PAGE 1
Prospectus for the T. Rowe Price Fixed Income Series, Inc., dated March 31,
1994, should be inserted here.
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T. ROWE PRICE LIMITED-TERM BOND PORTFOLIO
PROSPECTUS
May 17, 1994
T. Rowe Price
Fixed Income Series, Inc.
TABLE OF CONTENTS
Investment Summary...........................................................1
Investment Objective.........................................................2
Fund Characteristics and
Investment Program...........................................................2
Summary of Fund Fees and Expenses............................................3
Voting Rights................................................................3
Investing in Debt Securities.................................................3
Investment Practices.........................................................4
Performance Information......................................................8
Capital Stock................................................................8
Purchase and Redemption of Shares............................................9
NAV, Pricing, and Effective Date.............................................9
Dividends and Taxation......................................................10
Management of the Fund......................................................10
Expenses and Management Fee.................................................11
Other Insurance Products....................................................11
T. ROWE PRICE LOGO
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INVESTMENT SUMMARY
The Fund seeks a high level of income consistent with modest price fluctuation
by investing primarily in short- and intermediate-term investment grade debt
securities. It is designed for fixed income investors seeking a conservative,
income producing investment which experiences relatively modest changes in
share price.
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T. Rowe Price Associates, Inc. (T. Rowe Price) was founded in 1937 by the late
Thomas Rowe Price, Jr. As of December 31, 1993, the firm and its affiliates
managed over $50 billion for over three million individual and institutional
investor accounts.
This prospectus contains information that a prospective Contract Holder or
Participant should know about the Fund before investing. PLEASE KEEP IT FOR
FUTURE REFERENCE. A Statement of Additional Information for the Fund (dated
May 17, 1994) has been filed with the Securities and Exchange Commission and
is incorporated by reference in this prospectus. It is available at no charge
by contacting your insurance company.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION, OR ANY STATE SECURITIES COMMISSION, NOR HAS THE
SECURITIES AND EXCHANGE COMMISSION, OR ANY STATE SECURITIES COMMISSION, PASSED
UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE
CONTRARY IS A CRIMINAL OFFENSE.
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INVESTMENT OBJECTIVE
The Fund's investment objective is to seek a high level of income consistent
with modest price fluctuation by investing primarily in investment grade
securities.
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FUND CHARACTERISTICS
AND INVESTMENT PROGRAM
The Fund's investment program (described below) is intended to result in lower
share price fluctuation than a long-term bond fund. Additionally, the Fund's
income is expected to be above that of a money market fund but below that of a
long-term bond fund.
The Fund will invest at least 65% of its total assets in short- and
intermediate-term debt securities. These will include corporate, government
and mortgage-backed securities. The Fund's dollar weighted effective average
maturity will not exceed five years, although there are no maturity
limitations on individual securities purchased. Targeting effective maturity
provides additional flexibility in portfolio management but, all else being
equal, could result in higher volatility than would be true of a fund
targeting a stated maturity or maturity range.
At least 90% of the Fund's portfolio will be invested in securities rated in
the four highest credit categories by a nationally recognized rating agency,
or, if unrated, of equivalent quality as determined by T. Rowe Price. To
enhance yield, up to 10% of total assets can be invested in
below-investment-grade securities ("junk bonds"), including those with the
lowest rating.
While initially the Fund is expected to concentrate its investments in
domestic securities, it may over time invest up to 35% of its total assets in
foreign fixed income securities. When investing in foreign securities, the
Fund will seek to reduce the volatility stemming from currency exposure by
hedging a substantial portion, but not necessarily all, of its non-dollar
investments back to the U.S. dollar. Currency risk can not be eliminated
entirely, and there is no guarantee this hedging will work. In addition,
hedging costs are paid for out of the Fund's capital and are reflected in the
net asset value per share (not the Fund's yield).
The Fund's share price and yield will fluctuate with changing market
conditions, and your investment may be worth more or less when redeemed than
when purchased. The Fund should not be relied upon as a complete investment
program, nor used to play short-term swings in the bond markets. The Fund
cannot guarantee it will achieve its investment objective.
Shares of the Fund are currently being offered to insurance company separate
accounts established for the purpose of funding variable annuity contracts.
They may also be offered to insurance company separate accounts established
for the purpose of funding variable life contracts. Variable annuity and
variable life Contract Holders or Participants are not the shareholders of the
Fund. Rather, the separate account is the shareholder. The variable annuity
and variable life contracts are described in separate prospectuses issued by
the insurance companies. The Fund assumes no responsibility for such
prospectuses or variable annuity or life contracts.
Please see INVESTMENT PRACTICES for a more complete description of these and
other permissible Fund's investments.
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SUMMARY OF FUND FEES
AND EXPENSES
MANAGEMENT FEE. The Fund pays T. Rowe Price a single, all-inclusive fee of
0.70% of the Fund's average daily net assets to cover investment management
and operating expenses.
VARIABLE ANNUITY AND VARIABLE LIFE CHARGES. Variable annuity and variable life
fees and charges are in addition to those described above and are described in
the variable annuity prospectuses.
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VOTING RIGHTS
The shares of the Fund have equal voting rights. The various insurance
companies own the outstanding shares of the Fund in their separate accounts.
These separate accounts are registered under the Investment Company Act of
1940 or are excluded from registration thereunder. Under current law the
insurance companies must vote the shares held in registered separate accounts
in accordance with voting instructions received from variable Contract Holders
or Participants having the right to give such instructions.
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INVESTING IN DEBT SECURITIES
TOTAL RETURN COMPONENTS. The Fund's total return consists of (1) the change in
its net asset value per share and (2) the income it generates. The net asset
value of the Fund will be affected primarily by changes in interest rate
levels, the maturity of individual portfolio holdings, and the quality of the
securities held.
A general explanation.
INTEREST RATES. A bond is a contractual debt obligation to repay a stated debt
amount (the principal) on a specified date (the maturity) plus a specified
rate of interest for the use of the money. Most bonds pay a fixed rate of
interest known as the coupon rate, which is fixed for the term of the bond. A
bond's yield reflects the fixed annual interest as a percent of its current
price. This price (the bond's market value) must increase or decrease in order
to adjust the bond's yield to current interest rate levels. Therefore, bond
prices generally move in the opposite direction of interest rates.
MATURITY. Movements in interest rates typically have a greater effect on the
prices of longer term bonds than on those with shorter maturities. The
following table illustrates the effect of a change in interest rates on a
$1,000 bond with a 7% coupon.
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Principal value if rates:
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Increase Decrease
Bond - Maturity 1% 1%
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Short-term - 2 years $982 $1,019
Intermediate - 5 years $959 $1,043
Long-term - 20 years $901 $1,116
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This table is for illustrative purposes only and should not be taken as
representative of expected changes in the share price of the Fund.
T. Rowe Price will actively manage the Fund's portfolio maturity, consistent
with the Fund's objective, according to its interest rate outlook. During
periods of rising interest rates, a shorter average maturity may be adopted to
cushion the effect of falling bond prices on the Fund's share price. When
rates are falling and bond prices are rising, a longer average maturity may be
sought.
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CREDIT ANALYSIS. The quality of a bond is measured by credit risk--the ability
of the issuer to meet interest and principal payments on a timely basis.
Issuers who are believed to be good credit risks receive high quality ratings,
and those believed to be poor credit risks receive low quality ratings.
High-quality bonds involve less credit risk and typically offer a lower yield
than bonds of low quality. In determining the quality of an issuer, T. Rowe
Price considers publicly available ratings, but places primary emphasis on its
own credit analysis. This analysis may differ from the evaluations of public
rating agencies, such as Moody's Investors Service, Inc. or Standard & Poor's
Corporation. T. Rowe Price may also buy bonds from unrated issuers, which are
not necessarily of lower quality, but may be less marketable.
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INVESTMENT PRACTICES
This section takes a detailed look at some of the types of securities the Fund
may hold in its portfolio and the various kinds of investment practices that
may be used in day-to-day portfolio management. The Fund's investment program
is subject to further restrictions and risks described in the Statement of
Additional Information.
Shareholder approval is required to substantively change the Fund's objective
and certain investment restrictions noted in the following section as
"fundamental policies." The managers also follow certain "operating policies"
which can be changed without shareholder approval. However, significant
changes are discussed with shareholders in Fund reports.
TYPES OF PORTFOLIO SECURITIES
In seeking to meet its investment objective, the Fund may invest in any type
of interest-bearing security whose yield, credit quality, and maturity
characteristics are consistent with the Fund's investment program. These and
some of the other investment techniques the Fund may use are described in the
following pages.
Fundamental Policy. The Fund will not purchase a security if, as a result,
with respect to 75% of the Fund's total assets, more than 5% of its total
assets would be invested in securities of the issuer.
BONDS. A bond is an interest-bearing security - an IOU - issued by companies
or governmental units. The issuer has a contractual obligation to pay interest
at a stated rate on specific dates and to repay principal (the bond's face
value) on a specified date. An issuer may have the right to redeem or "call" a
bond before maturity, and the investor may have to reinvest the proceeds at
lower market rates.
A bond's annual interest income, set by its coupon rate, is usually fixed for
the life of the bond. Its yield (income as a percent of current price) will
fluctuate to reflect changes in interest rate levels. A bond's price rises
when interest rates fall, and vice versa so its yield is current (see the
table on page 3).
Bonds may be secured (backed by specified collateral) or unsecured (backed by
the issuer's general creditworthiness).
Certain bonds have interest rates that are adjusted periodically in order to
minimize fluctuations of their principal value. The maturity of those
securities may be shortened under certain specified conditions.
ASSET-BACKED SECURITIES. An underlying pool of assets, such as credit card or
automobile trade receivables or corporate loans or bonds, backs these bonds
and provides the interest and principal payments to investors. Credit quality
depends primarily on the quality of the underlying assets and the level of
credit support, if any, provided by the issuer.
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The underlying assets (i.e., loans) are subject to prepayments which can
shorten the securities' weighted average life and may lower their return. The
value of these securities also may change because of actual or perceived
changes in the creditworthiness of the originator, servicing agent, or of the
financial institution providing the credit support.
MORTGAGE-BACKED SECURITIES. The Fund may invest in a variety of mortgage
securities. Mortgage lenders pool individual home mortgages with similar
characteristics to back a certificate or bond, which is sold to investors such
as the Fund. Interest and principal payments generated by the underlying
mortgages are passed through to the investors. The "big three" issuers are
Government National Mortgage Association (GNMA), the Federal National Mortgage
Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation
(Freddie Mac). GNMA certificates are backed by the full faith and credit of
the U.S. Government, while others, such as Fannie Mae and Freddie Mac
certificates, are only supported by the ability to borrow from the U.S.
Treasury or supported only by the credit of the agency. Private mortgage
bankers also issue mortgage-backed securities.
Mortgage securities are subject to regular principal prepayments as homeowners
pay down or pay off their mortgages. When interest rates fall, the pace of
mortgage refinancings picks up. Refinanced mortgages are paid off at face
value (par), causing a loss for any investor who may have purchased the
security at a price above par. In such an environment, this risk limits the
potential price appreciation of these securities and can negatively affect the
Fund's net asset value. When rates rise, however, mortgage-backed securities
have historically experienced smaller price declines than comparable quality
bonds.
Additional mortgage-related securities in which the Fund may invest include:
[bullet]COLLATERALIZED MORTGAGE OBLIGATIONS (CMOS). CMOs are debt
securities that are fully collateralized by a portfolio of
mortgages or mortgage-backed securities. All interest and
principal payments from the underlying mortgages are passed
through to the CMOs in such a way as to create more definite
maturities than is the case with the underlying bonds. CMOs may
pay fixed or variable rates of interest, and certain CMOs have
priority over others with respect to the receipt of prepayments.
[bullet]STRIPPED MORTGAGE SECURITIES. Stripped mortgage securities are
created by separating the interest and principal payments
generated by a pool of mortgage-backed bonds to create two classes
of securities. Generally, one class receives only interest
payments (IOs) and one principal payments (POs).
IOs and POs are acutely sensitive to interest rate changes and to the rate of
principal prepayments. They are very volatile in price and may have lower
liquidity than most mortgage-backed securities. Certain CMOs may also exhibit
these qualities, especially those which pay variable rates of interest which
adjust inversely with and more rapidly than short-term interest rates. There
is no guarantee the Fund's investment in CMOs, IOs or POs will be successful,
and the Fund's total return could be adversely affected as a result.
Operating Policy. The Fund may invest up to 10% of its total assets in
stripped mortgage securities.
HYBRID INSTRUMENTS. These instruments can combine the characteristics of
securities, futures and options. For example, the principal amount, redemption
or conversion terms of a security could be related to the market price of some
commodity, currency or securities index. Such securities may bear interest or
pay dividends at below market (or even relatively nominal) rates. Under
certain conditions, the redemption value of such an investment could be zero.
Hybrids can have volatile prices and limited liquidity and their use by the
Fund may not be successful.
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Operating Policy. The Fund may invest up to 10% of its total assets in hybrid
instruments.
PRIVATE PLACEMENTS (RESTRICTED SECURITIES). These securities are sold directly
to a small number of investors, usually institutions. Unlike public offerings,
such securities are not registered with the SEC. Although certain of these
securities may be readily sold, for example under Rule 144A, the sale of
others may involve substantial delays and additional costs.
Operating Policy. The Fund will not invest more than 15% of its net assets in
illiquid securities.
FOREIGN SECURITIES. The Fund may invest in foreign securities. These include
non-dollar denominated securities traded outside of the U.S. and dollar
denominated securities traded in the U.S. (such as ADRs). Such investments
increase a portfolio's diversification and may enhance return, but they also
involve some special risks such as exposure to potentially adverse local
political and economic developments; nationalization and exchange controls;
potentially lower liquidity and higher volatility; possible problems arising
from accounting, disclosure, settlement, and regulatory practices that differ
from U.S. standards; and the chance that fluctuations in foreign exchange
rates will decrease the investment's value (favorable changes can increase its
value).
Operating Policy. The Fund may invest up to 35% of its total assets in foreign
securities.
TYPES OF MANAGEMENT PRACTICES
CASH POSITION. The Fund will hold a certain portion of its assets in money
market securities, including repurchase agreements, in the two highest rating
categories, maturing in one year or less. For temporary, defensive purposes,
the Fund may invest without limitation in such securities. This reserve
position provides flexibility in meeting redemptions, expenses, and the timing
of new investments, and serves as a short-term defense during periods of
unusual market volatility.
BORROWING MONEY AND TRANSFERRING ASSETS. The Fund can borrow money from banks
as a temporary measure for emergency purposes, to facilitate redemption
requests, or for other purposes consistent with the Fund's investment
objective and program. Such borrowings may be collateralized with Fund assets,
subject to restrictions.
Fundamental Policy. Borrowings may not exceed 33 1/3% of total Fund assets.
Operating Policies. The Fund may not transfer as collateral any portfolio
securities except as necessary in connection with permissible borrowings or
investments, and then such transfers may not exceed 33 1/3% of the Fund's
total assets. The Fund may not purchase additional securities when borrowings
exceed 5% of total assets.
FUTURES AND OPTIONS. Futures are often used to manage risk, because they
enable the investor to buy or sell an asset in the future at an agreed upon
price. Options give the investor the right, but not the obligation, to buy or
sell an asset at a predetermined price in the future. The Fund may buy and
sell futures contracts (and options on such contracts) to manage its exposure
to changes in interest rates, bond prices, and foreign currencies; as an
efficient means of adjusting its overall exposure to certain markets; and also
to adjust the portfolio's duration. The Fund may purchase, sell, or write call
and put options on securities, financial indices, and foreign currencies.
<PAGE>
Futures contracts and options may not always be successful hedges; their
prices can be highly volatile; using them could lower the Fund's total return,
and the potential loss from the use of futures can exceed the Fund's initial
investment in such contracts.
Operating Policies. Futures: Initial margin deposits and premiums on options
used for non-hedging purposes will not equal more than 5% of the Fund's net
assets. Options on securities: The total market value of securities against
which the Fund has written call or put options may not exceed 25% of its total
assets. The Fund will not commit more than 5% of its total assets to premiums
when purchasing call or put options.
INTEREST RATE SWAPS. The Fund may enter into various interest rate
transactions such as interest rate swaps and the purchase or sale of interest
rate caps and floors, to preserve a return or spread on a particular
investment or portion of its portfolio, to create synthetic securities, or to
structure transactions designed for other non-speculative purposes.
Operating Policy. The Fund will not invest more than 10% of its total assets
in interest rate swaps.
MANAGING FOREIGN CURRENCY RISK. Investors in non-U.S. dollar securities may
"hedge" their exposure to potentially unfavorable currency changes by
purchasing a contract to exchange one currency for another on some future date
at a specified exchange rate. In certain circumstances, a "proxy currency" may
be substituted for the currency in which the investment is denominated, a
strategy known as "proxy hedging." The Fund might also use these contracts to
create a synthetic bond issued by a U.S. company but with the dollar component
transformed into a foreign currency. Although foreign currency transactions
will be used primarily to protect the Fund's non-dollar securities from
adverse currency movements, they involve the risk that anticipated currency
movements will not occur and the Fund's total return could be reduced.
Operating Policy. The Fund will normally conduct its foreign exchange
transactions in cash or by entering into forward currency contracts expiring
in less than one year.
LENDING OF PORTFOLIO SECURITIES. Like other mutual funds, the Fund may lend
securities to broker-dealers, other institutions, or other persons to earn
additional income. The principal risk is the potential insolvency of the
broker-dealer or other borrower. In this event, the Fund could experience
delays in recovering its securities and possibly capital losses.
Fundamental Policy. The value of loaned securities may not exceed 33 1/3% of
the Fund's total assets.
WHEN-ISSUED AND FORWARD COMMITMENT CONTRACTS. The Fund may purchase securities
on a when-issued or delayed delivery basis or may purchase or sell securities
on a forward commitment basis. The price of these securities is fixed at the
time of the commitment to buy, but delivery and payment can take place a month
or more later. During the interim period, the market value of the securities
can fluctuate, and no interest accrues to the purchaser. At the time of
delivery, the value of the securities may be more or less than the purchase or
sale price. Depending on the Fund's other investments, purchase of these
securities could increase the level of fluctuations in the Fund's net asset
value.
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PORTFOLIO TRANSACTIONS. The Fund will not generally trade in securities for
short-term profits, but when circumstances warrant, securities may be
purchased and sold without regard to the length of time held. The portfolio
turnover rate for the Fund is not expected to exceed 200%. A high turnover
rate may increase transaction costs and result in taxable capital gains
distributed to shareholders.
HIGH YIELD INVESTING. The total return and yield of lower quality (high yield)
bonds can be expected to fluctuate more than the total return and yield of
higher quality, shorter-term bonds. Low-quality bonds are regarded as
predominantly speculative with respect to the issuer's continuing ability to
meet principal and interest payments. Successful investment in low and
lower-medium quality bonds involves greater investment risk and is highly
dependent on T. Rowe Price's credit analysis. A real or perceived economic
downturn or higher interest rates could cause a decline in high yield bond
prices, because such events could lessen the ability of highly leveraged
companies to make principal and interest payments. These bonds are thinly
traded and can be more difficult to sell and value accurately than
high-quality bonds. Because objective pricing data may be less available,
judgment may play a greater role in the valuation process.
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PERFORMANCE INFORMATION
TOTAL RETURN. The Fund may advertise total return figures on both a cumulative
and compound average annual basis and compare them to various indices, other
mutual funds or other performance measures. (The total return of the Fund will
consist primarily of interest income and secondarily of capital appreciation
or depreciation.) Cumulative total return compares the amount invested at the
beginning of a period with the amount redeemed at the end of the period,
assuming the reinvestment of all dividends and capital gain distributions. The
compound average annual total return indicates a yearly compound average of
the Fund's performance, derived from the cumulative total return. The annual
compound rate of return for the Fund may vary from any average. Further
information about the Fund's performance is contained in its annual report
which is available free of charge.
YIELD. The Fund may advertise a yield figure derived by dividing the Fund's
net investment income per share (as defined by applicable SEC regulations)
during a 30-day base period by the per-share price on the last day of the base
period.
Total returns and yields quoted for the Fund include the effect of deducting
the Fund's expenses, but may not include charges and expenses attributable to
any particular insurance product. Since you can only purchase shares of the
Fund through an insurance product, you should carefully review the prospectus
of the insurance product you have chosen for information on relevant charges
and expenses. Excluding these charges from quotations of the Fund's
performance has the effect of increasing the performance quoted.
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CAPITAL STOCK
T. Rowe Price Fixed Income Series, Inc. (the Corporation) is a Maryland
corporation organized in 1994 and registered with the Securities and Exchange
Commission under the Investment Company Act of 1940 as a diversified, open-end
investment company, commonly known as a "mutual fund." The Corporation is a
series fund and has the authority to issue other series in addition to the T.
Rowe Price Limited-Term Bond Portfolio currently in existence. A mutual fund,
such as the Fund, enables shareholders to: (1) obtain professional management
of investments, including T. Rowe Price's proprietary research; (2) diversify
their portfolio to a greater degree than would be generally possible if they
were investing as individuals and thereby reduce, but not eliminate risks; and
(3) simplify the recordkeeping and reduce transaction costs associated with
investments.
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The Fund has an Investment Advisory Committee composed of the following
members: Veena A. Kutler, President, Paul W. Boltz, Robert P. Campbell,
Michael J. Conelius, Christy M. DiPietro, Robert M. Rubino, Thomas E.
Tewksbury, Jay W. VanErt, Gwen G. Wagner and Edward A. Wiese. The Committee
Chairman has day-to-day responsibility for managing the Fund and works with
the Committee in developing and executing the Fund's investment program.
SHAREHOLDER RIGHTS. The Fund issues one class of capital stock, all shares of
which have equal rights with regard to voting, redemptions, dividends,
distributions, and liquidations. Fractional shares have voting rights and
participate in any distributions and dividends. Shareholders have no
preemptive or conversion rights; nor do they have cumulative voting rights.
When the Fund's shares are issued, they are fully paid and nonassessable. The
Fund does not routinely hold annual meetings of shareholders. However, if
shareholders representing at least 10% of all votes of the Fund entitled to be
cast so desire, they may call a special meeting of shareholders of the Fund
for the purpose of voting on the question of the removal of any director(s).
The total authorized capital stock of the Fund consists of 1,000,000,000
shares, each having a par value of $.0001. As of the date of this prospectus,
T. Rowe Price owned 10,000 shares of the Fund which represented all of the
Fund's outstanding shares. As of February 28, 1994, there were 3,272,854
shareholders in the other 55 T. Rowe Price Funds.
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PURCHASE AND REDEMPTION
OF SHARES
For instructions on how to purchase and redeem shares of the Fund, read the
separate account prospectus.
Shares of the Fund are sold and redeemed without the imposition of any sales
commission or redemption charge. However, certain deferred sales charges and
other charges may apply to the annuity contract. Those charges are disclosed
in the separate account prospectus.
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NAV, PRICING, AND
EFFECTIVE DATE
NET ASSET VALUE PER SHARE (NAV). The NAV per share, or share price, for the
Fund is normally determined as of 4:00 pm Eastern Time (ET) each day the New
York Stock Exchange is open. The Fund's share price is calculated by
subtracting its liabilities from its total assets and dividing the result by
the total number of shares outstanding. Among other things, the Fund's
liabilities include accrued expenses and dividends payable, and its total
assets include portfolio securities valued at market as well as income accrued
but not yet received.
PURCHASES. The insurance companies purchase shares of the Fund for separate
accounts, using premiums allocated by the Contract Holders or Participants.
