paid; (2) any
required redemptions of the APS have been made; (3) after giving effect to the
dividend or other distribution, the asset coverage requirements imposed by the
rating agencies then rating the APS would be satisfied; and (4) the Fund's total
assets, less all liabilities and indebtedness not deemed to be senior securities
under the 1940 Act (determined after deducting the amount of such dividend or
other distribution), are at least 200% of the liquidation value of the
outstanding APS (plus any outstanding indebtedness deemed to be senior
securities). Under certain circumstances, these limitations could impair the
ability of the Fund to maintain its qualification for treatment as a RIC. See
'Taxes.' For further information regarding the impact of the issuance of the APS
on the payment of dividends and other distributions on the Common Stock, see
'Special Leverage Considerations.'
DIVIDEND REINVESTMENT PLAN
The Fund has established the Plan, under which all Common Stockholders
whose shares are registered in their own names, or in the name of PaineWebber or
its nominee, have all dividends and other distributions on their shares of
Common Stock automatically reinvested in additional shares, unless such Common
Stockholders elect to receive cash. Common Stockholders may affirmatively elect
to receive all dividends and other distributions in cash paid by check mailed
directly to them by PNC Bank, National Association ('Transfer Agent'), as
dividend disbursing agent. Common Stockholders who elect to hold their shares in
the name of a broker or nominee other than PaineWebber or its nominee should
contact such broker or other nominee to determine whether, or how, they may
participate in the Plan. The ability of such Common Stockholders to participate
in the Plan may change if their shares of the Common Stock are transferred into
the name of another broker or nominee.
The Transfer Agent serves as agent for the Common Stockholders in
administering the Plan. After the Fund declares a dividend or determines to make
a capital gain distribution, the Transfer Agent, as agent for the participants,
receives the cash payment and uses it to buy shares of Common Stock in the open
market, on the NYSE or otherwise, for the participants' accounts. Such shares
may be purchased at prices that are higher or lower than the net asset value per
share of the Common Stock at the time of purchase. The number of shares
purchased with each dividend or other distribution for a particular Common
Stockholder equals the result obtained by dividing the amount of the dividend or
other distribution payable to that stockholder by the average price per share
(including applicable brokerage commissions) that the Transfer Agent was able to
obtain in the open market. The Fund will not issue any new shares of Common
Stock in connection with the Plan. The Transfer Agent maintains all stockholder
accounts in the Plan and furnishes written confirmations of all transactions in
the accounts, including information needed by stockholders for personal and tax
records. Shares in the account of each Plan participant are held by the Transfer
Agent in non-certificated form in the name of the participant, and each
stockholder's proxy includes those shares of Common Stock purchased pursuant to
the Plan.
There is no charge to participants for reinvesting dividends or other
distributions. The Transfer Agent's fees for the handling of reinvestment of
distributions are paid by the Fund. However, each participant pays a pro rata
share of brokerage commissions incurred with respect to the Transfer Agent's
open market purchases of Fund shares in connection with the reinvestment of
distributions.
21
<PAGE>
The automatic reinvestment of dividends and other distributions in shares
of Common Stock will not relieve participants of any income tax that may be
payable on such distributions. See 'Taxes.'
A holder who has elected to participate in the Plan may terminate
participation in the Plan at any time without penalty, and Common Stockholders
who have previously terminated participation in the Plan may rejoin it at any
time. Changes in elections must be made in writing to the Transfer Agent and
should include the stockholder's name and address as they appear on the share
certificate. An election to terminate participation in the Plan, until such
election is changed, will be deemed to be an election by a Common Stockholder to
take all subsequent distributions in cash. An election will be effective only
for distributions declared and having a record date at least ten days after the
date on which the election is received.
Experience under the Plan may indicate that changes are desirable.
Accordingly, the Fund reserves the right to amend or terminate the Plan with
respect to any dividend or other distribution if notice of the change is sent to
Plan participants at least 30 days before the record date for such distribution.
The Plan also may be amended or terminated by the Transfer Agent by at least 30
days' written notice to all Plan participants. All correspondence concerning the
Plan should be directed to the Transfer Agent at PNC Bank, National Association,
c/o PFPC Inc., P.O. Box 8950, Wilmington, Delaware 19899.
TAXES
The Fund intends to continue to qualify for treatment as a RIC under the
Internal Revenue Code. For each taxable year that the Fund so qualifies, it will
be relieved of federal income tax on that part of its investment company taxable
income (consisting generally of taxable net investment income, net short-term
capital gain and net realized gains from certain hedging transactions) and net
capital gain that is distributed to its stockholders.
Distributions by the Fund of the excess of tax-exempt interest income over
certain amounts disallowed as deductions, which the Fund designates as
'exempt-interest dividends,' generally may be excluded from gross income by its
stockholders for federal income tax purposes; those distributions may, however,
be taxable for state and local tax purposes. In order to pay exempt-interest
dividends, the Fund must (and intends to continue to) satisfy the requirement
that, at the close of each quarter of its taxable year, at least 50% of the
value of its total assets consists of obligations the interest on which is
tax-exempt.
If the Fund invests in any instruments that generate taxable income, under
the circumstances described in 'Other Investment Practices--Short-Term
Tax-Exempt and Taxable Investments,' distributions of the interest earned
thereon will be taxable to the Fund's stockholders as ordinary income to the
extent of its earnings and profits. Moreover, if the Fund realizes capital gains
as a result of market transactions, distributions of those gains also will be
taxable to its stockholders.
Interest on indebtedness incurred or continued by a stockholder to purchase
or carry shares of Common Stock is not deductible to the extent that interest
relates to exempt-interest dividends received from the Fund. If the Fund invests
in certain private activity bonds ('PABs'), the portion of the Fund's
exempt-interest dividends that is attributable to the interest it earns thereon
and that is specified in an annual notice from the Fund must be treated by its
stockholders as a Tax Preference Item in calculating their liability for the
AMT. Corporate stockholders, however, must include all of their exempt-interest
dividends in calculating their adjusted current earnings for purposes of the
AMT.
The Fund notifies its stockholders following the end of each calendar year
of the amounts of exempt-interest dividends, taxable dividends and capital gain
distributions paid (or deemed paid) that year and of any portion thereof that is
a Tax Preference Item. Dividends and other distributions declared by the Fund in
October, November or December of any year and payable to stockholders of record
on a date in any of those months will be deemed to have been paid by the Fund
and received by those stockholders on December 31 of that year if the
22
<PAGE>
distributions are paid by the Fund during the following January. Accordingly,
those distributions will be reported by those stockholders for the year in which
that December 31 falls.
Upon a sale or exchange of shares of Common Stock (including a sale
pursuant to a share repurchase or tender offer by the Fund), a Common
Stockholder generally will realize a taxable gain or loss (equal to the
difference between his adjusted basis for the shares and the amount realized),
which will be treated as a capital gain or loss if the shares are capital assets
in the stockholder's hands and will be a long-term capital gain or loss if the
shares have been held for more than one year. Notwithstanding this general rule,
however, any loss realized on a sale or exchange of shares of Common Stock (1)
will be disallowed to the extent of any exempt-interest dividends received on
those shares, and any loss not disallowed will be treated as a long-term, rather
than as a short-term, capital loss to the extent of any capital gain
distributions received thereon, if the shares were held for six months or less,
and (2) will be disallowed to the extent those shares are replaced by other
shares of Common Stock within a period of 61 days beginning 30 days before and
ending 30 days after the date of disposition of the shares (which could occur,
for example, as the result of participation in the Plan), in which event, the
replacement shares' basis will be adjusted to reflect the disallowed loss.
Investors also should be aware that if shares of the Common Stock are
purchased shortly before the record date for any distribution, the investor will
pay full price for the shares and could receive some portion of the price back
as an exempt-interest dividend, a taxable dividend or capital gain distribution.
The foregoing is only a summary of the important federal tax considerations
generally affecting the Fund and the Common Stockholders; see the SAI for a
further discussion. There may be other federal, state or local tax
considerations applicable to a particular investor. Prospective stockholders are
therefore urged to consult their tax advisers.
DESCRIPTION OF CAPITAL STOCK
The Fund is authorized to issue 200 million shares of capital stock, $.001
par value. Currently, 800 shares of capital stock are classified as APS Series
A, 800 shares of capital stock are classified as APS Series B, 800 shares of
capital stock are classified as APS Series C and 600 shares of capital stock are
classified as APS Series D. All remaining shares of capital stock are classified
as Common Stock. The description set forth below under 'Common Stock' and
'Auction Preferred Shares' is subject to the provisions contained in the Fund's
Articles of Incorporation and By-Laws.
COMMON STOCK
Shares of the Common Stock have no preemptive, conversion, exchange or
redemption rights. Each share has equal voting, dividend, distribution and
liquidation rights. The outstanding shares of Common Stock are, and those
offered hereby, when issued, will be, fully paid and nonassessable. Except as
otherwise indicated in this Prospectus and except as otherwise required by
applicable law, holders of shares of the APS have equal voting rights with
Common Stockholders (one vote per share) and will vote together with Common
Stockholders as a single class. All voting rights for the election of directors
are noncumulative, which means that the holders of more than 50% of the shares
can elect 100% of the directors then nominated for election if they choose to do
so and, in such event, the holders of the remaining shares will not be able to
elect any directors. However, the holders of the APS, voting as a class, are
entitled to elect two directors. The rights of the holders of the Common Stock
to elect directors and to vote on other matters are subject to the voting rights
of the APS, as discussed below under 'Description of Capital Stock--Auction
Preferred Shares.'
Under the rules of the NYSE applicable to listed companies, the Fund
normally is required to hold an annual meeting of stockholders in each year. If
the Fund is converted to an open-end investment company or if for any other
reason the Fund's shares are no longer listed on the NYSE (or any other national
securities exchange the
23
<PAGE>
rules of which require annual meetings of stockholders), the Fund may decide not
to hold annual meetings of stockholders. See 'Description of Capital
Stock--Common Stock Repurchases and Tender Offers; Description of Capital
Stock--Conversion to Open-End Investment Company.'
Shares of closed-end investment companies, including the Fund, frequently
trade at a discount to their net asset values. Whether investors will realize
gains or losses upon the sale of Common Stock will not depend directly upon the
Fund's net asset value, but will depend upon whether the market price of the
Common Stock at the time of sale is above or below the original purchase price
for the shares. This market risk is separate and distinct from the risk that the
Fund's net asset value may decrease. Accordingly, the Common Stock is designed
primarily for long-term investors, and investors in the Common Stock should not
view the Fund as a vehicle for short-term trading purposes.
Any additional offerings of the Fund's Common Stock, if made, will require
approval of its board of directors and will be subject to the requirement of the
1940 Act that shares may not be sold at a price below the then current net asset
value, exclusive of underwriting discounts and commissions, except, among other
things, in connection with an offering to existing stockholders or with the
consent of a majority of the holders of the Fund's outstanding voting
securities.
The following chart indicates the Fund's preferred and common shares
outstanding as of July 31, 1996.
<TABLE>
<CAPTION>
AMOUNT
AMOUNT OUTSTANDING
HELD EXCLUSIVE OF
BY AMOUNT HELD
REGISTRANT BY REGISTRANT
AMOUNT OR FOR ITS OR FOR ITS
TITLE OF CLASS AUTHORIZED ACCOUNT ACCOUNT
- ------------------------- ----------- ---------- ---------------
<S> <C> <C> <C>
Common Stock............. 199,997,000 -- 20,628,363
APS Series A............. 800 -- 800
APS Series B............. 800 -- 800
APS Series C............. 800 -- 800
APS Series D............. 600 -- 600
</TABLE>
AUCTION PREFERRED SHARES
General. Holders of the APS are entitled to receive cumulative cash
dividends at an adjustable rate determined through an auction process. See
'Special Leverage Considerations--Preferred Stock.' All outstanding shares of
APS are fully paid and non-assessable, have no preemptive or conversion rights
and are not subject to any sinking fund provisions. As long as the APS are
outstanding, the composition of the Fund's investment portfolio will reflect
guidelines established by the rating agencies rating the APS. See 'Appendix B'
to the SAI.
Liquidation Preference. Upon a liquidation of the Fund, whether voluntary
or involuntary, the holders of the APS then outstanding will be entitled to
receive and to be paid out of the assets of the Fund available for distribution
to its stockholders, before any payment or distribution shall be made on the
Common Stock or on any other class of stock of the Fund ranking junior to the
APS upon liquidation, an amount equal to the liquidation preference with respect
to the APS. The liquidation preference for the APS is $50,000 per share, plus an
amount equal to all dividends thereon (whether or not earned or declared)
accumulated but unpaid to the date of final distribution. After the payment to
the holders of the APS of the full preferential amounts, the holders of APS as
such shall have no right or claim to any of the remaining assets of the Fund.
Neither the sale of all or substantially all the property or business of the
Fund, nor the merger or consolidation of the Fund into or with any other
corporation nor the merger or consolidation of any other corporation into or
with the Fund shall be a liquidation, whether voluntary or involuntary, for the
purposes of this paragraph.
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<PAGE>
Voting Rights. Holders of the APS generally will have equal voting rights
with holders of Common Stock (one vote per share) and generally will vote
together with Common Stockholders as a single class. However, in connection with
the election of the Fund's directors, holders of outstanding shares of preferred
stock, including any APS, voting as a separate class, are entitled to elect two
of the Fund's directors; the remaining directors are elected by Common
Stockholders and preferred stockholders, including any APS, voting as a single
class. In addition, if at any time dividends (whether or not earned or declared)
on any outstanding preferred stock, including the APS, shall be due and unpaid
in an amount equal to two full years' dividends thereon, then the holders of
outstanding shares of preferred stock, including any APS, voting as a separate
class, will be entitled to elect a majority of the total number of directors of
the Fund so long as such dividends remain unpaid.
So long as any of the APS are outstanding, the Fund will not, without the
affirmative vote of a majority of the outstanding APS, determined with reference
to a 'majority of outstanding voting securities' as that term is defined in
Section 2(a)(42) of the 1940 Act (voting separately as one class): (a)
authorize, create or issue any class or series of stock ranking prior to or on a
parity with the APS with respect to the payment of dividends or the distribution
of assets upon liquidation or increase the authorized amount of APS (except that
the Fund may, without the vote of the holders of APS, authorize, create or issue
classes or series of preferred stock ranking on a parity with the APS with
respect to the payment of dividends and the distribution of assets upon
liquidation subject to continuing compliance by the Fund with the asset coverage
requirement of the 1940 Act and APS basic maintenance amount requirements
established by Moody's or S&P; provided that the Fund obtains written
confirmation from Moody's (if Moody's is then rating the APS) and S&P (if S&P is
then rating the APS) that the issuance of any such additional class or series of
preferred stock would not impair the rating then assigned by such rating agency
to the APS), (b) amend, alter or repeal the Fund's Articles of Incorporation
insofar as they relate to the APS ('APS Provisions'), whether by merger,
consolidation or otherwise, so as to affect any preference, right or power of
such APS or the holders thereof; provided that (i) none of the actions permitted
by the exception to (a) above will be deemed to affect such preferences, rights
or powers and (ii) the authorization, creation and issuance of classes or series
of stock ranking junior to the APS with respect to payment of dividends and the
distribution of assets upon liquidation will be deemed to affect such
preferences, rights or powers only if Moody's or S&P is then rating the Fund and
such issuance would, at the time thereof, cause the Fund not to satisfy the
asset coverage or APS basic maintenance amount referred to above, or (c) file a
voluntary application for relief under federal bankruptcy law or any similar
application under state law for so long as the Fund is solvent and does not
foresee becoming insolvent.
The Fund's board of directors may, however, without approval of the holders
of APS, amend, alter or repeal any or all of the definitions required to be
contained in the APS Provisions by the rating agencies in the event the Fund
receives written confirmation from the appropriate rating agency that any such
amendment, alteration or repeal would not impair the ratings then assigned to
the APS by such rating agency. Unless a higher percentage is provided for under
'Description of Capital Stock--Certain Anti-Takeover Provisions of the Articles
of Incorporation,' the affirmative vote of the holders of a majority of the
outstanding APS, voting as a separate class, will be required to approve any
plan of reorganization (as such term is defined under the 1940 Act) adversely
affecting such shares or any action requiring a vote of security holders under
Section 13(a) of the 1940 Act including, among other things, changes in the
Fund's investment objective or changes in the investment restrictions described
as fundamental policies under 'Investment Limitations' in the SAI. The class
vote of holders of APS described above will in each case be in addition to a
separate vote of the requisite percentage of shares of Common Stock necessary to
authorize the action in question. To the extent permitted by the 1940 Act, each
Series of APS may vote as a separate series in certain circumstances.
25
<PAGE>
The foregoing voting provisions will not apply with respect to the APS if,
at or prior to the time when a vote is required, such APS shall have been (i)
redeemed or (ii) called for redemption and sufficient funds shall have been
deposited in trust to effect such redemption.
Redemption, Purchase and Sale of APS by the Fund. The APS are redeemable by
the Fund in whole or in part at the original purchase price per share plus
accrued dividends per share and any applicable redemption premium. Any
redemption or purchase of shares of the APS or any other preferred stock by the
Fund will reduce the leverage applicable to shares of Common Stock, while any
resale of shares by the Fund will increase such leverage. See 'Special Leverage
Considerations.'
The board of directors, without the approval of the Common Stockholders,
may authorize an additional offering of preferred stock and may fix the terms of
the preferred stock to be offered.
COMMON STOCK REPURCHASES AND TENDER OFFERS
In recognition of the possibility that the Common Stock might trade at a
discount from net asset value and that any such discount may not be in the best
interest of Common Stockholders, the Fund's board of directors has determined
that it will from time to time consider taking action to attempt to reduce or
eliminate any discount. To that end, the board, in consultation with Mitchell
Hutchins, at least annually considers whether to repurchase shares of the Common
Stock in the open market or to make a tender offer for shares of the Common
Stock at their net asset value. At such times, the board may consider such
factors as the market price of the Common Stock, the net asset value of the
Common Stock, the liquidity of the assets of the Fund, whether such transactions
would impair the Fund's status as a RIC or result in a failure to comply with
applicable asset coverage requirements, general economic conditions and such
other events or conditions that may have a material effect on the Fund's ability
to consummate such transactions. The board may at any time, however, decide that
the Fund should not repurchase shares or make a tender offer. Common Stock will
not be repurchased unless after such repurchase the Fund would continue to
satisfy the asset coverage requirements imposed under the 1940 Act with respect
to the APS and asset coverage requirements that may be imposed by any rating
agency as a condition of its rating of the APS. The Fund may borrow to finance
repurchases and tender offers. Interest on any such borrowings will reduce the
Fund's net income. See 'Special Leverage Considerations--Borrowings.'
There is no assurance that repurchases or tender offers will result in the
Common Stock trading at a price that is equal or close to its net asset value
per share. The market price of shares of the Common Stock will be determined by,
among other things, the relative demand for and supply of such shares in the
market, the Fund's investment performance, the Fund's dividends and yield and
investor perception of the Fund's overall attractiveness as an investment as
compared with other investment alternatives. Nevertheless, the fact that the
Common Stock may be the subject of tender offers at net asset value from time to
time may reduce the spread that might otherwise exist between the market price
of the Common Stock and net asset value per share. In the opinion of Mitchell
Hutchins, sellers may be less inclined to accept a significant discount if they
have a reasonable expectation of being able to recover net asset value in
conjunction with a possible tender offer.
Although the board of directors believes that share repurchases and tender
offers generally would have a favorable effect on the market price of the Common
Stock, it should be recognized that the Fund's acquisition of shares of the
Common Stock would decrease the Fund's total assets and therefore have the
effect of increasing the Fund's expense ratio and decreasing the asset coverage
with respect to any outstanding APS. Because of the nature of the Fund's
investment objective, policies and portfolio, under current market conditions
Mitchell Hutchins anticipates that repurchases and tender offers generally
should not have a material, adverse effect on the Fund's investment performance
and that Mitchell Hutchins generally should not have any material difficulty in
disposing of portfolio securities in order to consummate share repurchases and
tender offers; however, this may not always be the case.
