MERRILL LYNCH
MUNICIPAL
STRATEGY
FUND, INC.
FUND LOGO
Annual Report
October 31, 1998
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 Agent
Common Stock:
Financial Data Services, Inc.
4800 Deer Lake Drive East
Jacksonville, FL 32246-6484
(800) 637-3863
Preferred Stock:
IBJ Schroder Bank & Trust Company
One State Street
New York, NY 10004
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
of 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
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 lever-aging 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 share-holders
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 of 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.
As a part of its investment strategy, the Fund may invest in certain
securities whose potential income return is inversely related to
changes in a floating interest rate ("inverse floaters"). In
general, interest rates on inverse floaters will decrease when short-
term interest rates increase and increase when short-term interest
rates decrease. Investments in inverse floaters may be
characterized as derivative securities and may subject the Fund to
the risks of reduced or eliminated interest payments and losses of
invested principal. In addition, inverse floaters have the effect of
providing investment leverage and, as a result, the market value of
such securities will generally be more volatile than that of fixed-
rate, tax-exempt securities. To the extent the Fund invests in
inverse floaters, therefore, the market value of the Fund's
portfolio and the net asset value of the Fund's shares may also be
more volatile than if the Fund did not invest in such securities.
Merrill Lynch Municipal Strategy Fund, Inc., October 31, 1998
DEAR SHAREHOLDER
For the year ended October 31, 1998, the Common Stock of Merrill
Lynch Municipal Strategy Fund, Inc. earned $0.737 per share income
dividends, which included earned and unpaid dividends of $0.055.
This represents a net annualized yield of 6.72%, based on a month-
end net asset value of $10.96 per share. Over the same period, the
total investment return on the Fund's Common Stock was +8.28%, based
on a change in per share net asset value from $10.87 to $10.96, and
assuming reinvestment of $0.733 per share income dividends and
$0.047 per share capital gains distributions.
For the six months ended October 31, 1998, the total investment
return on the Fund's Common Stock was +4.76%, based on a change in
per share net asset value from $10.74 to $10.96, and assuming
reinvestment of $0.289 per share income dividends.
For the six-month period ended October 31, 1998, the Fund's Auction
Market Preferred Stock had an average yield of 3.71%.
The Municipal Market Environment
During the three months ended October 31, 1998, long-term bond
yields declined significantly. The near absence of any inflationary
pressures in the United States continued to support historic low
interest rates. Additionally, foreign economic factors have
continued to outweigh US domestic fundamentals, as they have for
much of 1998. The economic crisis that began in Asia over a year ago
has spread both to Russia and South America. However, economic
factors in these countries have begun to negatively impact US
growth. For example, employment in the US manufacturing sector
declined in recent months as a result of reduced demand for export
goods. Concern that the modest decline in US economic growth seen
thus far would spread and intensify led the Federal Reserve Board to
lower short-term interest rates in late September, in mid-October
and in mid-November. These actions were taken to offset the drag of
foreign economies on future US growth.
US Treasury bond yields continued to benefit from a strong "flight
to quality" as foreign investors were drawn to the relative safe
haven of US Government securities. Additionally, the sharp equity
market correction, which began at the end of August, triggered a
further flight into US Treasury securities. Long-term US Treasury
bond yields fell by 75 basis points (0.75%) to approximately 5% by
the end of September. This is the lowest level since the US Treasury
reintroduced 30-year maturity bond auctions in 1977.
By early October, worldwide investor confidence began to rise,
reducing the demand for the safety and liquidity of US Treasury
securities. Investor confidence was restored by the belief that
major world governments, as well as the International Monetary Fund,
would take the necessary action to support weak domestic economies
in Asia and Latin America. Additionally, rapid recovery in US and
world equity markets caused some investors to reallocate funds from
US debt instruments back to various world equity markets. US
Treasury security yields rose for the remainder of the month to end
October at 5.15%. During the three-month period ended October 31,
1998, long-term Treasury security yields declined approximately 60
basis points.
During the past 12 months, the tax-exempt bond market has contended
with significant new-issue supply pressures. Over the past year,
more than $277 billion in new long-term tax-exempt bonds were
underwritten, an increase of almost 30% compared to the same period
a year ago. During the most recent six-month period, approximately
$140 billion in new long-term municipal bonds were underwritten,
representing an increase of more than 15% over the same six-month
period last year. This increased supply, coupled with the high
returns the US equity market generated for much of 1998, was one of
the major reasons municipal bond yields declined less than their
taxable counterparts during the period.
