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Principal Risk Factors
The Fund is a non-diversified, closed-end
management investment company designed primarily as a long-term investment and not as a trading vehicle. The Fund is not intended to be
a complete investment program and, due to the uncertainty inherent in all investments, there can be no assurance that the Fund will achieve
its investment objectives. The Fund’s performance and the value of its investments will vary in response to changes in interest
rates, inflation, the financial condition of a security’s issuer, ratings on a security and other market factors. Your securities
at any point in time may be worth less than you invested, even after taking into account the reinvestment of Fund dividends and distributions.
Below are the principal risks associated with an investment in the Fund.
Investment Risk and
Market Risk. An investment in the Fund is subject to investment
risk, including the possible loss of the entire amount that you invest. Your investment in the Common Stock represents an indirect investment
in the securities owned by the Fund, most
of which could be
purchased directly. The value of the Fund’s portfolio securities may move up or down, sometimes rapidly and unpredictably. At any
point in time, your Common Stock may be worth less than your original investment, even after taking into account the reinvestment of Fund
dividends and distributions.
Market Price Discount
from Net Asset Value. Shares of closed-end investment companies
frequently trade at a discount from their net asset value. This risk is separate and distinct from the risk that the Fund’s net
asset value could decrease as a result of its investment activities and may be a greater risk to investors expecting to sell their Common
Stock in a relatively short period following completion of this offering. Whether investors will realize gains or losses upon the sale
of the Common Stock will depend not upon the Fund’s net asset value but upon whether the market price of the Common Stock at the
time of sale is above or below the investor’s purchase price for the Common Stock.
Risks Related to Investments
in MBS. Investing in MBS entails various risks: credit risks,
liquidity risks, interest rate risks, market risks, operations risks, structural risks, geographical concentration risks, basis risks
and legal risks. Most MBS are subject to the significant credit risks inherent in the underlying collateral and to the risk that the servicer
fails to perform. MBS are subject to risks associated with their structure and execution, including the process by which principal and
interest payments are allocated and distributed to investors, how credit losses affect the issuing vehicle and the return to investors
in such MBS, whether the collateral represents a fixed set of specific assets or accounts, whether the underlying collateral assets are
revolving or closed-end, under what terms (including maturity of the MBS) any remaining balance in the accounts may revert to the issuing
entity and the extent to which the entity that is the actual source of the collateral assets is obligated to provide support to the issuing
vehicle or to the investors in such MBS. In addition, concentrations of MBS of a particular type, as well as concentrations of MBS issued
or guaranteed by affiliated obligors, serviced by the same servicer or backed by underlying collateral located in a specific geographic
region, may subject the MBS to additional risk.
The risks associated with MBS include:
(1) credit risk associated with the performance of the underlying mortgage properties and of the borrowers owning these properties; (2)
adverse changes in economic conditions and circumstances, which are more likely to have an adverse impact on MBS secured by loans on certain
types of commercial properties than on those secured by loans on residential properties; (3) prepayment risk, which can lead to significant
fluctuations in value of the MBS; (4) loss of all or part of the premium, if any, paid; and (5) decline in the market value of the security,
whether resulting from changes in interest rates, prepayments on the underlying mortgage collateral or perceptions of the credit risk
associated with the underlying mortgage collateral.
MBS represent an
interest in a pool of mortgages. When market interest rates decline, more mortgages are refinanced and the securities are paid off earlier
than expected. Prepayments may also occur on a scheduled basis or due to foreclosure. When market interest rates increase, the market
values of MBS decline. At the same time, however, mortgage refinancings and prepayments slow, lengthening the effective maturities of
these securities. As a result, the negative effect of the rate increase on the market value of MBS is usually more pronounced than it
is for other types of debt securities. In addition, due to increased instability in the credit markets, the market for some MBS has experienced
reduced liquidity and greater volatility with respect to the value of such securities, making it more difficult to value such securities.
Moreover, the relationship between borrower
prepayments and changes in interest rates may mean some high-yielding mortgage-related and asset-backed securities have less potential
for increases in value if market interest rates were to fall than conventional bonds with comparable maturities. In addition, in periods
of falling interest rates, the rate of prepayments tends to increase. During such periods, the reinvestment of prepayment proceeds by
the Fund will generally be at lower rates than the rates that were carried by the obligations that have been prepaid. Because of these
and other reasons, mortgage-related and asset-backed security’s total return and maturity may be difficult to predict precisely.
To the extent that the Fund purchases mortgage-related securities at a premium, prepayments (which may be made without penalty) may result
in loss of the Fund’s principal investment to the extent of premium paid.
The Fund’s success depends on
the Western Asset’s ability to analyze the relationship of changing interest rates on prepayments of the mortgage loans that underlie
the Fund’s MBS. Changes in interest rates and prepayments affect the market price of the target assets that the Fund intends to
purchase and any target assets that the Fund holds at a given time. As part of the Fund’s overall portfolio risk management, Western
Asset will analyze interest rate changes and prepayment trends separately and collectively to assess their effects on the Fund’s
investment portfolio. In conducting its analysis, Western Asset will depend on certain assumptions based upon historical trends with respect
to the relationship between interest rates and prepayments under normal market conditions. If the recent dislocations in the mortgage
market or other developments change the way that prepayment trends have historically responded to interest rate changes, Western Asset’s
ability to (1) assess the market value of the Fund’s investment portfolio, (2) implement any hedging strategies and (3) implement
techniques to reduce prepayment rate volatility would be significantly affected, which could materially adversely affect the Fund’s
financial position and results of operations.
In general, losses on a mortgaged property
securing a mortgage loan included in a securitization will be borne first by the equity holder of the property, then by a cash reserve
fund or letter of
credit, if any, then by the holder of a mezzanine loan or B-Note, if any, then by the “first loss” subordinated security
holder (generally, the “B-Piece” buyer) and then by the holder of a higher-rated security. In the event of default and the
exhaustion of any equity support, reserve fund, letter of credit, mezzanine loans or B-Notes, and any classes of securities junior to
those in which the Fund invests, the Fund will not be able to recover all of its investment in the MBS it purchases. MBS in which the
Fund invests may not contain reserve funds, letters of credit, mezzanine loans and/or junior classes of securities. The prices of lower
credit quality securities are generally less sensitive to interest rate changes than more highly rated investments, but more sensitive
to adverse economic downturns or individual issuer developments.
MBS generally are classified as either
CMBS or RMBS, each of which are subject to certain specific risks as further described below. See “—Non-Agency RMBS Risk”
and “—CMBS Risk.”
Non-Agency RMBS Risk.
Non-agency RMBS are securities issued by non-governmental issuers, the payments on which depend (except for rights or other assets designed
to assure the servicing or timely distribution of proceeds to holders of such securities) primarily on the cash flow from residential
mortgage loans made to borrowers that are secured (on a first priority basis or second priority basis, subject to permitted liens, easements
and other encumbrances) by residential real estate (one- to four- family properties) the proceeds of which are used to purchase real estate
and purchase or construct dwellings thereon (or to refinance indebtedness previously so used). Non-agency RMBS have no direct or indirect
government guarantees of payment and are subject to various risks as described herein.
Credit-Related Risk
Associated with Borrowers on Non-Agency RMBS. Credit-related
risk on non-agency RMBS arises from losses due to delinquencies and defaults by the borrowers in payments on the underlying mortgage loans
and breaches by originators and servicers of their obligations under the underlying documentation pursuant to which the non-agency RMBS
are issued. Residential mortgage loans are obligations of the borrowers thereunder only and are not typically insured or guaranteed by
any other person or entity. The rate of delinquencies and defaults on residential mortgage loans and the aggregate amount of the resulting
losses will be affected by a number of factors, including general economic conditions, particularly those in the area where the related
mortgaged property is located, the level of the borrower’s equity in the mortgaged property and the individual financial circumstances
of the borrower. If a residential mortgage loan is in default, foreclosure on the related residential property may be a lengthy and difficult
process involving significant legal and other expenses. The net proceeds obtained by the holder on a residential mortgage loan following
the foreclosure on the related property may be less than the total amount that remains due on the loan. The prospect of incurring a loss
upon the foreclosure
of the related property
may lead the holder of the residential mortgage loan to restructure the residential mortgage loan or otherwise delay the foreclosure process.
Impact of Real Estate
and Mortgage Loan Markets on Non-Agency RMBS. In addition
to the foregoing considerations, the market for defaulted residential mortgage loans and foreclosed real estate properties may be very
limited. In particular, the economic conditions that lead to a higher rate of delinquencies and defaults on a portfolio of real estate
mortgage loans may also lead to a reduction in the value of the related real estate properties, which in turn will result in greater losses
upon a foreclosure of the real estate properties. At any one time, a portfolio of non-agency RMBS may be backed by residential mortgage
loans that are highly concentrated in only a few states or regions. As a result, the performance of such residential mortgage loans may
be more susceptible to a downturn in the economy, including in particular industries that are highly represented in such states or regions,
natural calamities and other adverse conditions affecting such areas. In addition, the residential mortgage loans underlying non-agency
RMBS may include so-called “jumbo” residential mortgage loans, having original principal balances that are significantly
higher than is generally the case for residential mortgage loans. If the portfolio of residential mortgage loans underlying a non-agency
RMBS includes a high concentration of “jumbo” residential mortgage loans, the performance of the non-agency RMBS will be
more susceptible to the performance of individual borrowers and adverse economic conditions in general than would otherwise be the case.
Another factor that may contribute to,
and may in the future result in, higher delinquency and default rates is the increase in monthly payments on adjustable-rate mortgage
loans. Any increase in prevailing market interest rates may result in increased payments for borrowers who have adjustable-rate mortgage
loans. Moreover, with respect to hybrid mortgage loans after their initial fixed-rate period or other so-called adjustable-rate mortgage
loans, interest-only products or products having a lower rate, and with respect to mortgage loans with a negative amortization feature
which reach their negative amortization cap, borrowers may experience a substantial increase in their monthly payment even without an
increase in prevailing market interest rates. Increases in payments for borrowers may result in increased rates of delinquencies and defaults
on residential mortgage loans underlying the non-agency RMBS. The past performance of the market for non-agency RMBS is not a reliable
indicator of future performance because of the unprecedented and unpredictable performance of the residential mortgage loan market.
As a result of rising concerns about
increases in delinquencies and defaults on residential mortgage loans (particularly on subprime and adjustable-rate mortgage loans) and
as a result of increasing concerns about the financial strength of originators and servicers and their ability to perform their obligations
with respect to non-agency RMBS, there may be an adverse change in the market sentiments of investors about the market values and volatility
and the degree of
risk of non-agency RMBS generally. Some or all of the underlying residential mortgage loans in an issue of non-agency RMBS may have balloon
payments due on their respective maturity dates. Balloon residential mortgage loans involve a greater risk to a lender than fully amortizing
loans, because the ability of a borrower to pay such amount will normally depend on its ability to obtain refinancing of the related mortgage
loan or sell the related mortgaged property at a price sufficient to permit the borrower to make the balloon payment, which will depend
on a number of factors prevailing at the time such refinancing or sale is required, including, without limitation, the strength of the
local or national residential real estate markets, interest rates and general economic conditions and the financial condition of the borrower.
If borrowers are unable to make such balloon payments, the related issue of non-agency RMBS may experience losses.