26
<PAGE>
Any tender offer made by the Fund for shares of the Common Stock generally
would be at a price equal to the net asset value of the shares on a date
subsequent to the Fund's receipt of all tenders. Each offer would be made, and
the Common Stockholders would be notified, in accordance with the requirements
of the Securities Exchange Act of 1934 and the 1940 Act, either by publication
or mailing or both. Each person tendering shares would pay to the Fund's
Transfer Agent a service charge to help defray certain costs, including the
processing of tender forms, effecting payment, postage and handling. The Fund
expects that the costs of effecting a tender offer would exceed the aggregate of
all service charges received from those who tender their shares. Costs
associated with the tender would be charged against capital.
CONVERSION TO OPEN-END INVESTMENT COMPANY
The Fund's board of directors will consider from time to time whether it
would be in the best interests of the Fund and its Common Stockholders to
convert the Fund to an open-end investment company. If the board of directors
determines that such a conversion would be in the best interests of the Fund and
its Common Stockholders and is consistent with the 1940 Act, the board will
submit to the Fund's stockholders, at the next succeeding annual or special
meeting, a proposal to amend the Fund's Articles of Incorporation to so convert
the Fund. Such amendment would provide that, upon its adoption by the holders of
at least a majority of the Fund's outstanding shares entitled to vote thereon,
the Fund will convert from a closed-end to an open-end investment company. If
the Fund converted to an open-end investment company, it would be able to
continuously issue and offer for sale shares of the Common Stock, and each such
share could be presented to the Fund at the option of the holder thereof for
redemption at a price based on the then current net asset value per share. In
such event, the Fund could be required to liquidate portfolio securities to meet
requests for redemption, the Common Stock would no longer be listed on the NYSE
and certain investment policies of the Fund would require amendment. In
addition, conversion to an open-end investment company would require that the
Fund redeem any outstanding shares of APS. The Fund might have to liquidate
portfolio securities to finance such redemptions. See 'Special Leverage
Considerations.'
In considering whether to propose that the Fund convert to an open-end
investment company, the board of directors will consider various factors,
including, without limitation, the potential benefits and detriments to the Fund
and its stockholders of conversion, the potential alternatives and the benefits
and detriments associated therewith, and the feasibility of conversion given,
among other things, the Fund's investment objective and policies. In the event
of a conversion to an open-end investment company, the Fund may charge fees in
connection with the sale or redemption of its shares. There can be no assurance
that the board will conclude that such a conversion is in the best interest of
the Fund or Common Stockholders. As an open-end investment company, the Fund may
reserve the right to honor any request for redemption by making payment in whole
or in part in securities chosen by the Fund and valued in the same way as they
would be valued for purposes of computing the Fund's net asset value. If payment
is made in securities, a shareholder may incur brokerage expenses in converting
these securities into cash.
CERTAIN ANTI-TAKEOVER PROVISIONS OF THE ARTICLES OF INCORPORATION
The Fund presently has provisions in its Articles of Incorporation that
have the effect of limiting: (1) the ability of other entities or persons to
acquire control of the Fund; (2) the Fund's freedom to engage in certain
transactions; or (3) the ability of the Fund's directors or stockholders to
amend the Articles of Incorporation. These provisions of the Articles of
Incorporation may be regarded as 'anti-takeover' provisions. Under Maryland law
and the Fund's Articles of Incorporation, the affirmative vote of the holders of
at least a majority of the votes entitled to be cast is required for the
consolidation of the Fund with another corporation, a merger of the Fund with or
into another corporation (except for certain mergers in which the Fund is the
successor), a statutory share exchange in which the Fund is not the successor, a
sale or transfer of all or substantially all of the
27
<PAGE>
Fund's assets, the dissolution of the Fund and any amendment to the Fund's
Articles of Incorporation. In addition, the affirmative vote of the holders of
at least 66 2/3% (which is higher than that required under Maryland law or the
1940 Act) of the outstanding shares of the Fund's capital stock is required
generally to authorize any of the following transactions or to amend the
provisions of the Articles of Incorporation relating to such transactions:
(1) merger, consolidation or statutory share exchange of the Fund with or
into any other corporation;
(2) issuance of any securities of the Fund to any person or entity for cash;
(3) sale, lease or exchange of all or any substantial part of the assets of
the Fund to any entity or person (except assets having an aggregate
market value of less than $1,000,000); or
(4) sale, lease or exchange to the Fund, in exchange for securities of the
Fund, of any assets of any entity or person (except assets having an
aggregate fair market value of less than $1,000,000)
if such corporation, person or entity is directly, or indirectly through
affiliates, the beneficial owner of more than 5% of the outstanding shares of
the Fund (a 'Principal Shareholder'). A similar vote also would be required for
any amendment of the Articles of Incorporation to convert the Fund to an
open-end investment company by making any class of the Fund's capital stock a
'redeemable security,' as that term is defined in the 1940 Act. Such vote would
not be required with respect to any of the foregoing transactions, however,
when, under certain conditions, the board of directors approves the transaction,
although in certain cases involving merger, consolidation or statutory share
exchange or sale of all or substantially all of the Fund's assets or the
conversion of the Fund to an open-end investment company, the affirmative vote
of the holders of a majority of the outstanding shares of the Fund's capital
stock would nevertheless be required. Reference is made to the Articles of
Incorporation of the Fund, on file with the SEC, for the full text of these
provisions. These voting rights are in addition to the rights of the holders of
any preferred stock outstanding to vote as a single class on certain matters.
See 'Description of Capital Stock--Auction Preferred Shares.'
The provisions of the Articles of Incorporation described above and the
Fund's right to repurchase or make a tender offer for its shares could have the
effect of depriving the Common Stockholders of opportunities to sell their
shares at a premium over prevailing market prices by discouraging a third party
from seeking to obtain control of the Fund in a tender offer or similar
transaction. See 'Description of Capital Stock--Common Stock Repurchases and
Tender Offers; Description of Capital Stock--Conversion to Open-End Investment
Company.' The overall effect of these provisions is to render more difficult the
accomplishment of a merger or the assumption of control by a Principal
Shareholder. They provide, however, the advantage of potentially requiring
persons seeking control of the Fund to negotiate with its management regarding
the price to be paid and facilitating the continuity of the Fund's management,
investment objective and policies. The board of directors of the Fund has
considered the foregoing anti-takeover provisions and concluded that they are in
the best interests of the Fund and its stockholders.
CUSTODIAN, TRANSFER AND DIVIDEND DISBURSING AGENT AND REGISTRAR
State Street Bank and Trust Company, One Heritage Drive, North Quincy,
Massachusetts 02171, serves as custodian of the Fund's assets. PNC Bank,
National Association, whose principal business address is Broad and Chestnut
Streets, Philadelphia, Pennsylvania 19110, serves as transfer and dividend
disbursing agent and registrar with respect to the Common Stock. Bankers Trust
Company, Four Albany Street, New York, New York 10006 serves as the Auction
Agent with respect to the APS and acts as transfer agent, registrar, dividend
disbursing agent and agent for certain notifications for the Fund in connection
with the APS.
28
<PAGE>
FURTHER INFORMATION
Further information concerning these securities and the Fund may be found
in the Registration Statement, of which this Prospectus and the Fund's SAI
constitute a part, on file with the SEC.
TABLE OF CONTENTS OF STATEMENT OF ADDITIONAL INFORMATION
<TABLE>
<CAPTION>
PAGE
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<S> <C>
Investment Policies and Restrictions.................................. 1
Hedging and Related Income Strategies................................. 10
Directors and Officers................................................ 16
Control Persons and Principal Holders of Securities................... 22
Investment Advisory Arrangements...................................... 22
Portfolio Transactions................................................ 24
Valuation of Common Stock............................................. 25
Taxes................................................................. 26
Additional Information................................................ 28
Financial Information................................................. 29
Appendix A............................................................ A-1
Appendix B............................................................ B-1
</TABLE>
29
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APPENDIX A
TYPES OF MUNICIPAL OBLIGATIONS
The Fund may invest in the following types of Municipal Obligations and in
such other types of Municipal Obligations as become available on the market from
time to time.
MUNICIPAL BONDS
Municipal bonds are debt obligations issued to obtain funds for various
public purposes. The two principal classifications of municipal bonds are
'general obligation' and 'revenue' bonds. General obligation bonds are secured
by the issuer's pledge of its full faith, credit and taxing power for the
payment of principal and interest. Revenue bonds are payable only from the
revenues derived from a particular facility or class of facilities or, in some
cases, from the proceeds of a special excise tax or from another specific
source, such as the user of the facility being financed. Certain municipal bonds
are 'moral obligation' issues, which normally are issued by special purpose
public authorities. In the case of such issues, an express or implied 'moral
obligation' of a related government unit is pledged to the payment of the debt
service but is usually subject to annual budget appropriations.
INDUSTRIAL DEVELOPMENT BONDS AND PRIVATE ACTIVITY BONDS
Industrial development bonds ('IDBs') and private activity bonds ('PABs')
are municipal bonds issued by or on behalf of public authorities to finance
various privately operated facilities, such as airports or pollution control
facilities. IDBs and PABs are generally revenue bonds and thus are not payable
from the unrestricted revenue of the issuer. The credit quality of IDBs and PABs
is usually directly related to the credit standing of the user of the facilities
being financed. The Fund may invest more than 25% of its assets in IDBs and
PABs.
IDBs issued after August 15, 1986 generally are considered PABs, and to the
extent the Fund invests in such PABs, stockholders generally will be required to
include a portion of their exempt-interest dividends in calculating their
liability for the AMT. See 'Taxes.'
MUNICIPAL LEASE OBLIGATIONS
Municipal lease obligations are Municipal Obligations that may take the
form of leases, installment purchase contracts or conditional sales contracts,
or certificates of participation with respect to such contracts or leases.
Municipal lease obligations are issued by state and local governments and
authorities to purchase land or various types of equipment and facilities.
Although municipal lease obligations do not constitute general obligations of
the municipality for which the municipality's taxing power is pledged, they
ordinarily are backed by the municipality's covenant to budget for, appropriate
and make the payments due under the lease obligation. The leases underlying
certain Municipal Obligations, however, provide that lease payments are subject
to partial or full abatement if, because of material damage or destruction of
the leased property, there is substantial interference with the lessee's use or
occupancy of such property. This 'abatement risk' may be reduced by the
existence of insurance covering the leased property, the maintenance by the
lessee of reserve funds or the provision of credit enhancements such as letters
of credit.
The liquidity of municipal lease obligations varies. See 'Other Investment
Practices.' Certain municipal lease obligations contain 'non-appropriation'
clauses which provide that the municipality has no obligation to make lease or
installment purchase payments in future years unless money is appropriated for
such purpose on a yearly basis. In the case of a 'non-appropriation' lease, the
Fund's ability to recover under the lease in the event of non-appropriation or
default will be limited solely to the repossession of the leased property,
without recourse
A-1
<PAGE>
to the general credit of the lessee, and disposition of the property in the
event of foreclosure might prove difficult. The Fund does not intend to invest a
significant portion of its assets in such 'non-appropriation' municipal lease
obligations. There is no limitation on the Fund's ability to invest in other
municipal lease obligations.
ZERO COUPON OBLIGATIONS
The Fund may invest up to 10% of its total assets in zero coupon Municipal
Obligations. Such obligations include 'pure zero' obligations, which pay no
interest for their entire life (either because they bear no stated rate of
interest or because their stated rate of interest is not payable until
maturity), and 'zero/fixed' obligations, which pay no interest for an initial
period and thereafter pay interest currently. Zero coupon obligations also
include securities representing the principal-only components of Municipal
Obligations from which the interest components have been stripped and sold
separately by the holders of the underlying Municipal Obligations. Zero coupon
securities usually trade at a deep discount from their face or par value and
will be subject to greater fluctuations in market value in response to changing
interest rates than obligations of comparable maturities that make current
distributions of interest. While zero coupon Municipal Obligations will not
contribute to the cash available to the Fund for purposes of paying dividends to
stockholders, Mitchell Hutchins believes that limited investments in such
securities may facilitate the Fund's ability to preserve capital while
generating tax-free income through the accrual of original issue discount. Zero
coupon Municipal Obligations will not be counted as income-producing securities
for purposes of the Fund's policy of normally investing at least 65% of its
total assets in income-producing securities. Zero coupon Municipal Obligations
generally are liquid, although such liquidity may be reduced from time to time
due to interest rate volatility and other factors. See 'Other Investment
Practices.'
FLOATING AND VARIABLE RATE OBLIGATIONS
The Fund also may purchase floating and variable rate municipal notes and
bonds, which frequently permit the holder to demand payment of principal at any
time, or at specified intervals, and permit the issuer to prepay principal, plus
accrued interest, at its discretion after a specified notice period. The
issuer's obligations under the demand feature of such notes and bonds generally
are secured by bank letters of credit or other credit support arrangements.
There frequently will be no secondary market for variable and floating rate
obligations held by the Fund, although the Fund may be able to obtain payment of
principal at face value by exercising the demand feature of the obligation.
PARTICIPATION INTERESTS
The Fund may invest in participation interests in municipal bonds,
including IDBs, PABs and floating and variable rate securities. A participation
interest gives the Fund an undivided interest in a municipal bond owned by a
bank. The Fund has the right to sell the instrument back to the bank. Such right
is generally backed by the bank's irrevocable letter of credit or guarantee and
permits the Fund to draw on the letter of credit on demand, after specified
notice, for all or any part of the principal amount of the Fund's participation
interest plus accrued interest. Generally, the Fund intends to exercise the
demand under the letters of credit or other guarantees only upon a default under
the terms of the underlying bond, or to maintain the Fund's portfolio in
accordance with its investment objective and policies. The ability of a bank to
fulfill its obligations under a letter of credit or guarantee might be affected
by possible financial difficulties of its borrowers, adverse interest rate or
economic conditions, regulatory limitations or other factors. Mitchell Hutchins
will monitor the pricing, quality and liquidity of the participation interests
held by the Fund, and the credit standing of banks issuing letters of credit or
A-2
<PAGE>
guarantees supporting such participation interests on the basis of published
financial information reports of rating services and bank analytical services.
CUSTODIAL RECEIPTS
The Fund may acquire custodial receipts or certificates underwritten by
securities dealers or banks that evidence ownership of future interest payments,
principal payments or both on certain Municipal Obligations. The underwriter of
these certificates or receipts typically purchases Municipal Obligations and
deposits the obligations in an irrevocable trust or custodial account with a
custodian bank, which then issues receipts or certificates that evidence
ownership of the periodic unmatured coupon payments and the final principal
payment on the obligations. Custodial receipts evidencing specific coupon or
principal payments have the same economic attributes as zero coupon Municipal
Obligations described herein. Although under the terms of a custodial receipt
the Fund would be typically authorized to assert its rights directly against the
issuer of the underlying obligation, the Fund could be required to assert
through the custodian bank those rights that may exist against the underlying
issuer. Thus, in the event the underlying issuer fails to pay principal or
interest when due, the Fund may be subject to delays, expenses and risks that
are greater than those that would have been involved if the Fund had purchased a
direct obligation of the issuer. In addition, in the event that the trust or
custodial account in which the underlying security has been deposited is
determined to be an association taxable as a corporation, instead of a
non-taxable entity, the yield on the underlying security would be reduced in
recognition of any taxes paid.
INVERSE FLOATERS
The Fund may invest in Municipal Obligations on which the rate of interest
varies inversely with interest rates on other Municipal Obligations or an index.
Such obligations include components of securities on which interest is paid in
two separate parts--an auction component, which pays interest at a rate that is
set periodically through an auction process or other method, and a residual
component, which pays interest at a rate equal to the difference between the
rate that the issuer would have paid on a fixed-rate obligation at the time of
issuance and the rate paid on the auction component. The market value of an
inverse floater will be more volatile than that of a fixed-rate obligation and,
like most debt obligations, will vary inversely with changes in market interest
rates.
Because the interest rate paid to holders of residual components is
generally determined by subtracting the interest rate paid to the holders of
auction components from a fixed amount, the interest rate paid to residual
component holders will decrease as the auction component's rate increases and
increase as the auction component's rate decreases. Moreover, the extent of the
increases and decreases in market value of residual components may be larger
than comparable changes in the market value of an equal principal amount of a
fixed rate Municipal Obligation having similar credit quality, redemption
provisions and maturity.
PUT BONDS
Put bonds are municipal bonds which give the holder an unconditional right
to sell the bond back to the issuer or a remarketing agent at a specified price
and exercise date, which is typically well in advance of the bond's maturity
date. If the put is a 'one time only' put, the Fund ordinarily will sell the
bond or put the bond, depending on the more favorable price. If the bond has a
series of puts after the first put, the bond will be held as long as, in
Mitchell Hutchins' opinion, it is in the best interests of the Fund to do so.
The obligation to purchase the bond on the exercise date of the put may be
supported by a letter of credit or other credit support agreement from a bank,
insurance company or other financial institution, the credit standing of which
affects the credit standing of the obligation. There is no assurance that an
issuer or remarketing agent for a put bond will be able to
A-3
<PAGE>
repurchase the bond on the put exercise date if the Fund chooses to exercise its
right to put the bond back to the issuer or remarketing agent.
TENDER OPTION BONDS
Tender option bonds are long-term municipal securities sold by a bank
subject to a 'tender option' that gives the purchaser the right to tender them
to the bank at par plus accrued interest at designated times (the 'tender
option'). The tender option may be exercisable at intervals ranging from
bi-weekly to semi-annually, and the interest rate on the bonds is typically
reset at the end of the applicable interval in order to cause the bonds to have
a market value that approximates their par value. The tender option generally
would not be exercisable in the event of a default on, or significant
downgrading of, the underlying municipal securities. Therefore, the Fund's
ability to exercise the tender option will be affected by the credit standing of
both the bank involved and the issuer of the underlying securities. The Fund
does not expect to invest more than 5% of its net assets in tender option bonds
during the coming year.
MUNICIPAL DERIVATIVES
The Fund may invest in derivative securities that are Municipal
Obligations, or components thereof, that have been specially structured to
reflect investment characteristics ordinarily associated with other securities
or to have other special rights desired by investors. Generally, such securities
are designed to allow investors to take advantage of expected interest rate
trends or to hedge interest rate or other risks. The Fund does not expect to
invest more than 5% of its net assets in any particular form of municipal
derivative during the coming year other than detachable call options and
Municipal Obligations with embedded caps. Detachable call options are sold by
issuers of Municipal Obligations separately from the Municipal Obligations to
which the call options relate and permit the purchasers of the call options to
acquire the Municipal Obligations at the call price(s) and call date(s). In the
event that interest rates drop, the purchaser could exercise the call option to
acquire Municipal Obligations that yield above-market rates. The Fund expects
during the coming year only to acquire detachable call options relating to
Municipal Obligations that the Fund already owns or will acquire in the
immediate future and thereby, in effect, make such Municipal Obligations
non-callable so long as the Fund continues to hold the detachable call option.
Municipal Obligations with embedded caps provide for additional tax-free
payments for a stated period (generally a period that is shorter than the bond's
maturity) above the fixed-rated interest payable on the Municipal Obligation to
the extent that the average level of a particular index exceeds a specified base
level. The Fund would use Municipal Obligations with embedded caps to offset the
risk of increases in short-term interest rates while continuing to earn
tax-exempt income. Investments in municipal derivatives may be subject to the
same risks as floating rate Municipal Obligations, risks of adverse tax
determinations or, in the case of municipal derivatives used for hedging
purposes, risks similar to those for other hedging strategies. See 'Hedging and
Related Income Strategies'. The Fund will only invest in those municipal
derivatives that Mitchell Hutchins believes will facilitate the Fund's ability
to achieve its investment objective.
A-4
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<PAGE>
================================================================================
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS NOT CONTAINED IN THIS PROSPECTUS IN CONNECTION WITH THE OFFERING
MADE BY THIS PROSPECTUS AND, IF GIVEN OR MADE, SUCH INFORMATION OR
REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE FUND OR
PAINEWEBBER. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFERING BY THE FUND OR BY
PAINEWEBBER IN ANY JURISDICTION IN WHICH SUCH OFFERING MAY NOT LAWFULLY BE MADE.
