In
certain scenarios, investors in CoCos may suffer a loss of capital ahead of
equity holders or when equity holders do not. The prices of CoCos may be
volatile. There is no guarantee that the Fund will receive a return of principal
on CoCos. Any indication that an automatic write-down or conversion event may
occur can be expected to have a material adverse effect on the market price of
CoCos.
Convertible
securities are hybrid securities that combine the investment characteristics of
bonds and common stocks. Convertible securities typically consist of debt
securities or preferred securities that may be converted within a specified
period of time (typically for the entire life of the security) into a certain
amount of common stock or other equity security of the same or a different
issuer at a predetermined price. They also include debt securities with warrants
or common stock attached and derivatives combining the features of debt
securities and equity securities. Convertible securities entitle the holder to
receive interest paid or accrued on debt, or dividends paid or accrued on
preferred securities, until the security matures or is redeemed, converted or
exchanged.
The
market value of a convertible security generally is a function of its
“investment value” and its “conversion value.” A security’s “investment value”
represents the value of the security without its conversion feature (i.e., a
comparable non-convertible fixed income security). The investment value is
determined by, among other things, reference to its credit quality and the
current value of its yield to maturity or probable call date. At any given time,
investment value is dependent upon such factors as the general level of interest
rates, the yield of similar non-convertible securities, the financial strength
of the issuer and the seniority of the security in the issuer’s capital
structure. A security’s “conversion value” is determined by multiplying the
number of shares the holder is entitled to receive upon conversion or exchange
by the current price of the underlying security. If the conversion value of a
convertible security is significantly below its investment value, the
convertible security will trade like non-convertible debt or a preferred
security in the sense that its market value will not be influenced greatly by
fluctuations in the market price of the underlying security into which it can be
converted. Instead, the convertible security’s price will tend to move in the
opposite direction from interest rates. Conversely, if the conversion value of a
convertible security is significantly above its investment value, the market
value of the convertible security will be more heavily influenced by
fluctuations in the market price of the underlying stock. In that case, the
convertible security’s price may be as volatile as that of the common stock.
Because both interest rate and market movements can influence its value, a
convertible security is not generally as sensitive to interest rates as a
similar fixed income security, nor is it generally as sensitive to changes in
share price as its underlying stock.
The
Fund’s investments in convertible securities, particularly securities that are
convertible into securities of an issuer other than the issuer of the
convertible security, may be illiquid. The Fund’s investments in convertible
securities may at times include securities that have a mandatory conversion
feature, pursuant to which the securities convert automatically into common
stock or other equity securities (of the same or a different issuer) at a
specified date and a specified conversion ratio, or that are convertible at the
option of the issuer. For issues where the conversion of the security is not at
the option of the holder, the Fund may be required to convert the security into
the underlying common stock even at times when the value of the underlying
common stock or other equity security has declined substantially.
S-10
In
addition, some convertible securities are often rated below investment-grade or
are not rated, and therefore may be considered speculative investments. The
credit rating of a company’s convertible securities is generally lower than that
of its conventional debt securities. Convertible securities are normally
considered “junior” securities—that is, the company usually must pay interest on
its conventional corporate debt before it can make payments on its convertible
securities. Some convertible securities are particularly sensitive to interest
rate changes when their predetermined conversion price is much higher than the
issuing company’s common stock.
Corporate Debt
Securities
The
Fund may invest in corporate debt securities. The broad category of corporate
debt securities includes debt issued by companies of all kinds, including those
with small-, mid- and large-capitalizations. Corporate debt may be rated
investment-grade or below investment-grade and may carry variable or floating
rates of interest. Corporate debt securities are fixed income securities issued
by businesses to finance their operations, although corporate debt instruments
may also include bank loans to companies. Notes, bonds, debentures and
commercial paper are the most common types of corporate debt securities, with
the primary difference being their maturities and secured or unsecured status.
Commercial paper has the shortest term and is usually unsecured.
Because
of the wide range of types and maturities of corporate debt securities, as well
as the range of creditworthiness of its issuers, corporate debt securities have
widely varying potentials for return and risk profiles. Rates on corporate debt
securities are set according to prevailing interest rates at the time of the
issue, the credit rating of the issuer, the length of the maturity and other
terms of the security. For example, commercial paper issued by a large
established domestic corporation that is rated investment-grade may have a
modest return on principal, but carries relatively limited risk. On the other
hand, a long-term corporate note issued by a small non-U.S. corporation from an
emerging market country that has not been rated by an NRSRO may have the
potential for relatively large returns on principal, but carries a relatively
high degree of risk.
Corporate
debt securities carry both credit risk and interest rate risk. Credit risk is
the risk that the Fund could lose money if the issuer of a corporate debt
security is unable to pay interest or repay principal when it’s due. Some
corporate debt securities that are rated below investment-grade are generally
considered speculative because they present a greater risk of loss, including
default, than higher quality debt securities. The credit risk of a particular
issuer’s debt security may vary based on its priority for repayment. For
example, higher ranking (senior) debt securities have a higher priority than
lower ranking (subordinated) securities. This means that the issuer might not
make payments on subordinated securities while making payments on senior
securities. In addition, in the event of bankruptcy, holders of higher-ranking
senior securities may receive amounts otherwise payable to the holders of more
junior securities. Interest rate risk is the risk that the value of certain
corporate debt securities will tend to fall when interest rates rise. In
general, corporate debt securities with longer terms tend to fall more in value
when interest rates rise than corporate debt securities with shorter terms.
Additionally, corporate debt securities may also be subject to price volatility
due to such factors as market interest rates, market perception of the
creditworthiness of the issuer and general market liquidity.
In
addition, corporate restructurings, such as mergers, leveraged buyouts,
takeovers or similar corporate transactions are often financed by an increase in
a corporate issuer’s debt securities. As a result of the added debt burden, the
credit quality and market value of an issuer’s existing debt securities may
decline significantly.
Subject
to the limitations set forth below under “Limitations on the Use of
CFTC-Regulated Futures, Options on Futures and Swaps,” the Fund may use
derivative instruments as described below. Generally, a derivative is a
financial contract the value of which depends upon, or is derived from, the
value of an underlying asset, reference rate or index. Derivatives generally
take the form of contracts under which the parties agree to payments between
them based upon the performance of a wide variety of underlying references, such
as stocks, bonds, loans, commodities, interest rates, currency exchange rates,
and various domestic and foreign indices.
S-11
The
Fund may use derivatives for a variety of reasons, including as a substitute for
investing directly in securities, as part of a hedging strategy (that is, for
the purpose of reducing risk to the Fund), to manage the effective duration of
the Fund's portfolio, or for other purposes related to the management of the
Fund. Derivatives permit the Fund to increase or decrease the level of risk, or
change the character of the risk, to which its portfolio is exposed in much the
same way as the Fund can increase or decrease the level of risk, or change the
character of the risk, of its portfolio by making investments in specific
securities. However, derivatives may entail investment exposures that are
greater than their cost would suggest. As a result, a small investment in
derivatives could have a large impact on the Fund’s performance.