The continued increase in new bond issuance has required ever-lower
tax-exempt bond yields to generate the economic savings necessary
for additional municipal bond financings. Consequently, the pace of
new bond issuance has slowed in recent months. In fact, the trend
may be reversing. During the three months ended October 31, 1998,
just over $60 billion in new long-term municipal bonds were
underwritten, a decline of 4% compared to the same quarter a year
ago. During the month of October, there were less than $20 billion
in new municipal bond securities issued, a decline of over 10%
compared to October 1997. We will monitor this trend closely in the
coming months to determine if the supply pressures exerted thus far
in 1998 are abating and fostering a more balanced supply/demand
environment.
Throughout the three-month period ended October 31, 1998, municipal
bond yields followed a pattern that was similar to US Treasury
securities, although the yield declines were more muted. As measured
by the unmanaged Bond Buyer Revenue Bond Index, long-term, uninsured
tax-exempt revenue bond yields declined over 25 basis points to
5.09% by the end of September, their lowest level since the early
1970s. Municipal bond yields rose during October to end the period
at 5.24%. Over the past three months, long-term tax-exempt bond
yields declined almost 10 basis points.
Although municipal bond yields declined during the three-month
period, recent supply pressures and the absence of the safe haven
status enjoyed by US securities caused municipal bond yields to rise
relative to US Treasury bond yields. At October 31, 1998, long-term
tax-exempt bond yield spreads were attractive relative to US
Treasury securities of comparable maturities (over 100%), well in
excess of their historic range of 85%--88%. Tax-exempt bond yield
ratios have rarely exceeded 90% in the 1980s and 1990s.
Historically, yield spreads have been wider than these levels when
there have been potential changes in Federal tax codes that would
have adversely affected the tax-favored status of municipal bonds.
Currently, municipal bond investors find themselves in a unique
investment environment. Previous opportunities to purchase tax-
exempt bonds with yields exceeding that of comparable US Treasury
issues have been limited to relatively brief episodes and then
further limited to a few municipal credits undergoing specific
financial pressures. At present, almost the entire municipal bond
universe, across nearly all maturity and credit sectors, can be
purchased at yields greater than their taxable counterparts.
However, the current opportunity may quickly disappear should tax-
exempt bond supply pressures diminish or the safe-haven status of US
Treasury securities become less desirable. Under these conditions,
municipal bond ratios should quickly revert to more normal historic
percentages, certainly well below their presently attractive levels.
Portfolio Strategy
During the three-month period ended October 31, 1998, we maintained
the Fund's constructive strategy. Equity markets throughout the
world entered a very volatile stage, triggered by the currency
crisis in Asia and followed by turmoil in Russia and Latin America.
We believed a continuation of equity market declines would have a
negative impact on economic growth, further constraining global
inflation and allowing for further declines in long-term interest
rates. This proved to be true as the increase in financial market
volatility caused a flight to quality into US Treasury bonds,
pushing interest rates to historic lows. Our constructive strategy
enabled the Fund to fully participate in the bond market rally and
realize an attractive total return.
We believe that interest rates are likely to continue to trend lower
in the months ahead. Global economic growth appears to be slowing
substantially. Central banks throughout the world, including the US
Federal Reserve Board, are trying to stimulate economic growth by
easing monetary policy. However, these actions are likely to have a
delayed impact. Consequently, our investment outlook will remain
constructive until there are signs that the economy has started
responding to the monetary stimulus.
During the three-month period ended October 31, 1998, the yield on
the Fund's Auction Market Preferred Stock traded between 3.20% and
3.85%. 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 rates narrow, the
benefits of leverage will decline and, as a result, reduce the yield
to 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 thank you for your support of Merrill Lynch Municipal Strategy
Fund, Inc., and we look forward to serving your investment needs in
the months and years ahead.
