Strategies and Investments
In attempting to achieve its investment objective, the Fund may utilize, among others, one or more of the strategies or securities set forth below. The Fund may, in addition, invest in other instruments
(including derivative investments) or use other investment strategies that are developed or become available in the future and that are consistent with its objectives and restrictions. The investment strategies described below may be pursued
directly by the Fund.
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Borrowing and Other Forms of Leverage.
The Fund may borrow money to the extent
permitted by its investment policies and restrictions and applicable law. When the Fund borrows money or otherwise leverages its portfolio, the value of an investment in the Fund will be more volatile and other investment risks will tend to be
compounded. This is because leverage tends to exaggerate the effect of any increase or decrease in the value of the Funds holdings. In addition to borrowing money from banks, the Fund may engage in certain other investment transactions that
may be viewed as forms of financial leverage for example, entering into reverse repurchase agreements, investing collateral from loans of portfolio securities, entering into when-issued, delayed-delivery, or forward commitment transactions,
or using derivatives such as swaps, futures, forwards, and options.
Derivatives.
Some of the instruments in which
the Fund may invest may be referred to as derivatives, because their value derives from the value of an underlying asset, reference rate or index. These instruments include options, futures contracts, forward currency
contracts, swap agreements and similar instruments. The market value of derivative instruments and securities sometimes may be more volatile than those of other instruments and each type of derivative instrument may have its own special risks.
Some over-the-counter derivative instruments may expose the Fund to the credit risk of its counterparty. In the event the counterparty to
such a derivative instrument becomes insolvent, the Fund potentially could lose all or a large portion of its investment in the derivative instrument.
Investing for hedging purposes or to increase the Funds return may result in certain additional transaction costs that may reduce the Funds performance. In addition, when used for hedging
purposes, no assurance can be given that each derivative position will achieve a close correlation with the security or currency that is the subject of the hedge, or that a particular derivative position will be available when sought by the Adviser.
While hedging strategies involving derivatives can reduce the risk of loss, they can also reduce the opportunity for gain or even result in losses by offsetting favorable price movements in other Fund investments. Certain derivatives may create a
risk of loss greater than the amount invested.
Exchange-Traded Funds and other Investment Companies.
The Fund may
invest in shares of both open- and closed-end investment companies (including single country funds and ETFs) and trusts, limited partnerships, limited liability companies or other forms of business organizations, including other pooled investment
vehicles sponsored or advised by, or otherwise affiliated with, the Adviser or affiliates of the Adviser. Investing in another pooled vehicle exposes the Fund to all the risks of that pooled vehicle, and, in general, subjects it to a pro rata
portion of the other pooled vehicles fees and expenses. Provisions of the 1940 Act may limit the ability of the fund to invest in certain investment companies or may limit the amount of its assets that the Fund may invest in any investment
company or in investment companies in general.
As the shareholder of another investment company, the Fund would bear, along with other
shareholders, its pro rata portion of the other investment companys expenses, including advisory fees. Such expenses are in addition to the expenses the Fund pays in connection with its own operations. The Funds investments in other
investment companies may be limited by applicable law.
Despite the possibility of greater fees and expenses, investments in other investment
companies may nonetheless be attractive for several reasons, especially in connection with foreign investments. Because of restrictions on direct investment by U.S. entities in certain countries, investing indirectly in such countries (by purchasing
shares of another fund that is permitted to invest in such countries) may be the most practical and efficient way for the Fund to invest in such countries. In other cases, when a portfolio manager desires to make only a relatively small investment
in a particular country, investing through another fund that holds a diversified portfolio in that country may be more effective than investing directly in issuers in that country.
Among the types of investment companies in which the Fund may invest are Portfolio Depositary Receipts (
PDRs
) and Index Fund Shares (PDRs and Index Fund Shares are collectively referred
to as exchange-traded funds or ETFs). PDRs represent interests in a UIT holding a portfolio of securities that may be obtained from the UIT or purchased in the secondary market. Each PDR is intended to track the underlying securities,
trade like a share of common stock, and pay to PDR holders periodic dividends proportionate to those paid with respect to the underlying securities, less certain expenses. Index Fund Shares are shares issued by an open-end management investment
company that seeks to provide investment results that correspond generally to the price and yield performance of a specified index (Index Fund). Individual investments in PDRs generally are not redeemable, except upon termination of the UIT.
Similarly, individual investments in Index Fund Shares generally are not redeemable.
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However, large quantities of PDRs known as Creation Units are redeemable from the sponsor of the
UIT. ETFs include, among others, Standard & Poors Depositary Receipts (
SPDRs
), Optimized Funds as Listed Securities (
OPALS
), Dow Jones Industrial Average Instruments (
Diamonds
),
NASDAQ 100 tracking shares (
QQQ
) and I-Shares.
SPDRs.
SPDRs track the performance of a basket of stocks
intended to track the price performance and dividend yields of the S&P 500 until a specified maturity date. SPDRs are listed on the American Stock Exchange. Holders of SPDRs are entitled to receive quarterly distributions corresponding to
dividends received on shares contained in the underlying basket of stocks net of expenses. On the maturity date of the SPDRs UIT, the holders will receive the value of the underlying basket of stocks.
OPALS.
OPALS track the performance of adjustable baskets of stocks until a specified maturity date. Holders of OPALS are entitled to receive
semi-annual distributions corresponding to dividends received on shares contained in the underlying basket of stocks, net of expenses. On the maturity date of the OPALS UIT, the holders will receive the physical securities comprising the
underlying baskets.
I-Shares.
I-Shares are Index Fund Shares. I-Shares track the performance of specified equity market
indexes, including the S&P 500. I-Shares are listed on the New York Stock Exchange Arca and the Chicago Board Option Exchange. Holders of I-Shares are entitled to receive distributions not less frequently than annually corresponding to dividends
and other distributions received on shares contained in the underlying basket of stocks net of expenses.
Block sizes of ETF shares, also
known as Creation Units, are redeemable from the issuing ETF. The liquidity of smaller holdings of ETF shares will depend upon the existence of a secondary market.
Disruptions in the markets for the securities underlying ETFs purchased or sold by the Fund could result in losses on investments in ETFs. ETFs represent an unsecured obligation and therefore carry with
them the risk that the counterparty will default and the Fund may not be able to recover the current value of its investment. ETFs also carry the risk that the price the Fund pays or receives may be higher or lower than the ETFs net asset
value. ETFs are also subject to certain additional risks, including the risks of illiquidity and of possible trading halts due to market conditions or other reasons, based on the policies of the relevant exchange. ETFs and other investment companies
in which the Fund may invest may be leveraged, which would increase the volatility of the Funds net asset value.
Fixed-Income
Securities
. The Fund may invest in fixed-income securities. Fixed-income securities include a broad array of short-, medium-, and long-term obligations issued by the U.S. or foreign governments, government or international
agencies and instrumentalities, and corporate and private issuers of various types. The maturity date is the date on which a fixed-income security matures. This is the date on which the borrower must pay back the borrowed amount, which is known as
the principal. Some fixed-income securities represent uncollateralized obligations of their issuers; in other cases, the securities may be backed by specific assets (such as mortgages or other receivables) that have been set aside as collateral for
the issuers obligation. Fixed-income securities generally involve an obligation of the issuer to pay interest or dividends on either a current basis or at the maturity of the security, as well as the obligation to repay the principal amount of
the security at maturity. The rate of interest on fixed-income securities may be fixed, floating, or variable. Some securities pay a higher interest rate than the current market rate. An investor may have to pay more than the securitys
principal to compensate the seller for the value of the higher interest rate. This additional payment is a premium.
Fixed-income securities
are subject to credit risk, market risk and interest rate risk. Except to the extent values are affected by other factors such as developments relating to a specific issuer, generally the value of a fixed-income security can be expected to rise when
interest rates decline and, conversely, the value of such a security can be expected to fall when interest rates rise. Some fixed-income securities also involve prepayment or call risk. This is the risk that the issuer will repay the Fund the
principal on the security before it is due, thus depriving the Fund of a favorable stream of future interest or dividend payments. The Fund could buy another security, but that other security might pay a lower interest rate. In addition, many
fixed-income securities contain call or buy-back features that permit their issuers to call or repurchase the securities from their holders. Such securities may present risks based on payment expectations. Although the Fund would typically receive a
premium if an issuer were to redeem a security, if an issuer were to exercise a call option and redeem the security during times of declining interest rates, the Fund may realize a capital loss on its investment if the security was purchased at a
premium and the Fund may be forced to replace the called security with a lower yielding security.
Changes by nationally recognized securities
rating organizations (
NRSROs
) in their ratings of any fixed-income security or the issuer of a fixed-income security and changes in the ability of an issuer to make payments of interest and principal may also affect the value of
these investments. Changes in the value of portfolio securities generally will not affect income derived from these securities, but will affect the Funds net asset value.
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Because interest rates vary, it is impossible to predict the income, if any, for any particular period for
the Fund that invests in fixed-income securities. Fluctuations in the value of the Funds investments in fixed-income securities will cause the net asset value of each class of the Fund to fluctuate also.
Duration is an estimate of how much a bond Funds share price will fluctuate in response to a change in interest rates. If interest rates rise by
one percentage point, the share price of the Fund representing a portfolio of debt securities with an average duration of five years would be expected to decline by about 5%. If rates decrease by a percentage point, the share price of the Fund
representing a portfolio of debt securities with an average duration of five years would be expected to rise by about 5%. The greater the duration of a bond, the greater its percentage price volatility. Only a pure discount bond that is, one
with no coupon or sinking-fund payments has a duration equal to the remaining maturity of the bond, because only in this case does the present value of the final redemption payment represent the entirety of the present value of the bond. For
all other bonds, duration is less than maturity.
The Fund may invest in variable- or floating-rate securities, which bear interest at rates
subject to periodic adjustment or provide for periodic recovery of principal on demand. The value of the Funds investment in certain of these securities may depend on the Funds right to demand that a specified bank, broker-dealer, or
other financial institution either purchase such securities from the Fund at par or make payment on short notice to the Fund of unpaid principal and/or interest on the securities. These securities are subject to, among others, interest rate risk and
credit risk.
Generally, the Adviser uses the terms debt security, bond, and fixed-income instrument interchangeably, and regards them to mean
a security or instrument having one or more of the following characteristics: a fixed-income security, a security issued at a discount to its face value, a security that pays interest or a security with a stated principal amount that requires
repayment of some or all of that principal amount to the holder of the security. The terms debt security, bond, and fixed-income instrument are interpreted broadly by the Adviser as an instrument or security evidencing what is commonly referred to
as an IOU rather than evidencing the corporate ownership of equity unless that equity represents an indirect or derivative interest in one or more debt securities. For this purpose, the terms also include instruments that are intended to provide one
or more of the characteristics of a direct investment in one or more debt securities. As new fixed-income instruments are developed, the Adviser may invest in those opportunities for the Fund as well.
Equity Securities.
The Fund may invest in equity securities. Equity securities are securities that represent an ownership
interest (or the right to acquire such an interest) in a company and include common and preferred stock. Common stocks represent an equity or ownership interest in an issuer. Preferred stock represents an equity or ownership interest in an issuer
that pays dividends at a specified rate and that has priority over common stock in the payment of dividends. In the event an issuer is liquidated or declares bankruptcy, the claims of owners of bonds take priority over holders of preferred stock,
whose claims take priority over the claims of those who own common stock.
While offering greater potential for long-term growth, equity
securities generally are more volatile and riskier than some other forms of investment. Therefore, the value of an investment in the Fund may at times decrease instead of increase. The Funds investments may include securities traded
over-the-counter as well as those traded on a securities exchange. Some securities, particularly over-the-counter securities, may be more difficult to sell under some market conditions.
Smaller Company Equity Securities. The Fund may invest in equity securities of companies with small market capitalizations. Such investments may involve greater risk than is usually associated with
larger, more established companies. Companies with small market capitalizations often have limited product lines, markets or financial resources and may be dependent upon a relatively small management group. These securities may have limited
marketability and may be subject to more abrupt or erratic movements in price than securities of companies with larger market capitalizations or market averages in general. To the extent the Fund invests in securities with small market
capitalizations, the net asset value of the Fund may fluctuate more widely than market averages.
Futures
Contracts.
The Fund may purchase and sell futures contracts (each a
futures contract
), including interest rate and security index futures contracts, currency and currency index futures contracts, on securities
or currencies eligible for purchase by the Fund.
