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TRAVELERS SERIES FUND INC.
MFS TOTAL RETURN PORTFOLIO
388 GREENWICH STREET
NEW YORK, NEW YORK 10013
1-800-842-8573
The MFS Total Return Portfolio (the "Portfolio") is one of twelve
portfolios that currently comprise Travelers Series Fund Inc. (the "Fund"), the
investment underlying certain variable annuity and variable life insurance
contracts.
The Portfolio seeks above-average income (compared to a portfolio invested
entirely in equity securities) consistent with prudent employment of capital.
While current income is the primary objective, the Portfolio believes that there
should be a reasonable opportunity for growth of capital and income.
Shares of the Fund are offered ONLY to insurance company separate accounts
(the "Separate Accounts"), which fund certain variable annuity and variable life
insurance contracts (the "Contracts"). The Separate Accounts invest in shares of
the Fund in accordance with allocation instructions received from Contract
owners. Such allocation rights are further described in the accompanying
Contract prospectus.
Shares of the Portfolio are offered to Separate Accounts at their net asset
value, without a sales charge, next determined after receipt of an order by an
insurance company. The offering of shares of the Portfolio may be suspended from
time to time and the Fund reserves the right to reject any specific purchase
order.
THIS PROSPECTUS, WHICH SETS FORTH CONCISE INFORMATION ABOUT THE FUND THAT
PROSPECTIVE INVESTORS SHOULD KNOW BEFORE INVESTING, SHOULD BE READ AND RETAINED
FOR FUTURE REFERENCE. A STATEMENT OF ADDITIONAL INFORMATION ("SAI"), ALSO
REFERRED TO AS "PART B," DATED FEBRUARY 28, 1997 AS AMENDED FROM TIME TO TIME IS
HEREBY INCORPORATED BY REFERENCE INTO THIS PROSPECTUS AND IS AVAILABLE FROM THE
FUND, WITHOUT CHARGE, BY WRITING TO THE FUND AT THE ABOVE ADDRESS OR CALLING THE
TELEPHONE NUMBER LISTED ABOVE.
This Prospectus should be read in conjunction with the prospectus for
the Contracts.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION (THE "SEC") 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.
THE DATE OF THIS PROSPECTUS IS FEBRUARY 28, 1997.
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TABLE OF CONTENTS
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FINANCIAL HIGHLIGHTS............................................. 1
THE FUND'S INVESTMENT PROGRAM.................................... 2
SPECIAL INVESTMENT TECHNIQUES AND RISK CONSIDERATIONS............ 3
DIVIDENDS, DISTRIBUTIONS AND TAXES............................... 17
REDEMPTION OF SHARES............................................. 17
PERFORMANCE...................................................... 17
MANAGEMENT....................................................... 18
SHARES OF THE FUND............................................... 21
DETERMINATION OF NET ASSET VALUE................................. 22
APPENDIX A....................................................... 23
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FINANCIAL HIGHLIGHTS
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The following information for the three-year period ended October 31,
1996 of the Portfolio has been audited in conjunction with the annual audits of
the financial statements of the Fund by KPMG Peat Marwick LLP, independent
auditors. The 1996 financial statements and the independent auditorsO report
thereon appear in the October 31, 1996 Annual Report to Shareholders.
For a share of each capital stock outstanding throughout the period:
<TABLE>
<CAPTION>
MFS TOTAL RETURN
----------------------------------
1996 1995 1994(1)
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<S> <C> <C> <C>
NET ASSET VALUE, BEGINNING OF PERIOD $ 11.53 $ 9.98 $ 10.00
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INCOME FROM OPERATIONS:
Net investment income (2) 0.33 0.45 0.13
Net realized and unrealized gain (loss) 1.62 1.15 (0.15)
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Total Income from Operations 1.95 1.60 (0.02)
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LESS DISTRIBUTIONS FROM:
Net investment income (0.27) (0.05) --
Net realized gains (0.08) -- --
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Total Distributions (0.35) (0.05) --
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NET ASSET VALUE, END OF PERIOD $ 13.13 $ 11.53 $ 9.98
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TOTAL RETURN 17.16% 16.12% (0.20)%++
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NET ASSETS, END OF PERIOD (0000's) $134,529 $49,363 $ 8,504
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RATIOS TO AVERAGE NET ASSETS:
Expenses (2) 0.91% 0.95% 0.93%+
Net investment income 3.82 4.40 3.51%+
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PORTFOLIO TURNOVER RATE 139% 104% 18%
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AVERAGE COMMISSIONS PAID
ON EQUITY SECURITY TRANSACTIONS(3) $ 0.06 $ 0.04 --
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(1) For the period from June 16, 1994 (commencement of operations) to October
31, 1994.
(2) The Manager has waived all or part of its fees for the year ended October
31, 1995 and the period ended October 31, 1994. In addition, the Manager
has reimbursed the Portfolio for $13,857 in expenses for the period ended
October 31, 1994. If such fees were not waived and expenses not reimbursed,
the per share decreases in net investment income and the ratios of expenses
to average net assets of the Portfolio would have been as follows:
Expense Ratios
Per Share Decreases Without Fee Waivers
in Net Investment Income and Reimbursement
------------------------ -------------------
1995 $0.01 1.06%
1994 0.06 2.51+
(3) As of September 1995, the SEC instituted new guidelines requiring the
disclosure of average commissions per share.
(+) Annualized.
(++) Total return is not annualized, as it may not be representative of the
total return for the year.
(+) Annualized.
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THE FUND'S INVESTMENT PROGRAM
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The Portfolio's investment objectives and policies are described below.
Of course, no assurance can be given that the Portfolio's objective will be
achieved. Investors should realize that risk of loss is inherent in the
ownership of any securities and that shares of the Portfolio will fluctuate with
the market value of its securities. Additional information about the Portfolio's
investment policies and investment risks can be found herein under "Special
Investment Techniques and Risk Considerations" and in the SAI.
The investment objectives and certain investment restrictions designated
as such in the SAI are fundamental and may not be changed by the Directors
without shareholder approval. The Portfolio's investment policies, however, are
not fundamental and may be changed by the Directors without shareholder
approval.
INVESTMENT OBJECTIVES
The primary investment objective of the Portfolio is to obtain above-
average income (compared to a portfolio entirely invested in equity securities)
consistent with the prudent employment of capital. While current income is the
primary objective, the Portfolio believes that there should also be a reasonable
opportunity for growth of capital and income, since many securities offering a
better than average yield may also possess growth potential. Thus, in selecting
securities for its portfolio, the Portfolio considers each of these objectives.
Under normal market conditions, at least 25% of the Portfolio's assets will be
invested in fixed income securities and at least 40% and no more than 75% of the
Portfolio's assets will be invested in equity securities. The Portfolio is
managed by Travelers Investment Adviser, Inc. ("TIA" or the "Manager");
Massachusetts Financial Services Company serves as the Portfolio's sub-adviser
(the "Sub-Adviser") and is responsible for making all investment decisions on
behalf of the Portfolio.
INVESTMENT POLICIES
The Portfolio's policy is to invest in a broad list of securities,
including short-term obligations. The list may be diversified not only by
companies and industries, but also by type of security. Fixed income securities
and equity securities (which include: common and preferred stocks; securities
such as bonds, warrants or rights that are convertible into stock; and
depositary receipts for those securities) may be held by the Portfolio. Some
fixed income securities may also have a call on common stock by means of a
conversion privilege or attached warrants. The Portfolio may vary the percentage
of assets invested in any one type of security in accordance with the Sub-
Adviser's interpretation of economic and money market conditions, fiscal and
monetary policy and underlying security values. The Portfolio's debt investments
may consist of both "investment grade" securities (rated Baa or better by
Moody's Investors Service, Inc. ("Moody's") or BBB or better by Standard &
Poor's Ratings Group ("S&P") or Fitch Investors Service, Inc. ("Fitch")) and
securities that are unrated or are in the lower rating categories (rated Ba or
lower by Moody's or BB or lower by S&P or Fitch) (commonly known as "junk
bonds") including up to 20% of its net assets in nonconvertible fixed income
securities that are in these lower rating categories and comparable unrated
securities. See "Lower-Quality and Non-Rated Securities". Generally, most of the
Portfolio's long-term debt investments will consist of "investment grade"
securities. See Appendix A to this Prospectus for a description of these
ratings. It is not the Portfolio's policy to rely exclusively on ratings issued
by established credit rating agencies but rather to supplement such ratings with
the Sub-Adviser's own independent and ongoing review of credit quality.
AS NOTED ABOVE, THE PORTFOLIO INVESTS IN LOWER-RATED AND UNRATED CORPORATE DEBT
SECURITIES, COMMONLY KNOWN AS "JUNK BONDS." INVESTMENTS OF THIS TYPE ARE SUBJECT
TO A GREATER RISK OF LOSS OF PRINCIPAL AND INTEREST. PURCHASERS SHOULD CAREFULLY
ASSESS THE RISKS ASSOCIATED WITH AN INVESTMENT IN THIS PORTFOLIO. SEE "LOWER-
QUALITY AND NON-RATED SECURITIES".
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The Portfolio may invest up to 20% (and generally expects to invest
between 5% and 20%) of its total assets in foreign securities which are not
traded on a U.S. exchange (not including American Depositary Receipts). The
Portfolio may also invest in American Depository Receipts. The Portfolio may
also invest in emerging market securities, Brady Bonds, U.S. government
securities, mortgage pass-through securities, corporate asset-backed securities,
zero-coupon bonds, deferred interest bonds and payment-in-kind bonds. In
addition, the Portfolio may enter into repurchase agreements and mortgage dollar
roll transactions, may lend its portfolio securities, purchase securities on a
when-issued or forward delivery basis, enter into swap transactions and invest
in indexed securities and loan participations and other direct indebtedness. The
Portfolio may invest up to 15% of its net assets in illiquid securities and may
also invest in restricted securities, including Rule 144A Securities. Finally,
the Portfolio may engage in various options and futures transactions including
options on securities, options on stock indexes, options on foreign currencies,
stock indices and foreign currency futures contracts, options on futures
contracts, forward foreign currency exchange contracts and yield curve options.
See "Special Investment Techniques and Risk Considerations" for additional
information about these types of securities.
The Portfolio will be managed actively with respect to the Portfolio's
fixed income securities and the asset allocations modified as the Sub-adviser
deems necessary. Although the Portfolio does not intend to seek short-term
profits, fixed income securities will be sold whenever the sub-adviser believes
it is appropriate to do so without regard to the length of time the particular
asset may have been held. With respect to its equity securities the Portfolio
does not intend to trade in securities for short-term profits and anticipates
that portfolio securities ordinarily will be held for one year or longer.
