MERRILL LYNCH
MUNICIPAL
STRATEGY
FUND, INC.
FUND LOGO
Quarterly Report
January 31, 1997
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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
Gerald M. Richard, Treasurer
Mark B. Goldfus, Secretary
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) 637-3863
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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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.
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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.
DEAR SHAREHOLDER
For the three months ended January 31, 1997, the Common Stock of
Merrill Lynch Municipal Strategy Fund, Inc. earned $0.151 per share
income dividends. This represents a net annualized yield of 5.74%,
based on a month-end per share net asset value of $10.21. Over the
same period, the total investment return on the Fund's Common Stock
was +1.88%, based on a change in per share net asset value from
$10.17 to $10.21, and assuming reinvestment of $0.158 per share
income dividends.
For the three-month period ended January 31, 1997, the Fund's
Auction Market Preferred Stock had an average yield of 3.45%.
The Municipal Market Environment
Long-term fixed-income bond yields generally rose during the three
months ended January 31, 1997. Initially, US Treasury bond yields
fell approximately 20 basis points (0.20%) to 6.45% by late November
as low employment growth and continued low inflation combined to
support lower bond yields. Concurrently, long-term municipal revenue
bond yields, as measured by the Bond Buyer Revenue Bond Index,
declined almost 15 points to approximately 5.80%. However, signs of
increased economic activity and renewed inflation fears pushed bond
yields up for the remainder of the period. By the end of January, US
Treasury bond yields rose over 35 basis points to end the period at
approximately 6.80%. Similarly, long-term municipal revenue bond
yields rose approximately 20 basis points from their lows in late
November to approximately 6.00%. During the three months ended
January 31, 1997, US Treasury bond yields rose approximately 15
basis points, while tax-exempt bond yields rose only 8 basis points.
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The tax-exempt bond market performed well over the three months
ended January 31, 1997 largely as a result of continued strong
supply position. Approximately $50 billion in new municipal bonds
was issued during the three-month period ended January 31, 1997,
representing a decline of over 5% compared to the same period in
1996. This declining trend in bond issuance was even more apparent
recently. Slightly more than $10 billion in long-term bonds was
issued during January 1997, a decrease of over 15% compared to
January 1996 issuance.
However, a number of other factors prevented the municipal bond
market from enjoying even stronger performance. The historic
strength of the US equity market has attracted significant investor
interest. Additionally, as tax-exempt bond yields declined again
below 6%, some investors temporarily lost interest in the municipal
bond market. If interest rates continue to decline, as they did at
the end of 1994 and throughout 1995, investors, in general, will
quickly adjust to the new levels. The tax advantages generated by
municipal bonds quickly outweigh low nominal yields and investor
demand increases.
The Presidential and Congressional elections this past November
resurrected some investor concerns regarding continued Federal
deficit reduction and potential legislative restrictions upon the
municipal bond market. This situation was similar to that at the
beginning of 1996 when tax-exempt bond yields were negatively
impacted by fears that legislation reducing the tax advantage of
municipal bonds would be introduced to aid further deficit
reductions.
However, the US Treasury bond market's recent relatively strong
performance resulted in tax-exempt products becoming a particularly
attractive investment alternative. At current levels, long-term tax-
exempt revenue bonds yield over 88% of comparable US Treasury bond
yields. Current levels make tax-advantaged products more attractive
than they were in mid-year when yield ratios declined to
approximately 85%. For example, to an investor in the 36% Federal
income tax bracket, a current tax-exempt bond yield of 6% represents
a taxable equivalent yield of approximately 9.37%.
Looking forward, the supply of new bond issuance for 1997 is
expected to be very similar to that of 1996, with most annual
estimates falling in the $170 billion--$175 billion range. Investor
demand is also expected to regain its former strength, with 1997
total municipal redemptions (refundings, maturities and coupon
payments) in the $175 billion--$185 billion range. This overall
balance suggests that the positive technical backdrop the municipal
bond market enjoyed in 1996 could continue in 1997. However, it is
likely that seasonal factors may temporarily distort this overall
balanced technical scenario. During periods of reduced bond
issuance, the ease and ability to purchase tax-advantaged products
at their current attractive levels may be greatly restricted.
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Portfolio Strategy
During the three months ended January 31, 1997, Merrill Lynch
Municipal Strategy Fund, Inc. maintained a neutral posture. The
increased volatility in the bond market caused us to concentrate on
seeking to enhance tax-exempt income while preserving the Fund's net
asset value. The everchanging perception on the economy, and the
need for monetary tightening by the Federal Reserve Board, caused
large swings in interest rates over this time period. Flexibility
enabled us to take advantage of market fluctuations to enhance the
Fund's total return. We began purchasing interest-rate sensitive
bonds in the middle of January in anticipation of a bond market
rally.
The yield on the Fund's Auction Market Preferred Stock averaged
approximately 3.45% during the past three months, continuing to
benefit Common Stock shareholders. However, should the spread
between short-term and long-term interest rates narrow, the benefits
of leverage will diminish and the yield on the Fund's Common Stock
will be reduced. (For a complete explanation of the benefits and
risks of leveraging, see page 1 of this report.)
Looking ahead to the remainder of 1997, we will maintain a
constructive posture until the economy shows signs of accelerating.
We believe the economy will moderate in the first half of 1997 only
to reaccelerate at the end of the year, at which time the Federal
Reserve Board may be forced to raise short-term interest rates in an
effort to control inflation.
Sincerely,
(Arthur Zeikel)
Arthur Zeikel
President
(Vincent R. Giordano)
Vincent R. Giordano
Senior Vice President
(Robert A. DiMella)
Robert A. DiMella
Vice President and Portfolio Manager
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March 6, 1997
PORTFOLIO COMPOSITION
For the Quarter Ended January 31,1997
Top Ten States*
New York 17.62%
Illinois 8.78
Pennsylvania 7.88
Florida 7.28
Michigan 6.25
Colorado 5.23
Massachusetts 4.99
Indiana 4.28
Virginia 4.18
Connecticut 3.98
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Total Top Ten 70.47
Total Others 29.53
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Total Portfolio 100.00%
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Net assets as of January 31, 1997 were $124,801,095.
A pie chart depicting quality ratings of the fund's investments.
Quality Ratings*
(Based on Nationally Recognized Rating Services)
AAA/Aaa 29%
AA/Aa 23%
A/A 8%
BBB/Baa 28%
BB/Ba 4%
NR++ 8%
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[FN]
*Based on total market value of the portfolio as of January 31, 1997.
++Not Rated.
