MERRILL LYNCH
MUNICIPAL
STRATEGY
FUND, INC.
FUND LOGO
Quarterly Report
July 31, 1996
Officers and Directors
Arthur Zeikel, President and Director
Ronald W. Forbes, Director
Cynthia A. Montgomery, Director
Charles C. Reilly, Director
Kevin A. Ryan, Director
Richard R. West, Director
Terry K. Glenn, Executive Vice President
Vincent R. Giordano, Senior Vice President
Donald C. Burke, Vice President
Kenneth A. Jacob, Vice President
Gerald M. Richard, Treasurer
Mark B. Goldfus, Secretary
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Custodian
The Bank of New York
90 Washington Street
New York, NY 10286
Transfer Agent
Merrill Lynch Financial Data Services, Inc.
4800 Deer Lake Drive East
Jacksonville, FL 32246-6484
(800) 637-38631
This report, including the financial information herein, is
transmitted to the shareholders of Merrill Lynch Municipal Strategy
Fund, Inc. for their information. It is not a prospectus, circular
or representation intended for use in the purchase of shares of the
Fund or any securities mentioned in the report. Past performance
results shown in this report should not be considered a representation
of future performance. The Fund has leveraged its Common
Stock by issuing Preferred Stock to provide the Common Stock
shareholders with a potentially higher rate of return. Leverage
creates risks for Common Stock shareholders, including the
likelihood of greater volatility of net asset value and market price
shares of the Common Stock, and the risk that fluctuations in the
short-term dividend rates of the Preferred Stock may affect the
yield to Common Stock shareholders. Statements and other information
herein are as dated and are subject to change.
Merrill Lynch Municipal
Strategy Fund, Inc.
Box 9011
Princeton, NJ
08543-9011
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MERRILL LYNCH MUNICIPAL STRATEGY FUND, INC.
The Benefits and
Risks of
Leveraging
Merrill Lynch Municipal Strategy Fund, Inc. utilizes leveraging to
seek to enhance the yield and net asset value of its Common Stock.
However, these objectives cannot be achieved in all interest rate
environments. To leverage, the Fund issues Preferred Stock, which
pays dividends at prevailing short-term interest rates, and invests
the proceeds in long-term municipal bonds. The interest earned on
these investments is paid to Common Stock shareholders in the form
of dividends, and the value of these portfolio holdings is reflected
in the per share net asset value of the Fund's Common Stock.
However, in order to benefit Common Stock shareholders, the yield
curve must be positively sloped; that is, short-term interest rates
must be lower than long-term interest rates. At the same time, a
period of generally declining interest rates will benefit Common
Stock shareholders. If either of these conditions change, then the
risks of leveraging will begin to outweigh the benefits.
To illustrate these concepts, assume a fund's Common Stock
capitalization of $100 million and the issuance of Preferred Stock
for an additional $50 million, creating a total value of $150
million available for investment in long-term municipal bonds. If
prevailing short-term interest rates are approximately 3% and long-
term interest rates are approximately 6%, the yield curve has a
strongly positive slope. The fund pays dividends on the $50 million
of Preferred Stock based on the lower short-term interest rates. At
the same time, the fund's total portfolio of $150 million earns the
income based on long-term interest rates. Of course, increases in
short-term interest rates would reduce (and even eliminate) the
dividends on the Common Stock.
In this case, the dividends paid to Preferred Stock shareholders are
significantly lower than the income earned on the fund's long-term
investments, and therefore the Common Stock shareholders are the
beneficiaries of the incremental yield. However, if short-term
interest rates rise, narrowing the differential between short-term
and long-term interest rates, the incremental yield pick-up on the
Common Stock will be reduced or eliminated completely. At the same
time, the market value on the fund's Common Stock may, as a result,
decline. Furthermore, if long-term interest rates rise, the Common
Stock's net asset value will reflect the full decline in the price
of the portfolio's investments, since the value of the fund's
Preferred Stock does not fluctuate. In addition to the decline in
net asset value, the market value of the fund's Common Stock may
also decline.
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DEAR SHAREHOLDER
For the three months ended July 31, 1996, the Common Stock of
Merrill Lynch Municipal Strategy Fund, Inc. earned $0.145 per share
income dividends. This represents a net annualized yield of 5.79%,
based on a month-end per share net asset value of $9.93. Over the
same period, the total investment return on the Fund's Common Stock
was +3.25%, based on a change in per share net asset value from
$9.76 to $9.93, and assuming reinvestment of $0.145 per share income
dividends.
For the three-month period ended July 31, 1996, the Fund's Auction
Market Preferred Stock had an average yield of 3.53%.
The Municipal Market Environment
During the three months ended July 31, 1996, long-term municipal
bond yields posted significant declines. As measured by the Bond
Buyer Revenue Bond Index, yields on A-rated, uninsured tax-exempt
revenue bonds fell over 30 basis points (0.30%) to end the July
quarter at 6.02%. Municipal bond yields traded in a narrow range
through early July as the domestic economy continued to demonstrate
ongoing strength. However, the combination of the Federal Reserve
Board suggesting that growth was expected to slow later in 1996 and
the stock market declining in early July allowed tax-exempt bond
yields to fall as investors scrambled to purchase relatively scarce
securi-ties. As it has in recent quarters, the municipal bond market
continued to outperform its taxable counterpart. During the July
quarter, US Treasury bond yields rose somewhat to end the six-month
period ended July 31, 1996 at 6.97%, up 7 basis points.
