MERRILL LYNCH
MUNICIPAL
STRATEGY
FUND, INC.
FUND LOGO
Quarterly Report
July 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
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 leveraging to
seek to enhance the yield and net asset value of its Common Stock.
However, these objectives cannot be achieved in all interest rate
environments. To leverage, the Fund issues Preferred Stock, which
pays dividends at prevailing short-term interest rates, and invests
the proceeds in long-term municipal bonds. The interest earned on
these investments is paid to Common Stock shareholders in the form
of dividends, and the value of these portfolio holdings is reflected
in the per share net asset value of the Fund's Common Stock.
However, in order to benefit Common Stock shareholders, the yield
curve must be positively sloped; that is, short-term interest rates
must be lower than long-term interest rates. At the same time, a
period of generally declining interest rates will benefit Common
Stock shareholders. If either of these conditions change, then the
risks of leveraging will begin to outweigh the benefits.
To illustrate these concepts, assume a fund's Common Stock
capitalization of $100 million and the issuance of Preferred Stock
for an additional $50 million, creating a total value of $150
million available for investment in long-term municipal bonds. If
prevailing short-term interest rates are approximately 3% and long-
term interest rates are approximately 6%, the yield curve has a
strongly positive slope. The fund pays dividends on the $50 million
of Preferred Stock based on the lower short-term interest rates. At
the same time, the fund's total portfolio of $150 million earns the
income based on long-term interest rates. Of course, increases in
short-term interest rates would reduce (and even eliminate) the
dividends on the Common Stock.
In this case, the dividends paid to Preferred Stock shareholders are
significantly lower than the income earned on the fund's long-term
investments, and therefore the Common Stock shareholders are the
beneficiaries of the incremental yield. However, if short-term
interest rates rise, narrowing the differential between short-term
and long-term interest rates, the incremental yield pick-up on the
Common Stock will be reduced or eliminated completely. At the same
time, the market value on the fund's Common Stock may, as a result,
decline. Furthermore, if long-term interest rates rise, the Common
Stock's net asset value will reflect the full decline in the price
of the portfolio's investments, since the value of the fund's
Preferred Stock does not fluctuate. In addition to the decline in
net asset value, the market value of the fund's Common Stock may
also decline.
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 investment
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.
Merrill Lynch Municipal Strategy Fund, Inc., July 31, 1998
DEAR SHAREHOLDER
For the three months ended July 31, 1998, the Common Stock of
Merrill Lynch Municipal Strategy Fund, Inc. earned $0.139 per share
income dividends. This represents a net annualized yield of 4.97%,
based on a month-end net asset value of $10.90 per share. Over the
same period, the total investment return on the Fund's Common Stock
was +2.79%, based on a change in per share net asset value from
$10.74 to $10.90, and assuming reinvestment of $0.144 per share
income dividends.
For the three-month period ended July 31, 1998, the Fund's Auction
Market Preferred Stock had an average yield of 3.59%, which included
capital gains distributions.
The Municipal Market Environment
During the three months ended July 31, 1998, long-term tax-exempt
revenue bond yields moderately declined. Thus far this year, the
near absence of inflationary pressures continued to support low
interest rates. However, consistently strong domestic economic
growth has caused some investors to fear that the Federal Reserve
Board will be forced eventually to raise short-term interest rates.
Such action would be taken to ensure that the US economy's present
rate of growth would decelerate before any inflationary pressures
could develop.
However, the weakening financial conditions in many Asian countries
subsequently calmed investor fears of Federal Reserve Board
intervention, and fixed-income prices again moved higher. As
measured by the Bond Buyer Revenue Bond Index, long-term uninsured
municipal bond yields fell approximately 15 basis points (0.15%) to
end the July quarter at 5.36%. As in late 1997 and early 1998, US
Treasury bond yields benefited from a "flight to quality" as foreign
investors were drawn to the relative safe haven of US Government
securities. Long-term US Treasury bond yields declined approximately
40 basis points to end the July quarter at 5.71%.
