MERRILL LYNCH
MUNICIPAL
STRATEGY
FUND, INC.
FUND LOGO
Quarterly Report
January 31, 1999
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
Robert A. DiMella, Vice President
Kenneth A. Jacob, Vice President
John M. Loffredo, Vice President
Donald C. Burke, Vice President and
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 Whitehall 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 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 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, income 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, 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 these securities.
Merrill Lynch Municipal Strategy Fund, Inc., January 31, 1999
DEAR SHAREHOLDER
For the quarter ended January 31, 1999, the Common Stock of Merrill
Lynch Municipal Strategy Fund, Inc. earned $0.168 per share income
dividends. This represents a net annualized yield of 6.32%, based on
a month-end per share net asset value of $10.69. Over the same
period, the total investment return on the Fund's Common Stock was
+1.61%, based on a change in per share net asset value from $10.96
to $10.69, and assuming reinvestment of $0.349 per share ordinary
income dividends and $0.096 per share capital gains distributions.
For the three-month period ended January 31, 1999, the Fund's
Auction Market Preferred Stock had an average yield of 5.09%, which
included capital gains distributions.
The Municipal Market Environment
During the three months ended January 31, 1999, long-term bond
yields moved significantly lower. US domestic economic growth
remained moderate, with losses in the manufacturing sector offset by
strong growth in service-oriented industries. Industrial commodity
prices recently fell to their lowest level in over a decade. This
suggests that the current positive inflationary environment is
unlikely to be challenged in the near term. During the three-month
period ended January 31, 1999, the yield on the US Treasury 30-year
bond fell just under 15 basis points (0.15%) to 5.09%, and long-term
municipal revenue bond yields declined almost 10 basis points to
5.17%, as measured by the Bond Buyer Revenue Bond Index.
Throughout most of 1998, the municipal bond market's performance was
impeded by a significant increase in new-issue supply. However, in
recent months, the technical position of the tax-exempt market
improved. Over the last 12 months, almost $285 billion in new long-
term tax-exempt bonds was underwritten, an increase of almost 30%
compared to the same period a year ago. As municipal bond yields
declined in recent years, it has taken increasingly lower bond
yields to generate the cost savings necessary to refinance remaining
higher-couponed debt. Consequently, the rate of increases in
municipal bond issuance slowed in recent quarters. During the last
six months, more than $125 billion in new tax-exempt bonds was
issued, an increase of approximately 5% compared to the same period
a year ago. During the January 31, 1999 quarter, $63 billion in new
long-term municipal bonds was underwritten, representing an increase
of 5% compared to the January 31, 1998 quarter.
The pace of tax-exempt issuance continued to slow in 1999. January's
monthly issuance was less than $15 billion, representing a decline
of almost 25% compared to January 1998's volume. Additionally,
investors received more than $22 billion in coupon payments,
maturities and proceeds from early redemptions in January. Investors
can also expect to receive an additional $15 billion--$18 billion
in February for reinvestment. Consequently, investor demand has been
strong in recent months, easily matching, if not at times exceeding,
available supply. We will monitor this trend closely in the coming
months to determine if the supply pressures exerted in 1998 are
abating and fostering a more balanced supply/demand environment for
1999. Such an environment should allow the tax-exempt market's
performance to more closely mirror that of its taxable counterpart.
Foreign investors have rarely been active investors in the tax-
exempt bond market since they are unable to benefit from the
inherent tax advantage of municipal securities. Consequently, the
municipal bond market has not been able to benefit from the strong
"flight to quality" demand enjoyed by US Treasury securities since
late 1997. This inability has in large part resulted in
significantly smaller declines in municipal bond yields compared to
US Treasury securities. However, this has resulted in the
opportunity to purchase tax-exempt securities with yields very close
to or, in some instances, exceeding those of comparable US Treasury
bonds. By January 31, 1999, long-term tax-exempt bond yields were at
102% of US Treasury securities of comparable maturities, nearly
matching the least expensive level of the past year. Municipal bond
yield ratios have averaged approximately 95% for the last six months
and 92% for all of 1998. During 1997, tax-exempt bond yield ratios
averaged 84%. It is likely that the combination of the increase in
new-issue volume and the "safe-haven" status of US Treasury
securities drove municipal bond yield ratios to their present
attractive levels. Should new volume decline and/or foreign
financial markets regain stability in 1999, tax-exempt bond yield
ratios could quickly return to their more historic levels
(85%--88%).
Looking ahead, the expected combination of moderate economic growth
in the United States and continued negligible inflation suggests a
relatively stable interest rate environment into early 1999.
However, it is likely that foreign financial markets will again be a
critical factor in determining US bond yields. Economic problems in
Russia and Brazil remain unresolved, suggesting that additional
shocks to the world's financial system are possible. On the other
hand, the continued robustness of the US economy has led to some
back up in interest rates. However, at present these factors
indicate that there is little immediate risk of sustained
significant increases in long-term bond yields.
Portfolio Strategy
During the quarter ended January 31, 1999, our constructive
investment strategy remained unchanged. We believe economic weakness
in Asia, Russia and, more recently, in Brazil should offset the
current strength of the US economy. More important, the absence of
any material inflationary pressure in the United States and most of
the industrialized world should promote a relatively stable interest
rate environment in the near term. We do expect some interest rate
volatility as international economic crises, such as the recent
currency devaluation in Brazil, are by their nature difficult to
predict. However, we expect these episodes to be brief, allowing
interest rates in the UnitedStates to remain in their current range.
The yield on the Fund's Auction Market Preferred Stock has been
trading between 2.80% and 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 would decline and
the yield to the Common Stock will be reduced. (See page 1 of this
report to shareholders for a complete explanation of the benefits
and risks of leveraging.) Looking ahead, we expect little change in
our strategy or portfolio composition. We will focus on seeking to
preserve the Fund's net asset value while maintaining our current
income stream.
Sincerely,
(Terry K. Glenn)
Terry K. Glenn
Executive Vice 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
March 8, 1999
PORTFOLIO COMPOSITION
For the Quarter Ended January 31, 1999
Top Ten States*
California 13.29%
Florida 8.10
New York 7.81
Ohio 7.44
Connecticut 7.03
Colorado 6.86
Arizona 6.41
New Jersey 4.14
Virginia 3.59
Pennsylvania 3.59
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Total Top Ten 68.26
Total Others 31.74
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Total Portfolio 100.00%
=======
Net assets as of January 31, 1999 were $176,303,998.
Quality Ratings*
(Based on Nationally Recognized Rating Services)
A pie chart illustrating the following percentages:
AAA/Aaa 39%
AA/Aa 10%
A/A 7%
BBB/Baa 14%
BB/Ba 10%
B/B 6%
NR++ 12%
Other++++ 2%
[FN]
*Based on total market value of the portfolio as of January 31,
1999.
++Not Rated.
++++Temporary investments in short-term municipal securities.