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
(John M. Loffredo)
John M. Loffredo
Vice President and Portfolio Manager
December 8, 1998
Merrill Lynch Municipal Strategy Fund, Inc.,
October 31, 1998
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)
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
PCR Pollution Control Revenue Bonds
RITR Residual Interest Trust Receipts
S/F Single-Family
UT Unlimited Tax
VRDN Variable Rate Demand Notes
<TABLE>
SCHEDULE OF INVESTMENTS (in Thousands)
<CAPTION>
S&P Moody's Face Value
STATE Ratings Ratings Amount Issue (Note 1a)
<S> <S> <S> <C> <S> <C>
Alabama--1.9% NR* Aaa $ 2,815 Alabama HFA, S/F Home Mortgage Revenue Bonds, Series A-1,
6.60% due 4/01/2019 $ 3,032
Alaska--0.2% A1+ P1 300 Valdez, Alaska, Marine Terminal Revenue Refunding Bonds (Exxon
Pipeline Company Project), VRDN, Series B, 3.30% due 12/01/2033 (j) 300
Arizona--5.1% B B2 2,000 Apache County, Arizona, IDA, PCR, Refunding (Tucson Electric
Power Co. Project), Series A, 5.85% due 3/01/2028 1,992
BB+ Ba1 1,500 Maricopa County, Arizona, Pollution Control Corp., PCR, Refunding
(Public Service Co.), Series A, 5.75% due 11/01/2022 1,528
NR* B1 1,600 Phoenix, Arizona, IDA, Airport Facility Revenue Refunding
Bonds (America West Airlines Inc.), AMT, 6.30% due 4/01/2023 1,659
B B2 2,000 Pima County, Arizona, IDA, Industrial Revenue Bonds (Tucson
Electric Power Co. Project), Series B, 6% due 9/01/2029 2,016
NR* NR* 1,000 Show Low, Arizona, Improvement District No. 5, 6.375% due
1/01/2015 1,068
Arkansas--0.8% AAA NR* 1,155 Arkansas State Development Finance Authority, S/F Mortgage
Revenue Bonds (Mortgage-Backed Securities Program), AMT,
Series D, 6.80% due 1/01/2022 (g)(h) 1,253
California--16.5% AAA Aaa 11,000 Anaheim, California, Public Financing Authority, Lease Revenue
Bonds (Public Improvements Project), Sub-Series C, 5.10%** due
9/01/2031 (d) 2,058
A+ Aa3 2,725 California State Veterans, AMT, Series BH, 5.60% due 12/01/2032 2,808
AAA Aaa 2,895 San Diego, California, Convention Center Expansion Financing
Authority, Leasing Revenue Bonds, Series A, 4.75% due
4/01/2028 (c) 2,784
AAA Aaa 2,000 San Diego, California, IDR, RITR, 8.435% due 9/01/2019 (e) 2,368
AAA Aaa 10,000 San Diego, California, Public Facilities Financing Authority,
Sewer Revenue Bonds, 5% due 5/15/2025 (b) 9,985
AAA Aaa 7,500 San Francisco, California, City and County Airports Commission,
International Airport Revenue Refunding Bonds, Secured
Series--Issue 20, 4.50% due 5/01/2026 (a) 6,975
Colorado--8.5% NR* Aa2 1,835 Colorado HFA, S/F Program, AMT, Series D-1, 7.375% due 6/01/2026 2,008
NR* NR* 1,500 Denver, Colorado, Urban Renewal Authority, Tax Increment
Revenue Bonds (Downtown Denver), AMT, Series A, 7.75% due
9/01/2016 1,679
AAA Aaa 8,840 El Paso County, Colorado, School District No. 49 (Falcon),
UT, 6.50% due 12/01/2015 (a) 10,225
Connecticut--5.1% B+ Ba3 5,000 Conneticut State Developmemt Authority, PCR, Refunding
(Conneticut Light & Power), Series A, 5.85% due 9/01/2028 5,019
A+ NR* 2,000 Connecticut State Development Authority, Water Facility
Revenue Bonds (Bridgeport Hydraulic Co. Project), AMT,
6.15% due 4/01/2035 2,181
BBB- NR* 1,000 Connecticut State Health and Educational Facilities
Authority Revenue Bonds (University of New Haven), Series D,
6.70% due 7/01/2026 1,093
Florida--5.9% AAA Aaa 3,000 Florida State Turnpike Authority, Turnpike Revenue Bonds
(Department of Transportation), Series A, 4.50% due 7/01/2027 (b) 2,786
NR* Baa1 1,000 Jacksonville, Florida, Health Facilities Authority, IDR
(National Benevolent--Cypress Village), Series A, 6.25%
due 12/01/2026 1,073
AAA Aaa 5,550 Miami-Dade County, Florida, Special Obligation, Series B,
5.553%** due 10/01/2028 (a) 1,124
BBB+ Baa2 1,000 Nassau County, Florida, PCR, Refunding (ITT Rayonier Inc.