Prepayment Risk Associated
with Non-Agency RMBS. Non-agency RMBS are susceptible to prepayment
risks. Except in the case of certain types of non-agency RMBS, the mortgage loans underlying non-agency RMBS generally do not contain
prepayment penalties and a reduction in market interest rates will increase the likelihood of prepayments on the related non-agency RMBS,
resulting in a reduction in yield to maturity for most holders of such securities. In the case of certain home equity loan securities
and certain types of non-agency RMBS, even though the underlying mortgage loans often contain prepayment premiums, such prepayment premiums
may not be sufficient to discourage borrowers from prepaying their mortgage loans in the event of a reduction in market interest rates,
resulting in a reduction in the yield to maturity for holders of the related non-agency RMBS. In addition to reductions in the level of
market interest rates and the prepayment provisions of the mortgage loans, repayments on the residential mortgage loans underlying an
issue of non-agency RMBS may also be affected by a variety of economic, geographic and other factors, including the size difference between
the interest rates on the underlying residential mortgage loans (giving consideration to the cost of refinancing) and prevailing mortgage
rates and the availability of refinancing. In general, if prevailing interest rates fall significantly below the interest rates on the
related residential mortgage loans, the rate of prepayment on the underlying residential mortgage loans would be expected to increase.
Conversely, if prevailing interest rates rise to a level significantly above the interest rates on the related mortgage loans, the rate
of prepayment would be expected to decrease. Prepayments could reduce the yield received on the related issue of non-agency RMBS.
Non-agency RMBS typically contain provisions
that require repurchase of mortgage loans by the originator or other seller in the event of a breach of a representation or warranty regarding
loan quality and characteristics of such loan. Any repurchase of a mortgage loan as a result of a breach has the same effect on the yield
received on the related issue of non-agency RMBS as a prepayment of such mortgage loan. Any increase in breaches of representations and
the consequent repurchases of mortgage loans that result from inadequate underwriting procedures and policies and protections against
fraud will have
the same effect
on the yield on the related non-agency RMBS as an increase in prepayment rates. CMBS are also subject to prepayment risk, as described
above. Risk of prepayment may be reduced for commercial real estate property loans containing significant prepayment penalties or prohibitions
on principal payments for a period of time following origination.
The Fund may also invest in MBS which
are IO securities and PO securities. An IO security receives some or all of the interest portion of the underlying collateral and little
or no principal. A reference principal value called a notional value is used to calculate the amount of interest due. IO securities are
sold at a deep discount to their notional principal amount. A PO security does not receive any interest, is priced at a deep discount
to its redemption value and ultimately receives the redemption value. Generally speaking, when interest rates are falling and prepayment
rates are increasing, the value of a PO security will rise and the value of an IO security will fall. Conversely, when interest rates
are rising and prepayment rates are decreasing, generally the value of a PO security will fall and the value of an IO security will rise.
Legal Risks Associated
with Non-Agency RMBS. Legal risks can arise as a result of
the procedures followed in connection with the origination of the mortgage loans or the servicing thereof which may be subject to various
federal and state laws (including, without limitation, predatory lending laws), public policies and principles of equity regulating interest
rates and other charges, require certain disclosures, require licensing of originators, prohibit discriminatory lending practices, regulate
the use of consumer credit information and debt collection practices and may limit the servicer’s ability to collect all or part
of the principal of or interest on a residential mortgage loan, entitle the borrower to a refund of amounts previously paid by it or subject
the servicer to damages and sanctions. Specifically, provisions of federal predatory lending laws, such as the federal Truth-in-Lending
Act (as supplemented by the Home Ownership and Equity Protection Act of 1994) and Regulation Z, and various enacted state predatory lending
laws provide that a purchaser or assignee of specified types of residential mortgage loans (including an issuer of non-agency RMBS) may
be held liable for violations by the originator of such mortgage loans. Under such assignee liability provisions, a borrower is generally
given the right to assert against a purchaser of its mortgage loan any affirmative claims and defenses to payment such borrower could
assert against the originator of the loan or, where applicable, the home improvement contractor that arranged the loan. Liability under
such assignee liability provisions could, therefore, result in a disruption of cash flows allocated to the holders of non-agency RMBS
where either the issuer of such non-agency RMBS is liable in damages or is unable to enforce payment by the borrower. In most but not
all cases, the amount recoverable against a purchaser or assignee under such assignee liability provisions is limited to amounts previously
paid and still owed by the borrower. Moreover, sellers of residential mortgage loans to an issuer of non-agency RMBS typically represent
that the loans have been
originated in accordance
with all applicable laws and in the event such representation is breached, the seller typically must repurchase the offending loan.
Notwithstanding these protections, an
issuer of non-agency RMBS may be exposed to an unquantifiable amount of potential assignee liability because, first, the amount of potential
assignee liability under certain predatory lending laws is unclear and has yet to be litigated, and, second, in the event a predatory
lending law does not prohibit class action lawsuits, it is possible that an issuer of non-agency RMBS could be liable in damages for more
than the original principal amount of the offending loans held by it. In such circumstances the issuer of non-agency RMBS may be forced
to seek contribution from other parties, who may no longer exist or have adequate funds available to fund such contribution.
In addition, structural and legal risks
of non-agency RMBS include the possibility that, in a bankruptcy or similar proceeding involving the originator or the servicer (often
the same entity or affiliates), the assets of the issuer could be treated as never having been truly sold by the originator to the issuer
and could be substantively consolidated with those of the originator, or the transfer of such assets to the issuer could be voided as
a fraudulent transfer. Challenges based on such doctrines could result also in cash flow delays and losses on the related issue of non-agency
RMBS.
In some cases, servicers of non-agency
RMBS have been the subject of legal proceedings involving the origination and/or servicing practices of such servicers. Large groups of
private litigants and states attorneys general have brought such proceedings. Because of the large volume of mortgage loans originated
and serviced by such servicers, such litigation can cause heightened financial strain on servicers. In other cases, origination and servicing
practices may cause or contribute to such strain, because of representation and warranty repurchase liability arising in MBS and mortgage
loan sale transactions. Any such financial strain could cause servicers to service below required standards, causing delinquencies and
losses in any related MBS transaction to rise, and in extreme cases could cause the servicer to seek the protection of any applicable
bankruptcy or insolvency law. In any such proceeding, it is unclear whether the fees that the servicer charges in such transactions would
be sufficient to permit that servicer or a successor servicer to service the mortgage loans in such transaction adequately. If such fees
had to be increased, it is likely that the most subordinated security holders in such transactions would be effectively required to pay
such increased fees. Finally, these entities may be the subject of future laws designed to protect consumers from defaulting on their
mortgage loans. Such laws may have an adverse effect on the cash flows paid under such non-agency RMBS.
In the past year, a number of lenders
specializing in residential mortgages have sought bankruptcy protection, shut down or been refused further financings from their lenders.
In addition, certain lenders who service and/or issue non-agency RMBS have announced that they are being investigated by or have received
information requests from U.S. federal
and/or state authorities,
including the Securities and Exchange Commission. As a result of such investigations and other similar investigations and general concerns
about the adequacy or accuracy of disclosure of risks to borrowers and their understanding of such risks, U.S. financial regulators have
indicated that they may propose new guidelines for the mortgage industry. Guidelines, if introduced, together with the other factors described
herein, may make it more difficult for borrowers with weaker credit to refinance, which may lead to further increases in delinquencies,
extensions in duration and losses in mortgage-related assets. Furthermore, because some mortgage loans have high recoveries, and as property
values decline, increasing loan-to-value ratios, recoveries on some defaulted mortgage loans are more likely to be less than the amounts
owed under such mortgage loans, resulting in higher net losses than would have been the case had property values remained the same or
increased.
CMBS Risk.
CMBS are, generally, securities backed by obligations (including certificates of participation in obligations) that are principally secured
by mortgages on real property or interests therein having a multifamily or commercial use, such as regional malls, other retail space,
office buildings, industrial or warehouse properties, hotels, nursing homes and senior living centers. The market for CMBS developed more
recently and, in terms of total outstanding principal amount of issues, is relatively small compared to the market for residential single-family
mortgage-related securities. CMBS are subject to particular risks, including lack of standardized terms, shorter maturities than residential
mortgage loans and payment of all or substantially all of the principal only at maturity rather than regular amortization of principal.
Additional risks may be presented by the type and use of a particular commercial property. Special risks are presented by hospitals, nursing
homes, hospitality properties and certain other property types. Commercial property values and net operating income are subject to volatility,
which may result in net operating income becoming insufficient to cover debt service on the related mortgage loan. The repayment of loans
secured by income-producing properties is typically dependent upon the successful operation of the related real estate project rather
than upon the liquidation value of the underlying real estate. Furthermore, the net operating income from and value of any commercial
property is subject to various risks, including changes in general or local economic conditions and/or specific industry segments; the
solvency of the related tenants; declines in real estate values; declines in rental or occupancy rates; increases in interest rates, real
estate tax rates and other operating expenses; changes in governmental rules, regulations and fiscal policies; acts of God; terrorist
threats and attacks and social unrest and civil disturbances. Consequently, adverse changes in economic conditions and circumstances are
more likely to have an adverse impact on mortgage-related securities secured by loans on commercial properties than on those secured by
loans on residential properties. In addition, commercial lending generally is viewed as exposing the lender to a greater risk of loss
than one- to four- family residential lending. Commercial lending, for
example, typically
involves larger loans to single borrowers or groups of related borrowers than residential one- to four- family mortgage loans. In addition,
the repayment of loans secured by income producing properties typically is dependent upon the successful operation of the related real
estate project and the cash flow generated therefrom.
The exercise of remedies and successful
realization of liquidation proceeds relating to CMBS is also highly dependent on the performance of the servicer or special servicer.
In many cases, overall control over the special servicing of related underlying mortgage loans will be held by a “directing certificateholder”
or a “controlling class representative,” which is appointed by the holders of the most subordinate class of CMBS in such
series. The Fund may not have the right to appoint the directing certificateholder. In connection with the servicing of the specially
serviced mortgage loans, the related special servicer may, at the direction of the directing certificateholder, take actions with respect
to the specially serviced mortgage loans that could adversely affect the Fund’s interests. There may be a limited number of special
servicers available, particularly those that do not have conflicts of interest.
Western Asset will value the Fund’s
potential CMBS investments based on loss-adjusted yields, taking into account estimated future losses on the mortgage loans included in
the securitization’s pool of loans, and the estimated impact of these losses on expected future cash flows. Western Asset’s
loss estimates may not prove accurate, as actual results may vary from estimates. In the event that Western Asset overestimates the pool
level losses relative to the price the Fund pays for a particular CMBS investment, the Fund may experience losses with respect to such
investment.
Interest Rate Risk
Associated with Non-Agency RMBS and CMBS. The rate of interest
payable on certain non-agency RMBS and CMBS may be set or effectively capped at the weighted average net coupon of the underlying mortgage
loans themselves, often referred to as an “available funds cap.” As a result of this cap, the return to the holder of such
non-agency RMBS and CMBS is dependent on the relative timing and rate of delinquencies and prepayments of mortgage loans bearing a higher
rate of interest. In general, early prepayments will have a greater negative impact on the yield to the holder of such non-agency RMBS
and CMBS.
The value of fixed rate debt securities
can be expected to vary inversely with changes in prevailing interest rates. Fixed rate debt securities with longer maturities, which
tend to produce higher yields, are subject to potentially greater capital appreciation and depreciation than securities with shorter maturities.
Structural Risks Associated
with Non-Agency RMBS and CMBS. Because non-agency RMBS generally
are ownership or participation interests in pools of mortgage loans secured by a pool of one- to four-family residential properties underlying
the mortgage loan pool, the
non-agency RMBS
are entitled to payments provided for in the underlying agreement only when and if funds are generated by the underlying mortgage loan
pool. This likelihood of the return of interest and principal may be assessed as a credit matter. However, the holders of non-agency RMBS
do not have the legal status of secured creditors, and cannot accelerate a claim for payment on their securities, or force a sale of the
mortgage loan pool in the event that insufficient funds exist to pay such amounts on any date designated for such payment. The holders
of non-agency RMBS do not typically have any right to remove a servicer solely as a result of a failure of the mortgage pool to perform
as expected. A similar risk is associated with CMBS.