The Fund may enter into interest rate futures contracts and securities index futures
contracts (collectively referred to as
financial futures contracts
) for hedging or other purposes. Interest rate futures contracts obligate the long or short holder to take or make delivery of a specified quantity of a financial
instrument during a specified future period at a specified price. Securities index futures contracts, which are contracts to buy or sell units of a securities index at a specified future date at a price agreed upon when the contract is made, are
similar in economic effect, but they are based on a specific index of securities (rather than on specified securities) and are settled in cash.
-5-
The following example illustrates generally the manner in which index futures contracts operate. The
Standard & Poors 100 Stock Index (the
S&P 100 Index
) is composed of 100 selected common stocks, most of which are listed on the New York Stock Exchange (the
NYSE
). The S&P 100 Index
assigns relative weightings to the common stocks included in the Index, and the Index fluctuates with changes in the market values of those common stocks. In the case of the S&P 100 Index, contracts are to buy or sell 100 units. Thus, if the
value of the S&P 100 Index were $180, one contract would be worth $18,000 (100 units x $180). The stock index futures contract specifies that no delivery of the actual stocks making up the index will take place. Instead, settlement in cash must
occur upon the termination of the contract, with the settlement being the difference between the contract price and the actual level of the stock index at the expiration of the contract. For example, if the Fund enters into a futures contract to buy
100 units of the S&P 100 Index at a specified future date at a contract price of $180 and the S&P 100 Index is at $184 on that future date, the Fund will gain $400 (100 units x gain of $4). If the Fund enters into a futures contract to sell
100 units of the stock index at a specified future date at a contract price of $180 and the S&P 100 Index is at $182 on that future date, the Fund will lose $200 (100 units x loss of $2).
Positions in index futures may be closed out only on an exchange or board of trade which provides a secondary market for such futures.
In order to hedge its investments successfully using financial futures contracts, the Fund must invest in futures contracts with respect to securities, indexes or sub-indexes the movements of which will,
in the Advisers judgment, have a significant correlation with movements in the prices of the Funds portfolio securities.
There
are special risks associated with entering into financial futures contracts. The skills needed to use financial futures contracts effectively are different from those needed to select the Funds investments. There may be an imperfect
correlation between the price movements of financial futures contracts and the price movements of the securities in which the Fund invests. There is also a risk that the Fund will be unable to close a futures position when desired because there is
no liquid secondary market for it.
The risk of loss in trading financial futures can be substantial due to the low margin deposits required
and the extremely high degree of leverage involved in futures pricing. Relatively small price movements in a financial futures contract could have an immediate and substantial impact, which may be favorable or unfavorable to the Fund. It is possible
for a price-related loss to exceed the amount of the Funds margin deposit.
Although some financial futures contracts by their terms
call for the actual delivery or acquisition of securities at expiration, in most cases the contractual commitment is closed out before expiration. The offsetting of a contractual obligation is accomplished by purchasing (or selling as the case may
be) on a commodities or futures exchange an identical financial futures contract calling for delivery in the same month. Such a transaction, if effected through a member of an exchange, cancels the obligation to make or take delivery of the
securities. The Fund will incur brokerage fees when it purchases or sells financial futures contracts, and will be required to maintain margin deposits. If a liquid secondary market does not exist when the Fund wishes to close out a financial
futures contract, it will not be able to do so and will continue to be required to make daily cash payments of variation margin in the event of adverse price movements. There is no assurance that the Fund will be able to enter into closing
transactions.
The Fund may enter into futures contracts on other underlying assets or indexes, including physical commodities and indexes of
physical commodities.
At any time prior to expiration of a futures contract, the Fund may seek to close the position by taking an opposite
position which would typically operate to terminate the Funds position in the futures contract. A final determination of any variation margin is then made, additional cash is required to be paid by or released to the Fund and the Fund realizes
a loss or gain.
Margin Payments
. When the Fund purchases or sells a futures contract, it is required to deposit with its
custodian an amount of cash, U.S. Treasury bills, or other permissible collateral equal to a small percentage of the amount of the futures contract. This amount is known as initial margin. Initial margin requirements are established by the exchanges
on which futures contracts trade and may, from time to time, change. The nature of initial margin is different from that of margin in security transactions in that it does not involve borrowing money to finance transactions. Rather, initial margin
is similar to a performance bond or good faith deposit that is returned to the Fund upon termination of the contract, assuming the Fund satisfies its contractual obligations. In addition, brokers may establish margin deposit requirements in excess
of those required by the exchanges.
Subsequent payments to and from the broker occur on a daily basis in a process known as marking to
market. These payments are called variation margin and are made as the value of the underlying futures contract fluctuates. For example, when the Fund sells a futures contract and the price of the underlying index rises above the delivery price,
that Funds position declines in value. The Fund
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then pays the broker a variation margin payment equal to the difference between the delivery price of the futures contract and the value of the index underlying the futures contract. Conversely,
if the price of the underlying index falls below the delivery price of the contract, the Funds futures position increases in value. The broker then must make a variation margin payment equal to the difference between the delivery price of the
futures contract and the value of the index underlying the futures contract.
When the Fund terminates a position in a futures contract, a
final determination of variation margin is made, additional cash is paid by or to the Fund, and the Fund realizes a loss or a gain. Such closing transactions involve additional commission costs.
Options on Financial Futures Contracts.
The Fund may purchase and write call and put options on financial futures contracts. An option
on a financial futures contract gives the purchaser the right, in return for the premium paid, to assume a position in an index futures contract (a long position if the option is a call and a short position if the option is a put) at a specified
exercise price at any time during the period of the option. Upon exercise of the option, the holder would assume the underlying futures position and would receive a variation margin payment of cash or securities approximating the increase in the
value of the holders option position. If an option is exercised on the last trading day prior to the expiration date of the option, the settlement will be made entirely in cash based on the difference between the exercise price of the option
and the closing level of the index on which the futures contract is based on the expiration date. Purchasers of options who fail to exercise their options prior to the exercise date suffer a loss of the premium paid.
Special Risks of Transactions in Futures Contracts and Related Options
. Financial futures contracts entail risks. If the Advisers
judgment about the general direction of interest rates or markets is wrong, the Funds overall performance may be poorer than if no financial futures contracts had been entered into. For example, in some cases, securities called for by a
financial futures contract may not have been issued at the time the contract was written. In addition, the market prices of financial futures contracts may be affected by certain factors.
Liquidity Risks
. Positions in futures contracts may be closed out only on an exchange or board of trade which provides a secondary market for such futures. Although the Fund may intend
to purchase or sell futures only on exchanges or boards of trade where there appears to be an active secondary market, there is no assurance that a liquid secondary market on an exchange or board of trade will exist for any particular contract or at
any particular time. If there is not a liquid secondary market at a particular time, it may not be possible to close a futures position at such time and, in the event of adverse price movements, the Fund would continue to be required to make daily
cash payments of variation margin. However, in the event financial futures are used to hedge portfolio securities, such securities will not generally be sold until the financial futures can be terminated. In such circumstances, an increase in the
price of the portfolio securities, if any, may partially or completely offset losses on the financial futures.
The ability to establish and
close out positions in options on futures contracts will be subject to the development and maintenance of a liquid secondary market. It is not certain that such a market will develop. Although the Fund generally will purchase only those options for
which there appears to be an active secondary market, there is no assurance that a liquid secondary market on an exchange will exist for any particular option or at any particular time. In the event no such market exists for particular options, it
might not be possible to effect closing transactions in such options, with the result that the Fund would have to exercise the options in order to realize any profit.
Hedging risks.
There are several risks in connection with the use by the Fund of futures contracts and related options as a hedging device. One risk arises because of the imperfect
correlation between movements in the prices of the futures contracts and options and movements in the underlying securities or index or movements in the prices of the Funds securities which are the subject of a hedge. The Adviser will,
however, attempt to reduce this risk by purchasing and selling, to the extent possible, futures contracts and related options on securities and indexes the movements of which will, in its judgment, correlate closely with movements in the prices of
the underlying securities or index and the Funds portfolio securities sought to be hedged.
Successful use of futures contracts and
options by the Fund for hedging purposes is also subject to the Advisers ability to predict correctly movements in the direction of the market. It is possible that, where the Fund has purchased puts on futures contracts to hedge its portfolio
against a decline in the market, the securities or index on which the puts are purchased may increase in value and the value of securities held in the portfolio may decline. If this occurred, the Fund would lose money on the puts and also experience
a decline in the value of its portfolio securities. In addition, the prices of futures, for a number of reasons, may not correlate perfectly with movements in the underlying securities or index due to certain market distortions. First, all
participants in the futures market are subject to margin deposit requirements. Such requirements may cause investors to close futures contracts through offsetting transactions which could distort the normal relationship between the underlying
security or index and futures markets. Second, the margin requirements in the futures markets are less onerous than margin requirements in the securities markets in general, and as a result the futures markets may attract more speculators than the
securities markets do. Increased participation by speculators in the futures markets may also cause temporary price distortions. Due to the possibility of price distortion, even a correct forecast of general market trends by the Adviser still may
not result in a successful hedging transaction over a very short time period.
-7-
Other Risks.
The Fund will incur brokerage fees in connection with its futures and options
transactions. In addition, while futures contracts and options on futures will be purchased and sold to reduce certain risks, those transactions themselves entail certain other risks. Thus, while the Fund may benefit from the use of futures and
related options, unanticipated changes in interest rates or stock price movements may result in a poorer overall performance for the Fund than if it had not entered into any futures contracts or options transactions. Moreover, in the event of an
imperfect correlation between the futures position and the portfolio position that is intended to be protected, the desired protection may not be obtained and the Fund may be exposed to risk of loss.
The risks associated with purchasing and writing put and call options on financial futures contracts can be influenced by the market for financial
futures contracts. An increase in the market value of a financial futures contract on which the Fund has written an option may cause the option to be exercised. In this situation, the benefit to the Fund would be limited to the value of the exercise
price of the option and, if the Fund closes out the option, the cost of entering into the offsetting transaction could exceed the premium the Fund initially received for writing the option. In addition, the Funds ability to enter into an
offsetting transaction depends upon the markets demand for such financial futures contracts. If a purchased option expires unexercised, the Fund would realize a loss in the amount of the premium paid for the option.
The Adviser has claimed an exclusion from the definition of the term commodity pool operator under the Commodity Exchange Act
(
CEA
) pursuant to Rule 4.5 under the CEA (the
exclusion
) promulgated by the CFTC, in connection with its services to the Fund. To ensure the Advisers eligibility for the exclusion under Rule 4.5 as it has
recently been amended by the CFTC, the Fund may be limited in its ability to use futures and options on futures and to engage in certain swaps transactions. The Fund currently expects to operate in a manner that would permit the Adviser to continue
to claim the exclusion under Rule 4.5, which may adversely affect the Advisers ability to manage the Fund under certain market conditions and may adversely affect the Funds total return. In the event the Adviser becomes unable to rely on
the exclusion in Rule 4.5 and is required to register with the CFTC as a commodity pool operator, the Funds expenses may increase. The effect of the rule changes on the operations of the Fund and the Adviser is not fully known at this time.
Congress, various exchanges and regulatory and self-regulatory authorities have undertaken reviews of options and futures trading in light of
market volatility. Among the actions that have been taken or are proposed to be taken are new limits and reporting requirements for speculative positions, particularly in the energy markets, new or more stringent daily price fluctuation limits for
futures and options transactions, and increased margin requirements for various types of futures transactions. Additional measures are under active consideration and as a result there may be further actions that adversely affect the regulation of
the instruments in which the Fund invest. Subject to certain limitations, the Fund may enter into futures contracts or options on such contracts to attempt to protect against possible changes in the market value of securities held in or to be
purchased by the Fund resulting from interest rate or market fluctuations, to protect the Funds unrealized gains in the value of its portfolio securities, to facilitate the sale of such securities for investment purposes, to manage its
effective maturity or duration, or to establish a position in the derivatives markets as a temporary substitute for purchasing or selling particular securities. In connection with the purchase or sale of futures contracts, the Fund will be required
to either (i) segregate sufficient cash or other liquid assets to cover the outstanding position or (ii) cover the futures contract by either owning the instruments underlying the futures contracts or by holding a portfolio of securities
with characteristics substantially similar to the underlying index or stock index comprising the futures contracts or by holding a separate offsetting option permitting it to purchase or sell the same futures contract.