However, the Portfolio will effect trades whenever it believes that changes in
its portfolio securities are appropriate.
In addition, when the Sub-adviser believes that investing for defensive
purposes is appropriate, such as during periods of unusual or unfavorable market
or economic conditions, or in order to meet anticipated redemption requests, up
to 100% of the Portfolio's assets may be temporarily invested in cash (including
foreign currency) or cash equivalents including, but not limited to, obligations
of banks (including certificates of deposit, bankers' acceptances and repurchase
agreements) with assets of $1 billion or more, commercial paper, short-term
notes, obligations issued or guaranteed by the U.S. or any foreign government or
any of their agencies, authorities or instrumentalities and repurchase
agreements.
SPECIAL INVESTMENT TECHNIQUES AND RISK CONSIDERATIONS
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FOREIGN SECURITIES. The Portfolio may purchase securities issued by
foreign governments, corporations or banks. Investments in foreign securities
involve risks that are different in some respects from investments in securities
of U.S. issuers, such as the risk of fluctuations in the value of the currencies
in which they are denominated, the risk of adverse political, social, economic
and diplomatic developments, the possible imposition of exchange controls or
other foreign governmental laws or restrictions and, with respect to certain
countries, the possibility of expropriation of assets, nationalization or
confiscatory taxation or limitations on the removal of funds or other assets of
the Portfolio. Securities of some foreign companies and banks are less liquid
and more volatile than securities of comparable domestic companies and banks.
Non-U.S. securities markets, while growing in volume have, for the most part,
substantially less volume than U.S. markets, and there is generally less
government supervision and regulation of exchanges, brokers and issuers than
there is in the U.S. Dividend and interest income from non-U.S. securities will
generally be subject to withholding taxes by the country in which the issuer is
located and may not be recoverable by the Portfolio or the investors. There also
may be less publicly available information about foreign issuers than
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domestic issuers, and foreign issuers generally are not subject to the uniform
accounting, auditing and financial reporting standards, practices and
requirements applicable to domestic issuers. Delays may be encountered in
settling securities transactions in certain foreign markets, and the Portfolio
will incur costs in converting foreign currencies into U.S. dollars. Custody and
transaction charges are generally higher for foreign securities. There is also a
risk of the adoption of government regulations that might adversely affect the
payment of principal and interest on securities held by the Portfolio. In
addition, the Portfolio may encounter greater difficulties in invoking legal
processes abroad than would be the case in the U.S. Finally, changes in foreign
currency exchange rates will, to the extent the Portfolio does not adequately
hedge against such fluctuations, affect the value of securities in its portfolio
and the unrealized appreciation or depreciation of investments so far as U.S.
investors are concerned.
SECURITIES OF EMERGING MARKETS. Because of the special risks associated
with investing in emerging markets, an investment in the Portfolio should be
considered speculative. Investors are strongly advised to consider carefully the
special risks involved in emerging markets, which are in addition to the usual
risks of investing in developed foreign markets around the world.
Emerging market countries include any country determined by the Manager
or Sub-Adviser, to have an emerging market economy, taking into account a number
of factors, including the country's foreign currency debt rating, its political
and economic stability and the development of its financial and capital markets.
The Manager or Sub-Adviser determines an issuer's principal trading market for
its securities and the source of its revenues and assets. The issuer's principal
activities generally are deemed to be located in a particular country if: (a)
the security is issued or guaranteed by the government of that country or any of
its agencies, authorities or instrumentalities; (b) the issuer is organized
under the laws of, and maintains a principle office in, that country; (c) the
issuer has its principal securities trading market in that country; or (d) the
issuer has 50% or more of its assets in that country.
Investing in emerging markets involves risks relating to potential
political and economic instability within such markets and the risks of
expropriation, nationalization, confiscation of assets and property, the
imposition of restrictions on foreign investments and the repatriation of
capital invested. In Eastern Europe, for example, upon the accession to power of
Communist regimes in the past, the governments of a number of Eastern European
countries expropriated a large amount of property. The claims of many property
owners against those governments were never finally settled. There can be no
assurance that any investments that the Portfolio might make in an emerging
market would not be expropriated, nationalized or otherwise confiscated at some
time in the future. In the event of such expropriation, nationalization or other
confiscation in any emerging market, the Portfolio could lose its entire
investment in that market. Many emerging market countries have also experienced
substantial, and in some periods extremely high, rates of inflation for many
years. Inflation and rapid fluctuations in inflation rates have had and may
continue to have negative effects on the economics and securities of certain
emerging market countries.
Economies in emerging markets generally are dependent heavily upon
international trade and, accordingly, have been and may continue to be affected
adversely by trade barriers, exchange controls, managed adjustments in relative
currency values and other protectionist measures imposed or negotiated by the
countries with which they trade. These economies also have been and may continue
to be affected adversely by economic conditions in the countries in which they
trade.
The securities markets of emerging countries are substantially smaller,
less developed, less liquid and more volatile than the securities markets of the
United States and other more developed countries. Disclosure and regulatory
standards in many respects are less stringent than in the United States and
other major
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markets. There also may be a lower level of monitoring and regulation of
emerging securities markets and the activities of investors in such markets, and
enforcement of existing regulations has been extremely limited.
In addition, brokerage commissions, custodial services and other costs
relating to investment in foreign markets generally are more expensive than in
the United States, particularly with respect to emerging markets. Such markets
have different settlement and clearance procedures. In certain markets there
have been times when settlements have been unable to keep pace with the volume
of securities transactions, making it difficult to conduct such transactions.
The inability of the Portfolio to make intended securities purchases due to
settlement problems could cause it to miss attractive investment opportunities.
Inability to dispose of a portfolio security caused by settlement problems could
result either in losses to the Portfolio due to subsequent declines in value of
the portfolio security or, if the Portfolio has entered into a contract to sell
the security, could result in possible liability to the purchaser.
The risk also exists that an emergency situation may arise in one or
more emerging markets as a result of which trading of securities may cease or
may be substantially curtailed and prices for the portfolio securities in such
markets may not be readily available. Section 22(e) of the Investment Company
Act of 1940, as amended (the "1940 Act") permits a registered investment company
to suspend redemption of its shares for any period during which an emergency
exists, as determined by the SEC. Accordingly, if the Portfolio believes that
appropriate circumstances warrant, it will promptly apply to the SEC for a
determination that an emergency exists within the meaning of Section 22(a) of
the 1940 Act. During the period commencing from the Portfolio's identification
of such conditions until the date of SEC action, the portfolio securities in the
affected markets will be valued at fair value as determined in good faith by or
under the direction of the Board of Directors.
SOVEREIGN DEBT. The Portfolio may invest in sovereign debt securities of
emerging market governments including Brady Bonds. Investments in such
securities involve special risks. The issuer of the debt or the governmental
authorities that control the repayment of the debt may be unable or unwilling to
repay principal or interest when due in accordance with the terms of such debt.
Periods of economic uncertainty may result in the volatility of market prices of
sovereign debt obligations, and in turn the Portfolio's net asset value, to a
greater extent than the volatility inherent in domestic fixed income securities.
A sovereign debtor's willingness or ability to repay principal and pay
interest in a timely manner may be affected by, among other factors, its cash
flow situation, the extent of its foreign reserves, the availability of
sufficient foreign exchange on the date a payment is due, the relative size of
the debt service burden to the economy as a whole, the sovereign debtor's policy
toward principal international lenders and the political constraints to which a
sovereign debtor may be subject. Emerging market governments could default on
their sovereign debt. Such sovereign debtors also may be dependent on expected
disbursements from foreign governments, multilateral agencies and other entities
abroad to reduce principal and interest arrearages on their debt. The commitment
on the part of these governments, agencies and others to make such disbursements
may be conditioned on a sovereign debtor's implementation of economic reforms
and/or economic performance and the timely service of such debtor's obligations.
Failure to implement such reforms, achieve such levels of economic performance
or repay principal or interest when due, may result in the cancellation of such
third parties' commitments to lend funds to the sovereign debtor, which may
further impair such debtor's ability or willingness to timely service its debts.
The occurrence of political, social or diplomatic changes in one or more
of the countries issuing sovereign debt could adversely affect the Portfolio's
investments. Emerging markets are faced with social and political issues and
some of them have experienced high rates of inflation in recent years and have
extensive internal debt. Among other effects, high inflation and internal debt
service requirements may adversely affect the cost
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5
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and availability of future domestic sovereign borrowing to finance governmental
programs, and may have other adverse social, political and economic
consequences. Political changes or a deterioration of a country's domestic
economy or balance of trade may affect the willingness of countries to service
their sovereign debt. Although management intends to manage the Portfolio in a
manner that will minimize the exposure to such risks, there can be no assurance
that adverse political changes will not cause the Portfolio to suffer a loss of
interest or principal on any of its holdings.
In recent years, some of the emerging market countries in which the
Portfolio expects to invest have encountered difficulties in servicing their
sovereign debt obligations. Some of these countries have withheld payments of
interest and/or principal of sovereign debt. These difficulties have also led to
agreements to restructure external debt obligations -- in particular, commercial
bank loans, typically by rescheduling principal payments, reducing interest
rates and extending new credits to finance interest payments on existing debt.
In the future, holders of emerging market sovereign debt securities may be
requested to participate in similar rescheduling of such debt. Certain emerging
market countries are among the largest debtors to commercial banks and foreign
governments. Currently, Brazil, Russia and Mexico are among the largest debtors
among developing countries. At times certain emerging market countries have
declared moratoria on the payment of principal and interest on external debt;
such a moratorium is currently in effect in certain emerging market countries.
There is no bankruptcy proceeding by which a creditor may collect in whole or in
part sovereign debt on which an emerging market government has defaulted.
The ability of emerging market governments to make timely payments on
their sovereign debt securities is likely to be influenced strongly by a
country's balance of trade and its access to trade and other international
credits. A country whose exports are concentrated in a few commodities could be
vulnerable to a decline in the international prices of one or more of such
commodities. Increased protectionism on the part of a country's trading partners
could also adversely affect its exports. Such events could diminish a country's
trade account surplus, if any. To the extent that a country receives payments
for its exports in currencies other than hard currencies, its ability to make
hard currency payments could be affected.