Subordination Risk
Associated with Non-Agency RMBS and CMBS. The non-agency RMBS
and CMBS may be subordinated to one or more other senior classes of securities of the same series for purposes of, among other things,
offsetting losses and other shortfalls with respect to the related underlying mortgage loans. For example, in the case of certain non-agency
RMBS and CMBS, no distributions of principal will generally be made with respect to any class until the aggregate principal balances of
the corresponding senior classes of securities have been reduced to zero. As a result, non-agency RMBS and CMBS may be more sensitive
to risk of loss, writedowns, the non-fulfillment of repurchase obligations, overadvancing on a pool of loans and the costs of transferring
servicing than senior classes of securities.
Credit Risk and Counterparty
Risk. If an issuer or guarantor of a security held by the
Fund or a counterparty to a financial contract with the Fund defaults or its credit is downgraded, or is perceived to be less creditworthy,
or if the value of the assets underlying a security declines, the value of your investment will typically decline. Changes in actual or
perceived creditworthiness may occur quickly. The Fund could be delayed or hindered in its enforcement of rights against an issuer,
guarantor or counterparty. Subordinated securities are more likely to suffer a credit loss than non-subordinated securities of the same
issuer and will be disproportionately affected by a default, downgrade or perceived decline in creditworthiness.
Interest Rate Risk.
The market price of the Fund’s investments will change in response to changes in interest rates and other factors. During periods
of declining interest rates, the market price of fixed income securities generally rises. Conversely, during periods of rising interest
rates, the market price of such securities generally declines. The magnitude of these fluctuations in the market price of fixed income
securities is generally greater for securities with longer maturities. Additionally, such risk may be greater during the current period
of historically low interest rates. Fluctuations in the market price of the Fund’s securities will not affect interest income derived
from securities already owned by the Fund, but will be reflected in the Fund’s net asset value. The Fund may utilize certain strategies,
including investments in structured notes or interest rate swap or cap transactions, for the
purpose of reducing
the interest rate sensitivity of the portfolio and decreasing the Fund’s exposure to interest rate risk, although there is no assurance
that it will do so or that such strategies will be successful.
Leverage Risk.
The Fund is authorized to use leverage. The value of your investment may be more volatile if the fund borrows or uses instruments, such
as derivatives, that have a leveraging effect on the fund’s portfolio. Other risks described in the Prospectus also will be compounded
because leverage generally magnifies the effect of a change in the value of an asset and creates a risk of loss of value on a larger
pool of assets than the fund would otherwise have had. The fund may also have to sell assets at inopportune times to satisfy its obligations
created by the use of leverage or derivatives. The use of leverage is considered to be a speculative investment practice and may result
in the loss of a substantial amount, and possibly all, of the fund’s assets. In addition, the fund’s portfolio will be leveraged
if it exercises its right to delay payment on a redemption, and losses will result if the value of the fund’s assets declines between
the time a redemption request is deemed to be received by the fund and the time the fund liquidates assets to meet redemption requests.
ABS Risk.
The Fund may invest up to 20% of its Managed Assets in non-mortgage related ABS. Investing in ABS entails various risks, including credit
risks, liquidity risks, interest rate risks, market risks and legal risks. Credit risk is an important issue in ABS because of the significant
credit risks inherent in the underlying collateral and because issuers are primarily private entities. The structure of an ABS and the
terms of the investors’ interest in the collateral can vary widely depending on the type of collateral, the desires of investors
and the use of credit enhancements. Although the basic elements of all ABS are similar, individual transactions can differ markedly in
both structure and execution. Important determinants of the risk associated with issuing or holding the securities include the process
by which principal and interest payments are allocated and distributed to investors, how credit losses affect the issuing vehicle and
the return to investors in such ABS, whether collateral represents a fixed set of specific assets or accounts, whether the underlying
collateral assets are revolving or closed-end, under what terms (including the maturity of the ABS itself) any remaining balance in the
accounts may revert to the issuing entity and the extent to which the entity that is the actual source of the collateral assets is obligated
to provide support to the issuing vehicle or to the investors in such ABS. The Fund may invest in ABS that are subordinate in right of
payment and rank junior to other securities that are secured by or represent an ownership interest in the same pool of assets. In addition,
many of the transactions in which such securities are issued have structural features that divert payments of interest and/or principal
to more senior classes when the delinquency or loss experience of the pool exceeds certain levels. As a result, such securities have a
higher risk of loss as a result of delinquencies or losses on the underlying assets.
Below
Investment Grade (“High Yield” or “Junk”) Securities Risk.
A significant portion of the Fund’s portfolio may consist of below investment grade securities (high yield securities). The Fund
invests a substantial portion of its assets in MBS that were originally rated AAA, but subsequently have been downgraded to below investment
grade. High yield debt securities are generally subject to greater credit risks than higher-grade debt securities, including the risk
of default on the payment of interest or principal. High yield debt securities are considered speculative, typically have lower liquidity
and are more difficult to value than higher grade bonds. High yield debt securities tend to be volatile and more susceptible to adverse
events, credit downgrades and negative sentiments and may be difficult to sell at a desired price, or at all, during periods of uncertainty
or market turmoil.
Distressed Investments.
The Fund invests in distressed securities, which are securities and obligations of companies that are experiencing financial or business
difficulties. Distressed investments may result in significant returns to the Fund, but also involve a substantial degree of risk. Among
the risks inherent in distressed situations is the fact that it frequently may be difficult to obtain information as to the true condition
of the securities being purchased. The market prices of distressed securities are also subject to abrupt and erratic market movements
and above average price volatility, and the spread between the bid and asked prices of such securities may be greater than normally experienced.
The Fund intends to invest in distressed
investments including non-performing and sub-performing RMBS and CMBS, many of which are not publicly traded and which may involve a substantial
degree of risk. In certain periods, there may be little or no liquidity in the markets for these securities or instruments. In addition,
the prices of such securities or instruments may be subject to periods of abrupt and erratic market movements and above-average price
volatility. It may be more difficult to value such securities and the spread between the bid and asked prices of such securities may be
greater than normally expected. If the Western Asset’s evaluation of the risks and anticipated outcome of an investment in a distressed
security should prove incorrect, the Fund may lose a substantial portion or all of its investment.
Furthermore, investments in assets operating
in workout modes or under Chapter 11 of the United States Bankruptcy Code, as amended, and other comparable bankruptcy laws may, in certain
circumstances, be subject to certain additional potential liabilities that may exceed the value of the Fund’s original investment.
For example, under certain circumstances, lenders who have inappropriately exercised control of the management and policies of a debtor
may have their claims subordinated or disallowed or counterclaims may be filed and lenders may be found liable for damages suffered by
various parties as a result of such actions. In addition, under certain circumstances, payments to the Fund and distributions by the Fund
to its investors may be reclaimed if any such payment or distribution is later determined to have been a fraudulent conveyance or a preferential
payment.
The Fund is not
limited in its ability to invest in distressed investments.
Credit Risk Associated
with Originators and Servicers of Residential and Commercial Mortgage Loans.
A number of originators and servicers of residential and commercial mortgage loans, including some of the largest originators and servicers
in the residential and commercial mortgage loan market, have experienced serious financial difficulties, including some that are now subject
to federal insolvency proceedings. These difficulties have resulted from many factors, including increased competition among originators
for borrowers, decreased originations by such originators of mortgage loans and increased delinquencies and defaults on such mortgage
loans, as well as from increases in claims for repurchases of mortgage loans previously sold by them under agreements that require repurchase
in the event of breaches of representations regarding loan quality and characteristics. Such difficulties may affect the performance of
non-agency RMBS and CMBS backed by mortgage loans. Furthermore, the inability of the originator to repurchase such mortgage loans in the
event of loan representation breaches or the servicer to repurchase such mortgage loans upon a breach of its servicing obligations also
may affect the performance of related non-agency RMBS and CMBS. Delinquencies and losses on, and, in some cases, claims for repurchase
by the originator of, mortgage loans originated by some mortgage lenders have increased as a result of inadequate underwriting procedures
and policies, including inadequate due diligence, failure to comply with predatory and other lending laws and, particularly in the case
of any “no documentation” or “limited documentation” mortgage loans that may support non-agency RMBS, inadequate
verification of income and employment history. Delinquencies and losses on, and claims for repurchase of, mortgage loans originated by
some mortgage lenders have also resulted from fraudulent activities of borrowers, lenders, appraisers, and other residential mortgage
industry participants such as mortgage brokers, including misstatements of income and employment history, identity theft and overstatements
of the appraised value of mortgaged properties. Many of these originators and servicers are very highly leveraged. These difficulties
may also increase the chances that these entities may default on their warehousing or other credit lines or become insolvent or bankrupt
and thereby increase the likelihood that repurchase obligations will not be fulfilled and the potential for loss to holders of non-agency
RMBS, CMBS and subordinated security holders.
The servicers of non-agency RMBS and
CMBS are often the same entities as, or affiliates of, the originators of these mortgage loans. Accordingly, the financial risks relating
to originators of non-agency RMBS and CMBS described immediately above also may affect the servicing of non-agency RMBS and CMBS. In the
case of such servicers, and other servicers, financial difficulties may have a negative effect on the ability of servicers to pursue collection
on mortgage loans that are experiencing increased delinquencies and defaults and to maximize recoveries on sale of underlying properties
following foreclosure.
Non-agency RMBS
and CMBS typically provide that the servicer is required to make advances in respect of delinquent mortgage loans. However, servicers
experiencing financial difficulties may not be able to perform these obligations or obligations that they may have to other parties of
transactions involving these securities. Like originators, these entities are typically very highly leveraged. Such difficulties may cause
servicers to default under their financing arrangements. In certain cases, such entities may be forced to seek bankruptcy protection.
Due to the application of the provisions of bankruptcy law, servicers who have sought bankruptcy protection may not be required to advance
such amounts. Even if a servicer were able to advance amounts in respect of delinquent mortgage loans, its obligation to make such advances
may be limited to the extent that it does not expect to recover such advances due to the deteriorating credit of the delinquent mortgage
loans or declining value of the related mortgaged properties. Moreover, servicers may overadvance against a particular mortgage loan or
charge too many costs of resolution or foreclosure of a mortgage loan to a securitization, which could increase the potential losses to
holders of non-agency RMBS and CMBS. In such transactions, a servicer’s obligation to make such advances may also be limited to
the amount of its servicing fee. In addition, if an issue of non-agency RMBS and CMBS provides for interest on advances made by the servicer,
in the event that foreclosure proceeds or payments by borrowers are not sufficient to cover such interest, such interest will be paid
to the servicer from available collections or other mortgage income, thereby reducing distributions made on the non-agency RMBS and CMBS
and, in the case of senior-subordinated non-agency RMBS and CMBS described below, first from distributions that would otherwise be made
on the most subordinated non-agency RMBS and CMBS of such issue. Any such financial difficulties may increase the possibility of a servicer
termination and the need for a transfer of servicing and any such liabilities or inability to assess such liabilities may increase the
difficulties and costs in affecting such transfer and the potential loss, through the allocation of such increased cost of such transfer,
to subordinated security holders.