Project), 6.25% due 6/01/2010 1,053
NR* NR* 1,250 North Springs Improvement District, Florida, Special
Assessment Revenue Bonds (Heron Bay Project), 7% due 5/01/2019 1,320
NR* B1 2,260 Palm Bay, Florida, Lease Revenue Refunding Bonds (Florida
Education and Research Foundation Project), Series A, 6.85%
due 9/01/2013 2,246
Georgia--2.1% AAA Aa2 3,250 Georgia State Housing and Finance Authority, S/F Mortgage
Revenue Bonds, Series A, Sub-Series A-1, 6.125% due 12/01/2015 3,482
Illinois--4.1% NR* NR* 965 Beardstown, Illinois, IDR (Jefferson Smurfit Corp. Project), 8%
due 10/01/2016 1,119
Illinois Development Finance Authority Revenue Bonds, Series B:
AA- Aa3 3,285 (Presbyterian Home Lake), 6.30% due 9/01/2022 3,669
A1+ VMIG1++ 500 (Provena Health), VRDN, 3.70% due 5/01/2028 (a)(j) 500
NR* Baa1 1,250 Illinois Health Facilities Authority Revenue Bonds (Holy Cross
Hospital Project), 6.70% due 3/01/2014 1,364
Louisiana--2.5% B+ NR* 4,000 Port New Orleans, Louisiana, IDR, Refunding (Continental Grain
Co. Project), 6.50% due 1/01/2017 4,106
Maryland--1.9% NR* NR* 3,000 Maryland State Energy Financing Administration, Limited
Obligation Revenue Bonds (Cogeneration--AES Warrior Run),
AMT, 7.40% due 9/01/2019 3,117
Massachusetts AAA Aaa 3,615 Massachusetts State HFA, RITR, Series 29, 7.07% due
- --2.3% 12/01/2028 (a)(e) 3,796
Michigan--3.3% BB- NR* 1,350 Detroit, Michigan, Local Development Finance Authority,
Sub-Tax Increment Bonds Series A, 5.50% due 5/01/2021 1,331
Michigan State Hospital Finance Authority Revenue Bonds:
AAA Aaa 3,100 INFLOS (Sisters of Mercy), 9.02% due 2/15/2022 (d)(e) 3,596
A- A3 500 Refunding (Detroit Medical Center Obligation Group),
Series A, 6.50% due 8/15/2018 547
Mississippi BBB- Ba1 3,000 Mississippi Business Finance Corporation, PCR (System Energy
- --2.7% Resources Inc. Project),
5.875% due 4/01/2022 2,993
NR* NR* 1,400 Mississippi Development Bank, Special Obligation Refunding
Bonds (Diamond Lakes Utilities), Series A, 6.25% due 12/01/2017 1,443
Missouri--1.5% AAA NR* 2,160 Missouri State Housing Development Commission, Mortgage
Revenue Bonds, Series C-1, 6.55% due 9/01/2028 (g)(h) 2,408
Nevada--1.0% NR* NR* 1,530 Reno Sparks Convention and Vistors Authority, Nevada,
Limited Obligation Revenue Refunding Bonds, 6.40% due
11/01/2003 1,647
</TABLE>
Merrill Lynch Municipal Strategy Fund, Inc.,
October 31, 1998
<TABLE>
SCHEDULE OF INVESTMENTS (continued) (in Thousands)
<CAPTION>
S&P Moody's Face Value
STATE Ratings Ratings Amount Issue (Note 1a)
<S> <S> <S> <C> <S> <C>
New Jersey--4.4% AAA Aaa $ 3,300 New Jersey Economic Development Authority, Revenue
Refunding Bonds (Educational Testing Service), 4.75%
due 5/15/2025 (a) $ 3,197
New Jersey Health Care Facilities Financing Authority,
Revenue Refunding Bonds:
BBB Baa2 2,500 (Englewood Hospital & Medical Center), 6.75% due 7/01/2024 2,757
BBB Baa2 1,200 (Saint Elizabeth Hospital Obligation Group), 6% due 7/01/2014 1,277
New Mexico--2.6% Farmington, New Mexico, PCR, Refunding (Public Service