Shares are purchased at the NAV next determined after the insurance company
receives the premium payment in acceptable form. Initial and subsequent
payments allocated to the Fund are subject to the limits stated in the
separate account prospectus issued by the insurance company.
<PAGE>
REDEMPTIONS. The insurance companies redeem shares of the Fund to make benefit
or surrender payments under the terms of its Contracts. Redemptions are
processed on any day on which the New York Stock Exchange is open and are
priced at the Fund's NAV next determined after the insurance company receives
a surrender request in acceptable form.
PROCEEDS. Payment for redeemed shares will be made promptly, but in no event
later than seven days. However, the right of redemption may be suspended or
the date of payment postponed in accordance with the Investment Company Act of
1940. The amount received upon redemption of the shares of the Fund may be
more or less than the amount paid for the shares, depending on the
fluctuations in the market value of the assets owned by the Fund.
The Fund reserves the right to change the time at which purchases,
redemptions, and exchanges are priced if the New York Stock Exchange closes at
a time other than 4:00 pm ET or an emergency exists.
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DIVIDENDS AND TAXATION
For a discussion of the tax status of your variable annuity contract, refer to
the prospectus of your insurance company's separate account.
DIVIDENDS AND DISTRIBUTIONS. The policy of the Fund is to distribute all of
its net investment income and net capital gains each year to its shareholders,
which are the separate accounts established by the various insurance companies
in connection with their issuance of variable life insurance and variable
annuity contracts. Dividends from net investment income are declared daily and
paid monthly. All Fund distributions made to a separate account will be
reinvested automatically in additional Fund shares, unless a shareholder
(separate account) elects to receive distributions in cash. Under current law,
dividends and distributions made by the Fund to separate accounts, generally,
are not taxable to the separate accounts, the insurance company or the
Contract Holder, provided that separate account meets the diversification
requirements of Section 817(h) of the Internal Revenue Code of 1986, as
amended, and other tax related requirements are satisfied. The Fund intends to
diversify its investments in the manner required under Code Section 817(h).
FOREIGN TRANSACTIONS. If the Fund pays nonrefundable taxes to foreign
governments during the year, the taxes will reduce the Fund's dividends.
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MANAGEMENT OF THE FUND
INVESTMENT MANAGER. T. Rowe Price is responsible for selection and management
of the Fund's portfolio investments. T. Rowe Price serves as investment
manager to a variety of individual and institutional investors, including
limited and real estate partnerships and other mutual funds.
BOARD OF DIRECTORS. The management of the Fund's business and affairs is the
responsibility of the Fund's Board of Directors.
PORTFOLIO TRANSACTIONS. Decisions with respect to the purchase and sale of the
Fund's portfolio securities are made by T. Rowe Price. The Fund's Board of
Directors has authorized T. Rowe Price to utilize certain brokers indirectly
related to T. Rowe Price in the capacity of broker in connection with the
execution of the Fund's portfolio transactions.
INVESTMENT SERVICES. T. Rowe Price Investment Services, Inc., a wholly-owned
subsidiary of T. Rowe Price, is the distributor for this Fund as well as all
other T. Rowe Price Funds.
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TRANSFER AND DIVIDEND DISBURSING AGENT, SHAREHOLDER SERVICING AND
ADMINISTRATIVE. TRP Services, a wholly-owned subsidiary of T. Rowe Price,
serves the Fund as transfer and dividend disbursing agent. T. Rowe Price
calculates the daily share price and maintains the portfolio and general
accounting records of the Fund. The address for TRP Services is 100 East Pratt
Street, Baltimore, Maryland 21202.
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EXPENSES AND MANAGEMENT
FEE
Under the management agreement, all expenses of the Fund will be paid by T.
Rowe Price, except interest, taxes, brokerage commissions, directors' fees and
expenses (including counsel fees and expenses) and extraordinary expenses. The
Board of Directors of the Fund reserves the right to impose additional fees
against shareholder accounts to defray expenses which would otherwise be paid
by T. Rowe Price under the management agreement. The Board does not anticipate
levying such charges; such a fee, if charged, may be retained by the Fund or
paid to T. Rowe Price.
MANAGEMENT FEE. The Fund pays T. Rowe Price an annual all-inclusive fee of
0.70% based on its average daily net assets. This fee pays for investment
management services and other operating costs. The Fund calculates and accrues
the fee daily.
- ------------------------------------------------------------------------------
OTHER INSURANCE PRODUCTS
The Fund may serve as an investment medium for both variable annuity contracts
and variable life insurance policies. Shares of the Fund may be offered to
separate accounts established by any number of insurance companies. The Fund
currently does not foresee any disadvantages to variable annuity contract
owners due to the fact that the Fund may serve as an investment medium for
both variable life insurance policies and annuity contracts; however, due to
differences in tax treatment or other considerations, it is theoretically
possible that the interests of owners of annuity contracts and insurance
policies for which the Fund serves as an investment medium might at some time
be in conflict. However, the Fund's Board of Directors is required to monitor
events to identify any material conflicts between variable annuity contract
owners and variable life policy owners, and will determine what action, if
any, should be taken in the event of such a conflict. If such a conflict were
to occur, an insurance company participating in the Fund might be required to
redeem the investment of one or more of its separate accounts from the Fund.
This might force the Fund to sell securities at disadvantageous prices.
The Statement of Additional Information for the T. Rowe Price Fixed Income
Series, Inc., dated March 31, 1994, should be inserted here.
PAGE 1
STATEMENT OF ADDITIONAL INFORMATION
T. ROWE PRICE FIXED INCOME SERIES, INC.
T. Rowe Price Limited-Term Bond Portfolio
(the "Fund")
Shares of the Fund may be offered to insurance company separate accounts
established for the purpose of funding variable annuity contracts. They may
also be offered to insurance company separate accounts established for the
purpose of funding variable life contracts. Variable annuity and variable
life Contract Holders or Participants are not the shareholders of the Fund.
Rather, the separate account is the shareholder. The variable annuity and
variable life contracts are described in separate prospectuses issued by the
insurance companies. The Fund assumes no responsibility for such
prospectuses, or variable annuity or life contracts.
In the future, it is possible that the Fund may offer its shares to
separate accounts funding variable annuities, variable life insurance or other
insurance products of other insurance companies.
This Statement of Additional Information is not a prospectus but should
be read in conjunction with the Fund's prospectus dated May 15, 1994, which
may be obtained from T. Rowe Price Investment Services, Inc., 100 East Pratt
Street, Baltimore, Maryland 21202.
The date of this Statement of Additional Information is May 15, 1994.
PAGE 2
TABLE OF CONTENTS
Page Page
Adjustable Rate Securities . . . . Investment Performance . . . . . . .
Adjustable Rate Mortgage . . . . . Investment Programs. . . . . . . . .
Securities. . . . . . . . . . . . Investment Restrictions. . . . . . .
Asset-Backed Securities. . . . . . Legal Counsel. . . . . . . . . . . .
Capital Stock. . . . . . . . . . . Lending of Portfolio
Custodian. . . . . . . . . . . . . Securities. . . . . . . . . . . . .
Distributor for Fund . . . . . . . Management of Fund . . . . . . . . .
Dividends. . . . . . . . . . . . . Money Market Securities. . . . . . .
Federal and State Mortgage-Related Securities. . . . .
Registration of Shares. . . . . . Net Asset Value Per Share. . . . . .
Foreign Currency Transactions. . . Options. . . . . . . . . . . . . . .
Foreign Securities . . . . . . . . Portfolio Transactions . . . . . . .
Futures Contracts. . . . . . . . . Pricing of Securities. . . . . . . .
Hybrid Commodity and Security Principal Holders of Securities. . .
Instrument. . . . . . . . . . . . Ratings of Commercial Paper. . . . .
Illiquid or Restricted . . . . . . Ratings of Corporate Debt
Securities. . . . . . . . . . . . Securities. . . . . . . . . . . . .
Independent Accountants. . . . . . Repurchase Agreements. . . . . . . .
Industry Concentration . . . . . . Risk Factors . . . . . . . . . . . .
Interest Rate Transactions . . . . Tax Status . . . . . . . . . . . . .
Investment Management When-Issued Securities and Forward
Services. . . . . . . . . . . . . Commitment Contracts. . . . . . . .
Investment Objectives . Yield Information. . . . . . . . . .
and Policies . . . . . . . . . .
INVESTMENT OBJECTIVE AND POLICIES
The following information supplements the discussion of the Fund's
investment objective and policies discussed in the Fund's prospectus. The
Fund will not make a material change in its investment objective without
obtaining shareholder approval. Unless otherwise specified, the investment
programs and restrictions of the Fund is not fundamental policies. The Fund's
operating policies are subject to change by its Board of Directors without
shareholder approval. However, shareholders will be notified of a material
change in an operating policy. The Fund's fundamental policies may not be
changed without the approval of at least a majority of the outstanding shares
of the Fund or, if it is less, 67% of the shares represented at a meeting of
shareholders at which the holders of 50% or more of the shares are
represented.
The Fund's investment objective is to seek a high level of income
consistent with modest price fluctuation by investing primarily in investment
grade securities. The strategy of the Fund described below is intended to
result in lower share price fluctuation than a long-term bond fund.
Additionally, the Fund is expected to provide a yield above that of a money
market fund but below that of a long-term bond fund.
RISK FACTORS
Because of its investment policy, the Fund may not be suitable or
appropriate for all investors. The Fund is not a money market fund and is not
an appropriate investment for those whose primary objective is principal
PAGE 3
stability. There is risk in all investment. The Fund is designed for the
investor who seeks to participate in a diversified portfolio of short- and
intermediate-term investment grade bonds and other debt securities (up to 10%
of which may be below investment grade) which provide a higher rate of income
than a money market fund and less risk of capital fluctuation than a portfolio
of long-term debt securities. The value of the portfolio securities of the
Fund will fluctuate based upon market conditions. Although the Fund seeks to
reduce risk by investing in a diversified portfolio, such diversification does
not eliminate all risk. There can, of course, be no assurance that the Fund
will achieve these results. Reference is also made to the sections entitled
"Types of Securities" and "Portfolio Management Practices" for discussions of
the risks associated with the investments and practices described therein as
they apply to the Fund.
Debt Obligations. Yields on short and intermediate-term securities are
dependent on a variety of factors, including the general conditions of the
money and bond markets, the size of a particular offering, the maturity of the
obligation, and the credit quality and rating of the issue. Debt securities
with longer maturities tend to have higher yields and are generally subject to
potentially greater capital appreciation and depreciation than obligations
with shorter maturities and lower yields. The market prices of debt
securities usually vary, depending upon available yields. An increase in
interest rates will generally reduce the value of portfolio investments, and a
decline in interest rates will generally increase the value of portfolio
investments. The ability of the Fund to achieve its investment objective is
also dependent on the continuing ability of the issuers of the debt securities
in which the Fund invests to meet its obligations for the payment of interest
and principal when due. Although the Fund seeks to reduce risk by portfolio
diversification, credit analysis (considered by T. Rowe Price to be among the
most stringent in the investment management industry), and attention to trends
in the economy, industries and financial markets, such efforts will not
eliminate all risk. There can, of course, be no assurance that the Fund will
achieve its investment objective.
Mortgage Securities. The Fund may invest significantly in mortgage
securities. Because they consist of underlying mortgages, Mortgage Securities
may not be an effective means of "locking in" long-term interest rates due to
the need for the Fund to reinvest scheduled and unscheduled principal
payments. The incidence of unscheduled principal prepayments is also likely
to increase in mortgage pools owned by the Fund when prevailing mortgage loan
rates fall below the mortgage rates of the securities underlying the
individual pool. The effect of such prepayments in a falling rate environment
is to (1) cause the Fund to reinvest principal payments at the then lower
prevailing interest rate, and (2) reduce the potential for capital
appreciation beyond the face amount of the security and adversely affect the
return to the Fund. Conversely, in a rising interest rate environment such
prepayments can be reinvested at higher prevailing interest rates which will
reduce the potential effect of capital depreciation to which bonds are subject
when interest rates rise. In addition, prepayments of mortgage securities
purchased at a premium (or discount) will cause such securities to be paid off
at par, resulting in a loss (gain) to the Fund. T. Rowe Price will actively
manage the Fund's portfolio in an attempt to reduce the risk associated with
investment in mortgage-backed securities.
After purchase by a Fund, a security may cease to be rated or its rating
may be reduced below the minimum required for purchase by the Fund. For the
Fund, neither event would require a sale of such security by the Fund.
However, T. Rowe Price Associates, Inc. ("T. Rowe Price") will consider such
event in its determination of whether the Fund should continue to hold the
security. To the extent that the ratings given by Moody's Investors Service,
PAGE 4
Inc. ("Moody's"), Standard & Poor's Corporation ("S&P"), or Fitch Investors
Service, Inc. ("Fitch") may change as a result of changes in such
organizations or their rating systems, the Fund will attempt to use comparable
ratings as standards for investments in accordance with the investment
policies contained in the prospectus. When purchasing unrated securities, T.
Rowe Price, under the supervision of the Fund's Board of Directors, determines
whether the unrated security is of a quality comparable to that which the Fund
is allowed to purchase.
The Fund's share price and yield will fluctuate with changing market
conditions, and your investment may be worth more or less when redeemed than
when purchased. The Fund should not be relied upon as a complete investment
program, nor used to play short-term swings in the bond markets. The Fund
cannot guarantee it will achieve its investment objective.
Risk Factors of Foreign Investing
There are special risks in foreign investing. Certain of these risks
are inherent in any international mutual fund while others relate more to the
countries in which the Funds will invest. Many of the risks are more
pronounced for investments in developing or emerging countries, such as many
of the countries of Southeast Asia, Latin America, Eastern Europe and the
Middle East. Although there is no universally accepted definition, a
developing country is generally considered to be a country which is in the
initial stages of its industrialization cycle with a per capita gross national
product of less than $8,000.
Political and Economic Factors. Individual foreign economies of certain
countries may differ favorably or unfavorably from the United States' economy
in such respects as growth of gross national product, rate of inflation,
capital reinvestment, resource self-sufficiency and balance of payments
position. The internal politics of certain foreign countries are not as
stable as in the United States. For example, in 1991, the existing government
in Thailand was overthrown in a military coup. In 1992, there were two
military coup attempts in Venezuela and in 1992 the President of Brazil was
impeached. In addition, significant external political risks currently affect
some foreign countries. Both Taiwan and China still claim sovereignty of one
another and there is a demilitarized border between North and South Korea.
Governments in certain foreign countries continue to participate to a
significant degree, through ownership interest or regulation, in their
respective economies. Action by these governments could have a significant
effect on market prices of securities and payment of dividends. The economies
of many foreign countries are heavily dependent upon international trade and
are accordingly affected by protective trade barriers and economic conditions
of their trading partners. The enactment by these trading partners of
protectionist trade legislation could have a significant adverse effect upon
the securities markets of such countries.
Currency Fluctuations. The Funds will invest in securities denominated
in various currencies. Accordingly, a change in the value of any such
currency against the U.S. dollar will result in a corresponding change in the
U.S. dollar value of the Funds' assets denominated in that currency. Such
changes will also affect the Funds' income. Generally, when a given currency
appreciates against the dollar (the dollar weakens) the value of the Fund's
securities denominated in that currency will rise. When a given currency
depreciates against the dollar (the dollar strengthens) the value of the
Funds' securities denominated in that currency would be expected to decline.
PAGE 5
Investment and Repatriation of Restrictions. Foreign investment in the
securities markets of certain foreign countries is restricted or controlled in
varying degrees. These restrictions may limit at times and preclude
investment in certain of such countries and may increase the cost and expenses
of the Funds. Investments by foreign investors are subject to a variety of
restrictions in many developing countries. These restrictions may take the
form of prior governmental approval, limits on the amount or type of
securities held by foreigners, and limits on the types of companies in which
foreigners may invest. Additional or different restrictions may be imposed at
any time by these or other countries in which the Funds invest. In addition,
the repatriation of both investment income and capital from several foreign
countries is restricted and controlled under certain regulations, including in
some cases the need for certain government consents. For example, capital
invested in Chile normally cannot be repatriated for one year.
Market Characteristics. Foreign stock and bond markets are generally
not as developed or efficient as, and may be more volatile than, those in the
United States. While growing in volume, they usually have substantially less
volume than U.S. markets and the Funds' portfolio securities may be less
liquid and subject to more rapid and erratic price movements than securities
of comparable U.S. companies. Equity securities may trade at price/earnings
multiples higher than comparable United States securities and such levels may
not be sustainable. Fixed commissions on foreign stock exchanges are
generally higher than negotiated commissions on United States exchanges,
although the Funds will endeavor to achieve the most favorable net results on
their portfolio transactions. There is generally less government supervision
and regulation of foreign stock exchanges, brokers and listed companies than
in the United States. Moreover, settlement practices for transactions in
foreign markets may differ from those in United States markets. Such
differences may include delays beyond periods customary in the United States
and practices, such as delivery of securities prior to receipt of payment,
which increase the likelihood of a "failed settlement." Failed settlements
can result in losses to a Fund.
Investment Funds. The Funds may invest in investment funds which have
been authorized by the governments of certain countries specifically to permit
foreign investment in securities of companies listed and traded on the stock
exchanges in these respective countries. The Funds' investment in these funds
is subject to the provisions of the 1940 Act discussed on pages __ and __. If
the Funds invest in such investment funds, the Funds' shareholders will bear
not only their proportionate share of the expenses of the Funds (including
operating expenses and the fees of the investment manager), but also will bear
indirectly similar expenses of the underlying investment funds. In addition,
the securities of these investment funds may trade at a premium over their net
asset value.
Information and Supervision. There is generally less publicly available
information about foreign companies comparable to reports and ratings that are
published about companies in the United States. Foreign companies are also
generally not subject to uniform accounting, auditing and financial reporting
standards, practices and requirements comparable to those applicable to United
States companies. It also may be more difficult to keep currently informed of
corporate actions which affect the prices of portfolio securities.
Taxes. The dividends and interest payable on certain of the Funds'
foreign portfolio securities may be subject to foreign withholding taxes, thus
reducing the net amount of income available for distribution to the Funds'
shareholders. A shareholder otherwise subject to United States federal income
taxes may, subject to certain limitations, be entitled to claim a credit or
PAGE 6
deduction for U.S. federal income tax purposes for his or her proportionate
share of such foreign taxes paid by the Funds. (See "Tax Status," page __.)
Other. With respect to certain foreign countries, especially developing
and emerging ones, there is the possibility of adverse changes in investment
or exchange control regulations, expropriation or confiscatory taxation,
limitations on the removal of funds or other assets of the Funds, political or
social instability, or diplomatic developments which could affect investments
by U.S. persons in those countries.
Eastern Europe and Russia. Changes occurring in Eastern Europe and
Russia today could have long-term potential consequences. As restrictions
fall, this could result in rising standards of living, lower manufacturing
costs, growing consumer spending, and substantial economic growth. However,
investment in the countries of Eastern Europe and Russia is highly speculative
at this time. Political and economic reforms are too recent to establish a
definite trend away from centrally-planned economies and state owned
industries. In many of the countries of Eastern Europe and Russia, there is
no stock exchange or formal market for securities. Such countries may also
have government exchange controls, currencies with no recognizable market
value relative to the established currencies of western market economies,
little or no experience in trading in securities, no financial reporting
standards, a lack of a banking and securities infrastructure to handle such
trading, and a legal tradition which does not recognize rights in private
property. In addition, these countries may have national policies which
restrict investments in companies deemed sensitive to the country's national
interest. Further, the governments in such countries may require governmental
or quasi-governmental authorities to act as custodian of a Fund's assets
invested in such countries and these authorities may not qualify as a foreign
custodian under the Investment Company Act of 1940 and exemptive relief from
such Act may be required. All of these considerations are among the factors
which could cause significant risks and uncertainties to investment in Eastern
Europe and Russia. Each Fund will only invest in a company located in, or a
government of, Eastern Europe and Russia, if it believes the potential return
justifies the risk. To the extent any securities issued by companies in
Eastern Europe and Russia are considered illiquid, each Fund will be required
to include such securities within its 15% restriction on investing in illiquid
securities.
Special Risks of Investing in Junk Bonds
The following special considerations are additional risk factors
associated with the Fund's investments in lower rated debt securities.
Youth and Growth of the Lower Rated Debt Securities Market. The market
for lower rated debt securities is relatively new and its growth has
paralleled a long economic expansion. Past experience may not, therefore,
provide an accurate indication of future performance of this market,
particularly during periods of economic recession. An economic downturn or
increase in interest rates is likely to have a greater negative effect on this
market, the value of lower rated debt securities in the Fund's portfolio, the
Fund's net asset value and the ability of the bonds' issuers to repay
principal and interest, meet projected business goals and obtain additional
financing than on higher rated securities. These circumstances also may
result in a higher incidence of defaults than with respect to higher rated
securities. An investment in this Fund is more speculative than investment in
shares of a fund which invests only in higher rated debt securities.
Sensitivity to Interest Rate and Economic Changes. Prices of lower
rated debt securities may be more sensitive to adverse economic changes or
PAGE 7
corporate developments than higher rated investments. Debt securities with
longer maturities, which may have higher yields, may increase or decrease in
value more than debt securities with shorter maturities. Market prices of
lower rated debt securities structured as zero coupon or pay-in-kind
securities are affected to a greater extent by interest rate changes and may
be more volatile than securities which pay interest periodically and in cash.
Where it deems it appropriate and in the best interests of Fund shareholders,
the Fund may incur additional expenses to seek recovery on a debt security on
which the issuer has defaulted and to pursue litigation to protect the
interests of security holders of its portfolio companies.
Liquidity and Valuation. Because the market for lower rated securities
may be thinner and less active than for higher rated securities, there may be
market price volatility for these securities and limited liquidity in the
resale market. Nonrated securities are usually not as attractive to as many
buyers as rated securities are, a factor which may make nonrated securities
less marketable. These factors may have the effect of limiting the
availability of the securities for purchase by the Fund and may also limit the
ability of the Fund to sell such securities at their fair value either to meet
redemption requests or in response to changes in the economy or the financial
markets. Adverse publicity and investor perceptions, whether or not based on
fundamental analysis, may decrease the values and liquidity of lower rated
debt securities, especially in a thinly traded market. To the extent the Fund
owns or may acquire illiquid or restricted lower rated securities, these
securities may involve special registration responsibilities, liabilities and
costs, and liquidity and valuation difficulties. Changes in values of debt
securities which the Fund owns will affect its net asset value per share. If
market quotations are not readily available for the Fund's lower rated or
nonrated securities, these securities will be valued by a method that the
Fund's Board of Directors believes accurately reflects fair value. Judgment
plays a greater role in valuing lower rated debt securities than with respect
to securities for which more external sources of quotations and last sale
information are available.
Congressional Action. New and proposed laws may have an impact on the
market for lower rated debt securities. For example, as a result of the
Financial Institution's Reform, Recovery, and Enforcement Act of 1989, savings
and loan associations must dispose of their high yield bonds no later than
July 1, 1994. Qualified affiliates of savings and loan associations, however,
may purchase and retain these securities, and savings and loan associations
may divest these securities by sale to their qualified affiliates. T. Rowe
Price is unable at this time to predict what effect, if any, the legislation
may have on the market for lower rated debt securities.
Taxation. Special tax considerations are associated with investing in
lower rated debt securities structured as zero coupon or pay-in-kind
securities. The Fund accrues income on these securities prior to the receipt
of cash payments. The Fund must distribute substantially all of its income to
its shareholders to qualify for pass-through treatment under the tax laws and
may, therefore, have to dispose of its portfolio securities to satisfy
distribution requirements.