There can be no assurance that originators
and servicers of mortgage loans will not continue to experience serious financial difficulties or experience such difficulties in the
future, including becoming subject to bankruptcy or insolvency proceedings, or that underwriting procedures and policies and protections
against fraud will be sufficient in the future to prevent such financial difficulties or significant levels of default or delinquency
on mortgage loans. Because the recent financial difficulties experienced by such originators and services is unprecedented and unpredictable,
the past performance of the residential and commercial mortgage loans originated and serviced by them (and the corresponding performance
of the related non-agency RMBS and CMBS) is not a reliable indicator of the future performance of such residential mortgage loans (or
the related non-agency RMBS and CMBS).
Subprime
Mortgage Market Risk. The residential mortgage market in the
United States has experienced difficulties that may adversely affect the performance and market value of certain mortgages and mortgage-related
securities. Delinquencies and losses on residential mortgage loans (especially subprime and second-line mortgage loans) generally have
increased and may continue to increase, and a decline in or flattening of housing values (as has been experienced and may continue to
be experienced in many housing markets) may exacerbate such delinquencies and losses. Borrowers with adjustable rate mortgage loans are
more sensitive to changes in interest rates, which affect their monthly mortgage payments, and may be unable to secure replacement mortgages
at comparably low interest rates. Also, a number of residential mortgage loan originators have experienced serious financial difficulties
or bankruptcy. Largely due to the foregoing, reduced investor demand for mortgage loans and mortgage-related securities and increased
investor yield requirements have caused limited liquidity in the secondary market for mortgage-related securities, which can adversely
affect the market value of mortgage-related securities. It is possible that such limited liquidity in such secondary markets could continue
or worsen.
The Fund may acquire non-agency RMBS
backed by collateral pools of mortgage loans that have been originated using underwriting standards that are less restrictive than those
used in underwriting “prime mortgage loans” and “Alt-A mortgage loans.” These lower standards include mortgage
loans made to borrowers having imperfect or impaired credit histories, mortgage loans where the amount of the loan at origination is 80%
or more of the value of the mortgage property, mortgage loans made to borrowers with low credit scores, mortgage loans made to borrowers
who have other debt that represents a large portion of their income and mortgage loans made to borrowers whose income is not required
to be disclosed or verified. Due to economic conditions, including increased interest rates and lower home prices, as well as aggressive
lending practices, subprime mortgage loans have in recent periods experienced increased rates of delinquency, foreclosure, bankruptcy
and loss, and they are likely to continue to experience delinquency, foreclosure, bankruptcy and loss rates that are higher, and that
may be substantially higher, than those experienced by mortgage loans underwritten in a more traditional manner. Thus, because of the
higher delinquency rates and losses associated with subprime mortgage loans, the performance of non-agency RMBS backed by subprime mortgage
loans that the Fund may acquire could be correspondingly adversely affected, which could adversely impact the Fund’s results of
operations, financial condition and business.
If the economy of the United States
further deteriorates, the incidence of mortgage foreclosures, especially subprime mortgages, may continue to increase, which may adversely
affect the value of any MBS owned by the Fund. The U.S. Congress and various government regulatory authorities have discussed the possibility
of restructuring mortgages and imposing forbearance requirements on defaulted mortgages. Neither LMPFA nor
Western Asset can
predict the form any such modifications, forbearance or related regulations might take, and these regulations may adversely affect the
value of MBS owned by the Fund.
Risks Relating to
Investments in Mortgage Whole Loans.
Credit Risk Associated
With Investments in Mortgage Whole Loans. The holder of residential
and commercial mortgages assumes the risk that the related borrowers may default on their obligations to make full and timely payments
of principal and interest. In general, these investments carry greater investment risk than agency MBS/CMBS because the former are not
guaranteed as to principal or interest by the U.S. Government, any federal agency or any federally chartered corporation. As a result,
a mortgage whole loan is directly exposed to losses resulting from default and foreclosure. Therefore, the value of the underlying property,
the creditworthiness and financial position of the borrower, and the priority and enforceability of the lien are each of great importance.
Whether or not Legg Mason, Western Asset or their affiliates have participated in the negotiation of the terms of any such mortgages,
there can be no assurance as to the adequacy of the protection of the terms of the loan, including the validity or enforceability of the
loan and the maintenance of the anticipated priority and perfection of the applicable security interests. Furthermore, claims may be asserted
that might interfere with enforcement of the rights of the Fund. In the event of a foreclosure, the Fund may assume direct ownership of
the underlying real estate. The liquidation proceeds upon sale of such real estate may not be sufficient to recover the Fund’s
cost basis in the loan, resulting in a loss to the Fund. Any costs or delays involved in the effectuation of a foreclosure of the loan
or a liquidation of the underlying property will further reduce the proceeds and thus increase the loss.
Higher-than-expected rates of default
and/or higher-than-expected loss severities on these investments could adversely affect the value of these assets. Accordingly, defaults
in the payment of principal and/or interest on the Fund’s residential and commercial whole loans would likely result in the Fund
incurring losses of income from, and/or losses in market value relating to, these assets, which could materially adversely affect the
Fund’s results of operations.
Holders of residential and commercial
whole loans are subject to the risk that the related borrowers may default or have defaulted on their obligations to make full and timely
payments of principal and interest. A number of factors impact a borrower’s ability to repay including, among other things, changes
in employment status, changes in interest rates or the availability of credit, and changes in real estate values. In addition to the credit
risk associated with these assets, residential and commercial whole loans are less liquid than certain of the Fund’s other credit
sensitive assets, which may make them more difficult to dispose of if the need or desire arises. If actual results are different from
the Fund’s assumptions in determining the prices paid to acquire such loans, particularly if the market
value of the underlying
properties decreases significantly subsequent to purchase, we may incur significant losses, which could materially adversely affect the
Fund’s results.
Servicing-Related
Risks of Mortgage Whole Loans. We rely on third-party servicers
to service and manage the mortgages underlying the Fund’s loan portfolio. The ultimate returns generated by these investments may
depend on the quality of the servicer. If a servicer is not vigilant in seeing that borrowers make their required monthly payments, borrowers
may be less likely to make these payments, resulting in a higher frequency of default. If a servicer takes longer to liquidate non-performing
mortgages, the Fund’s losses related to those loans may be higher than originally anticipated. Any failure by servicers to service
these mortgages and/or to competently manage and dispose of REO properties could negatively impact the value of these investments and
the Fund’s financial performance. In addition, while we have contracted with third-party servicers to carry out the actual servicing
of the loans (including all direct interface with the borrowers), for loans that we purchase together with the related servicing rights,
we are nevertheless ultimately responsible, vis-à-vis the borrowers and state and federal regulators, for ensuring that the loans
are serviced in accordance with the terms of the related notes and mortgages and applicable law and regulation. In light of the current
regulatory environment, such exposure could be significant even though we might have contractual claims against the Fund’s servicers
for any failure to service the loans to the required standard.
The foreclosure process, especially
in judicial foreclosure states such as New York, Florida and New Jersey, can be lengthy and expensive, and the delays and costs involved
in completing a foreclosure, and then subsequently liquidating the REO property through sale, may materially increase any related loss.
In addition, at such time as title is taken to a foreclosed property, it may require more extensive rehabilitation than we estimated at
acquisition. Thus, a material amount of foreclosed residential mortgage loans, particularly in the states mentioned above, could result
in significant losses in the Fund’s residential and commercial whole loan portfolio and could materially adversely affect the Fund’s
results of operations.
Prepayment Risk Associated
With Investments in Mortgage Whole Loans. The residential
and commercial whole loans we acquire are backed by pools of residential and commercial mortgage loans. We receive payments, generally,
from the payments that are made on these underlying residential and commercial mortgage loans. While commercial mortgages frequently include
limitations on the ability of the borrower to prepay, Residential and Commercial mortgages generally do not. When borrowers prepay their
residential and commercial mortgage loans at rates that are faster than expected, the net result is prepayments that are faster than expected
on the residential and commercial whole loans. These faster than expected payments may adversely affect the Fund’s profitability.
We may purchase
residential and commercial whole loans that have a higher interest rate than the then prevailing market interest rate. In exchange for
this higher interest rate, we may pay a premium to par value to acquire the asset. In accordance with accounting rules, we amortize this
premium over the expected term of the asset based on the Fund’s prepayment assumptions. If the asset is prepaid in whole or in
part at a faster than expected rate, however, we must expense all or a part of the remaining unamortized portion of the premium that was
paid at the time of the purchase, which will adversely affect the Fund’s profitability.
Prepayment rates generally increase
when interest rates fall and decrease when interest rates rise, but changes in prepayment rates are difficult to predict. House price
appreciation, while increasing the value of the collateral underlying the Fund’s residential and commercial whole loans, may increase
prepayment rates as borrowers may be able to refinance at more favorable terms. Prepayments can also occur when borrowers default on their
residential and commercial mortgages and the mortgages are prepaid from the proceeds of a foreclosure sale of the property (an involuntary
prepayment), or when borrowers sell the property and use the sale proceeds to prepay the mortgage as part of a physical relocation. Prepayment
rates also may be affected by conditions in the housing and financial markets, increasing defaults on Residential and Commercial mortgage
loans, which could lead to an acceleration of the payment of the related principal, general economic conditions and the relative interest
rates on fixed-rate mortgages and ARMs. While we seek to manage prepayment risk, in selecting residential and commercial whole loans investments
we must balance prepayment risk against other risks, the potential returns of each investment and the cost of hedging the Fund’s
risks. No strategy can completely insulate us from prepayment or other such risks, and we may deliberately retain exposure to prepayment
or other risks.
In addition, a decrease in prepayment
rates may adversely affect the Fund’s profitability. When borrowers prepay their residential and commercial mortgage loans at slower
than expected rates, prepayments on the residential and commercial whole loans may be slower than expected. These slower than expected
payments may adversely affect the Fund’s profitability. We may purchase residential and commercial whole loans that have a lower
interest rate than the then prevailing market interest rate. In exchange for this lower interest rate, we may pay a discount to par value
to acquire the asset. In accordance with accounting rules, we accrete this discount over the expected term of the asset based on the Fund’s
prepayment assumptions. If the asset is prepaid at a slower than expected rate, however, we must accrete the remaining portion of the
discount at a slower than expected rate. This will extend the expected life of the asset and result in a lower than expected yield on
assets purchased at a discount to par.
Geographic
Concentration Risk Associated With Residential and Commercial Whole Loans.
The Fund’s performance depends on the economic conditions
in markets in which the properties securing the mortgage loans underlying the Fund’s investments are concentrated. A substantial
portion of the Fund’s portfolio securities may have underlying properties concentrated in specific geographies, including California.
The Fund’s financial condition, results of operations, the market price of the Fund’s common stock and the Fund’s
ability to make distributions to the Fund’s stockholders could be materially and adversely affected by this geographic concentration
if market conditions, such as an oversupply of space or a reduction in demand for real estate in an area, deteriorate in California. Moreover,
due to the geographic concentration of properties securing the mortgages underlying the Fund’s investments, the Fund may be disproportionately
affected by general risks such as natural disasters, including major wildfires, floods and earthquakes, severe or inclement weather, and
acts of terrorism should such developments occur in or near the markets in California in which such properties are located.
Other Risks Associated
with Mortgage Whole Loans. Mortgage whole loans have risks
above and beyond those discussed above. For example, mortgage whole loans are subject to “special hazard” risk (property
damage caused by hazards, such as earthquakes or environmental hazards, not covered by standard property insurance policies) and to bankruptcy
risk (reduction in a borrower’s mortgage debt by a bankruptcy court). In addition, claims may be assessed against the Fund on account
of its position as mortgage holder or property owner, including responsibility for tax payments, environmental hazards and other liabilities.
Tax Risks.