Thus far in 1998, the municipal bond market has experienced
unexpectedly strong supply pressures. These supply pressures have
prevented tax-exempt bond yields from declining as much as US
Treasury bond yields. During the first seven months of 1998, almost
$153 billion in new tax-exempt bonds were underwritten, an increase
of almost 50% compared to the same period a year ago. During the
quarter ended July 31, 1998, municipalities issued over $75 billion
in new securities, an increase of nearly 35% compared to the same
three-month period in 1997. Additionally, corporate issuers have
also viewed current interest rate levels as an opportunity to issue
significant amounts of taxable securities. For the first half of
1998, over $500 billion in investment-grade corporate bonds have
been underwritten, an increase of more than 70% compared to the same
period a year ago. This sizeable corporate bond issuance has tended
to both support generally higher fixed-income yields and reduce the
demand for tax-exempt bonds.
However, the recent pace of new municipal bond issuance is unlikely
to be maintained. Continued increases in bond issuance will require
lower and lower municipal bond yields to generate the economic
savings necessary for additional tax-exempt bond refinancings.
Preliminary estimates for 1998 total municipal bond issuance are in
the $200 billion--$225 billion range. These estimates suggest that
recent supply pressures are likely to abate later in the year.
Recently, municipal bond investors received approximately $30
billion in June and July in coupon payments, bond maturities and
proceeds from early redemptions. The demand generated by these
assets has helped to offset the increase in supply seen thus far
this year.
The continued impact of the Asian financial crisis on the US
domestic economy's future growth remains unclear. Current Asian
economic conditions continue to reflect ongoing weakness. Recent
trade data indicated that reduced US exports to these countries
might have lowered US economic growth by as much as 2% in the first
half of 1998. Since further trade deterioration is possible in the
coming months, we do not believe the Federal Reserve Board will be
willing to raise interest rates, barring a dramatic and unexpected
resurgence of domestic inflation.
These factors suggest that over the near term, interest rates in
general are unlikely to rise by any appreciable amount. Recent
supply pressures have caused municipal bond yield ratios to rise
relative to US Treasury bond yields. At July 31, 1998, long-term tax-
exempt bond yields were at attractive yield ratios relative to US
Treasury securities of comparable maturities (over 90%), well in
excess of their expected range of 85%--88%. Tax-exempt bond yield
ratios rarely exceeded 90% in the 1980s and 1990s. Previous
instances have usually been associated with potential changes in
Federal tax codes that would have adversely affected the tax-favored
status of municipal bonds. The present situation has developed
largely because of a temporary supply imbalance. These imbalances
should soon be corrected as tax-exempt bond issuance slows from its
current rapid pace later this year. Any further pressure on the
municipal market may well represent a very attractive investment
opportunity.
Portfolio Strategy
Our investment strategy remained largely unchanged during the July
quarter. We began the quarter with a constructive outlook on the
interest rate environment because we expected slower economic growth
and had a favorable outlook on inflation. Instability in global
equity markets as well as currency markets started to have a
negative impact on the global economy, including the domestic
manufacturing sector. Looking ahead, we expect to maintain our
constructive strategy. We believe the instability of the global
equity markets will continue to have a negative impact on the US
economy, allowing inflation and interest rates to decline further.
For the three months ended July 31, 1998, the yield on the Fund's
Auction Market Preferred Stock traded between 3.35%--3.80%.
Leverage continues to benefit the Fund's 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
August 28, 1998
PORTFOLIO COMPOSITION
For the Quarter Ended July 31, 1998
Top Ten States*
Florida 10.37%
Ohio 8.99
Colorado 8.69
Illinois 6.42
Arizona 6.04
Massachusetts 5.72
New York 5.59
New Mexico 4.28
Virginia 3.70
Texas 3.62
-------
Total Top Ten 63.42
Total Others 36.58
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Total Portfolio 100.00%
=======
Net assets as of July 31, 1998 were $162,742,913.
Quality Ratings*
(Based on Nationally Recognized Rating Services)
A pie chart illustrating the following percentages:
AAA/Aaa 36%
AA/Aa 12%
A/A 11%
BBB/Baa 13%
BB/Ba 9%
B/B 4%
NR++ 14%
Other++++ 1%
[FN]
*Based on total market value of the portfolio as of July 31, 1998.
++Not Rated.
++++Temporary investments in short-term municipal securities.