The Fund may purchase or sell interest rate futures for the purpose of hedging some or all of the value of its portfolio securities against changes in
prevailing interest rates or to manage its duration or effective maturity. If the Adviser anticipates that interest rates may rise and, concomitantly, the price of certain of its portfolio securities may fall, the Fund may sell futures contracts. If
declining interest rates are anticipated, the Fund may purchase futures contracts to protect against a potential increase in the price of securities the Fund intends to purchase. Subsequently, appropriate securities may be purchased by the Fund in
an orderly fashion; as securities are purchased, corresponding futures positions would be terminated by offsetting sales of contracts.
Junk Bond Securities.
The Fund may purchase lower-rated debt securities, sometimes referred to as junk bonds, and unrated
securities that have been determined by the Adviser to be of comparable quality. A security is generally considered to be below investment grade if it is rated Ba1 by Moodys Investors Service, Inc. (
Moodys
) and BB+ by
Standard & Poors Ratings Group (
S&P
), or lower, or the equivalent by any other nationally recognized statistical rating organization. See Appendix A for a description of these ratings.
-8-
While offering a greater potential opportunity for capital appreciation and higher yields compared to
higher-rated fixed income securities, junk bonds typically entail greater potential price volatility and may be less liquid than higher-rated securities. Junk bonds may be regarded as predominately speculative with respect to the issuers
continuing ability to meet principal and interest payments. They may also be more susceptible to real or perceived adverse economic and competitive industry conditions than higher-rated securities. Issuers of securities in default may fail to resume
principal or interest payments, in which case the Fund may lose its entire investment.
The lower ratings of certain securities held by the
Fund reflect a greater possibility that adverse changes in the financial condition of the issuer, or in general economic conditions, or both, or an unanticipated rise in interest rates, may impair the ability of the issuer to make payments of
interest and principal. The inability (or perceived inability) of issuers to make timely payment of interest and principal would likely make the values of securities held by the Fund more volatile and could limit the Funds ability to sell its
securities at prices approximating the values the Fund had placed on such securities. In the absence of a liquid trading market for securities held by it, the Fund may be unable at times to establish the fair market value of such securities. The
rating assigned to a security by Moodys or S&P does not reflect an assessment of the volatility of the securitys market value or of the liquidity of an investment in the security.
Like those of other fixed-income securities, the values of lower-rated securities fluctuate in response to changes in interest rates. Thus, a decrease in
interest rates generally will result in an increase in the value of the Funds fixed-income securities. Conversely, during periods of rising interest rates, the value of the Funds fixed-income securities generally will decline. In
addition, the values of such securities are also affected by changes in general economic conditions and business conditions affecting the specific industries of their issuers. Changes by recognized rating services in their ratings of any
fixed-income security and in the ability of an issuer to make payments of interest and principal may also affect the value of these investments. Changes in the values of portfolio securities generally will not affect cash income derived from such
securities, but will affect the Funds net asset value.
Issuers of lower-rated securities are often highly leveraged, so that their
ability to service their debt obligations during an economic downturn or during sustained periods of rising interest rates may be impaired. In addition, such issuers may not have more traditional methods of financing available to them, and may be
unable to repay debt at maturity by refinancing. The risk of loss due to default in payment of interest or principal by such issuers is significantly greater because such securities frequently are unsecured and subordinated to the prior payment of
senior indebtedness. Certain of the lower-rated securities in which the Fund may invest are issued to raise funds in connection with the acquisition of a company, in so-called leveraged buy-out transactions. The highly leveraged capital structure of
such issuers may make them especially vulnerable to adverse changes in economic conditions.
Under adverse market or economic conditions or in
the event of adverse changes in the financial condition of the issuer, the Fund could find it more difficult to sell lower-rated securities when the Adviser believes it advisable to do so or may be able to sell such securities only at prices lower
than might otherwise be available. In many cases, lower-rated securities may be purchased in private placements and, accordingly, will be subject to restrictions on resale as a matter of contract or under securities laws. Under such circumstances,
it may also be more difficult to determine the fair value of such securities for purposes of computing the Funds net asset value. In order to enforce its rights in the event of a default under lower-rated securities, the Fund may be required
to take possession of and manage assets securing the issuers obligations on such securities, which may increase the Funds operating expenses and adversely affect the Funds net asset value. The Fund may also be limited in its
ability to enforce its rights and may incur greater costs in enforcing its rights in the event an issuer becomes the subject of bankruptcy proceedings. In addition, the Funds intention to qualify as a regulated investment company
(
RIC
) under the Code may limit the extent to which the Fund may exercise its rights by taking possession of such assets.
Certain securities held by the Fund may permit the issuer at its option to call, or redeem, its securities. If an issuer were to redeem securities held
by the Fund during a time of declining interest rates, the Fund may not be able to reinvest the proceeds in securities providing the same investment return as the securities redeemed.
Lower-rated securities may be subject to certain risks not typically associated with investment grade securities, such as the following: (1) reliable and objective information about the value of
lower rated obligations may be difficult to obtain because the market for such securities may be thinner and less active than that for investment grade obligations; (2) adverse publicity and investor perceptions, whether or not based on
fundamental analysis, may decrease the values and liquidity of lower than investment grade obligations, and, in turn, adversely affect their market; (3) companies that issue lower rated obligations may be in the growth stage of their
development, or may be financially troubled or highly leveraged, so they may not have more traditional methods of financing available to them; (4) when other institutional investors dispose of their holdings of lower rated debt securities, the
general market and the prices for such securities could be adversely affected; and (5) the market for lower rated securities could be impaired if legislative proposals to limit their use in connection with corporate reorganizations or to limit
their tax and other advantages are enacted.
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Unrated Securities
. Subject to its investment policies, the Fund may purchase unrated
securities (which are not rated by a rating agency) if the Adviser determines that the securities are of comparable quality to rated securities that the Fund may purchase. Unrated securities may be less liquid than comparable rated securities and
involve the risk that the Adviser may not accurately evaluate the securitys comparative creditworthiness. Analysis of creditworthiness of issuers of high yield securities may be more complex than for issuers of higher-quality fixed income
securities. To the extent the Fund invests in high yield and/or unrated securities, the Funds success in achieving its investment objective may depend more heavily on the Advisers analysis than if the Fund invested exclusively in
higher-quality and rated securities.
Money Market Instruments.
The Fund may invest in money market instruments.
These instruments include, but are not limited to:
U.S. Government Securities
. Obligations issued or guaranteed as to
principal and interest by the United States or its agencies (such as the Export-Import Bank of the United States, Federal Housing Administration and Government National Mortgage Association) or its instrumentalities (such as the Federal Home Loan
Bank), including Treasury bills, notes and bonds.
Bank Obligations
. Obligations including certificates of deposit, fixed
time deposits and bankers acceptances, commercial paper (see below) and other debt obligations of banks subject to regulation by the U.S. Government and having total assets of $1 billion or more, and instruments secured by such
obligations, not including obligations of foreign branches of domestic banks except as permitted below.
Eurodollar Certificates of
Deposit
. Eurodollar certificates of deposit issued by foreign branches of domestic banks having total assets of $1 billion or more (investments in Eurodollar certificates may be affected by changes in currency rates or exchange
control regulations, or changes in governmental administration or economic or monetary policy in the United States and abroad).
Obligations of Savings Institutions
. Certificates of deposit of savings banks and savings and loan associations, having total assets of
$1 billion or more (investments in savings institutions above $100,000 in principal amount are not protected by federal deposit insurance).
Fully Insured Certificates of Deposit
. Certificates of deposit of banks and savings institutions, having total assets of less than $1
billion, if the principal amount of the obligation is insured by the Bank Insurance Fund or the Savings Association Insurance Fund (each of which is administered by the Federal Deposit Insurance Corporation), limited to $250,000 principal amount per
certificate and to 15% or less of the Funds net assets in all such obligations and in all illiquid assets, in the aggregate.
Commercial Paper
. The Fund may purchase commercial paper rated within the highest ratings categories by S&P or Moodys or, if
not rated, the security is determined by the Adviser to be of comparable quality.
Money Market Mutual Funds
. Shares of
United States money market investment companies.
Other Short-Term Obligations
. Debt securities initially issued with a
remaining maturity of 397 days or less and that have a short-term rating within ratings categories of at least A-1 by S&P or P-1 by Moodys.
Options.
The Fund may purchase and write (sell) call and put options, including options listed on U.S. or foreign securities exchanges or written in over-the-counter transactions
(
OTC Options
).
Exchange-listed options are issued by the Options Clearing Corporation (
OCC
) (in the
U.S.) or other clearing corporation or exchange which assures that all transactions in such options are properly executed. OTC Options are purchased from or sold (written) to dealers or financial institutions which have entered into direct
agreements with the Fund. With OTC Options, such variables as expiration date, exercise price and premium will be agreed upon between the Fund and the transacting dealer, without the intermediation of a third party such as the OCC. In the event the
counterparty to such a derivative instrument becomes insolvent, the Fund will lose all or substantially all of its investment in the derivative instrument, as well as the benefits derived therefrom. It is the position of the SEC that OTC Options are
illiquid.
Purchasing Call and Put Options
. The Fund may purchase a call option in order to close out a covered call
position (see Covered Call Writing below), to protect against an increase in price of a security it anticipates purchasing. The purchase of the call option to effect a closing transaction on a call written over-the-counter may be a
listed or an OTC Option. In either case, the call purchased is likely to be on the same securities and have the same terms as the written option. If purchased over-the-counter, the option would generally be acquired from the dealer or financial
institution which purchased the call written by the Fund.
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The Fund may purchase put options on securities which it holds in its portfolio to protect itself against a
decline in the value of the security and to close out written put option positions. If the value of the underlying security were to fall below the exercise price of the put purchased in an amount greater than the premium paid for the option, the
Fund would incur no additional loss. In addition, the Fund may sell a put option which it has previously purchased prior to the sale of the securities underlying such option. Such a sale would result in a net gain or loss depending whether the
amount received on the sale is more or less than the premium and other transaction costs paid on the put option which is sold. Such gain or loss could be offset in whole or in part by a change in the market value of the underlying security. If a put
option purchased by the Fund expired without being sold or exercised, the premium would be lost.
Covered Call Writing
. The
Fund is permitted to write covered call options on securities. Generally, a call option is covered if the Fund owns, or has the right to acquire, without additional cash consideration (or for additional cash consideration held for the Fund by its
custodian in a segregated account) the underlying security subject to the option, or otherwise segregates sufficient cash or U.S. Government securities or other liquid securities to cover the outstanding position. A call option is also covered if
the Fund holds a call on the same security as the underlying security of the written option, where the exercise price of the call used for coverage is equal to or less than the exercise price of the call written.
The writer of an option receives from the purchaser, in return for a call it has written, a premium (
i.e.
, the price of the option). Receipt of
these premiums may better enable the Fund to earn a higher level of current income than it would earn from holding the underlying securities alone. Moreover, the premium received will offset a portion of the potential loss incurred by the Fund if
the securities underlying the option are ultimately sold by the Fund at a loss. Furthermore, a premium received on a call written on a foreign currency will ameliorate any potential loss of value on the portfolio security due to a decline in the
value of the currency.
However, during the option period, the covered call writer has, in return for the premium on the option, given up the
opportunity for capital appreciation above the exercise price should the market price of the underlying security increase, but has retained the risk of loss should the price of the underlying security decline. The premium received will fluctuate
with varying economic market conditions. If the market value of the portfolio securities upon which call options have been written increases, the Fund may receive a lower total return from the portion of its portfolio upon which calls have been
written than it would have had such calls not been written.
With respect to listed options and certain OTC Options, during the option period,
the Fund may be required, at any time, to deliver the underlying security against payment of the exercise price on any calls it has written (exercise of certain listed and OTC Options may be limited to specific expiration dates). This obligation is
terminated upon the expiration of the option period or at such earlier time when the writer effects a closing purchase transaction. A closing purchase transaction is accomplished by purchasing an option of the same series as the option previously
written. However, once the Fund has been assigned an exercise notice, the Fund will be unable to effect a closing purchase transaction.