Investors should also be aware that certain sovereign debt instruments
in which the Portfolio may invest involve great risk. As noted above, sovereign
debt obligations issued by emerging market governments generally are deemed to
be the equivalent in terms of quality to securities rated below investment grade
by Moody's and S&P. Such securities are regarded as predominantly speculative
with respect to the issuer's capacity to pay interest and repay principal in
accordance with the terms of the obligations and involve major risk exposure to
adverse conditions. Some of such securities, with respect to which the issuer
currently may not be paying interest or may be in payment default, may be
comparable to securities rated D by S&P or C by Moody's. The Portfolio may have
difficulty disposing of and valuing certain sovereign debt obligations because
there may be a limited trading market for such securities. Because there is no
liquid secondary market for many of these securities, the Portfolio anticipates
that such securities could be sold only to a limited number of dealers or
institutional investors.
BRADY BONDS. The Portfolio may invest in "Brady Bonds," which are debt
restructurings that provide for the exchange of cash and loans for newly issued
bonds. Brady Bonds have been issued by the governments of Argentina, Brazil,
Bulgaria, Costa Rica, Dominican Republic, Ecuador, Jordan, Mexico, Nigeria,
Panama, the Philippines, Poland, Uruguay and Venezuela. In addition, Peru has
announced intentions to issue Brady Bonds. Approximately $139 billion in
principal amount of Brady Bonds has been issued as of the date of this
Prospectus, the largest proportion having been issued by Mexico and Venezuela.
Brady Bonds issued by Mexico and Venezuela currently are rated below investment
grade. As of the date of this Prospectus, the Portfolio is not aware of the
occurrence of any payment defaults on Brady Bonds. Investors should recognize,
however, that Brady Bonds have been issued only recently and, accordingly, do
not have a long payment history. Brady Bonds
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may be collateralized or uncollateralized, are issued in various currencies
(primarily the U.S. dollar) and are actively traded in the secondary market for
Latin American debt. The Salomon Brothers Brady Bond Index provides a benchmark
that can be used to compare returns of emerging market Brady Bonds with returns
in other bond markets, e.g., the U.S. bond market.
The Portfolio may invest in either collateralized or uncollateralized
Brady Bonds. U.S. dollar-denominated, collateralized Brady Bonds which may be
fixed rate par bonds or floating rate discount bonds, are collateralized in full
as to principal by U.S. Treasury zero coupon bonds having the same maturity as
the bonds. Interest payments on such bonds generally are collateralized by cash
or securities in an amount that, in the case of fixed rate bonds, is equal to at
least one year of rolling interest payments or, in the case of floating rate
bonds, initially is equal to at least one year's rolling interest payments based
on the applicable interest rate at that time and is adjusted at regular
intervals thereafter.
LOAN PARTICIPATIONS. The Portfolio may invest a portion of its assets in
loan participations ("Participations"). By purchasing a Participation, the
Portfolio acquires some or all of the interest of a bank or other lending
institution in a loan to a corporate or government borrower. The Participations
typically will result in the Portfolio having a contractual relationship only
with the lender not the borrower. The Portfolio will have the right to receive
payments of principal, interest and any fees to which it is entitled only from
the lender selling the Participation and only upon receipt by the lender of the
payments from the borrower. In connection with purchasing Participations, the
Portfolio generally will have no right to enforce compliance by the borrower
with the terms of the loan agreement relating to the loan, nor any rights of
set-off against the borrower, and the Portfolio may not directly benefit from
any collateral supporting the loan in which it has purchased the Participation.
As a result, the Portfolio will assume the credit risk of both the borrower and
the lender that is selling the Participation. In the event of the insolvency of
the lender selling a Participation, the Portfolio may be treated as a general
creditor of the lender and may not benefit from any set-off between the lender
and the borrower. The Portfolio will acquire Participations only if the lender
interpositioned between the Portfolio and the borrower is determined by
management to be creditworthy.
The Portfolio may have difficulty disposing of Participations. The
liquidity of such securities is limited and the Portfolio anticipates that such
securities could be sold only to a limited number of institutional investors.
The lack of a liquid secondary market could have an adverse impact on the value
of such securities and on the Portfolio's ability to dispose of particular
Participations when necessary to meet the Portfolio's liquidity needs or in
response to a specific economic event, such as a deterioration in the
creditworthiness of the borrower. The lack of a liquid secondary market for
Participations also may make it more difficult for the Portfolio to assign a
value to those securities for purposes of valuing the Portfolio's portfolio and
calculating its net asset value.
LOWER-QUALITY AND NON-RATED SECURITIES. The Portfolio may invest in
lower-quality securities. Investments in lower-rated securities are subject to
special risks, including a greater risk of loss of principal and non-payment of
interest. An investor should carefully consider the following factors before
investing in the Portfolio.
Generally, lower-quality securities offer a higher return potential than
higher-rated securities but involve greater volatility of price and greater risk
of loss of income and principal, including the possibility of default or
bankruptcy of the issuers of such securities. Lower-quality securities and
comparable non-rated securities will likely have large uncertainties or major
risk exposure to adverse conditions and are predominantly speculative with
respect to the issuer's capacity to pay interest and repay principal in
accordance with the terms of the
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obligation. The occurrence of adverse conditions and uncertainties would likely
reduce the value of securities held by the Portfolio, with a commensurate effect
on the value of the Portfolio's shares.
The markets in which lower-quality securities or comparable non-rated
securities are traded generally are more limited than those in which higher-
quality securities are traded. The existence of limited markets for these
securities may restrict the availability of securities for the Portfolio to
purchase and also may restrict the ability of the Portfolio to obtain accurate
market quotations for purposes of valuing securities and calculating net asset
value or to sell securities at their fair value. The public market for lower-
quality securities and comparable non-rated securities is relatively new and has
not fully weathered a major economic recession. Any such economic downturn could
adversely affect the ability of issuers' lower-quality securities to repay
principal and pay interest thereon.
While the market values of lower-quality securities and comparable non-
rated securities tend to react less to fluctuations in interest rate levels than
do those of higher-quality securities, the market values of certain of these
securities also tend to be more sensitive to individual corporate developments
and changes in economic conditions than higher-quality securities. In addition,
lower-quality securities and comparable non-rated securities generally present a
higher degree of credit risk. Issuers of lower-quality securities and comparable
non-rated securities are often highly leveraged and may not have more
traditional methods of financing available to them so that their ability to
service their debt obligations during an economic downturn or during sustained
periods of rising interest rates may be impaired. The risk of loss due to
default by such issuers is significantly greater because lower-quality
securities and comparable non-rated securities generally are unsecured and
frequently are subordinated to the prior payment of senior indebtedness. The
Portfolio may incur additional expenses to the extent that it is required to
seek recovery upon a default in the payment of principal or interest on its
portfolio holdings.
Fixed-income securities, including lower-quality securities and
comparable non-rated securities, frequently have call and buy-back features that
permit their issuers to call or repurchase the securities from their holders,
such as the Portfolio. If an issuer exercises these rights during periods of
declining interest rates, the Portfolio may have to replace the security with a
lower yielding security, resulting in a decreased return to the Portfolio.
In general, the ratings of nationally recognized statistical rating
organizations represent the opinions of these agencies as to the quality of
securities that they rate. Such ratings, however, are relative and subjective,
and are not absolute standards of quality and do not evaluate the market value
risk of the securities. It is possible that an agency might not change its
rating of a particular issue to reflect subsequent events. These ratings will be
used by the Portfolio as initial criteria for the selection of portfolio
securities, but the Portfolio also will rely upon the independent advice of the
Sub-Adviser, to evaluate potential investments.
In light of these risks, management will take various factors into
consideration in evaluating the creditworthiness of an issue, whether rated or
non-rated. These factors may include, among others, the issuer's financial
resources, its sensitivity to economic conditions and trends, the operating
history of and the community support for the facility financed by the issue, the
ability of the issuer's management and regulatory matters.
SECURITIES LENDING. The Portfolio may seek to increase its net
investment income by lending portfolio securities to unaffiliated brokers,
dealers and other financial institutions, provided such loans are callable at
any time and are continuously secured by cash or U.S. government securities or
other high-grade liquid debt securities equal to no less than the market value,
determined daily, of the securities loaned. The risks in
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lending portfolio securities consist of possible delay in receiving additional
collateral or in the recovery of the securities or possible loss of rights in
the collateral should the borrower fail financially.
REPURCHASE AGREEMENTS. The Portfolio may on occasion enter into
repurchase agreements, wherein the seller agrees to repurchase a security from
the Portfolio at an agreed-upon future date, normally the next business day. The
resale price is greater than the purchase price, which reflects the agreed-upon
rate of return for the period the Portfolio holds the security and which is not
related to the coupon rate on the purchased security. The Portfolio requires
continual maintenance of the market value of the collateral in amounts at least
equal to the resale price, thus risk is limited to the ability of the seller to
pay the agreed-upon amount on the delivery date; however, if the seller
defaults, realization upon the collateral by the Portfolio may be delayed or
limited or the Portfolio might incur a loss if the value of the collateral
securing the repurchase agreement declines and might incur disposition costs in
connection with liquidating the collateral. Repurchase agreements are considered
loans by the Portfolio. The Portfolio will only enter into repurchase agreements
with broker/dealers or other financial institutions that are deemed creditworthy
by management, under guidelines approved by the Board of Directors.
DOLLAR ROLL TRANSACTIONS. The Portfolio may enter into "dollar rolls"
pursuant to which the Portfolio sells mortgage-backed securities for delivery in
the future (generally within 30 days). During the roll period, the Portfolio
would forego principal and interest paid on such securities. The Portfolio would
be compensated by the difference between the current sales price and the forward
price for the future purchase, as well as by the interest earned on the cash
proceeds of the initial sale. Since the Portfolio will receive interest on the
securities in which it invests the transaction proceeds, such transactions may
involve leverage. However, since such securities must satisfy the quality
requirements of the Portfolio and will mature on or before the settlement date
on the transaction, management believes that such transactions do not present
the risks to the Portfolio that are associated with other types of leverage. The
Portfolio will only enter into covered rolls, where there is an offsetting cash
position or a cash equivalent security position which matures on or before the
forward settlement date of the dollar roll transaction. Dollar roll transactions
are considered borrowings by the Portfolio and will be subject to the
Portfolio's overall borrowing limitation. Dollar roll transactions are
considered speculative.
WHEN-ISSUED, DELAYED DELIVERY AND FORWARD COMMITMENT SECURITIES. The
Portfolio may purchase or sell securities on a when-issued, delayed delivery or
forward commitment basis. Such transactions arise when securities are purchased
or sold by the Portfolio with payment and delivery taking place in the future in
order to secure what is considered to be an advantageous price and yield to the
Portfolio at the time of entering into the transaction. Purchasing such
securities involves the risk of loss if the value of the securities declines
prior to settlement date. The sale of securities for delayed delivery involves
the risk that the prices available in the market on the delivery date may be
greater than those obtained in the sale transaction. The Portfolio's custodian
will maintain, in a segregated account on behalf of the Portfolio, cash, U.S.
government securities or other liquid high-grade debt obligations having a value
equal to or greater than the Portfolio's purchase commitments; the custodian
will likewise segregate securities sold on a delayed basis.