INVESTMENT PROGRAM
Set forth below is additional information about certain of the
investments described in the Fund's prospectus.
PAGE 8
TYPES OF SECURITIES
Debt Securities
Fixed income securities in which the Fund may invest include, but are
not limited to, those described below.
U.S. Government Obligations. Bills, notes, bonds, and other debt
securities issued by the U.S. Treasury. These are direct obligations of the
U.S. Government and differ mainly in the length of its maturities.
U.S. Government Agency Securities. Issued or guaranteed by U.S.
Government sponsored enterprises and federal agencies. These include
securities issued by the Federal National Mortgage Association, Government
National Mortgage Association, Federal Home Loan Bank, Federal Land Banks,
Farmers Home Administration, Banks for Cooperatives, Federal Intermediate
Credit Banks, Federal Financing Bank, Farm Credit Banks, the Small Business
Association, and the Tennessee Valley Authority. Some of these securities are
supported by the full faith and credit of the U.S. Treasury; and the remainder
are supported only by the credit of the instrumentality, which may or may not
include the right of the issuer to borrow from the Treasury.
Bank Obligations. Certificates of deposit, bankers' acceptances, and
other short-term debt obligations. Certificates of deposit are short-term
obligations of commercial banks. A bankers' acceptance is a time draft drawn
on a commercial bank by a borrower, usually in connection with international
commercial transactions. Certificates of deposit may have fixed or variable
rates. The Fund may invest in U.S. banks, foreign branches of U.S. banks,
U.S. branches of foreign banks and foreign branches of foreign banks.
Corporate Debt Securities. Outstanding nonconvertible corporate debt
securities (e.g., bonds and debentures). Corporate notes may have fixed,
variable, or floating rates.
Commercial Paper. Short-term promissory notes issued by corporations
primarily to finance short-term credit needs. Certain notes may have floating
or variable rates.
Foreign Government Securities. Issued or guaranteed by a foreign
government, province, instrumentality, political subdivision or similar unit
thereof.
Savings and Loan Obligations. Negotiable certificates of deposit and
other short-term debt obligations of savings and loan associations.
Supranational Agencies. The Fund may also invest in the securities of
certain supranational entities, such as the International Development Bank.
Mortgage-Related Securities
Investment in Mortgage-Backed Securities
The mortgage-related securities which the Fund may invest include, but
are not limited to, those described below.
Mortgage-Backed Securities. Mortgage-backed securities are securities
representing an interest in a pool of mortgages. The mortgages may be of a
variety of types, including adjustable rate, conventional 30-year fixed rate,
graduated payment, and 15-year. Principal and interest payments made on the
mortgages in the underlying mortgage pool are passed through to the Fund.
PAGE 9
This is in contrast to traditional bonds where principal is normally paid back
at maturity in a lump sum. Unscheduled prepayments of principal shorten the
securities' weighted average life and may lower its total return. (When a
mortgage in the underlying mortgage pool is prepaid, an unscheduled principal
prepayment is passed through to the Fund. This principal is returned to the
Fund at par. As a result, if a mortgage security were trading at a premium,
its total return would be lowered by prepayments, and if a mortgage security
were trading at a discount, its total return would be increased by
prepayments.) The value of these securities also may change because of
changes in the market's perception of the creditworthiness of the federal
agency that issued them. In addition, the mortgage securities market in
general may be adversely affected by changes in governmental regulation or tax
policies.
U.S. Government Agency Mortgage-Backed Securities. These are
obligations issued or guaranteed by the United States Government or one of its
agencies or instrumentalities, such as the Government National Mortgage
Association ("Ginnie Mae" or "GNMA"), the Federal National Mortgage
Association ("Fannie Mae" or "FNMA") and the Federal Home Loan Mortgage
Corporation ("Freddie Mac" or "FHLMC"). FNMA and FHLMC obligations are not
backed by the full faith and credit of the U.S. Government as GNMA
certificates are, but FNMA and FHLMC securities are supported by the
instrumentality's right to borrow from the United States Treasury. U.S.
Government Agency Mortgage-Backed Certificates provide for the pass-through to
investors of its pro-rata share of monthly payments (including any
prepayments) made by the individual borrowers on the pooled mortgage loans,
net of any fees paid to the guarantor of such securities and the servicer of
the underlying mortgage loans. Each of GNMA, FNMA and FHLMC guarantees timely
distributions of interest to certificate holders. GNMA and FNMA guarantee
timely distributions of scheduled principal. FHLMC has in the past guaranteed
only the ultimate collection of principal of the underlying mortgage loan;
however, FHLMC now issues Mortgage-Backed Securities (FHLMC Gold PCs) which
also guarantee timely payment of monthly principal reductions.
Ginnie Mae Certificates. Ginnie Mae is a wholly-owned corporate
instrumentality of the United States within the Department of Housing and
Urban Development. The National Housing Act of 1934, as amended (the "Housing
Act"), authorizes Ginnie Mae to guarantee the timely payment of the principal
of and interest on certificates that are based on and backed by a pool of
mortgage loans insured by the Federal Housing Administration under the Housing
Act, or Title V of the Housing Act of 1949 ("FHA Loans"), or guaranteed by the
Department of Veterans Affairs under the Servicemen's Readjustment Act of
1944, as amended ("VA Loans"), or by pools of other eligible mortgage loans.
The Housing Act provides that the full faith and credit of the United States
government is pledged to the payment of all amounts that may be required to be
paid under any guaranty. In order to meet its obligations under such
guaranty, Ginnie Mae is authorized to borrow from the United States Treasury
with no limitations as to amount.
Fannie Mae Certificates. Fannie Mae is a federally chartered and
privately owned corporation organized and existing under the Federal National
Mortgage Association Charter Act of 1938. FNMA Certificates represent a pro-
rata interest in a group of mortgage loans purchased by Fannie Mae. FNMA
guarantees the timely payment of principal and interest on the securities it
issues. The obligations of FNMA are not backed by the full faith and credit
of the U.S. Government.
Freddie Mac Certificates. Freddie Mac is a corporate instrumentality of
the United States created pursuant to the Emergency Home Finance Act of 1970,
as amended (the "FHLMC Act"). Freddie Mac Certificates represent a pro-rata
PAGE 10
interest in a group of mortgage loans (a "Freddie Mac Certificate group")
purchased by Freddie Mac. Freddie Mac guarantees timely payment of interest
and principal on certain securities it issues and timely payment of interest
and eventual payment of principal on other securities is issues. The
obligations of Freddie Mac are obligations solely of Freddie Mac and are not
backed by the full faith and credit of the U.S. Government.
When mortgages in the pool underlying a Mortgage-Backed Security are
prepaid by mortgagors or by result of foreclosure, such principal payments are
passed through to the certificate holders. Accordingly, the life of the
Mortgage-Backed Security is likely to be substantially shorter than the stated
maturity of the mortgages in the underlying pool. Because of such variation
in prepayment rates, it is not possible to predict the life of a particular
Mortgage-Backed Security, but FHA statistics indicate that 25- to 30-year
single family dwelling mortgages have an average life of approximately 12
years. The majority of Ginnie Mae Certificates are backed by mortgages of
this type, and, accordingly, the generally accepted practice treats Ginnie Mae
Certificates as 30-year securities which prepay full in the 12th year. FNMA
and Freddie Mac Certificates may have differing prepayment characteristics.
Fixed Rate Mortgage-Backed Securities bear a stated "coupon rate" which
represents the effective mortgage rate at the time of issuance, less certain
fees to GNMA, FNMA and FHLMC for providing the guarantee, and the issuer for
assembling the pool and for passing through monthly payments of interest and
principal.
Payments to holders of Mortgage-Backed Securities consist of the monthly
distributions of interest and principal less the applicable fees. The actual
yield to be earned by a holder of Mortgage-Backed Securities is calculated by
dividing interest payments by the purchase price paid for the Mortgage-Backed
Securities (which may be at a premium or a discount from the face value of the
certificate).
Monthly distributions of interest, as contrasted to semi-annual
distributions which are common for other fixed interest investments, have the
effect of compounding and thereby raising the effective annual yield earned on
Mortgage-Backed Securities. Because of the variation in the life of the pools
of mortgages which back various Mortgage-Backed Securities, and because it is
impossible to anticipate the rate of interest at which future principal
payments may be reinvested, the actual yield earned from a portfolio of
Mortgage-Backed Securities will differ significantly from the yield estimated
by using an assumption of a certain life for each Mortgage-Backed Security
included in such a portfolio as described above.
U.S. Government Agency Multiclass Pass-Through Securities. Unlike CMOs,
U.S. Government Agency Multiclass Pass-Through Securities, which include FNMA
Guaranteed REMIC Pass-Through Certificates and FHLMC Multi-Class Mortgage
Participation Certificates, are ownership interests in a pool of Mortgage
Assets. Unless the context indicates otherwise, all references herein to CMOs
include multiclass pass-through securities.
Multi-Class Residential Mortgage Securities. Such securities represent
interests in pools of mortgage loans to residential home buyers made by
commercial banks, savings and loan associations or other financial
institutions. Unlike GNMA, FNMA and FHLMC securities, the payment of
principal and interest on Multi-Class Residential Mortgage Securities is not
guaranteed by the U.S. Government or any of its agencies. Accordingly, yields
on Multi-Class Residential Mortgage Securities have been historically higher
than the yields on U.S. government mortgage securities. However, the risk of
loss due to default on such instruments is higher since they are not
PAGE 11
guaranteed by the U.S. Government or its agencies. Additionally, pools of
such securities may be divided into senior or subordinated segments. Although
subordinated mortgage securities may have a higher yield than senior mortgage
securities, the risk of loss of principal is greater because losses on the
underlying mortgage loans must be borne by persons holding subordinated
securities before those holding senior mortgage securities.
Privately-Issued Mortgage-Backed Certificates. These are pass-through
certificates issued by non-governmental issuers. Pools of conventional
residential mortgage loans created by such issuers generally offer a higher
rate of interest than government and government-related pools because there
are no direct or indirect government guarantees of payment. Timely payment of
interest and principal of these pools is, however, generally supported by
various forms of insurance or guarantees, including individual loan, title,
pool and hazard insurance. The insurance and guarantees are issued by
government entities, private insurance or the mortgage poolers. Such
insurance and guarantees and the creditworthiness of the issuers thereof will
be considered in determining whether a mortgage-related security meets the
Fund's quality standards. The Fund may buy mortgage-related securities
without insurance or guarantees if through an examination of the loan
experience and practices of the poolers, the investment manager determines
that the securities meet the Fund's quality standards.
The Fund expects that governmental, government-related or private
entities may create mortgage loan pools offering pass-through investments in
addition to those described above. The mortgages underlying these securities
may be alternative mortgage instruments, that is, mortgage instruments whose
principal or interest payments may vary or whose terms to maturity may differ
from customary long-term fixed rate mortgages. As new types of mortgage-
related securities are developed and offered to investors, the investment
manager will, consistent with the Fund's objective, policies and quality
standards, consider making investments in such new types of securities.
Collateralized Mortgage Obligations (CMOs)
CMOs are bonds that are collateralized by whole loan mortgages or
mortgage pass-through securities. The bonds issued in a CMO deal are divided
into groups, and each group of bonds is referred to as a "tranche". Under the
traditional CMO structure, the cash flows generated by the mortgages or
mortgage pass-through securities in the collateral pool are used to first pay
interest and then pay principal to the CMO bondholders. The bonds issued
under a CMO structure are retired sequentially as opposed to the pro rata
return of principal found in traditional pass-through obligations. Subject to
the various provisions of individual CMO issues, the cash flow generated by
the underlying collateral (to the extent it exceeds the amount required to pay
the stated interest) is used to retire the bonds. Under the CMO structure,
the repayment of principal among the different tranches is prioritized in
accordance with the terms of the particular CMO issuance. The "fastest-pay"
tranche of bonds, as specified in the prospectus for the issuance, would
initially receive all principal payments. When that tranche of bonds is
retired, the next tranche, or tranches, in the sequence, as specified in the
prospectus, receive all of the principal payments until they are retired. The
sequential retirement of bond groups continues until the last tranche, or
group of bonds, is retired. Accordingly, the CMO structure allows the issuer
to use cash flows of long maturity, monthly-pay collateral to formulate
securities with short, intermediate and long final maturities and expected
average lives.
In recent years, new types of CMO structures have evolved. These
include floating rate CMOs, planned amortization classes, accrual bonds and
PAGE 12
CMO residuals. These newer structures affect the amount and timing of
principal and interest received by each tranche from the underlying
collateral. Under certain of these new structures, given classes of CMOs have
priority over others with respect to the receipt of prepayments on the
mortgages. Therefore, depending on the type of CMOs in which the Fund
invests, the investment may be subject to a greater or lesser risk of
prepayment than other types of mortgage-related securities.
The primary risk of any mortgage security is the uncertainty of the
timing of cash flows. For CMOs, the primary risk results from the rate of
prepayments on the underlying mortgages serving as collateral. An increase or
decrease in prepayment rates (resulting from a decrease or increase in
mortgage interest rates) will affect the yield, average life and price of
CMOs. The prices of certain CMOs, depending on its structure and the rate of
prepayments, can be volatile. Some CMOs may also not be as liquid as other
securities.
Stripped Agency Mortgage-Backed Securities
Stripped Agency Mortgage-Backed securities represent interests in a pool
of mortgages, the cash flow of which has been separated into its interest and
principal components. "IOs" (interest only securities) receive the interest
portion of the cash flow while "POs" (principal only securities) receive the
principal portion. Stripped Agency Mortgage-Backed Securities may be issued
by U.S. Government Agencies or by private issuers similar to those described
below with respect to CMOs and privately-issued mortgage-backed certificates.
As interest rates rise and fall, the value of IOs tends to move in the same
direction as interest rates. The value of the other mortgage-backed
securities described herein, like other debt instruments, will tend to move in
the opposite direction compared to interest rates. Under the Internal Revenue
Code of 1986, as amended (the "Code"), POs may generate taxable income from
the current accrual of original issue discount, without a corresponding
distribution of cash to the Fund.
The cash flows and yields on IO and PO classes are extremely sensitive
to the rate of principal payments (including prepayments) on the related
underlying mortgage assets. For example, a rapid or slow rate of principal
payments may have a material adverse effect on the prices of IOs or POs,
respectively. If the underlying mortgage assets experience greater than
anticipated prepayments of principal, an investor may fail to recoup fully its
initial investment in an IO class of a stripped mortgage-backed security, even
if the IO class is rated AAA or Aaa or is derived from a full faith and credit
obligation. Conversely, if the underlying mortgage assets experience slower
than anticipated prepayments of principal, the price on a PO class will be
affected more severely than would be the case with a traditional
mortgage-backed security.
The staff of the Securities and Exchange Commission has advised the Fund
that it believes the Fund should treat IOs and POs, other than
government-issued IOs or POs backed by fixed rate mortgages, as illiquid
securities and, accordingly, limit its investments in such securities,
together with all other illiquid securities, to 15% of the Fund's net assets.
Under the Staff's position, the determination of whether a particular
government-issued IO and PO backed by fixed rate mortgages may be made on a
case by case basis under guidelines and standards established by the Fund's
Board of Directors. The Fund's Board of Directors has delegated to T. Rowe
Price the authority to determine the liquidity of these investments based on
the following guidelines: the type of issuer; type of collateral, including
age and prepayment characteristics; rate of interest on coupon relative to
current market rates and the effect of the rate on the potential for
PAGE 13
prepayments; complexity of the issue's structure, including the number of
tranches; size of the issue and the number of dealers who make a market in the
IO or PO. The Fund will treat non-government-issued IOs and POs not backed by
fixed or adjustable rate mortgages as illiquid unless and until the Securities
and Exchange Commission modifies its position.
Adjustable Rate Mortgages. Adjustable rate mortgage (ARM) securities
are collateralized by adjustable rate, rather than fixed rate, mortgages.
ARMs, like fixed rate mortgages, have a specified maturity date, and the
principal amount of the mortgage is repaid over the life of the mortgage.
Unlike fixed rate mortgages, the interest rate on ARMs is adjusted at regular
intervals based on a specified, published interest rate "index" such as a
Treasury rate index. The new rate is determined by adding a specific interest
amount, the "margin," to the interest rate of the index. Investment in ARM
securities allows the Fund to participate in changing interest rate levels
through regular adjustments in the coupons of the underlying mortgages,
resulting in more variable current income and lower price volatility than
longer term fixed rate mortgage securities. The ARM securities in which the
Fund expects to invest will generally adjust their interest rates at regular
intervals of one year or less. ARM securities are a less effective means of
locking in long-term rates than fixed rate mortgages since the income from
adjustable rate mortgages will increase during periods of rising interest
rates and decline during periods of falling rates.
Characteristics of Adjustable Rate Mortgage Securities -Interest Rate
Indices. The interest rates paid on adjustable rate securities are readjusted
periodically to an increment over some predetermined interest rate index.
Such readjustments occur at intervals ranging from one to 60 months. There
are three main categories of indexes: (1) those based on U.S. Treasury
securities (2) those derived from a calculated measure such as a cost of funds
index ("COFI") or a moving average of mortgage rates and (3) those based on
actively traded or prominently posted short-term, interest rates. Commonly
utilized indexes include the one-year, three-year and five-year constant
maturity Treasury rates, the three-month Treasury bill rate, the 180-day
Treasury bill rate, rates on longer-term Treasury securities, the 11th
District Federal Home Loan Bank Cost of Funds, the National Median Cost of
Funds, the one-month, three-month, six-month or one-year London Interbank
Offered Rate (LIBOR), the prime rate of a specific bank, or commercial paper
rates. Some indexes, such as the one-year constant maturity Treasury rate,
closely mirror changes in market interest rate levels. Others, such as the
11th District Home Loan Bank Cost of Funds index, tend to lag behind changes
in market rate levels. The market value of the Fund's assets and of the net
asset value of the Fund's shares will be affected by the length of the
adjustment period, the degree of volatility in the applicable indexes and the
maximum increase or decrease of the interest rate adjustment on any one
adjustment date, in any one year and over the life of the securities. These
maximum increases and decreases are typically referred to as "caps" and
"floors", respectively.
A number of factors affect the performance of the Cost of Funds Index
and may cause the Cost of Funds Index to move in a manner different from
indices based upon specific interest rates, such as the One Year Treasury
Index. Additionally, there can be no assurance that the Cost of Funds Index
will necessarily move in the same direction or at the same rate as prevailing
interest rates. Furthermore, any movement in the Cost of Funds Index as
compared to other indices based upon specific interest rates may be affected
by changes instituted by the FHLB of San Francisco in the method used to
PAGE 14
calculate the Cost of Funds Index. To the extent that the Cost of Funds Index
may reflect interest changes on a more delayed basis than other indices, in a
period of rising interest rates, any increase may produce a higher yield later
than would be produced by such other indices, and in a period of declining
interest rates, the Cost of Funds Index may remain higher than other market
interest rates which may result in a higher level of principal prepayments on
mortgage loans which adjust in accordance with the Cost of Funds Index than
mortgage loans which adjust in accordance with other indices.
LIBOR, the London interbank offered rate, is the interest rate that the
most creditworthy international banks dealing in U.S. dollar-denominated
deposits and loans charge each other for large dollar-denominated loans.
LIBOR is also usually the base rate for large dollar-denominated loans in the
international market. LIBOR is generally quoted for loans having rate
adjustments at one, three, six or 12 month intervals.
Caps and Floors. ARMs will frequently have caps and floors which limit
the maximum amount by which the interest rate to the residential borrower may
move up or down, respectively, each adjustment period and over the life of the
loan. Interest rate caps on ARM securities may cause them to decrease in
value in an increasing interest rate environment. Such caps may also prevent
their income from increasing to levels commensurate with prevailing interest
rates. Conversely, interest rate floors on ARM securities may cause their
income to remain higher than prevailing interest rate levels and result in an
increase in the value of such securities. However, this increase may be
tempered by the acceleration of prepayments.
Mortgage securities generally have a maximum maturity of up to 30 years.
However, due to the adjustable rate feature of ARM securities, their prices
are considered to have volatility characteristics which approximate the
average period of time until the next adjustment of the interest rate. As a
result, the principal volatility of ARM securities may be more comparable to
short- and intermediate-term securities than to longer term fixed rate
mortgage securities. Prepayments however, will increase their principal
volatility. See also the discussion of Mortgage-Backed Securities on page __.
Other Mortgage Related Securities. The Fund expects that governmental,
government-related or private entities may create mortgage loan pools offering
pass-through investments in addition to those described above. The mortgages
underlying these securities may be alternative mortgage instruments, that is,
mortgage instruments whose principal or interest payments may vary or whose
terms to maturity may differ from customary long-term fixed rate mortgages.
As new types of mortgage-related securities are developed and offered to
investors, the investment manager will, consistent with the Fund's objective,
policies and quality standards, consider making investments in such new types
of securities.
Asset-Backed Securities
The Fund may invest a portion of its assets in debt obligations known as
asset-backed securities.
The credit quality of most asset-backed securities depends primarily on
the credit quality of the assets underlying such securities, how well the
entity issuing the security is insulated from the credit risk of the
originator or any other affiliated entities and the amount and quality of any
credit support provided to the securities. The rate of principal payment on
asset-backed securities generally depends on the rate of principal payments
received on the underlying assets which in turn may be affected by a variety
of economic and other factors. As a result, the yield on any asset-backed
PAGE 15
security is difficult to predict with precision and actual yield to maturity
may be more or less than the anticipated yield to maturity. Asset-backed
securities may be classified either as pass-through certificates or
collateralized obligations.
Pass-through certificates are asset-backed securities which represent an
undivided fractional ownership interest in an underlying pool of assets.
Pass-through certificates usually provide for payments of principal and
interest received to be passed through to its holders, usually after deduction
for certain costs and expenses incurred in administering the pool. Because
pass-through certificates represent an ownership interest in the underlying
assets, the holders thereof bear directly the risk of any defaults by the
obligors on the underlying assets not covered by any credit support. See
"Types of Credit Support".
Asset-backed securities issued in the form of debt instruments, also
known as collateralized obligations, are generally issued as the debt of a
special purpose entity organized solely for the purpose of owning such assets
and issuing such debt. Such assets are most often trade, credit card or
automobile receivables. The assets collateralizing such asset-backed
securities are pledged to a trustee or custodian for the benefit of the
holders thereof. Such issuers generally hold no assets other than those
underlying the asset-backed securities and any credit support provided. As a
result, although payments on such asset-backed securities are obligations of
the issuers, in the event of defaults on the underlying assets not covered by
any credit support (see "Types of Credit Support"), the issuing entities are
unlikely to have sufficient assets to satisfy its obligations on the related
asset-backed securities.
Methods of Allocating Cash Flows. While many asset-backed securities
are issued with only one class of security, many asset-backed securities are
issued in more than one class, each with different payment terms. Multiple
class asset-backed securities are issued for two main reasons. First,
multiple classes may be used as a method of providing credit support. This is
accomplished typically through creation of one or more classes whose right to
payments on the asset-backed security is made subordinate to the right to such
payments of the remaining class or classes. See "Types of Credit Support".
Second, multiple classes may permit the issuance of securities with payment
terms, interest rates or other characteristics differing both from those of
each other and from those of the underlying assets. Examples include so-
called "strips" (asset-backed securities entitling the holder to
disproportionate interests with respect to the allocation of interest and
principal of the assets backing the security), and securities with class or
classes having characteristics which mimic the characteristics of non-asset-
backed securities, such as floating interest rates (i.e., interest rates which
adjust as a specified benchmark changes) or scheduled amortization of
principal.