Closing purchase transactions are ordinarily effected to realize a profit or loss on an outstanding call option, to prevent an underlying security from
being called, to permit the sale of an underlying security or to enable the Fund to write another call option on the underlying security with either a different exercise price or expiration date or both. The Fund may realize a net gain or loss from
a closing purchase transaction depending upon whether the amount of the premium received on the call option is more or less than the cost of effecting the closing purchase transaction. Any loss incurred in a closing purchase transaction may be
wholly or partially offset by unrealized appreciation in the market value of the underlying security. Conversely, a gain resulting from a closing purchase transaction could be offset in whole or in part or exceeded by a decline in the market value
of the underlying security.
If a call option expires unexercised, the Fund realizes a gain in the amount of the premium on the option less
the commission paid. Such a gain, however, may be offset by depreciation in the market value of the underlying security during the option period. If a call option is exercised, the Fund realizes a gain or loss from the sale of the underlying
security equal to the difference between the purchase price of the underlying security and the proceeds of the sale of the security plus the premium received on the option less the commission paid.
Covered Put Writing
. The Fund is permitted to write covered put options on securities. As a writer of a covered put option, the Fund
incurs an obligation to buy the security underlying the option from the purchaser of the put, at the options exercise price at any time during the option period, at the purchasers election (certain listed and OTC put options written by
the Fund will be exercisable by the purchaser only on a specific date). A put is covered if, at all times during the option period, the Fund maintains, in a segregated
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account, cash or other liquid assets in an amount equal to at least the exercise price of the option. Similarly, a short put position could be covered by the Fund by its purchase of a put option
on the same security as the underlying security of the written option, where the exercise price of the purchased option is equal to or more than the exercise price of the put written or less than the exercise price of the put written if the marked
to market difference is maintained by the Fund in cash or other liquid assets which the Fund holds in a segregated account. In writing puts, the Fund assumes the risk of loss should the market value of the underlying security decline below the
exercise price of the option (any loss being decreased by the receipt of the premium on the option written). In the case of listed options, during the option period, the Fund may be required, at any time, to make payment of the exercise price
against delivery of the underlying security. The operation of and limitations on covered put options in other respects are substantially identical to those of call options.
Options on Foreign Currencies.
The Fund may purchase and write options on foreign currencies for purposes similar to those involved with investing in foreign currency forward contracts.
For example, in order to protect against declines in the dollar value of portfolio securities which are denominated in a foreign currency, the Fund may purchase put options on an amount of such foreign currency equivalent to the current value of the
portfolio securities involved. As a result, the Fund would be enabled to sell the foreign currency for a fixed amount of U.S. dollars, thereby locking in the dollar value of the portfolio securities (less the amount of the premiums paid for the
options). Conversely, the Fund may purchase call options on foreign currencies in which securities it anticipates purchasing are denominated to secure a set U.S. dollar price for such securities and protect against a decline in the value of the U.S.
dollar against such foreign currency. The Fund may also purchase call and put options to close out written option positions. As with securities, these options may be covered.
The Fund may also write call options on foreign currency to protect against potential declines in its portfolio securities which are denominated in foreign currencies. If the U.S. dollar value of the
portfolio securities falls as a result of a decline in the exchange rate between the foreign currency in which it is denominated and the U.S. dollar, then a loss to the Fund occasioned by such value decline would be ameliorated by receipt of the
premium on the option sold. At the same time, however, the Fund gives up the benefit of any rise in value of the relevant portfolio securities above the exercise price of the option and, in fact, only receives a benefit from the writing of the
option to the extent that the value of the portfolio securities falls below the price of the premium received. The Fund may also write options to close out long call option positions. A put option on a foreign currency would be written by the Fund
for the same reason it would purchase a call option, namely, to hedge against an increase in the U.S. dollar value of a foreign security which the Fund anticipates purchasing. Here, the receipt of the premium would offset, to the extent of the size
of the premium, any increased cost to the Fund resulting from an increase in the U.S. dollar value of the foreign security. However, the Fund could not benefit from any decline in the cost of the foreign security which is greater than the price of
the premium received. The Fund may also write options to close out long put and call option positions.
The Funds ability to establish
and close out positions on foreign currency options is subject to the maintenance of a liquid secondary market for such options. Although the Fund will not purchase or write such options unless and until, in the opinion of the Adviser, the market
for them has developed sufficiently to ensure that the risks in connection with such options are not greater than the risks in connection with the underlying currency, there can be no assurance that a liquid secondary market will exist for a
particular option at any specific time. In addition, options on foreign currencies are affected by all of those factors which influence foreign exchange rates and investments generally.
The value of a foreign currency option depends upon the value of the underlying currency relative to the U.S. dollar. As a result, the price of the option position may vary with changes in the value of
either or both currencies and have no relationship to the investment merits of a foreign security, including foreign securities held in a hedged investment portfolio. Because foreign currency transactions occurring in the interbank market involve
substantially larger amounts than those that may be involved in the use of foreign currency options, investors may be disadvantaged by having to deal in an odd lot market (generally consisting of transactions of less than $1 million) for the
underlying foreign currencies at prices that are less favorable than for round lots.
Options on Futures Contracts.
The Fund
may also purchase and write call and put options on futures contracts which are traded on an exchange and enter into closing transactions with respect to such options to terminate an existing position. An option on a futures contract gives the
purchaser the right (in return for the premium paid) to assume a position in a futures contract (a long position if the option is a call and a short position if the option is a put) at a specified exercise price at any time during the term of the
option.
The Fund will purchase and write options on futures contracts for identical purposes to those set forth above for the purchase of a
futures contract (purchase of a call option or sale of a put option) and the sale of a futures contract (purchase of a put option or sale of a call option), or to close out a long or short position in futures contracts. If, for example, the Fund
wished to protect against an increase in interest rates and the resulting negative impact on the value of a portion of its fixed-income portfolio, it might write a call option on an interest rate futures contract, the underlying security of which
correlates with the portion of the portfolio the Fund seeks to hedge. Any premiums received in the writing of options on futures contracts may, of course, provide a further hedge against losses resulting from price declines in portions of the
Funds portfolio.
-12-
Repurchase Agreements.
Repurchase agreements, which may be viewed as a type of
secured lending by the Fund, 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 repurchase agreements will provide that the Fund
will sell back to the institution, and that the institution will repurchase, the underlying security (
collateral
) at a specified price and at a fixed time in the future, usually not more than seven days from the date of purchase.
The collateral will be maintained in a segregated account and, with respect to United States repurchase agreements, will be marked to market daily to ensure that the full value of the collateral, as specified in the repurchase agreement, does not
decrease below the repurchase price plus accrued interest. If such a decrease occurs, additional collateral will be requested and, when received, added to the account to maintain full collateralization. The Fund will accrue interest from the
institution until the date the repurchase occurs. Although this date is deemed by the Fund to be the maturity date of a repurchase agreement, the maturities of the collateral securities are not subject to any limits and may exceed one year.
Repurchase agreements that have more than seven days remaining to maturity will be considered illiquid for purposes of the restriction on the Funds investment in illiquid and restricted securities.
Reverse Repurchase Agreements.
Reverse repurchase agreements involve sales by the Fund of portfolio securities concurrently with
an agreement by the Fund to repurchase the same securities at a later date at a fixed price. Reverse repurchase agreements are speculative techniques involving leverage. Reverse repurchase agreements involve the risk that the market value of the
securities the Fund is obligated to repurchase under the agreement may decline below the repurchase price. Reverse repurchase agreements involve the risk that the buyer of the securities sold might be unable to deliver them when the Fund seeks to
repurchase the securities. If the buyer files for bankruptcy or becomes insolvent, the Fund may be delayed or prevented from recovering the security that it sold.
When, As and If Issued Securities.
The Fund may purchase securities on a when, as and if issued basis under which the issuance of the security depends upon the
occurrence of a subsequent event, such as approval of a merger, corporate reorganization, leveraged buyout or debt restructuring. The commitment for the purchase of any such security will not be recognized in the portfolio of the Fund until the
Adviser determines that issuance of the security is probable. The Fund may purchase securities on such basis without limit. The purchase of securities on a when, as and if issued basis may create investment leverage and increase the
volatility of the Funds net asset value. The Fund may also sell securities on a when, as and if issued basis provided that the issuance of the security will result automatically from the exchange or conversion of a security owned
by the Fund at the time of the sale.
When-Issued and Delayed Delivery Securities and Forward Commitments.
When
purchasing a security on a when-issued, delayed delivery, or forward commitment basis, the Fund assumes many of the benefits and risks of ownership of the security, including the risk of price and yield fluctuations, but does not take delivery of
the security until a date substantially after the date the transaction is entered into. Because the Fund is not required to pay for the security until the delivery date, these transactions may create investment leverage. When the Fund has sold a
security on a when-issued, delayed delivery, or forward commitment basis, the Fund does not participate in future gains or losses with respect to the security.
Swap Agreements.
The Fund may enter into swap agreements and other types of over-the-counter transactions such as caps, floors and collars with broker-dealers or other financial
institutions for hedging or investment purposes. An example of one type of swap involves the exchange by the Fund with another party of their respective commitments to pay or receive cash flows, for example, an exchange of floating rate payments for
fixed-rate payments. The purchase of a cap entitles the purchaser, to the extent that a specified index or other underlying financial measure exceeds a predetermined value on a predetermined date or dates, to receive payments on a notional principal
amount from the party selling the cap. The purchase of a floor entitles the purchaser, to the extent that a specified index or other underlying financial measure falls or other underlying measure below a predetermined value on a predetermined date
or dates, to receive payments on a notional principal amount from the party selling the floor. A collar combines elements of a cap and a floor.
Swap agreements and similar transactions can be individually negotiated and structured to include exposure to a variety of different types of investments
or market factors. Depending on their structures, swap agreements may increase or decrease the Funds exposure to long-or short-term interest rates (in the United States or abroad), foreign currency values, mortgage securities, mortgage rates,
corporate borrowing rates, or other factors such as security prices, inflation rates or the volatility of an index or one or more securities. For example, if the Fund agrees to exchange payments in U.S. dollars for payments in a non-U.S. currency,
the swap agreement would tend to decrease the Funds exposure to U.S. interest rates and increase its exposure to that non-U.S. currency and interest rates. The value of the Funds swap positions would increase or decrease depending on the
changes in value of the underlying rates, currency values, volatility or other indices or measures. Caps and floors have an effect similar to buying or writing options. Depending on how they are used, swap agreements may increase or decrease the
overall volatility of a funds investments and its share price. The Funds ability to engage in certain swap transactions may be limited by tax considerations.
-13-
The Funds ability to realize a profit from such transactions will depend on the ability of the
financial institutions with which it enters into the transactions to meet their obligations to the Fund. If a counterpartys creditworthiness declines, the value of the agreement would be likely to decline, potentially resulting in losses. If a
default occurs by the other party to such transaction, the Fund will have contractual remedies pursuant to the agreements related to the transaction, which may be limited by applicable law in the case of a counterpartys insolvency. Under
certain circumstances, suitable transactions may not be available to the Fund, or the Fund may be unable to close out its position under such transactions at the same time, or at the same price, as if it had purchased comparable publicly traded
securities. Swaps carry counterparty risks that cannot be fully anticipated. Also, because swap transactions typically involve a contract between the two parties, such swap investments can be extremely illiquid, as it is uncertain as to whether
another counterparty would wish to take assignment of the rights under the swap contract at a price acceptable to the Fund.
The Fund may also
enter into options on swap agreements (
swaptions
). A swaption is a contract that gives a counterparty the right (but not the obligation) to enter into a new swap agreement or to shorten, extend, cancel or otherwise modify an
existing swap agreement, at some designated future time on specified terms. The Fund may write (sell) and purchase put and call swaptions to the same extent it may make use of standard options on securities or other instruments. Swaptions are
generally subject to the same risks involved in the Funds use of options.
Credit Default Swaps
.
A credit
default swap is an agreement between the Fund and a counterparty that enables the Fund to buy or sell protection against a credit event related to a particular issuer. One party, acting as a protection buyer, makes periodic payments, which may be
based on, among other things, a fixed or floating rate of interest, to the other party, a protection seller, in exchange for a promise by the protection seller to make a payment to the protection buyer if a negative credit event (such as a
delinquent payment or default) occurs with respect to a referenced bond or group of bonds. Credit default swaps may also be structured based on the debt of a basket of issuers, rather than a single issuer, and may be customized with respect to the
default event that triggers purchase or other factors (for example, the Nth default within a basket, or defaults by a particular combination of issuers within the basket, may trigger a payment obligation). As a credit protection seller in a credit
default swap contract, the Fund would be required to pay the par (or other agreed-upon) value of a referenced debt obligation to the counterparty following certain negative credit events as to a specified third-party debtor, such as default by a
U.S. or non-U.S. corporate issuer on its debt obligations. In return for its obligation, the Fund would receive from the counterparty a periodic stream of payments, which may be based on, among other things, a fixed or floating rate of interest,
over the term of the contract provided that no event of default has occurred. If no default occurs, the Fund would keep the stream of payments, and would have no payment obligations to the counterparty. The Fund may sell credit protection in order
to earn additional income and/or to take a synthetic long position in the underlying security or basket of securities.