------------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
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<S> <C>
Fund Expenses................................... 2
Prospectus Summary.............................. 3
Financial Highlights............................ 9
The Fund........................................ 11
The Offering.................................... 11
Use of Proceeds................................. 11
Trading History................................. 11
Investment Objective and Policies............... 12
Insurance....................................... 13
Other Investment Practices...................... 15
Special Leverage Considerations................. 17
Management of the Fund.......................... 19
Dividends and Other Distributions; Dividend
Reinvestment Plan............................. 20
Taxes........................................... 22
Description of Capital Stock.................... 23
Custodian, Transfer and Dividend Disbursing
Agent and Registrar........................... 28
Further Information............................. 29
Table of Contents of Statement of Additional
Information................................... 29
Appendix A...................................... A-1
</TABLE>
================================================================================
================================================================================
INSURED MUNICIPAL
INCOME FUND INC.
COMMON STOCK
------------------------
P R O S P E C T U S
------------------------
PAINEWEBBER INCORPORATED
------------------------
AUGUST 1, 1996
================================================================================
(COPYRIGHT)1996 PAINEWEBBER, INC.
<PAGE>
INSURED MUNICIPAL INCOME FUND INC.
1285 AVENUE OF THE AMERICAS
NEW YORK, NEW YORK 10019
STATEMENT OF ADDITIONAL INFORMATION
Insured Municipal Income Fund Inc. ('Fund') is a diversified closed-end
management investment company. The Fund's investment objective is to achieve a
high level of current income that is exempt from federal income tax, consistent
with the preservation of capital. There is no assurance that the Fund will
achieve its investment objective.
Prior to April 12, 1996, the name of the Fund was 'PaineWebber Premier
Insured Municipal Income Fund Inc.' The Fund began doing business under the name
'Insured Municipal Income Fund' in August 1995, and shareholders approved a
change of the Fund's name to 'Insured Municipal Income Fund Inc.' on April 11,
1996.
Shares of the Fund's common stock ('Common Stock') may be offered from time
to time in order to effect over-the-counter ('OTC') secondary market sales by
PaineWebber Incorporated ('PaineWebber') in its capacity as a dealer and
secondary market-maker. PaineWebber may (but is not obligated to) make such a
secondary market.
Mitchell Hutchins Asset Management Inc. ('Mitchell Hutchins'), a wholly
owned subsidiary of PaineWebber, serves as investment adviser and administrator
of the Fund. This Statement of Additional Information ('SAI') is not a
prospectus and should be read only in conjunction with the Fund's current
Prospectus, dated August 1, 1996. Capitalized terms not otherwise defined herein
have the same meanings as in the Prospectus. Certain terms relating to the
Fund's Auction Preferred Shares ('APS') are defined in the Fund's Articles
Supplementary, which are on file with the Securities and Exchange Commission
('SEC'), Washington, D.C., as an exhibit to the registration statement of which
this Statement of Additional Information forms a part and may be obtained from
the SEC upon payment of the fee prescribed or inspected at the SEC's office at
no charge. A copy of the Prospectus may be obtained by contacting PaineWebber at
1285 Avenue of the Americas, New York, New York 10019, or calling toll free
1-800-852-4750. This Statement of Additional Information is dated August 1,
1996.
INVESTMENT POLICIES AND RESTRICTIONS
The following supplements the information contained in the Prospectus
concerning the Fund's investment policies and limitations.
RATINGS AS INVESTMENT CRITERIA
Moody's Investors Service, Inc. ('Moody's'), Standard & Poor's, a division
of The McGraw Hill Companies Inc. ('S&P'), and the other nationally recognized
statistical rating organizations ('NRSROs') are private services that provide
ratings of the credit quality of debt obligations, including Municipal
Obligations. It should be emphasized that ratings are general and are not
absolute standards of quality. Consequently, Municipal Obligations with the same
maturity, interest rate and rating may have different market prices. Also,
rating agencies may fail to make timely changes in credit ratings in response to
subsequent events, so that an issuer's financial condition may be better or
worse than is indicated by its rating. A description of Moody's and S&P's
ratings is included in Appendix A to this SAI.
<PAGE>
APS RATING AGENCY GUIDELINES
The Fund intends that, so long as the APS are outstanding, the composition
of its portfolio will reflect guidelines established by Moody's and S&P in
connection with their respective ratings of the APS. See Appendix B to this SAI.
MUNICIPAL OBLIGATIONS
Municipal Obligations, like other debt obligations, are subject to the risk
of non-payment. The ability of issuers of Municipal Obligations to make timely
payments of interest and principal may be adversely impacted in general economic
downturns and as relative governmental cost burdens are allocated and
reallocated among federal, state and local governmental units. Such non-payment
would result in a reduction of income to the Fund, and could result in a
reduction in the value of the Municipal Obligation experiencing non-payment and
a potential decrease in the net asset value of the Fund. Issuers of Municipal
Obligations might seek protection under the bankruptcy laws. In the event of
bankruptcy of such an issuer, the Fund could experience delays and limitations
with respect to the collection of principal and interest on such Municipal
Obligations and the Fund may not, in all circumstances, be able to collect all
principal and interest to which it is entitled. To enforce its rights in the
event of a default in the payment of interest or repayment of principal, or
both, the Fund may take possession of and manage the assets securing the
issuer's obligations on such securities, which may increase the Fund's operating
expenses and adversely affect the net asset value of the Fund.
The Fund may invest up to 20% of its total assets in Municipal Obligations
that are not insured but are backed by an escrow or trust account which contains
securities issued or guaranteed by the U.S. government or U.S. government
agencies sufficient in amount to ensure the payment of interest and principal on
the original interest payment and maturity dates ('collateralized obligations').
Such collateralized obligations may not have received a rating from Moody's, S&P
or another NRSRO. Such collateralized obligations will include, but are not
limited to, Municipal Obligations that have been (i) advance refunded where the
proceeds of the refunding have been used to purchase U.S. government or U.S.
government agency securities that are placed in escrow and whose interest or
maturing principal payments, or both, are sufficient to cover the remaining
scheduled debt service on the Municipal Obligations, or (ii) issued under state
and local housing finance programs which use the issuance proceeds to fund
mortgages that are then exchanged for U.S. government or U.S. government agency
securities and deposited with a trustee as security for the Municipal
Obligations. Such collateralized obligations are normally regarded by market
participants as having the credit characteristics of the underlying U.S.
government or U.S. government agency securities.
Under normal circumstances, the Fund does not invest 25% or more of its
total assets in any one industry. Governmental issuers of Municipal Obligations
are not considered part of any industry and, therefore, are not subject to this
limitation. Municipal Obligations backed only by the assets and revenues of
non-governmental entities, however, are considered to be issued by such
non-governmental entities and would be subject to this limitation. The Fund
reserves the right to invest more than 25% of its assets in issuers located in
the same state, although it has no present intention of doing so during the
coming year. Current rating agency requirements applicable to the rating of the
Fund's APS prohibit such investment. If the Fund were to invest more than 25% of
its total assets in issuers located in the same state, it would be more
susceptible to adverse economic, business or regulatory conditions in that
state.
INSURANCE FOR MUNICIPAL OBLIGATIONS
Effect of Insurance on Municipal Obligations. Municipal Obligations covered
by Original Issue Insurance or Secondary Market Insurance are themselves
assigned a rating of Aaa by Moody's, AAA by S&P or an equivalent rating from
another NRSRO, as the case may be, by virtue of such Aaa, AAA or equivalent
claims-
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paying ability of the insurer, and would generally be assigned a lower rating if
the rating were based primarily upon the credit characteristics of the issuer
without regard to the insurance feature. In the event Moody's, S&P or another
NRSRO should downgrade its assessment of the claims-paying ability of a
particular insurer, it could also be expected to downgrade the ratings assigned
to Municipal Obligations insured under Original Issue Insurance or Secondary
Market Insurance issued by such insurer.
The ratings, if any, assigned to Municipal Obligations insured under
Portfolio Insurance will be based primarily upon the credit characteristics of
the issuer without regard to the insurance feature, and will generally carry a
rating that is below Aaa or AAA. While in the portfolio of the Fund, however, a
Municipal Obligation backed by Portfolio Insurance will effectively be of the
same quality as a Municipal Obligation issued by an issuer of comparable credit
characteristics that is backed by Original Issue Insurance or Secondary Market
Insurance. In the event Moody's, S&P or another NRSRO should downgrade the
rating of the issuer of the Portfolio Insurance, the Municipal Obligations
insured under Portfolio Insurance issued by such insurer also would be of
reduced quality in the portfolio of the Fund.
Moody's, S&P and other NRSROs continually assess the claims-paying ability
of insurers and the credit characteristics of insurers and issuers, and there
can be no assurance that they will not downgrade their assessments subsequent to
the time the Fund purchases securities. A description of Moody's and S&P's
ratings of insurance companies' claims-paying ability is included in Appendix A
to this SAI.
Original Issue Insurance. Original Issue Insurance typically is purchased
from insurance companies, through payment of a single premium, with respect to a
particular issue of Municipal Obligations by the issuer thereof or a third party
(such as the underwriter) in conjunction with the original issuance of such
Municipal Obligations. Under such insurance, the insurer unconditionally insures
to the holder of the insured Municipal Obligation the timely payment of
principal and interest on such obligation when and as such payments shall become
due but shall not be paid by the issuer, except that in the event of any
acceleration of the due date of the principal by reason of mandatory or optional
redemption (other than acceleration by reason of a mandatory sinking fund
payment), default or otherwise, the payments insured may be made in such amounts
and at such times as payments of principal would have been due had there not
been such acceleration. The insurer is responsible for such payments less any
amounts received by the holder from any trustee for the Municipal Obligation
issuers or from any other source.
In the event that interest on or principal of a Municipal Obligation
covered by insurance is due for payment but is unpaid by reason of nonpayment by
the issuer thereof, the applicable insurer will make payments to its fiscal
agent ( 'Fiscal Agent') equal to such unpaid amounts of principal and interest
not later than one business day after the insurer has been notified that such
nonpayment has occurred (but not earlier than the date such payment is due). The
Fiscal Agent will disburse to the Fund the amount of principal and interest
which is then due for payment but is unpaid upon receipt by the Fiscal Agent of
(i) evidence of the Fund's right to receive payment of such principal and
interest and (ii) evidence, including any appropriate instruments of assignment,
that all of the rights of payment of such principal or interest then due for
payment shall thereupon vest in the insurer. Upon payment by the insurer of any
principal or interest payments with respect to any Municipal Obligations, the
insurer will succeed to the rights of the Fund with respect to such payment.
Original Issue Insurance remains in effect as long as the Municipal
Obligations covered thereby remain outstanding and the insurer remains in
business, regardless of whether the Fund ultimately disposes of such Municipal
Obligations. Consequently, Original Issue Insurance may be considered to
represent an element of market value with respect to the Municipal Obligations
so insured, but the exact effect, if any, of this insurance on such market value
cannot be estimated.
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Secondary Market Insurance. Subsequent to the time of original issuance of
a Municipal Obligation, the Fund or a third party may, upon the payment of a
single premium, purchase insurance on such Municipal Obligation. Secondary
Market Insurance generally provides the same type of coverage as is provided by
Original Issue Insurance and, as is the case with Original Issue Insurance,
Secondary Market Insurance remains in effect as long as the Municipal
Obligations covered thereby remain outstanding and the insurer remains in
business, regardless of whether the Fund ultimately disposes of such Municipal
Obligations. All premiums respecting Municipal Obligations covered by Original
Issue Insurance or Secondary Market Insurance are paid in advance by the issuer
or other party obtaining the insurance.
One of the purposes of acquiring Secondary Market Insurance with respect to
a particular Municipal Obligation would be to enable the Fund to enhance the
value of such Municipal Obligation. The Fund, for example, might seek to
purchase a particular Municipal Obligation and obtain Secondary Market Insurance
with respect thereto if, in the opinion of Mitchell Hutchins, the market value
of such municipal security, as insured, would exceed the current value of the
Municipal Obligation without insurance plus the cost of the Secondary Market
Insurance. Similarly, if the Fund owns but wishes to sell a Municipal Obligation
that is then covered by Portfolio Insurance, the Fund might seek to obtain
Secondary Market Insurance with respect thereto if, in the opinion of Mitchell
Hutchins, the net proceeds of a sale by the Fund of such obligation, as insured,
would exceed the current value of such obligation plus the cost of the Secondary
Market Insurance.
Portfolio Insurance. The Fund currently intends to emphasize investments in
Municipal Obligations that have Original Issue Insurance or Secondary Market
Insurance. However, the Fund may purchase one or more policies of Portfolio
Insurance, each of which would insure the payment of principal and interest on
specified eligible Municipal Obligations purchased by the Fund. Except as
described below, Portfolio Insurance generally provides the same type of
coverage as is provided by Original Issue Insurance or Secondary Market
Insurance. Municipal Obligations insured under one Portfolio Insurance policy
generally would not be insured under any other policy purchased by the Fund
unless the Fund intended to purchase Secondary Market Insurance to facilitate
sale of particular Municipal Obligations. A Municipal Obligation is eligible for
coverage under a policy if it meets certain requirements of the insurer.
Portfolio Insurance is intended to reduce financial risk, but the cost thereof
and compliance with investment restrictions imposed under the policy will reduce
the yield to Common Stockholders of the Fund.
Portfolio Insurance policies are effective only as to Municipal Obligations
owned and held by the Fund, and do not cover Municipal Obligations for which the
contract for purchase of such Municipal Obligation fails. A 'when-issued'
Municipal Obligation will be covered under a Portfolio Insurance policy upon the
settlement date of the issue of such 'when-issued' Municipal Obligation.
In determining whether to insure Municipal Obligations held by the Fund, an
insurer will apply its own standards, which would be expected to correspond
generally to the standards it has established for determining the insurability
of new issues of Municipal Obligations. See 'Original Issue Insurance' above.
Any Portfolio Insurance policy purchased by the Fund will be
non-cancellable and will remain in effect so long as the Fund is in existence,
the Municipal Obligations covered by the policy continue to be held by the Fund,
and the Fund pays the premiums for the policy. Each insurer generally will
reserve the right at any time upon 90 days' written notice to the Fund to refuse
to insure any additional securities purchased by the Fund after the effective
date of such notice. The board of directors of the Fund generally will reserve
the right to terminate each policy upon seven days' written notice to an insurer
if it determines that the cost of such policy is not reasonable in relation to
the value of the insurance to the Fund.
Each Portfolio Insurance policy will terminate as to any Municipal
Obligation that has been redeemed from or sold by the Fund on the date of such
redemption or the settlement date of such sale, and an insurer will not
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have any liability thereafter under a policy as to any such Municipal
Obligation, except that if the date of such redemption or the settlement date of
such sale occurs after a record date and before the related payment date with
respect to any such Municipal Obligation, the policy will terminate as to such
Municipal Obligation on the business day immediately following such payment
date. Each policy will terminate as to all Municipal Obligations covered thereby
on the date on which the last of the covered Municipal Obligations mature, are
redeemed or are sold by the Fund.
One or more policies of Portfolio Insurance may provide the Fund, pursuant
to an irrevocable commitment of the insurer, with the option to exercise the
right to obtain permanent insurance ('Permanent Insurance') (which would be
Secondary Market Insurance) with respect to a Municipal Obligation that is to be
sold by the Fund. The Fund would exercise the right to obtain Permanent
Insurance upon payment of a single, predetermined insurance premium payable from
the proceeds of the sale of such Municipal Obligation. It is expected that the
Fund would exercise the right to obtain Permanent Insurance for a Municipal
Obligation, only if, in the opinion of Mitchell Hutchins, upon such exercise the
net proceeds from the sale by the Fund of such obligation, as insured, would
exceed the proceeds from the sale of such obligation without insurance. The
Permanent Insurance premium with respect to each such obligation is determined
based upon the insurability of each such obligation as of the date of purchase
by the Fund and will not be increased or decreased for any change in the
creditworthiness of such obligation unless such obligation is in default as to
payment of principal or interest, or both. In such event, the Permanent
Insurance premium shall be subject to an increase predetermined at the date of
purchase by the Fund.
Because each Portfolio Insurance policy will terminate as to Municipal
Obligations sold by the Fund on the date of sale, in which event the insurer
will be liable only for those payments of principal and interest that are then
due and owing (unless Permanent Insurance is obtained by the Fund), the
provision for this insurance will not enhance the marketability of securities
held by the Fund. The Fund generally intends to retain any insured securities
covered by Portfolio Insurance that are in default or in significant risk of
default. To the extent that the Fund holds such defaulted securities, it may be
limited in its ability to manage its investment portfolio and to purchase other
Municipal Obligations. On the other hand, since Original Issue Insurance and
Secondary Market Insurance will remain in effect as long as Municipal
Obligations covered thereby are outstanding, such insurance may enhance the
marketability of such securities even when such securities are in default or in
significant risk of default, but the exact effect, if any, on the marketability
cannot be estimated. Accordingly, the Fund may determine to retain or,
alternatively, to sell Municipal Obligations covered by Original Issue Insurance
or Secondary Market Insurance that are in default or in significant risk of
default.
It is anticipated that certain of the Municipal Obligations to be purchased
by the Fund will be insured under policies obtained by persons other than the
Fund. In instances in which the Fund purchases Municipal Obligations insured
under policies obtained by persons other than the Fund, the Fund does not pay
the premiums for such policies; rather the cost of such policies may be
reflected in a higher purchase price for such Municipal Obligations.
Accordingly, the yield on such Municipal Obligations may be lower than that on
similar uninsured Municipal Obligations. Premiums for a Portfolio Insurance
policy generally would be paid by the Fund monthly, and adjusted for purchases
and sales of Municipal Obligations covered by the policy during the month. The
yield on the Fund's portfolio is reduced to the extent of the insurance premiums
paid by the Fund which, in turn, will depend upon the characteristics of the
covered Municipal Obligations held by the Fund. In the event the Fund were to
purchase Secondary Market Insurance with respect to any Municipal Obligations
then covered by a Portfolio Insurance policy, the coverage and the obligation of
the Fund to pay monthly premiums under such policy would cease with such
purchase.
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WHEN-ISSUED AND DELAYED DELIVERY SECURITIES
As stated in the Prospectus, the Fund may purchase Municipal Obligations on
a when-issued basis, or may purchase or sell Municipal Obligations for delayed
delivery. A security purchased on a when-issued or delayed delivery basis is
recorded as an asset on the commitment date and is subject to changes in market
value, generally based upon changes in the level of interest rates. Thus,
fluctuations in the value of the security from the time of the commitment date
will affect the Fund's net asset value. When the Fund commits to purchase
securities on a when-issued or delayed delivery basis, its custodian will set
aside in a segregated account cash or liquid securities with a value, marked to
market daily, not less than the amount of the commitment. If necessary,
additional assets will be placed in the account daily so that the value of the
account will equal or exceed the amount of the Fund's purchase commitment.
STAND-BY COMMITMENTS
The Fund may acquire 'stand-by commitments' with respect to Municipal
Obligations it purchases or holds. Under a stand-by commitment, which resembles
a put option, a broker, dealer or bank is obligated to repurchase at the Fund's
option specified securities at a specified price. The Fund's ability to exercise
a stand-by commitment is subject to the ability of the seller to make payment on
demand. The Fund will acquire stand-by commitments solely to facilitate
liquidity and does not intend to exercise the rights afforded by the commitments
for trading purposes. The Fund anticipates that stand-by commitments will be
available from brokers, dealers, and banks without the payment of any direct or
indirect consideration. The Fund may pay for stand-by commitments if payment is
deemed necessary, thus increasing to a degree the cost of the underlying
Municipal Obligation and similarly decreasing the obligation's yield.
The Fund would enter into stand-by commitments only with those brokers,
banks or dealers that, in the opinion of Mitchell Hutchins, present minimal
credit risks. The Fund's right to exercise stand-by commitments would be
unconditional and unqualified. A stand-by commitment would not be transferable
by the Fund, although the Fund could sell the underlying securities to a third
party at any time. The acquisition of a stand-by commitment would not ordinarily
affect the valuation or maturity of the underlying Municipal Obligations.