Asset-backed securities in which the payment streams on the underlying
assets are allocated in a manner different than those described above may be
issued in the future. The Fund may invest in such asset-backed securities if
such investment is otherwise consistent with its investment objectives and
policies and with the investment restrictions of the Fund.
Types of Credit Support. Asset-backed securities are often backed by a
pool of assets representing the obligations of a number of different parties.
To lessen the effect of failures by obligors on underlying assets to make
payments, such securities may contain elements of credit support. Such credit
support falls into two classes: liquidity protection and protection against
PAGE 16
ultimate default by an obligor on the underlying assets. Liquidity protection
refers to the provision of advances, generally by the entity administering the
pool of assets, to ensure that scheduled payments on the underlying pool are
made in a timely fashion. Protection against ultimate default ensures
ultimate payment of the obligations on at least a portion of the assets in the
pool. Such protection may be provided through guarantees, insurance policies
or letters of credit obtained from third parties, through various means of
structuring the transaction or through a combination of such approaches.
Examples of asset-backed securities with credit support arising out of the
structure of the transaction include "senior-subordinated securities"
(multiple class asset-backed securities with certain classes subordinate to
other classes as to the payment of principal thereon, with the result that
defaults on the underlying assets are borne first by the holders of the
subordinated class) and asset-backed securities that have "reserve funds"
(where cash or investments, sometimes funded from a portion of the initial
payments on the underlying assets, are held in reserve against future losses)
or that have been "overcollateralized" (where the scheduled payments on, or
the principal amount of, the underlying assets substantially exceeds that
required to make payment of the asset-backed securities and pay any servicing
or other fees). The degree of credit support provided on each issue is based
generally on historical information respecting the level of credit risk
associated with such payments. Delinquency or loss in excess of that
anticipated could adversely affect the return on an investment in an asset-
backed security.
Automobile Receivable Securities. The Fund may invest in Asset-Backed
Securities which are backed by receivables from motor vehicle installment
sales contracts or installment loans secured by motor vehicles ("Automobile
Receivable Securities"). Since installment sales contracts for motor vehicles
or installment loans related thereto ("Automobile Contracts") typically have
shorter durations and lower incidences of prepayment, Automobile Receivable
Securities generally will exhibit a shorter average life and are less
susceptible to prepayment risk.
Most entities that issue Automobile Receivable Securities create an
enforceable interest in its respective Automobile Contracts only by filing a
financing statement and by having the servicer of the Automobile Contracts,
which is usually the originator of the Automobile Contracts, take custody
thereof. In such circumstances, if the servicer of the Automobile Contracts
were to sell the same Automobile Contracts to another party, in violation of
its obligation not to do so, there is a risk that such party could acquire an
interest in the Automobile Contracts superior to that of the holders of
Automobile Receivable Securities. Also although most Automobile Contracts
grant a security interest in the motor vehicle being financed, in most states
the security interest in a motor vehicle must be noted on the certificate of
title to create an enforceable security interest against competing claims of
other parties. Due to the large number of vehicles involved, however, the
certificate of title to each vehicle financed, pursuant to the Automobile
Contracts underlying the Automobile Receivable Security, usually is not
amended to reflect the assignment of the seller's security interest for the
benefit of the holders of the Automobile Receivable Securities. Therefore,
there is the possibility that recoveries on repossessed collateral may not, in
some cases, be available to support payments on the securities. In addition,
various state and federal securities laws give the motor vehicle owner the
right to assert against the holder of the owner's Automobile Contract certain
defenses such owner would have against the seller of the motor vehicle. The
assertion of such defenses could reduce payments on the Automobile Receivable
Securities.
PAGE 17
Credit Card Receivable Securities. The Fund may invest in Asset Backed
Securities backed by receivables from revolving credit card agreements
("Credit Card Receivable Securities"). Credit balances on revolving credit
card agreements ("Accounts") are generally paid down more rapidly than are
Automobile Contracts. Most of the Credit Card Receivable Securities issued
publicly to date have been Pass-Through Certificates. In order to lengthen
the maturity of Credit Card Receivable Securities, most such securities
provide for a fixed period during which only interest payments on the
underlying Accounts are passed through to the security holder and principal
payments received on such Accounts are used to fund the transfer to the pool
of assets supporting the related Credit Card Receivable Securities of
additional credit card charges made on an Account. The initial fixed period
usually may be shortened upon the occurrence of specified events which signal
a potential deterioration in the quality of the assets backing the security,
such as the imposition of a cap on interest rates. The ability of the issuer
to extend the life of an issue of Credit Card Receivable Securities thus
depends upon the continued generation of additional principal amounts in the
underlying accounts during the initial period and the non-occurrence of
specified events. An acceleration in cardholders' payment rates or any other
event which shortens the period during which additional credit card charges on
an Account may be transferred to the pool of assets supporting the related
Credit Card Receivable Security could shorten the weighted average life and
yield of the Credit Card Receivable Security.
Credit cardholders are entitled to the protection of a number of state
and federal consumer credit laws, many of which give such holder the right to
set off certain amounts against balances owed on the credit card, thereby
reducing amounts paid on Accounts. In addition, unlike most other Asset
Backed Securities, Accounts are unsecured obligations of the cardholder.
Other Assets. T. Rowe Price anticipates that Asset Backed Securities
backed by assets other than those described above will be issued in the
future. The Fund may invest in such securities in the future if such
investment is otherwise consistent with its investment objective and policies.
Hybrid Instruments
Hybrid Instruments have recently been developed and combine the elements
of futures contracts or options with those of debt, preferred equity or a
depository instrument. Often these Hybrid Instruments are indexed to the
price of a commodity, a particular currency or a domestic or foreign debt or
equity securities index. Hybrid Instruments may take a variety of forms,
including, but not limited to, debt instruments with interest or principal
payments or redemption terms determined by reference to the value of a
currency or commodity or securities index at a future point in time, preferred
stock with dividend rates determined by reference to the value of a currency,
or convertible securities with the conversion terms related to a particular
commodity.
The risks of investing in Hybrid Instruments reflect a combination of
the risks from investing in securities, options, futures, and currencies,
including volatility and lack of liquidity. Reference is made to the
discussion of futures, forward contracts, and options herein, for a discussion
of these risks. Further, the prices of the Hybrid Instrument and the related
commodity or currency may not move in the same direction or at the same time.
Hybrid Instruments may bear interest or pay preferred dividends at below
market (or even relatively nominal) rates. Alternatively, Hybrid Instruments
may bear interest at above market rates but bear an increased risk of
principal loss (or gain). In addition, because the purchase and sale of
Hybrid Instruments could take place in an over-the-counter market or in a
PAGE 18
private transaction between the Fund and the seller of the Hybrid Instrument,
the creditworthiness of the contra party to the transaction would be a risk
factor which the Fund would have to consider. Hybrid Instruments also may not
be subject to regulation of the Commodities Futures Trading Commission
("CFTC"), which generally regulates the trading of commodity futures by U.S.
persons the SEC, which regulates the offer and sale of securities, or any
other governmental regulatory authority.
Adjustable Rate Securities
Certain securities may be issued with adjustable interest rates that are
reset periodically by pre-determined formulas or indexes in order to minimize
movements in the principal value of the investment. Such securities may have
long-term maturities, but may be treated as a short-term investment under
certain conditions. Generally, as interest rates decrease or increase, the
potential for capital appreciation or depreciation on these securities is less
than for fixed-rate obligations. These securities may take the following
forms:
Variable Rate Securities. Variable rate instruments may take the form
of domestic certificates of deposit which provide for the adjustment of
its interest rate on set dates and which, upon adjustment, can
reasonably be expected to have a market value which approximates its par
value. A variable rate instrument, the principal amount of which is
scheduled to be paid in 397 calendar days or less, is deemed to have a
maturity equal to the period remaining until the next readjustment of
the interest rate. A variable rate instrument which is subject to a
demand feature which entitles the purchaser to receive the principal
amount of the underlying security or securities, either (i) upon notice
of no more than 30 days, or (ii) at specified intervals not exceeding
397 calendar days and upon no more than 30 days' notice, is deemed to
have a maturity equal to the longer of the period remaining until the
next readjustment of the interest rate or the period remaining until the
principal amount can be recovered through demand.
Floating Rate Securities. Floating rate may take the form of corporate
or bank holding company notes or Eurodollar certificates of deposit.
These instruments provide for the adjustment of its interest rates
whenever a specified interest rate changes and which, at any time, can
reasonably be expected to have a market value that approximates its par
value. Floating rate instruments with demand features are deemed to
have a maturity equal to the period remaining until the principal amount
can be recovered through demand. An instrument that is issued or
guaranteed by the U.S. Government or any agency thereof which has a
variable rate of interest readjusted no less frequently than every 762
days may be deemed to have a maturity equal to the period remaining
until the next readjustment of the interest rate.
Put Option Bonds. Long-term obligations with maturities longer than one
year may provide purchasers an optional or mandatory tender of the
security at par value at predetermined intervals, often ranging from one
month to several years (e.g., a 30-year bond with a five-year tender
period). These instruments are deemed to have a maturity equal to the
period remaining to the put date.
When-Issued Securities and Forward Commitment Contracts
The Fund may purchase securities on a "when-issued" or delayed delivery
basis ("When-Issueds") and the Fund may purchase securities on a forward
commitment basis ("Forwards"). The price of such securities, which may be
PAGE 19
expressed in yield terms, is fixed at the time the commitment to purchase is
made, but delivery and payment for take place at a later date. Normally, the
settlement date occurs within 90 days of the purchase for When-Issueds, but
may be substantially longer for Forwards. During the period between purchase
and settlement, no payment is made by the Fund to the issuer and no interest
accrues to the Fund. The purchase of these securities will result in a loss
if its value declines prior to the settlement date. This could occur, for
example, if interest rates increase prior to settlement. The longer the
period between purchase and settlement the greater these risks are. At the
time the Fund makes the commitment to purchase these securities, it will
record the transaction and reflect the value of the security in determining
its net asset value. The Fund will cover these securities by maintaining cash
and/or liquid, high-grade debt securities with its custodian bank equal in
value to commitments for them during the time between purchase and settlement.
Therefore, the longer this period, the longer the time during which
alternative investment options are not available to the Fund (to the extent of
the securities used for cover). Such securities either will mature or, if
necessary, be sold on or before the settlement date.
To the extent the Fund remains fully or almost fully invested (in
securities with a remaining maturity of more than one year) at the same time
it purchases these securities, there will be greater fluctuations in the
Fund's net asset value than if the Fund did not purchase them.
Illiquid or Restricted Securities
Restricted securities may be sold only in privately negotiated
transactions or in a public offering with respect to which a registration
statement is in effect under the Securities Act of 1933 (the "1933 Act").
Where registration is required, the Fund may be obligated to pay all or part
of the registration expenses and a considerable period may elapse between the
time of the decision to sell and the time the Fund may be permitted to sell a
security under an effective registration statement. If, during such a period,
adverse market conditions were to develop, the Fund might obtain a less
favorable price than prevailed when it decided to sell. Restricted securities
will be priced at fair value as determined in accordance with procedures
prescribed by the Fund's Board of Directors. If through the appreciation of
illiquid securities or the depreciation of liquid securities, the Fund should
be in a position where more than 15% of the value of its net assets are
invested in illiquid assets, including restricted securities, the Fund will
take appropriate steps to protect liquidity.
Notwithstanding the above, the Fund may purchase securities which, while
privately placed, are eligible for purchase and sale under Rule 144A under the
1933 Act. This rule permits certain qualified institutional buyers, such as
the Fund, to trade in privately placed securities even though such securities
are not registered under the 1933 Act. T. Rowe Price under the supervision of
the Fund's Board of Directors, will consider whether securities purchased
under Rule 144A are illiquid and thus subject to the Fund's restriction of
investing no more than 15% of its net assets in illiquid securities. A
determination of whether a Rule 144A security is liquid or not is a question
of fact. In making this determination, T. Rowe Price will consider the
trading markets for the specific security taking into account the unregistered
nature of a Rule 144A security. In addition, T. Rowe Price could consider the
(1) frequency of trades and quotes, (2) number of dealers and potential
purchases, (3) dealer undertakings to make a market, and (4) the nature of the
security and of marketplace trades (e.g., the time needed to dispose of the
security, the method of soliciting offers and the mechanics of transfer). The
liquidity of Rule 144A securities would be monitored, and if as a result of
changed conditions it is determined that a Rule 144A security is no longer
PAGE 20
liquid, a Fund's holdings of illiquid securities would be reviewed to
determine what, if any, steps are required to assure that the Fund does not
invest more than 15% of its net assets in illiquid securities. Investing in
Rule 144A securities could have the effect of increasing the amount of a
Fund's assets invested in illiquid securities if qualified institutional
buyers are unwilling to purchase such securities.
There are, of course, other types of securities that are, or may become
available, which are similar to the foregoing and the Fund may invest in these
securities.
PORTFOLIO MANAGEMENT PRACTICES
Lending of Portfolio Securities
Securities loans are made to broker-dealers or institutional investors
or other persons, pursuant to agreements requiring that the loans be
continuously secured by collateral at least equal at all times to the value of
the securities lent marked to market on a daily basis. The collateral
received will consist of cash, U.S. government securities, letters of credit
or such other collateral as may be permitted under its investment program.
While the securities are being lent, the Fund will continue to receive the
equivalent of the interest or dividends paid by the issuer on the securities,
as well as interest on the investment of the collateral or a fee from the
borrower. The Fund has a right to call each loan and obtain the securities on
five business days' notice or, in connection with securities trading on
foreign markets, within such longer period of time which coincides with the
normal settlement period for purchases and sales of such securities in such
foreign markets. The Fund will not have the right to vote securities while
they are being lent, but it will call a loan in anticipation of any important
vote. The risks in lending portfolio securities, as with other extensions of
secured credit, 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. Loans will only be made to
firms deemed by T. Rowe Price to be of good standing and will not be made
unless, in the judgment of T. Rowe Price, the consideration to be earned from
such loans would justify the risk.
Other Lending/Borrowing
Subject to approval by the Securities and Exchange Commission, the Fund
may make loans to, or borrow funds from, other mutual funds sponsored or
advised by T. Rowe Price or Price-Fleming (collectively, "Price Funds"). The
Fund has no current intention of engaging in these practices at this time.
Repurchase Agreements
The Fund may enter into a repurchase agreement through which an investor
(such as the Fund) purchases a security (known as the "underlying security")
from a well-established securities dealer or a bank that is a member of the
Federal Reserve System. Any such dealer or bank will be on T. Rowe Price's
approved list and have a credit rating with respect to its short-term debt of
at least A1 by Standard & Poor's Ratings Group, P1 by Moody's Investors
Service, or the equivalent rating by T. Rowe Price. At that time, the bank or
securities dealer agrees to repurchase the underlying security at the same
price, plus specified interest. Repurchase agreements are generally for a
short period of time, often less than a week. Repurchase agreements which do
not provide for payment within seven days will be treated as illiquid
PAGE 21
securities. The Fund will only enter into repurchase agreements where (i) the
underlying securities are of the type (excluding maturity limitations) which
the Fund's investment guidelines would allow it to purchase directly, (ii) the
market value of the underlying security, including interest accrued, will be
at all times equal to or exceed the value of the repurchase agreement, and
(iii) payment for the underlying security is made only upon physical delivery
or evidence of book-entry transfer to the account of the custodian or a bank
acting as agent. In the event of a bankruptcy or other default of a seller of
a repurchase agreement, a Fund could experience both delays in liquidating the
underlying security and losses, including: (a) possible decline in the value
of the underlying security during the period while the Fund seeks to enforce
its rights thereto; (b) possible subnormal levels of income and lack of access
to income during this period; and (c) expenses of enforcing its rights.
Reverse Repurchase Agreements
Although the Fund has no current intention, in the foreseeable future,
of engaging in reverse repurchase agreements, the Fund reserves the right to
do so. Reverse repurchase agreements are ordinary repurchase agreements in
which a Fund is the seller of, rather than the investor in, securities, and
agrees to repurchase them at an agreed upon time and price. Use of a reverse
repurchase agreement may be preferable to a regular sale and later repurchase
of the securities because it avoids certain market risks and transaction
costs. A reverse repurchase agreement may be viewed as a type of borrowing by
the Fund, subject to Investment Restriction (1). (See "Investment
Restrictions," page __.)
Options
Writing Covered Call Options
The Fund may write (sell) American or European style "covered" call
options and purchase options to close out options previously written by a
Fund. In writing covered call options, a Fund expects to generate additional
premium income which should serve to enhance the Fund's total return and
reduce the effect of any price decline of the security or currency involved in
the option. Covered call options will generally be written on securities or
currencies which, in T. Rowe Price's opinion, are not expected to have any
major price increases or moves in the near future but which, over the long
term, are deemed to be attractive investments for a Fund.
A call option gives the holder (buyer) the "right to purchase" a
security or currency at a specified price (the exercise price) at expiration
of the option (European style) or at any time until a certain date (the
expiration date) (American style). So long as the obligation of the writer of
a call option continues, he may be assigned an exercise notice by the broker-
dealer through whom such option was sold, requiring him to deliver the
underlying security or currency against payment of the exercise price. This
obligation terminates upon the expiration of the call option, or such earlier
time at which the writer effects a closing purchase transaction by
repurchasing an option identical to that previously sold. To secure his
obligation to deliver the underlying security or currency in the case of a
call option, a writer is required to deposit in escrow the underlying security
or currency or other assets in accordance with the rules of a clearing
corporation. The Fund will write only covered call options. This means that
a Fund will own the security or currency subject to the option or an option to
purchase the same underlying security or currency, having an exercise price
equal to or less than the exercise price of the "covered" option, or will
establish and maintain with its custodian for the term of the option, an
account consisting of cash, U.S. government securities or other liquid high-
PAGE 22
grade debt obligations having a value equal to the fluctuating market value of
the optioned securities or currencies.
Portfolio securities or currencies on which call options may be written
will be purchased solely on the basis of investment considerations consistent
with the Fund's investment objective. The writing of covered call options is
a conservative investment technique believed to involve relatively little risk
(in contrast to the writing of naked or uncovered options, which the Fund will
not do), but capable of enhancing a Fund's total return. When writing a
covered call option, a Fund, in return for the premium, gives up the
opportunity for profit from a price increase in the underlying security or
currency above the exercise price, but conversely retains the risk of loss
should the price of the security or currency decline. Unlike one who owns
securities or currencies not subject to an option, a Fund has no control over
when it may be required to sell the underlying securities or currencies, since
it may be assigned an exercise notice at any time prior to the expiration of
its obligation as a writer. If a call option which a Fund has written
expires, the Fund will realize a gain in the amount of the premium; however,
such gain may be offset by a decline in the market value of the underlying
security or currency during the option period. If the call option is
exercised, the Fund will realize a gain or loss from the sale of the
underlying security or currency. The Fund does not consider a security or
currency covered by a call to be "pledged" as that term is used in the Fund's
policy which limits the pledging or mortgaging of its assets.
The premium received is the market value of an option. The premium a
Fund will receive from writing a call option will reflect, among other things,
the current market price of the underlying security or currency, the
relationship of the exercise price to such market price, the historical price
volatility of the underlying security or currency, and the length of the
option period. Once the decision to write a call option has been made, T.
Rowe Price, in determining whether a particular call option should be written
on a particular security or currency, will consider the reasonableness of the
anticipated premium and the likelihood that a liquid secondary market will
exist for those options. The premium received by a Fund for writing covered
call options will be recorded as a liability of the Fund. This liability will
be adjusted daily to the option's current market value, which will be the
latest sale price at the time at which the net asset value per share of a Fund
is computed (close of the New York Stock Exchange), or, in the absence of such
sale, the latest asked price. The option will be terminated upon expiration
of the option, the purchase of an identical option in a closing transaction,
or delivery of the underlying security or currency upon the exercise of the
option.
Closing transactions will be effected in order to realize a profit on an
outstanding call option, to prevent an underlying security or currency from
being called, or, to permit the sale of the underlying security or currency.
Furthermore, effecting a closing transaction will permit a Fund to write
another call option on the underlying security or currency with either a
different exercise price or expiration date or both. If a Fund desires to
sell a particular security or currency from its portfolio on which it has
written a call option, or purchased a put option, it will seek to effect a
closing transaction prior to, or concurrently with, the sale of the security
or currency. There is, of course, no assurance that a Fund will be able to
effect such closing transactions at favorable prices. If a Fund cannot enter
into such a transaction, it may be required to hold a security or currency
that it might otherwise have sold. When a Fund writes a covered call option,
it runs the risk of not being able to participate in the appreciation of the
underlying securities or currencies above the exercise price, as well as the
risk of being required to hold on to securities or currencies that are
PAGE 23
depreciating in value. This could result in higher transaction costs. The
Fund will pay transaction costs in connection with the writing of options to
close out previously written options. Such transaction costs are normally
higher than those applicable to purchases and sales of portfolio securities.
Call options written by a Fund will normally have expiration dates of
less than nine months from the date written. The exercise price of the
options may be below, equal to, or above the current market values of the
underlying securities or currencies at the time the options are written. From
time to time, a Fund may purchase an underlying security or currency for
delivery in accordance with an exercise notice of a call option assigned to
it, rather than delivering such security or currency from its portfolio. In
such cases, additional costs may be incurred.
A Fund will realize a profit or loss from a closing purchase transaction
if the cost of the transaction is less or more than the premium received from
the writing of the option. Because increases in the market price of a call
option will generally reflect increases in the market price of the underlying
security or currency, any loss resulting from the repurchase of a call option
is likely to be offset in whole or in part by appreciation of the underlying
security or currency owned by the Fund.
In order to comply with the requirements of several states, the Fund
will not write a covered call option if, as a result, the aggregate market
value of all portfolio securities or currencies covering call or put options
exceeds 25% of the market value of the Fund's net assets. Should these state
laws change or should the Fund obtain a waiver of its application, the Fund
reserves the right to increase this percentage. In calculating the 25% limit,
the Fund will offset, against the value of assets covering written calls and
puts, the value of purchased calls and puts on identical securities or
currencies with identical maturity dates.
Writing Covered Put Options
The Fund may write American or European style covered put options and
purchase options to close out options previously written by the Fund. A put
option gives the purchaser of the option the right to sell, and the writer
(seller) has the obligation to buy, the underlying security or currency at the
exercise price during the option period (American style) or at the expiration
of the option (European style). So long as the obligation of the writer
continues, he may be assigned an exercise notice by the broker-dealer through
whom such option was sold, requiring him to make payment of the exercise price
against delivery of the underlying security or currency. The operation of put
options in other respects, including its related risks and rewards, is
substantially identical to that of call options.
The Fund would write put options only on a covered basis, which means
that the Fund would maintain in a segregated account cash, U.S. government
securities or other liquid high-grade debt obligations in an amount not less
than the exercise price or the Fund will own an option to sell the underlying
security or currency subject to the option having an exercise price equal to
or greater than the exercise price of the "covered" option at all times while
the put option is outstanding. (The rules of a clearing corporation currently
require that such assets be deposited in escrow to secure payment of the
exercise price.) A Fund would generally write covered put options in
circumstances where T. Rowe Price wishes to purchase the underlying security
or currency for the Fund's portfolio at a price lower than the current market
price of the security or currency. In such event a Fund would write a put
option at an exercise price which, reduced by the premium received on the
option, reflects the lower price it is willing to pay. Since a Fund would
PAGE 24
also receive interest on debt securities or currencies maintained to cover the
exercise price of the option, this technique could be used to enhance current
return during periods of market uncertainty. The risk in such a transaction
would be that the market price of the underlying security or currency would
decline below the exercise price less the premiums received. Such a decline
could be substantial and result in a significant loss to the Fund. In
addition, a Fund, because it does not own the specific securities or
currencies which it may be required to purchase in exercise of the put, cannot
benefit from appreciation, if any, with respect to such specific securities or
currencies.