While
transactions in some derivatives may be effected on established exchanges, many
other derivatives are privately negotiated and entered into in the
over-the-counter (“
) market with a
single counterparty. When exchange-traded derivatives are purchased and sold, a
clearing agency associated with the exchange stands between each buyer and
seller and effectively guarantees performance of each contract, either on a
limited basis through a guaranty fund or to the full extent of the clearing
agency’s balance sheet. Transactions in OTC derivatives not subject to a
clearing requirement have no such protection. Each party to an uncleared OTC
derivative bears the risk that its direct counterparty will default. In
addition, OTC derivatives are generally less liquid than exchange-traded
derivatives because they often can only be closed out with the other party to
the transaction.
The
use of derivative instruments is subject to applicable regulations of the SEC,
the CFTC, various state regulatory authorities and, with respect to
exchange-traded derivatives, the several exchanges upon which they are traded.
As discussed above under “Asset Coverage Requirements,” in order to engage in
certain transactions in derivatives, the Fund may be required to hold offsetting
positions or to hold cash or liquid securities in a segregated account or
designated on the Fund’s books. In addition, the Fund’s ability to use
derivative instruments may be limited by tax considerations.
The
particular derivative instruments the Fund can use are described below. The
Fund’s portfolio managers may decide not to employ some or all of these
instruments, and there is no assurance that any derivatives strategy used by the
Fund will succeed. The Fund may employ new derivative instruments and strategies
when they are developed, if those investment methods are consistent with the
Fund’s investment objective and are permissible under applicable regulations
governing the Fund.
The
Fund may purchase put and call options on specific securities (including groups
or "baskets" of specific securities), interest rates, stock indices and/or bond
indices. In addition, the Fund may write put and call options on such financial
instruments.
The Fund may purchase put and call options on securities.
A put option on a security gives the purchaser of the option the right (but not
the obligation) to sell, and the writer of the option the obligation to buy, the
underlying security at a stated price (the “exercise price”) at any time before
the option expires. A call option on a security gives the purchaser the right
(but not the obligation) to buy, and the writer the obligation to sell, the
underlying security at the exercise price at any time before the option expires.
The purchase price for a put or call option is the “premium” paid by the
purchaser for the right to sell or buy.
The
Fund may purchase put options to hedge against a decline in the value of its
portfolio. By using put options in this way, the Fund would reduce any profit it
might otherwise have realized in the underlying security by the amount of the
premium paid for the put option and by transaction costs. In similar fashion,
the Fund may purchase call options to protect against an increase in the price
of securities that the Fund anticipates purchasing in the future, a practice
sometimes referred to as “anticipatory hedging.” The premium paid for the call
option plus any transaction costs will reduce the benefit, if any, realized by
the Fund upon exercise of the option, and, unless the price of the underlying
security rises sufficiently, the option may expire unexercised.
Options on Interest Rates and
Indices.
The Fund may purchase put and call options on interest rates
and on stock and bond indices. An option on interest rates or on an index gives
the holder the right to receive, upon exercise of the option, an amount of cash
if the closing value of the underlying interest rate or index is greater than,
in the case of a call, or less than, in the case of a put, the exercise price of
the
S-12
option.
This amount of cash is equal to the difference between the exercise-settlement
value of the interest rate option or the closing price of the index and the
exercise price of the option expressed in dollars times a specified multiple
(the “multiplier”). The writer of the option is obligated, for the premium
received, to make delivery of this amount. Settlements for interest rate and
index options are always in cash.
The
Fund may write (sell) put and call options. These transactions would be
undertaken principally to produce additional income. The Fund receives a premium
from writing options which it retains whether or not the option is exercised.
The Fund may write straddles consisting of a combination of a call and a put
written on the same underlying instrument.
The
Fund will write a call option on a security only if (a) the Fund owns the
security underlying the call, (b) the Fund has an absolute and immediate
right to acquire that security without additional cash consideration (or, if
additional cash consideration is required, cash or other liquid assets in such
amount are segregated), or (c) the Fund holds a call on the same security where
the exercise price of the call is (i) equal to or less than the exercise
price of the call written, or (ii) greater than the exercise price of the call
written, provided the difference is maintained by the Fund in segregated liquid
assets.
The
Fund will write a call option on a basket of securities or an index only if (a)
the Fund segregates liquid assets in an amount equal to the contract value of
the index or basket, or (b) the Fund holds a call on the same index or basket as
the call written where the exercise price of the call held is (i) equal to or
less than the exercise price of the call written, or (ii) greater than the
exercise price of the call written, provided the difference is maintained by the
Fund in segregated liquid assets.
The
Fund will write a put option on a security, basket of securities or index only
if (a) the Fund segregates liquid assets equal to the exercise price or (b) the
Fund holds a put on the same security, basket of securities or index as the put
written where the exercise price of the put held is (i) equal to or greater than
the exercise price of the put written, or (ii) less than the exercise price of
the put written, provided the difference is maintained by the Fund in segregated
liquid assets.
When
the Fund writes a straddle, sufficient assets will be segregated to meet the
Fund’s immediate obligations. The Fund may segregate the same liquid assets for
both the call and put options in a straddle where the exercise price of the call
and put are the same, or the exercise price of the call is higher than that of
the put. In such cases, the Fund will also segregate liquid assets equivalent to
the amount, if any, by which the put is “in the money.”
Expiration or Exercise of
Options.
If an option purchased by the Fund expires unexercised, the
Fund realizes a capital loss equal to the premium paid. If an option written by
the Fund expires unexercised, the Fund realizes a capital gain equal to the
premium received at the time the option was written. Prior to the earlier of
exercise or expiration, an exchange traded option may be closed out by an
offsetting purchase or sale of an option of the same series (type, exchange,
underlying security or index, exercise price, and expiration). There can be no
assurance, however, that a closing purchase or sale transaction can be effected
when the Fund desires.
The
Fund may sell put or call options it has previously purchased, which could
result in a net gain or loss depending on whether the amount realized on the
sale is more or less than the premium and other transaction costs paid on the
put or call option which is sold. Prior to exercise or expiration, an option may
be closed out by an offsetting purchase or sale of an option of the same series.
The Fund will realize a capital gain from a closing purchase transaction if the
cost of the closing option is less than the premium received from writing the
option, or, if it is more, the Fund will realize a capital loss. If the premium
received from a closing sale transaction is more than the premium paid to
purchase the option, the Fund will realize a capital gain or, if it is less, the
Fund will realize a capital loss. The principal factors affecting the market
value of a put or a call option include supply and demand, interest rates, the
current market price of the underlying security or index in relation to the
exercise price of the option, the volatility of the underlying security or
index, and the time remaining until the expiration date.
The
Fund may engage in futures transactions. The Fund may buy and sell futures
contracts that relate to (1) interest rates, (2) debt securities, (3) bond
indices, (4) stock indices and (5) individual stocks.
S-13
The
Fund may only enter into futures contracts which are standardized and traded on
a U.S. or foreign exchange, board of trade or similar entity, or quoted on an
automated quotation system.
