MERRILL LYNCH
MUNICIPAL
STRATEGY
FUND, INC.
[FUND LOGO]
STRATEGIC
Performance
Annual Report
October 31, 1997
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 #MSTR01 -- 10/97
[RECYCLE LOGO] Printed on post-consumer recycled paper
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 pickup 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.
Merrill Lynch Municipal Strategy Fund, Inc., October 31, 1997
DEAR SHAREHOLDER
For the year ended October 31, 1997, the Common Stock of Merrill Lynch
Municipal Strategy Fund, Inc. earned $0.592 per share income dividends,
which included earned and unpaid dividends of $0.051. This represents a
net annualized yield of 5.45%, based on a month-end per share net asset
value of $10.87. Over the same period, the total investment return on the
Fund's Common Stock was +13.08%, based on a change in per share net asset
value from $10.17 to $10.87, and assuming reinvestment of $0.598 per share
income dividends.
For the six-month period ended October 31, 1997, the total investment
return on the Fund's Common Stock was +10.09%, based on a change in per
share net asset value from $10.15 to $10.87, and assuming reinvestment of
$0.302 per share income dividends.
For the six-month period ended October 31, 1997, the Fund's Auction Market
Preferred Stock had an average yield of 3.48%.
The Municipal Market Environment
During the three-month period ended October 31, 1997, long-term tax-exempt
bond yields rose slightly, as measured by the Bond Buyer Revenue Bond
Index. On a weekly basis, bond yields were buffeted by alternating
indicators of strong and weak economic growth. The general financial
environment has remained one of solid economic growth tempered by few or
no inflationary pressures. Economic growth remained strong enough,
however, to suggest that the Federal Reserve Board (FRB) might find it
necessary to raise short-term interest rates to slow economic growth and
curtail any incipient inflationary pressures. For the three-month period
ended October 31, 1997, long-term municipal bond yields rose approximately
ten basis points (0.10%) to 5.60%
Similarly, long-term US Treasury bond yields generally moved higher during
most of the three-month period ended October 31, 1997. However, the
turmoil in the world's equity markets during the last week in October
resulted in a significant rally in the Treasury bond market. The US
Treasury bond market was the beneficiary of a flight to quality mainly by
foreign investors whose own domestic markets have continued to be very
volatile. Prior to the initial decline in Asian equity markets, long-term
US Treasury bond yields declined 15 basis points to 6.15%, their lowest
level of 1997.
The tax-exempt bond market's continued underperformance as compared to its
taxable counterpart, has been largely in response to its ongoing weakening
technical position. As municipal bond yields have declined, municipalities
have hurriedly rushed to refinance outstanding higher-couponed debt with
new issues financed at present low rates. During the last six months, over
$118 billion in new long-term tax-exempt issues were underwritten, an
increase of over 25% versus the comparable period a year ago. As interest
rates have continued to decline, these refinancings have intensified
municipal bond issuance. During the past three months, approximately $60
billion in new long-term municipal securities were underwritten, an
increase of over 34% as compared to the October 1996 quarter.
The recent trend toward larger and larger bond issues has also continued.
However, issues of such magnitude usually must be attractively priced to
ensure adequate investor interest. Obviously, the yields of other
municipal bond issues are impacted by the yield premiums such large
issuers have been required to pay. Much of the municipal bond market's
recent underperformance can be traced to market pressures that these large
bond issuances have exerted.
In our opinion, the recent correction in world equity markets has enhanced
the near-term prospects for continued low, if not declining, interest
rates in the United States. It is likely that the recent correction will
result in slower US domestic growth in the coming months. This decline is
likely to be generated in part by reduced US export growth. Additionally,
some decline in consumer spending can also be expected in response to
reduced consumer confidence. Perhaps more importantly, it is likely that
barring a dramatic and unexpected resurgence in domestic growth, the FRB
will be unwilling to raise interest rates until the full impact of the
equity market's corrections can be established.
All of these factors suggest that for at least the near term, interest
rates, including tax-exempt bond yields, are unlikely to rise by any
appreciable amount. It is probable that municipal bond yields will remain
under some pressure as a result of continued strong new-issue supply.
However, the recent pace of municipal bond issuance is likely to be
unsustainable. Continued increases in bond issuance will require lower
tax-exempt bond yields to generate the economic savings necessary for
additional municipal bond refinancing. With tax-exempt bond yields at
already attractive yield ratios relative to US Treasury bonds
(approximately 90% at the end of October) any further pressure on the
municipal market may represent an attractive investment opportunity.
Portfolio Strategy
At the beginning of 1997, our outlook was for higher interest rates. Since
the bond market had rallied in anticipation of a weakening economy with no
possibility of a FRB tightening, we perceived a risk of sudden change in
investor expectations. At this time, the Fund remained fully invested as
we purchased bonds less sensitive to interest rate volatility, such as
shorter-duration bonds. This strategy proved beneficial as economic data
released during the fourth quarter of 1996 and the first quarter of 1997
showed significant signs of strength. As a result, the FRB increased
short-term interest rates 25 basis points and pushed tax-exempt interest
rates to 6% by the middle of April. Anticipating further tightening, we
remained cautious on the bond market and concentrated on protecting the
Fund's net asset value and maintaining as high a level as possible of
tax-exempt income.