Company--San Juan Project):
BB+ Ba1 3,000 Series A, 6.30% due 12/01/2016 3,204
BB+ Ba1 1,000 Series D, 6.375% due 4/01/2022 1,084
New York--6.8% AAA Aaa 3,000 New York City, New York, Municipal Water Finance Authority,
Water and Sewer System Revenue Bonds, RITR, Series 11,
8.02% due 6/15/2026 (d)(e) 3,510
A- A3 1,000 New York City, New York, Refunding, GO, UT, Series F, 6%
due 8/01/2013 1,097
AAA Aaa 5,000 Port Authority of New York and New Jersey, Consolidated
Revenue Bonds, 116th Series, 4.25% due 10/01/2026 (b) 4,453
NR* A3 2,000 United Nations Development Corporation of New York, Revenue
Refunding Bonds, Series C, 5.50% due 7/01/2017 2,018
North AA Aa3 4,345 North Carolina Medical Care Community, Health Care Facilities
Carolina--3.9% Revenue Bonds (Duke University Health System), Series B,
5% due 6/01/2028 4,240
AA Aa2 1,940 North Carolina S/F, HFA, Series II, 6.20% due 3/01/2016 2,088
Ohio--5.8% BBB NR* 4,875 Dayton, Ohio, Special Facilities Revenue Refunding Bonds
(Emery Air Freight), Series A, 5.625% due 2/01/2018 4,941
AAA Aaa 3,000 Ohio HFA, Mortgage Revenue Bonds, RITR, AMT, Series 15, 6.82%
due 9/01/2019 (d)(e)(h) 3,102
NR* NR* 1,400 Ohio State Higher Educational Facility Commission Revenue
Bonds (University of Findlay Project), 6.125% due 9/01/2016 1,469
Oklahoma--1.2% AAA Baa 1,650 Holdenville, Oklahoma, Industrial Authority, Correctional
Facility Revenue Bonds, 6.60% due 7/01/2006 (f)(i) 1,950
Oregon--1.1% NR* Aa2 1,615 Oregon State Housing and Community Services Department, S/F
Mortgage Program Revenue Bonds, AMT, Series E, 7.10% due
7/01/2014 1,734
Pennsylvania AAA Aaa 2,950 Keystone Oaks, Pennsylvania, School District, IRS, UT,
- --2.7% Series D, 7.876% due 9/04/2002 (c)(e)(i) 3,474
NR* NR* 1,000 Lehigh County, Pennsylvania, General Purpose Authority,
Revenue Refunding Bonds (Kidspeace Obligation Group), 6%
due 11/01/2023 1,001
South AAA Aaa 1,000 Fairfield County, South Carolina, PCR (South Carolina Gas
Carolina--0.7% & Electric Co.), 6.50% due 9/01/2014 (a) 1,108
Tennessee--1.1% NR* NR* 1,610 Hardeman County, Tennessee, Correctional Facilities Revenue
Bonds (Correctional Facilities Corp.), 7.75% due 8/01/2017 1,815
Texas--0.6% 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 1,029
Utah--0.7% NR* NR* 1,000 Tooele County, Utah, PCR, Refunding (Laidlaw Environmental),
AMT, Series A, 7.55% due 7/01/2027 1,110
Virginia--3.7% NR* NR* 1,500 Dulles Town Center Community Development Authority, Virginia,
Special Assessment Tax Bonds (Dulles Town Center Project),
6.25% due 3/01/2026 1,540
AAA NR* 1,910 Newport News, Virginia, Redevelopment and Housing Authority,
Revenue Refunding Bonds, Series A, 5.85% due 12/20/2030 (h) 2,005
Pocahontas Parkway Association, Virginia, Connector Toll
Road Revenue Bonds (Route 895):
NR* Ba1 6,200 (First Tier), Sub-Series C, 6.25%** due 8/15/2031 825
BBB- Baa3 10,000 Senior-Series B, 5.90%** due 8/15/2029 1,686
Wyoming--0.9% NR* P1 1,500 Uinta County, Wyoming, PCR, Refunding (Chevron USA Inc.