The Fund may enter
into credit default swap contracts as protection buyer in order to hedge against the risk of default on the debt of a particular issuer or basket of issuers or attempt to profit from a deterioration or perceived deterioration in the creditworthiness
of the particular issuer(s) (also known as buying credit protection). This would involve the risk that the investment may expire worthless and would only generate gain in the event of an actual default by the issuer(s) of the underlying
obligation(s) (or, as applicable, a credit downgrade or other indication of financial instability). It would also involve the risk that the seller may fail to satisfy its payment obligations to the Fund. The purchase of credit default swaps involves
costs, which will reduce the Funds return.
Credit default swaps involve a number of special risks. A protection seller may have to pay
out amounts following a negative credit event greater than the value of the reference obligation delivered to it by its counterparty and the amount of periodic payments previously received by it from the counterparty. When the Fund acts as a seller
of a credit default swap, it is exposed to, among other things, leverage risk because if an event of default occurs the seller must pay the buyer the full notional value of the reference obligation. Each party to a credit default swap is subject to
the credit risk of its counterparty (the risk that its counterparty may be unwilling or unable to perform its obligations on the swap as they come due). The value of the credit default swap to each party will change based on changes in the actual or
perceived creditworthiness of the underlying issuer.
A protection buyer may lose its investment and recover nothing should an event of
default not occur. The Fund may seek to realize gains on its credit default swap positions, or limit losses on its positions, by selling those positions in the secondary market. There can be no assurance that a liquid secondary market will exist at
any given time for any particular credit default swap or for credit default swaps generally.
The market for credit default swaps has become
more volatile in recent years as the creditworthiness of certain counterparties has been questioned and/or downgraded. The parties to a credit default swap may be required to post collateral to each other. If the Fund posts initial or periodic
collateral to its counterparty, it may not be able to recover that collateral from the counterparty in accordance with the terms of the swap. In addition, if the Fund receives collateral from its counterparty, it may be delayed or prevented from
realizing on the collateral in the event of the insolvency or bankruptcy of the counterparty. The Fund may exit its obligations under a credit default swap only by terminating the contract and paying applicable breakage fees, or by entering into an
offsetting credit default swap position, which may cause the Fund to incur more losses.
-14-
Total Return Swaps
. The Fund may also enter into total return swap agreements, which are
contracts in which one party agrees to make periodic payments to another party based on the change in market value of the assets underlying the contract, which may include a specified security, basket of securities or securities indices during the
specified period, in return for periodic payments based on a fixed or variable interest rate or the total return from other underlying assets. Total return swap agreements may be used to obtain exposure to a security or market without owning or
taking physical custody of such security or investing directly in such market. Total return swap agreements may effectively add leverage to the Funds portfolio because, in addition to its total net assets, the Fund would be subject to
investment exposure on the notional amount of the swap.
Total return swap agreements are subject to the risk that a counterparty will default
on its payment obligations to the Fund thereunder. Swap agreements also bear the risk that the Fund will not be able to meet its obligation to the counterparty. The Fund may enter into total return swaps on a net basis (i.e., the two payment streams
are netted against one another with the Fund receiving or paying, as the case may be, only the net amount of the two payments). The net amount of the excess, if any, of the Funds obligations over its entitlements with respect to each total
return swap will be accrued on a daily basis, and an amount of liquid assets having an aggregate net asset value at least equal to the accrued excess will be segregated by the Fund. If the total return swap transaction is entered into on other than
a net basis, the full amount of the Funds obligations will be accrued on a daily basis, and the full amount of the Funds obligations will be segregated by the Fund in an amount equal to or greater than the market value of the liabilities
under the total return swap agreement or the amount it would have cost the Fund initially to make an equivalent direct investment, plus or minus any amount the Fund is obligated to pay or is to receive under the total return swap agreement.
Many swaps are complex and often valued subjectively. Many over-the-counter derivatives are complex and their valuation often requires
modeling and judgment, which increases the risk of mispricing or incorrect valuation. The pricing models used may not produce valuations that are consistent with the values the Fund realizes when it closes or sells an over-the-counter derivative.
Valuation risk is more pronounced when the Fund enters into over-the-counter derivatives with specialized terms because the market value of those derivatives in some cases is determined in part by reference to similar derivatives with more
standardized terms. Incorrect valuations may result in increased cash payment requirements to counterparties, undercollateralization and/or errors in calculation of the Funds net asset value.
Securities Loans.
The Fund may make secured loans of its portfolio securities, on either a short-term or long-term basis,
amounting to not more than 33-1/3% of its total assets, thereby potentially realizing additional income. The risks in lending portfolio securities, as with other extensions of credit, consist of possible delay in recovery of the securities or
possible loss of rights in the collateral should the borrower fail financially. If a borrower defaults, the value of the collateral may decline before the Fund can dispose of it. As a matter of policy, securities loans are made to broker-dealers
pursuant to agreements requiring that the loans be continuously secured by collateral consisting of cash or short-term debt obligations at least equal at all times to the value of the securities on loan, marked-to-market daily. The borrower pays to
the Fund an amount equal to any dividends or interest received on securities lent. The Fund retains all or a portion of the interest received on investment of the cash collateral or receives a fee from the borrower. The Fund bears the risk of any
loss on the investment of the collateral; any such loss may exceed, potentially by a substantial amount, any profit to the Fund from its securities lending activities. Although voting rights, or rights to consent, with respect to the loaned
securities may pass to the borrower, the Fund retains the right to call the loans at any time on reasonable notice, and it will do so to enable the Fund to exercise voting rights on any matters materially affecting the investment. The Fund may also
call such loans in order to sell the securities. The Fund may pay fees in connection with arranging loans of its portfolio securities.
Mortgage-backed and Asset-backed Securities.
Mortgage-backed securities, including CMOs and certain stripped mortgage-backed
securities, represent a participation in, or are secured by, mortgage loans. Asset-backed securities are structured like mortgage-backed securities, but instead of mortgage loans or interests in mortgage loans, the underlying assets may include such
items as motor vehicle installment sales or installment loan contracts, leases of various types of real and personal property and receivables from credit card agreements. The cash flow generated by the underlying assets is applied to make required
payments on the securities and to pay related administrative expenses. The amount of residual cash flow resulting from a particular issue of asset-backed or mortgage-backed securities depends on, among other things, the characteristics of the
underlying assets, the coupon rates on the securities, prevailing interest rates, the amount of administrative expenses and the actual prepayment experience on the underlying assets. The Fund may invest in any such instruments or variations as may
be developed, to the extent consistent with its investment objectives and policies and applicable regulatory requirements. In general, the collateral supporting asset-backed securities is of a shorter maturity than mortgage loans and is likely to
experience substantial prepayments.
-15-
Mortgage-backed securities have yield and maturity characteristics corresponding to the underlying assets.
Unlike traditional debt securities, which may pay a fixed rate of interest until maturity, when the entire principal amount comes due, payments on certain mortgage-backed securities include both interest and a partial repayment of principal. Besides
the scheduled repayment of principal, repayments of principal may result from the voluntary prepayment, refinancing or foreclosure of the underlying mortgage loans. If property owners make unscheduled prepayments of their mortgage loans, these
prepayments will result in early payment of the applicable mortgage-backed securities. In that event the Fund may be unable to invest the proceeds from the early payment of the mortgage-backed securities in an investment that provides as high a
yield as the mortgage-backed securities. Consequently, early payment associated with mortgage-backed securities may cause these securities to experience significantly greater price and yield volatility than that experienced by traditional
fixed-income securities. The occurrence of mortgage prepayments is affected by factors including the level of interest rates, general economic conditions, the location and age of the mortgage and other social and demographic conditions. During
periods of falling interest rates, the rate of mortgage prepayments tends to increase, thereby tending to decrease the life of mortgage-backed securities. During periods of rising interest rates, the rate of mortgage prepayments usually decreases,
thereby tending to increase the life of mortgage-backed securities. If the life of a mortgage-backed security is inaccurately predicted, the Fund may not be able to realize the rate of return it expected.
Adjustable rate mortgage securities (
ARMs
), like traditional mortgage-backed securities, are interests in pools of mortgage loans that
provide investors with payments consisting of both principal and interest as mortgage loans in the underlying mortgage pool are paid off by the borrowers. Unlike fixed-rate mortgage-backed securities, ARMs are collateralized by or represent
interests in mortgage loans with variable rates of interest. These interest rates are reset at periodic intervals, usually by reference to an interest rate index or market interest rate. Although the rate adjustment feature may act as a buffer to
reduce sharp changes in the value of adjustable rate securities, these securities are still subject to changes in value based on, among other things, changes in market interest rates or changes in the issuers creditworthiness. Because the
interest rates are reset only periodically, changes in the interest rate on ARMs may lag changes in prevailing market interest rates. Also, some ARMs (or the underlying mortgages) are subject to caps or floors that limit the maximum change in the
interest rate during a specified period or over the life of the security. As a result, changes in the interest rate on an ARM may not fully reflect changes in prevailing market interest rates during certain periods.
The Fund may also invest in hybrid ARMs, whose underlying mortgages combine fixed-rate and adjustable rate features.
Mortgage-backed and asset-backed securities are less effective than other types of securities as a means of locking in attractive long-term interest
rates. One reason is the need to reinvest prepayments of principal; another is the possibility of significant unscheduled prepayments resulting from declines in interest rates. These prepayments would have to be reinvested at lower rates. The
automatic interest rate adjustment feature of mortgages underlying ARMs likewise reduces the ability to lock-in attractive rates. As a result, mortgage-backed and asset-backed securities may have less potential for capital appreciation during
periods of declining interest rates than other securities of comparable maturities, although they may have a similar risk of decline in market value during periods of rising interest rates. Prepayments may also significantly shorten the effective
maturities of these securities, especially during periods of declining interest rates. Conversely, during periods of rising interest rates, a reduction in prepayments may increase the effective maturities of these securities, subjecting them to a
greater risk of decline in market value in response to rising interest rates than traditional debt securities, and, therefore, potentially increasing the volatility of the Fund.
At times, some mortgage-backed and asset-backed securities will have higher than market interest rates and therefore will be purchased at a premium above their par value. Prepayments may cause losses on
securities purchased at a premium.
CMOs may be issued by a U.S. Government agency or instrumentality or by a private issuer. Although payment
of the principal of, and interest on, the underlying collateral securing privately issued CMOs may be guaranteed by the U.S. Government or its agencies or instrumentalities, these CMOs represent obligations solely of the private issuer and are not
insured or guaranteed by the U.S. Government, its agencies or instrumentalities or any other person or entity.
Prepayments could cause early
retirement of CMOs. CMOs are designed to reduce the risk of prepayment for certain investors by issuing multiple classes of securities, each having different maturities, interest rates and payment schedules, and with the principal and interest on
the underlying mortgages allocated among the several classes in various ways. Payment of interest or principal on some classes or series of CMOs may be subject to contingencies or some classes or series may bear some or all of the risk of default on
the underlying mortgages. CMOs of different classes or series are generally retired in sequence as the underlying mortgage loans in the mortgage pool are repaid. If enough mortgages are repaid ahead of schedule, the classes or series of a CMO with
the earliest maturities generally will be retired prior to their maturities. Thus, the early retirement of particular classes or series of a CMO would have the same effect as the prepayment of mortgages underlying other mortgage-backed securities.
Conversely, slower than anticipated prepayments can extend the effective maturities of CMOs, subjecting them to a greater risk of decline in market value in response to rising interest rates than traditional debt securities, and, therefore,
potentially increasing their volatility.