Surprisingly, the bond market staged a significant rally during the summer
months, and long-term tax-exempt yields declined nearly 75 basis points.
In our opinion, this occurred as a result of the economy turning decidedly
weaker in the second quarter of 1997. Fortunately, higher-coupon bonds,
which we purchased for defensive measures, outperformed aggressively
structured bonds since they were now advance refunding candidates. We
maintained a defensive, fully invested posture for the Fund for the
remainder of the 12-month period ended October 31, 1997 as the bond market
remained in a narrow 25 basis point trading range.
For the 12-month period ended October 31, 1997, the total return of the
Fund's Common Stock was achieved largely through our high-yield
investments. We invested approximately 15% the Fund's net assets in high-
yield, non-investment grade issuers. These types of issues provide a
significant yield advantage over investment-grade bonds, in addition to
price appreciation potential. During the 12 months ended October 31, 1997,
the yield on AAA-rated municipal bonds declined approximately 25 basis
points as compared to an average of a 100 basis point decline in the high-
yield sector. In addition, the credit quality of the Fund's high-yield
issuers improved during this time.
Looking ahead, our outlook is for lower interest rates. The economic
expansion is now entering its seventh year with benign inflation. Equity
markets throughout the world have entered into a very volatile stage
triggered by the currency crisis in Southeast Asia. We believe a
continuation of equity market declines may have a negative impact on
economic growth, thereby constraining global inflation.
The yield on the Fund's Auction Market Preferred Stock was trading between
3.25% -- 4.00% during the past year. Leverage continues to benefit the
Common Stock shareholders by significantly augmenting their yield.
However, should the spread between short-term and long-term tax-exempt
interest rates narrow, the benefits of leverage will decline and, as a
result, reduce the yield on the Fund's Common Stock. (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,
/S/ARTHUR ZEIKEL
Arthur Zeikel
President
/S/VINCENT R. GIORDANO
Vincent R. Giordano
Senior Vice President
/S/ROBERT A. DIMELLA
Robert A. DiMella
Vice President and Portfolio Manager
/S/JOHN M. LOFFREDO
John M. Loffredo
Vice President and Portfolio Manager
December 10, 1997
<TABLE>
<CAPTION>
Merrill Lynch Municipal Strategy Fund, Inc., October 31, 1997
SCHEDULE OF INVESTMENTS (in Thousands)
S&P Moody's Face Value
STATE Ratings Ratings Amount Issue (Note 1a)
<S> <C> <C> <C> <C> <C>
Alabama -- 2.0% NR* Aaa $2,815 Alabama HFA, S/F Home Mortgage Revenue Bonds, Series A-1, 6.60% due 4/01/2019 $3,013
Arizona -- 4.1% A1+ P1 2,200 Maricopa County, Arizona, PCR, Refunding (Arizona Public Service Co.),
VRDN, Series C, 4% due 5/01/2029 (h) 2,200
B B2 2,000 Pima County, Arizona, IDA, Industrial Revenue Bonds (Tucson Power Co. Project),
Series B, 6% due 9/01/2029 2,019
NR* NR* 1,875 Show Low, Arizona, Improvement District No. 5, 6.375% due 1/01/2015 1,877
Arkansas -- 0.8% AAA NR* 1,180 Arkansas State Development Finance Authority, S/F Mortgage Revenue Bonds
(Mortgage-Backed Securities Program), AMT, Series D, 6.80% due 1/01/2022 (f)(g) 1,268
California -- AAA Aaa 2,000 San Diego, California, IDR, RITR, 8.185% due 9/01/2019 (e) 2,270
1.5%
Colorado -- 9.3% NR* Aa2 2,000 Colorado HFA, S/F Program, AMT, Series D-1, 7.375% due 6/01/2026 2,230
NR* NR* 1,500 Denver, Colorado, Urban Renewal Authority, Tax Increment Revenue Bonds
(Downtown Denver), AMT, Series A, 7.75% due 9/01/2016 1,652
AAA Aaa 8,840 El Paso County, Colorado, Falcon School District No. 49, UT, 6.50% due
12/01/2015 (a) 10,058
Connecticut -- BBB- NR* 1,000 Connecticut State Health and Educational Facilities Authority Revenue Bonds
0.7% (University of New Haven), Series D, 6.70% due 7/01/2026 1,070
Florida -- 6.8% AAA Aaa 1,000 Dade County, Florida, Aviation Revenue Bonds (Miami International Airport),