Project), VRDN, 3.30% due 8/15/2020 (j) 1,500
Total Investments (Cost--$160,311)--101.6% 165,965
Liabilities in Excess of Other Assets--(1.6%) (2,626)
--------
Net Assets--100.0% $163,339
========
<FN>
(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, 1998.
(f)Connie Lee Insured.
(g)FNMA Collateralized.
(h)GNMA Collateralized.
(i)Prerefunded.
(j)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, 1998.
*Not Rated.
**Represents a zero coupon bond; the interest rate shown is the
effective yield at the time of purchase by the Fund.
++Highest short-term rating by Moody's Investors Service, Inc.
Ratings of issues shown have not been audited by Deloitte and Touche
LLP.
See Notes to Financial Statements.
</TABLE>
Quality
Profile
The quality ratings of securities in the Fund as of October 31, 1998
were as follows:
Percent of
S&P Rating/Moody's Rating Net Assets
AAA/Aaa 49.1%
AA/Aa 10.1
A/A 4.3
BBB/Baa 12.4
BB/Ba 11.7
B/B 3.5
NR (Not Rated) 9.1
Other++ 1.4
[FN]
++Temporary investments in short-term municipal securities.
Merrill Lynch Municipal Strategy Fund, Inc., October 31, 1998
<TABLE>
STATEMENT OF ASSETS, LIABILITIES AND CAPITAL
<CAPTION>
As of October 31, 1998
<S> <S> <C> <C>
Assets: Investments, at value (identified cost--$160,311,294) (Note 1a) $165,965,234
Cash 43,356
Receivables:
Securities sold $ 3,863,900
Interest 2,362,470
Capital shares sold 467,988 6,694,358
------------
Deferred organization expenses (Note 1e) 124,780
Prepaid registration fees and other assets (Note 1e) 7,427
------------
Total assets 172,835,155
------------
Liabilities: Payables:
Securities purchased 9,008,469
Dividends to shareholders (Note 1f) 205,470
Investment advisory fees (Note 2) 57,284
Administration fees (Note 2) 35,803 9,307,026
------------
Accrued expenses and other liabilities 188,973
------------
Total liabilities 9,495,999
------------
Net Assets: Net assets $163,339,156
============
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 (10,523,555 shares
issued and outstanding) $ 1,052,355
Paid-in capital in excess of par 105,809,560
Undistributed realized capital gains on investments--net 2,823,301
Unrealized appreciation on investments--net 5,653,940
------------
Total--Equivalent to $10.96 net asset value per share of
Common Stock 115,339,156
------------
Total capital $163,339,156
============
<FN>
*Auction Market Preferred Stock.
See Notes to Financial Statements.
</TABLE>
<TABLE>
STATEMENT OF OPERATIONS
<CAPTION>
For the Year Ended October 31, 1998
<S> <S> <C> <C>
Investment Interest and amortization of premium and discount earned $ 9,025,997
Income (Note 1d):
Expenses: Investment advisory fees (Note 2) $ 787,978
Administrative fees (Note 2) 393,989
Transfer agent fees 134,859
Registration fees 129,990
Commission fees 121,766
Professional fees 106,678
Printing and shareholder reports 86,940
Accounting services (Note 2) 65,847
Amortization of organization expenses (Note 1e) 62,134
Directors' fees and expenses 28,715
Custodian fees 16,817
Pricing fees 11,771
Listing fees 5,235
Other 13,443
------------
Total expenses before reimbursement 1,966,162
Reimbursement of expenses (Note 2) (204,377)
------------
Total expenses after reimbursement 1,761,785
------------
Investment income--net 7,264,212
------------
Realized & Realized gain on investments--net 3,377,592
Unrealized Change in unrealized appreciation on investments--net (298,794)
(Gain) on ------------
Investments--Net Net Increase in Net Assets Resulting from Operations $ 10,343,010
(Notes 1b, ============
1d & 3):
See Notes to Financial Statements.