REPURCHASE AGREEMENTS AND REVERSE REPURCHASE AGREEMENTS
The Fund is authorized to enter into repurchase agreements with respect to
any obligation issued or guaranteed by the U.S. government, its agencies or
instrumentalities and also with respect to commercial paper, bank certificates
of deposit and bankers' acceptances. Repurchase agreements are transactions in
which the Fund would purchase securities from a bank or recognized securities
dealer and simultaneously commit to resell those securities to the bank or
dealer at an agreed-upon date and price reflecting a market rate of interest
unrelated to the coupon rate or maturity of the purchased securities. The Fund
would maintain custody of the underlying securities prior to their repurchase;
thus, the obligation of the bank or securities dealer to pay the repurchase
price on the date agreed to would, in effect, be secured by such securities. If
the value of such securities were less than the repurchase price, plus any
agreed-upon additional amount, the other party to the agreement would be
required to provide additional collateral so that at all times the collateral is
at least equal to the repurchase price, plus any agreed-upon additional amount.
The difference between the total amount to be received upon repurchase of the
securities and the price which was paid by the Fund upon acquisition would be
accrued as interest and included in the Fund's net investment income.
Repurchase agreements carry certain risks not associated with direct
investments in securities, including possible declines in the market value of
the underlying securities and delays and costs to the Fund if the other party to
the repurchase agreement becomes insolvent. The Fund intends to enter into
repurchase agreements only with banks and dealers in transactions believed by
Mitchell Hutchins to present minimal credit risks in
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accordance with guidelines established by the Fund's board of directors.
Mitchell Hutchins will review and monitor the creditworthiness of such
institutions under the board's general supervision.
The Fund may also enter into reverse repurchase agreements with the same
parties with whom it may enter into repurchase agreements. Under a reverse
repurchase agreement, the Fund would sell securities and agree to repurchase
(and the buyer would be required to resell) them at a mutually agreed date and
price. At the time the Fund enters into a reverse repurchase agreement, it will
establish and maintain a segregated account with an approved custodian
containing cash or liquid securities having a value, marked to market daily, not
less than the repurchase price (including accrued interest). The market value of
securities sold under reverse repurchase agreements typically is greater than
the proceeds of the sale, and accordingly, the market value of the securities
sold is likely to be greater than the value of the securities in which the Fund
invests those proceeds. Thus, reverse repurchase agreements involve the risk
that the buyer of the securities sold by the Fund might be unable to deliver
them when the Fund seeks to repurchase. In the event the buyer of securities
under a reverse repurchase agreement files for bankruptcy or becomes insolvent,
such buyer or its trustee or receiver may receive an extension of time to
determine whether to enforce the Fund's obligation to repurchase the securities,
and the Fund's use of the proceeds of the reverse repurchase agreement may
effectively be restricted pending such decision.
Reverse repurchase agreements will be treated as borrowings for purposes of
calculating the Fund's borrowing limitation. In addition to the foregoing
borrowings, the Fund may borrow money for emergency or temporary purposes (e.g.,
clearance of transactions, share repurchases or tender offers) in an amount not
exceeding 5% of the value of the Fund's total assets (not including the amount
borrowed). See 'Investment Limitations.'
ILLIQUID SECURITIES
As noted in the Prospectus, the Fund may invest up to 20% of its net assets
in illiquid securities. The board of directors has delegated the function of
making day-to-day determinations of liquidity to Mitchell Hutchins, pursuant to
guidelines approved by the board. Mitchell Hutchins takes into account a number
of factors in reaching liquidity decisions, including: (1) the frequency of
trades for the security; (2) the number of dealers that make quotes for the
security; (3) the number of dealers that have undertaken to make a market in the
security; (4) the number of other potential purchasers; and (5) the nature of
the security and how trading is effected (e.g., the time needed to sell the
security, how offers are solicited and the mechanics of transfer). Mitchell
Hutchins monitors the liquidity of securities in the Fund's portfolio and
reports periodically on liquidity decisions to the board of directors.
In making determinations as to the liquidity of municipal lease
obligations, Mitchell Hutchins will distinguish between direct investments in
municipal lease obligations (or participations therein) and investments in
securities that may be supported by municipal lease obligations or certificates
of participation therein. Since these municipal lease obligation-backed
securities are based on a well-established means of securitization, Mitchell
Hutchins does not believe that investing in such securities presents the same
liquidity issues as direct investments in municipal lease obligations. The
assets used as cover for any OTC options written by the Fund would be considered
illiquid unless the OTC options are sold to qualified dealers who agree that the
Fund may repurchase any OTC option it writes at a maximum price to be calculated
by a formula set forth in the option agreement. The cover for an OTC option
written subject to this procedure will be considered illiquid only to the extent
that the maximum repurchase price under the formula exceeds the intrinsic value
of the option.
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SHORT SALES 'AGAINST THE BOX'
The Fund may engage in short sales of securities it owns or has the right
to acquire at no added cost through conversion or exchange of other securities
it owns (short sales 'against the box'). A short sale is effected by selling a
security and having the executing broker borrow the securities being sold on
behalf of the Fund. The Fund is obligated to replace the borrowed securities at
a date in the future. When the Fund sells short, it will establish a margin
account with the broker effecting the short sale and will deposit collateral
with the broker. In addition, the Fund will maintain with its custodian, in a
segregated account, the securities that could be used to cover the short sale.
The Fund will incur transaction costs, including interest expense, in connection
with opening, maintaining and closing short sales against the box. The Fund
currently does not intend to have obligations under short sales that at any time
during the coming year exceed 5% of the Fund's net assets.
The Fund might make a short sale 'against the box' in order to hedge
against market risks when Mitchell Hutchins believes that the price of a
security may decline, thereby causing a decline in the value of a security owned
by the Fund or a security convertible into or exchangeable for a security owned
by the Fund, or when Mitchell Hutchins wants to sell a security that the Fund
owns at a current price, but also wishes to defer recognition of gain or loss
for federal income tax purposes. In such case, any loss in the Fund's long
position after the short sale should be reduced by a gain in the short position.
Conversely, any gain in the long position should be reduced by a loss in the
short position. The extent to which gains or losses in the long position are
reduced will depend upon the amount of the securities sold short relative to the
amount of the securities the Fund owns, either directly or indirectly, and in
the case where the Fund owns convertible securities, changes in the investment
values or conversion premiums of such securities.
INVESTMENT LIMITATIONS
The following fundamental investment limitations cannot be changed without
the affirmative vote of the lesser of (a) more than 50% of the outstanding
shares of the Fund or (b) 67% or more of such shares present at a stockholders'
meeting if more than 50% of the outstanding shares are represented at the
meeting in person or by proxy. If a percentage restriction is adhered to at the
time of an investment or transaction, a later increase or decrease in percentage
resulting from a change in values of portfolio securities or the amount of total
assets will not be considered a violation of any of the following limitations or
of any of the Fund's investment policies. The Fund will not:
(1) purchase securities of any one issuer if, as a result, more than
5% of the Fund's total assets would be invested in securities of that
issuer or the Fund would own or hold more than 10% of the outstanding
voting securities of that issuer, except that up to 25% of the Fund's total
assets may be invested without regard to this limitation, and except that
this limitation does not apply to securities issued or guaranteed by the
U.S. government, its agencies and instrumentalities or to securities issued
by other investment companies.
(2) purchase any security if, as a result of that purchase, 25% or
more of the Fund's total assets would be invested in securities of issuers
having their principal business activities in the same industry, except
that this limitation does not apply to securities issued or guaranteed by
the U.S. government, its agencies or instrumentalities or to municipal
securities.
(3) issue senior securities (including borrowing money from banks and
other entities and through reverse repurchase agreements), except (a) the
Fund may borrow in an amount not in excess of 33 1/3% of total assets
(including the amount of senior securities issued, but reduced by any
liabilities and indebtedness not constituting senior securities), (b) the
Fund may issue preferred stock having a liquidation preference in an amount
which, combined with the amount of any liabilities or indebtedness
constituting senior securities,
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is not in excess of 50% of its total assets (computed as provided in clause
(a) above) and (c) the Fund may borrow up to an additional 5% of its total
assets (not including the amount borrowed) for temporary or emergency
purposes.
(4) make loans, except through loans of portfolio securities or
through repurchase agreements, provided that for purposes of this
restriction, the acquisition of bonds, debentures, other debt securities or
instruments, or participations or other interests therein and investments
in government obligations, commercial paper, certificates of deposit,
bankers' acceptances or similar instruments will not be considered the
making of a loan.
(5) engage in the business of underwriting securities of other
issuers, except to the extent that the Fund might be considered an
underwriter under the federal securities laws in connection with its
disposition of portfolio securities.
(6) purchase or sell real estate, except that investments in
securities of issuers that invest in real estate and investments in
mortgage-backed securities, mortgage participations or other instruments
supported by interests in real estate are not subject to this limitation,
and except that the Fund may exercise rights under agreements relating to
such securities, including the right to enforce security interests and to
hold real estate acquired by reason of such enforcement until that real
estate can be liquidated in an orderly manner.
(7) purchase or sell physical commodities unless acquired as a result
of owning securities or other instruments, but the Fund may purchase, sell
or enter into financial options and futures, forward and spot currency
contracts, swap transactions and other financial contracts or derivative
instruments.
The following interpretation applies to, but is not a part of,
fundamental limitation (1):
Each state (including the District of Columbia and Puerto
Rico), territory and possession of the United States, each
political subdivision, agency, instrumentality and authority
thereof, and each multi-state agency of which a state is a
member is a separate 'issuer.' When the assets and revenues of
an agency, authority, instrumentality or other political
subdivision are separate from the government creating the
subdivision and the security is backed only by the assets and
revenues of the subdivision, such subdivision would be deemed
to be the sole issuer. Similarly, in the case of an Industrial
Development Bond or Private Activity Bond, if that bond is
backed only by the assets and revenues of the non-governmental
user, then that non-governmental user would be deemed to be the
sole issuer. However, if the creating government or another
entity guarantees a security, then to the extent that the value
of all securities issued or guaranteed by that government or
entity and owned by the Fund exceeds 10% of the Fund's total
assets, the guarantee would be considered a separate security
and would be treated as issued by that government or entity.
This restriction does not limit the percentage of the Fund's
assets that may be invested in Municipal Obligations insured by
any given insurer.
The following investment restrictions are not fundamental and may be
changed by the Fund's board of directors without shareholder approval.
The Fund will not:
(1) purchase securities on margin, except for short-term credit
necessary for clearance of portfolio transactions and except that the Fund
may make margin deposits in connection with its use of financial options
and futures, forward and spot currency contracts, swap transactions and
other financial contracts or derivative instruments.
(2) engage in short sales of securities or maintain a short position,
except that the Fund may (a) sell short 'against the box' and (b) maintain
short positions in connection with its use of financial options and
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futures, forward and spot currency contracts, swap transactions and other
financial contracts or derivative instruments.
(3) invest in oil, gas or mineral exploration or development programs
or leases, except that investments in securities of issuers that invest in
such programs or leases and investments in asset-backed securities
supported by receivables generated from such programs or leases are not
subject to this prohibition.
HEDGING AND RELATED INCOME STRATEGIES
As discussed in the Prospectus, Mitchell Hutchins may use a variety of
financial instruments ('Hedging Instruments'), including certain options,
futures contracts (sometimes referred to as 'futures'), options on futures
contracts and interest rate protection transactions, to attempt to hedge the
Fund's portfolio and may use options to attempt to enhance the Fund's income.
The Fund may enter into options, futures and interest rate protection
transactions that approximate (but do not exceed) the full value of its
portfolio. Any income realized from the use of options and futures would be
taxable to stockholders.
Hedging strategies can be broadly categorized as 'short hedges' and 'long
hedges.' A short hedge is a purchase or sale of a Hedging Instrument intended to
partially or fully offset potential declines in the value of one or more
investments held in the Fund's portfolio. Thus, in a short hedge the Fund takes
a position in a Hedging Instrument the price of which is expected to move in the
opposite direction of the price of the investment being hedged. For example, the
Fund might purchase a put option on a security to hedge against a potential
decline in the value of that security. If the price of the security declined
below the exercise price of the put, the Fund could exercise the put and thus
limit its loss below the exercise price to the premium paid plus transaction
costs. In the alternative, because the value of the put option can be expected
to increase as the value of the underlying security declines, the Fund might be
able to close out the put option and realize a gain to offset the decline in the
value of the security.
Conversely, a long hedge is a purchase or sale of a Hedging Instrument
intended partially or fully to offset potential increases in the acquisition
cost of one or more investments that the Fund intends to acquire. Thus, in a
long hedge the Fund takes a position in a Hedging Instrument the price of which
is expected to move in the same direction as the price of the prospective
investment being hedged. For example, the Fund might purchase a call option on a
security it intends to purchase in order to hedge against an increase in the
cost of the security. If the price of the security increased above the exercise
price of the call, the Fund could exercise the call and thus limit its
acquisition cost to the exercise price plus the premium paid and transaction
costs. Alternatively, the Fund might be able to offset the price increase by
closing out an appreciated call option and realizing a gain.
Hedging Instruments on securities generally are used to hedge against price
movements in one or more particular securities positions that the Fund owns or
intends to acquire. Hedging Instruments on debt securities may be used to hedge
either individual securities or broad fixed income market sectors.
The use of Hedging Instruments is subject to applicable regulations of the
SEC, the several options and futures exchanges upon which they are traded and
the Commodity Futures Trading Commission ('CFTC') and may become subject to
regulation by various state regulatory authorities. In addition, the Fund's
ability to use Hedging Instruments will be limited by tax considerations. See
'Taxes.'
In addition to the products, strategies and risks described below, Mitchell
Hutchins expects additional opportunities to develop in connection with options,
futures contracts and other hedging techniques. These new opportunities may
become available as Mitchell Hutchins develops new techniques, as regulatory
authorities broaden the range of permitted transactions and as new options,
futures contracts or other techniques are developed. Mitchell Hutchins may
utilize these opportunities to the extent that they are consistent with the
Fund's investment objective and permitted by the Fund's investment limitations
and applicable regulatory authorities.
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SPECIAL RISKS OF HEDGING STRATEGIES
The use of Hedging Instruments involves special considerations and risks,
as described below. Risks pertaining to particular Hedging Instruments are
described in the sections that follow.
(1) Successful use of most Hedging Instruments depends upon Mitchell
Hutchins' ability to predict movements of the overall securities and interest
rate markets, which requires different skills than predicting changes in the
prices of individual securities. While Mitchell Hutchins is experienced in the
use of Hedging Instruments, there can be no assurance that any particular
hedging strategy adopted will succeed.
(2) There might be imperfect correlation, or even no correlation, between
price movements of a Hedging Instrument and price movements of the investments
being hedged. For example, if the value of a Hedging Instrument used in a short
hedge increased by less than the decline in value of the hedged investment, the
hedge would not be fully successful. Such a lack of correlation might occur due
to factors unrelated to the value of the investments being hedged, such as
speculative or other pressures on the markets in which Hedging Instruments are
traded. The effectiveness of hedges using Hedging Instruments on indexes will
depend on the degree of correlation between price movements in the index and
price movements in the securities being hedged.
(3) Hedging strategies, if successful, can reduce risk of loss by wholly or
partially offsetting the negative effect of unfavorable price movements in the
investments being hedged. However, hedging strategies can also reduce
opportunity for gain by offsetting the positive effect of favorable price
movements in the hedged investments. For example, if the Fund entered into a
short hedge because Mitchell Hutchins projected a decline in the price of a
security in the Fund's portfolio, and the price of that security increased
instead, the gain from that increase might be wholly or partially offset by a
decline in the price of the Hedging Instrument. Moreover, if the price of the
Hedging Instrument declined by more than the increase in the price of the
security, the Fund could suffer a loss. In either such case, the Fund would have
been in a better position had it not hedged at all.
(4) As described below, the Fund might be required to maintain assets as
'cover,' maintain segregated accounts or make margin payments when it takes
positions in Hedging Instruments involving obligations to third parties (i.e.,
Hedging Instruments other than purchased options). If the Fund were unable to
close out its positions in such Hedging Instruments, it might be required to
continue to maintain such assets or accounts or make such payments until the
position expired or matured. These requirements might impair the Fund's ability
to sell a portfolio security or make an investment at a time when it would
otherwise be favorable to do so, or require that the Fund sell a portfolio
security at a disadvantageous time. The Fund's ability to close out a position
in a Hedging Instrument prior to expiration or maturity depends on the existence
of a liquid secondary market or, in the absence of such a market, the ability
and willingness of a contra party to enter into a transaction closing out the
position. Therefore, there is no assurance that any hedging position can be
closed out at a time and price that is favorable to the Fund.
COVER FOR HEDGING STRATEGIES
Transactions using Hedging Instruments, other than purchased options,
expose the Fund to an obligation to another party. The Fund will not enter into
any such transactions unless it owns either (1) an offsetting ('covered')
position in securities or other options or futures contracts or (2) cash and
liquid, short-term debt securities, with a value sufficient at all times to
cover its potential obligations to the extent not covered as provided in (1)
above. The Fund will comply with SEC guidelines regarding cover for hedging
transactions and will, if the guidelines so require, set aside cash or liquid
securities in a segregated account with its custodian in the prescribed amount,
marked to market daily.
Assets used as cover or held in a segregated account cannot be sold while
the position in the corresponding Hedging Instrument is open, unless they are
replaced with similar assets. As a result, the commitment of a large
11
<PAGE>
portion of the Fund's assets to cover or segregated accounts could impede
portfolio management or the Fund's ability to meet redemption requests or other
current obligations.
OPTIONS
The Fund may purchase put and call options, and write (sell) covered call
options and covered put options, on debt securities. The purchase of call
options serves as a long hedge, and the purchase of put options serves as a
short hedge. Writing covered put or call options can enable the Fund to enhance
income by reason of the premiums paid by the purchasers of such options.
However, if the market price of the security underlying a covered put option
declines to less than the exercise price on the option, minus the premium
received, the Fund would expect to suffer a loss. Writing covered call options
serves as a limited short hedge, because declines in the value of the hedged
investment would be offset to the extent of the premium received for writing the
option. However, if the security appreciates to a price higher than the exercise
price of the call option, it can be expected that the option will be exercised
and the Fund will be obligated to sell the security at less than its market
value. If the covered call option is an OTC option, the securities or other
assets used as cover would be considered illiquid to the extent described under
'Investment Policies and Restrictions--Illiquid Securities.'
The value of an option position will reflect, among other things, the
current market value of the underlying investment, the time remaining until
expiration, the relationship of the exercise price to the market price of the
underlying investment, the historical price volatility of the underlying
investment and general market conditions. Options normally have expiration dates
of up to nine months. Options that expire unexercised have no value.
The Fund may effectively terminate its right or obligation under an option
by entering into a closing transaction. For example, the Fund may terminate its
obligation under a call option that it had written by purchasing an identical
call option; this is known as a closing purchase transaction. Conversely, the
Fund may terminate a position in a put or call option it had purchased by
writing an identical put or call option; this is known as a closing sale
transaction. Closing transactions permit the Fund to realize profits or limit
losses on an option position prior to its exercise or expiration.
The Fund may purchase or write both exchange-traded and OTC options.
However, exchange-traded or liquid OTC options on Municipal Obligations are not
currently available. Exchange-traded options in the United States are issued by
a clearing organization affiliated with the exchange on which the option is
listed which, in effect, guarantees completion of every exchange-traded option
transaction. In contrast, OTC options are contracts between the Fund and its
contra party (usually a securities dealer or a bank) with no clearing
organization guarantee. Thus, when the Fund purchases or writes an OTC option,
it relies on the contra party to make or take delivery of the underlying
investment upon exercise of the option. Failure by the contra party to do so
would result in the loss of any premium paid by the Fund as well as the loss of
any expected benefit of the transaction.
Generally, OTC options on debt securities are European style options. This
means that the option is only exercisable immediately prior to its expiration.
This is in contrast to American-style options, which are exercisable at any time
prior to the expiration date of the option.