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Prepayments could result in losses on stripped mortgage-backed securities. Stripped mortgage-backed
securities are usually structured with two classes that receive different portions of the interest and principal distributions on a pool of mortgage loans. The yield to maturity on an interest only or
IO
class of stripped
mortgage-backed securities is extremely sensitive not only to changes in prevailing interest rates but also to the rate of principal payments (including prepayments) on the underlying assets. A rapid rate of principal prepayments may have a
measurable adverse effect on the Funds yield to maturity to the extent it invests in IOs. If the assets underlying the IO experience greater than anticipated prepayments of principal, the Fund may fail to recoup fully its initial investment in
these securities. Principal only or
POs
tend to increase in value if prepayments are greater than anticipated and decline if prepayments are slower than anticipated. The secondary market for stripped mortgage-backed securities may
be more volatile and less liquid than that for other mortgage-backed securities, potentially limiting the Funds ability to buy or sell those securities at any particular time.
Subprime mortgage loans, which typically are made to less creditworthy borrowers, have a higher risk of default than conventional mortgage loans. Therefore, mortgage-backed securities backed by subprime
mortgage loans may suffer significantly greater declines in value due to defaults or the increased risk of default.
The risks associated with
other asset-backed securities (including in particular the risks of issuer default and of early prepayment) are generally similar to those described above for CMOs. In addition, because asset-backed securities generally do not have the benefit of a
security interest in the underlying assets that is comparable to a mortgage, asset-backed securities present certain additional risks that are not present with mortgage-backed securities. The ability of an issuer of asset-backed securities to
enforce its security interest in the underlying assets may be limited. For example, revolving credit receivables are generally unsecured and the debtors on such receivables are entitled to the protection of a number of state and federal consumer
credit laws, many of which give debtors the right to set-off certain amounts owed, thereby reducing the balance due. Automobile receivables generally are secured, but by automobiles, rather than by real property.
Asset-backed securities may be collateralized by the fees earned by service providers. The values of asset-backed securities may be substantially
dependent on the servicing of the underlying asset and are therefore subject to risks associated with the negligence or malfeasance by their servicers and to the credit risk of their servicers. In certain circumstances, the mishandling of related
documentation may also affect the rights of the security holders in and to the underlying collateral. The insolvency of entities that generate receivables or that utilize the assets may result in added costs and delays in addition to losses
associated with a decline in the value of the underlying assets.
Federal, state and local government officials and representatives as well as
certain private parties have proposed actions to assist homeowners who own or occupy property subject to mortgages. Certain of those proposals involve actions that would affect the mortgages that underlie or relate to certain mortgage-related
securities, including securities or other instruments which the Fund may hold or in which they may invest. Some of those proposals include, among other things, lowering or forgiving principal balances; forbearing, lowering or eliminating interest
payments; or utilizing eminent domain powers to seize mortgages, potentially for below market compensation. The prospective or actual implementation of one or more of these proposals may significantly and adversely affect the value and liquidity of
securities held by the Fund and could cause the Funds net asset value to decline, potentially significantly. Tremendous uncertainty remains in the market concerning the resolution of these issues; the range of proposals and the potential
implications of any implemented solution is impossible to predict.
Collateralized Mortgage Obligations (CMOs) and Multiclass
Pass-Through Securities.
CMOs are debt obligations collateralized by mortgage loans or mortgage pass-through securities. CMOs may be collateralized by Government National Mortgage Association (
Ginnie Mae
),
Federal National Mortgage Association (
Fannie Mae
), or Federal Home Loan Mortgage Corporation (
Freddie Mac
) certificates, but also may be collateralized by whole loans or private mortgage pass-through securities
(such collateral is collectively hereinafter referred to as
Mortgage Assets
). Mortgage Assets may be collateralized by commercial or residential uses. Multiclass pass-through securities are equity interests in a trust composed of
Mortgage Assets. Payments of principal of and interest on the Mortgage Assets, and any reinvestment income thereon, may require the Fund to pay debt service on the CMOs or make scheduled distributions on the multiclass pass-through securities. CMOs
may be issued by federal agencies, or by private originators of, or investors in, mortgage loans, including savings and loan associations, mortgage banks, commercial banks, investment banks and special purpose subsidiaries of the foregoing. The
issuer of a series of mortgage pass-through securities may elect to be treated as a Real Estate Mortgage Investment Conduit (REMIC). REMICs include governmental and/or private entities that issue a fixed pool of mortgages secured by an interest in
real property. REMICs are similar to CMOs in that they issue multiple classes of securities, but unlike CMOs, which are required to be structured as debt securities, REMICs may be structured as indirect ownership interests in the underlying assets
of the REMICs themselves. Although CMOs and REMICs differ in certain respects, characteristics of CMOs described below apply in most cases to REMICs, as well.
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In a CMO, a series of bonds or certificates is issued in multiple classes. Each class of CMOs, often
referred to as a tranche, is issued at a specific fixed or floating coupon rate and has a stated maturity or final distribution date. Principal prepayments on the Mortgage Assets may cause the CMOs to be retired substantially earlier than their
stated maturities or final distribution dates. Interest is paid or accrues on all classes of the CMOs on a monthly, quarterly or semiannual basis. Certain CMOs may have variable or floating interest rates and others may be stripped mortgage
securities. For more information on stripped mortgage securities, see Stripped Mortgage Securities below.
The principal of and
interest on the Mortgage Assets may be allocated among the several classes of a CMO series in a number of different ways. Generally, the purpose of the allocation of the cash flow of a CMO to the various classes is to obtain a more predictable cash
flow to certain of the individual tranches than exists with the underlying collateral of the CMO. As a general rule, the more predictable the cash flow is on a CMO tranche, the lower the anticipated yield will be on that tranche at the time of
issuance relative to prevailing market yields on other mortgage-backed securities. As part of the process of creating more predictable cash flows on most of the tranches in a series of CMOs, one or more tranches generally must be created that absorb
most of the volatility in the cash flows on the underlying mortgage loans. The yields on these tranches are generally higher than prevailing market yields on mortgage-backed securities with similar maturities. As a result of the uncertainty of the
cash flows of these tranches, the market prices of and yield on these tranches generally are more volatile.
CMO
Residuals
. CMO residuals are mortgage securities issued by agencies or instrumentalities of the U.S. Government or by private originators of, or investors in, mortgage loans, including savings and loan associations, homebuilders,
mortgage banks, commercial banks, investment banks and special purpose entities of the foregoing. The cash flow generated by the mortgage assets underlying a series of a CMO is applied first to make required payments of principal and interest on the
securities or certificates issued by the CMO and second to pay the related administrative expenses and any management fee of the issuer. The residual in a CMO structure generally represents the interest in any excess cash flow remaining after making
the foregoing payments. Each payment of such excess cash flow to a holder of the related CMO residual represents income and/or a return of capital. The amount of residual cash flow resulting from a CMO will depend on, among other things, the
characteristics of the mortgage assets, the coupon rate of each class of CMO, prevailing interest rates, the amount of administrative expenses and the pre-payment experience on the mortgage assets. In particular, the yield to maturity on CMO
residuals is extremely sensitive to pre-payments on the related underlying mortgage assets. In addition, if a series of a CMO includes a class that bears interest at an adjustable rate, the yield to maturity on the related CMO residual will also be
extremely sensitive to changes in the level of the index upon which interest rate adjustments are based. As described below with respect to stripped mortgage-backed securities, in certain circumstances the Fund may fail to recoup fully its initial
investment in a CMO residual. CMO residuals are generally purchased and sold by institutional investors through several investment banking firms acting as brokers or dealers. In addition, CMO residuals may, or pursuant to an exemption therefrom, may
not have been registered under the Securities Act. CMO residuals, whether or not registered under the Securities Act, may be subject to certain restrictions on transferability, and may be deemed illiquid.
Government Mortgage Pass-Through Securities.
The Fund may invest in mortgage pass-through securities representing participation
interests in pools of residential mortgage loans purchased from individual lenders by an agency, instrumentality or sponsored corporation of the United States government (
Federal Agency
) or originated by private lenders and
guaranteed, to the extent provided in such securities, by a Federal Agency. Such securities, which are ownership interests in the underlying mortgage loans, differ from conventional debt securities, which provide for periodic payment of interest in
fixed amounts (usually semiannually) and principal payments at payments (not necessarily in fixed amounts) that are a pass-through of the monthly interest and principal payments (including any prepayments) made by the individual borrowers on the
pooled mortgage loans, net of any fees paid to the guarantor of such securities and the servicer of the underlying mortgage loans.
The
government mortgage pass-through securities in which the Fund may invest include those issued or guaranteed by Ginnie Mae, Fannie Mae and Freddie Mac. Ginnie Mae certificates are direct obligations of the U.S. Government and, as such, are backed by
the full faith and credit of the United States. Fannie Mae is a federally chartered, privately owned corporation and Freddie Mac is a corporate instrumentality of the United States. Fannie Mae and Freddie Mac certificates are not backed by the full
faith and credit of the United States but the issuing agency or instrumentality has the right to borrow, to meet its obligations, from an existing line of credit with the U.S. Treasury. The U.S. Treasury has no legal obligation to provide such line
of credit and may choose not to do so.
Certificates for these types of mortgage-backed securities evidence an interest in a specific pool of
mortgages. These certificates are, in most cases, modified pass-through instruments, wherein the issuing agency guarantees the payment of principal and interest on mortgages underlying the certificates, whether or not such amounts are collected by
the issuer on the underlying mortgages.
The Housing and Economic Recovery Act of 2008 (
HERA
) authorized the Secretary of
the Treasury to support Fannie Mae, Freddie Mac, and the Federal Home Loan Banks (
FHLBs
) (collectively, the
GSEs
) by purchasing obligations and other securities from those government-sponsored enterprises. HERA
gave the Secretary of the Treasury broad authority to determine the conditions and amounts of such purchases.
-18-
On September 6, 2008, the Federal Housing Finance Agency (
FHFA
) placed Fannie Mae
and Freddie Mac into conservatorship. As the conservator, FHFA succeeded to all rights, titles, powers and privileges of Fannie Mae and Freddie Mac and of any stockholder, officer or director of Fannie Mae and Freddie Mac with respect to Fannie Mae
and Freddie Mac and the assets of Fannie Mae and Freddie Mac. FHFA selected a new chief executive officer and chairman of the board of directors for Fannie Mae and Freddie Mac.
In connection with the conservatorship, the U.S. Treasury, exercising powers granted to it under HERA, entered into a Senior Preferred Stock Purchase Agreement (
SPA
) with each of Fannie
Mae and Freddie Mac pursuant to which the U.S. Treasury will purchase up to an aggregate of $100 billion of each of Fannie Mae and Freddie Mac to maintain a positive net worth in each enterprise. This agreement contains various covenants that
severely limit each enterprises operations. In exchange for entering into these agreements, the U.S. Treasury received $1 billion of each enterprises senior preferred stock and warrants to purchase 79.9% of each enterprises common
stock. On February 18, 2009, the U.S. Treasury announced that it was doubling the size of its commitment to each enterprise under the Senior Preferred Stock Program to $200 billion. The U.S. Treasurys obligations under the Senior
Preferred Stock Program are for an indefinite period of time for a maximum amount of $200 billion per enterprise. On December 24, 2009, the U.S. Treasury announced further amendments to the SPAs which included additional financial support for
each GSE through the end of 2012 and changes to the limits on their retained mortgage portfolios. Although legislation has been enacted to support certain GSEs, including the FHLBs, Freddie Mac and Fannie Mae, there is no assurance that GSE
obligations will be satisfied in full, or that such obligations will not decrease in value or default. It is difficult, if not impossible, to predict the future political, regulatory or economic changes that could impact the GSEs and the values of
their related securities or obligations.
Fannie Mae and Freddie Mac are continuing to operate as going concerns while in conservatorship and
each remain liable for all of its obligations, including its guaranty obligations, associated with its mortgage-backed securities. The SPA is intended to enhance each of Fannie Maes and Freddie Macs ability to meet its obligations.
Under the Federal Housing Finance Regulatory Reform Act of 2008 (the
Reform Act
), which was included as part of Housing
and Economic Recovery Act of 2008, FHFA, as conservator or receiver, has the power to repudiate any contract entered into by Fannie Mae or Freddie Mac prior to FHFAs appointment as conservator or receiver, as applicable, if FHFA determines, in
its sole discretion, that performance of the contract is burdensome and that repudiation of the contract promotes the orderly administration of Fannie Maes or Freddie Macs affairs. The Reform Act requires FHFA to exercise its right to
repudiate any contract within a reasonable period of time after its appointment as conservator or receiver.