CONVERTIBLE SECURITIES. The Portfolio can invest in convertible
securities. Convertible securities are fixed-income securities that may be
converted at either a stated price or stated rate into underlying shares of
common stock. Convertible securities have general characteristics similar to
both fixed-income and equity securities. Although to a lesser extent than with
fixed-income securities, the market value of convertible securities tends to
decline as interest rates increase and, conversely, tends to increase as
interest rates decline. In addition, because of the conversion feature, the
market value of convertible securities tends to vary
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with fluctuations in the market value of the underlying common stocks and,
therefore, also will react to variations in the general market for equity
securities.
Convertible securities are investments which provide for a stable stream
of income with generally higher yields than common stocks. There can be no
assurance of current income because the issuers of the convertible securities
may default on their obligations. Synthetic convertible securities differ from
convertible securities in certain respects, including that each component of a
synthetic convertible security has a separate market value and responds
differently to market fluctuations. Investing in synthetic convertible
securities involves the risk normally involved in holding the securities
comprising the synthetic convertible security.
BORROWING. The Portfolio may borrow from banks, on a secured or
unsecured basis.
ILLIQUID AND RESTRICTED SECURITIES. The Portfolio may purchase
securities that are not registered ("restricted securities") under the
Securities Act of 1933, as amended (the "1933 Act"), but can be offered and sold
to "qualified institutional buyers" under Rule 144A under the 1933 Act ("Rule
144A"). The Portfolio may also invest a portion of its assets in illiquid
investments, which include repurchase agreements maturing in more than seven
days and restricted securities. The Board of Directors may determine, based upon
a continuing review of the trading markets for the specific restricted security,
that such restricted securities are liquid. The Board of Directors has adopted
guidelines and delegated to management the daily function of determining and
monitoring liquidity of restricted securities available pursuant to Rule 144A.
The Board, however, retains sufficient oversight and is ultimately responsible
for the determinations. Since it is not possible to predict with assurance
exactly how the market for Rule 144A restricted securities will develop, the
Board will carefully monitor the Portfolio's investments in these securities,
focusing on such important factors, among others, as valuation, liquidity and
availability of information. Investments in restricted securities could have the
effect of increasing the level of illiquidity in the Portfolio to the extent
that qualified institutional buyers become for a time uninterested in purchasing
these restricted securities. The Portfolio may also purchase restricted
securities that are not registered under Rule 144A.
ZERO-COUPON BONDS, DEFERRED INTEREST BONDS AND PAYMENT-IN-KIND BONDS.
The Portfolio may invest in zero-coupon and payment-in-kind bonds, and also may
invest in deferred interest bonds. Zero-coupon and deferred interest bonds are
issued at a significant discount from their principal amount. While zero-coupon
bonds do not require the periodic payment of interest, deferred interest bonds
provide for a period of delay before the regular payment of interest begins.
Payment-in-kind bonds allow the issuer, at its option, to make current interest
payments on the bonds either in cash or in additional bonds. The value of zero-
coupon bonds is subject to greater fluctuation in market value in response to
changes in market interest rates than bonds of comparable maturity which pay
interest currently. Both zero-coupon and payment-in-kind bonds allow an issuer
to avoid the need to generate cash to meet current interest payments.
Accordingly, such bonds may involve greater credit risks than bonds that pay
interest currently. Even though such bonds do not pay current interest in cash,
the Portfolio is nonetheless required to accrue interest income on such
investments and to distribute such amounts at least annually to shareholders.
Accordingly, for the Portfolio to continue to qualify for tax treatment as a
regulated investment company and to avoid certain excise taxes, the Portfolio
may be required to distribute as a dividend an amount that is greater than the
total amount of cash it actually receives. These distributions must be made from
the Portfolio's cash assets or, if necessary, from the proceeds of sales of
portfolio securities. The Portfolio will not be able to purchase additional
income-producing securities with cash used to make such distributions and its
current income ultimately may be reduced as a result.
FUTURES, OPTIONS AND CURRENCY TRANSACTIONS. Consistent with its
investment objective and policies, the Portfolio may enter into contracts for
the purchase or sale for future delivery of fixed-income securities,
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foreign currencies or contracts based on financial indices including interest
rates or an index of U.S. government or foreign government securities or equity
or fixed-income securities ("futures contracts"), and may buy and write put and
call options to buy or sell futures contracts ("options on futures contracts").
When a Portfolio buys or sells a futures contract it incurs a contractual
obligation to receive or deliver the underlying instrument (or a cash payment
based on the difference between the underlying instrument's closing price and
the price at which the contract was entered into) at a specified price on a
specified date. An option on a futures contract gives the Portfolio the right
(but not the obligation) to buy or sell a futures contract at a specified price
on or before a specified date.
The Portfolio will not enter into transactions in futures contracts and
options on futures contracts for speculation and will not enter into such
transactions other than to hedge against potential changes in interest or
currency exchange rates or the price of a security or a securities index which
might correlate with or otherwise adversely affect either the value of the
Portfolio's securities or the prices of securities which the Portfolio is
considering buying at a later date. The Portfolio, however, may enter into
futures contracts and options on futures contracts for non-hedging purposes,
provided that the aggregate initial margin and premiums on such non-hedging
positions does not exceed 5% of the liquidation value of the Portfolio's assets.
Although futures contracts by their terms call for the delivery or
acquisition of the underlying commodities or a cash payment based on the value
of the underlying commodities, in most cases the contractual obligation is
offset before the delivery date of the contract by buying, in the case of a
contractual obligation to sell, or selling, in the case of a contractual
obligation to buy, an identical futures contract on a commodities exchange. Such
a transaction cancels the obligation to make or take delivery of the
commodities. Since all transactions in the futures market are made through a
member of, and are offset or fulfilled through a clearinghouse associated with,
the exchange on which the contracts are traded, the Portfolio will incur
brokerage fees when it buys or sells futures contracts.
The Portfolio will not (1) enter into any futures contracts or options
on futures contracts if immediately thereafter the aggregate margin deposits on
all outstanding futures contracts positions held by the Portfolio and premiums
paid on outstanding options on futures contracts, after taking into account
unrealized profits and losses, would exceed 5% of the market value of the total
assets of the Portfolio or (2) enter into any futures contracts or options on
futures contracts if the aggregate amount of the Portfolio's commitments under
outstanding futures contracts positions and options on futures contracts written
by the Portfolio would exceed the market value of the total assets of the
Portfolio. See the Statement of Additional Information for further discussion of
the use, risks and costs associated with futures contracts and options on
futures contracts.
FORWARD CURRENCY TRANSACTIONS. The Portfolio may enter into forward
foreign currency exchange contracts ("forward currency contracts") to attempt to
minimize the risk to the Portfolio from adverse changes in the relationship
between the U.S. dollar and other currencies. A forward currency contract is an
obligation to buy or sell an amount of a specified currency for an agreed price
(which may be in U.S. dollars or a foreign currency) at a future date which is
individually negotiated between currency traders and their customers. The
Portfolio may enter into a forward currency contract, for example, when it
enters into a contract to buy or sell a security denominated in a foreign
currency in order to "lock in" the U.S. dollar price of the security
("transaction hedge"). Additionally, when the Portfolio believes that a foreign
currency in which the portfolio securities are denominated may suffer a
substantial decline against the U.S. dollar, the Portfolio may enter into a
forward currency contract to sell an amount of that foreign currency
approximating the value of some or all of the portfolio securities denominated
in that currency, or, when the Portfolio believes that the U.S. dollar may
suffer a substantial decline against a foreign currency, the Portfolio may enter
into a forward currency contract to buy that foreign currency for a fixed U.S.
dollar amount ("position hedge"). The Portfolio
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also may enter into a forward currency contract with respect to a currency where
the Portfolio is considering the purchase of investments denominated in that
currency but has not yet done so ("anticipatory hedge"). In any of these
circumstances the Portfolio may, alternatively, enter into a forward currency
contract with respect to a different foreign currency when the Portfolio
believes that the U.S. dollar value of that currency will correlate with the
U.S. dollar value of the currency in which portfolio securities of, or being
considered for purchase by, the Portfolio are denominated ("cross hedge"). The
Portfolio may invest in forward currency contracts with stated contract values
of up to the value of the Portfolio's assets. The Portfolio may enter into
forward currency contracts for non-hedging purposes, subject to applicable law.
The Portfolio also may enter into forward contracts to buy or sell at a
later date instruments in which the Portfolio may invest directly or on
financial indices based on those instruments. The market for those types of
forward contracts is developing and it is not currently possible to identify
instruments on which forward contracts might be created in the future. See the
SAI for further discussion of the use, risks and costs of forward contracts.
The Portfolio may also enter into currency swaps where each party
exchanges one currency for another on a particular date and agrees to reverse
the exchange on a later date at a specific exchange rate.
Currency Risks. The Portfolio will be affected favorably or unfavorably
by exchange control regulations or changes in the exchange rates between such
currencies and the U.S. dollar. Changes in currency exchange rates will
influence the value of the Portfolio's shares and also may affect the value of
dividends and interest earned by the Portfolio and gains and losses realized by
the Portfolio. Currencies generally are evaluated on the basis of fundamental
economic criteria (e.g., relative inflation and interest rate levels and trends,
growth rate forecasts, balance of payments status and economic policies) as well
as technical and political data. The exchange rates between the U.S. dollar and
other currencies are determined by supply and demand in the currency exchange
markets, the international balance of payments, governmental intervention,
speculation and other economic and political conditions. If the currency in
which a security is denominated appreciates against the U.S. dollar, the dollar
value of the security will increase. Conversely, a decline in the exchange rate
of the currency would adversely affect the value of the security expressed in
U.S. dollars.
Options on Securities and on Foreign Currencies. In an effort to reduce
fluctuations in net asset value or to increase its portfolio return, the
Portfolio may write covered put and call options and may buy put and call
options and warrants on securities traded on U.S. and foreign securities
exchanges. The purpose of such transactions is to hedge against changes in the
market value of portfolio securities caused by fluctuating interest rates,
fluctuating currency exchange rates and changing market conditions, and to close
out or offset existing positions in such options or futures contracts as
described below. The Portfolio may write and buy options on the same types of
securities that the Portfolio could buy directly and may buy options on
financial indices as described above with respect to futures contracts. There
are no specific limitations on the writing and buying of options on securities.