Series C, 5.125% due 10/01/2027 (d) 969
AA- VMIG1+ 500 Dade County, Florida, IDA, Exempt Facilities Revenue Refunding Bonds
(Florida Power and Light Co.), VRDN, 3.65% due 6/01/2021 (h) 500
A1 NR* 200 Escambia County, Florida, PCR, Refunding (Gulf Power Co. Project),
VRDN, 3.75% due 7/01/2022 (h) 200
NR* Baa1 1,000 Jacksonville, Florida, Health Facilities Authority, IDR (National
Benevolent -- Cypress Village), Series A, 6.25% due 12/01/2026 1,057
BBB+ Baa2 1,000 Nassau County, Florida, PCR, Refunding (ITT Rayonier Inc. Project),
6.25% due 6/01/2010 1,052
NR* Baa 2,260 Palm Bay, Florida, Lease Revenue Refunding Bonds (Florida Education and
Research Foundation Project), Series A, 6.85% due 9/01/2013 2,508
A1 VMIG1+ 600 Pinellas County, Florida, Health Facilities Authority, Revenue
Refunding Bonds
(Pooled Hospital Loan Program), DATES, 3.65% due 12/01/2015 (h) 600
BBB- NR* 3,140 Santa Rosa Bay, Florida, Bridge Authority, 6.25% due 7/01/2028 3,287
Georgia -- 5.8% AA Aa3 2,000 Atlanta, Georgia, GO, UT, Series A, 6.125% due 12/01/2023 2,161
A1 VMIG1+ 2,500 Burke County, Georgia, Development Authority, PCR (Georgia Power
Company -- Vogtle Project), VRDN, 2nd Series, 3.65% due 4/01/2025 (h) 2,500
AA+ Aa2 3,875 Georgia State Housing & Finance Authority, S/F Mortgage Revenue Bonds,
Sub-Series A-1, 6.125% due 12/01/2015 4,086
Illinois -- 5.2% NR* NR* 980 Beardstown, Illinois, IDR (Jefferson Smurfit Corp. Project), 8% due 10/01/2016 1,114
AAA Aaa 1,630 Illinois Development Finance Authority, PCR, Refunding (Commerce Edison
Company Project), Series D, 6.75% due 3/01/2015 (c) 1,823
AA- Aa3 3,285 Illinois Development Finance Authority Revenue Bonds (Presbyterian Home Lake),
Series B, 6.30% due 9/01/2022 3,528
NR* Baa1 1,250 Illinois Health Facilities Authority Revenue Bonds (Holy Cross Hospital Project),
6.70% due 3/01/2014 1,331
Indiana -- 2.1% NR* NR* 1,500 Indiana Health Facilities Financing Authority Revenue Bonds (Hartsfield
Village Project), Series A, 6.375% due 8/15/2027 1,509
AAA Aaa 1,500 Tippecanoe County, Indiana, School Building Corp. (First Mortgage), 6% due
7/15/2013 (a) 1,583
Louisiana -- 2.8% BB NR* 4,000 Port New Orleans, Louisiana, IDR, Refunding (Continental Grain Co. Project),
6.50% due 1/01/2017 4,232
Maryland -- 2.2% NR* NR* 2,000 Maryland State Energy Financing Administration, Limited Obligation Revenue Bonds
(Cogeneration -- AES Warrior Run), AMT, 7.40% due 9/01/2019 2,195
A- NR* 1,000 Maryland State Energy Financing Administration, Solid Waste Disposal Revenue
Bonds (Wheelabrator Water Projects), AMT, 6.30% due 12/01/2010 1,084
Massachusetts -- A- NR* 5,000 Massachusetts State Health and Educational Facilities Authority, Revenue
3.5% Refunding Bonds (Melrose Wakefield Hospital), Series B, 6.25% due 7/01/2012 5,266
Michigan -- 2.7% Michigan State Hospital Finance Authority Revenue Bonds:
AAA Aaa 3,100 INFLOS (Sisters of Mercy), 8.767% due 2/15/2022 (d)(e) 3,522
A A2 500 Refunding (Detroit Medical Center Obligated Group), Series A, 6.50% due 8/15/2018 539
Missouri -- 1.6% AAA NR* 2,175 Missouri State Housing Development Commission Mortgage Revenue Bonds,
Series C-1, 6.55% due 9/01/2028 (f)(g) 2,376
Montana -- 2.1% AA Aa2 3,000 Montana State Board of Housing, S/F Mortgage Refunding Bonds, Series A-1,
5.95% due 12/01/2027 3,094
Nevada -- 1.1% NR* NR* 1,530 Reno-Sparks Convention and Vistors Authority, Nevada, Limited Obligation
Revenue Refunding Bonds, 6.40% due 11/01/2003 1,616
New Jersey -- AAA Aaa 3,985 New Jersey Environmental Infrastructure Trust (Wastewater Treatment),
8.5% 5% due 9/01/2017 3,906
New Jersey Health Care Facilities Financing Authority, Revenue Refunding Bonds:
BBB Baa2 2,500 (Englewood Hospital & Medical Center), 6.75% due 7/01/2024 2,719
AAA Aaa 4,950 (Kennedy), Series A, 5.125% due 7/01/2027 (a) 4,785
BBB Baa2 1,200 (Saint Elizabeth Hospital Obligation Group), 6% due 7/01/2014 1,239
New Mexico -- A1+ P1 600 Farmington, New Mexico, PCR, Refunding (Arizona Public Service Co.),
5.6% VRDN, Series B, 3.70% due 9/01/2024 (h) 600