A
futures contract is an agreement between two parties to buy and sell a security,
index or interest rate (each a “
”) for a set price on a future date. Certain futures
contracts, such as futures contracts relating to individual securities, call for
making or taking delivery of the underlying financial instrument. However, these
contracts generally are closed out before delivery by entering into an
offsetting purchase or sale of a matching futures contract. Other futures
contracts, such as futures contracts on interest rates and indices, do not call
for making or taking delivery of the underlying financial instrument, but rather
are agreements pursuant to which two parties agree to take or make delivery of
an amount of cash equal to the difference between the value of the financial
instrument at the close of the last trading day of the contract and the price at
which the contract was originally written. These contracts also may be settled
by entering into an offsetting futures contract.
Unlike
when the Fund purchases or sells a security, no price is paid or received by the
Fund upon the purchase or sale of a futures contract. Initially, the Fund will
be required to deposit with its futures broker (also known as a futures
commission merchant (“
)) an amount of
cash or securities equal to a specified percentage of the contract amount. This
amount is known as initial margin. The margin deposit is intended to ensure
completion of the contract. Minimum initial margin requirements are established
by the futures exchanges and may be revised. In addition, FCMs may establish
margin deposit requirements that are higher than the exchange minimums. Cash
held as margin is generally invested by the FCM in high-quality instruments
permitted under CFTC regulations, with returns retained by the FCM and interest
paid to the Fund on the cash at an agreed-upon rate. The Fund will also receive
any interest paid from coupon-bearing securities, such as Treasury securities,
held in margin accounts. Subsequent payments to and from the FCM, called
variation margin, will be made on a daily basis as the price of the underlying
financial instrument fluctuates, making the futures contract more or less
valuable, a process known as marking the contract to market. Changes in
variation margin are recorded by the Fund as unrealized gains or losses. At any
time prior to expiration of the futures contract, the Fund may elect to close
the position by taking an opposite position that will operate to terminate its
position in the futures contract. A final determination of variation margin is
then made, additional cash is required to be paid by or released to the Fund,
and the Fund realizes a gain or loss. In the event of the bankruptcy or
insolvency of an FCM that holds margin on behalf of the Fund, the Fund may be
entitled to the return of margin owed to it only in proportion to the amount
received by the FCM’s other customers, potentially resulting in losses to the
Fund. Futures transactions also involve brokerage costs.
Most
U.S. futures exchanges limit the amount of fluctuation permitted in futures
contract prices during a single trading day. The daily limit establishes the
maximum amount that the price of a futures contract may vary either up or down
from the previous day’s settlement price at the end of a trading session. Once
the daily limit has been reached in a particular type of futures contract, no
trades may be made on that day at a price beyond that limit. The daily limit
governs only price movement during a particular trading day and therefore does
not limit potential losses, because the limit may prevent the liquidation of
unfavorable positions. Futures contract prices have occasionally moved to the
daily limit for several consecutive trading days with little or no trading,
thereby preventing prompt liquidation of futures positions and subjecting some
futures traders to substantial losses.
The
Fund may purchase or write put and call options on futures contracts. A futures
option gives the holder the right, in return for the premium paid, to assume a
long position (call) or short position (put) in a futures contract at a
specified exercise price prior to the expiration of the option. Upon exercise of
a call option, the holder acquires a long position in the futures contract and
the writer is assigned the opposite short position. In the case of a put option,
the opposite is true. Prior to exercise or expiration, a futures option may be
closed out by an offsetting purchase or sale of a futures option of the same
series.
The
Fund may use options on futures contracts in connection with hedging strategies.
The writing of a call option or the purchasing of a put option on a futures
contract constitutes a partial hedge against declining prices of the securities
which are deliverable upon exercise of the futures contract. If the futures
price at expiration of a written call option is below the exercise price, the
Fund will retain the full amount of the option premium which provides a partial
hedge against any decline that may have occurred in the
S-14
Fund’s
holdings of securities. If the futures price when the option is exercised is
above the exercise price, however, the Fund will incur a loss, which may be
offset, in whole or in part, by the increase in the value of the securities held
by the Fund that were being hedged. Writing a put option or purchasing a call
option on a futures contract serves as a partial hedge against an increase in
the value of the securities the Fund intends to acquire.
When
writing a call option, the Fund must either segregate liquid assets with a value
equal to the fluctuating market value of the optioned futures contract, or the
Fund must own an option to purchase the same futures contract having an exercise
price that is (i) equal to or less than the exercise price of the call written,
or (ii) greater than the exercise price of the call written, provided the
difference is maintained by the Fund in segregated liquid assets.
When
writing a put option, the Fund must segregate liquid assets in an amount not
less than the exercise price, or own a put option on the same futures contract
where the exercise price of the put held is (i) equal to or greater than the
exercise price of the put written, or (ii) less than the exercise price of the
put written, provided the difference is maintained by the Fund in segregated
liquid
assets.
As
with investments in futures contracts, the Fund is required to deposit and
maintain margin with respect to put and call options on futures contracts
written by it.
The
Fund may enter into equity, interest rate, currency and credit default swap
agreements.
The
Fund may enter into swap transactions for any purpose consistent with its
investment objective and strategies, such as for the purpose of attempting to
obtain or preserve a particular return or spread at a lower cost than obtaining
a return or spread through purchases and/or sales of instruments in other
markets, to protect against currency fluctuations, as a duration management
technique, to protect against an increase in the price of securities the Fund
anticipates purchasing at a later date, to reduce risk arising from the
ownership of a particular instrument, or to gain exposure to certain securities,
reference rates, sectors or markets.
Swap
agreements are two party contracts entered into primarily by institutional
investors for a specified period of time. In a standard swap transaction, two
parties agree to exchange the returns (or differentials in rates of return)
earned or realized on a particular predetermined asset, reference rate or index.
The gross returns to be exchanged or swapped between the parties are generally
calculated with respect to a notional amount, e.g., the return on or increase in
value of a particular dollar amount invested at a particular interest rate or in
a basket of securities representing a particular index. The notional amount of
the swap agreement generally is only used as a basis upon which to calculate the
obligations that the parties to the swap agreement have agreed to exchange. The
Fund’s current obligations under a net swap agreement will be accrued daily
(offset against any amounts owed to the Fund) and the Fund will segregate assets
determined to be liquid by the Sub-Adviser for any accrued but unpaid net
amounts owed to a swap counterparty. See “Asset Coverage Requirements”
above.
In
a typical equity swap, one party agrees to pay another party the return on a
stock, stock index or basket of stocks in return for a specified interest rate.
By entering into an equity index swap, for example, the index receiver can gain
exposure to stocks making up the index of securities without actually purchasing
those stocks. Equity index swaps involve not only the risk associated with
investment in the securities represented in the index, but also the risk that
the performance of such securities, including dividends, will not exceed the
return on the interest rate that the Fund will be committed to pay.