The Fund's ability to establish and close out positions in exchange-listed
options depends on the existence of a liquid market. The Fund intends to
purchase or write only those exchange-traded options for which there appears to
be a liquid secondary market. However, there can be no assurance that such a
market will exist at any particular time. Closing transactions can be made for
OTC options only by negotiating directly with the contra party, or by a
transaction in the secondary market if any such market exists. Although the Fund
will enter into OTC options only with contra parties that are expected to be
capable of entering into closing transactions with the Fund, there is no
assurance that the Fund will in fact be able to close out an OTC option position
at a favorable
12
<PAGE>
price prior to expiration. In the event of insolvency of the contra party, the
Fund might be unable to close out an OTC option position at any time prior to
its expiration.
If the Fund were unable to effect a closing transaction for an option it
had purchased, it would have to exercise the option to realize any profit. The
inability to enter into a closing purchase transaction for a covered call option
written by the Fund could cause material losses because the Fund would be unable
to sell the investment used as cover for the written option until the option
expires or is exercised.
In the event that options on indexes of municipal and non-municipal debt
securities become available, the Fund may purchase and write put and call
options on such indexes in much the same manner as the more traditional options
discussed above, except that index options may serve as a hedge against overall
fluctuations in the debt securities market (or market sectors) rather than
anticipated increases or decreases in the value of a particular security.
FUTURES
The Fund may purchase and sell municipal bond index futures, other interest
rate futures and options thereon. The purchase of futures or call options
thereon can serve as a long hedge, and the sale of futures or the purchase of
put options thereon can serve as a short hedge. Writing covered call options on
futures contracts can serve as a limited short hedge, using a strategy similar
to that used for writing covered call options on securities or indexes.
Similarly, writing covered put options on futures contracts can serve as a
limited long hedge.
Futures strategies also can be used to manage the average duration of the
Fund's portfolio. If Mitchell Hutchins wishes to shorten the average duration of
the Fund, the Fund may sell a futures contract or a call option thereon, or
purchase a put option on that futures contract. If Mitchell Hutchins wishes to
lengthen the average duration of the Fund, the Fund may buy a futures contract
or a call option thereon, or sell a put option thereon.
No price is paid upon entering into a futures contract. Instead, at the
inception of a futures contract the Fund is required to deposit in a segregated
account with its custodian, in the name of the futures broker through whom the
transaction was effected, 'initial margin' consisting of cash, U.S. government
securities or other liquid, high-grade debt securities, in an amount generally
equal to 10% or less of the contract value. Margin must also be deposited when
writing a call option on a futures contract, in accordance with applicable
exchange rules. Unlike margin in securities transactions, initial margin on
futures contracts does not represent a borrowing, but rather is in the nature of
a performance bond or good-faith deposit that is returned to the Fund at the
termination of the transaction if all contractual obligations have been
satisfied. Under certain circumstances, such as periods of high volatility, the
Fund may be required by an exchange to increase the level of its initial margin
payment, and initial margin requirements might be increased generally in the
future by regulatory action.
Subsequent 'variation margin' payments are made to and from the futures
broker daily as the value of the futures position varies, a process known as
'marking to market.' Variation margin does not involve borrowing, but rather
represents a daily settlement of the Fund's obligations with respect to an open
futures position. When the Fund purchases an option on a future, the premium
paid plus transaction costs is all that is at risk. In contrast, when the Fund
purchases or sells a futures contract or writes a call option thereon, it is
subject to daily variation margin calls that could be substantial in the event
of adverse price movements. If the Fund has insufficient cash to meet daily
variation margin requirements, it might need to sell securities at a time when
such sales are disadvantageous.
13
<PAGE>
Holders and writers of futures positions and options on futures can enter
into offsetting closing transactions, similar to closing transactions on
options, by selling or purchasing, respectively, an instrument identical to the
instrument held or written. Positions in futures and options on futures may be
closed only on an exchange or board of trade that provides a secondary market.
The Fund intends to enter into futures transactions only on exchanges or boards
of trade where there appears to be a liquid secondary market. However, there can
be no assurance that such a market will exist for a particular contract at a
particular time. Secondary markets for options on futures are currently in the
development stage, and the Fund will not trade options on futures on any
exchange or board of trade unless, in Mitchell Hutchins' opinion, the markets
for such options have developed sufficiently that the liquidity risks for such
options are not greater than the corresponding risks for futures.
Under certain circumstances, futures exchanges may establish daily limits
on the amount that the price of a future or related option can vary from the
previous day's settlement price; once that limit is reached, no trades may be
made that day at a price beyond the limit. Daily price limits do not limit
potential losses because prices could move to the daily limit for several
consecutive days with little or no trading, thereby preventing liquidation of
unfavorable positions.
If the Fund were unable to liquidate a futures or related options position
due to the absence of a liquid secondary market or the imposition of price
limits, it could incur substantial losses. The Fund would continue to be subject
to market risk with respect to the position. In addition, except in the case of
purchased options, the Fund would continue to be required to make daily
variation margin payments and might be required to maintain the position being
hedged by the future or option or to maintain cash or securities in a segregated
account.
Certain characteristics of the futures market might increase the risk that
movements in the prices of futures contracts or related options might not
correlate perfectly with movements in the prices of the investments being
hedged. For example, all participants in the futures and related options markets
are subject to daily variation margin calls and might be compelled to liquidate
futures or related options positions whose prices are moving unfavorably to
avoid being subject to further calls. These liquidations could increase price
volatility of the instruments and distort the normal price relationship between
the futures or options and the investments being hedged. Also, because initial
margin deposit requirements in the futures market are less onerous than margin
requirements in the securities markets, there might be increased participation
by speculators in the futures markets. This participation also might cause
temporary price distortions. In addition, activities of large traders in both
the futures and securities markets involving arbitrage, 'program trading' and
other investment strategies might result in temporary price distortions.
GUIDELINE FOR FUTURES AND RELATED OPTIONS
To the extent that the Fund enters into futures contracts and options on
futures positions that are not for bona fide hedging purposes (as defined by the
CFTC), the aggregate initial margin and premiums on these positions (excluding
the amount by which options are 'in-the-money') may not exceed 5% of the Fund's
net assets.
The Fund may use the following hedging instruments:
OPTIONS ON DEBT SECURITIES--A call option is a contract pursuant to which
the purchaser of the option, in return for a premium, has the right to buy the
security underlying the option at a specified price at any time during the term,
or upon the expiration, of the option. The writer of the call option, who
receives the premium, has the obligation, upon exercise of the option, to
deliver the underlying security against payment of the exercise price. A put
option is a similar contract which gives its purchaser, in return for a premium,
the right to sell the underlying security at a specified price during the option
term or upon expiration. The writer of the put option, who receives the premium,
has the obligation, upon exercise, to buy the underlying security at the
exercise price. Options on debt securities are traded primarily in the OTC
market rather than on any of the several options exchanges.
14
<PAGE>
OPTIONS ON INDEXES OF DEBT SECURITIES--An index assigns relative values to
the securities included in the index and fluctuates with changes in the market
values of such securities. Index options operate in the same way as more
traditional options except that exercises of index options are effected with
cash payments and do not involve delivery of securities. Thus, upon exercise of
an index option, the purchaser will realize and the writer will pay, an amount
based on the difference between the exercise price and the closing price of the
index.
MUNICIPAL BOND INDEX FUTURES CONTRACTS--A municipal bond index futures
contract is a bilateral agreement pursuant to which one party agrees to accept
and the other party agrees to make delivery of an amount of cash equal to a
specified dollar amount times the difference between the index value at the
close of trading of the contract and the price at which the futures contract is
originally struck. No physical delivery of the bonds comprising the index is
made; generally contracts are closed out prior to the expiration date of the
contract.
MUNICIPAL DEBT AND INTEREST RATE FUTURES CONTRACTS--A municipal debt or
interest rate futures contract is a bilateral agreement pursuant to which one
party agrees to accept and the other party agrees to make delivery of the
specific type of debt security called for in the contract at a specified future
time and at a specified price. Although such futures contracts by their terms
call for actual delivery or acceptance of debt securities, in most cases the
contracts are closed out before the settlement date without making or taking of
delivery.
OPTIONS ON FUTURES CONTRACTS--Options on futures contracts are similar to
options on securities except that an option on a futures contract gives the
purchaser the right, in return for the premium, to assume a position in a
futures contract (a long position if the option is a call and a short position
if the option is a put), rather than to purchase or sell a security, at a
specified price at any time during the option term. Upon exercise of the option,
the delivery of the futures position to the holder of the option will be
accompanied by delivery of the accumulated balance, which represents the amount
by which the market price of the futures contract exceeds, in the case of a
call, or is less than, in the case of a put, the exercise price of the option on
the future. The writer of an option, upon exercise, will assume a short position
in the case of a call, and a long position in the case of put.
INTEREST RATE PROTECTION TRANSACTIONS--The Fund may enter into interest
rate protection transactions, including interest rate swaps and interest rate
caps, collars and floors. Interest rate swap transactions involve an agreement
between two parties to exchange payments that are based, for example, on
variable and fixed rates of interest and that are calculated on the basis of a
specified amount of principal (the 'notional principal amount') for a specified
period of time. Interest rate cap and floor transactions involve an agreement
between two parties in which the first party agrees to make payments to the
counterparty when a designated market interest rate goes above (in the case of a
cap) or below (in the case of a floor) a designated level on predetermined dates
or during a specified time period. Interest rate collar transactions involve an
agreement between two parties in which payments are made when a designated
market interest rate either goes above a designated level or goes below a
designated floor level on predetermined dates or during a specified time period.
The Fund would enter into interest rate protection transactions to preserve
a return or spread on a particular investment or portion of its portfolio, to
protect against any increase in the price of securities the Fund anticipates
purchasing at a later date or to effectively fix the rate of interest that it
pays on one or more borrowings or series of borrowings. The Fund would use these
transactions as a hedge and not as a speculative investment. Interest rate
protection transactions are subject to risks comparable to those described above
with respect to other hedging strategies.
The Fund may enter into interest rate swaps, caps, collars and floors on
either an asset-based or liability-based basis, depending on whether it is
hedging its assets or its liabilities, and will usually enter into interest rate
swaps on a net basis (i.e., the two payment streams are netted out, with the
Fund receiving or paying, as the case may be, only the net amount of the two
payments). Inasmuch as these interest rate protection transactions are entered
into for good faith hedging purposes, and inasmuch as segregated accounts will
be established with
15
<PAGE>
respect to such transactions, Mitchell Hutchins and the Fund believe such
obligations do not constitute senior securities and, accordingly, will not treat
them as being subject to its borrowing restrictions. The net amount of the
excess, if any, of the Fund's obligations over its entitlements with respect to
each interest rate swap will be accrued on a daily basis and an amount of cash,
U.S. government securities or other liquid high grade debt obligations having an
aggregate net asset value at least equal to the accrued excess will be
maintained in a segregated account by a custodian that satisfies the
requirements of the Investment Company Act of 1940 ('1940 Act'). The Fund also
will establish and maintain such segregated accounts with respect to its total
obligations under any interest rate swaps that are not entered into on a net
basis and with respect to any interest rate caps, collars and floors that are
written by the Fund.
The Fund will enter into interest rate protection transactions only with
banks and recognized securities dealers determined by Mitchell Hutchins to
present minimal credit risks in accordance with guidelines established by the
Fund's board of directors. If there is a default by the other party to such a
transaction, the Fund will have to rely on its contractual remedies (which may
be limited by bankruptcy, insolvency or similar laws) pursuant to the agreements
related to the transaction.
The swap market has grown substantially in recent years with a large number
of banks and investment banking firms acting both as principals and as agents
utilizing standardized swap documentation. Caps, collars and floors are more
recent innovations for which documentation is less standardized, and
accordingly, they are less liquid than swaps.
DIRECTORS AND OFFICERS
The overall management of the business and affairs of the Fund is vested
with its board of directors. The board of directors approves all significant
agreements between the Fund and persons or companies furnishing services to it,
including the Fund's agreements with its investment adviser and administrator,
custodian and transfer and dividend disbursing agent and registrar. The
day-to-day operations of the Fund are delegated to its officers and to Mitchell
Hutchins, subject always to the investment objective and policies of the Fund
and to general supervision by the board of directors.
The business addresses, ages and principal occupations during the past five
years of the directors and executive officers of the Fund are:
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME, ADDRESS*; AGE WITH THE FUND OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
Margo N. Alexander**; 49 Director and Mrs. Alexander is president,
President chief executive officer and
a director of Mitchell
Hutchins (since January
1995) and also an executive
vice president and director
of PaineWebber. Mrs.
Alexander is president and a
director or trustee of 30
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Richard Q. Armstrong; 61 Director Mr. Armstrong is chairman and
78 West Brother Drive principal of RQA Enterprises
Greenwich, CT 06830 (management consulting firm)
(since April 1991 and
principal occupation since
March 1995). Mr. Armstrong
is also director of Hi Lo
Automotive, Inc. He was
chairman of the board, chief
executive officer and
co-owner of
</TABLE>
16
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME, ADDRESS*; AGE WITH THE FUND OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
Adirondack Beverages
(producer and distributor of
soft drinks and
sparkling/still waters)
(October 1993-March 1995).
Mr. Armstrong was a partner
of The New England
Consulting Group (management
consulting firm) (December
1992-September 1993). He was
managing director of LVMH
U.S. Corporation (U.S.
subsidiary of the French
luxury goods conglomerate,
Luis Vuitton Moet Hennessey
Corporation) (1987-1991) and
chairman of its wine and
spirits subsidiary,
Schieffelin &
Somerset Company
(1987-1991). Mr. Armstrong
is a director or trustee of
29 investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment advisor.
E. Garrett Bewkes, Jr.**; 69.. Director and Mr. Bewkes is a director of
Chairman of the Paine Webber Group Inc. ('PW
Board of Group') (holding company of
Directors Mitchell Hutchins and
PaineWebber). Prior to
December 1995, he was a
consultant to PW Group.
Prior to 1988, he was
chairman of the board,
president and chief
executive officer of the
American Bakeries Company.
Mr. Bewkes is a director of
Interstate Bakeries
Corporation and NaPro
BioTherapeutics, Inc. Mr.
Bewkes is a director or
trustee of 30 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
</TABLE>
<TABLE>
<S> <C> <C>
Richard R. Burt; 49 Director Mr. Burt is chairman of
1101 Connecticut Avenue, N.W. International Equity
Washington, D.C. 20036 Partners (international
investments and consulting
firm) (since March 1994) and
a partner of McKinsey &
Company (management
consulting firm) (since
1991). He is also a director
of American Publishing
Company. He was the chief
negotiator in the Strategic
Arms Reduction Talks with
the former Soviet Union
(1989-1991) and the U.S.
Ambassador to the Federal
Republic of Germany
(1985-1989). Mr. Burt is a
director or trustee of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Mary C. Farrell**; 46 Director Ms. Farrell is a managing
director, senior investment
strategist and member of the
Investment Policy Committee
of PaineWebber. Ms. Farrell
joined PaineWebber in 1982.
She is a member of the
Financial Women's
</TABLE>
17
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME, ADDRESS*; AGE WITH THE FUND OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
Association and Women's
Economic Roundtable and is
employed as a regular
panelist on Wall $treet Week
with Louis Rukeyser. She
also serves on the Board of
Overseers of New York
University's Stern School of
Business. Ms. Farrell is a
director or trustee of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Meyer Feldberg; 54 Director Mr. Feldberg is Dean and
Columbia University Professor of Management of
101 Uris Hall the Graduate School of
New York, NY 10027 Business, Columbia
University. Prior to 1989,
he was president of the
Illinois Institute of
Technology. Dean Feldberg is
also a director of AMSCO
International Inc. (medical
instrument and supplies),
Federated Department Stores
Inc., and New World
Communications Group
Incorporated. Dean Feldberg
is a director or trustee of
29 investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
George W. Gowen; 66 Director Mr. Gowen is a partner in the
666 Third Avenue law firm of Dunnington,
New York, NY 10017 Bartholow & Miller. Prior to
May 1994, he was a partner
in the law firm of Fryer,
Ross & Gowen. Mr. Gowen is
also a director of Columbia
Real Estate Investments,
Inc. Mr. Gowen is a director
or trustee of 29 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Frederic V. Malek; 59 Director Mr. Malek is chairman of
901 15th Street, N.W. Thayer Capital Partners
Suite 300 (investment bank) and a
Washington, D.C. 20005 co-chairman and director of
CB Commercial Group Inc.
(real estate). From January
1992 to November 1992, he
was campaign manager of
Bush-Quayle '92. From 1990
to 1992, he was vice
chairman and, from 1989 to
1990, he was president of
Northwest Airlines Inc., NWA
Inc. (holding company of
Northwest Airlines Inc.) and
Wings Holdings Inc. (holding
company of NWA Inc.). Prior
to 1989, he was employed by
the Marriott Corporation
(hotels, restaurants,
airline catering and
contract feeding), where he
most recently was an
executive vice president and
president of Marriott Hotels
and Resorts. Mr. Malek is
also a director of American
Management Systems, Inc.
(management consulting and
computer-related services),
Automatic Data Processing,
Inc., Avis, Inc. (passenger
car rental), FPL Group,
</TABLE>
18
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME, ADDRESS*; AGE WITH THE FUND OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
Inc. (electric services),
National Education
Corporation and Northwest
Airlines Inc. Mr. Malek is a
director or trustee of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Carl W. Schafer; 60 Director Mr. Schafer is president of
P.O. Box 1164 the Atlantic Foundation
Princeton, NJ 08542 (charitable foundation
supporting mainly ocean-
ographic exploration and
research). He also is a
director of Roadway Express,
Inc. (trucking), The
Guardian Group of Mutual
Funds, Evans Systems, Inc.
(a moter fuels, convenience
store and diversified
company), Hidden Lake Gold
Mines Ltd. (gold mining),
Electronic Clearing House,
Inc. (financial transactions
processing), Wainoco Oil
Corporation and Nutraceutix,
Inc. (biotechnology). Prior
to January 1993, Mr. Schafer
was chairman of the
Investment Advisory
Committee of the Howard
Hughes Medical Institute.
Mr. Schafer is a director or
trustee of 29 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
John R. Torell III; 57 Director Mr. Torell is chairman of
767 Fifth Avenue Torell Management, Inc.
Suite 4605 (financial advisory firm),
New York, NY 10153 chairman of Telesphere
Corporation (electronic
provider of financial
information) and a partner
of Zilkha & Company
(merchant banking and
private investment company).
He is the former chairman
and chief executive officer
of Fortune Bancorp
(1990-1991 and 1990-1994,
respectively), the former
chairman, president and
chief executive officer of
CalFed, Inc. (savings
association) (1988 to 1989)
and former president of
Manufacturers Hanover Corp.
(bank) (prior to 1988). Mr.
Torell is also a director of
American Home Products
Corp., New Colt Inc.
(armament manufacturer) and
Volt Information Sciences,
Inc. Mr. Torell is a
director or trustee of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Teresa M. Boyle; 37 Vice President Ms. Boyle is a first vice
president and manager--
advisory administration of
Mitchell Hutchins. Prior to
November 1993, she was
compliance manager of
Hyperion Capital Management,
Inc., an investment advisory
firm. Prior to April 1993,
Ms. Boyle was a vice
president and manager--legal
administration of Mitchell
</TABLE>
19
<PAGE>
<TABLE>
POSITION BUSINESS EXPERIENCE;
NAME, ADDRESS*; AGE WITH THE FUND OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S><C> <C>
Hutchins. Ms. Boyle is a
vice president of 30
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Elbridge T. Gerry III; 39 Vice President Mr. Gerry is a senior vice
president and a portfolio
manager of Mitchell
Hutchins. Prior to January
1996, he was with J.P.
Morgan Private Banking where
he was responsible for
managing municipal assets,
including several municipal
bond funds. Mr. Gerry is a
vice president of four
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
C. William Maher; 35 Vice President Mr. Maher is a first vice
and Assistant president and a senior
Treasurer manager of the mutual fund
finance division of Mitchell
Hutchins. Mr. Maher is a
vice president and assistant
treasurer of 30 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Ann E. Moran; 39 Vice President Ms. Moran is a vice president
and Assistant of Mitchell Hutchins. Ms.
