MERRILL LYNCH
MUNICIPAL
STRATEGY
FUND, INC.
FUND LOGO
Quarterly Report
July 31, 1999
Officers and Directors
Terry K. Glenn, President and Director
Ronald W. Forbes, Director
Cynthia A. Montgomery, Director
Charles C. Reilly, Director
Kevin A. Ryan, Director
Richard R. West, Director
Arthur Zeikel, Director
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
William E. Zitelli, 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 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 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, interest rates on inverse floaters will decrease when short-
term interest rates increase and increase when short-term interest
rates decrease. Invest-ments 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., July 31, 1999
DEAR SHAREHOLDER
For the three months ended July 31, 1999, the Common Stock of
Merrill Lynch Municipal Strategy Fund, Inc. earned $0.137 per share
income dividends. This represents a net annualized yield of 5.53%,
based on a month-end net asset value of $9.90 per share. During the
same period, the total investment return on the Fund's Common Stock
was -4.98%, based on a change in per share net asset value from
$10.56 to $9.90, and assuming reinvestment of $0.136 per share
income dividends.
For the three-month period ended July 31, 1999, the Fund's Auction
Market Preferred Stock had an average yield of 3.16%.
The Municipal Market Environment
During the three months ended July 31, 1999, long-term bond yields
continued to rise. Steady US economic growth combined with
improvement in foreign economies, most notably Japan and Brazil, as
well as an inflation scare in early May put upward pressure on bond
yields throughout the period. Continued strong US employment growth,
particularly the decline in the US unemployment rate to 4.2% in
early June, was among the reasons the Federal Reserve Board cited
for raising short-term interest rates in late June. US Treasury bond
yields reacted by climbing above 6.15% by late June before improving
somewhat to 6.10% by July 31, 1999. During the quarter ended July
31, 1999, yields on long-term US Treasury bonds increased
approximately 45 basis points (0.45%).
Long-term tax-exempt bond yields also rose during the last three
months. Until early May, the municipal bond market had been able to
withstand much of the upward pressure on bond yields. However,
investor concerns regarding ongoing US economic strength and the
fear of additional moves by the Federal Reserve Board eventually
pushed municipal bond yields higher throughout June and July. The
yields on long-term tax-exempt revenue bonds rose more than 35 basis
points to 5.65%, as measured by the Bond Buyer Revenue Bond Index.
The ability of the tax-exempt bond market to withstand much of the
recent upward pressure on long-term fixed-income bond yields has
been a reflection of the continued strong technical position the
municipal bond market has enjoyed in recent quarters. During the
last six months, more than $120 billion in long-term municipal bonds
was underwritten, a decrease of more than 20% compared to the same
period a year ago. During the past three months, more than $60
billion in municipal bonds was underwritten. This quarterly issuance
represents a decline of nearly 25% compared to the same three-month
period in 1998.
Recently, the municipal supply position deteriorated even further.
Total issuance in July 1999 of $16.5 billion was more than 30% lower
than July 1998 levels. Additionally, in June and July, investors
received more than $40 billion in coupon income and proceeds from
bond maturities and early bond redemptions. These proceeds have
generated significant retail investor interest, easily absorbing the
recent diminished supply. This very favorable supply/demand position
allowed the tax-exempt bond market to outperform its taxable
counterpart in recent months.
However, the recent relative outperformance of the municipal bond
market has somewhat reduced the very attractive tax-exempt bond
yield ratios that were available at the end of 1998. In December
1998, long-term, uninsured municipal bond yields were higher than
those of their taxable counterparts. Historically, long-term tax-
exempt bond yields have been approximately 82%--85% of long-term US
Treasury bond yields. Municipal bond yields rose at a lower rate in
recent months than US Treasury bond yields, causing the yield ratio
to decline. At July 31, 1999, long-term municipal bond yields were
approximately 92% of their taxable counterparts. Current ratios,
while lower than those available at the end of 1998, still represent
historically attractive levels. We expect the municipal bond market
to maintain its strong technical position for the remainder of 1999.