Interest
rate swaps are financial instruments that involve the exchange of one type of
interest rate for another type of interest rate cash flow on specified dates in
the future. Some of the different types of interest rate swaps are
“fixed-for-floating rate swaps,” “termed basis swaps” and “index amortizing
swaps.” Fixed-for-floating rate swaps involve the exchange of fixed interest
rate cash flows for floating rate cash flows. Termed basis swaps entail cash
flows to both parties based on floating interest rates, where the interest rate
indices are different. Index amortizing swaps are typically fixed-for-floating
swaps where the notional amount changes if certain conditions are met. Like a
traditional investment in a debt security, the Fund could lose money by
investing in an interest rate swap if interest rates change
adversely.
A
currency swap is an agreement between two parties in which one party agrees to
make interest rate payments in one currency and the other promises to make
interest rate payments in another
S-15
currency.
The Fund may enter into a currency swap when it has one currency and desires a
different currency. Typically the interest rates that determine the currency
swap payments are fixed, although occasionally one or both parties may pay a
floating rate of interest. Unlike an interest rate swap, however, the principal
amounts are exchanged at the beginning of the contract and returned at the end
of the contract. Changes in non-U.S. exchange rates and changes in interest
rates may negatively affect currency swaps.
A
credit default swap is a bilateral contract that enables an investor to buy or
sell protection against a defined-issuer credit event. The Fund may enter into
credit default swap agreements either as a buyer or a seller. The Fund may buy
protection to attempt to mitigate the risk of default or credit quality
deterioration in one or more of its individual holdings or in a segment of the
fixed income securities market to which it has exposure, or to take a “short”
position in individual bonds or market segments which it does not own. The Fund
may sell protection in an attempt to gain exposure to the credit quality
characteristics of particular bonds or market segments without investing
directly in those bonds or market segments.
As
the buyer of protection in a credit default swap, the Fund will pay a premium
(by means of an upfront payment or a periodic stream of payments over the term
of the agreement) in return for the right to deliver a referenced bond or group
of bonds to the protection seller and receive the full notional or par value (or
other agreed upon value) upon a default (or similar event) by the issuer(s) of
the underlying referenced obligation(s). If no default occurs, the protection
seller would keep the stream of payments and would have no further obligation to
the Fund. Thus, the cost to the Fund would be the premium paid with respect to
the agreement. If a credit event occurs, however, the Fund may elect to receive
the full notional value of the swap in exchange for an equal face amount of
deliverable obligations of the reference entity that may have little or no
value. The Fund bears the risk that the protection seller may fail to satisfy
its payment obligations.
If
the Fund is a seller of protection in a credit default swap and no credit event
occurs, the Fund would generally receive an up-front payment or a periodic
stream of payments over the term of the swap. If a credit event occurs, however,
generally the Fund would have to pay the buyer the full notional value of the
swap in exchange for an equal face amount of deliverable obligations of the
reference entity that may have little or no value. As the protection seller, the
Fund effectively adds economic leverage to its portfolio because, in addition to
being subject to investment exposure on its total net assets, the Fund is
subject to investment exposure on the notional amount of the swap. Thus, the
Fund bears the same risk as it would by buying the reference obligations
directly, plus the additional risks related to obtaining investment exposure
through a derivative instrument discussed below under “Risks Associated with
Swap Transactions.”
Risks Associated with Swap
Transactions.
The
use of swap transactions is a highly specialized activity which involves
strategies and risks different from those associated with ordinary portfolio
security transactions. If the Sub-Adviser is incorrect in its forecasts of
default risks, market spreads or other applicable factors the investment
performance of the Fund would diminish compared with what it would have been if
these techniques were not used. As the protection seller in a credit default
swap, the Fund effectively adds economic leverage to its portfolio because, in
addition to being subject to investment exposure on its total net assets, the
Fund is subject to investment exposure on the notional amount of the swap. The
Fund may only close out a swap or other two-party contract with its particular
counterparty, and may only transfer a position with the consent of that
counterparty. In addition, the price at which the Fund may close out such a two
party contract may not correlate with the price change in the underlying
reference asset. If the counterparty defaults, the Fund will have contractual
remedies, but there can be no assurance that the counterparty will be able to
meet its contractual obligations or that the Fund will succeed in enforcing its
rights. It also is possible that developments in the derivatives market,
including potential government regulation, could adversely affect the Fund’s
ability to terminate existing swap or other agreements or to realize amounts to
be received under such agreements.
Interest
Rate Caps, Collars and Floors
The
Fund may enter into interest rate caps, floors and collars. Caps and floors have
an effect similar to buying or writing options. In a typical cap or floor
agreement, one party agrees to make payments only under specified circumstances,
usually in return for payment of a fee by the other party. For example, the
buyer of an interest rate cap obtains the right to receive payments to the
extent that a specified interest rate exceeds an agreed-upon level. The seller
of an interest rate floor is obligated to make payments to the extent that a
specified interest rate falls below an agreed-upon level. An interest rate
collar involves selling a cap and purchasing a floor or vice versa to protect
the Fund against interest rate movements exceeding given minimum or maximum
levels.
S-16
Limitations on the Use of
CFTC-Regulated Futures, Options on Futures and Swaps
The
Fund will limit its direct investments in CFTC-regulated futures, options on
futures and swaps (“
”)
to the extent necessary for the Adviser to claim the exclusion from regulation
as a commodity pool operator with respect to the Fund under CFTC Rule 4.5, as
such rule may be amended from time to time. Under Rule 4.5 as currently in
effect, the Fund will limit its trading activity in CFTC Derivatives (excluding
activity for “bona fide hedging purposes,” as defined by the CFTC) such that it
meets one of the following tests:
·
Aggregate
initial margin and premiums required to establish its positions in CFTC
Derivatives do not exceed 5% of the liquidation value of the Fund’s portfolio,
after taking into account unrealized profits and losses on such positions;
or
·
Aggregate
net notional value of its positions in CFTC Derivatives does not exceed 100% of
the liquidation value of the Fund’s portfolio, after taking into account
unrealized profits and losses on such positions.
With
respect to the Fund, the Adviser has filed a notice of eligibility for exclusion
from the definition of the term commodity pool operator under the Commodity
Exchange Act and therefore is not subject to registration or regulation as a
commodity pool operator thereunder.
The
requirements for qualification as a regulated investment company may also limit
the extent to which the Fund may invest in CFTC Derivatives. See “Tax
Matters—Qualification as a Regulated Investment Company.”
Federal Income Tax Treatment of
Futures Contracts and Options
The
Fund’s transactions in futures contracts and options will be subject to special
provisions of the Internal Revenue Code of 1986, as amended (the “
”), that, among
other things, may affect the character of gains and losses realized by the Fund
(i.e., may affect whether gains or losses are ordinary or capital, or short-term
or long-term), may accelerate recognition of income to the Fund and may defer
Fund losses. These rules could, therefore, affect the character, amount and
timing of distributions to shareholders. These provisions also (a) will require
the Fund to mark-to-market certain types of the positions in its portfolio
(i.e., treat them as if they were closed out) and (b) may cause the Fund to
recognize income without receiving cash with which to make distributions in
amounts necessary to satisfy the 90% distribution requirement for qualifying to
be taxed as a regulated investment company and the distribution requirement for
avoiding excise taxes.