To qualify for the favorable U.S. federal income tax treatment generally accorded to regulated investment companies, among other things,
the Fund must derive in each taxable year at least 90% of its gross income from certain prescribed sources and satisfy certain distribution
and asset diversification requirements. If for any taxable year the Fund does not qualify as a regulated investment company, all of its
taxable income (including its net capital gain) would be subject to tax at regular corporate rates without any deduction for distributions
to stockholders, and such distributions would be taxable as ordinary dividends to the extent of the Fund’s current and accumulated
earnings and profits.
Risk of Taxable Income
in Excess of Economic Income. The Fund expects to acquire
debt instruments in the secondary market for less than their stated redemption price at maturity. The discount at which such debt instruments
are acquired may reflect doubts about their ultimate collectability rather than current market interest rates. The amount of such discount
will nevertheless generally be treated as “market discount” for U.S. federal income tax purposes. Market discount on a debt
instrument accrues ratably on a daily basis, unless an election is made to accrue market discount on the basis of the constant yield to
maturity of the debt instrument, based generally on the assumption that all future payments
on the debt instrument
will be made. Absent an election to accrue currently, accrued market discount is reported as income when, and to the extent that, any
payment of principal of the debt instrument is made. Payments on residential mortgage loans are ordinarily made monthly, and include both
principal and interest, and consequently accrued market discount may have to be included in income each month as if the debt instrument
were assured of ultimately being collected in full.
Similarly, many of the debt instruments
(including MBS) that the Fund purchases will likely have been issued with original issue discount (“OID”), which discount
might reflect doubt as to whether the entire principal amount of such debt instruments will ultimately prove to be collectible. The Fund
will be required to report such OID based on a constant yield method and income will be accrued and be currently taxable based on the
assumption that all future projected payments due on such debt instruments will be made.
Finally, in the event that any debt
instruments (including MBS) acquired by the Fund are delinquent as to mandatory principal and interest payments, or in the event payments
with respect to a particular debt instrument are not made when due, the Fund may nonetheless be required to continue to recognize the
unpaid interest as taxable income as it accrues, despite doubt as to its ultimate collectability. Similarly, the Fund may be required
to accrue interest income with respect to subordinate MBS at the stated rate regardless of whether corresponding cash payments are received
or are ultimately collectible.
Risks Associated with
the Fund’s Ability To Satisfy Regulated Investment Company Distribution Requirements.
The Fund generally must distribute annually at least 90% of its taxable income, excluding any net capital gain, in order to maintain its
qualification as a regulated investment company for U.S. federal income tax purposes. To the extent that the Fund satisfies this distribution
requirement, but distributes less than 100% of its taxable income and net capital gain, the Fund will be subject to U.S. federal corporate
income tax on the Fund’s undistributed taxable income. In addition, the Fund will be subject to a 4% nondeductible excise tax if
the actual amount that the Fund distributes to its stockholders in a calendar year is less than a minimum amount specified under U.S.
federal income tax laws. The Fund intends to make distributions to its stockholders to comply with the requirements of the Code and to
avoid paying U.S. federal income taxes and, if practicable, excise taxes, on undistributed taxable income. However, differences in timing
between the recognition of taxable income and the actual receipt of cash could require the Fund to sell assets (including (i) cash, (ii)
bank deposits, (iii) Treasury securities with maturities of not more than 90 calendar days, (iv) money market mutual funds that (a) are
registered with the SEC and regulated under Rule 2a-7 promulgated under the 1940 Act and (b) invest exclusively in direct obligations
of the United States or obligations the prompt payment of the principal of and interest on which is unconditionally guaranteed by the
United States, (v) repurchase agreements secured by Treasury securities (if permitted by the Treasury) and (vi)
any other investment
approved by the Treasury in writing (collectively, “Temporary Investments”)) or borrow funds on a short-term or long-term
basis or issue cash-stock dividends (described below) to meet the distribution requirements of the Code.
The Fund may find it difficult or impossible
to meet distribution requirements in certain circumstances. Due to the nature of the assets in which the Fund intends to invest, the Fund’s
taxable income may exceed the Fund’s net income as determined based on generally accepted accounting principles (“GAAP”)
because, for example, realized capital losses will be deducted in determining the Fund’s GAAP net income but may not be deductible
in computing the Fund’s taxable income required to be distributed. In addition, the Fund may invest in assets, including debt instruments
requiring the Fund to accrue OID, that generate taxable income (referred to as “phantom income”) in excess of economic income
or in advance of the corresponding cash flow from the assets. In addition, if the debt instruments provide for “payment-in-kind”
or PIK interest, the Fund may recognize OID for federal income tax purposes. Moreover, the Fund may acquire distressed debt investments
that are subsequently modified by agreement with the borrower. If the amendments to the outstanding debt are “significant modifications”
under the applicable Treasury regulations, the modified debt may be considered to have been reissued to the Fund in a debt-for-debt exchange
with the borrower. In that event, if the debt is considered to be “publicly traded” for federal income tax purposes, the
modified debt in the hands of the Fund may be considered to have been issued with OID to the extent the fair-market value of the modified
debt is less than the principal amount of the outstanding debt. Also, certain previously modified debt that the Fund acquires in the secondary
market may be considered to have been issued with OID at the time it was modified. In general, the Fund will be required to accrue OID
on a debt instrument as taxable income in accordance with applicable federal income tax rules even though no cash payments may be received
on such debt instrument. In the event a borrower with respect to a particular debt instrument encounters financial difficulty rendering
it unable to pay stated interest as due, the Fund may nonetheless be required to continue to recognize the unpaid interest as taxable
income. Similarly, the Fund may be required to accrue interest income with respect to subordinate MBS at the stated rate regardless of
when their corresponding cash payments are received. Further, the Fund may invest in assets that accrue market discount income, which
may result in the recognition of taxable income in excess of the Fund’s economic gain in certain situations or the deferral of
a portion of the Fund’s interest deduction paid on debt incurred to acquire or carry such assets.
Due to each of these potential timing
differences between income recognition or expense deduction and cash receipts or disbursements, there is a significant risk that the Fund
may have substantial taxable income in excess of cash available for distribution. To satisfy its distribution requirements, the Fund may
borrow on unfavorable terms or distribute amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment
of debt. In addition,
the Fund may make distributions in its Common Stock to satisfy the distribution requirements necessary to maintain the Fund’s status
as a regulated investment company for U.S. federal income tax purposes and to avoid U.S. federal income and excise taxes, but no assurances
can be given in this regard. Moreover, if the Fund’s only feasible alternative were to make a taxable distribution of the Fund’s
Common Stock to comply with the regulated investment company distribution requirements for any taxable year and the value of the Fund’s
Common Stock was not sufficient at such time to make a distribution to its Common Stockholders in an amount at least equal to the minimum
amount required to comply with such regulated investment company distribution requirements, the Fund would generally fail to qualify as
a regulated investment company for such taxable year.
Despite undertaking the efforts mentioned
in the previous paragraph, the Fund may not be able to distribute the amounts necessary to satisfy the distribution requirements necessary
to maintain its regulated investment company status for U.S. federal income taxes and to avoid U.S. federal income and excise taxes. If
the Fund were unable to satisfy the 90% distribution requirement or otherwise were to fail to qualify as a regulated investment company
in any year, material adverse tax consequences would result to investors. The Fund would be taxed in the same manner as an ordinary corporation
and distributions to the Fund’s Common Stockholders would not be deductible by the Fund in computing its taxable income. To qualify
again to be taxed as a regulated investment company in a subsequent year, the Fund would be required to distribute to its Common Stockholders
its earnings and profits attributable to non-regulated investment company years reduced by an interest charge on 50% of such earnings
and profits payable by the Fund to the Internal Revenue Service (“IRS”). In addition, if the Fund failed to qualify as a
regulated investment company for a period greater than two taxable years, then the Fund would be required to elect to recognize and pay
tax on any net built-in gain (the excess of aggregate gain, including items of income, over aggregate loss that would have been realized
if the Fund had been liquidated) or, alternatively, be subject to taxation on such built-in gain recognized for a period of 5 years, in
order to qualify as a regulated investment company in a subsequent year.
Government Intervention
in Financial Markets Risk. United States federal and state
governments and foreign governments, their regulatory agencies or self-regulatory organizations may take actions designed to support certain
financial institutions and segments of the financial markets that have experienced extreme volatility, and in some cases a lack of liquidity,
that affect the regulation of the securities in which the Fund invests, or the issuers of such securities, in ways that are unforeseeable
issuers of corporate fixed income securities might seek protection under the bankruptcy laws. Legislation or regulation may also change
the way in which the Fund itself is regulated. Such legislation or regulation could limit or preclude the Fund’s ability to achieve
its investment objectives. Western Asset monitors developments and seeks to manage the
Fund’s portfolio
in a manner consistent with achieving the Fund’s investment objective, but there can be no assurance that it will be successful
in doing so.
Currency Risk. The
value of investments in securities denominated in foreign currencies increases or decreases as the rates of exchange between those currencies
and the U.S. dollar change. Currency conversion costs and currency fluctuations could erase investment gains or add to investment losses.
Currency exchange rates can be volatile, and are affected by factors such as general economic conditions, the actions of the U.S. and
foreign governments or central banks, the imposition of currency controls and speculation. The Fund may be unable or may choose not to
hedge its foreign currency exposure.
Extension Risk. Extension,
or slower prepayments of the underlying mortgage loans, would extend the time it would take to receive cash flows and would generally
compress the yield on non-agency RMBS and CMBS. Rising interest rates can cause the average maturity of the Fund to lengthen due to a
drop in mortgage prepayments. This will increase both the sensitivity to rising interest rates and the potential for price declines of
the Fund.
“Widening”
Risk. The prices of non-agency RMBS or CMBS may decline substantially,
for reasons that may not be attributable to any of the other risks described in this prospectus. In particular, purchasing assets at what
may appear to be “undervalued” levels is no guarantee that these assets will not be trading at even more “undervalued”
levels at a time of valuation or at the time of sale. It may not be possible to predict, or to protect against, such “spread widening”
risk.
Management Risk. The
Fund is subject to management risk because it is an actively managed investment portfolio. Western Asset and each individual portfolio
manager will apply investment techniques and risk analyses in making investment decisions for the Fund, but there can be no guarantee
that these will produce the desired results.
Credit Crisis Liquidity
and Volatility Risk. The markets for credit instruments, including
MBS, have experienced periods of extreme illiquidity and volatility. General market uncertainty and consequent repricing risk have led
to market imbalances of sellers and buyers, which in turn have resulted in significant valuation uncertainties in a variety of MBS. These
conditions resulted, and in many cases continue to result in, greater volatility, less liquidity, widening credit spreads and a lack of
price transparency, with many MBS remaining illiquid and of uncertain value. These market conditions may make valuation of some of the
Fund’s MBS uncertain and/or result in sudden and significant valuation increases or declines in its holdings. A significant decline
in the value of the Fund’s portfolio would likely result in a significant decline in the value of your investment in Common Stock.
The debt and equity capital markets
in the United States have been negatively impacted by significant write-offs in the financial services sector relating to subprime mortgages
and the re-pricing of credit risk in the broadly syndicated market, among other things. These events,
along with the deterioration
of the housing market and the failure of major financial institutions, have led to worsening general economic conditions, which have materially
and adversely impacted the broader financial and credit markets and have reduced the availability of debt and equity capital for the market
as a whole and financial firms in particular. These developments may increase the volatility of the value of securities owned by the Fund
and also may make it more difficult for the Fund to accurately value securities or to sell securities on a timely basis. These developments
have adversely affected the broader economy, and may continue to do so, which in turn may adversely affect the ability of issuers of securities
owned by the Fund to make payments of principal and interest when due, lead to lower credit ratings and increase defaults. Such developments
could, in turn, reduce the value of securities owned by the Fund and adversely affect the net asset value of the Fund. In addition, the
prolonged continuation or further deterioration of current market conditions could adversely impact the Fund’s portfolio.