In order to comply with the requirements of several states, the Fund
will not write a covered put option if, as a result, the aggregate market
value of all portfolio securities or currencies covering put or call options
exceeds 25% of the market value of the Fund's net assets. Should these state
laws change or should the Fund obtain a waiver of its application, the Fund
reserves the right to increase this percentage. In calculating the 25% limit,
the Fund will offset, against the value of assets covering written puts and
calls, the value of purchased puts and calls on identical securities or
currencies with identical maturity dates.
Purchasing Put Options
The Fund may purchase American or European style put options. As the
holder of a put option, the Fund has the right to sell the underlying security
or currency at the exercise price at any time during the option period
(American style) or at the expiration of the option (European style). The
Fund may enter into closing sale transactions with respect to such options,
exercise them or permit them to expire. The Fund may purchase put options for
defensive purposes in order to protect against an anticipated decline in the
value of its securities or currencies. An example of such use of put options
is provided below.
A Fund may purchase a put option on an underlying security or currency
(a "protective put") owned by the Fund as a defensive technique in order to
protect against an anticipated decline in the value of the security or
currency. Such hedge protection is provided only during the life of the put
option when a Fund, as the holder of the put option, is able to sell the
underlying security or currency at the put exercise price regardless of any
decline in the underlying security's market price or currency's exchange
value. For example, a put option may be purchased in order to protect
unrealized appreciation of a security or currency where T. Rowe Price deems it
desirable to continue to hold the security or currency because of tax
considerations. The premium paid for the put option and any transaction costs
would reduce any capital gain otherwise available for distribution when the
security or currency is eventually sold.
The Fund may also purchase put options at a time when the Fund does not
own the underlying security or currency. By purchasing put options on a
security or currency it does not own, a Fund seeks to benefit from a decline
in the market price of the underlying security or currency. If the put option
is not sold when it has remaining value, and if the market price of the
underlying security or currency remains equal to or greater than the exercise
price during the life of the put option, a Fund will lose its entire
investment in the put option. In order for the purchase of a put option to be
profitable, the market price of the underlying security or currency must
decline sufficiently below the exercise price to cover the premium and
transaction costs, unless the put option is sold in a closing sale
transaction.
PAGE 25
To the extent required by the laws of certain states, the Fund may not
be permitted to commit more than 5% of its assets to premiums when purchasing
put and call options. Should these state laws change or should the Fund
obtain a waiver of its application, the Fund may commit more than 5% of its
assets to premiums when purchasing call and put options. The premium paid by
a Fund when purchasing a put option will be recorded as an asset of the Fund.
This asset will be adjusted daily to the option's current market value, which
will be the latest sale price at the time at which the net asset value per
share of the Fund is computed (close of New York Stock Exchange), or, in the
absence of such sale, the latest bid price. This asset will be terminated
upon expiration of the option, the selling (writing) of an identical option in
a closing transaction, or the delivery of the underlying security or currency
upon the exercise of the option.
Purchasing Call Options
The Fund may purchase American or European style call options. As the
holder of a call option, the Fund has the right to purchase the underlying
security or currency at the exercise price at any time during the option
period (American style) or at the expiration of the option (European style).
The Fund may enter into closing sale transactions with respect to such
options, exercise them or permit them to expire. The Fund may purchase call
options for the purpose of increasing its current return or avoiding tax
consequences which could reduce its current return. The Fund may also
purchase call options in order to acquire the underlying securities or
currencies. Examples of such uses of call options are provided below.
Call options may be purchased by a Fund for the purpose of acquiring the
underlying securities or currencies for its portfolio. Utilized in this
fashion, the purchase of call options enables a Fund to acquire the securities
or currencies at the exercise price of the call option plus the premium paid.
At times the net cost of acquiring securities or currencies in this manner may
be less than the cost of acquiring the securities or currencies directly.
This technique may also be useful to a Fund in purchasing a large block of
securities or currencies that would be more difficult to acquire by direct
market purchases. So long as it holds such a call option rather than the
underlying security or currency itself, a Fund is partially protected from any
unexpected decline in the market price of the underlying security or currency
and in such event could allow the call option to expire, incurring a loss only
to the extent of the premium paid for the option.
To the extent required by the laws of certain states, the Fund may not
be permitted to commit more than 5% of its assets to premiums when purchasing
call and put options. Should these state laws change or should the Fund
obtain a waiver of its application, the Fund may commit more than 5% of its
assets to premiums when purchasing call and put options. The Fund may also
purchase call options on underlying securities or currencies it owns in order
to protect unrealized gains on call options previously written by it. A call
option would be purchased for this purpose where tax considerations make it
inadvisable to realize such gains through a closing purchase transaction.
Call options may also be purchased at times to avoid realizing losses.
Dealer (Over-the-Counter) Options
The Fund may engage in transactions involving dealer options. Certain
risks are specific to dealer options. While a Fund would look to a clearing
corporation to exercise exchange-traded options, if the Fund were to purchase
PAGE 26
a dealer option, it would rely on the dealer from whom it purchased the option
to perform if the option were exercised. Failure by the dealer to do so would
result in the loss of the premium paid by a Fund as well as loss of the
expected benefit of the transaction.
Exchange-traded options generally have a continuous liquid market while
dealer options have none. Consequently, a Fund will generally be able to
realize the value of a dealer option it has purchased only by exercising it or
reselling it to the dealer who issued it. Similarly, when a Fund writes a
dealer option, it generally will be able to close out the option prior to its
expiration only by entering into a closing purchase transaction with the
dealer to which the Fund originally wrote the option. While the Fund will
seek to enter into dealer options only with dealers who will agree to and
which are expected to be capable of entering into closing transactions with
the Fund, there can be no assurance that the Fund will be able to liquidate a
dealer option at a favorable price at any time prior to expiration. Until a
Fund, as a covered dealer call option writer, is able to effect a closing
purchase transaction, it will not be able to liquidate securities (or other
assets) or currencies used as cover until the option expires or is exercised.
In the event of insolvency of the contra party, a Fund may be unable to
liquidate a dealer option. With respect to options written by a Fund, the
inability to enter into a closing transaction may result in material losses to
the Fund. For example, since a Fund must maintain a secured position with
respect to any call option on a security it writes, the Fund may not sell the
assets which it has segregated to secure the position while it is obligated
under the option. This requirement may impair a Fund's ability to sell
portfolio securities or currencies at a time when such sale might be
advantageous.
The Staff of the SEC has taken the position that purchased dealer
options and the assets used to secure the written dealer options are illiquid
securities. The Fund may treat the cover used for written OTC options as
liquid if the dealer agrees that the Fund may repurchase the OTC option it has
written for a maximum price to be calculated by a predetermined formula. In
such cases, the OTC option would be considered illiquid only to the extent the
maximum repurchase price under the formula exceeds the intrinsic value of the
option. Accordingly, the Fund will treat dealer options as subject to the
Fund's limitation on unmarketable securities. If the SEC changes its position
on the liquidity of dealer options, the Fund will change its treatment of such
instrument accordingly.
Interest Rate Transactions
The Fund may enter into various interest rate transactions such as
interest rate swaps and the purchase or sale of interest rate caps and floors,
to preserve a return or spread on a particular investment or portion of its
portfolio, to create synthetic securities, or to structure transactions
designed for other non-speculative purposes.
Interest rate swaps involve the exchange by the Fund with third parties
of its respective commitments to pay or receive interest, e.g., an exchange of
floating rate payments for fixed rate payments. The purchase of an interest
rate cap entitles the purchaser, 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 party selling the interest rate
cap. The purchase of an interest rate floor entitles the purchaser, to the
extent that a specified index falls below a predetermined interest rate, to
receive payments of interest on a contractually-based principal amount from
the party selling the interest rate floor. In circumstances in which T. Rowe
Price anticipates that interest rates will decline, the Fund might, for
PAGE 27
example, enter into an interest rate swap as the floating rate payor. In the
case where the Fund purchase such an interest rate swap, if the floating rate
payments fell below the level of the fixed rate payment set in the swap
agreement, the Fund's counterparties would pay the Fund's amounts equal to
interest computed at the difference between the fixed and floating rates over
the national principal amount. Such payments would offset or partially offset
the decrease in the payments the Fund would receive in respect of floating
rate assets being hedged. In the case of purchasing an interest rate floor,
if interest rates declined below the floor rate, the Fund would receive
payments from the counterparties which would wholly or partially offset the
decrease in the payments they would receive in respect of the financial
instruments being hedged.
The Fund will usually enter into interest rate swaps on a net basis,
i.e., the two payment streams are netted out, with the Fund receiving or
paying, as the case may be, only the net amount of the two payments. The net
amount of the excess, if any, of the Fund's obligations over its entitlements
with respect to each interest rate swap will be accrued on a daily basis and
an amount of cash or high-quality liquid securities having an aggregate net
asset value at least equal to the accrued excess will be maintained in an
account by the Fund's custodian. If the Fund enters into an interest rate
swap on other than a net basis, the Fund would maintain an account in the full
amount accrued on a daily basis of the Fund's obligations with respect to the
swap. To the extent the Fund sells (i.e., writes) caps and floors, it will
maintain in an account cash or high-quality liquid debt securities having an
aggregate net asset value at least equal to the full amount, accrued on a
daily basis, of the Fund's obligations with respect to any caps or floors.
The Fund will not enter into any interest rate swap, cap or floor transaction
unless the unsecured senior debt or the claims paying ability of the
counterparty thereto is rated at least A by S&P. T. Rowe Price will monitor
the creditworthiness of counterparties on an ongoing basis. If there is a
default by the other parties to such a transaction, the Fund will have
contractual remedies pursuant to the agreements related to the transaction.
The swap market has grown substantially in recent years with a large
number of banks and investment banking firms acting both as principals and as
agents utilizing standardized swap documentation. T. Rowe Price has
determined that, as a result, the swap market has become relative liquid. The
Fund may enter into interest rate swaps only with respect to positions held in
its portfolio. Interest rate swaps do not involve the delivery of securities
or other underlying assets or principal. Accordingly, the risk of loss with
respect to interest rate swaps is limited to the net amount of interest
payments that the Fund is contractually obligated to make. If the other
parties to interest rate swaps default, the Fund's risk of loss consists of
the net amount of interest payments that the Fund is contractually entitled to
receive. Since interest rate swaps are individually negotiated, the Fund
expects to achieve an acceptable degree of correlation between its right to
receive interest on loan interests and its right and obligation to receive and
pay interest pursuant to interest rate swaps.
The aggregate purchase price of caps and floors held by the Fund may not
exceed 10% of the Fund's total assets. The Fund may sell (i.e., write) caps
and floors without limitation, subject to the account coverage requirement
described above.
PAGE 28
Futures Contracts
Transactions in Futures
The Fund may enter into futures contracts, including interest rate and
currency futures ("futures or futures contracts").
Interest rate or currency futures contracts may be used as a hedge
against changes in prevailing levels of interest rates or currency exchange
rates in order to establish more definitely the effective return on securities
or currencies held or intended to be acquired by the Fund. In this regard,
the Fund could sell interest rate or currency futures as an offset against the
effect of expected increases in interest rates or currency exchange rates and
purchase such futures as an offset against the effect of expected declines in
interest rates or currency exchange rates.
The Fund will enter into futures contracts which are traded on national
or foreign futures exchanges, and are standardized as to maturity date and
underlying financial instrument. Futures exchanges and trading in the United
States are regulated under the Commodity Exchange Act by the CFTC. Futures
are traded in London, at the London International Financial Futures Exchange,
in Paris, at the MATIF, and in Tokyo, at the Tokyo Stock Exchange. Although
techniques other than the sale and purchase of futures contracts could be used
for the above-referenced purposes, futures contracts offer an effective and
relatively low cost means of implementing the Fund's objectives in these
areas.
Regulatory Limitations
The Fund will engage in futures contracts and options thereon only for
bona fide hedging, yield enhancement, and risk management purposes, in each
case in accordance with rules and regulations of the CFTC and applicable state
law.
The Fund may not purchase or sell futures contracts or related options
if, with respect to positions which do not qualify as bona fide hedging under
applicable CFTC rules, the sum of the amounts of initial margin deposits and
premiums paid on those positions would exceed 5% of the net asset value of the
Fund after taking into account unrealized profits and unrealized losses on any
such contracts it has entered into; provided, however, that in the case of an
option that is in-the-money at the time of purchase, the in-the-money amount
may be excluded in calculating the 5% limitation. For purposes of this policy
options on futures contracts and foreign currency options traded on a
commodities exchange will be considered "related options". This policy may be
modified by the Board of Directors/Trustees without a shareholder vote and
does not limit the percentage of the Fund's assets at risk to 5%.
In accordance with the rules of the State of California, the Fund may
have to apply the above 5% test without excluding the value of initial margin
and premiums paid for bona fide hedging positions.
The Fund's use of futures contracts will not result in leverage.
Therefore, to the extent necessary, in instances involving the purchase of
futures contracts or the writing of call or put options thereon by the Fund,
an amount of cash, U.S. government securities or other liquid, high-grade debt
obligations, equal to the market value of the futures contracts and options
thereon (less any related margin deposits), will be identified in an account
with the Fund's custodian to cover the position, or alternative cover (such as
owning an offsetting position) will be employed. Assets used as cover or held
in an identified account cannot be sold while the position in the
PAGE 29
corresponding option or future is open, unless they are replaced with similar
assets. As a result, the commitment of a large portion of a Fund's assets to
cover or identified accounts could impede portfolio management or the fund's
ability to meet redemption requests or other current obligations.
If the CFTC or other regulatory authorities adopt different (including
less stringent) or additional restrictions, the Fund would comply with such
new restrictions.
Trading in Futures Contracts
A futures contract provides for the future sale by one party and
purchase by another party of a specified amount of a specific financial
instrument (e.g., units of a debt security) for a specified price, date, time
and place designated at the time the contract is made. Brokerage fees are
incurred when a futures contract is bought or sold and margin deposits must be
maintained. Entering into a contract to buy is commonly referred to as buying
or purchasing a contract or holding a long position. Entering into a contract
to sell is commonly referred to as selling a contract or holding a short
position.
Unlike when the Fund purchases or sells a security, no price would be
paid or received by the Fund upon the purchase or sale of a futures contract.
Upon entering into a futures contract, and to maintain the Fund's open
positions in futures contracts, the Fund would be required to deposit with its
custodian in a segregated account in the name of the futures broker an amount
of cash, U.S. government securities, suitable money market instruments, or
liquid, high-grade debt securities, known as "initial margin." The margin
required for a particular futures contract is set by the exchange on which the
contract is traded, and may be significantly modified from time to time by the
exchange during the term of the contract. Futures contracts are customarily
purchased and sold on margins that may range upward from less than 5% of the
value of the contract being traded.
If the price of an open futures contract changes (by increase in the
case of a sale or by decrease in the case of a purchase) so that the loss on
the futures contract reaches a point at which the margin on deposit does not
satisfy margin requirements, the broker will require an increase in the
margin. However, if the value of a position increases because of favorable
price changes in the futures contract so that the margin deposit exceeds the
required margin, the broker will pay the excess to the Fund.
These subsequent payments, called "variation margin," to and from the
futures broker, are made on a daily basis as the price of the underlying
assets fluctuate making the long and short positions in the futures contract
more or less valuable, a process known as "marking to the market." The Fund
expects to earn interest income on its margin deposits.
Although certain futures contracts, by their terms, require actual
future delivery of and payment for the underlying instruments, in practice
most futures contracts are usually closed out before the delivery date.
Closing out an open futures contract purchase or sale is effected by entering
into an offsetting futures contract sale or purchase, respectively, for the
same aggregate amount of the identical securities and the same delivery date.
If the offsetting purchase price is less than the original sale price, the
Fund realizes a gain; if it is more, the Fund realizes a loss. Conversely, if
the offsetting sale price is more than the original purchase price, the Fund
realizes a gain; if it is less, the Fund realizes a loss. The transaction
costs must also be included in these calculations. There can be no assurance,
however, that the Fund will be able to enter into an offsetting transaction
PAGE 30
with respect to a particular futures contract at a particular time. If the
Fund is not able to enter into an offsetting transaction, the Fund will
continue to be required to maintain the margin deposits on the futures
contract.
As an example of an offsetting transaction in which the underlying
instrument is not delivered, the contractual obligations arising from the sale
of one contract of September Treasury Bills on an exchange may be fulfilled at
any time before delivery of the contract is required (i.e., on a specified
date in September, the "delivery month") by the purchase of one contract of
September Treasury Bills on the same exchange. In such instance, the
difference between the price at which the futures contract was sold and the
price paid for the offsetting purchase, after allowance for transaction costs,
represents the profit or loss to the Fund.
Special Risks of Transactions in Futures Contracts
Volatility and Leverage. The prices of futures contracts are volatile
and are influenced, among other things, by actual and anticipated changes in
the market and interest rates, which in turn are affected by fiscal and
monetary policies and national and international political and economic
events.
Most United States futures exchanges limit the amount of fluctuation
permitted in futures contract prices during a single trading day. The daily
limit establishes the maximum amount that the price of a futures contract may
vary either up or down from the previous day's settlement price at the end of
a trading session. Once the daily limit has been reached in a particular type
of futures contract, no trades may be made on that day at a price beyond that
limit. The daily limit governs only price movement during a particular
trading day and therefore does not limit potential losses, because the limit
may prevent the liquidation of unfavorable positions. Futures contract prices
have occasionally moved to the daily limit for several consecutive trading
days with little or no trading, thereby preventing prompt liquidation of
futures positions and subjecting some futures traders to substantial losses.
Because of the low margin deposits required, futures trading involves an
extremely high degree of leverage. As a result, a relatively small price
movement in a futures contract may result in immediate and substantial loss,
as well as gain, to the investor. For example, if at the time of purchase,
10% of the value of the futures contract is deposited as margin, a subsequent
10% decrease in the value of the futures contract would result in a total loss
of the margin deposit, before any deduction for the transaction costs, if the
account were then closed out. A 15% decrease would result in a loss equal to
150% of the original margin deposit, if the contract were closed out. Thus, a
purchase or sale of a futures contract may result in losses in excess of the
amount invested in the futures contract. However, the Fund would presumably
have sustained comparable losses if, instead of the futures contract, it had
invested in the underlying financial instrument and sold it after the decline.
Furthermore, in the case of a futures contract purchase, in order to be
certain that the Fund has sufficient assets to satisfy its obligations under a
futures contract, the Fund earmarks to the futures contract money market
instruments equal in value to the current value of the underlying instrument
less the margin deposit.
Liquidity. The Fund may elect to close some or all of its futures
positions at any time prior to their expiration. The Fund would do so to
reduce exposure represented by long futures positions or short futures
positions. The Fund may close its positions by taking opposite positions
PAGE 31
which would operate to terminate the Fund's position in the futures contracts.
Final determinations of variation margin would then be made, additional cash
would be required to be paid by or released to the Fund, and the Fund would
realize a loss or a gain.
Futures contracts may be closed out only on the exchange or board of
trade where the contracts were initially traded. Although the Fund intends to
purchase or sell futures contracts only on exchanges or boards of trade where
there appears to be an active market, there is no assurance that a liquid
market on an exchange or board of trade will exist for any particular contract
at any particular time. In such event, it might not be possible to close a
futures contract, and in the event of adverse price movements, the Fund would
continue to be required to make daily cash payments of variation margin.
However, in the event futures contracts have been used to hedge the underlying
instruments, the Fund would continue to hold the underlying instruments
subject to the hedge until the futures contracts could be terminated. In such
circumstances, an increase in the price of underlying instruments, if any,
might partially or completely offset losses on the futures contract. However,
as described below, there is no guarantee that the price of the underlying
instruments will, in fact, correlate with the price movements in the futures
contract and thus provide an offset to losses on a futures contract.
Hedging Risk. A decision of whether, when, and how to hedge involves
skill and judgment, and even a well-conceived hedge may be unsuccessful to
some degree because of unexpected market behavior, market or interest rate
trends. There are several risks in connection with the use by the Fund of
futures contracts as a hedging device. One risk arises because of the
imperfect correlation between movements in the prices of the futures contracts
and movements in the prices of the underlying instruments which are the
subject of the hedge. T. Rowe Price will, however, attempt to reduce this
risk by entering into futures contracts whose movements, in its judgment, will
have a significant correlation with movements in the prices of the Fund's
underlying instruments sought to be hedged.
Successful use of futures contracts by the Fund for hedging purposes is
also subject to T. Rowe Price's ability to correctly predict movements in the
direction of the market. It is possible that, when the Fund has sold futures
to hedge its portfolio against a decline in the market, the index, indices, or
instruments underlying futures might advance and the value of the underlying
instruments held in the Fund's portfolio might decline. If this were to
occur, the Fund would lose money on the futures and also would experience a
decline in value in its underlying instruments. However, while this might
occur to a certain degree, T. Rowe Price believes that over time the value of
the Fund's portfolio will tend to move in the same direction as the market
indices used to hedge the portfolio. It is also possible that if the Fund
were to hedge against the possibility of a decline in the market (adversely
affecting the underlying instruments held in its portfolio) and prices instead
increased, the Fund would lose part or all of the benefit of increased value
of those underlying instruments that it has hedged, because it would have
offsetting losses in its futures positions. In addition, in such situations,
if the Fund had insufficient cash, it might have to sell underlying
instruments to meet daily variation margin requirements. Such sales of
underlying instruments might be, but would not necessarily be, at increased
prices (which would reflect the rising market). The Fund might have to sell
underlying instruments at a time when it would be disadvantageous to do so.
In addition to the possibility that there might be an imperfect
correlation, or no correlation at all, between price movements in the futures
contracts and the portion of the portfolio being hedged, the price movements
PAGE 32
of futures contracts might not correlate perfectly with price movements in the
underlying instruments due to certain market distortions. First, all
participants in the futures market are subject to margin deposit and
maintenance requirements. Rather than meeting additional margin deposit
requirements, investors might close futures contracts through offsetting
transactions, which could distort the normal relationship between the
underlying instruments and futures markets. Second, the margin requirements
in the futures market are less onerous than margin requirements in the
securities markets, and as a result the futures market might attract more
speculators than the securities markets do. Increased participation by
speculators in the futures market might also cause temporary price
distortions. Due to the possibility of price distortion in the futures market
and also because of the imperfect correlation between price movements in the
underlying instruments and movements in the prices of futures contracts, even
a correct forecast of general market trends by T. Rowe Price might not result
in a successful hedging transaction over a very short time period.
Options on Futures Contracts
The Fund may purchase and sell options on the same types of futures in
which it may invest.
Options on futures are similar to options on underlying instruments
except that options on futures give the purchaser the right, in return for the
premium paid, to assume a position in a futures contract (a long position if
the option is a call and a short position if the option is a put), rather than
to purchase or sell the futures contract, at a specified exercise price at any
time during the period of the option. Upon exercise of the option, the
delivery of the futures position by the writer of the option to the holder of
the option will be accompanied by the delivery of the accumulated balance in
the writer's futures margin account which represents the amount by which the
market price of the futures contract, at exercise, exceeds (in the case of a
call) or is less than (in the case of a put) the exercise price of the option
on the futures contract. Purchasers of options who fail to exercise their
options prior to the exercise date suffer a loss of the premium paid.