A put option gives the holder the right, upon payment of a premium, to
deliver a specified amount of a security to the writer of the option on or
before a fixed date at a predetermined price. A call option gives the holder the
right, upon payment of a premium, to call upon the writer to deliver a specified
amount of a security on or before a fixed date at a predetermined price.
A call option is "covered" if the Portfolio owns the underlying security
covered by the call. If a "covered" call option expires unexercised, the writer
realizes a gain in the amount of the premium received. If the covered call
option is exercised, the writer realizes either a gain or loss from the sale or
purchase of the
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underlying security with the proceeds to the writer being increased by the
amount of the premium. Prior to its expiration, a call option may be closed out
by means of a purchase of an identical option. Any gain or loss from such
transaction will depend on whether the amount paid is more or less than the
premium received for the option plus related transaction costs. The Portfolio
also may write a covered call option to cross-hedge if the Portfolio does not
own the underlying security. The option is designed to provide a hedge against a
decline in value in another security which the Portfolio owns or has the right
to acquire.
In purchasing an option, the Portfolio would be in a position to realize
a gain if, during the option period, the price of the underlying security
increased (in the case of a call) or decreased (in the case of a put) by an
amount in excess of the premium paid and would realize a loss if the price of
the underlying security did not increase (in the case of a call) or decrease (in
the case of a put) during the period by more than the amount of the premium. If
a put or call option bought by the Portfolio were permitted to expire without
being sold or exercised, the Portfolio would lose the amount of the premium.
Although they entitle the holder to buy equity securities, warrants on
and options to purchase equity securities do not entitle the holder to dividends
or voting rights with respect to the underlying securities, nor do they
represent any rights in the assets of the issuer of those securities.
If a put or call option written by the Portfolio were exercised, the
Portfolio would be obligated to buy or sell the underlying security at the
exercise price. Writing a put option involves the risk of a decrease in the
market value of the underlying security, in which case the option could be
exercised and the underlying security would then be sold by the option holder to
the Portfolio at a higher price than its current market value. Writing a call
option involves the risk of an increase in the market value of the underlying
security, in which case the option could be exercised and the underlying
security would then be sold by the Portfolio to the option holder at a lower
price than its current market value. Those risks could be reduced by entering
into an offsetting transaction. The Portfolio retains the premium received from
writing a put or call option whether or not the option is exercised.
The Portfolio may buy put and call options and may write covered put and
call options on foreign currencies to hedge against declines in the U.S. dollar
value of foreign currency-denominated securities held by the Portfolio and
against increases in the U.S. dollar cost of foreign currency-denominated
securities being considered for purchase by the Portfolio. As in the case of
other options, however, the writing of an option on a foreign currency will
constitute only a partial hedge, up to the amount of the premium received, and
the Portfolio could be required to buy or sell foreign currencies at
disadvantageous exchange rates, thereby incurring losses. The purchase of an
option on a foreign currency may constitute an effective hedge against
fluctuations in exchange rates, although, in the event of rate movements adverse
to the Portfolio's options position, the option may expire worthless and the
Portfolio will lose the amount of the premium. There is no specific percentage
limitation on the Portfolio's investments in options on foreign currencies.
The Portfolio may buy or write options in privately negotiated
transactions on the types of securities and indices based on the types of
securities in which the Portfolio is permitted to invest directly. The Portfolio
will effect such transactions only with investment dealers and other financial
institutions (such as commercial banks or savings and loan institutions) deemed
creditworthy, and only pursuant to procedures adopted by management for
monitoring the creditworthiness of those entities. To the extent that an option
bought or written by the Portfolio in a negotiated transaction is illiquid, the
value of an option bought or the amount of the Portfolio's obligations under an
option written by the Portfolio, as the case may be, will be subject to the
Portfolio's limitation on illiquid investments. In the case of illiquid options,
it may not be possible for the
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Portfolio to effect an offsetting transaction at a time when management believes
it would be advantageous for the Portfolio to do so. See the SAI for a further
discussion of the use, risks and costs of option trading.
SWAPS AND SWAP-RELATED PRODUCTS. As one way of managing its exposure to
different types of investments, the Portfolio may enter into interest rate
swaps, currency swaps and other types of available swap agreements, such as
caps, collars and floors. Swaps involve the exchange by the Portfolio with
another party of cash payments based upon different interest rate indexes,
currencies, and other prices or rates, such as the value of mortgage prepayment
rates. For example, in the typical interest rate swap, the Portfolio might
exchange a sequence of cash payments based on a floating rate index for cash
payments based on a fixed rate. Payments made by both parties to a swap
transaction are based on a principal amount determined by the parties.
The Portfolio may also purchase and sell caps, floors and collars. In a
typical cap or floor agreement, one party agrees to make payments only under
specified circumstances, usually in return for payment of a fee by the
counterparty. For example, the purchase of an interest rate cap entitles the
buyer, to the extent that a specified index exceeds a predetermined interest
rate, to receive payments of interest on a contractually-based principal amount
from the counterparty selling such interest rate cap. The sale of an interest
rate floor obligates the seller to make payments to the extent that a specified
interest rate falls below an agreed-upon level. A collar arrangement combines
elements of buying a cap and selling a floor.
Swap agreements will tend to shift the Portfolio's investment exposure
from one type of investment to another. For example, if the Portfolio agreed to
exchange payments in dollars for payments in foreign currency, in each case
based on a fixed rate, the swap agreement would tend to decrease the Portfolio's
exposure to U.S. interest rates and increase its exposure to foreign currency
and interest rates. Caps and floors have an effect similar to buying or writing
options. Depending on how they are used, swap agreements may increase or
decrease the overall volatility of the Portfolio's investments and its share
price and yield.
Swap agreements are sophisticated hedging instruments that typically
involve a small investment of cash relative to the magnitude of risks assumed.
As a result, swaps can be highly volatile and may have a considerable impact on
the Portfolio's performance. Swap agreements are subject to risks related to the
counterparty's ability to perform, and may decline in value if the
counterparty's creditworthiness deteriorates. The Portfolio may also suffer
losses if it is unable to terminate outstanding swap agreements or reduce its
exposure through offsetting transactions.
Swaps, caps, floors and collars are highly specialized activities which
involve certain risks. See the SAI for a further discussion on the risks
involved in these activities.
SPECIAL INVESTMENT CONSIDERATIONS AND RISKS WITH RESPECT TO FUTURES,
OPTIONS AND CURRENCY TRANSACTIONS AND SWAPS AND SWAP-RELATED PRODUCTS. The
successful use of the investment practices described above with respect to
futures contracts, options on futures contracts, forward contracts, options on
securities and on foreign currencies, and swaps and swap-related products draws
upon skills and experience which are different from those needed to select the
other instruments in which the Portfolio invests. Should interest or exchange
rates or the prices of securities or financial indices move in an unexpected
manner, the Portfolio may not achieve the desired benefits of futures, options,
swaps and forwards or may realize losses and thus be in a worse position than if
such strategies had not been used. Unlike many exchange-traded futures contracts
and options on futures contracts, there are no daily price fluctuation limits
with respect to options on currencies, forward contracts and other negotiated or
over-the-counter instruments, and adverse market movements could therefore
continue to an unlimited extent over a period of time. In addition, the
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correlation between movements in the price of the securities and currencies
hedged or used for cover will not be perfect and could produce unanticipated
losses.
With respect to interest rate swaps, the Portfolio recognizes that such
arrangements are relatively illiquid and will include the principal amount of
the obligations owed to it under a swap as an illiquid security for purposes of
the Portfolio's investment restrictions except to the extent a third party (such
as a large commercial bank) has guaranteed the Portfolio's ability to offset the
swap at any time.
The Portfolio's ability to dispose of its positions in the foregoing
instruments will depend on the availability of liquid markets in the
instruments. Markets in a number of the instruments are relatively new and still
developing, and it is impossible to predict the amount of trading interest that
may exist in those instruments in the future. Particular risks exist with
respect to the use of each of the foregoing instruments and could result in such
adverse consequences to the Portfolio as the possible loss of the entire premium
paid for an option bought by the Portfolio, the inability of the Portfolio, as
the writer of a covered call option, to benefit from the appreciation of the
underlying securities above the exercise price of the option and the possible
need to defer closing out positions in certain instruments to avoid adverse tax
consequences. As a result, no assurance can be given that the Portfolio will be
able to use those instruments effectively for the purposes set forth above. See
the SAI for a further discussion of the use, risks and costs of these
instruments.
In connection with its transactions in futures, options, swaps and
forwards, the Portfolio may be required to place assets in a segregated account
with the Portfolio's custodian bank to ensure that the Portfolio will be able to
meet its obligations under these instruments. Assets held in a segregated
account generally may not be disposed of for so long as the Portfolio maintains
the positions giving rise to the segregation requirement. Segregation of a large
percentage of the Portfolio's assets could impede implementation of the
Portfolio's investment policies or the Portfolio's ability to meet redemption
requests or other current obligations.
MORTGAGE-BACKED SECURITIES. The Portfolio may invest in mortgage-backed
securities, which represent pools of mortgage loans assembled for sale to
investors by various governmental agencies and government-related organizations,
such as Government National Mortgage Association ("GNMA"), Federal National
Mortgage Association ("FNMA") and Federal Home Loan Mortgage Corporation
("FHLMC"), as well as by private issuers such as commercial banks, savings and
loan institutions, mortgage bankers and private mortgage insurance companies.
Mortgage-backed securities provide a monthly payment consisting of interest and
principal payments. Additional payment may be made out of unscheduled repayments
of principal resulting from the sale of the underlying residential property,
refinancing or foreclosure, net of fees or costs that may be incurred.
Prepayments of principal on mortgage-backed securities may tend to increase due
to refinancing of mortgages as interest rates decline. Prompt payment of
principal and interest on GNMA mortgage pass through certificates is backed by
the full faith and credit of the United States. FNMA guaranteed mortgage pass-
through certificates are solely the obligations of those entities but are
supported by the discretionary authority of the U.S. government to purchase the
agencies' obligations. Mortgage pools created by private organizations generally
offer a higher rate of interest than governmental and government-related pools
because there are no direct or indirect guarantees of payments in the former
pools. Timely payment of interest and principal in these pools, however, may be
supported by various forms of private insurance or guarantees, including
individual loan, title, pool and hazard insurance. There can be no assurance
that the private insurers can meet their obligations under the policies.