Treasurer Moran is a vice president
and assistant treasurer of
30 investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Dianne E. O'Donnell; 44 Vice President Ms. O'Donnell is a senior vice
and Secretary president and deputy general
counsel of Mitchell
Hutchins. Ms. O'Donnell is a
vice president and secretary
of 29 investment companies
for which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
Victoria E. Schonfeld; 45 Vice President Ms. Schonfeld is a managing
director and general counsel
of Mitchell Hutchins. Prior
to May 1994, she was a
partner in the law firm of
Arnold & Porter. Ms.
Schonfeld is a vice
president of 30 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Paul H. Schubert; 33 Vice President Mr. Schubert is a first vice
and Assistant president and a senior
Treasurer manager of the mutual fund
finance division of Mitchell
Hutchins. From August 1992
to August 1994, he was a
vice president of BlackRock
Financial Management L.P.
Prior to August 1992, he was
an audit manager with Ernst
& Young LLP. Mr. Schubert is
a vice president and
assistant treasurer of 30
investment
</TABLE>
20
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME, ADDRESS*; AGE WITH THE FUND OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Julian F. Sluyters; 36 Vice President Mr. Sluyters is a senior vice
and Treasurer president and the director
of the mutual fund finance
division of Mitchell
Hutchins. Prior to 1991, he
was an audit senior manager
with Ernst & Young LLP. Mr.
Sluyters is a vice president
and treasurer of 30
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
<S> <C> <C>
Gregory K. Todd; 39 Vice President Mr. Todd is a first vice
and Assistant president and associate
Secretary general counsel of Mitchell
Hutchins. Prior to 1993, he
was a partner in the firm of
Shereff, Friedman, Hoffman &
Goodman. Mr. Todd is a vice
president and assistant
secretary of nine investment
companies and vice president
and secretary of one
investment company for which
Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Keith A. Weller; 34 Vice President Mr. Weller is a first vice
and Assistant president and associate
Secretary general counsel of Mitchell
Hutchins. Prior to May 1995,
he was an attorney in
private practice. Mr. Weller
is a vice president and
assistant secretary of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
</TABLE>
- ------------------
* Unless otherwise indicated, the business address of each listed person is
1285 Avenue of the Americas, New York, New York 10019.
** Mrs. Alexander, Mr. Bewkes and Ms. Farrell are 'interested persons' of the
Fund, as defined in the 1940 Act by reason of their positions with Mitchell
Hutchins, PaineWebber and/or PW Group.
The Fund pays directors who are not 'interested persons' of the Fund $1,000
annually and $150 for each board meeting and for each meeting of a board
committee (other than committee meetings held on the same day as a board
meeting). Messrs. Feldberg and Torell receive additional annual compensation
aggregating $15,000 annually from all the funds within the PaineWebber fund
complex. All directors are reimbursed for any expenses incurred in attending
meetings. Because Mitchell Hutchins performs substantially all of the services
necessary for the operation of the Fund, the Fund requires no employees. No
officer, director or employee of PaineWebber or Mitchell Hutchins presently
receives any compensation from the Fund for acting as a director or officer. The
1940 Act requires that the holders of the outstanding shares of the preferred
stock, including the APS, voting as a separate class, have the right to select
at least two of the Fund's directors at all times. The table below includes
certain information relating to the compensation of the Fund's current directors
who held office with the Fund or other PaineWebber funds for the last fiscal and
calendar years.
21
<PAGE>
COMPENSATION TABLE
<TABLE>
<CAPTION>
TOTAL
COMPENSATION
FROM THE FUND
AGGREGATE AND THE FUND
NAME OF COMPENSATION COMPLEX PAID
PERSON, POSITION FROM THE FUND* TO DIRECTORS+
- --------------------------------------------------------------------- --------------- ---------------
<S> <C> <C>
Richard Q. Armstrong, Director ...................................... $ 2,125 $ 9,000
Richard R. Burt, Director ........................................... 1,875 7,750
Meyer Feldberg, Director ............................................ 3,000 106,375
George W. Gowen, Director**.......................................... -- 99,750
Frederic V. Malek, Director**........................................ -- 99,750
Carl W. Schafer, Director**.......................................... -- 118,175
John R. Torell III, Director ........................................ 3,000 28,125
</TABLE>
- ------------------
Only independent members of the board of directors are compensated by the Fund
and identified above; directors who are 'interested persons,' as defined in the
1940 Act, do not receive compensation.
* Represents fees paid to each director during the fiscal year ended March 31,
1996; the Fund does not have a pension or retirement plan.
** Elected as a director at a shareholder meeting held on April 11, 1996.
+ Represents total compensation paid to each director by the Fund and the Fund
Complex during the calendar year ended December 31, 1995.
CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES
As of July 25, 1996, Cede & Co. (the nominee for The Depository Trust
Company) owned of record 19,294,510 shares of the Fund's Common Stock or 93.5%
of the outstanding shares of the Fund's Common Stock. To the knowledge of the
Fund, no person is the beneficial owner of 5% or more of its Common Stock.
As of July 31, 1996, the directors and officers of the Fund beneficially
owned less than 1% of the outstanding shares of the Fund's Common Stock.
INVESTMENT ADVISORY ARRANGEMENTS
Mitchell Hutchins is the Fund's investment adviser and administrator
pursuant to a contract dated May 26, 1993 with the Fund ('Advisory Contract').
Pursuant to the Advisory Contract, Mitchell Hutchins provides a continuous
investment program for the Fund and makes investment decisions and places orders
to buy, sell or hold particular securities. As administrator, Mitchell Hutchins
supervises all matters relating to the operation of the Fund and obtains for it
corporate, administrative and clerical personnel, office space, equipment and
services, including arranging for the periodic preparation, updating, filing and
dissemination of proxy materials, tax returns and reports to the Fund's board of
directors, shareholders and regulatory authorities.
In addition to the payments to Mitchell Hutchins under the Advisory
Contract described above, the Fund pays certain other costs including: (1) the
costs (including brokerage commissions) of securities purchased or sold by the
Fund and any losses incurred in connection therewith; (2) expenses incurred on
behalf of the Fund by Mitchell Hutchins; (3) organizational expenses of the
Fund, whether or not advanced by Mitchell Hutchins; (4) filing fees and expenses
relating to the registration and qualification of the Common Stock under federal
and state securities laws; (5) fees and salaries payable to directors who are
not interested persons of the Fund or
22
<PAGE>
Mitchell Hutchins; (6) all expenses incurred in connection with the directors'
services, including travel expenses; (7) taxes (including any income or
franchise taxes) and governmental fees; (8) costs of any liability,
uncollectible items of deposit and any other insurance or fidelity bonds; (9)
any costs, expenses or losses arising out of a liability of or claims for
damages or other relief asserted against the Fund for violation of any law; (10)
legal, accounting and auditing expenses, including legal fees of special counsel
for the independent directors; (11) charges of custodians, transfer agents and
other agents; (12) costs of preparing share certificates; (13) expenses of
printing and distributing reports to stockholders; (14) any extraordinary
expenses (including fees and disbursements of counsel) incurred by the Fund;
(15) fees, voluntary assessments and other expenses incurred in connection with
membership in investment company organizations; (16) costs of mailing and
tabulating proxies and costs of meetings of stockholders, the board and any
committees thereof; (17) the costs of investment company literature and other
publications provided to directors and officers; (18) costs of mailing,
stationery and communications equipment; (19) interest charges on borrowings;
(20) fees and expenses of listing and maintaining any listing of the Fund's
shares on the New York Stock Exchange, Inc. ('NYSE') or any other national
securities exchange; and (21) costs and expenses (including rating agency fees)
associated with the issuance of any preferred stock.
The Advisory Contract was approved by the Fund's board of directors and by
a majority of the directors who neither are interested persons of the Fund nor
have any direct or indirect financial interest in the Advisory Contract
('Independent Directors'), on February 23, 1993 and by its initial stockholder
on May 26, 1993. Unless sooner terminated, the Advisory Contract will remain in
effect for two years from its execution. Thereafter, if not terminated, the
Advisory Contract will continue automatically for successive annual periods,
provided that such continuance is specifically approved at least annually: (1)
by a majority vote of the Independent Directors cast in person at a meeting
called for the purpose of voting on such approval; and (2) by the board of
directors or by vote of a majority of the outstanding voting securities (i.e.,
the Common Stockholders and any preferred stockholders, voting as a single
class) of the Fund.
Under the Advisory Contract, Mitchell Hutchins will not be liable for any
error of judgment or mistake of law or for any loss suffered by the Fund in
connection with the Advisory Contract, except a loss resulting from willful
misfeasance, bad faith or gross negligence on the part of Mitchell Hutchins in
the performance of its duties or from reckless disregard of its duties and
obligations under the Advisory Contract. The Advisory Contract is terminable by
vote of the board of directors or by the holders of a majority of the
outstanding voting securities of the Fund, at any time without penalty, on 60
days' written notice to Mitchell Hutchins. The Advisory Contract may also be
terminated by Mitchell Hutchins on 60 days' written notice to the Fund. The
Advisory Contract terminates automatically upon its assignment.
For the fiscal years ended March 31, 1996, March 31, 1995 and for the
fiscal period June 8, 1993 (commencement of operations) through March 31, 1994,
the Fund paid or accrued to Mitchell Hutchins $3,988,174 (of which $927,265 was
waived by Mitchell Hutchins), $3,195,714 and $2,447,841, respectively, in
investment advisory and administration fees.
Mitchell Hutchins personnel may invest in securities for their own accounts
pursuant to a code of ethics that describes the fiduciary duty owed to
shareholders of the PaineWebber mutual funds and other Mitchell Hutchins
advisory accounts held by all Mitchell Hutchins' directors, officers and
employees, that establishes procedures for personal investing and restricts
certain transactions. For example, employee accounts generally must be
maintained at PaineWebber, personal trades in most securities require
pre-clearance and short-term trading and participation in initial public
offerings generally are prohibited. In addition, the code of ethics puts
restrictions on the timing of personal investing in relation to trades by
PaineWebber funds and other Mitchell Hutchins advisory clients.
23
<PAGE>
PORTFOLIO TRANSACTIONS
Subject to policies established by the board of directors, Mitchell
Hutchins is responsible for the execution of the Fund's portfolio transactions
and the allocation of brokerage transactions. In executing portfolio
transactions, Mitchell Hutchins seeks to obtain the best net results for the
Fund, taking into account such factors as the price (including the applicable
dealer spread or brokerage commission), size of order, difficulty of execution
and operational facilities of the firm involved. Municipal Obligations in which
the Fund invests generally are traded on the OTC market on a 'net' basis without
a stated commission through dealers acting for their own account and not as
brokers. Prices paid to dealers in principal transactions generally include a
'spread,' which is the difference between the prices at which the dealer is
willing to purchase and sell a specific security at that time. For the fiscal
years ended March 31, 1996, March 31, 1995 and for the fiscal period June 8,
1993 (commencement of operations) to March 31, 1994, the Fund paid no brokerage
commissions.
In placing orders with dealers, Mitchell Hutchins attempts to obtain the
best net price and the most favorable execution of its orders. Mitchell Hutchins
may purchase and sell portfolio securities from and to dealers who provide the
Fund with research, analysis, statistical or pricing advice or similar services.
Portfolio transactions will not be directed by the Fund to dealers solely on the
basis of research and advice provided. The Fund will not purchase portfolio
securities at a higher price or sell such securities at a lower price in
connection with transactions effected with a dealer, acting as principal, who
furnishes research services to Mitchell Hutchins than would be the case if no
weight were given by Mitchell Hutchins to the dealer's furnishing of such
services. Moreover, Mitchell Hutchins will not enter into any explicit soft
dollar arrangements relating to principal transactions and will not receive in
principal transactions the types of services which could be purchased for hard
dollars. Mitchell Hutchins may engage in agency transactions in OTC equity and
debt securities in return for research and execution services. These
transactions are entered into only in compliance with procedures ensuring that
the transaction (including commissions) is at least as favorable as it would
have been if effected directly with a market-maker that did not provide research
for execution services. These procedures include Mitchell Hutchins receiving
multiple quotes from dealers before executing the transaction on an agency
basis. Research services furnished by the dealers through which or with which
the Fund effects securities transactions may be used by Mitchell Hutchins in
advising other funds or accounts they advise and, conversely, research services
furnished to Mitchell Hutchins in connection with other funds or accounts that
Mitchell Hutchins advises may be used in advising the Fund. Although it is not
possible to place a dollar value on those services, it is the opinion of
Mitchell Hutchins that the receipt of such services should not reduce its
overall research expenses. Information and research received from brokers and
dealers is in addition to, and not in lieu of, the services required to be
performed by Mitchell Hutchins under the Advisory Contract.
Investment decisions for the Fund and for other investment accounts managed
by Mitchell Hutchins will be made independently of each other in light of
differing considerations for the various accounts. However, the same investment
decision may occasionally be made for the Fund and one or more such accounts. In
such cases, simultaneous transactions are inevitable. Purchases or sales then
will be averaged as to price and allocated between the Fund and such other
account(s) as to amount according to a formula deemed equitable to the Fund and
such account(s). While in some cases this practice could have a detrimental
effect upon the price or value of the security as far as the Fund is concerned,
or upon its ability to complete its entire order, in other cases it is believed
that coordination and the ability to participate in volume transactions will be
beneficial to the Fund.
The Fund will not purchase securities that are offered in underwritings in
which PaineWebber, Mitchell Hutchins or any of their affiliates is a member of
the underwriting or selling group, except pursuant to procedures adopted by the
board of directors pursuant to Rule 10f-3 under the 1940 Act. Among other
things, these procedures require that the commission or spread paid in
connection with such a purchase be reasonable and fair,
24
<PAGE>
that the purchase be at not more than the public offering price prior to the end
of the first business day after the date of the public offering and that
PaineWebber, Mitchell Hutchins and their affiliates not participate in or
benefit from the sale to the Fund.
PORTFOLIO TURNOVER
For the fiscal years ended March 31, 1996 and March 31, 1995, the Fund's
portfolio turnover rate was 4% and 4%, respectively. Portfolio turnover may vary
from year to year and will not be a limiting factor when Mitchell Hutchins deems
portfolio changes appropriate. The portfolio turnover rate is calculated by
dividing the lesser of the Fund's annual sales or purchases of portfolio
securities (exclusive of purchases or sales of securities whose maturities at
the time of acquisition were one year or less) by the monthly average value of
the long-term securities in the portfolio during the year.
VALUATION OF COMMON STOCK
The net asset value of the Common Stock is determined weekly, as directed
by the Fund's board of directors, and also is determined monthly as of the close
of regular trading on the NYSE on the last day of the month on which the NYSE is
open for trading. The net asset value per share of Common Stock is computed by
dividing the value of the securities held by the Fund plus any cash or other
assets (including interest and dividends accrued but not yet received and earned
discount) minus all liabilities (including accrued expenses) and the liquidation
preference of any outstanding preferred stock by the total number of shares of
Common Stock outstanding at such time.
When market quotations are readily available, the Fund's debt securities
are valued based upon those quotations. When market quotations for options and
futures positions held by the Fund are readily available, those positions are
valued based upon such quotations. Market quotations generally are not available
for options traded in the OTC market. When market quotations for options and
futures positions or any other securities and assets of the Fund are not readily
available, they are valued at fair value as determined in good faith by or under
the direction of the board of directors, generally based upon appraisals
received from a pricing service using a computerized matrix system or derived
from information concerning the security or similar securities received from
recognized dealers in those securities. Notwithstanding the above, debt
securities with maturities of 60 days or less generally are valued at amortized
cost if their original term to maturity was 60 days or less, or by amortizing
the difference between their fair value as of the 61st day prior to maturity and
their maturity value if their original term to maturity exceeded 60 days, unless
in either case the board of directors or its delegate determines that this does
not represent fair value.
25
<PAGE>
TAXES
TAXATION OF THE FUND
General. In order to continue to qualify for treatment as a regulated
investment company ('RIC') under the Internal Revenue Code, the Fund must
distribute to its stockholders for each taxable year at least 90% of the sum of
its net interest income excludable from gross income under section 103(a) of the
Internal Revenue Code ('tax-exempt income') plus its investment company taxable
income (consisting generally of taxable net investment income, net short-term
capital gain and net realized gains from certain hedging transactions)
('Distribution Requirement') and must meet several additional requirements.
Among these requirements are the following: (1) the Fund must derive at least
90% of its gross income each taxable year from dividends, interest, payments
with respect to securities loans and gains from the sale or other disposition of
securities, or other income (including gains from options or futures contracts)
derived with respect to its business of investing in securities ('Income
Requirement'); (2) the Fund must derive less than 30% of its gross income each
taxable year from the sale or other disposition of securities, options or
futures contracts held for less than three months ('Short-Short Limitation');
(3) at the close of each quarter of the Fund's taxable year, at least 50% of the
value of its total assets must be represented by cash and cash items, U.S.
government securities, securities of other RICs and other securities, with those
other securities limited, in respect of any one issuer, to an amount that does
not exceed 5% of the value of the Fund's total assets; and (4) at the close of
each quarter of the Fund's taxable year, not more than 25% of the value of its
total assets may be invested in securities (other than U.S. government
securities or the securities of other RICs) of any one issuer. If the Fund
failed to qualify for treatment as a RIC for any taxable year, it would be taxed
as an ordinary corporation on its taxable income for that year (even if that
income was distributed to its stockholders) and all distributions out of its
earnings and profits (including those attributable to tax-exempt income) would
be taxable to its stockholders as dividends (that is, ordinary income).
The Fund will be subject to a nondeductible 4% excise tax ('Excise Tax') to
the extent it fails to distribute by the end of any calendar year at least 98%
of the sum of its ordinary income (not including tax-exempt income) for that
year and its capital gain net income for the one-year period ending on October
31 of that year, plus certain other amounts. For these purposes, any such
taxable income retained by the Fund, and on which it pays federal income tax,
will be treated as having been distributed.
While any shares of preferred stock are outstanding, the Fund may not
declare any cash dividend or other distribution on the Common Stock unless, at
the time of the declaration, the Fund satisfies certain dividend payment and
asset coverage requirements. See 'Special Leverage Considerations' in the
Prospectus. Any such suspension of distributions on the Common Stock could
prevent the Fund from satisfying the Distribution Requirement and avoiding
imposition of the Excise Tax. For so long as the Fund has outstanding preferred
stock, it will be required to allocate each particular type of its income for
each taxable year (such as tax-exempt income, net realized capital gains, and
other taxable income) between the two classes of shares, Common Stock and
preferred stock, in proportion to the total distributions paid to each such
class for that year. It is not expected that any portion of the Fund's
distributions will be eligible for the dividends-received deduction available
for corporations.
Pursuant to a published ruling of the Internal Revenue Service, insurance
proceeds received by the Fund from an insurer with whom the Fund maintains a
policy described in the Prospectus will be treated as tax-exempt interest income
to the same extent as if such payments were made by the issuer of the insured
Municipal Obligations and will be eligible for distribution as part of the
Fund's exempt-interest dividends. In the case of a failure by a municipality to
appropriate funds sufficient to satisfy a Municipal Obligation, it is unclear
whether
26
<PAGE>
payments made by an insurer in place of interest on such non-appropriated
obligation will be excludable from gross income for federal income tax purposes.
The Fund may acquire zero coupon Municipal Obligations issued with original
issue discount. As the holder of such a security, the Fund would have to include
in gross income for purposes of the Distribution and Income Requirements and the
Short-Short Limitation the original issue discount that accrues on the security
for the taxable year, even if the Fund receives no payment on the security
during the year. Because the Fund annually must distribute at least 90% of its
tax-exempt income and investment company taxable income, including any accrued
original issue discount, to satisfy the Distribution Requirement, it may be
required in a particular year to distribute as a dividend an amount that is
greater than the total amount of cash it actually receives. Those distributions
will be made from the Fund's cash assets or from the proceeds of sales of
portfolio securities or from borrowings, if necessary. The Fund may realize
taxable capital gains or losses from those sales, which would increase or
decrease its investment company taxable income or net capital gain (the excess
of net long-term capital gain over net short-term capital loss). Because of the
Short-Short Limitation, any such gains realized on the disposition of securities
held for less than three months would reduce the Fund's ability to sell other
securities, or options or futures, held for less than three months that it might
wish to sell in the ordinary course of its portfolio management.