As an alternative to writing or purchasing call and put options on
interest rate futures, the Fund may write or purchase call and put options on
financial indices. Such options would be used in a manner similar to the use
of options on futures contracts. From time to time, a single order to
purchase or sell futures contracts (or options thereon) may be made on behalf
of the Fund and other T. Rowe Price Funds. Such aggregated orders would be
allocated among the Funds and the other T. Rowe Price Funds in a fair and non-
discriminatory manner.
Special Risks of Transactions in Options on Futures Contracts
The risks described under "Special Risks of Transactions on Futures
Contracts" are substantially the same as the risks of using options on
futures. In addition, where the Fund seeks to close out an option position by
writing or buying an offsetting option covering the same index, underlying
instrument or contract and having the same exercise price and expiration date,
its ability to establish and close out positions on such options will be
subject to the maintenance of a liquid secondary market. Reasons for the
absence of a liquid secondary market on an exchange include the following: (i)
there may be insufficient trading interest in certain options; (ii)
restrictions may be imposed by an exchange on opening transactions or closing
transactions or both; (iii) trading halts, suspensions or other restrictions
may be imposed with respect to particular classes or series of options, or
PAGE 33
underlying instruments; (iv) unusual or unforeseen circumstances may interrupt
normal operations on an exchange; (v) the facilities of an exchange or a
clearing corporation may not at all times be adequate to handle current
trading volume; or (vi) one or more exchanges could, for economic or other
reasons, decide or be compelled at some future date to discontinue the trading
of options (or a particular class or series of options), in which event the
secondary market on that exchange (or in the class or series of options) would
cease to exist, although outstanding options on the exchange that had been
issued by a clearing corporation as a result of trades on that exchange would
continue to be exercisable in accordance with their terms. There is no
assurance that higher than anticipated trading activity or other unforeseen
events might not, at times, render certain of the facilities of any of the
clearing corporations inadequate, and thereby result in the institution by an
exchange of special procedures which may interfere with the timely execution
of customers' orders.
Additional Futures and Options Contracts
Although the Fund has no current intention of engaging in futures or
options transactions other than those described above, it reserves the right
to do so. Such futures and options trading might involve risks which differ
from those involved in the futures and options described above.
Foreign Futures and Options
Participation in foreign futures and foreign options transactions
involves the execution and clearing of trades on or subject to the rules of a
foreign board of trade. Neither the National Futures Association nor any
domestic exchange regulates activities of any foreign boards of trade,
including the execution, delivery and clearing of transactions, or has the
power to compel enforcement of the rules of a foreign board of trade or any
applicable foreign law. This is true even if the exchange is formally linked
to a domestic market so that a position taken on the market may be liquidated
by a transaction on another market. Moreover, such laws or regulations will
vary depending on the foreign country in which the foreign futures or foreign
options transaction occurs. For these reasons, when the Fund trades foreign
futures or foreign options contracts, it may not be afforded certain of the
protective measures provided by the Commodity Exchange Act, the CFTC's
regulations and the rules of the National Futures Association and any domestic
exchange, including the right to use reparations proceedings before the
Commission and arbitration proceedings provided by the National Futures
Association or any domestic futures exchange. In particular, funds received
from the Fund for foreign futures or foreign options transactions may not be
provided the same protections as funds received in respect of transactions on
United States futures exchanges. In addition, the price of any foreign
futures or foreign options contract and, therefore, the potential profit and
loss thereon may be affected by any variance in the foreign exchange rate
between the time the Fund's order is placed and the time it is liquidated,
offset or exercised.
Foreign Currency Transactions
A forward foreign currency exchange contract involves an obligation to
purchase or sell a specific currency at a future date, which may be any fixed
number of days from the date of the contract agreed upon by the parties, at a
price set at the time of the contract. These contracts are principally traded
in the interbank market conducted directly between currency traders (usually
large, commercial banks) and their customers. A forward contract generally
has no deposit requirement, and no commissions are charged at any stage for
trades.
PAGE 34
The Fund may enter into forward contracts for a variety of purposes in
connection with the management of the foreign securities portion of its
portfolio. The Fund's use of such contracts would include, but not be limited
to, the following:
First, when the Fund enters into a contract for the purchase or sale of
a security denominated in a foreign currency, it may desire to "lock in" the
U.S. dollar price of the security. By entering into a forward contract for
the purchase or sale, for a fixed amount of dollars, of the amount of foreign
currency involved in the underlying security transactions, the Fund will be
able to protect itself against a possible loss resulting from an adverse
change in the relationship between the U.S. dollar and the subject foreign
currency during the period between the date the security is purchased or sold
and the date on which payment is made or received.
Second, when T. Rowe Price believes that one currency may experience a
substantial movement against another currency, including the U.S. dollar, it
may enter into a forward contract to sell or buy the amount of the former
foreign currency, approximating the value of some or all of the Fund's
portfolio securities denominated in such foreign currency. Alternatively,
where appropriate, the Fund may hedge all or part of its foreign currency
exposure through the use of a basket of currencies or a proxy currency where
such currency or currencies act as an effective proxy for other currencies.
In such a case, the Fund may enter into a forward contract where the amount of
the foreign currency to be sold exceeds the value of the securities
denominated in such currency. The use of this basket hedging technique may be
more efficient and economical than entering into separate forward contracts
for each currency held in the Fund. The precise matching of the forward
contract amounts and the value of the securities involved will not generally
be possible since the future value of such securities in foreign currencies
will change as a consequence of market movements in the value of those
securities between the date the forward contract is entered into and the date
it matures. The projection of short-term currency market movement is
extremely difficult, and the successful execution of a short-term hedging
strategy is highly uncertain. Under normal circumstances, consideration of
the prospect for currency parities will be incorporated into the longer term
investment decisions made with regard to overall diversification strategies.
However, T. Rowe Price believes that it is important to have the flexibility
to enter into such forward contracts when it determines that the best
interests of the Fund will be served.
Third, the Fund may use forward contracts when the Fund wishes to hedge
out of the dollar into a foreign currency in order to create a synthetic bond
or money market instrument--the security would be issued in U.S. dollars but
the dollar component would be transformed into a foreign currency through a
forward contract.
The Fund may enter into forward contacts for any other purpose
consistent with the Fund's investment objective and program. However, the
Fund will not enter into a forward contract, or maintain exposure to any such
contract(s), if the amount of foreign currency required to be delivered
thereunder would exceed the Fund's holdings of liquid, high-grade debt
securities and currency available for cover of the forward contract(s). In
determining the amount to be delivered under a contract, the Fund may net
offsetting positions.
At the maturity of a forward contract, the Fund may sell the portfolio
security and make delivery of the foreign currency, or it may retain the
security and either extend the maturity of the forward contract (by "rolling"
that contract forward) or may initiate a new forward contract.
PAGE 35
If the Fund retains the portfolio security and engages in an offsetting
transaction, the Fund will incur a gain or a loss (as described below) to the
extent that there has been movement in forward contract prices. If the Fund
engages in an offsetting transaction, it may subsequently enter into a new
forward contract to sell the foreign currency. Should forward prices decline
during the period between the Fund's entering into a forward contract for the
sale of a foreign currency and the date it enters into an offsetting contract
for the purchase of the foreign currency, the Fund will realize a gain to the
extent the price of the currency it has agreed to sell exceeds the price of
the currency it has agreed to purchase. Should forward prices increase, the
Fund will suffer a loss to the extent of the price of the currency it has
agreed to purchase exceeds the price of the currency it has agreed to sell.
The Fund's dealing in forward foreign currency exchange contracts will
generally be limited to the transactions described above. However, the Fund
reserves the right to enter into forward foreign currency contracts for
different purposes and under different circumstances. Of course, the Fund is
not required to enter into forward contracts with regard to its foreign
currency-denominated securities and will not do so unless deemed appropriate
by T. Rowe Price. It also should be realized that this method of hedging
against a decline in the value of a currency does not eliminate fluctuations
in the underlying prices of the securities. It simply establishes a rate of
exchange at a future date. Additionally, although such contracts tend to
minimize the risk of loss due to a decline in the value of the hedged
currency, at the same time, they tend to limit any potential gain which might
result from an increase in the value of that currency.
Although the Fund values its assets daily in terms of U.S. dollars, it
does not intend to convert its holdings of foreign currencies into U.S.
dollars on a daily basis. It will do so from time to time, and investors
should be aware of the costs of currency conversion. Although foreign
exchange dealers do not charge a fee for conversion, they do realize a profit
based on the difference (the "spread") between the prices at which they are
buying and selling various currencies. Thus, a dealer may offer to sell a
foreign currency to the Fund at one rate, while offering a lesser rate of
exchange should the Fund desire to resell that currency to the dealer.
Federal Tax Treatment of Options, Futures Contracts and Forward Foreign
Exchange Contracts
The Fund may enter into certain option, futures, and forward foreign
exchange contracts, including options and futures on currencies, which will be
treated as Section 1256 contracts or straddles.
Transactions which are considered Section 1256 contracts will be
considered to have been closed at the end of the Fund's fiscal year and any
gains or losses will be recognized for tax purposes at that time. Such gains
or losses from the normal closing or settlement of such transactions will be
characterized as 60% long-term capital gain or loss and 40% short-term capital
gain or loss regardless of the holding period of the instrument. The Fund
will be required to distribute net gains on such transactions to shareholders
even though it may not have closed the transaction and received cash to pay
such distributions.
Options, futures and forward foreign exchange contracts, including
options and futures on currencies, which offset a foreign dollar denominated
bond or currency position may be considered straddles for tax purposes, in
which case a loss on any position in a straddle will be subject to deferral to
the extent of unrealized gain in an offsetting position. The holding period
PAGE 36
of the securities or currencies comprising the straddle will be deemed not to
begin until the straddle is terminated. For securities offsetting a purchased
put, this adjustment of the holding period may increase the gain from sales of
securities held less than three months. The holding period of the security
offsetting an "in-the-money qualified covered call" option on an equity
security will not include the period of time the option is outstanding.
Losses on written covered calls and purchased puts on securities,
excluding certain "qualified covered call" options on equity securities, may
be long-term capital loss, if the security covering the option was held for
more than twelve months prior to the writing of the option.
In order for the Fund to continue to qualify for federal income tax
treatment as a regulated investment company, at least 90% of its gross income
for a taxable year must be derived from qualifying income; i.e., dividends,
interest, income derived from loans of securities, and gains from the sale of
securities or currencies. Pending tax regulations could limit the extent that
net gain realized from option, futures or foreign forward exchange contracts
on currencies is qualifying income for purposes of the 90% requirement. In
addition, gains realized on the sale or other disposition of securities,
including option, futures or foreign forward exchange contracts on securities
or securities indexes and, in some cases, currencies, held for less than three
months, must be limited to less than 30% of the Fund's annual gross income.
In order to avoid realizing excessive gains on securities or currencies held
less than three months, the Fund may be required to defer the closing out of
option, futures or foreign forward exchange contracts) beyond the time when it
would otherwise be advantageous to do so. It is anticipated that unrealized
gains on Section 1256 option, futures and foreign forward exchange contracts,
which have been open for less than three months as of the end of the Fund's
fiscal year and which are recognized for tax purposes, will not be considered
gains on securities or currencies held less than three months for purposes of
the 30% test.
INVESTMENT RESTRICTIONS
Fundamental policies may not be changed without the approval of the
lesser of (1) 67% of a Fund's shares present at a meeting of shareholders if
the holders of more than 50% of the outstanding shares are present in person
or by proxy or (2) more than 50% of a Fund's outstanding shares. Other
restrictions in the form of operating policies are subject to change by the
Fund's Board of Directors without shareholder approval. Any investment
restriction which involves a maximum percentage of securities or assets shall
not be considered to be violated unless an excess over the percentage occurs
immediately after, and is caused by, an acquisition of securities or assets
of, or borrowings by, a Fund.
Fundamental Policies
As a matter of fundamental policy, the Fund may not:
(1) Borrowing. Borrow money except that the Fund may (i) borrow
for non-leveraging, temporary or emergency purposes and (ii)
engage in reverse repurchase agreements and make other
investments or engage in other transactions, which may
involve a borrowing, in a manner consistent with the Fund's
investment objective and program, provided that the
combination of (i) and (ii) shall not exceed 33 1/3% of the
value of the Fund's total assets (including the amount
borrowed) less liabilities (other than borrowings) or such
PAGE 37
other percentage permitted by law. Any borrowings which
come to exceed this amount will be reduced in accordance
with applicable law. The Fund may borrow from banks, other
Price Funds or other persons to the extent permitted by
applicable law;
(2) Commodities. Purchase or sell physical commodities; except
that it may enter into futures contracts and options
thereon;
(3) Industry Concentration. Purchase the securities of any
issuer if, as a result, more than 25% of the value of the
Fund's total assets would be invested in the securities of
issuers having their principal business activities in the
same industry;
(4) Loans. Make loans, although the Fund may (i) lend portfolio
securities and participate in an interfund lending program
with other Price Funds provided that no such loan may be
made if, as a result, the aggregate of such loans would
exceed 33 1/3% of the value of the Fund's total assets;
(ii) purchase money market securities and enter into
repurchase agreements; and (iii) acquire
publicly-distributed or privately-placed debt securities and
purchase debt;
(5) Percent Limit on Assets Invested in Any One Issuer.
Purchase a security if, as a result, with respect to 75% of
the value of its total assets, more than 5% of the value of
the Fund's total assets would be invested in the securities
of a single issuer, except securities issued or guaranteed
by the U.S. Government or any of its agencies or
instrumentalities;
(6) Percent Limit on Share Ownership of Any One Issuer.
Purchase a security if, as a result, with respect to 75% of
the value of the Fund's total assets, more than 10% of the
outstanding voting securities of any issuer would be held by
the Fund (other than obligations issued or guaranteed by the
U.S. Government, its agencies or instrumentalities);
(7) Real Estate. Purchase or sell real estate unless acquired
as a result of ownership of securities or other instruments
(but this shall not prevent the Fund from investing in
securities or other instruments backed by real estate or in
securities of companies engaged in the real estate
business);
(8) Senior Securities. Issue senior securities except in
compliance with the Investment Company Act of 1940; or
(9) Underwriting. Underwrite securities issued by other
persons, except to the extent that the Fund may be deemed to
be an underwriter within the meaning of the Securities Act
of 1933 in connection with the purchase and sale of its
portfolio securities in the ordinary course of pursuing its
investment program.
PAGE 38
NOTES
The following notes should be read in connection with the above-
described fundamental policies. The notes are not fundamental
policies.
With respect to investment restrictions (1) and (4), the Fund
will not borrow from or lend to any other Price Fund unless each
Fund applies for and receives an exemptive order from the SEC or
the SEC issues rules permitting such transactions. The Fund has no
current intention of engaging in any such activity and there is no
assurance the SEC would grant any order requested by the Fund or
promulgate any rules allowing the transactions.
With respect to investment restriction (2), the Fund does not
consider currency contracts or hybrid investments to be
commodities.
For purposes of investment restriction (3), U.S., state or local
governments, or related agencies or instrumentalities, are not
considered an industry. Industries are determined by reference to
the classifications of industries set forth in the Fund's Annual
Reports.
For purposes of investment restriction (4), the Fund will consider
the acquisition of a debt security to include the execution of a
note or other evidence of an extension of credit with a term of
more than nine months.
For purposes of investment restriction (5), the Fund will consider
repurchase agreements fully collateralized with U.S. government
securities to be U.S. government securities.
Operating Policies
As a matter of operating policy, the Fund may not:
(1) Borrowing. The Fund will not purchase additional securities
when money borrowed exceeds 5% of its total assets;
(2) Control of Portfolio Companies. Invest in companies for the
purpose of exercising management or control;
(3) Equity Securities. Purchase any common stocks or other
equity securities;
(4) Futures Contracts. Purchase a futures contract or an option
thereon if, with respect to positions in futures or options
on futures which do not represent bona fide hedging, the
aggregate initial margin and premiums on such options would
exceed 5% of the Fund's net asset value;
(5) Illiquid Securities. Purchase illiquid securities and
securities of unseasoned issuers if, as a result, more than
15% of its net assets would be invested in such
securities;
PAGE 39
(6) Investment Companies. Purchase securities of open-end or
closed-end investment companies except in compliance with
the Investment Company Act of 1940 and applicable state
law;
(7) Margin. Purchase securities on margin, except (i) for use
of short-term credit necessary for clearance of purchases of
portfolio securities and (ii) it may make margin deposits in
connection with futures contracts or other permissible
investments;
(8) Mortgaging. Mortgage, pledge, hypothecate or, in any
manner, transfer any security owned by the Fund as security
for indebtedness except as may be necessary in connection
with permissible borrowings or investments and then such
mortgaging, pledging or hypothecating may not exceed 33 1/3%
of the Fund's total assets at the time of borrowing or
investment;
(9) Oil and Gas Programs. Purchase participations or other
direct interests in or enter into leases with respect to,
oil, gas, or other mineral exploration or development
programs;
(10) Options, Etc. Invest in puts, calls, straddles, spreads, or
any combination thereof, except to the extent permitted by
the prospectus and Statement of Additional Information;
(11) Ownership of Portfolio Securities by Officers and
Directors/Trustees. Purchase or retain the securities of
any issuer if, to the knowledge of the Fund's management,
those officers and directors of the Fund, and of its
investment manager, who each owns beneficially more than .5%
of the outstanding securities of such issuer, together own
beneficially more than 5% of such securities;
(12) Short Sales. Effect short sales of securities;
(13) Unseasoned Issuers. Purchase a security (other than
obligations issued or guaranteed by the U.S., any foreign,
state or local government, their agencies or
instrumentalities) if, as a result, more than 5% of the
value of the Fund's total assets would be invested in the
securities of issuers which at the time of purchase had been
in operation for less than three years (for this purpose,
the period of operation of any issuer shall include the
period of operation of any predecessor or unconditional
guarantor of such issuer). This restriction does not apply
to securities of pooled investment vehicles or mortgage or
asset-backed securities; or
(14) Warrants. Invest in warrants if, as a result thereof, more
than 2% of the value of the total assets of the Fund would
be invested in warrants which are not listed on the New York
Stock Exchange, the American Stock Exchange, or a recognized
foreign exchange, or more than 5% of the value of the total
assets of the Fund would be invested in warrants whether or
not so listed. For purposes of these percentage
limitations, the warrants will be valued at the lower of
PAGE 40
cost or market and warrants acquired by the Fund in units or
attached to securities may be deemed to be without value.
Notwithstanding anything in the above fundamental and operating
restrictions to the contrary, each Fund may invest all of its assets in a
single investment company or a series thereof in connection with a "master-
feeder" arrangement. Such an investment would be made where the Fund (a
"Feeder"), and one or more other Funds with the same investment objective and
program as the Fund, sought to accomplish its investment objective and program
by investing all of its assets in the shares of another investment company
(the "Master"). The Master would, in turn, have the same investment objective
and program as the Fund. The Fund would invest in this manner in an effort to
achieve the economies of scale associated with having a Master fund make
investments in portfolio companies on behalf of a number of Feeder funds.
MANAGEMENT OF FUND
The officers and directors of the Fund are listed below. Unless
otherwise noted, the address of each is 100 East Pratt Street, Baltimore,
Maryland 21202. Except as indicated, each has been an employee of T. Rowe
Price for more than five years. In the list below, the Fund's directors who
are considered "interested persons" of T. Rowe Price as defined under
Section 2(a)(19) of the Investment Company Act of 1940 are noted with an
asterisk (*). These directors are referred to as inside directors by virtue
of its officership, directorship, and/or employment with T. Rowe Price.
ROBERT P. BLACK, Director--Retired; formerly President, Federal Reserve Bank
of Richmond; Address: 10 Dahlgren Road, Richmond, Virginia 23233
CALVIN W. BURNETT, PH.D., Director--President, Coppin State College; Director,
Maryland Chamber of Commerce and Provident Bank of Maryland; President,
Baltimore Area Council Boy Scouts of America; Vice President, Board of
Directors, The Walters Art Gallery; Address: 2000 North Warwick Avenue,
Baltimore, Maryland 21216
*GEORGE J. COLLINS, President and Director--President, Managing Director, and
Chief Executive Officer, T. Rowe Price; Director, Rowe Price-Fleming
International, Inc., T. Rowe Price Trust Company and T. Rowe Price Retirement
Plan Services, Inc., Chartered Investment Counselor
ANTHONY W. DEERING, Director--Director, President and Chief Operating Officer,
The Rouse Company, real estate developers, Columbia, Maryland; Advisory
Director, Kleinwort, Benson (North America) Corporation, a registered broker-
dealer; Address: 10275 Little Patuxent Parkway, Columbia, Maryland 21044
F. PIERCE LINAWEAVER, Director--President, F. Pierce Linaweaver & Associates,
Inc.; formerly (1987-1991) Executive Vice President, EA Engineering, Science,
and Technology, Inc., and (1987-1990) President, EA Engineering, Inc.,
Baltimore, Maryland; Address: The Legg Mason Tower, 111 South Calvert Street,
Suite 2700, Baltimore, Maryland 21202
*JAMES S. RIEPE, Vice President and Director--Managing Director, T. Rowe
Price; Chairman of the Board, T. Rowe Price Services, Inc., T. Rowe Price
Retirement Plan Services, Inc., and T. Rowe Price Trust Company; President and
Director, T. Rowe Price Investment Services, Inc; Director, Rhone-Poulenc
Rorer, Inc.
JOHN G. SCHREIBER, Director--President, Schreiber Investments, a real estate
investment company; Director and formerly (1/80-12/90) Executive Vice
President, JMB Realty Corporation, a national real estate investment manager
and developer; Address: 1115 East Illinois Road, Lake Forest, Illinois 60045
ANNE MARIE WHITTEMORE, Director--Partner, law firm of McGuire, Woods, Battle &
Boothe, Richmond, Virginia; formerly, Chairman (1991-1993) and Director (1989-
1993), Federal Reserve Bank of Richmond; Director, Owens & Minor, Inc., USF&G
Corporation, Old Dominion University, and James River Corporation; Member,
PAGE 41
Richmond Bar Association and American Bar Association; Address: One James
Center, 901 East Cary Street, Richmond, Virginia 23219-4030
VEENA A. KUTLER, Executive Vice President--Vice President, T. Rowe Price and
Rowe Price-Fleming International, Inc.
ROBERT P. CAMPBELL, Vice President--Vice President, T. Rowe Price and Rowe
Price-Fleming International, Inc.; formerly (4/80-5/90) Vice President and
Director, Private Finance, New York Life Insurance Company, New York, New York
MICHAEL J. CONELIUS, Vice President--Assistant Vice President, T. Rowe Price
CHRISTY M. DIPIETRO, Vice President--Vice President, T. Rowe Price and T. Rowe
Price Trust Company
HENRY H. HOPKINS, Vice President--Managing Director, T. Rowe Price; Vice
President and Director, T. Rowe Price Investment Services, Inc., T. Rowe Price
Services, Inc., and T. Rowe Price Trust Company; Vice President, Rowe Price-
Fleming International, Inc. and T. Rowe Price Retirement Plan Services, Inc.
JAMES M. MCDONALD, Vice President--Vice President, T. Rowe Price
ROBERT M. RUBINO, Vice President--Vice President, T. Rowe Price
EDWARD A. WIESE, Vice President--Vice President, T. Rowe Price, Rowe Price-
Fleming International, Inc. and T. Rowe Price Trust Company
LENORA V. HORNUNG, Secretary--Vice President, T. Rowe Price
CARMEN F. DEYESU, Treasurer--Vice President, T. Rowe Price, T. Rowe Price
Services, Inc., and T. Rowe Price Trust Company
DAVID S. MIDDLETON, Controller--Vice President, T. Rowe Price, T. Rowe Price
Services, Inc., and T. Rowe Price Trust Company
ROGER L. FIERY, III, Assistant Vice President--Vice President, T. Rowe Price
and Rowe Price-Fleming International, Inc.