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Collateralized mortgage obligations are a type of bond secured by an underlying
pool of mortgages or mortgage pass-through certificates that are structured to
direct payments on underlying collateral to different series of classes of the
obligations.
To the extent that the Portfolio purchases mortgage-related securities
at a premium, mortgage foreclosures and prepayments of principal (which may be
made at any time without penalty) may result in some loss of the Portfolio's
principal investment to the extent of the premium paid. The yield of the
Portfolio may be affected by reinvestment of prepayments at higher or lower
rates than the original investment. In addition, like other debt securities, the
values of mortgage-related securities, including government and government
related mortgage pools, generally will fluctuate in response to market interest
rates .
OTHER ASSET-BACKED SECURITIES. The Portfolio may invest in asset-backed
securities arising through the grouping by governmental, government-related and
private organizations of loans, receivables and other assets originated by
various lenders. Interests in pools of these assets differ from other forms of
debt securities, which normally provide for periodic payment of interest in
fixed amounts with principal paid at maturity or specified call dates. Instead,
asset-backed securities provide periodic payments which generally consist of
both interest and principal payments.
The estimated life of an asset-backed security varies with the
prepayment experience with respect to the underlying debt instruments. The rate
of such prepayments, and hence the life of an asset-backed security, will be
primarily a function of current market interest rates, although other economic
and demographic factors may be involved. For example, falling interest rates
generally result in an increase in the rate of prepayments of mortgage loans
while rising interest rates generally decrease the rate of prepayments. An
acceleration in prepayments in response to sharply falling interest rates will
shorten the security's average maturity and limit the potential appreciation in
the security's value relative to a conventional debt security. Consequently,
asset-backed securities are not as effective in locking in high long-term
yields. Conversely, in periods of sharply rising rates, prepayments generally
slow, increasing the security's average life and its potential for price
depreciation.
U.S. GOVERNMENT SECURITIES. The Portfolio may invest in U.S. government
securities, which are debt obligations issued or guaranteed as to payment of
principal and interest by the U.S. government (including Treasury bills, notes
and bonds, certain mortgage participation certificates and collateralized
mortgage obligations) or by its agencies and instrumentalities (such as GNMA,
the Student Loan Marketing Association, the Tennessee Valley Authority, the Bank
for Cooperatives, the Farmers Home Administration, Federal Farm Credit Banks,
Federal Home Loan Banks, Federal Intermediate Credit Banks, Federal Land Banks,
the Export-Import Bank of the U.S., the Federal Housing Administration, FHLMC,
the U.S. Postal Service, the Federal Financing Bank and FNMA). Some of these
securities (such as Treasury bills) are supported by the full faith and credit
of the U.S. Treasury; others (such as obligations of the Federal Home Loan Bank)
are supported by the right of the issuer to borrow from the Treasury; while
still others (such as obligations of FNMA and the Student Loan Marketing
Association) are supported only by the credit of the instrumentality.
PORTFOLIO TURNOVER. Although it is anticipated that most investments of
the Portfolio will be long-term in nature, the rate of portfolio turnover will
depend upon market and other conditions, and it will not be a limiting factor
when management believes that portfolio changes are appropriate. The Portfolio's
historical portfolio turnover rates are included in the Financial Highlights
table above. A higher rate of portfolio turnover may result in higher
transaction costs, including brokerage commissions.
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DIVIDENDS, DISTRIBUTIONS AND TAXES
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The Portfolio intends to qualify as a "regulated investment company"
under Subchapter M of the Internal Revenue Code of 1986, as amended ("Code"). To
qualify, the Portfolio must meet certain tests, including distributing at least
90% of its investment company taxable income, and deriving less than 30% of its
gross income from the sale or other disposition of certain investments held for
less than three months. The Portfolio intends at least annually to declare and
make distributions of substantially all of its taxable income and net taxable
capital gains to its shareowners (i.e. the Separate Accounts). Such
distributions are automatically reinvested in additional shares of the Portfolio
at net asset value and are includable in gross income of the Separate Accounts
holding such shares. See the accompanying Contract prospectus for information
regarding the federal income tax treatment of distributions to the Separate
Accounts and to holders of the Contracts.
The Portfolio is also subject to asset diversification regulations
promulgated by the U.S. Treasury Department under the Code. The regulations
generally provide that, as of the end of each calendar quarter or within 30 days
thereafter, no more than 55% of the total assets of the Portfolio may be
represented by any one investment, no more than 70% by any two investments, no
more than 80% by any three investments, and no more than 90% by any four
investments. For this purpose all securities of the same issuer are considered a
single investment. If the Portfolio should fail to comply with these
regulations, Contracts invested in the Portfolio would not be treated as
annuity, endowment or life insurance contracts under the Code.
REDEMPTION OF SHARES
================================================================================
The redemption price of the shares of the Portfolio will be the net
asset value next determined after receipt by the Fund of a redemption order from
a Separate Account, which may be more or less than the price paid for the
shares. The Fund will ordinarily make payment within one business day, though
redemption proceeds must be remitted to a Separate Account on or before the
third day following receipt of proper tender, except on a day on which the New
York Stock Exchange is closed or as permitted by the SEC in extraordinary
circumstances.
PERFORMANCE
================================================================================
From time to time the Fund may include the Portfolio's total return,
average annual total return, yield and current distribution return in
advertisements and/or other types of sales literature. THESE FIGURES ARE BASED
ON HISTORICAL EARNINGS AND ARE NOT INTENDED TO INDICATE FUTURE PERFORMANCE. In
addition, these figures will not reflect the deduction of the charges that are
imposed on the Contracts by the Separate Account (see Contract prospectus)
which, if reflected, would reduce the performance quoted. Total return is
computed for a specified period of time assuming reinvestment of all income
dividends and capital gains distributions at net asset value on the ex-dividend
dates at prices calculated as stated in this Prospectus, then dividing the value
of the investment at the end of the period so calculated by the initial amount
invested and subtracting 100%. The standard average annual total return, as
prescribed by the SEC, is derived from this total return, which provides the
ending redeemable value. Such standard total return information may also be
accompanied with nonstandard total return information over different periods of
time by means of aggregate, average, year-by-year, or other types of total
return figures. The yield of the Portfolio refers to the net investment income
earned by investments in the Portfolio over a thirty-day period. This net
investment income is then annualized, i.e., the amount of income earned by the
investments during that thirty-day period is assumed to be earned each 30-day
period for twelve periods and is expressed as a percentage of the investments.
The yield quotation is calculated according to a formula prescribed by the SEC
to facilitate comparison with yields quoted by other investment companies. The
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Fund calculates current distribution return for the Portfolio by dividing the
distributions from investment income declared during the most recent period by
the net asset value on the last day of the period for which current distribution
return is presented. A Portfolio's current distribution return may vary from
time to time depending on market conditions, the composition of its investment
portfolio and operating expenses. These factors and possible differences in the
methods used in calculating current distribution return, and the charges that
are imposed on the Contracts by the Separate Account, should be considered when
comparing the Portfolio's current distribution return to yields published for
other investment companies and other investment vehicles.
MANAGEMENT
================================================================================
TRAVELERS INVESTMENT ADVISER, INC.
TIA manages the investment operations of the Portfolio pursuant to a
management agreement entered into by the Fund on behalf of the Portfolio. Under
the management agreement TIA is responsible for furnishing or causing to be
furnished to the Portfolio advice and assistance with respect to the
acquisition, holding or disposal of investments and recommendations with respect
to other aspects and affairs of the Portfolio, office space and equipment, and
the services of the officers and employees of the Fund. TIA has entered into a
Sub-Administrative Services Agreement with an affiliate (the "Sub-
Administrator") to: (a) assist TIA in supervising all aspects of the Portfolio's
operations; (b) supply the Portfolio with office facilities, statistical and
research services, data processing services, clerical, accounting and
bookkeeping services; and (c) prepare reports to the Portfolio's shareholders,
reports to and filings with the SEC and state blue sky authorities, if
applicable. TIA pays the Sub-Administrator a fee, from the management fee, in an
amount equal to an annual rate of 0.10% of the Portfolio's average daily net
assets.
The Fund and TIA have also entered into a subadvisory agreement on
behalf of the Portfolio. Pursuant to the subadvisory agreement, the Sub-Adviser
is responsible for the day-to-day operations and investment decisions for the
Portfolio and is authorized, in its discretion and without prior consultation
with TIA, to: (a) manage the Portfolio's assets in accordance with the
Portfolio's investment objective(s) and policies as stated in the Prospectus and
the SAI; (b) make investment decisions for the Portfolio; (c) place purchase and
sale orders for portfolio transactions on behalf of the Portfolio; and (d)
employ professional portfolio managers and securities analysts who provide
research services to the Portfolio.
For the services provided by TIA, the Portfolio pays TIA an annual
management fee calculated at a rate equal to 0.80% of its average daily net
assets, paid monthly.
Although the management fee paid by the Portfolio is greater than that
paid by most mutual funds, management has determined that each fee is comparable
to the fee charged by other investment advisers of mutual funds that have
similar investment objectives and policies.
The management agreement further provides that all other expenses not
specifically assumed by TIA under the management agreement on behalf of the
Portfolio are borne by the Fund. Expenses payable by the Fund include, but are
not limited to, all charges of custodians and shareholder servicing agents,
expenses of preparing, printing and distributing all prospectuses, proxy
material, reports and notices to shareholders, all expenses of shareholders' and
directors' meetings, filing fees and expenses relating to the registration and
qualification of the Fund's shares and the Fund under federal and state
securities laws and maintaining such registrations and qualifications (including
the printing of the Fund's registration statements), fees of auditors and legal
counsel, costs of performing portfolio valuations, out-of-pocket expenses of
directors and fees of directors who are not "interested persons" as defined in
the 1940 Act,
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interest, taxes and governmental fees, fees and commissions of every kind,
expenses of issue, repurchase or redemption of shares, insurance expense,
association membership dues, all other costs incident to the Fund's existence
and extraordinary expenses such as litigation and indemnification expenses.
Direct expenses are charged to the Portfolio; general corporate expenses are
allocated on the basis of relative net assets.
TIA was incorporated in 1996 under the laws of Delaware. It is an
indirect wholly-owned subsidiary of Travelers Group Inc. ("Travelers"), which is
a financial services holding company engaged, through its subsidiaries,
principally in four business segments: investment services, consumer finance
services, life insurance services and property & casualty insurance services.
TIA is located at 388 Greenwich Street, New York, New York 10013. TIA and its
affiliates may in the future act as investment advisers for other accounts.