Farmington, New Mexico, PCR, Refunding (Public Service Company --
San Juan Project):
BB+ Ba1 3,000 Series A, 6.30% due 12/01/2016 3,172
BB+ Ba1 2,000 Series D, 6.375% due 4/01/2022 2,124
AAA NR* 2,500 New Mexico Mortgage Finance Authority, S/F Mortgage Revenue Bonds, AMT,
Series E-2, 5.75% due 7/01/2029 (f)(g) 2,508
New York -- 6.9% AAA Aaa 6,000 New York City, New York, Municipal Water Finance Authority, Water and Sewer
System Revenue Bonds, Series B, 5.875% due 6/15/2026 (d) 6,239
BBB+ Baa1 1,000 New York City, New York, Refunding, GO, UT, Series F, 6% due 8/01/2013 1,043
BBB+ Baa1 1,000 New York State Thruway Authority, Service Contract Revenue Bonds (Local
Highway and Bridge), 5.75% due 4/01/2016 1,028
NR* A3 2,000 United Nations Development Corporation of New York, Revenue Refunding Bonds,
Series C, 5.50% due 7/01/2017 2,001
North Carolina -- A+ A1 1,100 North Carolina Medical Care Commission, Hospital Revenue Bonds
2.2% (Rex Hospital Project), 6.25% due 6/01/2017 1,175
AA Aa2 1,970 North Carolina S/F, HFA, Series II, 6.20% due 3/01/2016 2,082
Ohio -- 3.3% BBB NR* 1,750 Dayton, Ohio, Special Facilities Revenue Refunding Bonds (Emery Air
Freight Corp. -- Emery Worldwide Air Inc.), Series F, 6.05% due 10/01/2009 1,858
NR* NR* 1,400 Ohio State Higher Educational Facility Commission Revenue Bonds
(University of Findlay Project), 6.125% due 9/01/2016 1,446
AAA Aaa 1,500 Ohio State Water Development Authority, Pollution Control Facilities
Revenue Refunding Bonds (Pennsylvania Power Co. Project), 6.15% due
8/01/2023 (c) 1,606
Oklahoma -- 1.2% AAA Baa 1,650 Holdenville, Oklahoma, Industrial Authority, Correctional Facility Revenue
Bonds, 6.60% due 7/01/2010 (j) 1,843
Oregon -- 2.5% AAA Aaa 2,000 Multnomah County, Oregon, Educational Facilities Revenue Refunding
Bonds (University of Portland Project), 5% due 4/01/2018 (c) 1,930
NR* Aa2 1,630 Oregon State Housing and Community Services Department, S/F Mortgage
Program Revenue Bonds, AMT, Series E, 7.10% due 7/01/2014 1,736
Pennsylvania -- AAA Aaa 2,000 Hampton Township, Pennsylvania, School District, UT, 5% due 9/01/2027 (b) 1,908
4.8% AAA Aaa 2,950 Keystone Oaks, Pennsylvania, School District, IRS, UT, Series D,
7.521% due 9/01/2016 (c)(e) 3,145
NR* NR* 2,000 Pennsylvania Economic Development Financing Authority, Resource
Recovery Revenue Bonds (Northampton Generating), AMT, Series A,
6.50% due 1/01/2013 2,073
South Carolina -- AAA Aaa 2,000 Fairfield County, South Carolina, PCR (South Carolina Gas and Electric Co.),
1.5% 6.50% due 9/01/2014 (a) 2,200
Tennessee -- NR* NR* 1,610 Hardeman County, Tennessee, Correctional Facilities Revenue Bonds
1.2% (Correctional Facilities Corp.), 7.75% due 8/01/2017 1,792
Texas -- 12.6% Harris County, Texas, Health Facilities Development Corporation, Hospital
Revenue Bonds:
A- A2 3,250 (Memorial Hospital Systems Project), Series A, 6.625% due 6/01/2004 (i) 3,686
A1+ NR* 2,000 (Methodist Hospital), VRDN, 4% due 12/01/2025 (h) 2,000
A1+ NR* 2,700 Refunding (Methodist Hospital), VRDN, 3.70% due 12/01/2026 (h) 2,700
BB Ba2 1,000 Houston, Texas, Airport System Revenue Bonds, Special Facilities
(Continental Airline Terminal Improvement), AMT, Series B, 6.125% due 7/15/2027 1,030
AAA Aaa 6,500 Tarrant County, Texas, Health Facilities Development Corp., Health System
Revenue Bonds (Texas Health Resources), Series A, 5% due 2/15/2026 (a) 6,116
AAA Aaa 3,250 Texas State Department, Housing and Community Affairs, S/F Mortgage Revenue
Teams, Series A, Class 3, AMT, 5.80% due 9/01/2029 (a) 3,275
Utah -- 0.7% NR* NR* 1,000 Tooele County, Utah, PCR, Refunding (Laidlaw Environmental),
AMT, Series A, 7.55% due 7/01/2027 1,095
Virginia AAA NR* 1,160 Newport News, Virginia, Redevelopment and Housing Authority, Revenue
0.8% Refunding Bonds, Series A, 5.85% due 12/20/2030 (g) 1,192
------------
Total Investments (Cost -- $152,688) -- 106.1% 158,641
Liabilities in Excess of Other Assets -- (6.1%) (9,178)
------------
Net Assets -- 100.0% $149,463
============
(a) MBIA Insured.