EDWARD T. SCHNEIDER, Assistant Vice President--Assistant Vice President, T.
Rowe Price and Vice President, T. Rowe Price Services, Inc.
INGRID I. VORDEMBERGE, Assistant Vice President--Employee, T. Rowe Price
The Fund's Executive Committee, comprised of Messrs. Collins and Riepe,
has been authorized by its Board of Directors to exercise all powers of the
Board to manage the Fund in the intervals between meetings of the Board,
except the powers prohibited by statute from being delegated.
PRINCIPAL HOLDERS OF SECURITIES
As of the date of the prospectus, the officers and directors of the
Fund, as a group, owned less than 1% of the outstanding shares of the Fund.
INVESTMENT MANAGEMENT SERVICES
Services Provided by T. Rowe Price
Under the Management Agreement with the Corporation relating to the
Fund, T. Rowe Price provides the Fund with discretionary investment services.
Specifically, T. Rowe Price is responsible for supervising and directing the
investments of the Fund in accordance with its investment objectives,
programs, and restrictions as provided in the prospectus and this Statement of
Additional Information. T. Rowe Price is also responsible for effecting all
security transactions on behalf of the Fund, including the allocation of
principal business and portfolio brokerage and the negotiation of commissions.
In addition to these services, T. Rowe Price provides the Fund with certain
corporate administrative services, including: maintaining the Fund's corporate
existence, corporate records, and registering and qualifying the Fund's shares
under federal and state laws; monitoring the financial, accounting, and
administrative functions of the Fund; maintaining liaison with the agents
employed by the Fund such as the Fund's custodian and transfer agent;
assisting the Fund in the coordination of such agents' activities; and
PAGE 42
permitting T. Rowe Price's employees to serve as officers, directors, and
committee members of the Fund without cost to the Fund.
The Fund's Management Agreement also provides that T. Rowe Price, its
directors, officers, employees, and certain other persons performing specific
functions for the Fund will only be liable to the Fund for losses resulting
from willful misfeasance, bad faith, gross negligence, or reckless disregard
of duty.
Management Fee
The Fund pays T. Rowe Price an annual all-inclusive fee (the "Fee") of
0.70%. The Fee is paid monthly to the T. Rowe Price on the first business day
of the next succeeding calendar month and is the sum of the daily Fee accruals
for each month. The daily Fee accrual for any particular day is calculated by
multiplying the fraction of one (1) over the number of calendar days in the
year by the appropriate Fee rate and multiplying this product by the net
assets of the Fund for that day as determined in accordance with the Fund's
prospectus as of the close of business from the previous business day on which
the Fund was open for business.
The Management Agreement between the Fund and T. Rowe Price provides
that T. Rowe Price will pay all expenses of the Fund's operations, except
interest, taxes, brokerage commissions and other charges incident to the
purchase, sale or lending of the Fund's portfolio securities, directors' fees
and expenses (including counsel fees and expenses) and such nonrecurring or
extraordinary expenses that may arise, including the costs of actions, suits,
or proceedings to which the Fund is a party and the expenses the Fund may
incur as a result of its obligation to provide indemnification to its
officers, directors and agents. However, the Board of Directors of the Fund
reserves the right to impose additional fees against shareholder accounts to
defray expenses which would otherwise be paid by T. Rowe Price under the
Management Agreement. The Board does not anticipate levying such charges;
such a fee, if charged, may be retained by the Fund or paid to T. Rowe Price.
DISTRIBUTOR FOR FUND
T. Rowe Price Investment Services, Inc. ("Investment Services"), a
Maryland corporation formed in 1980 as a wholly-owned subsidiary of T. Rowe
Price, serves as the distributor of the Fund. Investment Services is
registered as a broker-dealer under the Securities Exchange Act of 1934 and is
a member of the National Association of Securities Dealers, Inc. The offering
of the Fund's shares is continuous.
Investment Services is located at the same address as the Fund and T.
Rowe Price -- 100 East Pratt Street, Baltimore, Maryland 21202.
Investment Services serves as distributor to the Fund pursuant to
individual Underwriting Agreements ("Underwriting Agreements"), which provide
that Investment Services will pay all fees and expenses in connection with:
registering and qualifying the Fund's shares under the various state "blue
sky" laws; preparing, setting in type, printing, and mailing its prospectuses
and reports to shareholders; issuing its shares, including expenses of
confirming purchase orders; printing and distributing prospectuses and reports
for use in offering and selling shares for the Fund; preparing, setting in
type, printing, and mailing all sales literature and advertising; Investment
Services' federal and state registrations as a broker-dealer; and offering and
selling shares for the Fund. The Underwriting Agreements provide that the
PAGE 43
Fund is responsible for interest, taxes and such nonrecurring or extraordinary
expenses that may arise, including the costs of actions, suits or proceedings
to which the Fund is a party and the expenses the Fund may incur as a result
of its obligation to provide indemnification to Investment Services.
Investment Services' expenses are paid by T. Rowe Price.
Investment Services acts as the agent of the Fund in connection with the
sale of its shares in all states in which the shares are qualified and in
which Investment Services is qualified as a broker-dealer. Under the
Underwriting Agreement, Investment Services accepts orders for Fund shares at
net asset value. No sales charges are paid by investors or the Fund.
CUSTODIAN
State Street Bank and Trust Company is the custodian for the Fund's
domestic securities and cash, but it does not participate in the Fund's
investment decisions. Portfolio securities purchased in the U.S. are
maintained in the custody of the Bank and may be entered into the Federal
Reserve Book Entry System, or the security depository system of the Depository
Trust Corporation. The Fund has entered into a Custodian Agreement with The
Chase Manhattan Bank, N.A., London, pursuant to which portfolio securities
which are purchased outside the United States are maintained in the custody of
various foreign branches of The Chase Manhattan Bank and such other
custodians, including foreign banks and foreign securities depositories as are
approved by the Fund's Board of Directors in accordance with regulations under
the Investment Company Act of 1940. The Bank's main office is at 225 Franklin
Street, Boston, Massachusetts 02110. The address for The Chase Manhattan
Bank, N.A., London is Woolgate House, Coleman Street, London, EC2P 2HD,
England.
PORTFOLIO TRANSACTIONS
Investment or Brokerage Discretion
Decisions with respect to the purchase and sale of portfolio securities
on behalf of the Fund is made by T. Rowe Price. T. Rowe Price is also
responsible for implementing these decisions, including the negotiation of
commissions and the allocation of portfolio brokerage and principal business.
The Fund's purchases and sales of portfolio securities are normally done on a
principal basis and do not involve the payment of a commission although they
may involve the designation of selling concessions. That part of the
discussion below relating solely to brokerage commissions would not normally
apply to a Fund. However, it is included because T. Rowe Price does manage a
significant number of common stock portfolios which do engage in agency
transactions and pay commissions and because some research and services
resulting from the payment of such commissions may benefit the Fund.
How Brokers and Dealers are Selected
Fixed Income Securities
Fixed income securities are generally purchased from the issuer or a
primary market-maker acting as principal for the securities on a net basis,
with no brokerage commission being paid by the client, although the price
usually includes an undisclosed compensation. Transactions placed through
dealers serving as primary market-makers reflect the spread between the bid
and asked prices. Securities may also be purchased from underwriters at
prices which include underwriting fees.
PAGE 44
T. Rowe Price may effect principal transactions on behalf of a Fund with
a broker or dealer who furnishes brokerage and/or research services, designate
any such broker or dealer to receive selling concessions, discounts or other
allowances, or otherwise deal with any such broker or dealer in connection
with the acquisition of securities in underwritings. The Fund may receive
brokerage and research services in connection with such designations in fixed
priced underwritings. T. Rowe Price may receive research services in
connection with brokerage transactions, including designations in fixed price
offerings.
In purchasing and selling a Fund's portfolio securities, it is T. Rowe
Price's policy to obtain quality execution at the most favorable prices
through responsible brokers and dealers and, in the case of agency
transactions (in which a Fund does not generally engage), at competitive
commission rates. However, under certain conditions, a Fund may pay higher
brokerage commissions in return for brokerage and research services. In
selecting broker-dealers to execute a Fund's portfolio transactions,
consideration is given to such factors as the price of the security, the rate
of the commission, the size and difficulty of the order, the reliability,
integrity, financial condition, general execution and operational capabilities
of competing brokers and dealers, and brokerage and research services provided
by them. It is not the policy of T. Rowe Price to seek the lowest available
commission rate where it is believed that a broker or dealer charging a higher
commission rate would offer greater reliability or provide better price or
execution.
How Evaluations are Made of the Overall Reasonableness of Brokerage
Commissions Paid
On a continuing basis, T. Rowe Price seeks to determine what levels of
commission rates are reasonable in the marketplace for transactions executed
on behalf of the Fund. In evaluating the reasonableness of commission rates,
T. Rowe Price considers: (a) historical commission rates, both before and
since rates have been fully negotiable; (b) rates which other institutional
investors are paying, based on available public information; (c) rates quoted
by brokers and dealers; (d) the size of a particular transaction, in terms of
the number of shares, dollar amount, and number of clients involved; (e) the
complexity of a particular transaction in terms of both execution and
settlement; (f) the level and type of business done with a particular firm
over a period of time; and (g) the extent to which the broker or dealer has
capital at risk in the transaction.
Description of Research Services Received from Brokers and Dealers
T. Rowe Price receives a wide range of research services from brokers
and dealers. These services include information on the economy, industries,
groups of securities, individual companies, statistical information,
accounting and tax law interpretations, political developments, legal
developments affecting portfolio securities, technical market action, pricing
and appraisal services, credit analysis, risk measurement analysis,
performance analysis and analysis of corporate responsibility issues. These
services provide both domestic and international perspective. Research
services are received primarily in the form of written reports, computer
generated services, telephone contacts and personal meetings with security
analysts. In addition, such services may be provided in the form of meetings
arranged with corporate and industry spokespersons, economists, academicians
and government representatives. In some cases, research services are
generated by third parties but are provided to T. Rowe Price by or through
broker-dealers.
PAGE 45
Research services received from brokers and dealers are supplemental to
T. Rowe Price's own research effort and, when utilized, are subject to
internal analysis before being incorporated by T. Rowe Price into its
investment process. As a practical matter, it would not be possible for T.
Rowe Price to generate all of the information presently provided by brokers
and dealers. T. Rowe Price pays cash for certain research services received
from external sources. T. Rowe Price also allocates brokerage for research
services which are available for cash. While receipt of research services
from brokerage firms has not reduced T. Rowe Price's normal research
activities, the expenses of T. Rowe Price could be materially increased if it
attempted to generate such additional information through its own staff. To
the extent that research services of value are provided by brokers or dealers,
T. Rowe Price may be relieved of expenses which it might otherwise bear.
T. Rowe Price has a policy of not allocating brokerage business in
return for products or services other than brokerage or research services. In
accordance with the provisions of Section 28(e) of the Securities Exchange Act
of 1934, T. Rowe Price may from time to time receive services and products
which serve both research and non-research functions. In such event, T. Rowe
Price makes a good faith determination of the anticipated research and non-
research use of the product or service and allocates brokerage only with
respect to the research component.
Commissions to Brokers who Furnish Research Services
Certain brokers and dealers who provide quality brokerage and execution
services also furnish research services to T. Rowe Price. With regard to the
payment of brokerage commissions, T. Rowe Price has adopted a brokerage
allocation policy embodying the concepts of Section 28(e) of the Securities
Exchange Act of 1934, which permits an investment adviser to cause an account
to pay commission rates in excess of those another broker or dealer would have
charged for effecting the same transaction, if the adviser determines in good
faith that the commission paid is reasonable in relation to the value of the
brokerage and research services provided. The determination may be viewed in
terms of either the particular transaction involved or the overall
responsibilities of the adviser with respect to the accounts over which it
exercises investment discretion. Accordingly, while T. Rowe Price cannot
readily determine the extent to which commission rates charged by broker-
dealers reflect the value of its research services, T. Rowe Price would expect
to assess the reasonableness of commissions in light of the total brokerage
and research services provided by each particular broker. T. Rowe Price may
receive research, as defined in Section 28(e), in connection with selling
concessions and designations in fixed price offerings in which the Fund
participates.
Internal Allocation Procedures
T. Rowe Price has a policy of not precommitting a specific amount of
business to any broker or dealer over any specific time period. Historically,
the majority of brokerage placement has been determined by the needs of a
specific transaction such as market-making, availability of a buyer or seller
of a particular security, or specialized execution skills. However, T. Rowe
Price does have an internal brokerage allocation procedure for that portion of
its discretionary client brokerage or selling concessions business where
special needs do not exist, or where the business may be allocated among
several brokers or dealers which are able to meet the needs of the
transaction.
Each year, T. Rowe Price assesses the contribution of the brokerage and
research services provided by brokers and dealers, and attempts to allocate a
PAGE 46
portion of its brokerage and selling concession business in response to these
assessments. Research analysts, counselors, various investment committees,
and the Trading Department each seek to evaluate the brokerage and research
services they receive from brokers and dealers and make judgments as to the
level of business which would recognize such services. In addition, brokers
and dealers sometimes suggest a level of business they would like to receive
in return for the various brokerage and research services they provide.
Actual business received by any firm may be less than the suggested
allocations but can, and often does, exceed the suggestions, because the total
business is allocated on the basis of all the considerations described above.
In no case is a broker or dealer excluded from receiving business from T. Rowe
Price because it has not been identified as providing research services.
Miscellaneous
T. Rowe Price's brokerage allocation policy is consistently applied to
all its fully discretionary accounts, which represent a substantial majority
of all assets under management. Research services furnished by brokers or
dealers through which T. Rowe Price effects securities transactions may be
used in servicing all accounts (including non-Fund accounts) managed by T.
Rowe Price. Conversely, research services received from brokers or dealers
which execute transactions for the Fund is not necessarily used by T. Rowe
Price exclusively in connection with the management of the Fund.
From time to time, orders for clients may be placed through a
computerized transaction network.
The Fund does not allocate business to any broker-dealer on the basis of
its sales of the Fund's shares. However, this does not mean that broker-
dealers who purchase Fund shares for its clients will not receive business
from the Fund.
Some of T. Rowe Price's other clients have investment objectives and
programs similar to those of the Fund. T. Rowe Price may occasionally make
recommendations to other clients which result in its purchasing or selling
securities simultaneously with the Fund. As a result, the demand for
securities being purchased or the supply of securities being sold may
increase, and this could have an adverse effect on the price of those
securities. It is T. Rowe Price's policy not to favor one client over another
in making recommendations or in placing orders. T. Rowe Price frequently
follows the practice of grouping orders of various clients for execution which
generally results in lower commission rates being attained. In certain cases,
where the aggregate order is executed in a series of transactions at various
prices on a given day, each participating client's proportionate share of such
order reflects the average price paid or received with respect to the total
order. T. Rowe Price has established a general investment policy that it will
ordinarily not make additional purchases of a common stock of a company for
its clients (including the T. Rowe Price Funds) if, as a result of such
purchases, 10% or more of the outstanding common stock of such company would
be held by its clients in the aggregate.
To the extent possible, T. Rowe Price intends to recapture solicitation
fees paid in connection with tender offers through T. Rowe Price Investment
Services, Inc., the Fund's distributor. At the present time, T. Rowe Price
does not recapture commissions or underwriting discounts or selling group
concessions in connection with taxable securities acquired in underwritten
offerings. T. Rowe Price does, however, attempt to negotiate elimination of
all or a portion of the selling-group concession or underwriting discount when
purchasing tax-exempt municipal securities on behalf of its clients in
underwritten offerings.
PAGE 47
Transactions with Related Brokers and Dealers
As provided in the Investment Management Agreement between the Fund and
T. Rowe Price, T. Rowe Price is responsible not only for making decisions with
respect to the purchase and sale of the Fund's portfolio securities, but also
for implementing these decisions, including the negotiation of commissions and
the allocation of portfolio brokerage and principal business. It is expected
that T. Rowe Price may place orders for the Fund's portfolio transactions with
broker-dealers through the same trading desk T. Rowe Price uses for portfolio
transactions in domestic securities. The trading desk accesses brokers and
dealers in various markets in which the Fund's foreign securities are located.
These brokers and dealers may include of certain affiliates of Robert Fleming
Holdings Limited ("Robert Fleming Holdings") and Jardine Fleming Group Limited
("JFG"), persons indirectly related to T. Rowe Price. Robert Fleming
Holdings, through Copthall Overseas Limited, a wholly-owned subsidiary, owns
25% of the common stock of Rowe Price-Fleming International, Inc. ("RPFI"), an
investment adviser registered under the Investment Advisers Act of 1940.
Fifty percent of the common stock of RPFI is owned by TRP Finance, Inc., a
wholly-owned subsidiary of T. Rowe Price, and the remaining 25% is owned by
Jardine Fleming International Holdings Limited, a subsidiary of JFG. JFG is
50% owned by Robert Fleming Holdings and 50% owned by Jardine Matheson
Holdings Limited. Orders for the Fund's portfolio transactions placed with
affiliates of Robert Fleming Holdings and JFG will result in commissions being
received by such affiliates.
The Board of Directors of the Fund has authorized T. Rowe Price to
utilize certain affiliates of Robert Fleming and JFG in the capacity of broker
in connection with the execution of the Fund's portfolio transactions. These
affiliates include, but are not limited to, Jardine Fleming (Securities)
Limited ("JFS"), a wholly-owned subsidiary of JFG, Robert Fleming & Co.
Limited ("RF&Co."), Jardine Fleming Australia Securities Limited, and Robert
Fleming, Inc. (a New York brokerage firm). Other affiliates of Robert Fleming
Holdings and JFG also may be used. Although it does not believe that the
Fund's use of these brokers would be subject to Section 17(e) of the
Investment Company Act of 1940, the Board of Directors of the Fund has agreed
that the procedures set forth in Rule 17(e)(1) under that Act will be followed
when using such brokers.
PRICING OF SECURITIES
Fixed income securities are generally traded in the over-the-counter
market. Investments in domestic securities with remaining maturities of one
year or more and foreign securities are stated at fair value using bid-side
valuation as furnished by dealers who make markets in such securities or by an
independent pricing service, which considers yield or price of bonds of
comparable quality, coupon, maturity, and type, as well as prices quoted by
dealers who make markets in such securities. Domestic securities with
remaining maturities less than one year are stated at fair value which is
determined by using a matrix system that establishes a value for each security
based on bid-side money market yields.
There are a number of pricing services available, and the Board of
Directors, on the basis of an ongoing evaluation of these services, may use or
may discontinue the use of any pricing service in whole or in part.
PAGE 48
For the purposes of determining a Fund's net asset value per share, all
assets and liabilities initially expressed in foreign currencies are converted
into U.S. dollars at the mean of the bid and offer prices of such currencies
against U.S. dollars quoted by any major bank.
Assets and liabilities for which the above valuation procedures are
inappropriate or are deemed not to reflect fair value are stated at fair
value, as determined in good faith by or under the supervision of officers of
the Fund as authorized by its Board of Directors.
NET ASSET VALUE PER SHARE
The purchase and redemption price of the Fund's shares is equal to the
Fund's net asset value per share or share price. The Fund determines its net
asset value per share by subtracting the Fund's liabilities (including accrued
expenses and dividends payable) from its total assets (the market value of the
securities the Fund holds plus cash and other assets, including income accrued
but not yet received) and dividing the result by the total number of shares
outstanding. The net asset value per share of the Fund is calculated as of
the close of trading on the New York Stock Exchange ("NYSE") every day the
NYSE is open for trading. The net asset value of the Money Fund is also
calculated as of 12:00 noon (Eastern time) every day the NYSE is open for
trading. The NYSE is closed on the following days: New Year's Day,
Washington's Birthday, Good Friday, Memorial Day, Independence Day, Labor Day,
Thanksgiving Day, and Christmas Day.
Determination of net asset value (and the offering, sale, redemption and
repurchase of shares) for a Fund may be suspended at times (a) during which
the NYSE is closed, other than customary weekend and holiday closings, (b)
during which trading on the NYSE is restricted, (c) during which an emergency
exists as a result of which disposal by a Fund of securities owned by it is
not reasonably practicable or it is not reasonably practicable for the Fund
fairly to determine the value of its net assets, or (d) during which a
governmental body having jurisdiction over the Fund may by order permit such a
suspension for the protection of the Fund's shareholders; provided that
applicable rules and regulations of the Securities and Exchange Commission (or
any succeeding governmental authority) shall govern as to whether the
conditions prescribed in (b), (c), or (d) exist.
DIVIDENDS
Unless the separate account elects otherwise, the Fund's annual capital
gain distributions, if any, will be reinvested on the reinvestment date using
the NAV per share of that date. The reinvestment date normally precedes the
payment date by about 10 days although the exact timing is subject to change.
TAX STATUS
The Fund intends to qualify as a "regulated investment company" under
Subchapter M of the Internal Revenue Code of 1986, as amended ("Code") and
also intends to diversify its assets in accordance with regulations under Code
Section 817(h).
In 1987, the Treasury Department indicated that it may issue regulations
addressing the circumstances in which a policyholder's control of the
investments of the insurance company separate account would result in the
policyholder being treated as the owner of such assets. Although there is no
PAGE 49
present indication that such regulations will be issued, their adoption could
alter the tax treatment of the policyholder, separate account or insurance
company.
For tax purposes, the Fund must declare dividends equal to at least 98%
of ordinary income (as of December 31) and capital gains (as of October 31) in
order to avoid a federal excise tax and distribute 100% of ordinary income and
capital gains as of December 31 to avoid a federal income tax. In certain
circumstances, the Fund may not be required to comply with the excise tax
distribution requirements. It does not make any difference whether dividends
and capital gain distributions are paid in cash or in additional shares.
At the time a shareholder acquires Fund shares, the Fund's net asset
value may reflect undistributed income, capital gains or net unrealized
appreciation of securities held by the Fund which may be subsequently
distributed as either dividends or capital gain distributions.
If, in any taxable year, the Fund should not qualify as a regulated
investment company under the Code: (i) the Fund would be taxed at normal
corporate rates on the entire amount of its taxable income, if any, without
deduction for dividends or other distributions to shareholders; and (ii) the
Fund's distributions to the extent made out of the Fund's current or
accumulated earnings and profits would be treated as ordinary dividends by
shareholders (regardless of whether they would otherwise have been considered
capital gain dividends), and (iii) the separate accounts investing in the Fund
may fail to satisfy the requirements of Code Section 817(h) which in turn
could adversely affect the tax status of life insurance and annuity contracts
with premiums invested in the affected separate accounts.
To the extent the Fund invests in foreign securities, the following
would apply:
Passive Foreign Investment Companies
The Fund may purchase the securities of certain foreign investment funds
or trusts called passive foreign investment companies. In addition to bearing
their proportionate share of the fund's expenses (management fees and
operating expenses) shareholders will also indirectly bear similar expenses of
such funds. Capital gains on the sale of such holdings will be deemed to be
ordinary income regardless of how long the Fund holds its investment. In
addition, the Fund may be subject to corporate income tax and an interest
charge on certain dividends and capital gains earned from these investments,
regardless of whether such income and gains are distributed to
shareholders.
In accordance with tax regulations, the Fund intends to treat these
securities as sold on the last day of the Fund's fiscal year and recognize any
gains for tax purposes at that time; losses will not be recognized. Such
gains will be considered ordinary income which the Fund will be required to
distribute even though it has not sold the security and received cash to pay
such distributions.