Investment Focus.
The Fund invests a substantial portion of its assets in MBS and mortgage whole loans. As a result, the Fund will be affected to a greater
degree by events affecting the MBS and mortgage whole loan markets, than if it invested in a broader array of securities, and such impact
could be considerably greater than if it did not focus its investments to such an extent, particularly as a result of the leveraged nature
of its investments. Such restrictions on the type of securities in which the Fund may invest may adversely affect the Fund’s ability
to achieve its investment objectives.
The Fund employs a variety of proprietary
risk analytics and risk management tools in connection with making and monitoring portfolio investments. Prospective investors should
be aware that no risk management or portfolio analytics system is fail-safe, and no assurance can be given that risk frameworks employed
by either LMPFA and/or Western Asset (e.g., stop-win, stop-loss, Sharpe Ratios, loss limits, value-at-risk or any other methodology now
known or later developed) will achieve their objectives and prevent or otherwise limit substantial losses. No assurance can be given that
the risk management systems and techniques or pricing models will accurately predict future trading patterns or the manner in which investments
are priced in financial markets in the future. In addition, certain risk management tools may rely on certain assumptions (e.g., historical
interest rates, anticipated rate trends) and such assumptions may prove incorrect.
Competition for Investment
Opportunities. Identifying, completing and realizing attractive
portfolio investments is competitive and involves a high degree of uncertainty. The Fund’s profitability depends, in large part,
on its ability to acquire target assets at attractive prices. In acquiring its target assets, the Fund will compete with a variety of
institutional investors, including specialty finance companies, public and private funds (including other funds managed by LMPFA or Western
Asset), commercial and investment banks, commercial finance and insurance companies and other financial institutions. Many of the Fund’s
competitors are
substantially larger and have considerably greater financial, technical, marketing and other resources than does the Fund. Some competitors
may have a lower cost of funds and access to funding sources that may not be available to the Fund, such as funding from the U.S. government,
if the Fund is not eligible to participate in certain programs established by the U.S. government. In addition, some of the Fund’s
competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments
and establish more relationships than the Fund. Furthermore, competition for investments in the Fund’s target assets may lead to
the price of such assets increasing, which may further limit the Fund’s ability to generate desired returns. The Fund cannot assure
you that the competitive pressures it faces will not have a material adverse effect on its business, financial condition and results of
operations. Also, as a result of this competition, desirable investments in the Fund’s target assets may be limited in the future
and the Fund may not be able to take advantage of attractive investment opportunities from time to time, as the Fund can provide no assurance
that it will be able to identify and make investments that are consistent with its investment objectives. Additional third-party managed
investment funds with similar objectives may be formed in the future. Given the foregoing, it is possible that competition for appropriate
portfolio investments may increase, thus reducing the number of attractive portfolio investment opportunities available to the Fund and
may adversely affect the terms upon which investments can be made. There can be no assurance that the Fund will be able to locate, consummate
and exit investments that satisfy its investment objective, or that it will be able to invest the net proceeds from this offering in MBS
to the extent necessary to achieve its investment objectives.
Inflation/Deflation
Risk. Inflation risk is the risk that the value of certain
assets or income from the Fund’s investments will be worth less in the future as inflation decreases the value of money. As inflation
increases, the real value of the Common Stock and distributions on the Common Stock can decline. In addition, during any periods of rising
inflation, the dividend rates or borrowing costs associated with the Fund’s use of leverage would likely increase, which would
tend to further reduce returns to stockholders. Deflation risk is the risk that prices throughout the economy decline over time—the
opposite of inflation. Deflation may have an adverse effect on the creditworthiness of issuers and may make issuer defaults more likely,
which may result in a decline in the value of the Fund’s portfolio.
Reinvestment Risk.
Reinvestment risk is the risk that income from the Fund’s portfolio will decline if and when the Fund invests the proceeds from
matured, traded or called bonds at market interest rates that are below the portfolio’s current earnings rate. A decline in income
could affect the market price of Common Stock or your overall returns.
Reverse Repurchase
Agreements Risk. The Fund’s use of reverse repurchase
agreements involves many of the same risks involved in the Fund’s use of leverage, as the proceeds from
reverse repurchase
agreements generally will be invested in additional securities. There is a risk that the market value of the securities acquired in the
reverse repurchase agreement may decline below the price of the securities that the Fund has sold but remains obligated to repurchase.
In addition, there is a risk that the market value of the securities retained by the Fund may decline. If the buyer of securities under
a reverse repurchase agreement were to file for bankruptcy or experience insolvency, the Fund may be adversely affected. Also, in entering
into reverse repurchase agreements, the Fund would bear the risk of loss to the extent that the proceeds of the reverse repurchase agreement
are less than the value of the underlying securities. In addition, due to the interest costs associated with reverse repurchase agreements
transactions, the Fund’s net asset value will decline, and, in some cases, the Fund may be worse off than if it had not used such
instruments.
Repurchase Agreements
Risk. Subject to its investment objectives and policies, the
Fund may invest in repurchase agreements for investment purposes. Repurchase agreements typically involve the acquisition by the Fund
of debt securities from a selling financial institution such as a bank, savings and loan association or broker-dealer. The agreement provides
that the Fund will sell the securities back to the institution at a fixed time in the future. The Fund does not bear the risk of a decline
in the value of the underlying security unless the seller defaults under its repurchase obligation. In the event of the bankruptcy or
other default of a seller of a repurchase agreement, the Fund could experience both delays in liquidating the underlying securities and
losses, including (1) possible decline in the value of the underlying security during the period in which the Fund seeks to enforce its
rights thereto; (2) possible lack of access to income on the underlying security during this period; and (3) expenses of enforcing its
rights. While repurchase agreements involve certain risks not associated with direct investments in debt securities, the Fund follows
procedures approved by the Fund’s Board of Directors that are designed to minimize such risks. These procedures include effecting
repurchase transactions only with large, well-capitalized and well-established financial institutions whose financial condition will be
continually monitored by Western Asset. In addition, as described above, the value of the collateral underlying the repurchase agreement
will be at least equal to the repurchase price, including any accrued interest earned on the repurchase agreement. In the event of a default
or bankruptcy by a selling financial institution, the Fund generally will seek to liquidate such collateral. However, the exercise of
the Fund’s right to liquidate such collateral could involve certain costs or delays and, to the extent that proceeds from any sale
upon a default of the obligation to repurchase were less than the repurchase price, the Fund could suffer a loss.
Variable Debt Risk.
The absence of an active secondary market with respect to particular variable and floating rate instruments could make it difficult for
the Fund to dispose of a variable or floating rate note if the issuer defaulted on its payment obligation or during
periods that the
Fund is not entitled to exercise its demand rights, and the Fund could, for these or other reasons, suffer a loss with respect to such
instruments.
Structured Notes and
Related Instruments Risk. The Fund may invest in “structured”
notes and other related instruments, which are privately negotiated debt obligations where the principal and/or interest is determined
by reference to the performance of a benchmark asset, market or interest rate (an “embedded index”), such as selected securities,
an index of securities or specified interest rates, or the differential performance of two assets or markets, such as indexes reflecting
bonds. Structured instruments may be issued by corporations, including banks, as well as by governmental agencies. Structured instruments
frequently are assembled in the form of medium-term notes, but a variety of forms are available and may be used in particular circumstances.
The terms of such structured instruments normally provide that their principal and/or interest payments are to be adjusted upwards or
downwards (but ordinarily not below zero) to reflect changes in the embedded index while the structured instruments are outstanding. As
a result, the interest and/or principal payments that may be made on a structured product may vary widely, depending on a variety of factors,
including the volatility of the embedded index and the effect of changes in the embedded index on principal and/or interest payments.
The rate of return on structured notes may be determined by applying a multiplier to the performance or differential performance of the
referenced index(es) or other asset(s). Application of a multiplier involves leverage that will serve to magnify the potential for gain
and the risk of loss.
Insolvency Considerations
with Respect to Issuers of Indebtedness. Various laws enacted
for the protection of U.S. creditors may apply to MBS in which the Fund invests. If a court in a lawsuit brought by an unpaid creditor
or representative of the creditors of an issuer of MBS, such as a trustee in bankruptcy, were to find that the issuer did not receive
fair consideration or reasonably equivalent value for incurring the indebtedness, and after giving effect to such indebtedness, the issuer
(i) was insolvent, (ii) was engaged in a business for which the remaining assets of such issuer constituted unreasonably small capital
or (iii) intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they mature, such court could
determine to invalidate, in whole or in part, such indebtedness as a fraudulent conveyance, to subordinate such indebtedness to existing
or future creditors of such issuer, or to recover amounts previously paid by such issuer in satisfaction of such indebtedness. The measure
of insolvency for purposes of the foregoing will vary. Generally, an issuer would be considered insolvent at a particular time if the
sum of its debts were then greater than all of its property at a fair valuation, or if the present fair saleable value of its assets was
then less than the amount that would be required to pay its probable liabilities on its existing debts as they became absolute and matured.
There can be no assurance as to what standard a court would apply in order to determine whether the issuer was “insolvent”
after giving effect to the incurrence of the
indebtedness in
which the Fund invested or that, regardless of the method of valuation, a court would not determine that the issuer was “insolvent”
upon giving effect to such incurrence. In addition, in the event of the insolvency of an issuer of indebtedness in which the Fund invests,
payments made on such indebtedness could be subject to avoidance as a “preference” if made within a certain period of time
(which may be as long as one year) before insolvency. In general, if payments on indebtedness are avoidable, whether as fraudulent conveyances
or preferences, such payments can be recaptured from the Fund.
Portfolio Valuation
for Financial Accounting and Other Reporting Purposes. Valuations
of the portfolio investments may involve uncertainties and judgment determinations. Third-party pricing information can vary considerably
from one dealer or pricing service to another, and may at times not be available regarding certain of the investments of the Fund. A disruption
in the secondary markets for the investments of the Fund may make it difficult to obtain accurate market quotations for purposes of valuing
portfolio investments for financial accounting, borrowing and other reporting purposes. Further, because of the overall size and concentrations
in particular markets and maturities of positions that may be held by the Fund from time to time, the liquidation values of portfolio
investments may differ significantly from the valuations of such portfolio investments derived from the valuation methods described herein.
Some of the Fund’s portfolio
investments will be in the form of securities that are not publicly traded. The fair value of securities and other investments that are
not publicly traded may not be readily determinable. The Fund will value these investments quarterly at fair value, as determined in accordance
with Statement of Financial Accounting Standards, or SFAS, No. 157, “Fair Value Measurements,” which may include unobservable
inputs. Because such valuations are subjective, the fair value of certain of the Fund’s assets may fluctuate over short periods
of time and the Fund’s determinations of fair value may differ materially from the values that would have been used if a ready
market for these securities existed. The value of the Fund’s Common Stock could be adversely affected if the Fund’s determinations
regarding the fair value of these investments were materially higher than the values that it ultimately realizes upon their disposal.
Inverse Floating Rate
Securities and Tender Option Bonds Risk. Subject to certain
limitations, the Fund may invest in inverse floating rate securities. Typically, inverse floating rate securities represent beneficial
interests in a special purpose trust (sometimes called a “tender option bond trust”) formed by a third party sponsor for
the purpose of holding MBS purchased from the Fund or from another third party. An investment in an inverse floating rate security may
involve greater risk than an investment in a fixed-rate bond. Because changes in the interest rate on the underlying security or index
inversely affect the residual interest paid on the inverse floating rate security, the value of an inverse floating rate security is generally
more volatile than that of a fixed-rate bond.