(b) FGIC Insured.
(c) AMBAC Insured.
(d) FSA Insured.
(e) The interest rate is subject to change periodically and inversely based upon prevailing market rates. The
interest rate shown is the rate in effect at October 31, 1997.
(f) FNMA Collateralized.
(g) GNMA Collateralized.
(h) The interest rate is subject to change periodically based upon prevailing market rates. The interest rate
shown is the rate in effect at October 31, 1997.
(i) Prerefunded.
(j) Insured by Connie Lee.
* Not Rated.
+ Highest short-term rating by Moody's Investors Service, Inc.
Ratings of issues shown have not been audited by Deloitte and Touche LLP.
PORTFOLIO ABBREVIATIONS
To simplify the listings of Merrill Lynch Municipal Strategy Fund, Inc.'s portfolio holdings in
the Schedule of Investments, we have abbreviated the names of many of the securities according
to the list below and at right.
AMT Alternative Minimum Tax (subject to)
DATES Daily Adjustable Tax-Exempt Securities
GO General Obligation Bonds
HFA Housing Finance Agency
IDA Industrial Development Authority
IDR Industrial Development Revenue Bonds
INFLOS Inverse Floating Rate Municipal Bonds
IRS Inverse Rate Securities
RITR Residual Interest Trust Receipts
PCR Pollution Control Revenue Bonds
S/F Single-Family
UT Unlimited Tax
VRDN Variable Rate Demand Notes
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENT OF ASSETS, LIABILITIES AND CAPITAL
As of October 31, 1997
<S> <C> <C> <C>
Assets: Investments, at value (identified cost -- $152,688,471) (Note 1a) $158,641,205
Cash 361,988
Receivables:
Securities sold $7,357,733
Interest 2,358,403
Capital shares sold 49,996 9,766,132
-------------
Deferred organization expenses (Note 1e) 186,914
Prepaid expenses and other assets (Note 1e) 56,491
-------------
Total assets 169,012,730
-------------
Liabilities: Payables:
Securities purchased 19,193,580
Dividends to shareholders (Note 1f) 144,015
Investment advisory fees (Note 2) 40,142
Administration fees (Note 2) 33,452 19,411,189
-------------
Accrued expenses and other liabilities 138,722
-------------
Total liabilities 19,549,911
-------------
Net Assets: Net assets $149,462,819
=============
Capital: Capital Stock (200,000,000 shares authorized) (Note 4):
Preferred Stock, par value $.10 per share (2,480 shares of AMPS* issued and
1,920 shares outstanding at $25,000 per share liquidation preference) $48,000,000
Common Stock, par value $.10 per share (9,333,017 shares issued and
outstanding) $933,302
Paid-in capital in excess of par 92,775,533
Undistributed investment income -- net 19,200
Undistributed realized capital gains on investments -- net 1,782,050
Unrealized appreciation on investments -- net 5,952,734
-------------
Total -- Equivalent to $10.87 net asset value per share of Common Stock 101,462,819
-------------
Total capital $149,462,819
=============
* Auction Market Preferred Stock.