FHFA, in its capacity as
conservator, has indicated that it has no intention to repudiate the guaranty obligations of Fannie Mae or Freddie Mac because FHFA views repudiation as incompatible with the goals of the conservatorship. However, in the event that FHFA, as
conservator or if it is later appointed as receiver for Fannie Mae or Freddie Mac, were to repudiate any such guaranty obligation, the conservatorship or receivership estate, as applicable, would be liable for actual direct compensatory damages in
accordance with the provisions of the Reform Act. Any such liability could be satisfied only to the extent of Fannie Maes or Freddie Macs available assets. The future financial performance of Fannie Mae and Freddie Mac is heavily
dependent on the performance of the U.S. housing market.
In the event of repudiation, the payments of interest to holders of Fannie Mae, or
Freddie Mac mortgage-backed securities would be reduced if payments on the mortgage loans represented in the mortgage loan groups related to such mortgage-backed securities are not made by the borrowers or advanced by the servicer. Any actual direct
compensatory damages for repudiating these guaranty obligations may not be sufficient to offset any shortfalls experienced by such mortgage-backed security holders.
Further, in its capacity as conservator or receiver, FHFA has the right to transfer or sell any asset or liability of Fannie Mae or Freddie Mac without any approval, assignment or consent. Although FHFA
has stated that it has no present intention to do so, if FHFA, as conservator or receiver, were to transfer any such guaranty obligation to another party, holders of Fannie Mae or Freddie Mac mortgage-backed securities would have to rely on that
party for satisfaction of the guaranty obligation and would be exposed to the credit risk of that party.
In addition, certain rights provided
to holders of mortgage-backed securities issued by Fannie Mae and Freddie Mac under the operative documents related to such securities may not be enforced against FHFA, or enforcement of such rights may be delayed, during the conservatorship or any
future receivership. The operative documents for Fannie Mae and Freddie Mac mortgage-backed securities may provide (or with respect to securities issued prior to the date of the appointment of the conservator may have provided) that upon the
occurrence of an event of default on the part of Fannie Mae or Freddie Mac, in its capacity as guarantor, which includes
-19-
the appointment of a conservator or receiver, holders of such mortgage-backed securities have the right to replace Fannie Mae or Freddie Mac as trustee if the requisite percentage of
mortgage-backed security holders consent. The Reform Act prevents mortgage-backed security holders from enforcing such rights if the event of default arises solely because a conservator or receiver has been appointed. The Reform Act also provides
that no person may exercise any right or power to terminate, accelerate or declare an event of default under certain contracts to which Fannie Mae or Freddie Mac is a party, or obtain possession of or exercise control over any property of Fannie Mae
or Freddie Mac, or affect any contractual rights of Fannie Mae or Freddie Mac, without the approval of FHFA, as conservator or receiver, for a period of 45 or 90 days following the appointment of FHFA as conservator or receiver, respectively.
Inverse Floaters.
An inverse floater is a type of instrument that bears a floating or variable interest rate that
moves in the opposite direction to interest rates generally or the interest rate on another security or index. Changes in interest rates generally, or the interest rate of the other security or index, inversely affect the interest rate paid on the
inverse floater, with the result that the inverse floaters price will be considerably more volatile than that of a fixed-rate bond. Brokers typically create inverse floaters by depositing an income-producing instrument, which may be a
mortgage-backed security, in a trust. The trust in turn issues a variable rate security and inverse floaters. The returns on the inverse floaters may be leveraged, increasing substantially their volatility and interest rate sensitivity. The rate at
which interest is paid by the trust on an inverse floater may vary by a magnitude that exceeds the magnitude of the change in a reference rate of interest (typically a short term interest rate), and the market prices of inverse floaters may as
a result be highly sensitive to changes in interest rates and in prepayment rates on the underlying securities, and may decrease significantly when interest rates increase or prepayment rates change. The interest rate for the variable rate security
is typically determined by an index or an auction process, while the inverse floater holder receives the balance of the income from the underlying income-producing instrument less an auction fee.
Loans, Assignments, and Participations.
The Fund may make loans, and may acquire or invest in loans made by others. The Fund may
acquire a loan interest directly by acting as a member of the original lending syndicate. Alternatively, the Fund may acquire some or all of the interest of a bank or other lending institution in a loan to a particular borrower, by means of a
novation, an assignment, or a participation. In a novation, the Fund assumes all of the rights of a lending institution in a loan, including the right to receive payments of principal and interest and other amounts directly from the borrower and to
enforce its rights as a lender directly against the borrower. The Fund assumes the position of a co-lender with other syndicate members. As an alternative, the Fund may purchase an assignment of a portion of a lenders interest in a loan. In
this case, the Fund may be required generally to rely upon the assigning financial institution to demand payment and enforce its rights against the borrower, but would otherwise be entitled to the benefit of all of the financial institutions
rights in the loan. The Fund may also purchase a participating interest in a portion of the rights of a lending institution in a loan. In such case, the Fund will generally be entitled to receive from the lending institution amounts equal to the
payments of principal, interest and premium, if any, on the loan received by the institution, but will not generally be entitled to enforce its rights directly against the agent bank or the borrower, and must rely for that purpose on the lending
institution. In the case of an assignment or a participation, the value of the Funds loan investment will depend at least in part on the credit standing of the assigning or participating institution. The loans in which the Fund may invest
include those that pay fixed rates of interest and those that pay floating rates
i.e.
, rates that adjust periodically based on a known lending rate, such as a banks prime rate. Investments in loans may be of any quality,
including distressed loans. The Fund also may gain exposure to loans and related investments through the use of total return swaps and/or other derivative instruments and through private funds and other pooled investment vehicles,
including some which may be sponsored or advised by the Adviser (see Derivatives).
Many loans are made by a syndicate of banks,
represented by an agent bank (the
Agent
) which has negotiated and structured the loan and which is responsible generally for collecting interest, principal, and other amounts from the borrower on its own behalf and on behalf of
the other lending institutions in the syndicate (the
Lenders
), and for enforcing its and their other rights against the borrower. Each of the lending institutions, including the Agent, lends to the borrower a portion of the total
amount of the loan, and retains the corresponding interest in the loan. Unless, under the terms of the loan or other indebtedness, the Fund has direct recourse against the borrower, the Fund may have to rely on the Agent or other financial
intermediary to apply appropriate credit remedies against a borrower.
The Funds ability to receive payments of principal and interest
and other amounts in connection with loan participations held by it will depend primarily on the financial condition of the borrower (and, in some cases, the lending institution from which it purchases the loan). The value of collateral, if any,
securing a loan can decline, or may be insufficient to meet the borrowers obligations or may be difficult to liquidate. In addition, the Funds access to collateral may be limited by bankruptcy or other insolvency laws. The failure by the
Fund to receive scheduled interest or principal payments on a loan would adversely affect the income of the Fund and would likely reduce the value of its assets, which would be reflected in a reduction in the Funds net asset value. Loans that
are fully secured offer the Fund more protection than an unsecured loan in the event of non-payment of scheduled interest or principal. However, there is no assurance that the liquidation of collateral from a secured loan would satisfy the corporate
borrowers obligation, or that the collateral can be liquidated. Indebtedness of companies whose creditworthiness is poor involves substantially greater risks, and may be highly speculative. Some companies may never pay off their indebtedness,
or may pay only a small fraction of the amount owed. Consequently, when investing in indebtedness of companies with poor credit, the Fund bears a substantial risk of losing the entire amount invested.
-20-
Banks and other lending institutions generally perform a credit analysis of the borrower before originating
a loan or participating in a lending syndicate. In selecting the loans in which the Fund will invest, however, the Adviser will not rely solely on that credit analysis, but will perform its own investment analysis of the borrowers. The
Advisers analysis may include consideration of the borrowers financial strength and managerial experience, debt coverage, additional borrowing requirements or debt maturity schedules, changing financial conditions, and responsiveness to
changes in business conditions and interest rates. Because loans in which the Fund may invest may not be rated by independent credit rating agencies, a decision by the Fund to invest in a particular loan may depend heavily on the Advisers or
the original lending institutions credit analysis of the borrower.
Loans and other types of direct indebtedness may not be readily
marketable and may be subject to restrictions on resale. In some cases, negotiations involved in disposing of indebtedness may require weeks to complete. Consequently, some indebtedness may be difficult or impossible to dispose of readily at what
the Adviser believes to be a fair price. Additionally, even where there is a market for certain loans the settlement period may be extended, up to several weeks or longer. That means the Fund may have a limited ability to receive payment promptly on
the sale of some of the loans in its portfolio. In addition, valuation of illiquid indebtedness involves a greater degree of judgment in determining the Funds net asset value than if that value were based on available market quotations, and
could result in significant variations in the Funds daily share price. At the same time, some loan interests are traded among certain financial institutions and accordingly may be deemed liquid. The Adviser will determine the liquidity of the
Funds investments by reference to, among other things, market conditions and contractual provisions. Assignments and participations are generally not registered under the Securities Act, and thus investments in them may be limited by the
Funds limitation on investment in illiquid securities.
Investments in loans through a direct loan or novation may involve additional
risks to the Fund. For example, if a loan is foreclosed, the Fund could become part owner of any collateral, and would bear the costs and liabilities associated with owning and disposing of the collateral. In addition, it is conceivable that under
emerging legal theories of lender liability, the Fund could be held liable as co-lender. It is unclear whether loans and other forms of direct indebtedness offer securities law protections against fraud and misrepresentation. In the absence of
definitive regulatory guidance, the Fund relies on the Advisers research in an attempt to avoid situations where fraud or misrepresentation could adversely affect the Fund.
It is the position of the SEC that, in the case of loan participations or assignments where a bank or other lending institution serves as a financial intermediary between the Fund and the corporate
borrower, if the participation does not shift to the Fund the direct debtor-creditor relationship with the borrower, the Fund should treat both the lending bank or other lending institution and the borrower as issuers. If and to the
extent the Fund treats a financial intermediary as an issuer of indebtedness, the Fund may in certain circumstances be limited in its ability to invest in indebtedness related to a single financial intermediary, or a group of intermediaries engaged
in the same industry, even if the underlying borrowers represent many different companies and industries.
Economic exposure to loan interests
through the use of derivative transactions, including, among others, total return swaps, may involve greater risks than if the Fund had invested in the loan interest directly during a primary distribution or through assignments of, novations of or
participations in a bank loan acquired in secondary markets since, in addition to the risks described above, certain derivative transactions may be subject to leverage risk and greater illiquidity risk, counterparty risk, valuation risk and other
risks.
In managing the Fund, the Adviser may seek to avoid the receipt of material, non-public information (
Confidential
Information
) about the issuers of floating rate loans or other investments being considered for acquisition by the Fund or held in the Funds portfolio if the receipt of the Confidential Information would restrict one or more of the
Advisers clients, including, potentially, the Fund, from trading in securities they hold or in which they may invest. In many instances, issuers offer to furnish Confidential Information to prospective purchasers or holders of the
issuers loans or other securities. In circumstances when the Adviser declines to receive Confidential Information from these issuers, the Fund may be disadvantaged in comparison to other investors, including with respect to evaluating the
issuer and the price the Fund would pay or receive when it buys or sells those investments. Further, in situations when the Fund is asked, for example, to grant consents, waivers or amendments with respect to such investments, the Advisers
ability to assess such consents, waivers and amendments may be compromised. In certain circumstances, the Adviser may determine to receive Confidential Information, including on behalf of clients other than the Fund. Receipt of Confidential
Information by the Adviser could limit the Funds ability to sell certain investments held by the Fund or pursue certain investment opportunities on behalf of the Fund, potentially for a substantial period of time. In certain situations, the
Adviser may create information walls around persons (
walled-off personnel
) having access to the Confidential Information to limit the restrictions on others at the Adviser. Those measures could impair the ability of walled-off
personnel to assist in managing the Fund. Also, certain issuers of senior floating
-21-
rate loans, other bank loans and related investments may not have any publicly traded securities (
Private Issuers
) and may offer private information pursuant to confidentiality
agreements or similar arrangements. The Adviser may access such private information, while recognizing that the receipt of that information could potentially limit the Funds ability to trade in certain securities if the Private Issuer later
issues publicly traded securities. If the Adviser intentionally or unintentionally comes into possession of Confidential Information, it may be unable, potentially for a substantial period of time, to sell certain investments held by the Fund.