Hedging Strategies. The use of hedging strategies, such as writing
(selling) and purchasing options and futures, involves complex rules that will
determine for income tax purposes the character and timing of recognition of the
gains and losses the Fund realizes in connection therewith. These rules also may
require the Fund to 'mark to market' (that is, treat as sold for their fair
market value) at the end of each taxable year certain positions in its
portfolio, which may cause the Fund to recognize income without receiving cash
with which to make distributions necessary to satisfy the Distribution
Requirement and to avoid imposition of the Excise Tax. In that event, the Fund
might have to liquidate securities to enable it to make the required
distributions, which would cause it to recognize gains or losses and might
affect its ability to satisfy the Short-Short Limitation.
Gains from options and futures derived by the Fund with respect to its
business of investing in securities will qualify as permissible income under the
Income Requirement. However, income from the disposition of options and futures
will be subject to the Short-Short Limitation if they are held for less than
three months.
If the Fund satisfies certain requirements, any increase in value of a
position that is part of a 'designated hedge' will be offset by any decrease in
value (whether realized or not) of the offsetting hedging position during the
period of the hedge for purposes of determining whether the Fund satisfies the
Short-Short Limitation. Thus, only the net gain (if any) from the designated
hedge will be included in gross income for purposes of that limitation. The Fund
will consider whether it should seek to qualify for this treatment for its
hedging transactions. To the extent the Fund does not qualify for this
treatment, it may be forced to defer the closing out of certain options and
futures beyond the time when it otherwise would be advantageous to do so, in
order for the Fund to continue to qualify as a RIC.
TAXATION OF STOCKHOLDERS
Entities or other persons who are 'substantial users' (or persons related
to 'substantial users') of facilities financed by IDBs or PABs should consult
their tax advisers before purchasing shares of Common Stock because, for users
of certain of these facilities, the interest on such bonds is not exempt from
federal income tax. For these purposes, the term 'substantial user' is defined
generally to include a 'non-exempt person' who regularly uses in trade or
business a part of a facility financed from the proceeds of IDBs or PABs.
27
<PAGE>
Up to 85% of social security and railroad retirement benefits may be
included in taxable income for recipients whose modified adjusted gross income
(including income from tax-exempt sources such as the Fund) plus 50% of their
net benefits exceeds certain base amounts. Exempt-interest dividends are still
tax-exempt to the extent described in the Prospectus; they are only included in
the calculation of whether a recipient's income exceeds the established amounts.
Distributions of the Fund's net capital gain, if any, will be taxable to
its stockholders as long-term capital gains, regardless of the length of time
they held their Fund shares.
A participant in the Fund's Dividend Reinvestment Plan will be treated as
having received a distribution in the amount of the cash used to purchase shares
of Common Stock on his behalf, including a pro rata portion of the brokerage
fees incurred by the Transfer Agent. See 'Dividends and Other Distributions;
Dividend Reinvestment Plan' in the Prospectus.
The Fund is required to withhold 31% of all taxable dividends, capital gain
distributions and repurchase proceeds payable to any individuals and certain
other noncorporate stockholders who do not provide the Fund with a correct
taxpayer identification number. Withholding at that rate from taxable dividends
and capital gain distributions also is required for stockholders who otherwise
are subject to backup withholding.
ADDITIONAL INFORMATION
SHARE REPURCHASES AND TENDERS
As discussed in the Prospectus, the Fund's board of directors may tender
for its shares to reduce or eliminate the discount to net asset value at which
the Fund's shares might trade. Even if a tender offer has been made, it will be
the board's announced policy, which may be changed by the board, not to accept
tenders or effect repurchases (or, if a tender offer has not been made, not to
initiate a tender offer) if: (1) such transactions, if consummated, would (a)
result in the delisting of the Common Stock from the NYSE (the NYSE having
advised the Fund that it would consider delisting if the aggregate market value
of the outstanding shares is less than $5,000,000, the number of publicly held
shares falls below 600,000 or the number of round-lot holders falls below
1,200), (b) impair the Fund's status as a RIC under the Internal Revenue Code
(which would eliminate the Fund's eligibility to deduct dividends paid to its
stockholders, thus causing the Fund's income to be fully taxed at the corporate
level in addition to the taxation of stockholders upon dividends received from
the Fund) or (c) cause the Fund to violate applicable asset coverage or similar
requirements on outstanding preferred stock or borrowings; (2) the Fund would
not be able to liquidate portfolio securities in an orderly manner and
consistent with the Fund's investment objective and policies in order to
repurchase its shares; or (3) there is, in the board's judgment, any (a)
material legal action or proceeding instituted or threatened challenging such
transactions or otherwise materially adversely affecting the Fund, (b)
suspension of trading or limitation on prices of securities generally on the
NYSE or any other exchange on which portfolio securities of the Fund are traded,
(c) declaration of a banking moratorium by federal or state authorities or any
suspension of payment by banks in the United States, New York State or any state
in which the Fund invests, (d) limitation affecting the Fund or the issuers of
its portfolio securities imposed by federal or state authorities on the
extension of credit by lending institutions, (e) commencement of war, armed
hostilities or other international or national calamity directly or indirectly
involving the United States or (f) other event or condition that would have a
material adverse effect on the Fund or its stockholders if shares were
repurchased. The board of directors may modify these conditions in light of
experience.
28
<PAGE>
COUNSEL
The law firm of Kirkpatrick & Lockhart LLP, 1800 Massachusetts Avenue,
N.W., Washington, D.C. 20036-1800 counsel to the Fund, has passed upon the
legality of the Common Stock offered by the Fund's Prospectus. Kirkpatrick &
Lockhart LLP also acts as counsel to Mitchell Hutchins and PaineWebber in
connection with other matters.
INDEPENDENT AUDITORS
Ernst & Young LLP, 787 Seventh Avenue, New York, New York 10019, serves as
the independent auditors for the Fund.
FINANCIAL INFORMATION
The Fund's Annual Report to Shareholders for the fiscal year ended March
31, 1996 is a separate document supplied with this Statement of Additional
Information and the financial statements, accompanying notes and report of
independent auditors appearing therein are incorporated by reference in this
Statement of Additional Information.
29
<PAGE>
APPENDIX A
RATINGS OF INSURANCE COMPANY CLAIMS-PAYING ABILITY
The claims-paying ability of insurance companies is rated by Moody's and
S&P. Descriptions of these ratings are set forth below:
DESCRIPTION OF MOODY'S RATINGS OF INSURANCE COMPANY CLAIMS-PAYING ABILITY
AAA. Insurance companies rated Aaa offer exceptional financial security.
While the financial strength of these companies is likely to change, such
changes as can be visualized are most unlikely to impair their fundamentally
strong position.
AA. Insurance companies rated Aa offer excellent financial security.
Together with the Aaa group they constitute what are generally known as high
grade companies. They are rated lower than Aaa companies because long-term risks
appear somewhat larger.
A. Insurance companies rated A offer good financial security. However,
elements may be present which suggest a susceptibility to impairment sometime in
the future.
BAA. Insurance companies rated Baa offer adequate financial security.
However, certain protective elements may be lacking or may be characteristically
unreliable over any great length of time.
Note: Numeric modifiers are used to refer to the ranking within the group--one
being the highest and three being the lowest. However, the financial strength of
companies within a generic rating symbol (Aa, for example) is broadly the same.
DESCRIPTION OF S&P'S RATINGS OF INSURANCE COMPANY CLAIMS-PAYING ABILITY
AAA. Superior financial security on an absolute and relative basis.
Capacity to meet policyholder obligations is overwhelming under a variety of
economic and underwriting conditions.
AA. Excellent financial security. Capacity to meet policyholder obligations
is strong under a variety of economic and underwriting conditions.
A. Good financial security, but capacity to meet policyholder obligations
is somewhat susceptible to adverse economic and underwriting conditions.
BBB. Adequate financial security, but capacity to meet policyholder
obligations is susceptible to adverse economic and underwriting conditions.
Note: Plus (+) and minus (-) signs indicate relative standing within a category,
and are not indications of likely upgrades or downgrades.
RATINGS OF MUNICIPAL BONDS AND COMMERCIAL PAPER
Municipal bonds are rated by Moody's and S&P. Moody's also publishes
separate ratings for municipal notes. Descriptions of these ratings, together
with the ratings assigned by Moody's and S&P to commercial paper, are set forth
below.
A-1
<PAGE>
DESCRIPTION OF MOODY'S MUNICIPAL BOND RATINGS
AAA. Bonds which are rated Aaa are judged to be of the best quality and
carry the smallest degree of investment risk. Interest payments are protected by
a large or by an exceptionally stable margin and principal is secure. While the
various protective elements are likely to change, such changes as can be
visualized are most unlikely to impair the fundamentally strong position of such
issues.
AA. Bonds which are rated Aa are judged to be of high quality by all
standards. They are rated lower than the Aaa bonds because margins of protection
may not be as large as in Aaa securities, or fluctuation of protective elements
may be of greater amplitude, or there may be other elements present which make
the long-term risks appear somewhat larger than in Aaa securities.
A. Bonds which are rated A possess many favorable investment attributes and
are considered to be upper medium grade obligations. Factors giving security to
principal and interest are considered adequate, but elements may be present
which suggest a susceptibility to impairment sometime in the future.
BAA. Bonds which are rated Baa are considered as medium grade obligations,
i.e., they are neither highly protected nor poorly secured. Interest payments
and principal security appear adequate for the present but certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
Note: Those bonds in the Aa, A and Baa groups which Moody's believes possess the
strongest investment attributes are designated by the symbols Aa1, A1 and Baa1.
DESCRIPTION OF S&P'S MUNICIPAL BOND RATINGS
AAA. Debt rated AAA has the highest rating assigned by S&P. Capacity to pay
interest and repay principal is extremely strong.
AA. Debt rated AA has a very strong capacity to pay interest and repay
principal and differs from the highest rated issues only in small degree.
A. Debt rated A has a strong capacity to pay interest and repay principal
although it is somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than debt in higher rated categories.
BBB. Debt rated BBB is regarded as having adequate capacity to pay interest
and repay principal. Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher rated categories.
Note: Plus (+) or Minus (-): The ratings from 'AA' to 'BBB' may be modified by
the addition of a plus or minus sign to show relative standing within the major
categories.
DESCRIPTION OF MOODY'S HIGHEST RATINGS OF STATE AND MUNICIPAL NOTES AND OTHER
SHORT-TERM LOANS
Moody's ratings for state and municipal notes and other short-term loans
are designated 'Moody's Investment Grade' ('MIG' or, for variable or floating
rate obligations, 'VMIG'). Such ratings recognize the differences between
short-term credit risk and long-term risk. Factors affecting the liquidity of
the borrower and short-term cyclical elements are critical in short-term
ratings. Symbols used will be as follows:
A-2
<PAGE>
MIG-1/VMIG-1. This designation denotes best quality. There is present
strong protection by established cash flows, superior liquidity support or
demonstrated broad based access to the market for refinancing or both.
MIG-2/VMIG-2. This designation denotes high quality. Margins of protection
are ample although not so large as in the preceding group.
DESCRIPTION OF S&P'S RATINGS OF STATE AND MUNICIPAL NOTES AND OTHER SHORT-TERM
LOANS
S&P's tax exempt note ratings are generally given to such notes that mature
in three years or less. The two higher rating categories are as follows:
SP-1. Very strong or strong capacity to pay principal and interest. Those
issues determined to possess overwhelming safety characteristics will be given a
plus (+) designation.
SP-2. Satisfactory capacity to pay principal and interest.
DESCRIPTION OF COMMERCIAL PAPER RATINGS
Issuers assigned Prime-1 by Moody's have a superior capacity for repayment
of senior short-term promissory obligations. Prime-1 repayment capacity will
often be evidenced by many of the following characteristics: leading market
positions in well-established industries; high rates of return on funds
employed; conservative capitalization structures with moderate reliance on debt
and ample asset protection; broad margins in earning coverage of fixed financial
charges and high internal cash generation; well established access to a range of
financial markets and assured sources of alternate liquidity. Issuers assigned
Prime-2 have a strong ability for repayment of short-term promissory
obligations. This will normally be evidenced by many of the characteristics
cited above but to a lesser degree. Earnings trends and coverage ratios, while
sound, may be more subject to variation. Capitalization characteristics, while
still appropriate, may be more affected by external conditions. Ample alternate
liquidity is maintained.
Issues assigned A by S&P, the highest rating category, are regarded as
having the greatest capacity for timely repayment. Issues in this category are
delineated with the numbers 1, 2 and 3 to indicate the relative degree of
safety. The A-1 designation indicates that the degree of safety regarding timely
payment is strong. Those issues determined to possess extremely strong safety
characteristics are denoted with a plus sign (+) designation. The A-2
designation indicates that the capacity for timely payment is satisfactory.
However, the relative degree of safety is not as high as for issues designated
A-1.
A-3
<PAGE>
APPENDIX B
RATING AGENCY GUIDELINES
S&P AAA RATING GUIDELINES. For purposes of calculating the Discounted Value
of the Fund's portfolio under current S&P guidelines, the fair market value of
Municipal Obligations eligible for consideration under such guidelines ('S&P
Eligible Assets') must be discounted by certain discount factors set forth in
the table below ('S&P Discount Factors'). The Discounted Value of a Municipal
Obligation under S&P guidelines is the fair market value thereof divided by the
S&P Discount Factors. The S&P Discount Factor used to discount a particular
Municipal Obligation will be determined by reference to (i)(A) in the event such
Municipal Obligation is not covered by insurance or is covered by an Original
Issuance Insurance policy or a Portfolio Insurance policy which does not provide
the Fund with the option to obtain permanent insurance equivalent to Original
Issue or Secondary Market Insurance ('Permanent Insurance') with respect to such
Municipal Obligation, or which is not escrow backed, the S&P or Moody's rating
on such Municipal Obligation, (B) in the event such Municipal Obligation is
covered by a Secondary Market Insurance policy, the S&P insurance claims-paying
ability rating of the issuer of the policy or (C) in the event such Municipal
Obligation is guaranteed or is covered by a Portfolio Insurance policy which
provides the Fund with the option to obtain Permanent Insurance with respect to
such Municipal Obligation, at the Fund's option the S&P or Moody's rating on
such Municipal Obligation or the S&P insurance claims-paying ability rating of
the guarantor or issuer of the Portfolio Insurance policy, and (ii) the 'S&P
Exposure Period' (currently, 3 Business Days). S&P Discount Factors for a range
of exposure periods are set forth below:
<TABLE>
<CAPTION>
S&P DISCOUNT FACTORS
RATING CATEGORY
------------------------
S&P EXPOSURE PERIOD AAA AA A BBB
- ---------------------------------------- --- --- --- ---
<S> <C> <C> <C> <C>
40 Business Days........................ 190% 195% 210% 250%
22 Business Days........................ 170 175 190 230
10 Business Days........................ 155 160 175 215
7 Business Days........................ 150 155 170 210
3 Business Days........................ 130 135 150 190
</TABLE>
Since the S&P Exposure Period currently applicable to the Fund is three
Business Days, the S&P Discount Factors currently applicable to S&P Eligible
Assets will be determined by reference to the factors set forth opposite the
line entitled '3 Business Days.' Notwithstanding the foregoing, (i) the S&P
Discount Factor for short-term Municipal Obligations will be 115%, so long as
such Municipal Obligations are rated A-1+ or SP-1+ by S&P and mature or have a
demand feature exercisable within 30 days or less, or 125% if such Municipal
Obligations are not rated by S&P but are rated VMIG-1, MIG-1 or Prime-1 by
Moody's; provided, however, that any such Moody's-rated short-term Municipal
Obligations which have demand features exercisable within 30 days or less must
be backed by a letter of credit, liquidity facility or guarantee from a bank or
other financial institution with a short-term rating of at least A-1+ from S&P;
and further provided that such Moody's-rated short-term Municipal Obligations
may comprise no more than 50% of short-term Municipal Obligations that qualify
as S&P Eligible Assets and (ii) no S&P Discount Factor will be applied to cash
or to Receivables for Municipal Obligations Sold. For purposes of the foregoing,
Anticipation Notes rated SP-1+ or, if not rated by S&P, rated MIG-1 or VMIG-1 by
Moody's, which do not mature or have a demand feature at par exercisable in 30
days and which do not have a long-term rating, will be considered to be
short-term Municipal Obligations. 'Receivables for Municipal Obligations Sold,'
for purposes of calculating S&P Eligible Assets as of any
B-1
<PAGE>
Valuation Date, means the book value of receivables for Municipal Obligations
sold as of or prior to such Valuation Date if such receivables are due within
five business days of such Valuation Date.
The S&P guidelines impose certain minimum issue size, issuer, geographical
diversification and other requirements for purposes of determining S&P Eligible
Assets:
(1) In order to be considered S&P Eligible Assets, Municipal
Obligations owned by the Fund must:
(a) Be interest bearing and pay interest at least semi-annually;
(b) Be payable with respect to principal and interest in U.S.
dollars;
(c) Be publicly rated BBB or higher by S&P or, if not rated by S&P
but rated by Moody's, be rated at least A by Moody's; provided that such
Moody's-rated Municipal Obligations will be included in S&P Eligible
Assets only to the extent the fair market value of such Municipal
Obligations does not exceed 50% of the aggregate fair market value of
S&P Eligible Assets. For purposes of determining the S&P Discount
Factors applicable to such Moody's-rated Municipal Obligations, any such
Municipal Obligation will be deemed to have an S&P rating which is one
full rating category lower than its Moody's rating;
(d) Not be private placements; and
(e) Be part of an issue with an original issue size of at least $20
million or, if of an issue with an original issue size below $20 million
(but in no event lower than $10 million), be issued by an issuer with a
total of at least $50 million of securities outstanding.
(2) Municipal Obligations of any one issuer or guarantor (excluding
bond insurers) will be considered S&P Eligible Assets only to the extent
the fair market value of such Municipal Obligations does not exceed 10% of
the aggregate fair market value of S&P Eligible Assets, provided that 2% is
added to the applicable S&P Discount Factor for every 1% by which the fair
market value of such Municipal Obligations exceeds 5% of the aggregate fair
market value of S&P Eligible Assets.
(3) Municipal Obligations issued by issuers in any one state
(including the District of Columbia), territory or possession of the United
States will be considered S&P Eligible Assets only to the extent the fair
market value of such Municipal Obligations does not exceed 20% of the
aggregate fair market value of S&P Eligible Assets.
For purposes of determining as of any Valuation Date whether the Fund has
S&P Eligible Assets with an aggregate Discounted Value at least equal to the APS
Basic Maintenance Amount, the Fund will include as a liability in the
calculation of the APS Basic Maintenance Amount an amount calculated
semi-annually equal to 150% of the estimated cost of obtaining Permanent
Insurance with respect to S&P Eligible Assets that (i) are covered by Portfolio
Insurance policies which provide the Fund with the option to obtain such
Permanent Insurance and (ii) are discounted by an S&P Discount Factor determined
by reference to the insurance claims-paying ability of the issuer of such
Portfolio Insurance policy.