Consequently, there appears to be little reason for the tax-exempt
bond market to underperform the taxable US Treasury bond market.
This suggests that the present bond yield ratio is likely to be
stable in the coming months and a return to a ratio in excess of
100% of taxable Treasury securities is improbable.
Looking ahead, it appears to us that long-term municipal bond yields
will trade in a relatively tight range near current levels. Strong
US economic performance is being balanced by nearly negligible
inflation data, as well as improvements in productivity in both
manufacturing and service industries. We believe that future moves
by the Federal Reserve Board have largely been discounted by bond
markets and are to a great extent reflected in present bond yields.
Any improvement in bond prices is likely to be contingent upon
weakening in both US employment growth and consumer spending. The
100 basis point rise in US Treasury bond yields seen thus far this
year is likely to negatively affect US economic growth. The US
housing market will be among the first sectors likely to be
affected, as some declines have already been evidenced because of
higher mortgage rates. We believe it is also unrealistic to expect
double-digit returns in US equity markets to continue indefinitely.
Much of the US consumer's wealth is tied to recent stock market
appreciation. Any slowing in these incredible growth rates is likely
to reduce consumer spending. We believe that these factors suggest
that the worst of the recent increase in bond yields has passed and
stable, if not slightly improving, bond prices may be expected.
Portfolio Strategy
At the quarter ended July 31, 1999, the US economy was strong and
inflation was low. We opted to maintain a fully invested position
going into the quarter and sought to maintain a high level of tax-
exempt income. We believed that in the absence of any material
inflationary pressures and given the enhanced productivity of US
companies, any increases in US economic strength would not result in
significant increases in interest rates.
However, the Federal Reserve Board raised interest rates in May.
Modest improvements in foreign economies also played a factor in the
Federal Reserve Board's decision to raise short-term interest rates,
which pushed long-term interest rates higher as well. We remained
fully invested, believing that the recent spike in bond yields would
be temporary. Unfortunately, concerns lingered that the Federal
Reserve Board would continue to tighten monetary policy, which
occurred after the close of the period at the end of August. These
concerns pushed long-term bond yields higher and faster than we
expected, negatively affecting Fund performance for the quarter.
Short-term tax-exempt interest rates provided a significant yield
benefit to Merrill Lynch Municipal Strategy Fund, Inc.'s Common
Stock shareholders. Although the Federal Reserve Board increased
short-term taxable interest rates, with a possibility of more
tightening to follow, interest rates on the Fund's Preferred Stock
have remained at or below historical averages for much of the past
three months. However, should the spread between long-term and short-
term interest rates narrow, the benefits of the leverage will
decline and as a result, reduce the yield on the Fund's Common
Stock. (See page 1 of this report to shareholders for a complete
explanation of the benefits and risks of leveraging.)
Sincerely,
(Terry K. Glenn)
Terry K. Glenn
President
(Vincent R. Giordano)
Vincent R. Giordano
Senior Vice President
(Robert A. DiMella)
Robert A. DiMella
Vice President and Co-Portfolio Manager
(John M. Loffredo)
John M. Loffredo
Vice President and Co-Portfolio Manager
September 14, 1999
PORTFOLIO COMPOSITION
For the Quarter Ended July 31, 1999
Top Ten States*
New York 13.04%
California 10.76
Ohio 8.65
Connecticut 7.68
Colorado 6.72
Arizona 5.74
Virginia 4.55
Florida 4.06
Illinois 3.48
New Mexico 3.45
-------
Total Top Ten 68.13
Total Others 31.87
-------
Total Portfolio 100.00%
=======
Net assets as of July 31, 1999 were $173,266,822.
Quality Ratings*
(Based on Nationally Recognized Rating Services)
A pie chart illustrating the following percentages:
AAA/Aaa 47%
AA/Aa 6%
A/A 5%
BBB/Baa 16%
BB/Ba 7%
B/B 8%
NR++ 10%
Other++++ 1%
[FN]
*Based on total market value of the portfolio as of July 31, 1999.
++Not Rated.
++++Temporary investments in short-term municipal securities.