THE SUB-ADVISER
MASSACHUSETTS FINANCIAL SERVICES COMPANY. Massachusetts Financial
Services Company ("MFS") serves as Sub-Adviser to the MFS Total Return Portfolio
pursuant to a subadvisory agreement. Pursuant to the subadvisory agreement TIA
pays MFS an annual fee calculated at the rate of 0.375% of the Portfolio's
average daily net assets.
MFS also serves as investment adviser to each of the funds in the MFS
Family of Funds and to MFS/Sun Life Series Trust, MFS Institutional Trust, MFS
Variable Insurance Trust, MFS Union Standard Trust, MFS Municipal Income Trust,
MFS Government Markets Income Trust, MFS Multimarket Income Trust, MFS
Intermediate Income Trust, MFS Charter Income Trust, MFS Special Value Trust,
Sun Growth Variable Annuity Fund, Inc. and seven variable accounts, each of
which is a registered investment company established by Sun Life Assurance
Company of Canada (U.S.)("Sun Life of Canada (U.S.)") in connection with the
sale of various fixed/variable annuity contracts. MFS and its wholly owned
subsidiary, MFS Institutional Advisors, Inc., also provide investment advice to
substantial private clients.
MFS is located at 500 Boylston Street, Boston, Massachusetts 02116. MFS
is America's oldest mutual fund organization. MFS and its predecessor
organizations have a history of money management dating from 1924 and the
founding of the first mutual fund in the United States, Massachusetts Investors
Trust. Net assets under the management of the MFS organization were
approximately $52.3 billion on behalf of approximately 2.2 million investors
accounts as of November 29, 1996. As of such date, the MFS organization managed
approximately $20.9 billion of assets in fixed income securities. MFS is a
subsidiary of Sun Life of Canada (U.S.) which in turn is a wholly owned
subsidiary of Sun Life Assurance Company of Canada ("Sun Life"). Sun Life, a
mutual life insurance company, is one of the largest international life
insurance companies and has been operating in the U.S. since 1895, establishing
a headquarters office here in 1973. The executive officers of MFS report to the
Chairman of Sun Life.
David M. Calabro, a Vice President of MFS, Geoffrey L. Kurinsky, a
Senior Vice President of MFS, Judith N. Lamb, a Vice President of MFS, Lisa B.
Nurme, a Vice President of MFS, and Maura A. Shaughnessy, a Vice President of
MFS, are the Fund's portfolio managers. Mr. Calabro is the head of this
portfolio management team and a manager of the common stock portion of the
Fund's portfolio. Mr. Calabro has been employed by MFS since 1992 and served as
an analyst and sector portfolio manager with Fidelity Investments prior to that
time. Mr. Kurinsky, the manager of the Fund's fixed income securities, has been
employed by MFS since 1987. Ms. Lamb, the manager of the Fund's convertible
securities, has been employed by MFS since 1992, and served as an analyst with
Fidelity Investments prior to that time. Ms. Nurme, a manager of the common
stock portion of the Fund's portfolio, has been employed by MFS since
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<PAGE>
1987. Ms. Shaughnessy, also a manager of the common stock portion of the Fund's
portfolio, has been employed by MFS since 1991 and served as an analyst with
Harvard Management Company prior to that time.
MFS has established a strategic alliance with Foreign & Colonial
Management Ltd. ("Foreign & Colonial"). Foreign & Colonial is a subsidiary of
two of the world's oldest financial services institutions, the London-based
Foreign & Colonial Investment Trust PLC, which pioneered the idea of investment
management in 1868, and HYPO-BANK (Bayerische Hypotheken-und Weschsel-Bank AG),
the oldest publicly listed bank in Germany, founded in 1835. As part of this
alliance, the portfolio managers and investment analysts of MFS and Foreign &
Colonial will share their views on a variety of investment related issues, such
as the economy, securities markets, portfolio securities and their issuers,
investment recommendations, strategies and techniques, risk analysis, trading
strategies and other portfolio management matters. MFS has access to the
extensive international equity investment expertise of Foreign & Colonial, and
Foreign & Colonial has access to the extensive U.S. equity investment expertise
of MFS. MFS and Foreign & Colonial each have investment personnel working in
each other's offices in Boston and London, respectively.
In certain instances there may be securities which are suitable for the
Fund's portfolio as well as for portfolios of other clients of MFS or clients of
Foreign & Colonial. Some simultaneous transactions are inevitable when several
clients receive investment advice from MFS and Foreign & Colonial, particularly
when the same security is suitable for more than one client. While in some cases
this arrangement could have a detrimental effect on the price or availability of
the security as far as the Fund is concerned, in other cases, however, it may
produce increased investment opportunities for the Fund.
BOARD OF DIRECTORS
Overall responsibility for management and supervision of the Fund rests
with the Fund's Board of Directors. The Directors approve all significant
agreements between the Fund and the companies that furnish services to the Fund
and the Portfolio, including agreements with the Fund's distributor, investment
managers, investment sub-advisers, custodian and transfer agent. The SAI
contains background information regarding each Director and executive officer of
the Fund.
PORTFOLIO TRANSACTIONS AND DISTRIBUTION
TIA and the Sub-Adviser are subject to the supervision and direction of
the Fund's Board of Directors and manage the Portfolio in accordance with its
investment objective and policies, make investment decisions for the Portfolio,
place orders to purchase and sell securities and employ professionals who
provide research services. All orders for transactions in securities on behalf
of the Portfolio are made by management, with broker-dealers selected by
management, including affiliated brokers. In placing orders management will seek
to obtain the most favorable price and execution available. In selecting broker-
dealers, management may consider research and brokerage services furnished to it
and its affiliates.
The Fund's Board of Directors has determined that transactions for the
Fund may be executed through any broker-dealer affiliate of the Fund
("Affiliated Broker") if, in the judgement of management, the use of an
Affiliated Broker is likely to result in price and execution at least as
favorable to the Fund as those obtainable through other qualified broker-
dealers, and if, in the transaction, the Affiliated Broker charges the Fund a
fair and reasonable rate consistent with that charged to comparable unaffiliated
customers in similar transactions. The Fund will not deal with an Affiliated
Broker in any transaction in which such Affiliated Broker acts as principal.
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SHARES OF THE FUND
================================================================================
GENERAL
The Fund, an open-end managed investment company, was incorporated in
Maryland on February 22, 1994. The Fund has an authorized capital of
6,000,000,000 shares with a par value of $.00001 per share. The Board of
Directors has authorized the issuance of twelve series of shares, each
representing shares in one of twelve separate Portfolios. The Directors also
have the power to create additional series of shares. The assets of each
Portfolio will be segregated and separately managed and a shareowner's interest
is in the assets of the Portfolio in which he or she holds shares.
VOTING RIGHTS
The Fund offers its shares only for purchase by insurance company
separate accounts. Thus, the insurance company is technically the shareholder of
the Fund and, under the 1940 Act, is deemed to be in control of the Fund.
Nevertheless, with respect to any Fund shareholder meeting, an insurance company
will solicit and accept timely voting instructions from its contractowners who
own units in a separate account investment division which corresponds to shares
in the Fund in accordance with the procedures set forth in the accompanying
prospectus for the applicable contract issued by the insurance company and to
the extent required by law. Shares of the Fund attributable to contractowner
interests for which no voting instructions are received will be voted by an
insurance company in proportion to the shares for which voting instructions are
received.
Each share of a Portfolio represents an equal proportionate interest in
that Portfolio with each other share of the same Portfolio and is entitled to
such dividends and distributions out of the net income of that Portfolio as are
declared in the discretion of the Directors. Shareowners are entitled to one
vote for each share held and will vote by individual Portfolio except to the
extent required by the 1940 Act. The Fund is not required to hold annual
shareowner meetings, although special meetings may be called for the Fund as a
whole, or a specific Portfolio, for purposes such as electing or removing
Directors, changing fundamental policies or approving a management contract.
Shareowners may cause a meeting of shareowners to be held upon a vote of 10% of
the Fund's outstanding shares for the purpose of voting on the removal of
Directors.
AVAILABILITY OF THE FUND
Investment in the Fund is only available to owners of either variable
annuity or variable life insurance contracts issued by insurance companies
through their separate accounts. It is possible that in the future it may become
disadvantageous for both variable annuity and variable life insurance separate
accounts to be invested simultaneously in the Fund. However, the Fund does not
currently foresee any disadvantages to the contractowners of the different
contracts which are funded by such separate accounts. The Board monitors events
for the existence of any material irreconcilable conflict between or among such
owners, and each insurance company will take whatever remedial action may be
necessary to resolve any such conflict. Such action could include the sale of
Fund shares by one or more of the insurance company separate accounts which fund
these contracts, which could have adverse consequences to the Fund. Material
irreconcilable conflicts could result from, for example: (a) changes in state
insurance laws; (b) changes in U.S. federal income tax laws; or (c) differences
in voting instructions between those given by variable annuity contractowners
and those given by variable life insurance contractowners. If the Board were to
conclude that separate series of the Fund should be established for variable
annuity and variable life separate accounts, each insurance company would bear
the attendant expenses. Should this become necessary, contractowners would
presumably no longer have the economies of scale resulting from a larger
combined mutual fund.
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DETERMINATION OF NET ASSET VALUE
================================================================================
The net asset value of the Portfolio's shares is determined as of the
close of regular trading on the New York Stock Exchange ("NYSE"), which is
currently 4:00 P.M. New York City time on each day that the NYSE is open, by
dividing the Portfolio's net assets by the number of its shares outstanding.
Securities owned by the Portfolio for which market quotations are readily
available are valued at current market value or, in their absence, at fair
value. Securities traded on an exchange are valued at last sales price on the
principal exchange on which each such security is traded, or if there were no
sales on that exchange on the valuation date, the last quoted sale, up to the
time of valuation, on the other exchanges. If instead there were no sales on the
valuation date with respect to these securities, such securities are valued at
the mean of the latest published closing bid and asked prices. Over-the-counter
securities are valued at last sales price or, if there were no sales that day,
at the mean between the bid and asked prices. Options, futures contracts and
options thereon that are traded on exchanges are also valued at last sales
prices as of the close of the principal exchange on which each is listed or if
there were no such sales on the valuation date, the last quoted sale, up to the
time of valuation, on other exchanges. In the absence of any sales on the
valuation date, valuation shall be the mean of the latest closing bid and asked
prices. Fixed income obligations are valued at the mean of bid and asked prices
based on market quotations for those securities or if no quotations are
available, then for securities of similar type, yield and maturity. Securities
with a remaining maturity of 60 days or less are valued at amortized cost where
the Board of Directors has determined that amortized cost is fair value.