Risks and Special
Considerations Concerning Derivatives
The
use of derivative instruments involves certain general risks and considerations
as described below.
1)
Market
risk is the risk that the value of the underlying assets may go up or down.
Adverse movements in the value of an underlying asset can expose the Fund to
losses. The successful use of derivative instruments depends upon a variety of
factors, particularly the portfolio managers' ability to predict movements in
the relevant markets, which may require different skills than predicting changes
in the prices of individual securities. There can be no assurance that any
particular strategy adopted will
succeed.
2)
Counterparty risk is the risk that a loss may be sustained as a
result of the failure of a counterparty to comply with the terms of a derivative
instrument. The counterparty risk for exchange-traded derivatives is generally
less than for OTC derivatives, since generally a clearing agency, which is the
issuer or counterparty to each exchange-traded instrument, provides a guarantee
of performance. For many OTC instruments, there is no similar clearing agency
guarantee and there is less regulation or supervision of transactions. In all
transactions, the Fund will bear the risk that the counterparty will default,
and this could result in a loss of the expected benefit of the derivative
transactions and possibly other losses to the Fund. The Fund will enter into
derivatives transactions only with counterparties that its portfolio managers
reasonably believe are capable of performing under the
contract.
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3)
Correlation risk is the risk that there might be an imperfect
correlation, or even no correlation, between price movements of a derivative
instrument and price movements of investments
being
hedged.
When
a
derivative
transaction
is
used
to
completely
hedge
another
position,
changes in the market value of the combined position (the derivative instrument
plus the position being hedged) result from an imperfect correlation between the
price movements of the two instruments.
With
a perfect hedge, the value of the combined position remains unchanged with any
change in the price of the underlying asset. With an imperfect hedge, the value
of the derivative instrument and its hedge are not
perfectly
correlated.
For
example,
if
the
value
of
a
derivative
instrument
used
in
a
short
hedge
(such
as writing a call option, buying a put option or selling a futures contract)
increased by less than the decline in value of the hedged investments, the hedge
would not be perfectly correlated. This might occur due to factors unrelated to
the value of the investments being hedged, such as speculative or other
pressures
on
the
markets
in
which
these
instruments
are
traded.
The
effectiveness
of
hedges
using
instruments on indices will depend, in part, on the degree of correlation
between price movements in the index and the price movements in the investments
being
hedged.
4)
Liquidity risk is the risk that a derivative instrument cannot be
sold, closed out or replaced quickly at or very close to its fundamental value.
Generally, exchange contracts are very liquid because the exchange clearinghouse
is the counterparty of every contract. OTC transactions are less liquid than
exchange-traded derivatives since they often can only be closed out with the
other party to the transaction. The Fund might be required by applicable
regulatory requirements to maintain assets as “cover,” maintain segregated
accounts, and/or make margin payments when it takes positions in derivative
instruments involving obligations to third parties (i.e., instruments other than
purchase options). If the Fund is unable to close out its positions in such
instruments, it might be required to continue to maintain such assets or
accounts or make such payments until the position expires, matures or is closed
out. These requirements might impair the Fund’s ability to sell a security or
make an investment at a time when it would otherwise be favorable to do so, or
require that the Fund sell a portfolio security at a disadvantageous time. The
Fund’s ability to sell or close out a position in an instrument prior to
expiration or maturity depends upon the existence of a liquid secondary market
or, in the absence of such a market, the ability and willingness of the
counterparty to enter into a transaction closing out the position. There is no
assurance that any derivatives position can be sold or closed out at a time and
price that is favorable to the Fund.
5)
Legal
risk is the risk of loss caused by the unenforceability of a party’s obligations
under the derivative. While a party seeking price certainty agrees to surrender
the potential upside in exchange for downside protection, the party taking the
risk is looking for a positive payoff. Despite this voluntary assumption of
risk, a counterparty that has lost money in a derivative transaction may try to
avoid
payment
by
exploiting
various
legal
uncertainties
about
certain
derivative
products.
6)
Systemic or “Interconnection”
Risk.
Systemic or interconnection risk is the risk that a disruption
in the financial markets will cause difficulties for all market participants. In
other words, a disruption in one market will spill over into other markets,
perhaps creating a chain reaction. Much of the OTC derivatives market takes
place among the OTC dealers themselves, thus creating a large interconnected web
of financial obligations. This interconnectedness raises the possibility that a
default by one large dealer could create losses for other dealers and
destabilize the entire market for OTC derivative
instruments.
7)
Leverage risk
is
the
risk that the
Fund
may
be more
volatile than
if
it had not
been leveraged
due
to
leverage’s tendency
to
exaggerate
the
effect
of
any
increase
or
decrease
in
the
value
of
the
Fund’s
portfolio
securities.
The
use
of
leverage
may
also
cause
the
Fund
to
liquidate
portfolio
positions
when
it
may
not
be
advantageous
to
do
so
to
satisfy
its
obligations
or
to
meet
segregation
requirements.
8)
.
The Dodd-Frank Act Wall Street Reform and Consumer Protection Act (the “
)
has initiated a dramatic revision of the U.S. financial regulatory framework and
covers a broad range of topics, including (among many others) a reorganization
of federal financial regulators; a process intended to improve financial
systemic stability and the resolution of potentially insolvent financial firms;
and new rules for derivatives trading. Instruments in which the Fund may
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invest,
or the issuers of such instruments, may be affected by this legislation and
regulation in ways that are unforeseeable. Certain of the implementing
regulations have not yet been finalized or made effective. Accordingly, the
ultimate impact of the Dodd-Frank Act, including on the derivative instruments
in which the Fund may invest, is not yet certain.
Investment Companies and Other
Pooled Investment Vehicles
The
Fund may invest in other investment companies, such as open-end funds,
closed-end funds, unit investment trusts, and exchange-traded funds (“
”) registered
under the 1940 Act ("
"),
that invest primarily in Fund-eligible investments. Under the 1940 Act, the
Fund’s investment in such securities is generally limited to 3% of the total
voting stock of any one investment company; 5% of the Fund’s total assets with
respect to any one investment company; and 10% of the Fund’s total assets in the
aggregate. Many 1940 Act ETFs, however, have obtained exemptive relief from the
SEC to permit unaffiliated funds to invest in their shares beyond these
statutory limits, subject to certain conditions and pursuant to contractual
arrangements between the ETFs and the investing funds. The Fund may rely on
these exemptive orders in investing in 1940 Act ETFs. The Fund’s investments in
other investment companies may include money market mutual funds. Investments in
money market funds are not subject to the percentage limitations set forth
above.
ETFs
in which the Fund may invest are a type of index fund bought and sold on a
securities exchange. An ETF trades like common stock and represents a portfolio
of securities designed to track a particular market index. ETFs can give
exposure to all or a portion of the U.S. market, a foreign market, a region, a
commodity, a currency, or to any other index that an ETF tracks. The risks of
owning an ETF generally reflect the risks of owning the underlying securities
they are designed to track, although lack of liquidity in an ETF could result in
it being more volatile and ETFs have management fees that increase their costs.