The municipal bond market continued to enjoy the same strong
technical position during the July quarter that it has for much of
1996. The rate of increase in new bond issuance recently slowed.
Over the last six months, approximately $90 billion in new long-term
municipal securities were underwritten. This represents an increase
of slightly more than 20% versus the comparable period a year
earlier. However, during the July quarter, approximately $43 billion
in securities were issued, essentially unchanged from the amount
issued during the July 1995 quarter. In July 1996, less than $10
billion in new municipal securities were underwritten. This is the
lowest issuance for the month of July since 1990. This relative
decline in bond issuance can be expected to continue as bond
issuance historically declines during the summer months. Also, bond
issuance dedicated toward refinancing existing debt fell in response
to higher bond yields.
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At the same time investor demand remained consistently strong. With
nominal new issue yields above 6%, retail investor interest was
steady. Additionally, investors received over $50 billion this June
and July in assets derived from coupon income, bond maturities and
proceeds from early redemptions. Annual new bond issuance has
declined in recent years and is expected to remain below levels seen
in the early 1990s. Consequently, as the higher-couponed bonds
issued in the early-to-mid 1980s were redeemed at their first
optional call date, the total number of outstanding tax-exempt bonds
has declined. This combination of a declining net supply and
significant amounts of new assets has helped maintain investor
demand in recent months.
It is unlikely that the municipal bond market will continue to
significantly outperform US Treasury securities in the near future.
The tax-exempt bond market's recent performance led to the yield
ratio between long-term taxable and tax-exempt securities falling
from in excess of 90% to approximately 85%. While historically still
very attractive, some institutional investors, particularly short-
term traders, began to view the tax-exempt bond market's recent
outperformance as an opportunity to sell a relatively expensive
asset. However, to the long-term investor, such a sale would
represent the loss of an attractively priced asset which may not be
easily replaced given the relative scarcity of municipal bonds under
present supply conditions.
Looking forward, no clear consensus for the direction of interest
rates currently exists. Perhaps, the primary focus going forward
will be the extent to which the increase in interest rates seen thus
far in 1996 will negatively impact future economic growth. Should
growth slow in the interest rate-sensitive sectors of the economy,
like housing, auto and consumer spending, as many economists assert
is likely, then bond yields are likely to decline. Under such a
scenario, the municipal bond market's performance is likely to
closely mirror that of the US Treasury bond market.
Portfolio Strategy
Merrill Lynch Municipal Strategy Fund, Inc. started the July quarter
with a neutral stance on the interest rate outlook. There was a
considerable amount of negative news priced into the market, and we
believed any surprises (such as a slower economy or slower
employment increases) could rally the market substantially. The bond
market did in fact rally early in the quarter, enabling us to sell
more interest rate-sensitive bonds to put the Fund in a defensive
position for possible further interest rate volatility. This
strategy helped protect the Fund from the significant back up in
interest rates from the middle of May to early June. Once again, we
believed the bond market oversold and used this weakness as a buying
opportunity. This enabled us to fully participate in the rally at
the end of June. We sold into the rally, and our investment strategy
is once again neutral as we await signs of the relative strength of
the economy.
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The yield on the Fund's Auction Market Preferred Stock traded
between 3.40%--3.60% during the past three months. This continued to
generate significant beneficial impact on the yield to the Fund's
Common Stock shareholders. However, should the spread between short-
term and long-term interest rates narrow, the benefits of the
leverage will decline and the yield on the Common Stock will be
reduced. (For a complete explanation of the benefits and risks of
leveraging, see page 1 of this report to shareholders.)
In Conclusion
We appreciate your ongoing interest in Merrill Lynch Municipal
Strategy Fund, Inc., and we look forward to serving your investment
needs in the months and years to come.
Sincerely,
(Arthur Zeikel)
Arthur Zeikel
President
(Vincent R. Giordano)
Vincent R. Giordano
Senior Vice President
(Robert A. DiMella)
Robert A. DiMella
Portfolio Manager
August 27, 1996
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PORTFOLIO COMPOSITION
For the Quarter Ended July 31, 1996
Top Ten States*
Colorado 14.31%
Michigan 10.31
Texas 10.22
New York 8.37
Florida 6.27
Puerto Rico 4.77
Massachusetts 4.56
Pennsylvania 4.45
North Carolina 4.19
Indiana 3.83
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Total Top Ten 71.28
Total Others 28.72
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Total Portfolio 100.00%
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Net assets as of July 31, 1996 were $110,652,607.
Quality Ratings*
(Based on Nationally Recognized Rating Services)
A pie chart depicting quality ratings of the Fund's investments.
AAA/Aaa 44%
AA/Aa 7%
A/A 17%
BBB/Baa 19%
BB/Ba 2%
NR+ 3%
Other++ 8%
[FN]
*Based on total market value of the portfolio as of July 31, 1996.
++Not Rated.
++++Temporary investments in short-term municipal securities.
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