Premiums received on the sale of call options will be included in the
Portfolio's net assets, and current market value of such options sold by the
Portfolio will be subtracted from the Portfolio's net assets. Any other
investments of the Portfolio, including restricted securities and listed
securities for which there is a thin market or that trade infrequently (i.e.,
securities for which prices are not readily available), are valued at a fair
value determined by the Board of Directors in good faith. This value generally
is determined as the amount that the Portfolio could reasonably expect to
receive from an orderly disposition of these assets over a reasonable period of
time but in no event more than seven days. The value of any security or
commodity denominated in a currency other than U.S. dollars will be converted
into U.S. dollars at the prevailing market rate as determined by management.
Foreign securities trading may not take place on all days on which the
NYSE is open. Further, trading takes place in various foreign markets on days on
which the NYSE is not open. Accordingly, the determination of the net asset
value of the Portfolio may not take place contemporaneously with the
determination of the prices of investments held by the Portfolio. Events
affecting the values of investments that occur between the time their prices are
determined and 4:00 P.M. on each day that the NYSE is open will not be reflected
in the Portfolio's net asset value unless management under the supervision of
the Fund's Board of Directors, determines that the particular event would
materially affect the net asset value. As a result, the Portfolio's net asset
value may be significantly affected by such trading on days when a shareholder
has no access to the Portfolio.
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APPENDIX A
================================================================================
RATINGS ON DEBT OBLIGATIONS
BOND (AND NOTES) RATINGS
MOODY'S INVESTORS SERVICE, INC.
Aaa - Bonds that are rated "Aaa" are judged to be of the best quality.
They carry the smallest degree of investment risk and are generally referred to
as "gilt edged." Interest payments are protected by a large or by an
exceptionally stable margin and principal is secure. While the various
protective elements are likely to change, such changes as can be visualized are
most unlikely to impair the fundamentally strong position of such issues.
Aa - Bonds that are rated "Aa" are judged to be of high quality by all
standards. Together with the "Aaa" group they comprise what are generally known
as high grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in "Aaa" securities or fluctuation of
protective elements may be of greater amplitude or there may be other elements
present that make the long term risks appear somewhat larger than in "Aaa"
securities.
A - Bonds that are rated "A" possess many favorable investment
attributes and are to be considered as upper medium grade obligations. Factors
giving security to principal and interest are considered adequate but elements
may be present that suggest a susceptibility to impairment sometime in the
future.
Baa - Bonds that 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.
Ba - Bonds which are rated Ba are judged to have speculative elements;
their future cannot be considered as well assured. Often the protection of
interest and principal payments may be very moderate and thereby not well
safeguarded during both good and bad times over the future. Uncertainty of
position characterizes bonds in this class.
B - Bonds which are rated B generally lack characteristics of the
desirable investment. Assurance of interest and principal payments or of
maintenance of other terms of the contract over any long period of time may be
small.
Caa - Bonds which are rated Caa are of poor standing. Such issues may be
in default or there may be present elements of danger with respect to principal
or interest.
Ca - Bonds which are rated Ca represent obligations which are
speculative in a high degree. Such issues are often in default or have other
marked shortcomings.
C - Bonds which are rated C are the lowest class of bonds and issues so
rated can be regarded as having extremely poor prospects of ever attaining any
real investment standing.
Note: The modifier 1 indicates that the security ranks in the higher end
of its generic rating category; the modifier 2 indicates a mid-range ranking;
and the modifier 3 indicates that the issue ranks in the lower end of its
generic rating category.
STANDARD & POOR'S
AAA - Debt rated "AAA" has the highest rating assigned by Standard &
Poor's. Capacity to pay interest and repay principal is extremely strong.
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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 an 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.
BB, B, CCC, CC, C - Debt rated 'BB', 'B', 'CCC', 'CC' or 'C' is
regarded, on balance, as predominantly speculative with respect to capacity to
pay interest and repay principal in accordance with the terms of the obligation.
'BB' indicates the lowest degree of speculation and 'C' the highest degree of
speculation. While such debt will likely have some quality and protective
characteristics, these are outweighed by large uncertainties or major risk
exposures to adverse conditions.
PLUS (+) OR MINUS (-): The ratings from 'AA' to 'B' may be modified by
the addition of a plus or minus sign to show relative standing within the major
rating categories.
PROVISIONAL RATINGS: The letter "p" indicates that the rating is
provisional. A provisional rating assumes the successful completion of the
project being financed by the debt being rated and indicates that payment of
debt service requirements is largely or entirely dependent upon the successful
and timely completion of the project. This rating, however, while addressing
credit quality subsequent to completion of the project, makes no comment on the
likelihood of, or the risk of default upon failure of, such completion. The
investor should exercise judgment with respect to such likelihood and risk.
L - The letter "L" indicates that the rating pertains to the principal
amount of those bonds where the underlying deposit collateral is fully insured
by the Federal Savings & Loan Insurance Corp. or the Federal Deposit Insurance
Corp.
+ - Continuance of the rating is contingent upon S&P's receipt of
closing documentation confirming investments and cash flow.
* - Continuance of the rating is contingent upon S&P's receipt of an
executed copy of the escrow agreement.
NR - Indicates no rating has been requested, that there is insufficient
information on which to base a rating, or that S&P does not rate a particular
type of obligation as a matter of policy.
FITCH INVESTORS SERVICE, INC.
AAA - Bonds considered to be investment grade and of the highest credit
quality. The obligor has an exceptionally strong ability to pay interest and
repay principal which is unlikely to be affected by reasonably foreseeable
events.
AA - Bonds considered to be investment grade and of very high credit
quality. The obligor's ability to pay interest and repay principal is very
strong, although not quite as strong as bonds rated "AAA". Because bonds rated
in the "AAA" and "AA" categories are not significantly vulnerable to foreseeable
future developments, short-term debt of these issuers is generally rated "F-1+".
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A - Bonds considered to be investment grade and of very high credit
quality. The obligor's ability to pay interest and repay principal is considered
to be strong, but may be more vulnerable to adverse changes in economic
conditions and circumstances than bonds with higher ratings.
BBB - Bonds considered to be investment grade and of satisfactory credit
quality. The obligor's ability to pay interest and repay principal is considered
to be adequate. Adverse changes in economic conditions and circumstances,
however, are more likely to have adverse impact on these bonds, and therefore
impair timely payment. The likelihood that the ratings of these bonds will fall
below investment grade is higher than for bonds with higher ratings.
BB - Bonds are considered speculative. The obligor's ability to pay
interest and repay principal may be affected over time by adverse economic
changes. However, business and financial alternatives can be identified which
could assist the obligor in satisfying its debt service requirements.
B - Bonds are considered highly speculative. While bonds in this class
are currently meeting debt service requirements, the probability of continued
timely payment of principal and interest reflects the obligor's limited margin
safety and the need for reasonable business and economic activity throughout the
life of the issue.
CCC - Bonds have certain identifiable characteristics which if not
remedied, may lead to default. The ability to meet obligations requires an
advantageous business and economic environment.
CC - Bonds are minimally protected. Default in payment of interest
and/or principal seems probable over time.
C - Bonds are in imminent default in payment of interest or principal.
Plus (+) Minus (-) - Plus and minus signs are used with a rating symbol
to indicate the relative position of a credit within the rating category. Plus
and minus signs, however, are not used in the "AAA" category.
NR - Indicates that Fitch does not rate the specific issue.
CONDITIONAL - A conditional rating is premised on the successful
completion of a project or the occurrence of a specific event.
SUSPENDED - A rating is suspended when Fitch deems the amount of
information available from the issuer to be inadequate for rating purposes.
WITHDRAWN - A rating will be withdrawn when an issue matures or is
called or refinanced and at Fitch's discretion when an issuer fails to furnish
proper and timely information.
FITCHALERT - Ratings are placed on FitchAlert to notify investors of an
occurrence that is likely to result in a rating change and the likely direction
of such change. These are designated as "Positive", indicating a potential
upgrade, "Negative", for potential downgrade, or "Evolving", where ratings may
be lowered. FitchAlert is relatively short-term, and should be resolved within
12 months.
COMMERCIAL PAPER RATINGS
MOODY'S INVESTORS SERVICE, INC.
Issuers rated "Prime-1" (or related supporting institutions) have a
superior capacity for repayment of short-term promissory obligations. Prime-1
repayment will normally be evidenced by the following characteristics: leading
market positions in well-established industries; high rates of return on funds
employed; conservative capitalization structures with moderate reliance on debt
and ample asset protection;
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broad margins in earnings coverage of fixed financial changes and high internal
cash generation; well-established access to a range of financial markets and
assured sources of alternate liquidity.
Issuers rated "Prime-2" (or related supporting institutions) have strong
capacity 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, will be more subject to
variation. Capitalization characteristics, while still appropriate, may be more
affected by external conditions. Ample alternate liquidity is maintained.
STANDARD & POOR'S
A-1 - This designation indicates that the degree of safety regarding
timely payment is either overwhelming or very strong. Those issuers determined
to possess overwhelming safety characteristics will be denoted with a plus (+)
sign designation.
A-2 - Capacity for timely payment on issues with this designation is
strong. However, the relative degree of safety is not as high as for issues
designated A-1 .
IBCA LIMITED OR ITS AFFILIATE, IBCA INC.
A-1+ - This designation indicates the highest capacity for timely
repayment.
A-1 - Capacity for timely repayment on issues with this designation is
very strong.
A-2 - This designation indicates a strong capacity for timely repayment,
although such capacity may be susceptible to adverse changes in business,
economic or financial conditions.
FITCH INVESTORS SERVICE, INC.
F-1+ - Indicates the strongest degree of assurance for timely payment.
F-1 - This designation reflects an assurance of timely payment only
slightly less in degree than issues rated F-1+.
F-2 - This indicates a satisfactory degree of assurance for timely
payment, although the margin of safety is not as great as indicated by the F-1+
and F-1 categories.
DUFF & PHELPS INC.
Duff 1+ - Indicates the highest certainty of timely payment: short-term
liquidity is clearly outstanding, and safety is just below risk-free United
States Treasury short-term obligations.
Duff 1 - Indicates a high certainty of timely payment.
Duff 2 - Indicates a good certainty of timely payment: liquidity factors
and company fundamentals are sound.
THE THOMSON BANKWATCH ("TBW")
TBW-1 - Indicates a very high degree of likelihood that principal and
interest will be paid on a timely basis.
TBW-2 - While the degree of safety regarding timely repayment of
principal and interest is strong, the relative degree of safety is not as high
as for issues rated TBW-1.
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