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENT OF OPERATIONS
For the Year Ended October 31, 1997
<S> <C> <C> <C>
Investment Interest and amortization of premium and discount earned $7,862,361
Income (Note 1d):
Expenses: Investment advisory fees (Note 2) $657,929
Administrative fees (Note 2) 328,965
Transfer agent fees 113,071
Commission fees 100,805
Registration fees 90,198
Printing and shareholder reports 73,334
Professional fees 63,810
Amortization of organization expenses (Note 1e) 62,134
Accounting services (Note 2) 61,452
Listing fees 48,341
Directors' fees and expenses 24,596
Custodian fees 14,655
Pricing fees 8,513
Other 41,080
------------
Total expenses before reimbursement 1,688,883
Reimbursement of expenses (Note 2) (424,822)
------------
Total expenses after reimbursement 1,264,061
------------
Investment income -- net 6,598,300
------------
Realized & Realized gain on investments -- net 2,242,563
Unrealized Change in unrealized appreciation on investments -- net 4,017,788
Gain on ------------
Investments -- Net Net Increase in Net Assets Resulting from Operations $12,858,651
(Notes 1b, 1d & 3): ============
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENTS OF CHANGES IN NET ASSETS
For the For the Period
Year Ended Nov. 3, 1995+
Increase (Decrease) in Net Assets: Oct. 31, 1997 To Oct. 31, 1996
<S> <C> <C> <C>
Operations: Investment income -- net $6,598,300 $4,841,127
Realized gain (loss) on investments -- net 2,242,563 (460,513)
Change in unrealized appreciation on investments -- net 4,017,788 1,934,946
------------ ------------
Net increase in net assets resulting from operations 12,858,651 6,315,560
------------ ------------
Dividends to Investment income -- net:
Shareholders Common Stock (5,164,727) (4,173,956)
(Note 1f): Preferred Stock (1,418,941) (662,603)
------------ ------------
Net decrease in net assets resulting from dividends to shareholders (6,583,668) (4,836,559)
------------ ------------
Capital Stock Proceeds from issuance of Preferred Stock 10,000,000 38,000,000
Transactions Net increase in net assets derived from Common Stock transactions 11,614,959 82,293,876
(Notes 1e & 4): Offering costs resulting from the issuance of Preferred Stock -- (300,000)
------------ ------------
Net increase in net assets derived from capital stock transactions 21,614,959 119,993,876
------------ ------------
Net Assets: Total increase in net assets 27,889,942 121,472,877
Beginning of period 121,572,877 100,000
------------ ------------
End of period* $149,462,819 $121,572,877
------------ ------------
* Undistributed investment income -- net $19,200 $4,568
============ ============
+ Commencement of operations.
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
FINANCIAL HIGHLIGHTS
The Following Per Share Data and Ratios Have Been Derived
from Information Provided in the Financial Statements. For the For the Period
Year Ended Nov. 3, 1995+
Increase (Decrease) in Net Asset Value: Oct. 31, 1997 To Oct. 31, 1996
<S> <C> <C> <C>
Per Share Net asset value, beginning of period $10.17 $10.00
Operating -------- --------
Performance: Investment income -- net .75 .68
Realized and unrealized gain on investments -- net .70 .21
-------- --------
Total from investment operations 1.45 .89
-------- --------
Less dividends to Common Stock shareholders:
Investment income -- net (.59) (.59)
-------- --------
Effect of Preferred Stock activity:++
Dividends to Preferred Stock shareholders:
Investment income -- net (.16) (.09)
Capital charge resulting from issuance of Preferred Stock -- (.04)
-------- --------
Total effect of Preferred Stock activity (.16) (.13)
-------- --------
Net asset value, end of period $10.87 $10.17
======== ========
Total Investment Based on net asset value per share 13.08% 7.81%++++
Return:** ======== ========
Ratios to Expenses, net of reimbursement .96% .53%*
Average Net ======== ========
Assets:*** Expenses 1.28% 1.26%*
======== ========
Investment income -- net 5.01% 5.40%*
======== ========
Supplemental Net assets, net of Preferred Stock, end of period (in thousands) $101,463 $83,573
Data: ======== ========
Preferred Stock outstanding, end of period (in thousands) $48,000 $38,000
======== ========
Portfolio turnover 144.34% 234.41%
======== ========
Leverage: Asset coverage per $1,000 $3,114 $3,199
======== ========
Dividends Per Share Investment income -- net $897 $564
on Preferred Stock ======== ========
Outstanding:
* Annualized.
** Total investment returns exclude the effects of the contingent deferred sales charge, if any.
The Fund is a continously offered, closed-end fund, the shares of which are offered at net asset
value. Therefore, no separate market exists.
*** Do not reflect the effect of dividends to Preferred Stock shareholders.
+ Commencement of operations.
++ The Fund's Preferred Stock was initially issued on March 11, 1996.
++++ Aggregate total investment return.
See Notes to Financial Statements.
</TABLE>
Merrill Lynch Municipal Strategy Fund, Inc., October 31, 1997
NOTES TO FINANCIAL STATEMENTS
1. Significant Accounting Policies:
Merrill Lynch Municipal Strategy Fund, Inc. (the "Fund") is registered
under the Investment Company Act of 1940 as a continuously offered, non-
diversified, closed-end management investment company. The following is a
summary of significant accounting policies followed by the Fund.
(a) Valuation of investments -- Municipal bonds and other portfolio
securities in which the Fund invests are traded primarily in the over-the-
counter markets and are valued at the last available bid price in the
over-the-counter market or on the basis of yield equivalents as obtained
from one or more dealers that make markets in the securities. Financial
futures contracts and options thereon, which are traded on exchanges, are
valued at their settlement prices as of the close of such exchanges.