</TABLE>
Merrill Lynch Municipal Strategy Fund, Inc.,
October 31, 1998
<TABLE>
STATEMENTS OF CHANGES IN NET ASSETS
<CAPTION>
For the Year Ended
October 31,
Increase (Decrease) in Net Assets: 1998 1997
<S> <S> <C> <C>
Operations: Investment income--net $ 7,264,212 $ 6,598,300
Realized gain on investments--net 3,377,592 2,242,563
Change in unrealized appreciation on investments--net (298,794) 4,017,788
------------ ------------
Net increase in net assets resulting from operations 10,343,010 12,858,651
------------ ------------
Dividends & Investment income--net:
Distributions to Common Stock (5,962,701) (5,164,727)
Shareholders Preferred Stock (1,320,711) (1,418,941)
(Note 1f): Realized gain on investments--net:
Common Stock (1,715,643) --
Preferred Stock (620,698) --
------------ ------------
Net decrease in net assets resulting from dividends and
distributions to shareholders (9,619,753) (6,583,668)
------------ ------------
Capital Stock Proceeds from issuance of Preferred Stock -- 10,000,000
Transactions Net proceeds from issuance of Common Stock 13,153,080 11,614,959
(Note 4): ------------ ------------
Net increase in net assets derived from capital stock
transactions 13,153,080 21,614,959
------------ ------------
Net Assets: Total increase in net assets 13,876,337 27,889,942
Beginning of year 149,462,819 121,572,877
------------ ------------
End of year* $163,339,156 $149,462,819
============ ============
<FN>
*Undistributed investment income--net $ -- $ 19,200
============ ============
See Notes to Financial Statements.
</TABLE>
<TABLE>
FINANCIAL HIGHLIGHTS
<CAPTION>
For the
The following per share data and ratios have Period
been derived from information provided in the November 3,
financial statements. For the Year Ended 1995++ to
October 31, October 31,
Increase (Decrease) in Net Asset Value: 1998 1997 1996
<S> <S> <C> <C> <C>
Per Share Net asset value, beginning of period $ 10.87 $ 10.17 $ 10.00
Operating ------------ ------------ ------------
Performance: Investment income--net .73 .75 .68
Realized and unrealized gain on investments--net .35 .70 .21
------------ ------------ ------------
Total from investment operations 1.08 1.45 .89
------------ ------------ ------------
Less dividends and distributions to Common Stock
shareholders:
Investment income--net (.60) (.59) (.59)
Realized gain on investments--net (.19) -- --
------------ ------------ ------------
Total dividends and distributions to Common Stock
shareholders (.79) (.59) (.59)
------------ ------------ ------------
Effect of Preferred Stock activity:++++
Dividends and distributions to Preferred Stock
shareholders:
Investment income--net (.13) (.16) (.09)
Realized gain on investments--net (.07) -- --
Capital charge resulting from issuance of
Preferred Stock -- -- (.04)
------------ ------------ ------------
Total effect of Preferred Stock activity (.20) (.16) (.13)
------------ ------------ ------------
Net asset value, end of period $ 10.96 $ 10.87 $ 10.17
============ ============ ============
Total Investment Based on net asset value per share 8.28% 13.08% 7.81%+++
Return:** ============ ============ ============
Ratios to Average Expenses, net of reimbursement 1.12% .96% .53%*
Net Assets:*** ============ ============ ============
Expenses 1.25% 1.28% 1.26%*
============ ============ ============
Investment income--net 4.61% 5.01% 5.40%*
============ ============ ============
Supplemental Net assets, net of Preferred Stock, end of
Data: period (in thousands) $ 115,339 $ 101,463 $ 83,573
============ ============ ============
Preferred Stock outstanding, end of period
(in thousands) $ 48,000 $ 48,000 $ 38,000
============ ============ ============
Portfolio turnover 141.53% 144.34% 234.41%
============ ============ ============
Leverage: Asset coverage per $1,000 $ 3,403 $ 3,114 $ 3,199
============ ============ ============
Dividends Investment income--net $ 533 $ 897 $ 564
Per Share on ============ ============ ============
Preferred Stock
Outstanding:
<FN>
*Annualized.
**Total investment returns exclude the effects of the contingent
deferred sales charge, if any. The Fund is a continuously 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, 1998
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 written or purchased are
valued at the last sale price in the case of exchange-traded
options. In the case of options traded in the over-the-counter
market, valuation is the last asked price (options written) or the
last bid price (options purchased). 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.