Inverse floating
rate securities have interest rate adjustment formulas which generally reduce or, in the extreme, eliminate the interest paid to the Fund
when short-term interest rates rise, and increase the interest paid to the Fund when short-term interest rates fall. Inverse floating
rate securities have varying degrees of liquidity, and the market for these securities is relatively volatile. These securities tend to
underperform the market for fixed-rate bonds in a rising interest rate environment, but tend to outperform the market for fixed-rate bonds
when interest rates decline. Shifts in long-term interest rates may, however, alter this tendency.
During times of reduced market liquidity,
such as at the present, the Fund may not be able to sell MBS readily at prices reflecting the values at which the securities are carried
on the Fund’s books. Sales of large blocks of MBS by market participants, such as the Fund, that are seeking liquidity can further
reduce MBS prices in an illiquid market. The Fund may seek to make sales of large blocks of MBS as part of its investment strategy or
it may be required to raise cash to re-collateralize, unwind or “collapse” tender option bond trusts that issued inverse
floating rate securities to the Fund or to make payments to such trusts to enable them to pay for tenders of the short-term securities
they have issued if the remarketing agents for those MBS are unable to sell the short-term securities in the marketplace to other buyers.
The Fund’s potential exposure to losses related to or on inverse floating rate securities may increase beyond the value of the
Fund’s inverse floater investments as the Fund may potentially be liable to fulfill all amounts owed to holders of the floating
rate certificates.
Although volatile, inverse floating
rate securities typically offer the potential for yields exceeding the yields available on fixed-rate bonds with comparable credit quality,
coupon, call provisions and maturity. These securities usually permit the investor to convert the floating rate to a fixed rate (normally
adjusted downward), and this optional conversion feature may provide a partial hedge against rising rates if exercised at an opportune
time.
Investment in inverse floating rate
securities may amplify the effects of the Fund’s use of leverage. Any economic effect of leverage through the Fund’s purchase
of inverse floating rate securities will create an opportunity for increased Common Stock net income and returns, but may also result
in losses if the cost of leverage exceeds the value of the securities underlying the tender option bond trust or the return on the inverse
floating rate securities purchased by the Fund.
Other Investment Companies
Risk. The Fund may invest in the securities of other investment
companies. Such securities may be leveraged. As a result, the Fund may be indirectly exposed to leverage through an investment in such
securities. Utilization of leverage is a speculative investment technique and involves certain risks. An investment in securities of other
investment companies that are leveraged may expose the Fund to higher volatility in
the market value
of such securities and the possibility that the Fund’s long-term returns on such securities (and, indirectly, the long-term returns
of the Common Stock) will be diminished.
Risks Related to Fund
Distributions. Limited liquidity in the MBS market may affect
the market price of MBS securities, thereby adversely affecting the net asset values of the Fund and its ability to make dividend distributions.
Derivatives Risk.
The Fund may invest in derivative instruments, such as options contracts, futures contracts, options on futures contracts, indexed securities,
credit linked notes, credit default swaps and other swap agreements for investment, hedging and risk management purposes; provided that
the Fund’s use of derivative instruments, as measured by the total notional amount of all such instruments, will not exceed 20%
of its Managed Assets. With respect to this limitation, the Fund may net derivatives with opposite exposure to the same underlying instrument.
Notwithstanding the foregoing, the Fund may invest without limitation in Treasury futures, Eurodollar futures, interest rate swaps, swaptions
or similar instruments and combinations thereof. Using derivatives can increase Fund losses and reduce opportunities for gains when market
prices, interest rates, currencies, or the derivatives themselves behave in a way not anticipated by the Fund. Using derivatives also
can have a leveraging effect and increase Fund volatility. Certain derivatives have the potential for unlimited loss, regardless of the
size of the initial investment. Derivatives may not be available at the time or price desired, may be difficult to sell, unwind or value,
and the counterparty may default on its obligations to the Fund. Derivatives are generally subject to the risks applicable to the assets,
rates, indices or other indicators underlying the derivative. The value of a derivative may fluctuate more than the underlying assets,
rates, indices or other indicators to which it relates. Use of derivatives may have different tax consequences for the Fund than an investment
in the underlying security, and those differences may affect the amount, timing and character of income distributed to shareholders. The
U.S. government and foreign governments are in the process of adopting and implementing regulations governing derivatives markets, including
mandatory clearing of certain derivatives, margin and reporting requirements. The ultimate impact of the regulations remains unclear.
Additional regulation of derivatives may make derivatives more costly, limit their availability or utility, otherwise adversely affect
their performance or disrupt markets.
Effective August 19, 2022, the Fund
began operating under Rule 18f-4 under the 1940 Act which, among other things, governs the use of derivative investments and certain financing
transactions (e.g. reverse repurchase agreements) by registered investment companies. Among other things, Rule 18f-4 requires funds that
invest in derivative instruments beyond a specified limited amount to apply a value at risk (VaR) based limit to their use of certain
derivative instruments and financing transactions and to adopt and implement a derivatives
risk management
program. A fund that uses derivative instruments in a limited amount is not subject to the full requirements of Rule 18f-4. Compliance
with Rule 18f-4 by the Fund could, among other things, make derivatives more costly, limit their availability or utility, or otherwise
adversely affect their performance. Rule 18f-4 may limit the Fund’s ability to use derivatives as part of its investment strategy.
Credit default swap contracts involve
heightened risks and may result in losses to the Fund. Credit default swaps may be illiquid and difficult to value. When the Fund sells
credit protection via a credit default swap, credit risk increases since the Fund has exposure to both the issuer whose credit is the
subject of the swap and the counterparty to the swap.
Short Sales Risk.
To the extent the Fund makes use of short sales for investment
and/or risk management purposes, the Fund may be subject to risks associated with selling short. Short sales are transactions in which
the Fund sells securities or other instruments that the Fund does not own. Short sales expose the Fund to the risk that it will be required
to cover its short position at a time when the securities have appreciated in value, thus resulting in a loss to the Fund. The Fund may
engage in short sales where it does not own or have the right to acquire the security sold short at no additional cost. The Fund’s
loss on a short sale theoretically could be unlimited in a case where the Fund is unable, for whatever reason, to close out its short
position. In addition, the Fund’s short selling strategies may limit its ability to benefit from increases in the markets. If the
Fund engages in short sales, it will segregate liquid assets, enter into offsetting transactions or own positions covering its obligations;
however, such segregation and cover requirements will not limit or offset losses on related positions. Short selling also involves a form
of financial leverage that may exaggerate any losses realized by the Fund. Also, there is the risk that the counterparty to a short sale
may fail to honor its contractual terms, causing a loss to the Fund. The Fund will incur transaction costs with any short sales, which
will be borne by shareholders. Finally, regulations imposed by the SEC or other regulatory bodies relating to short selling may restrict
the Fund’s ability to engage in short selling.
The Fund’s obligation to replace
a borrowed security is secured by collateral deposited with the broker-dealer, usually cash, U.S. government securities or other liquid
securities similar to those borrowed. The Fund is also required to segregate similar collateral to the extent, if any, necessary so that
the value of both collateral amounts in the aggregate is at all times equal to at least 100% of the current market value of the security
sold short. Depending on arrangements made with the broker-dealer from which the Fund borrowed the security regarding payment over of
any payments received by us on such security, the Fund may not receive any payments (including interest) on the collateral deposited with
such broker-dealer.
Risks of Short Economic
Exposure Through Derivatives. The use by the Fund of derivatives
such as options, forwards or futures contracts for investment and/or risk management
purposes may subject
the Fund to risks associated with short economic exposure through such derivatives. Taking a short economic position through derivatives
exposes the Fund to the risk that it will be obligated to make payments to its counterparty if the underlying asset appreciates in value,
thus resulting in a loss to the Fund. The Fund’s loss on a short position using derivatives theoretically could be unlimited.
Liquidity Risk. The
Fund may invest in MBS, for which there is no readily available trading market or which are otherwise illiquid. Liquidity risk exists
when particular investments are difficult to sell. Securities may become illiquid after purchase by the Fund, particularly during periods
of market turmoil. When the Fund holds illiquid investments, the portfolio may be harder to value, especially in changing markets, and
if the Fund is forced to sell these investments in order to segregate assets or for other cash needs, the Fund may suffer a loss.
When-Issued and Delayed-Delivery
Transactions Risk. The Fund may purchase fixed income securities
on a when-issued basis, and may purchase or sell those securities for delayed delivery. When-issued and delayed-delivery transactions
occur when securities are purchased or sold by the Fund with payment and delivery taking place in the future to secure an advantageous
yield or price. Securities purchased on a when-issued or delayed-delivery basis may expose the Fund to counterparty risk of default as
well as the risk that securities may experience fluctuations in value prior to their actual delivery. The Fund will not accrue income
with respect to a when-issued or delayed-delivery security prior to its stated delivery date. Purchasing securities on a when-issued or
delayed-delivery basis can involve the additional risk that the price or yield available in the market when the delivery takes place may
not be as favorable as that obtained in the transaction itself.
Non-Diversification
Risk. The Fund is classified as “non-diversified”
under the 1940 Act. As a result, it can invest a greater portion of its assets in obligations of a single issuer than a “diversified”
fund. The Fund may therefore be more susceptible than a diversified fund to being adversely affected by any single corporate, economic,
political or regulatory occurrence. The Fund intends to qualify for the special tax treatment available to “regulated investment
companies” under Subchapter M of the Code, and thus intends to satisfy the diversification requirements of Subchapter M, including
the less stringent diversification requirement that applies to the percent of its total assets that are represented by cash and cash items
(including receivables), U.S. government securities, the securities of other regulated investment companies and certain other securities.
Risks Related to Potential
Conflicts of Interest. FTFA, Western Asset and the portfolio
managers have interests which may conflict with the interests of the Fund. LMPFA and Western Asset may at some time in the future manage
and/or advise other investment funds or accounts with the same or substantially similar investment objective and strategies as the Fund.
As a result, FTFA, Western Asset and the Fund’s portfolio managers
may devote unequal
time and attention to the management of the Fund and those other funds and accounts, and may not be able to formulate as complete a strategy
or identify equally attractive investment opportunities as might be the case if they were to devote substantially more attention to the
management of the Fund. LMPFA, Western Asset and the Fund’s portfolio managers may identify a limited investment opportunity that
may be suitable for multiple funds and accounts, and the opportunity may be allocated among these several funds and accounts, which may
limit the Fund’s ability to take full advantage of the investment opportunity. Additionally, transaction orders may be aggregated
for multiple accounts for purpose of execution, which may cause the price or brokerage costs to be less favorable to the Fund than if
similar transactions were not being executed concurrently for other accounts. At times, a portfolio manager may determine that an investment
opportunity may be appropriate for only some of the funds and accounts for which he or she exercises investment responsibility, or may
decide that certain of the funds and accounts should take differing positions with respect to a particular security. In these cases, the
portfolio manager may place separate transactions for one or more funds or accounts which may affect the market price of the security
or the execution of the transaction, or both, to the detriment or benefit of one or more other funds and accounts. For example, a portfolio
manager may determine that it would be in the interest of another account to sell a security that the Fund holds, potentially resulting
in a decrease in the market value of the security held by the Fund.
The portfolio managers may also engage
in cross trades between funds and accounts, may select brokers or dealers to execute securities transactions based in part on brokerage
and research services provided to FTFA or Western Asset which may not benefit all funds and accounts equally and may receive different
amounts of financial or other benefits for managing different funds and accounts. Finally, FTFA or its affiliates may provide more services
to some types of funds and accounts than others.