An ETF may fail to accurately track the returns of the market segment or index
that it is designed to track, and the price of an ETF’s shares may fluctuate. In
addition, because they, unlike traditional mutual funds, are traded on an
exchange, ETFs are subject to the following risks: (i) the performance of the
ETF may not replicate the performance of the underlying index that it is
designed to track; (ii) the market price of the ETF’s shares may trade at a
premium or discount to the ETF’s net asset value; (iii) an active trading market
for an ETF may not develop or be maintained; and (iv) there is no assurance that
the requirements of the exchange necessary to maintain the listing of the ETF
will continue to be met or remain unchanged. Trading in an ETF may be halted if
the trading in one or more of the ETF’s underlying securities is halted, which
could result in the ETF being more volatile. In the event substantial market or
other disruptions affecting ETFs should occur in the future, the liquidity and
value of the Fund’s shares could also be substantially and adversely
affected.
The
Fund may also invest in pooled investment vehicles other than registered
investment companies. The Fund will only invest in other pooled investment
vehicles that invest primarily in Fund-eligible investments.
If
the Fund invests in other investment companies or pooled investment vehicles,
Fund shareholders will bear not only their proportionate share of the Fund’s
expenses, but also, indirectly, the similar expenses of the underlying
investment companies or pooled investment vehicles. Shareholders would also be
exposed to the risks associated not only with the Fund, but also with the
portfolio investments of the underlying investment companies or pooled
investment vehicles. Shares of certain closed-end funds may at times be acquired
at market prices representing premiums to their net asset values. Shares
acquired at a premium to their net asset value may be more likely to
subsequently decline in price, resulting in a loss to the Fund and its
shareholders.
Lending of Portfolio
Securities
In
order to generate additional income, the Fund may lend portfolio securities
representing up to one-third of the value of its total assets to broker-dealers,
banks or other institutional borrowers of securities that the Adviser has
determined are creditworthy. The securities lending agent will generally bear
the risk that a borrower may default on its obligation to return loaned
securities, however the Fund bears the risk that the securities lending agent
may default on its contractual obligations to the Fund. The Fund also bears the
market risk with respect to the investment of the cash collateral used to secure
the loan. The Fund may lose money on its investment of cash collateral or may
fail to earn sufficient income on its
S-19
investments
to meet its obligations to the borrower. The Fund will pay a portion of the
income earned on other lending transactions to the placing broker and may pay
administrative and custodial fees in connection with these loans.
In
these loan arrangements, the Fund will receive cash collateral equal to at least
102% of the value of the securities loaned as determined at the time of loan
origination. If the market value of the loaned securities increases, the
borrower must furnish additional collateral to the Fund. During the time
portfolio securities are on loan, the borrower pays the Fund any dividends or
interest paid on the securities. Loans are subject to termination at any time by
the Fund or the borrower. While the Fund does not have the right to vote
securities on loan, it would terminate the loan and regain the right to vote if
that were considered important with respect to the investment.
When
the Fund lends portfolio securities to a borrower, payments in lieu of dividends
made by the borrower to the Fund will not constitute “qualified dividends”
taxable at the same rate as long-term capital gains, even if the actual
dividends would have constituted qualified dividends had the Fund held the
securities. See “Taxation.”
Master Limited
Partnerships
A
master limited partnership ("
") is an entity,
most commonly a limited partnership, that is taxed as a partnership, publicly
traded and listed on a national securities exchange. Holders of common units of
MLPs typically have limited control and limited voting rights as compared to
holders of a corporation’s common shares. Preferred units issued by MLPs are not
typically listed or traded on an exchange. Holders of preferred units can be
entitled to a wide range of voting and other rights. Debt securities of MLPs are
similar to debt securities of other companies. Such securities may be rated or
unrated, may be above or below investment-grade quality, and may carry fixed or
floating interest rates. MLPs are limited by the Code to only apply to
enterprises that engage in certain businesses, mostly pertaining to the use of
natural resources, such as petroleum and natural gas extraction and
transportation, although some other enterprises may also qualify as MLPs.
There
are certain tax risks associated with investments in MLPs. The benefit derived
from an investment in an MLP is largely dependent on the MLP being treated as a
partnership for federal income tax purposes. A change to current tax law, or a
change in the underlying business mix of a given MLP, could result in an MLP
being treated as a corporation for federal income tax purposes. If an MLP were
treated as a corporation, the MLP would be required to pay federal income tax on
its taxable income. This would reduce the amount of cash available for
distribution by the MLP, which could result in a reduction of the value of the
Fund’s investment in the MLP and lower income to the Fund. Additionally, since
MLPs generally conduct business in multiple states, the Fund may be subject to
income or franchise tax in each of the states in which the partnership does
business. The additional cost of preparing and filing the tax returns and paying
the related taxes may adversely impact the Fund’s return on its investment in
MLPs.
Investments
held by MLPs may be relatively illiquid, limiting the MLPs’ ability to vary
their portfolios promptly in response to changes in economic or other
conditions, and MLPs may have limited financial resources. Securities of MLPs
may trade infrequently and in limited volume, and they may be subject to more
abrupt or erratic price movements than common shares of larger or more
broadly-based companies. The Fund’s investment in MLPs also subjects the Fund to
the risks associated with the specific industry or industries in which the MLPs
invest. MLPs are generally considered interest-rate sensitive investments, and
during periods of interest rate volatility, may not provide attractive
returns.
Mortgage-Backed
Securities
A
mortgage-backed security is a type of pass-through security, which is a security
representing pooled debt obligations repackaged as interests that pass income
through an intermediary to investors. In the case of mortgage-backed securities,
the ownership interest is in a pool of mortgage loans. Residential
mortgage-backed securities (“
”) are backed
by a pool of mortgages on residential property while commercial mortgage-backed
securities (“
”) are backed
by a pool of mortgages on commercial property.
Mortgage-backed
securities are most commonly issued or guaranteed by the Government National
Mortgage Association (“
” or “
”), Federal
National Mortgage Association (“
”
S-20
or
“
”) or Federal
Home Loan Mortgage Corporation (“
” or “
”), but may
also be issued or guaranteed by other private issuers.
GNMA
is a government-owned corporation that is an agency of the U.S. Department of
Housing and Urban Development. It guarantees, with the full faith and credit of
the United States, full and timely payment of all monthly principal and interest
on its mortgage-backed securities.
Government-related
guarantors (i.e., not backed by the full faith and credit of the U.S.
government) include FNMA and FHLMC. FNMA is a government-sponsored corporation.
FNMA purchases conventional (i.e., not insured or guaranteed by any government
agency) residential mortgages from a list of approved seller/servicers which
include state and federally chartered savings and loan associations, mutual
savings banks, commercial banks and credit unions and mortgage bankers.