Options, which are traded on exchanges, are valued at their last sale
price as of the close of such exchanges or, lacking any sales, at the last
available bid price. Short-term investments with remaining maturities of
sixty days or less are valued at amortized cost, which approximates market
value. Securities and assets for which market quotations are not readily
available are valued at fair value as determined in good faith by or under
the direction of the Board of Directors of the Fund, including valuations
furnished by a pricing service retained by the Fund, which may utilize a
matrix system for valuations. The procedures of the pricing service and
its valuations are reviewed by the officers of the Fund under the general
supervision of the Board of Directors.
(b) Derivative financial instruments -- The Fund may engage in various
portfolio strategies to seek to increase its return by hedging its
portfolio against adverse movements in the debt markets. Losses may arise
due to changes in the value of the contract or if the counterparty does
not perform under the contract.
[bullet] Financial futures contracts -- The Fund may purchase or sell
interest rate futures contracts and options on such futures contracts for
the purpose of hedging the market risk on existing securities or the
intended purchase of securities. Futures contracts are contracts for
delayed delivery of securities at a specific future date and at a specific
price or yield. Upon entering into a contract, the Fund deposits and
maintains as collateral such initial margin as required by the exchange on
which the transaction is effected. Pursuant to the contract, the Fund
agrees to receive from or pay to the broker an amount of cash equal to the
daily fluctuation in value of the contract. Such receipts or payments are
known as variation margin and are recorded by the Fund as unrealized gains
or losses. When the contract is closed, the Fund records a realized gain
or loss equal to the difference between the value of the contract at the
time it was opened and the value at the time it was closed.
[bullet] Options -- The Fund is authorized to write covered call options
and purchase put options. When the Fund writes an option, an amount equal
to the premium received by the Fund is reflected as an asset and an
equivalent liability. The amount of the liability is subsequently marked
to market to reflect the current market value of the option written.
When a security is purchased or sold through an exercise of an option,
the related premium paid (or received) is added to (or deducted from) the
basis of the security acquired or deducted from (or added to) the proceeds
of the security sold. When an option expires (or the Fund enters into a
closing transaction), the Fund realizes a gain or loss on the option to
the extent of the premiums received or paid (or gain or loss to the extent
the cost of the closing transaction exceeds the premium paid or received).
Written and purchased options are non-income producing investments.
(c) Income taxes -- It is the Fund's policy to comply with the
requirements of the Internal Revenue Code applicable to regulated
investment companies and to distribute substantially all of its taxable
income to its shareholders. Therefore, no Federal income tax provision is
required.
(d) Security transactions and investment income -- Security transactions
are recorded on the dates the transactions are entered into (the trade
dates). Interest income is recognized on the accrual basis. Discounts and
market premiums are amortized into interest income. Realized gains and
losses on security transactions are determined on the identified cost
basis.
(e) Deferred organization and offering expenses -- Deferred organization
expenses are amortized on a straight-line basis over a five-year period.
Direct expenses relating to the public offering of the Common and
Preferred Stock were charged to capital at the time of issuance. Prepaid
registration fees are charged to expense as the related shares are issued.
(f) Dividends and distributions -- Dividends from net investment income
are declared daily and paid monthly. Distributions of capital gains are
recorded on the ex-dividend dates.
2. Investment Advisory Agreement and Transactions with Affiliates:
The Fund has entered into an Investment Advisory Agreement with Fund
Asset Management, L.P. ("FAM"). The general partner of FAM is Princeton
Services, Inc. ("PSI"), an indirect wholly-owned subsidiary of Merrill
Lynch & Co., Inc. ("ML & Co."), which is the limited partner.
FAM is responsible for the management of the Fund's portfolio and
provides the necessary personnel, facilities, equipment and certain other
services necessary to the operations of the Fund. For such services, the
Fund pays a monthly fee at an annual rate of 0.50% of the Fund's average
daily net assets. For the year ended October 31, 1997, FAM earned fees of
$657,929, of which $424,822 was voluntarily waived.
The Fund also has entered into an Administrative Services Agreement with
FAM whereby FAM will receive a fee equal to an annual rate of 0.25% of the
Fund's average daily net assets, in return for the performance of
administrative services (other than investment advice and related porfolio
activities) necessary for the operation of the Fund.
A contingent deferred sales charge will be imposed on most shares
accepted for tender which have been held for less than three years. For
the year ended October 31, 1997, Merrill Lynch Funds Distributors, Inc.
("MLFD") earned contingent deferred sales charges of $85,662 relating to
the tender of the Fund's shares.
Merrill Lynch Financial Data Services, Inc. ("MLFDS"), a wholly-owned
subsidiary of ML & Co., is the Fund's transfer agent.
Accounting services are provided to the Fund by FAM at cost.
Certain officers and/or directors of the Fund are officers and/or
directors of FAM, PSI, MLFDS, MLFD, and/or ML & Co.