There is no guarantee that the policies
and procedures adopted by FTFA, Western Asset and the Fund will be able to identify or mitigate the conflicts of interest that arise between
the Fund and any other investment funds or accounts that FTFA and/or Western Asset may manage or advise from time to time.
Portfolio Turnover
Risk. The Fund’s annual portfolio turnover rate may
vary greatly from year to year. Changes to the investments of the Fund may be made regardless of the length of time particular investments
have been held. A high portfolio turnover rate may result in increased transaction costs for the Fund in the form of increased dealer
spreads and other transactional costs, which may have an adverse impact on the Fund’s performance. In addition, high portfolio
turnover may result in the realization of net short-term capital gains by the Fund which, when distributed to stockholders, will be taxable
as ordinary income. A high portfolio turnover may increase the Fund’s current and accumulated earnings and
profits, resulting
in a greater portion of the Fund’s distributions being treated as a dividend to the Fund’s stockholders. The portfolio turnover
rate of the Fund will vary from year to year, as well as within a given year.
Anti-Takeover Provisions
Risk. The Charter and Bylaws of the Fund include provisions
that are designed to limit the ability of other entities or persons to acquire control of the Fund for short-term objectives, including
by converting the Fund to open-end status or changing the composition of the Board, that may be detrimental to the Fund’s ability
to achieve its primary investment objective of seeking high current income. The Bylaws also contain a provision providing that the Board
of Directors has adopted a resolution to opt in the Fund to the provisions of the Maryland Control Share Acquisition Act (“MCSAA”).
There can be no assurance, however, that such provisions will be sufficient to deter professional arbitrageurs that seek to cause the
Fund to take actions that may not be consistent with its investment objective or aligned with the interests of long-term shareholders,
such as liquidating debt investments prior to maturity, triggering taxable events for shareholders and decreasing the size of the Fund.
Such provisions may limit the ability of shareholders to sell their shares at a premium over prevailing market prices by discouraging
an investor from seeking to obtain control of the Fund.
Market Events Risk.
The market values of securities or other assets will fluctuate,
sometimes sharply and unpredictably, due to factors such as economic events, governmental actions or intervention, actions taken by the
U.S. Federal Reserve or foreign central banks, market disruptions caused by trade disputes, labor strikes or other factors, political
developments, armed conflicts, economic sanctions and countermeasures in response to sanctions, major cybersecurity events, the global
and domestic effects of widespread or local health, weather or climate events, and other factors that may or may not be related to the
issuer of the security or other asset. Economies and financial markets throughout the world are increasingly interconnected. Economic,
financial or political events, trading and tariff arrangements, public health events, terrorism, wars, natural disasters and other circumstances
in one country or region could have profound impacts on global economies or markets. As a result, whether or not the fund invests in securities
of issuers located in or with significant exposure to the countries or markets directly affected, the value and liquidity of the fund’s
investments may be negatively affected. Ongoing armed conflicts between Russia and Ukraine in Europe and among Israel, Hamas and other
militant groups in the Middle East have caused and could continue to cause significant market disruptions and volatility. The hostilities
and sanctions resulting from those hostilities have and could continue to have a significant impact on certain fund investments as well
as fund performance and liquidity. Following Russia’s invasion of Ukraine in 2022, Russian stocks lost all, or nearly all, of their
market value. Other securities or markets could be similarly affected by past or future geopolitical or other events or conditions. Furthermore,
events involving limited liquidity, defaults, non-performance or other adverse developments that
affect one industry,
such as the financial services industry, or concerns or rumors about any events of these kinds, have in the past and may in the future
lead to market-wide liquidity problems, may spread to other industries, and could negatively affect the value and liquidity of the fund’s
investments.
The long-term impact of the COVID-19
pandemic and its subsequent variants on economies, markets, industries and individual issuers is not known. The U.S. government and the
Federal Reserve, as well as certain foreign governments and central banks, took extraordinary actions to support local and global economies
and the financial markets in response to the COVID-19 pandemic. This and other government intervention into the economy and financial
markets have resulted in a large expansion of government deficits and debt, the long term consequences of which are not known.
Raising the ceiling on U.S. government
debt has become increasingly politicized. Any failure to increase the total amount that the U.S. government is authorized to borrow could
lead to a default on U.S. government obligations, with unpredictable consequences for economies and markets in the U.S. and elsewhere.
Recently, inflation and interest rates have been volatile and may increase in the future. These circumstances could adversely affect the
value and liquidity of the fund’s investments, impair the fund’s ability to satisfy redemption requests, and negatively
impact the fund’s performance.
The United States and other countries
are periodically involved in disputes over trade and other matters, which may result in tariffs, investment restrictions and adverse impacts
on affected companies and securities. For example, the United States has imposed tariffs and other trade barriers on Chinese exports,
has restricted sales of certain categories of goods to China, and has established barriers to investments in China. Trade disputes may
adversely affect the economies of the United States and its trading partners, as well as companies directly or indirectly affected and
financial markets generally. The United States government has prohibited U.S. persons from investing in Chinese companies designated as
related to the Chinese military. These and possible future restrictions could limit the fund’s opportunities for investment and
require the sale of securities at a loss or make them illiquid. Moreover, the Chinese government is involved in a longstanding dispute
with Taiwan that has included threats of invasion. If the political climate between the United States and China does not improve or continues
to deteriorate, if China were to attempt unification of Taiwan by force, or if other geopolitical conflicts develop or get worse, economies,
markets and individual securities may be severely affected both regionally and globally, and the value of the fund’s assets may
go down.
Legal and Regulatory
Risk. Legal, tax and regulatory changes could occur and may
adversely affect the Fund and its ability to pursue its investment strategies and/or increase the costs of implementing such strategies.
New (or revised) laws or regulations may be imposed by the CFTC, the SEC, the U.S. Federal Reserve or other banking regulators, other
governmental regulatory
authorities or self-regulatory organizations that supervise the financial markets that could adversely affect the Fund. In particular,
these agencies are empowered to promulgate a variety of new rules pursuant to recently enacted financial reform legislation in the United
States. The Fund also may be adversely affected by changes in the enforcement or interpretation of existing statutes and rules by these
governmental regulatory authorities or self-regulatory organizations.
In addition, the securities and futures
markets are subject to comprehensive statutes, regulations and margin requirements. The CFTC, the SEC, the Federal Deposit Insurance Corporation,
other regulators and self-regulatory organizations and exchanges are authorized under these statutes, regulations and otherwise to take
extraordinary actions in the event of market emergencies. The Fund and the Investment Manager have historically been eligible for exemptions
from certain regulations. However, there is no assurance that the Fund and FTFA will continue to be eligible for such exemptions.
The U.S. Government enacted legislation
that provides for new regulation of the derivatives market, including clearing, margin, reporting, recordkeeping, and registration requirements.
Although the CFTC has released final rules relating to clearing, reporting, recordkeeping and registration requirements under the legislation,
certain of the provisions are subject to further final rule making, and thus its ultimate impact remains unclear. New regulations could,
among other things, restrict the Fund’s ability to engage in derivatives transactions (for example, by making certain types of
derivatives transactions no longer available to the Fund) and/or increase the costs of such derivatives transactions (for example, by
increasing margin or capital requirements), and the Fund may be unable to execute its investment strategies as a result. It is unclear
how the regulatory changes will affect counterparty risk.
The CFTC and certain futures exchanges
have established limits, referred to as “position limits,” on the maximum net long or net short positions which any person
may hold or control in particular options and futures contracts; those position limits may also apply to certain other derivatives positions
the Fund may wish to take. All positions owned or controlled by the same person or entity, even if in different accounts, may be aggregated
for purposes of determining whether the applicable position limits have been exceeded. Thus, even if the Fund does not intend to exceed
applicable position limits, it is possible that different clients managed by the Investment Manager and its affiliates may be aggregated
for this purpose. Therefore it is possible that the trading decisions of the Investment Manager may have to be modified and that positions
held by the Fund may have to be liquidated in order to avoid exceeding such limits. The modification of investment decisions or the elimination
of open positions, if it occurs, may adversely affect the performance of the Fund.
The SEC has in the past adopted interim
rules requiring reporting of all short positions above a certain de minimis threshold and may adopt rules requiring monthly public
disclosure in the
future. In addition, other non-U.S. jurisdictions where the Fund may trade have adopted reporting requirements. To the extent that the
Fund takes a short position, if such short position or strategy become generally known, it could have a significant effect on the Fund’s
ability to implement its investment strategy. In particular, it would make it more likely that other investors could cause a “short
squeeze” in the securities held short by the Fund forcing the Fund to cover its positions at a loss. Such reporting requirements
also may limit the Investment Manager’s ability to access management and other personnel at certain companies where the Fund seeks
to take a short position. In addition, if other investors engage in copycat behavior by taking positions in the same issuers as the Fund,
the cost of borrowing securities to sell short could increase drastically and the availability of such securities to the Fund could decrease
drastically. Such events could make the Fund unable to execute its investment strategy. In addition, the SEC and other regulatory and
self-regulatory authorities have implemented various rules and may adopt additional rules in the future that may impact those engaging
in short selling activity. If additional rules were adopted regarding short sales, they could restrict the Fund’s ability to engage
in short sales in certain circumstances, and the Fund may be unable to execute certain investment strategies as a result.
The SEC and regulatory authorities in
other jurisdictions may adopt (and in certain cases, have adopted) bans on short sales of certain securities in response to market events.
Bans on short selling may make it impossible for the Fund to execute certain investment strategies.
Valuation Risk.
The sales price the Fund could receive for any particular portfolio investment may differ from the Fund’s valuation of the investment,
particularly for securities that trade in thin or volatile markets or that are valued using a fair value methodology. These differences
may increase significantly and affect Fund investments more broadly during periods of market volatility. The Fund’s ability to
value its investments may be impacted by technological issues and/or errors by pricing services or other third party service providers.
The valuation of the Fund’s investments involves subjective judgment.
Operational Risk.
The valuation of the Fund’s investments may be negatively impacted because of the operational risks arising from factors such as
processing errors and human errors, inadequate or failed internal or external processes, failures in systems and technology, changes in
personnel, and errors caused by third party service providers or trading counterparties. It is not possible to identify all of the operational
risks that may affect the Fund or to develop processes and controls that completely eliminate or mitigate the occurrence of such failures.
The Fund and its shareholders could be negatively impacted as a result.
Cybersecurity Risk.
Like other funds and business enterprises, the fund, the manager,
the subadvisers and their service providers are subject to the risk of cyber incidents occurring
from time to time.
Cybersecurity incidents, whether intentionally caused by third parties or otherwise, may allow an unauthorized party to gain access to
fund assets, fund or customer data (including private shareholder information) or proprietary information, cause the fund, the manager,
the subadvisers and/or their service providers (including, but not limited to, fund accountants, custodians, sub-custodians, transfer
agents and financial intermediaries) to suffer data breaches, data corruption or loss of operational functionality, or prevent fund investors
from purchasing, redeeming or exchanging shares, receiving distributions or receiving timely information regarding the fund or their investment
in the fund. The fund, the manager, and the subadvisers have limited ability to prevent or mitigate cybersecurity incidents affecting
third party service providers, and such third party service providers may have limited indemnification obligations to the fund, the manager,
and/or the subadvisers. Cybersecurity incidents may result in financial losses to the fund and its shareholders, and substantial costs
may be incurred in order to prevent or mitigate any future cybersecurity incidents. Issuers of securities in which the fund invests are
also subject to cybersecurity risks, and the value of these securities could decline if the issuers experience cybersecurity incidents.
New ways to carry out cyber attacks
continue to develop. There is a chance that some risks have not been identified or prepared for, or that an attack may not be detected,
which puts limitations on the fund’s ability to plan for or respond to a cyber attack.
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