Pass-through securities issued by FNMA are guaranteed as to timely payment of
principal and interest by FNMA, but are not backed by the full faith and credit
of the U.S. government. FHLMC was created by Congress in 1970 for the purpose of
increasing the availability of mortgage credit for residential housing. It is a
government-sponsored corporation that issues Participation Certificates (“
”), which are
pass-through securities, each representing an undivided interest in a pool of
residential mortgages. FHLMC guarantees the timely payment of interest and
ultimate collection of principal, but PCs are not backed by the full faith and
credit of the U.S. government.
On
September 6, 2008, the Federal Housing Finance Agency (“
”) placed FNMA
and FHLMC into conservatorship. As the conservator, FHFA succeeded to all
rights, titles, powers and privileges of FNMA and FHLMC and of any stockholder,
officer or director of FNMA and FHLMC with respect to FNMA and FHLMC and the
assets of FNMA and FHLMC. FHFA selected a new chief executive officer and
chairman of the board of directors for each of FNMA and FHLMC. In addition, the
U.S. Treasury Department agreed to provide FNMA and FHLMC with up to $100
billion of capital each to ensure that they are able to continue to provide
ongoing liquidity to the U.S. home mortgage market. FNMA and FHLMC are
continuing to operate as going concerns while in conservatorship and each remain
liable for all of its obligations, including its guaranty obligations,
associated with its mortgage-backed securities.
Privately Issued
Mortgage-Backed Securities.
Mortgage-backed securities issued by
private issuers, whether or not such obligations are subject to guarantees by
the private issuer, may entail greater risk than obligations directly or
indirectly guaranteed by the U.S. government. Any investments the Fund makes in
mortgage-related securities that are issued by private issuers have some
exposure to subprime loans as well as to the mortgage and credit markets
generally. Private issuers include commercial banks, savings associations,
mortgage companies, investment banking firms, finance companies and special
purpose finance entities (called special purpose vehicles or structured
investment vehicles) and other entities that acquire and package mortgage loans
for resale as mortgage-related securities. Unlike mortgage-related securities
issued or guaranteed by the U.S. government or one of its sponsored entities,
mortgage-related securities issued by private issuers do not have a government
or government-sponsored entity guarantee, but may have credit enhancement
provided by external entities such as banks or financial institutions or
achieved through the structuring of the transaction itself. Examples of such
credit support arising out of the structure of the transaction include: (1) the
issuance of senior and subordinated securities (e.g., the issuance of securities
by a special purpose vehicle in multiple classes or “tranches,” with one or more
classes being senior to other subordinated classes as to the payment of
principal and interest, with the result that defaults on the underlying mortgage
loans are borne first by the holders of the subordinated class); (2) the
creation of “reserve funds” (in which case cash or investments, sometimes funded
from a portion of the payments on the underlying mortgage loans, are held in
reserve against future losses); and (3) “overcollateralization” (in which case
the scheduled payments on, or the principal amount of, the underlying mortgage
loans exceeds that required to make payment of the securities and pay any
servicing or other fees). However, there can be no guarantee that credit
enhancements, if any, will be sufficient to prevent losses in the event of
defaults on the underlying mortgage loans.
In
addition, mortgage-related securities that are issued by private issuers are not
subject to the underwriting requirements for the underlying mortgages that are
applicable to those mortgage-related securities that have a government or
government-sponsored entity guarantee. As a result, the mortgage loans
underlying private mortgage-related securities may, and frequently do, have less
favorable
S-21
collateral,
credit risk or other underwriting characteristics than government or
government-sponsored mortgage-related securities and have wider variances in a
number of terms including interest rate, term, size, purpose and borrower
characteristics. Privately issued pools more frequently include second
mortgages, high loan-to-value mortgages and manufactured housing loans. The
coupon rates and maturities of the underlying mortgage loans in a private-label
mortgage-related securities pool may vary to a greater extent than those
included in a government guaranteed pool, and the pool may include subprime
mortgage loans. Subprime loans refer to loans made to borrowers with weakened
credit histories or with a lower capacity to make timely payments on their
loans. For these reasons, the loans underlying these securities have had in many
cases higher default rates than those loans that meet government underwriting
requirements.
The
risk of non-payment is greater for mortgage-related securities that are backed
by mortgage pools that contain subprime loans, but a level of risk exists for
all loans. Market factors adversely affecting mortgage loan repayments may
include a general economic turndown, high unemployment, a general slowdown in
the real estate market, a drop in the market prices of real estate, or an
increase in interest rates resulting in higher mortgage payments by holders of
adjustable rate mortgages.
Privately
issued mortgage-related securities are generally less liquid than obligations
directly or indirectly guaranteed by the U.S. government or a
government-sponsored entity, especially when there is a perceived weakness in
the mortgage and real estate market sectors. Without an active trading market,
mortgage-related securities held in the Fund’s portfolio may be particularly
difficult to value because of the complexities involved in assessing the value
of the underlying mortgage loans.
The
average life of a mortgage-backed security is likely to be substantially less
than the original maturity of the mortgage pools underlying the securities.
Prepayments of principal by mortgagors and mortgage foreclosures will usually
result in the return of the greater part of principal invested far in advance of
the maturity of the mortgages in the pool or can result in credit losses.
Collateralized Mortgage
Obligations.
Collateralized mortgage obligations (“
”) are debt
obligations collateralized by mortgage loans or mortgage pass-through securities
(collateral collectively referred to hereinafter as “
”).
Multi-class pass-through securities are interests in a trust composed of
Mortgage Assets. All references in this section to CMOs include multi-class
pass-through securities. Principal prepayments on the Mortgage Assets may cause
the CMOs to be retired substantially earlier than their stated maturities or
final distribution dates, resulting in a loss of all or part of the premium if
any has been paid. Interest is paid or accrues on all classes of the CMOs on a
monthly, quarterly or semi-annual basis. The principal and interest payments on
the Mortgage Assets may be allocated among the various classes of CMOs in
several ways. Typically, payments of principal, including any prepayments, on
the underlying mortgages are applied to the classes in the order of their
respective stated maturities or final distribution dates, so that no payment of
principal is made on CMOs of a class until all CMOs of other classes having
earlier stated maturities or final distribution dates have been paid in
full.
Stripped Mortgage-Backed
Securities.
Stripped mortgage-backed securities (“
”) are
derivative multi-class mortgage securities. SMBS are usually structured with two
classes that receive different proportions of the interest and principal
distributions from a pool of mortgage assets. The Fund will only invest in SMBS
whose mortgage assets are U.S. government obligations. A common type of SMBS
will be structured so that one class receives some of the interest and most of
the principal from the mortgage assets, while the other class receives most of
the interest and the remainder of the principal. If the underlying mortgage
assets experience greater than anticipated prepayments of principal, the Fund
may fail to fully recoup its initial investment in these securities. The market
value of any class which consists primarily or entirely of principal payments
generally is unusually volatile in response to changes in interest rates.
Risks of Investing in
Mortgage-Backed Securities.