3. Investments:
Purchases and sales of investments, excluding short-term securities, for
the year ended October 31, 1997 were $207,179,298 and $185,239,565,
respectively.
Net realized and unrealized gains (losses) as of October 31, 1997 were as
follows:
Realized Unrealized
Gains (Losses) Gains
Long-term investments $2,544,513 $5,952,734
Financial futures contracts (301,950) --
------------ -----------
Total $2,242,563 $5,952,734
============ ===========
As of October 31, 1997, net unrealized appreciation for Federal income tax
purposes aggregated $5,935,894, of which $5,937,994 related to appreciated
securities and $2,100 related to depreciated securities. The aggregate
cost of investments at October 31, 1997, for Federal income tax purposes
was $152,705,311.
4. Capital Stock Transactions:
The Fund is authorized to issue 200,000,000 shares of capital stock,
including Preferred Stock, par value $.10 per share, all of which were
initially classified as Common Stock. The Board of Directors is
authorized, however, to reclassify any unissued shares of capital stock
without approval of the holders of Common Stock.
Transactions in Common Stock were as follows:
For the Year Ended Dollar
October 31, 1997 Shares Amount
Shares sold 1,457,495 $15,202,668
Shares issued to shareholders
in reinvestment of dividends 128,620 1,344,046
------------ ------------
Total issued 1,586,115 16,546,714
Shares tendered (471,994) (4,931,755)
------------ ------------
Net increase 1,114,121 $11,614,959
============ ============
For the Period
November 3, 1995+ to Dollar
October 31, 1996 Shares Amount
Shares sold 8,321,280 $83,406,334
Shares issued to shareholders
in reinvestment of dividends 87,288 867,654
------------ ------------
Total issued 8,408,568 84,273,988
Shares tendered (199,672) (1,980,112)
------------ ------------
Net increase 8,208,896 $82,293,876
============ =============
+ Prior to November 3, 1995 (commencement of operations), the Fund issued
10,000 shares to FAM for $100,000.
Preferred Stock
Auction Market Preferred Stock ("AMPS") are shares of Preferred Stock of
the Fund that entitle their holders to receive cash dividends at an annual
rate that may vary for the successive dividend periods. The yield in
effect at October 31, 1997 was 3.65%.
In connection with the offering of AMPS, the Board of Directors
reclassified 40,000 shares of unissued capital stock as AMPS. For the year
ended October 31, 1997 and the period ended November 3, 1995 to October
31, 1996, 400 shares and 1,520 shares of Preferred Stock were sold,
respectively. As of October 31, 1997, there were 2,480 AMPS issued and
1,920 shares outstanding with a liquidation preference of $25,000 per
share.
The Fund pays commissions to certain broker dealers at the end of each
auction at an annual rate ranging from 0.25% to 1.00%, calculated on the
proceeds of each auction. For the year ended October 31, 1997, Merrill
Lynch, Pierce, Fenner & Smith Inc., an affiliate of FAM, earned $100,708
as commissions.
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders,
Merrill Lynch Municipal Strategy Fund, Inc.:
We have audited the accompanying statement of assets, liabilities and
capital, including the schedule of investments, of Merrill Lynch Municipal
Strategy Fund, Inc. as of October 31, 1997, the related statements of
operations for the year then ended and changes in net assets, and the
financial highlights for the year then ended and the period November 3,
1995 (commencement of operations) to October 31, 1996. These financial
statements and the financial highlights are the responsibility of the
Fund's management. Our responsibility is to express an opinion on these
financial statements and the financial highlights based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements and the
financial highlights are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included
confirmation of securities owned at October 31, 1997 by correspondence
with the custodian and brokers. An audit also includes assessing the
accounting principles used and significant estimates made by management,
as well as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Merrill Lynch
Municipal Strategy Fund, Inc. as of October 31, 1997, the results of its
operations, the changes in its net assets and the financial highlights for
the respective stated periods in conformity with generally accepted
accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
December 10, 1997
IMPORTANT TAX INFORMATION (UNAUDITED)
All of the net investment income distributions paid by Merrill Lynch
Municipal Strategy Fund, Inc. during its taxable year ended October 31,
1997 qualify as tax-exempt interest dividends for Federal income tax
purposes. Additionally, there were no capital gains distributed by the
Fund during the year.
Please retain this information for your records.
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
Robert A. DiMella, Vice President
Kenneth A. Jacob, Vice President
John M. Loffredo, Vice President
Gerald M. Richard, Treasurer
Patrick D. Sweeney, Secretary
Custodian
The Bank of New York
90 Washington Street
New York, NY 10286
Transfer Agents
Common Stock:
Merrill Lynch Financial Data Services, Inc.
4800 Deer Lake Drive East
Jacksonville, FL 32246-6484
Preferred Stock:
IBJ Schroder Bank & Trust Company
One State Street
New York, NY 10004