Foreign Currency Gains and Losses
Foreign currency gains and losses, including the portion of gain or loss
on the sale of debt securities attributable to foreign exchange rate
fluctuations, are ordinary income for tax purposes. If the net effect of
these transactions is a gain, the dividend paid by the Fund will be increased;
if the result is a loss, the income dividend paid by the Fund will be
PAGE 50
decreased. Adjustments, to reflect these gains and losses will be made at the
end of the Fund's taxable year.
YIELD INFORMATION
From time to time, the Fund may advertise a yield figure calculated in
the following manner:
An income factor is calculated for each security in the portfolio based
upon the security's market value at the beginning of the period and yield as
determined in conformity with regulation of the Securities and Exchange
Commission. The income factors are then totalled for all securities in the
portfolio. Next, expenses of the Fund for the period net of expected
reimbursement are deducted from the income to arrive at net income, which is
then converted to a per-share amount by dividing net income by the average
number of shares outstanding during the period. The net income per share is
divided by the net asset value on the last day of the period to produce a
monthly yield which is then annualized. Quoted yield factors are for
comparison purposes only, and are not intended to indicate future performance
or forecast the dividend per share of the Fund.
INVESTMENT PERFORMANCE
Total Return Performance
The Fund's calculation of total return performance includes the
reinvestment of all capital gain distributions and income dividends for the
period or periods indicated, without regard to tax consequences to a
shareholder in the Fund. Total return is calculated as the percentage change
between the beginning value of a static account in the Fund and the ending
value of that account measured by the then current net asset value, including
all shares acquired through reinvestment of income and capital gains
dividends. The results shown are historical and should not be considered
indicative of the future performance of a Fund. Each average annual compound
rate of return is derived from the cumulative performance of the Fund over the
time period specified. The annual compound rate of return for the Fund over
any other period of time will vary from the average.
From time to time, in reports and promotional literature, one or more of
the T. Rowe Price funds, including this Fund, may compare its performance to
Overnight Government Repurchase Agreements, Treasury bills, notes, and bonds,
certificates of deposit, and money market deposit accounts. Performance may
also be compared to (1) indices of broad groups of managed and unmanaged
securities considered to be representative of or similar to Fund portfolio
holdings; (2) other mutual funds; or (3) other measures of performance set
forth in publications such as:
Advertising News Service, Inc., "Bank Rate Monitor+ - The Weekly
Financial Rate Reporter" is a weekly publication which lists the yields
on various money market instruments offered to the public by 100 leading
banks and thrift institutions in the U.S., including loan rates offered
by these banks. Bank certificates of deposit differ from mutual funds
in several ways: the interest rate established by the sponsoring bank
is fixed for the term of a CD; there are penalties for early withdrawal
from CDs; and the principal on a CD is insured.
PAGE 51
Donoghue Organization, Inc., "Donoghue's Money Fund Report" is a weekly
publication which tracks net assets, yield, maturity and portfolio
holdings on approximately 380 money market mutual funds offered in the
U.S. These funds are broken down into various categories such as U.S.
Treasury, Domestic Prime and Euros, Domestic Prime and Euros and
Yankees, and Aggressive.
First Boston High Yield Index. It shows statistics on the Composite
Index and analytical data on new issues in the marketplace and low-grade
issuers.
Lipper Analytical Services, Inc., "Lipper-Fixed Income Fund Performance
Analysis" is a monthly publication which tracks net assets, total
return, principal return and yield on over 1900 fixed income mutual
funds offered in the United States.
Merrill Lynch, Pierce, Fenner & Smith, Inc., "Taxable Bond Indices" is a
monthly publication which lists principal, coupon and total return on
over 100 different taxable bond indices tracked by Merrill Lynch,
together with the par weighted characteristics of each Index.
Morningstar, Inc. - is a widely used independent research firm which
rates mutual funds by overall performance, investment objectives, and
assets.
Salomon Brothers Inc., "Analytical Record of Yields and Yield Spreads"
is a publication which tracks historical yields and yield spreads on
short-term market rates, public obligations of the U.S. Treasury and
agencies of the U.S. Government, public corporate debt obligations,
municipal debt obligations and preferred stocks.
Salomon Brothers Inc., "Bond Market Round-up" is a weekly publication
which tracks the yields and yield spreads on a large, but select, group
of money market instruments, public corporate debt obligations, and
public obligations of the U.S. Treasury and agencies of the U.S.
Government.
Salomon Brothers Inc., "Market Performance" - a monthly publication
which tracks principal return, total return and yield on the Salomon
Brothers Broad investment - Grade Bond Index and the components of the
Index as well as some money market instruments not included in the
index.
Shearson Lehman Brothers, Inc., "The Bond Market Report" - a monthly
publication which tracks principal, coupon and total return on the
Shearson Lehman Govt./Corp. Index and Shearson Lehman Aggregate Bond
Index, as well as all the components of these Indices.
Telerate Systems, Inc., a market data distribution network computer
system which tracks a broad range of financial markets including, the
daily rates on money market instruments, public corporate debt
obligations and public obligations of the U.S. Treasury and agencies of
the U.S. Government.
Wall Street Journal, is a national daily financial news publication
which lists the yields and current market values on money market
instruments, public corporate debt obligations, public obligations of
the U.S. Treasury and agencies of the U.S. Government as well as common
stocks, preferred stocks, convertible preferred stocks, options and
PAGE 52
commodities; in addition to indices prepared by the research departments
of such financial organizations as Shearson Lehman/American Express
Inc., and Merrill Lynch, Pierce, Fenner and Smith, Inc., including
information provided by the Federal Reserve Board.
Performance rankings and ratings reported periodically in national
financial publications such as MONEY, FORBES, BUSINESS WEEK, BARRON'S, etc.
will also be used.
Benefits of Investing in High-Quality Bond Funds
o Higher Income
Bonds have generally provided a higher income than money market
securities because yield usually increased with longer maturities. For
instance, the yield on the 30-year Treasury bond usually exceeds the
yield on the 1-year Treasury bill or 5-year Treasury note. However,
securities with longer maturities fluctuate more in price than those
with shorter maturities. Therefore, the investor must weigh the
advantages of higher yields against the possibility of greater
fluctuation in the principal value of your investment.
o Income Compounding
Investing in bond mutual funds allows investors to benefit from easy and
convenient compounding because you can automatically reinvest monthly
dividends in additional fund shares. Each month investors earn interest
on a larger number of shares. Also, reinvesting dividends removes the
temptation to spend the income.
o Broad Diversification
Each share of a mutual fund represents an interest in a large pool of
securities, so even a small investment is broadly diversified by
maturity. Since most bonds trade efficiently only in very large blocks,
mutual funds provide a degree of diversification that may be difficult
for individual investors to achieve on its own.
o Lower Portfolio Volatility
Investing a portion of one's assets in longer term, high-quality bonds
can help smooth out the fluctuations in your overall investment results,
because bond prices do not necessarily move with stock prices. Also,
bonds usually have higher income yields than stocks, thus increasing the
total income component of your portfolio. This strategy should also add
stability to overall results, as income is always a positive component
of total return.
o Liquidity
A bond fund can supplement a money market fund or bank account as a
source of capital for unexpected contingencies. T. Rowe Price fixed-
income funds offer you easy access to money through free checkwriting
and convenient redemption and exchange features. Of course, the value
of a bond fund's shares redeemed through checkwriting may be worth more
or less than its value at the time of its original purchase.
PAGE 53
Suitability
High-quality bond funds are most suitable for the following objectives:
obtaining a higher current income with minimal credit risk; compounding
of income over time; or diversifying overall investments to reduce
volatility.
IRAs
An IRA is a long-term investment whose objective is to accumulate
personal savings for retirement. Due to the long-term nature of the
investment, even slight differences in performance will result in
significantly different assets at retirement. Mutual funds, with its
diversity of choice, can be used for IRA investments. Generally, individuals
may need to adjust its underlying IRA investments as its time to retirement
and tolerance for risk changes.
Other Features and Benefits
The Fund is a member of the T. Rowe Price Family of Funds and may help
investors achieve various long-term investment goals, such as investing money
for retirement, saving for a down payment on a home, or paying college costs.
To explain how the Fund could be used to assist investors in planning for
these goals and to illustrate basic principles of investing, various
worksheets and guides prepared by T. Rowe Price Associates, Inc. and/or T.
Rowe Price Investment Services, Inc. may be made available. These currently
include: the Asset Mix Worksheet which is designed to show shareholders how to
reduce its investment risk by developing a diversified investment plan: the
College Planning Guide which discusses various aspects of financial planning
to meet college expenses and assists parents in projecting the costs of a
college education for its children; the Retirement Planning Kit (also
available in a PC version) which includes a detailed workbook to determine how
much money you may need for retirement and suggests how you might invest to
reach your goal; and the Retirees Financial Guide which includes a detailed
workbook to determine how much money you can afford to spend and still
preserve your purchasing power and suggest how you might invest to reach your
goal. From time to time, other worksheets and guides may be made available as
well. Of course, an investment in the Fund cannot guarantee that such goals
will be met.
To assist investors in understanding the different returns and risk
characteristics of various investments, the aforementioned guides will include
presentation of historical returns of various investments using published
indices. An example of this is shown on the next page.
PAGE 54
Historical Returns for Different Investments
Annualized returns for periods ended 12/31/93
50 years 20 years 10 years 5 years
Small-Company Stocks 15.3% 18.8% 10.0% 13.3%
Large-Company Stocks 12.3 12.8 14.9 14.5
Foreign Stocks N/A 14.4 17.9 2.3
Long-Term Corporate Bonds 5.6 10.2 14.0 13.0
Intermediate-Term U.S.
Gov't. Bonds 5.7 9.8 11.4 11.3
Treasury Bills 4.6 7.5 6.4 5.6
U.S. Inflation 4.3 5.9 3.7 3.9
Sources: Ibbotson Associates, Morgan Stanley. Foreign stocks reflect
performance of The Morgan Stanley Capital International EAFE Index, which
includes some 1,000 companies representing the stock markets of Europe,
Australia, New Zealand, and the Far East. This chart is for illustrative
purposes only and should not be considered as performance for, or the
annualized return of, any T. Rowe Price Fund. Past performance does not
guarantee future results.
Also included will be various portfolios demonstrating how these
historical indices would have performed in various combinations over a
specified time period in terms of return. An example of this is shown below.
Performance of Retirement Portfolios*
Asset Mix Average Annualized Value
Returns 20 Years of
Ended 12/31/93 $10,000
Investment
After Period
_____________________ ______________________ ____________
Nominal Real Best Worst
Portfolio Growth Income Safety Return Return** Year Year
I. Low
Risk 40% 40% 20% 11.3% 5.4% 24.9% -9.3%$ 79,775
II. Moderate
Risk 60% 30% 10% 12.1% 6.2% 29.1% -15.6%$ 90,248
III. High
Risk 80% 20% 0% 12.9% 7.0% 33.4% -21.9%$100,031
Source: T. Rowe Price Associates; data supplied by Lehman Brothers, Wilshire
Associates, and Ibbotson Associates.
PAGE 55
* Based on actual performance for the 20 years ended 1993 of stocks (85%
Wilshire 5000 and 15% Europe, Australia, Far East [EAFE] Index), bonds
(Lehman Brothers Aggregate Bond Index from 1976-93 and Lehman Brothers
Government/Corporate Bond Index from 1974-75), and 30-day Treasury bills
from January 1974 through December 1993. Past performance does not
guarantee future results. Figures include changes in principal value and
reinvested dividends and assume the same asset mix is maintained each
year. This exhibit is for illustrative purposes only and is not
representative of the performance of any T. Rowe Price fund.
** Based on inflation rate of 5.9% for the 20-year period ended 12/31/93.
Redemptions in Kind
In the unlikely event a shareholder of the Fund were to receive an in
kind redemption of portfolio securities of the Fund, brokerage fees could be
incurred by the shareholder in subsequent sale of such securities.
Issuance of Fund Shares for Securities
Transactions involving issuance of Fund shares for securities or assets
other than cash will be limited to (1) bona fide reorganizations; (2)
statutory mergers; or (3) other acquisitions of portfolio securities that: (a)
meet the investment objective and policies of the Fund; (b) are acquired for
investment and not for resale except in accordance with applicable law; (c)
have a value that is readily ascertainable via listing on or trading in a
recognized United States or international exchange or market; and (d) are not
illiquid.
CAPITAL STOCK
The Charter of the T. Rowe Price Fixed Income Series, Inc. (the
"Corporation") authorizes its Board of Directors to classify and reclassify
any and all shares which are then unissued, including unissued shares of
capital stock into any number of classes or series, each class or series
consisting of such number of shares and having such designations, such powers,
preferences, rights, qualifications, limitations, and restrictions, as shall
be determined by the Board subject to the Investment Company Act and other
applicable law. The shares of any such additional classes or series might
therefore differ from the shares of the present class and series of capital
stock and from each other as to preferences, conversions or other rights,
voting powers, restrictions, limitations as to dividends, qualifications or
terms or conditions of redemption, subject to applicable law, and might thus
be superior or inferior to the capital stock or to other classes or series in
various characteristics. The Corporation's Board of Directors may increase or
decrease the aggregate number of shares of stock or the number of shares of
stock of any class or series that the Fund has authorized to issue without
shareholder approval.
Except to the extent that the Corporation's Board of Directors might
provide by resolution that holders of shares of a particular class are
entitled to vote as a class on specified matters presented for a vote of the
holders of all shares entitled to vote on such matters, there would be no
right of class vote unless and to the extent that such a right might be
construed to exist under Maryland law. The Charter contains no provision
entitling the holders of the present class of capital stock to a vote as a
class on any matter. Accordingly, the preferences, rights, and other
characteristics attaching to any class of shares, including the present class
of capital stock, might be altered or eliminated, or the class might be
combined with another class or classes, by action approved by the vote of the
PAGE 56
holders of a majority of all the shares of all classes entitled to be voted on
the proposal, without any additional right to vote as a class by the holders
of the capital stock or of another affected class or classes.
The various insurance companies own the outstanding shares of the Fund
in their separate accounts. These separate accounts are registered as
investment companies under the 1940 Act or are excluded from registration.
Each insurance company, as the Shareholder, is entitled to one vote for each
full share held (and fractional votes for fractional shares held). Under the
current laws the insurance companies must vote the shares held in registered
separate accounts in accordance with voting instructions received from
variable Contract Holders or Participants. Fund shares for which Contract
Holders or Participants are entitled to give voting instructions, but as to
which no voting instructions are received, and shares owned by the insurance
companies or affiliated companies in the separate accounts, will be voted in
proportion to the shares for which voting instructions have been received.
There will normally be no meetings of shareholders for the purpose of
electing directors unless and until such time as less than a majority of the
directors holding office have been elected by shareholders, at which time the
directors then in office will call a shareholders' meeting for the election of
directors. Except as set forth above, the directors shall continue to hold
office and may appoint successor directors. Voting rights are not cumulative,
so that the holders of more than 50% of the shares voting in the election of
directors can, if they choose to do so, elect all the directors of the Fund,
in which event the holders of the remaining shares will be unable to elect any
person as a director. As set forth in the By-Laws of the Corporation, a
special meeting of shareholders of the Corporation shall be called by the
Secretary of the Corporation on the written request of shareholders entitled
to cast at least 10% of all the votes of the Corporation entitled to be cast
at such meeting. Shareholders requesting such a meeting must pay to the
Corporation the reasonably estimated costs of preparing and mailing the notice
of the meeting. The Corporation, however, will otherwise assist the
shareholders seeking to hold the special meeting in communicating to the other
shareholders of the Corporation to the extent required by Section 16(c) of the
Investment Company Act of 1940.
FEDERAL AND STATE REGISTRATION OF SHARES
The Fund's shares are registered for sale under the Securities Act of
1933, and the Fund or its shares are registered under the laws of all states
which require registration, as well as the District of Columbia and Puerto
Rico.
LEGAL COUNSEL
Shereff, Friedman, Hoffman, & Goodman, whose address is 919 Third Avenue,
New York, New York 10022, is legal counsel to the Fund.
INDEPENDENT ACCOUNTANTS
Price Waterhouse, 7 St. Paul Street, Suite 1700, Baltimore, Maryland
21202, Baltimore, Maryland 21202, are independent accountants to the Fund.
The Statement of Assets and Liabilities of the Fund as of May 11, 1994,
included in the Statement of Additional Information has been so included in
reliance on the report of Price Waterhouse, given on the authority of said
firm as experts in auditing and accounting.
PAGE 57
RATINGS OF COMMERCIAL PAPER
Moody's Investors Service, Inc. The rating of Prime-1 is the highest
commercial paper rating assigned by Moody's. Among the factors considered by
Moody's in assigning ratings are the following: valuation of the management
of the issuer; economic evaluation of the issuer's industry or industries and
an appraisal of speculative-type risks which may be inherent in certain areas;
evaluation of the issuer's products in relation to competition and customer
acceptance; liquidity; amount and quality of long-term debt; trend of earnings
over a period of 10 years; financial strength of the parent company and the
relationships which exist with the issuer; and recognition by the management
of obligations which may be present or may arise as a result of public
interest questions and preparations to meet such obligations. These factors
are all considered in determining whether the commercial paper is rated P1,
P2, or P3.
Standard & Poor's Corporation. Commercial paper rated A (highest quality) by
S&P has the following characteristics: liquidity ratios are adequate to meet
cash requirements; long-term senior debt is rated "A" or better, although in
some cases "BBB" credits may be allowed. The issuer has access to at least
two additional channels of borrowing. Basic earnings and cash flow have an
upward trend with allowance made for unusual circumstances. Typically, the
issuer's industry is well established and the issuer has a strong position
within the industry. The reliability and quality of management are
unquestioned. The relative strength or weakness of the above factors
determines whether the issuer's commercial paper is rated A1, A2, or A3.
Fitch Investors Service, Inc.: Fitch 1 - Highest grade. Commercial paper
assigned this rating is regarded as having the strongest degree of assurance
for timely payment. Fitch 2 - Very good grade. Issues assigned this rating
reflect an assurance of timely payment only slightly less in degree than the
strongest issues.
RATINGS OF CORPORATE DEBT SECURITIES
Moody's Investors Service, Inc.
Aaa - Bonds rated Aaa are judged to be of the best quality. They carry the
smallest degree of investment risk.
Aa - Bonds 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.
A - Bonds rated A possess many favorable investment attributes and are to be
considered as upper medium grade obligations.
Baa - Bonds 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 rated Ba are judged to have speculative elements: its 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 characterize
bonds in this class.
PAGE 58
B - Bonds rated B generally lack characteristics of the desirable investment.
Assurance of interest and principal payments of or maintenance of other terms
of the contract over any long period of time may be small.
Caa - Bonds 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 rated Ca represent obligations which are speculative in a high
degree. Such issues are often in default or have other marked short-comings.
Standard & Poor's Corporation
AAA - This is the highest rating assigned by Standard & Poor's to a debt
obligation and indicates an extremely strong capacity to pay principal and
interest.
AA - Bonds rated AA also qualify as high-quality debt obligations. Capacity
to pay principal and interest is very strong.
A - Bonds rated A have a strong capacity to pay principal and interest,
although they are somewhat more susceptible to the adverse effects of changes
in circumstances and economic conditions.
BBB - Bonds rated BBB are regarded as having an adequate capacity to pay
principal and interest. Whereas they normally exhibit adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay principal and interest for bonds
in this category than for bonds in the A category.
BB, B, CCC, CC - Bonds rated BB, B, CCC, and CC are regarded on balance, as
predominantly speculative with respect to the issuer's capacity to pay
interest and repay principal in accordance with the terms of the obligation.
BB indicates the lowest degree of speculation and CC the highest degree of
speculation. While such bonds will likely have some quality and protective
characteristics, these are outweighed by large uncertainties or major risk
exposures to adverse conditions.
Fitch Investors Service, Inc.: AAA - High grade, broadly marketable, suitable
for investment by trustees and fiduciary institutions, and liable to but
slight market fluctuation other than through changes in the money rate. The
prime feature of a "AAA" bond is the showing of earnings several times or many
times interest requirements for such stability of applicable interest that
safety is beyond reasonable question whenever changes occur in conditions.
Other features may enter, such as a wide margin of protection through
collateral, security or direct lien on specific property. Sinking funds or
voluntary reduction of debt by call or purchase are often factors, while
guarantee or assumption by parties other than the original debtor may
influence its rating. AA - Of safety virtually beyond question and readily
salable. Their merits are not greatly unlike those of "AAA" class but a bond
so rated may be junior though of strong lien, or the margin of safety is less
strikingly broad. The issue may be the obligation of a small company,
strongly secured, but influenced as to rating by the lesser financial power of
the enterprise and more local type of market.
PAGE 59
T. ROWE PRICE FIXED INCOME SERIES, INC.
STATEMENT OF ASSETS AND LIABILITIES
May 11, 1994
Limited-Term
Bond Portfolio
Assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Deferred Organizational Expenses . . . . . . . . . . . . 4,070
Total Assets. . . . . . . . . . . . . . . . . . . 104,070
Liabilities
Amount due Manager . . . . . . . . . . . . . . . . . . . 1,570
Accrued Expenses . . . . . . . . . . . . . . . . . . . . 2,500
Total Liabilities . . . . . . . . . . . . . . . . 4,070
Net Assets - offering and redemption price of
$5.00 per share; 1,000,000,000 shares of
$.0001 par value capital stock
authorized; 20,000 shares outstanding. . . . . . . . . . $100,000
NOTE TO STATEMENT OF ASSETS AND LIABILITIES
T. Rowe Price Fixed Income Series, Inc. (the "Corporation") was organized
on March 16, 1994, as a Maryland corporation and is registered under the
Investment Company Act of 1940. The Corporation is a series fund, of which
the Limited-Term Bond Portfolio (the "Fund"), a diversified, open-end
management investment company, is the only portfolio currently established.
The Corporation has had no operations other than those matters related to
organization and registration as an investment company, the registration of
shares for sale under the Securities Act of 1933, and the sale of 20,000
shares of the Fund at $5.00 per share on May 11, 1994 to T. Rowe Price
Associates, Inc. The Fund has entered into an investment management agreement
with T. Rowe Price Associates, Inc. (the "Manager") which is described in the
Statement of Additional Information under the heading "Investment Management
Services."
Organizational expenses of $4,070 have been accrued at May 11, 1994, and
will be amortized on a straight-line basis over a period not to exceed sixty
months. The Manager has agreed to advance certain organizational expenses
incurred by the Fund and will be reimbursed for such expenses approximately
six months after the commencement of the Fund's operations.
The Manager has agreed that in the event any of its initial shares are
redeemed during the 60-month amortization period of the deferred
organizational expenses, proceeds from a redemption of the shares representing
the initial capital will be reduced by a pro rata portion of any unamortized
organizational expenses.
PAGE 60
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholder of
T. Rowe Price Fixed Income Series, Inc.
In our opinion, the accompanying statement of assets and liabilities
presents fairly, in all material respects, the financial position of the T.
Rowe Price Limited-Term Bond Portfolio (a Fund constituting T. Rowe Price
Fixed Income Series, Inc.) at May 11, 1994, in conformity with generally
accepted accounting principles. This financial statement is the
responsibility of the Fund's management; our responsibility is to express an
opinion on this financial statement based on our audit. We conducted our
audit of this financial statement in accordance with generally accepted
auditing standards which require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statement is free of material
misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statement, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audit provides a reasonable basis for the opinion expressed above.
/s/PRICE WATERHOUSE
PRICE WATERHOUSE
Baltimore, Maryland
May 12, 1994