For so long as shares of any series of APS are Outstanding and S&P is
rating such APS, the Fund will not, unless the Fund has received written
confirmation from S&P that any such action would not impair the rating then
assigned by S&P to the APS, engage in any one or more of the following
transactions: engage in reverse repurchase agreement transactions; borrow money,
except that the Fund may, without obtaining the written confirmation described
above, borrow money for the purposes of clearing securities transactions if the
APS Basic Maintenance Amount would continue to be satisfied after giving effect
to such borrowing; issue any class or
B-2
<PAGE>
series of shares ranking prior to or on a parity with the APS with respect to
the payment of dividends or the distribution of assets upon dissolution,
liquidation or winding up of the Fund, or reissue any APS previously purchased
or redeemed by the Fund; lend portfolio securities; merge or consolidate with
any corporation; engage in repurchase agreement transactions in which the term
of such repurchase obligation is longer than 90 days, in which the underlying
security is a security other than United States Treasury securities (not
inclusive of zero-coupon securities), demand deposits, certificates of deposit,
or bankers acceptances in which the counter-party or its affiliates have
securities rated A-1+ by S&P with respect to such underlying security; or engage
in short sale transactions. In addition, as long as shares of APS are so rated
or unless such confirmation has been received, the Fund will not enter into
interest rate caps, collars or floors, purchase or sell futures contracts or
options thereon or write uncovered put or uncovered call options on portfolio
securities except that (i) the Fund may engage in any S&P Hedging Transactions
based on the Municipal Index, provided that the Fund shall not engage in any S&P
Hedging Transaction based on the Municipal Index (other than Closing
Transactions) which would cause the Fund at the time of such transaction to own
or have sold the least of (1) more than 1,000 outstanding futures contracts
based on the Municipal Index, (2) outstanding futures contracts based on the
Municipal Index and on the Treasury Bonds exceeding in number 25% of the
quotient of the fair market value of the Fund's total assets divided by 100,000
or (3) outstanding futures contracts based on the Municipal Index exceeding in
number 10% of the average number of daily traded futures contracts based on the
Municipal Index, in the month prior to the time of effecting such transaction as
reported by The Wall Street Journal and (ii) the Fund may engage in S&P Hedging
Transactions based on Treasury Bonds, provided that the Fund shall not engage in
any S&P Hedging Transaction based on Treasury Bonds (other than Closing
Transactions) which would cause the Fund at the time of such transaction to own
or have sold the lesser of (1) outstanding futures contracts based on Treasury
Bonds and on the Municipal Index exceeding in number 25% of the quotient of the
fair market value of the Fund's total assets divided by 100,000 or (2)
outstanding futures contracts based on Treasury Bonds exceeding in number 10% of
the average number of daily traded futures contracts based on the Treasury
Bonds, in the month prior to the time of effecting such transaction as reported
by The Wall Street Journal.
For so long as shares of any series of APS are rated by S&P, the Fund will
engage in Closing Transactions to close out any outstanding futures contract
which the Fund owns or has sold or any outstanding option thereon owned by the
Fund in the event (i) the Fund does not have S&P Eligible Assets with an
aggregate Discounted Value equal to or greater than the APS Basic Maintenance
Amount on two consecutive Valuation Dates and (ii) the Fund is required to pay
Variation Margin on the second such Valuation Date. For so long as shares of any
series of APS are rated by S&P, the Fund will engage in a Closing Transaction to
close out any outstanding futures contract or option thereon in the month prior
to the delivery month under the terms of such futures contract or option thereon
unless the Fund holds securities deliverable under such terms. For purposes of
determining S&P Eligible Assets to determine compliance with the APS Basic
Maintenance Amount, no amounts on deposit with the Fund's custodian or broker
representing Initial Margin or Variation Margin shall constitute S&P Eligible
Assets. For so long as shares of any series of APS are rated by S&P, when the
Fund writes a futures contract or option thereon, it will maintain an amount of
cash, cash equivalents or short-term, money market securities in a segregated
account with the Fund's custodian, so that the amount so segregated plus the
amount of Initial Margin and Variation Margin held in the account of the Fund's
broker equals the fair market value of the futures contract, except that in the
event the Fund writes a futures contract or option thereon which requires
delivery of an underlying security, the Fund shall hold such underlying
security.
Moody's 'aaa' Rating Guidelines. For purposes of calculating the Discounted
Value of the Fund's portfolio under current Moody's guidelines, the fair market
value of Municipal Obligations eligible for consideration under such guidelines
('Moody's Eligible Assets') must be discounted by certain discount factors set
forth in the table below ('Moody's Discount Factors'). The Discounted Value of a
Municipal Obligation
B-3
<PAGE>
under Moody's guidelines is the fair market value thereof divided by the Moody's
Discount Factor. The Moody's Discount Factor used to discount a particular
Municipal Obligation will be determined by reference to (i)(A) in the event such
Municipal Obligation is not covered by insurance or is covered by an Original
Issue Insurance policy or a Portfolio Insurance policy which does not provide
the Fund with the option to obtain Permanent Insurance with respect to such
Municipal Obligation, or which is not escrow backed, the Moody's or S&P rating
on such Municipal Obligation, (B) in the event such Municipal Obligation is
covered by a Secondary Insurance policy, the Moody's insurance financial
strength rating of the issuer of the policy or (C) in the event such Municipal
Obligation is guaranteed or is covered by a Portfolio Insurance Policy which
provides the Fund with the option to obtain Permanent Insurance with respect to
such Municipal Obligation, at the Fund's option the Moody's or S&P rating on
such Municipal Obligation or the Moody's insurance financial strength rating of
the guarantor or issuer of the Portfolio Insurance policy, and (ii) the 'Moody's
Exposure Period' currently, the 47-day period commencing on a given Valuation
Date). Moody's Discount Factors for a range of exposure periods are set forth
below:
<TABLE>
<CAPTION>
MOODY'S DISCOUNT FACTORS
RATING CATEGORY
-----------------------------------------------------------------------
VMIG-1 SP-1+
MOODY'S EXPOSURE PERIOD AAA(1) AA(1) A(1) BAA(1) OTHER(2) (1) (3) (4) (3) (4)
- ---------------------------------------------------- ------ ----- ---- ------ -------- ----------- -------
<S> <C> <C> <C> <C> <C> <C> <C>
7 weeks or less..................................... 151% 159% 168% 202% 229% 136% 148%
8 weeks or less but greater than 7 weeks............ 154 164 173 205 235 137 149
9 weeks or less but greater than 8 weeks............ 158 169 179 209 242 138 150
</TABLE>
- ------------------
(1) Moody's rating.
(2) Municipal Obligations not rated by Moody's but rated BBB-, BBB or BBB+ by
S&P.
(3) Municipal Obligations rated MIG-1, VMIG-1 or Prime-1 or, if not rated by
Moody's, rated SP-1+ by S&P which do not mature or have a demand feature at
par exercisable within the Moody's Exposure Period and which do not have a
long-term rating.
(4) For the purposes of the definition of Moody's Eligible Assets, these
securities will have an assumed rating of 'A' by Moody's.
The Fund will not obtain any Portfolio Insurance policies without prior
written confirmation from Moody's that the use of such policies will not
adversely affect the Moody's rating of the APS.
Since the Moody's Exposure Period currently applicable to the Fund is 47
days, the Moody's Discount Factors currently applicable to Moody's Eligible
Assets will be determined by reference to the factors set forth opposite the
line entitled '7 weeks or less.' However, if the Moody's Discount Factor used to
discount a particular Municipal Obligation is determined by reference to the
insurance financial strength rating of the insurer of such Municipal Obligation,
such Moody's Discount Factor will be increased by an amount equal to 50% of the
difference between (i) the percentage set forth in the above table under the
applicable rating category, and (ii) the percentage set forth in the above table
under the rating category that is one rating category below the applicable
rating category.
Notwithstanding the foregoing, (i) no Moody's Discount Factor will be
applied to short-term Municipal Obligations so long as such Municipal
Obligations are rated at least MIG-1, VMIG-1 or Prime-1 by Moody's and mature or
have a demand feature at par exercisable within the Moody's Exposure Period, and
the Moody's Discount Factor for such Municipal Obligations will be 125% as long
as such Municipal Obligations are rated
B-4
<PAGE>
A-1-/AA or SP-1+/AA by S&P and mature or have a demand feature at par
exercisable within the Moody's Exposure Period and (ii) no Moody's Discount
Factor will be applied to cash or to the Receivables for Municipal Obligations
Sold. 'Receivables for Municipal Obligations Sold,' for purposes of calculating
Moody's Eligible Assets as of any Valuation Date, means no more that the
aggregate of the following: (i) the book value of receivables for Municipal
Obligations sold as of or prior to such Valuation Date if such receivables are
due within five business days of such Valuation Date, and if the trades which
generated such receivables are (x) settled through clearinghouse firms with
respect to which the Fund has received prior written authorization from Moody's
or (y) with counterparties having a Moody's long-term debt rating of at least
Baa3; and (ii) the Moody's Discounted Value of Municipal Obligations sold as of
or prior to such Valuation Date which generated receivables, if such receivables
are due within the Moody's Exposure Period but do not comply with either of
conditions (x) or (y).
The Moody's guidelines impose certain minimum issue size, issuer,
geographical diversification and other requirements for purposes of determining
Moody's Eligible Assets, as set forth in the table below:
<TABLE>
<CAPTION>
MINIMUM ISSUE MAXIMUM MAXIMUM STATE OR
SIZE UNDERLYING TERRITORY
RATING (MILLIONS) OBLIGOR** CONCENTRATION**
- -------------------- ------------- ---------- -----------------------
<S> <C> <C> <C>
Aaa................. $10 100% 100%
Aa.................. 10 20 60
A................... 10 10 40
Baa................. 10 6 20
Other*.............. 10 4 12
</TABLE>
- ------------------
* Municipal Obligations not rated by Moody's but rated at least BBB--by S&P.
** The referenced percentages represent maximum cumulative totals for the
related rating category and each lower rating category.
Current Moody's guidelines also require that Municipal Obligations
constituting Moody's Eligible Assets pay interest in cash, be publicly rated Baa
or higher by Moody's or, if not rated by Moody's but rated by S&P, that they be
rated at least BBB by S&P, and that they not have suspended ratings. For
purposes of determining the Moody's Discount Factors applicable to such
S&P-rated Municipal Obligations, any such Municipal Obligations (excluding
short-term Municipal Obligations) will be deemed to have a Moody's rating which
is one full rating category lower than its S&P rating. For purposes of
calculation of Minimum Issue Size, Maximum Underlying Obligor and Maximum State
or Territory Concentration, Moody's Eligible Assets shall be calculated without
including cash and Municipal Obligations rated MIG-1, VMIG-1 or Prime-1 or, if
not rated by Moody's, rated SP-1+ by S&P, which either mature or have a demand
feature at par exercisable within the Moody's Exposure Period. Where the Fund
sells an asset and agrees to repurchase such asset in the future, the Discounted
Value of such asset will constitute a Moody's Eligible Asset and the amount the
Fund is required to pay upon repurchase of such asset will count as a liability
for the purposes of the APS Basic Maintenance Amount. Where the Fund purchases
an asset and agrees to sell it to a third party in the future, cash receivable
by the Fund thereby will constitute a Moody's Eligible Asset if the long-term
debt of such other party is rated at least A2 by Moody's and such agreement has
a term of 30 days or less; otherwise the Discounted Value of such asset will
constitute a Moody's Eligible Asset.
B-5
<PAGE>
For purposes of determining as of any Valuation Date whether the Fund has
Moody's Eligible Assets with an aggregate Discounted Value at least equal to the
APS Basic Maintenance Amount, the Fund shall include as a liability in the
calculation of the APS Basic Maintenance Amount an amount calculated
semi-annually equal to 150% of the estimated cost of obtaining Permanent
Insurance with respect to Moody's Eligible Assets that (i) are covered by
Portfolio Insurance policies which provide the Fund with the option to obtain
such Permanent Insurance and (ii) are discounted by a Moody's Discount Factor
determined by reference to the insurance claims-paying ability rating of the
issuer of such Portfolio Insurance policy.
Notwithstanding the foregoing, an asset will not be considered a Moody's
Eligible Asset to the extent that it has been irrevocably deposited for the
payment of (A)(i) through (A)(vii) under the definition of APS Basic Maintenance
Amount or it is subject to any material lien, mortgage, pledge, security
interest or security agreement of any kind (collectively, 'Liens'), except for
(a) Liens which are being contested in good faith by appropriate proceedings and
which Moody's has indicated to the Fund will not affect the status of such asset
as a Moody's Eligible Asset, (b) Liens for taxes that are not then due and
payable or that can be paid thereafter without penalty, (c) Liens to secure
payment for services rendered or cash advanced to the Fund by Mitchell Hutchins,
State Street Bank and Trust Company or the Auction Agent and (d) Liens by virtue
of any repurchase agreement.
For so long as the shares of any series of APS are Outstanding and the APS
are rated by Moody's, the Fund will not, unless it has received written
confirmation from Moody's that any such action would not impair the ratings then
assigned by Moody's to the APS, engage in any one or more of the following
transactions: (1) incur any indebtedness, except that the Fund may, without
obtaining the prior written approval described above, incur indebtedness for the
purpose of clearing securities transactions if the Discounted Value of Moody's
Eligible Assets would equal or exceed the APS Basic Maintenance Amount after
giving effect to such indebtedness; (2) issue any class or series of shares
ranking prior to or on a parity with the APS with respect to the payment of
dividends or the distribution of assets upon dissolution, liquidation or winding
up of the Fund, or reissue any APS previously purchased or redeemed by the Fund;
(3) engage in short sale transactions; or (4) except as necessary to effect
Closing Transactions, engage in transactions in options on securities, futures
contracts or options on futures contracts, except that in connection with
Moody's Hedging Transactions: (A) the Fund may buy call or put options on
securities; (B) the Fund may write covered call options on securities; (C) the
Fund may write put options on securities; (D) the Fund may enter into positions
in futures contracts based on the Municipal Index provided that the Fund shall
not engage in any such transaction which would cause the Fund at the time of
such transaction to own or have sold (1) outstanding futures contracts based on
the Municipal Index exceeding in number 10% of the rolling average number of
daily traded futures contracts based on the Municipal Index in the 30 calendar
days prior to the time of effecting such transaction as reported by The Wall
Street Journal or (2) outstanding futures contracts based on the Muncipal Index
and options on such futures contracts having an aggregate fair market value
(taking into account the fair market value of futures contracts based on
Treasury Bonds) exceeding the fair market value of Moody's Eligible Assets owned
by the Fund; (E) the Fund may enter into futures contracts on Treasury Bonds
provided that the Fund shall not engage in any such transaction which would
cause the Fund at the time of such transaction to own or have sold (1)
outstanding futures contracts based on Treasury Bonds and options on such
futures contracts having an aggregate fair market value (taking into account the
fair market value of futures contracts based on the Municipal Index) exceeding
40% of the aggregate fair market value of Moody's Eligible Assets owned by the
Fund and rated Aa by Moody's (or, if not rated by Moody's but rated by S&P,
rated AAA by S&P) or (2) outstanding futures contracts based on Treasury Bonds
and options on such futures contracts having an aggregate fair market value
(taking into account the fair market value of futures contracts based on the
Municipal Index) exceeding 80% of the aggregate fair market value of Moody's
Eligible Assets owned by the Fund and rated Baa or A by Moody's (or, if not
rated by Moody's but
B-6
<PAGE>
rated by S&P, rated A or AA by S&P); for purposes of the foregoing clauses (D)
and (E), the Fund shall be deemed to own the number of futures contracts that
underlie any outstanding option written by the Fund; and (F) the Fund may buy
call or put options on futures contracts on the Municipal Index or Treasury
Bonds, may write put options on such futures contracts (provided, that if the
contract would require delivery of a security, that security must be held by the
Fund) and may write call options on such futures if it owns the futures contract
subject to the option.
For so long as shares of any series of APS are rated by Moody's, the Fund
will engage in Closing Transactions to close out any outstanding futures
contract based on the Municipal Index if the open interest with respect to such
futures contracts based on the Municipal Index as reported by The Wall Street
Journal is less than 5,000. For so long as shares of APS are rated by Moody's,
the Fund will engage in a Closing Transaction to close out any outstanding
futures contract by no later than the fifth Business Day of the month in which
such contract expires and will engage in a Closing Transaction to close out any
outstanding option on a futures contract by no later than the first Business Day
of the month in which such option expires. For so long as shares of APS are
rated by Moody's, the Fund will engage in transactions with respect to futures
contracts or options thereon having only the next settlement date or the
settlement date immediately thereafter.
For purposes of valuation of Moody's Eligible Assets (i) if the Fund writes
a call option, the underlying asset will be valued as follows: (A) if the option
is exchanged-traded and may be offset readily or if the option expires before
the earliest possible redemption of the APS, at the lower of the Discounted
Value of the underlying security of the option and the exercise price of the
option or (B) otherwise, it has no value; (ii) if the Fund writes a put option,
the underlying asset will be valued as follows: the lesser of (A) exercise price
and (B) the Discounted Value of the underlying security; (iii) if the Fund is a
seller under a futures contract, the underlying security will be valued at the
lower of (A) settlement price and (B) Discounted Value of the underlying
security; provided that, if a contract matures within the Moody's Exposure
Period, the security may be valued at the settlement price; (iv) if the Fund is
the buyer under a futures contract, the underlying security will be valued at
the lower of (A) the settlement price and (B) the Discounted Value of the
underlying security; provided that, if the contract matures within the Moody's
Exposure Period, the security may be valued at Discounted Value of the
underlying security; and (v) call or put option contracts which the Fund buys
have no value. For so long as shares of any series of APS are rated by Moody's:
(1) the Fund will not engage in options and futures transactions for leveraging
or speculative purposes; (2) the Fund will not write any anticipatory call
options or sell any anticipatory contracts pursuant to which the Fund hedges the
anticipated purchase of an asset prior to completion of such purchase; (3) the
Fund will not enter into an option or futures transaction unless, after giving
effect thereto, the Fund would continue to have Moody's Eligible Assets with an
aggregate Discounted Value equal to or greater than the APS Basic Maintenance
Amount; (4) for purposes of the APS Basic Maintenance Amount (i) assets in
margin accounts are not Moody's Eligible Assets, (ii) 10% of the settlement
price of assets sold under a futures contract, the settlement price of assets
purchased under a futures contract and the settlement price of an underlying
futures contract if the Fund writes put options on futures contracts will
constitute liabilities of the Fund and (iii) if the Fund writes call options on
futures contracts and does not own the underlying futures contract, 105% of the
fair market value of the underlying futures contract will constitute a liability
of the Fund; (5) the Fund shall enter into only exchange-traded futures and
shall write only exchange-traded options on exchanges approved by Moody's; (6)
where delivery may be made to the Fund with any of a class of securities, the
Fund shall assume for purposes of the APS Basic Maintenance Amount that it takes
delivery of that security which yields it the least value; (7) the Fund will not
engage in forward contracts; (8) the Fund will enter into futures contracts as
seller only if it owns the underlying security; and (9) there shall be a
quarterly audit made of the Fund's futures and options transactions by the
Fund's independent accountants to confirm that the Fund is in compliance with
these standards.
B-7
<PAGE>
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NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS NOT CONTAINED IN THE PROSPECTUS OR IN THIS STATEMENT OF
ADDITIONAL INFORMATION IN CONNECTION WITH THE OFFERING MADE BY THE PROSPECTUS
AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED
UPON AS HAVING BEEN AUTHORIZED BY THE FUND OR PAINEWEBBER. THE PROSPECTUS AND
THIS STATEMENT OF ADDITIONAL INFORMATION DO NOT CONSTITUTE AN OFFERING BY THE
FUND OR BY PAINEWEBBER IN ANY JURISDICTION IN WHICH SUCH OFFERING MAY NOT
LAWFULLY BE MADE.
------------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Investment Policies and Restrictions........... 1
Hedging and Related Income Strategies.......... 10
Directors and Officers......................... 16
Control Persons and Principal Holders of
Securities................................... 22
Investment Advisory Arrangements............... 22
Portfolio Transactions......................... 24
Valuation of Common Stock...................... 25
Taxes.......................................... 26
Additional Information......................... 28
Financial Information.......................... 29
Appendix A..................................... A-1
Appendix B..................................... B-1
</TABLE>
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INSURED MUNICIPAL
INCOME FUND INC.
COMMON STOCK
------------------------
STATEMENT OF ADDITIONAL
INFORMATION
------------------------
PAINEWEBBER INCORPORATED
------------------------
AUGUST 1, 1996
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(Copyright)1996 PaineWebber Incorporated