Investment in mortgage-backed securities
poses several risks, including, among others, prepayment, market and credit
risk. Prepayment risk reflects the risk that borrowers may prepay their
mortgages faster than expected, thereby affecting the investment’s average life
and perhaps its yield. Whether or not a mortgage loan is prepaid is almost
entirely controlled by the borrower. Borrowers are most likely to exercise
prepayment options at the time when it is least advantageous to investors,
generally prepaying mortgages as interest rates fall, and slowing payments as
S-22
interest
rates rise. Besides the effect of prevailing interest rates, the rate of
prepayment and refinancing of mortgages may also be affected by home value
appreciation, ease of the refinancing process and local economic conditions.
Market risk reflects the risk that the price of a security may fluctuate over
time. The price of mortgage-backed securities may be particularly sensitive to
prevailing interest rates, the length of time the security is expected to be
outstanding and the liquidity of the issue. In a period of unstable interest
rates, there may be decreased demand for certain types of mortgage-backed
securities, and the Fund invested in such securities wishing to sell them may
find it difficult to find a buyer, which may in turn decrease the price at which
they may be sold. Credit risk reflects the risk that the Fund may not receive
all or part of its principal because the issuer or credit enhancer has defaulted
on its obligations. Obligations issued by U.S. government-related entities are
guaranteed as to the payment of principal and interest, but are not backed by
the full faith and credit of the U.S. government. The performance of private
label mortgage-backed securities, issued by private institutions, is based on
the financial health of those institutions. With respect to GNMA certificates,
although GNMA guarantees timely payment even if homeowners delay or default,
tracking the “pass-through” payments may, at times, be difficult.
The
risks to which CMBS are subject differ somewhat from the risks to which RMBS are
subject. CMBS are typically backed by a much smaller number of mortgages than
RMBS are, so problems with one or a small number of mortgages backing a CMBS can
have a large impact on its value. As CMBS have a less diversified pool of loans
backing them, they are much more susceptible to property-specific risk. The
values of CMBS are also more sensitive to macroeconomic trends. For example,
when the economy slows rents generally decrease and vacancies generally increase
for commercial real estate. Similarly, as many CMBS have a large exposure to
retail properties, events that negatively impact the retail industry can also
negatively impact the value of CMBS.
Municipal Bonds and Other
Municipal Obligations
The
Fund may invest in municipal bonds and other municipal obligations. These bonds
and other obligations are issued by the states and by their local and
special-purpose political subdivisions. The term “municipal bond” includes
short-term municipal notes issued by the states and their political
subdivisions, including, but not limited to, tax anticipation notes (“
”), bond
anticipation notes (“
”), revenue
anticipation notes (“
”),
construction loan notes, tax free commercial paper, and tax free participation
certificates. In general, municipal obligations include debt obligations issued
by states, cities and local authorities to obtain funds for various public
purposes, including construction of a wide range of public facilities such as
airports, bridges, highways, hospitals, housing, mass transportation, schools,
streets and water and sewer works.
General
obligation bonds are backed by the issuer’s pledge of its faith, credit, and
taxing power for the payment of principal and interest. The taxes that can be
levied for the payment of debt service may be limited or unlimited as to rate
and amount. For a limited obligation or revenue bond, the only security is
typically the net revenue derived from payments by a particular facility or
class of facilities financed by the proceeds of the bonds or, in some cases,
from the proceeds of a special tax or other special revenues. Although the
security behind these bonds varies widely, many lower rated bonds provide
additional security in the form of a debt service reserve fund that may also be
used to make principal and interest payments on the issuer’s obligations. In
addition, some revenue obligations (as well as general obligations) are insured
by a bond insurance company or backed by a letter of credit issued by a banking
institution. The credit quality of revenue bonds is usually directly related to
the credit standing of the user of the facility being financed or of an
institution which provides a guarantee, letter of credit or other credit
enhancement for the bond issue. Revenue bonds do not generally constitute the
pledge of the credit of the issuer of such bonds and are generally not secured
by the taxing power of the municipality. Revenue bonds are included in the term
municipal obligations if the interest paid thereon is exempt from federal income
tax. Revenue bonds may include, but are not limited to, pollution control,
health care, housing, education-related and industrial development bonds.
Generally,
the creditworthiness of a local municipal obligation is unrelated to that of the
municipal obligations of the state itself if the state has no responsibility to
guarantee or otherwise make payments on those local municipal obligations.
Generally,
interest received on municipal obligations is exempt from federal income tax.
The tax-exempt nature of the interest on a municipal obligation is generally the
subject of a bond counsel opinion
S-23
delivered
in connection with the issuance of the instrument. Tax opinions are generally
provided at the time the municipal security is initially issued and neither the
Fund or its portfolio managers will independently review the bases for those tax
opinions or guarantee that the tax opinions are correct. There is no assurance
that the Internal Revenue Service will agree with bond counsel’s opinion that
such interest is tax-exempt or that the interest payments on such municipal
obligations will continue to be tax exempt for the life of the municipal
obligation. Issuers or other parties generally enter into covenants requiring
continuing compliance with federal tax requirements to preserve the tax-free
status of interest payments over the life of the municipal obligation. If at any
time the covenants are not complied with, or if the Internal Revenue Service
otherwise determines that the issuer did not comply with relevant tax
requirements, interest payments from a municipal obligation could become
federally taxable, possibly retroactively to the date the municipal obligation
was issued, and an investor may need to file an amended income tax return.
Obligations
of issuers of municipal obligations are subject to the provisions of bankruptcy,
insolvency and other laws affecting the rights and remedies of creditors. The
application of state law to municipal obligation issuers could produce varying
results among the states or among municipal obligation issuers within a state.
These uncertainties could have a significant impact on the prices of the
municipal obligations in which the Fund invests. In addition, issuers of
municipal obligations may become subject to the laws enacted in the future by
Congress, state legislatures or referenda extending the time for payment of
principal and/or interest, or imposing other constraints upon enforcement of
such obligations or upon municipalities to levy taxes. There is also the
possibility that, as a result of legislation or other conditions, the power or
ability of any issuer to pay, when due, the principal of and interest on its
municipal obligations may be materially affected.
The
two general classifications of municipal bonds are “general obligation” bonds
and “revenue” bonds. General obligation bonds are secured by the governmental
issuer’s pledge of its faith, credit and taxing power for the payment of
principal and interest upon a default by the issuer of its principal and
interest payment obligations. They are usually paid from general revenues of the
issuing governmental entity. Revenue bonds, on the other hand, are usually
payable only out of a specific revenue source rather than from general revenues.
Revenue bonds ordinarily are not backed by the faith, credit or general taxing
power of the issuing governmental entity. The principal and interest on revenue
bonds for private facilities are typically paid out of rents or other specified
payments made to the issuing governmental entity by a private company which uses
or operates the facilities. Examples of these types of obligations are
industrial revenue bond and pollution control revenue bonds. Industrial revenue
bonds are issued by governmental entities to provide financing aid to community
facilities such as hospitals, hotels, business or residential complexes,
convention halls and sport complexes. Pollution control revenue bonds are issued
to finance air, water and solids pollution control systems for privately
operated industrial or commercial facilities.