* Financial futures contracts--The Fund may purchase or sell
financial 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.
* 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 prepaid registration fees--Deferred
organization expenses are amortized on a straight-line basis over a
period not exceeding five years. In accordance with Statement of
Position 98-5, any unamortized organization expenses will be
expensed on the first day of the next fiscal year beginning after
December 15, 1998. This charge will not have any material impact on
the operations of the Fund. 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, including proceeds from the
issuance of Preferred Stock. For year ended October 31, 1998, FAM
earned fees of $787,978, of which $204,377 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 portfolio activities) necessary for the operation of the
Fund.
For the year ended October 31, 1998, Merrill Lynch Funds
Distributors ("MLFD"), a division of Princeton Funds Distributor,
Inc. ("PFD"),earned early withdrawal charges of $146,028 relating to
the tender of the Fund's shares.
Financial Data Services, Inc. ("FDS"), 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, FDS, PFD, and/or ML & Co.
3. Investments:
Purchases and sales of investments, excluding short-term securities,
for the year ended October 31, 1998 were $233,575,979 and
$220,747,936, respectively.
Net realized gains (losses) for the the year ended October 31, 1998
and net unrealized gains as of October 31, 1998 were as follows:
Realized Unrealized
Gains (Losses) Gains
Long-term investments $ 3,557,017 $ 5,653,940
Financial futures contracts (179,425) --
----------- -----------
Total $ 3,377,592 $ 5,653,940
=========== ===========
As of October 31, 1998, net unrealized appreciation for Federal
income tax purposes aggregated $5,637,444, of which $6,392,697
related to appreciated securities and $755,253 related to
depreciated securities. The aggregate cost of investments at October
31, 1998 for Federal income tax purposes was $160,327,790.
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, 1998 Shares Amount
Shares sold 2,294,432 $25,204,676
Shares issued to shareholders in
reinvestment of dividends and
distributions 200,364 2,192,687
------------ -----------
Total issued 2,494,796 27,397,363
Shares tendered (1,304,258) (14,244,283)
------------ -----------
Net increase 1,190,538 $13,153,080
============ ===========
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
============ ===========
Preferred Stock
Auction Market Preferred Stock ("AMPS") are shares of Preferred
Stock of the Fund, with a par value of $.10 per share and a
liquidation preference of $25,000 per share, 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, 1998 was 3.10%.
In connection with the offering of AMPS, the Board of Directors
reclassified 40,000 shares of unissued capital stock as AMPS. AMPS
shares outstanding during the year ended October 31, 1998 remained
constant and during the year ended October 31, 1997 increased by 400
as a result of shares sold.
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, 1998, Merrill Lynch, Pierce, Fenner & Smith Inc., an
affiliate of FAM, earned $120,839 as commissions.
Merrill Lynch Municipal Strategy Fund, Inc.,
October 31, 1998
<AUDIT-REPORT>
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, 1998, the related
statements of operations for the year then ended and changes in net
assets for each of the years in the two-year period then ended, and
the financial highlights for each of the years in the two-year
period 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, 1998 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, 1998,
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, 1998
</AUDIT-REPORT>
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, 1998 qualify as tax-exempt interest dividends for Federal income
tax purposes. Additionally, the following table summarizes the
taxable capital gains distributions paid by the Fund during the
year:
<TABLE>
Payable Short-Term Long-Term
Date Capital Gains Capital Gains
<S> <C> <C> <C>
Common Stock Shareholders 12/31/97 $ .141037 $ .047102*
Preferred Stock Shareholders 11/13/97 $21.13 $ 6.55*
11/20/97 $21.84 $ 6.85*
11/28/97 $23.82 $ 7.54*
12/04/97 $18.31 $ 5.88*
12/11/97 $21.29 $ 6.92*
12/18/97 $19.30 $ 6.40*
12/26/97 $25.96 $ 8.83*
01/02/98 $22.90 $ 8.23*
01/08/98 $ 9.50 $ 4.09*
10/15/98 $15.17 $10.62**
10/22/98 $16.24 $11.45**
10/29/98 $14.62 $10.38**
<FN>
*Of this distribution, 58.08% is subject to the 28% tax rate and
41.92% is subject to the 20% tax rate.
**The entire distribution is subject to the 20% tax rate.
Please retain this information for your records.
</TABLE>