The Adviser is, and may be in the future, affiliated with certain large financial institutions (
affiliates
) that hold
interests in an entity that are of a different class or type than the class or type of interest held by the Fund. For example, an affiliate may hold securities in an entity that are senior or junior to the securities held by the Fund, which could
mean that the affiliate will be entitled to different payments or other rights, or that in a workout or other distressed scenario the interests of the affiliate might be adverse to those of the Fund and the affiliate might recover all or part of its
investment while the Fund might not. Conflicts also will arise in cases where the Fund and affiliates invest in different parts of an issuers capital structure, including circumstances in which one or more affiliates may own private securities
or obligations of an issuer and the Fund may own public securities of the same issuer. For example, an affiliate may acquire a loan, loan participation, or a loan assignment of a particular borrower in which the Fund has an equity investment. In
negotiating the terms and conditions of any such investments, or any subsequent amendments or waivers, the Adviser may find that its own interests, the interests of an affiliate, and/or the interests of the Fund could conflict. The Adviser may seek
to avoid such conflicts, and, as a result, the Adviser may choose not to make such investments on behalf of the Fund. Those foregone investment opportunities may adversely affect the Funds performance if similarly attractive opportunities are
not available or cannot be identified.
Lending Fees
.
In the process of buying, selling and holding loans, the
Fund may receive and/or pay certain fees. These fees are in addition to interest payments received and may include facility fees, commitment fees, commissions and prepayment penalty fees. When the Fund buys a loan it may receive a facility fee and
when it sells a loan it may pay a facility fee. On an ongoing basis, the Fund may receive a commitment fee based on the undrawn portion of the underlying line of credit portion of the loan. In certain circumstances, the Fund may receive a prepayment
penalty fee upon the prepayment of a loan by a borrower. Other fees received by the Fund may include covenant waiver fees and covenant modification fees.
Borrower Covenants
.
A borrower under a loan typically may be required to comply with various restrictive covenants contained in a loan agreement or note purchase agreement
between the borrower and the Lender or lending syndicate (the
Loan Agreement
). Such covenants, in addition to requiring the scheduled payment of interest and principal, may include restrictions on dividend payments and other
distributions to stockholders, provisions requiring the borrower to maintain specific minimum financial ratios and limits on total debt. In addition, the Loan Agreement may contain a covenant requiring the borrower to prepay the loan with any free
cash flow. Free cash flow is generally defined as net cash flow after scheduled debt service payments and permitted capital expenditures, and includes the proceeds from asset dispositions or sales of securities. A breach of a covenant which is not
waived by the Agent, or by the lenders directly, as the case may be, is normally an event of acceleration; i.e., the Agent, or the lenders directly, as the case may be, has the right to call the outstanding loan. The typical practice of an Agent or
a Lender in relying exclusively or primarily on reports from the borrower may involve a risk of fraud by the borrower. In the case of a loan in the form of a participation, the agreement between the buyer and seller may limit the rights of the
holder of a loan to vote on certain changes which may be made to the Loan Agreement, such as waiving a breach of a covenant.
Administration of Loans
.
In certain loans, including participations, the Agent administers the terms of the Loan
Agreement. In such cases, the Agent is normally responsible for the collection of principal and interest payments from the borrower and the apportionment of these payments to the credit of all institutions which are parties to the Loan Agreement.
The Fund will generally rely upon the Agent or an intermediate participant to receive and forward to the Fund its portion of the principal and interest payments on the loan. Furthermore, unless under the terms of a participation agreement the Fund
has direct recourse against the borrower, the Fund will rely on the Agent and the other members of the lending syndicate to use appropriate credit remedies against the borrower. The Agent is typically responsible for monitoring compliance with
covenants contained in the Loan Agreement based upon reports prepared by the borrower. The seller of the loan usually does, but is often not obligated to, notify holders of loans of any failures of compliance. The Agent may monitor the value of the
collateral, if any, and if the value of such collateral declines, may accelerate the loan, may give the borrower an opportunity to provide additional collateral or may seek other protection for the benefit of the participants in the loan. The Agent
is compensated by the borrower for providing these services under a Loan Agreement, and such compensation may include special fees paid upon structuring and funding the loan and other fees paid on a continuing basis. With respect to loans for which
the Agent does not perform such administrative and enforcement functions, the Adviser will perform such tasks on behalf of the Fund, although a collateral bank will typically hold any collateral on behalf of the Fund and the other lenders pursuant
to the applicable Loan Agreement.
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A financial institutions appointment as Agent may usually be terminated in the event that it fails to
observe the requisite standard of care or becomes insolvent, enters Federal Deposit Insurance Corporation (
FDIC
) receivership, or, if not FDIC insured, enters into bankruptcy or insolvency proceedings. A successor Agent would
generally be appointed to replace the terminated Agent, and assets held by the Agent under the Loan Agreement should remain available to holders of loans. However, if assets held by the Agent for the benefit of the Fund were determined to be subject
to the claims of the Agents general creditors, the Fund might incur certain costs and delays in realizing payment on a loan, or suffer a loss of principal and/or interest. In situations involving other intermediate participants similar risks
may arise.
Prepayments
.
Loans may require, in addition to scheduled payments of interest and principal, the
prepayment of the loan from free cash flow, as defined above. The degree to which borrowers prepay loans, whether as a contractual requirement or at their election, may be affected by general business conditions, the financial condition of the
borrower and competitive conditions among lenders, among others. As such, prepayments cannot be predicted with accuracy. Upon a prepayment, either in part or in full, the actual outstanding debt on which the Fund derives interest income will be
reduced. However, the Fund may , but will not necessarily, receive both a prepayment penalty fee from the prepaying borrower and a facility fee upon the purchase of a new loan with the proceeds from the prepayment of the former.
Bridge Financings
.
Loans may be designed to provide temporary or bridge financing to a borrower pending the
sale of identified assets or the arrangement of longer-term loans or the issuance and sale of debt obligations. Loans may also be obligations of borrowers who have obtained bridge loans from other parties. A borrowers use of bridge loans
involves a risk that the borrower may be unable to locate permanent financing to replace the bridge loan, which may impair the borrowers perceived creditworthiness or its willingness or ability to repay the bridge loan.
Senior Loans
.
Senior floating rate loans may be made to or issued by U.S. or non-U.S. banks or other corporations
(
Senior Loans
). Senior Loans include senior floating rate loans and institutionally traded senior floating rate debt obligations issued by asset-backed pools and other issues, and interests therein. Senior Loan interests may be
acquired from U.S. or foreign commercial banks, insurance companies, finance companies or other financial institutions that have made loans or are members of a lending syndicate or from other holders of loan interests. Senior Loans typically pay
interest at rates which are re-determined periodically on the basis of a floating base lending rate (such as the London Inter-Bank Offered Rate,
LIBOR
) plus a premium. Senior Loans are typically of below investment grade quality.
Senior Loans generally (but not always) hold the most senior position in the capital structure of a borrower and are often secured with collateral.
From time to time, the Adviser and its affiliates may borrow money from various banks in connection with their business activities. Such banks may also sell Senior Loans to or acquire them from the Fund
or may be intermediate participants with respect to Senior Loans in which the Fund owns interests. Such banks may also act as Agents for Senior Loans held by the Fund.
To the extent that the collateral, if any, securing a Senior Loan consists of the stock of the borrowers subsidiaries or other affiliates, the Fund will be subject to the risk that this stock will
decline in value. Such a decline, whether as a result of bankruptcy proceedings or otherwise, could cause the Senior Loan to be undercollateralized or unsecured. In most credit agreements there is no formal requirement to pledge additional
collateral. In addition, a Senior Loan may be guaranteed by, or fully secured by assets of, shareholders or owners, even if the Senior Loans are not otherwise collateralized by assets of the borrower. There may be temporary periods when the
principal asset held by a borrower is the stock of a related company, which may not legally be pledged to secure a secured Senior Loan. On occasions when such stock cannot be pledged, the secured Senior Loan will be temporarily unsecured until the
stock can be pledged or is exchanged for or replaced by other assets, which will be pledged as security for such Senior Loan. However, the borrowers ability to dispose of such securities, other than in connection with such pledge or
replacement, will be strictly limited for the protection of the holders of secured Senior Loans.
If a borrower becomes involved in bankruptcy
proceedings, a court potentially could invalidate the Funds security interest in any loan collateral or subordinate the Funds rights under a secured Senior Loan to the interests of the borrowers unsecured creditors. Such action by
a court could be based, for example, on a fraudulent conveyance claim to the effect that the borrower did not receive fair consideration for granting the security interest in the loan collateral to the Fund. For secured Senior Loans made
in connection with a highly leveraged transaction, consideration for granting a security interest may be deemed inadequate if the proceeds of such loan were not received or retained by the borrower, but were instead paid to other persons, such as
shareholders of the borrower, in an amount which left the borrower insolvent or without sufficient working capital. There are also other events, such as the failure to perfect a security interest due to faulty documentation or faulty official
filings, which could lead to the invalidation of the Funds security interest in any loan collateral. If the Funds security interest in loan collateral is invalidated or a secured Senior Loan is subordinated to other debt of a borrower in
bankruptcy or other proceedings, it is unlikely that the Fund would be able to recover the full amount of the principal and interest due on the secured Senior Loan.
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Delayed Funding Loans and Revolving Credit Facilities
.
Delayed funding loans
and revolving credit facilities are borrowing arrangements in which the lender agrees to make loans up to a maximum amount upon demand by the borrower during a specified term. A revolving credit facility differs from a delayed funding loan in that
as the borrower repays the loan, an amount equal to the repayment may be borrowed again during the term of the revolving credit facility. Delayed funding loans and revolving credit facilities usually provide for floating or variable rates of
interest. These commitments may have the effect of requiring the Fund to increase its exposure to a company at a time when it might not otherwise be desirable to do so (including a time when the companys financial condition makes it unlikely
that such amounts will be repaid or which the Fund needs to sell other assets to raise cash to satisfy its obligor).
Mortgage Dollar
Rolls.
The Fund may enter into mortgage dollar rolls with a bank or a broker-dealer. A mortgage dollar roll is a transaction in which the Fund sells mortgage-related securities for immediate settlement and simultaneously purchases
the same type of securities for forward settlement at a discount. While the Fund begins accruing interest on the newly purchased securities from the purchase or trade date, it is able to invest the proceeds from the sale of its previously owned
securities, which will be used to pay for the new securities. The use of mortgage dollar rolls is a speculative technique involving leverage, and can have an economic effect similar to borrowing money for investment purposes.
Private Mortgage Pass-Through Securities.
Private mortgage pass-through securities are structured similarly to the Ginnie Mae,
Fannie Mae and Freddie Mac mortgage pass-through securities and are issued by United States and foreign private issuers such as originators of and investors in mortgage loans, including savings and loan associations, mortgage banks, commercial
banks, investment banks and special purpose subsidiaries of the foregoing. These securities usually are backed by a pool of conventional fixed rate or adjustable rate mortgage loans. Since private mortgage pass-through securities typically are not
guaranteed by an entity having the credit status of Ginnie Mae, Fannie Mae and Freddie Mac, such securities generally are structured with one or more types of credit enhancement.
Mortgage Assets often consist of a pool of assets representing the obligations of a number of different parties. There are usually fewer properties in a pool of assets backing commercial mortgage-backed
securities than in a pool of assets backing residential mortgage-backed securities hence they may be more sensitive to the performance of fewer Mortgage Assets. To lessen the effect of failures by obligors on underlying assets to make payments,
those securities may contain elements of credit support, which fall into two categories: (i) liquidity protection and (ii) protection against losses resulting from ultimate default by an obligor on the underlying assets. Liquidity
protection refers to the provision of advances, generally by the entity administering the pool of assets, to ensure that the receipt of payments on the underlying pool occurs in a timely fashion. Protection against losses resulting from default
ensures ultimate payment of the obligations on at least a portion of the assets in the pool. This protection may be provided through guarantees, insurance policies or letters of credit obtained by the issuer or sponsor from third parties, through
various means of structuring the transaction or through a combination of such approaches. The degree of credit support provided for each issue is generally based on historical information respecting the level of credit risk associated with the
underlying assets. Delinquencies or losses in excess of those anticipated could adversely affect the return on an investment in a security.
Stripped Mortgage Securities.
Stripped mortgage securities may be issued by Federal Agencies, or by private originators of, or
investors in, mortgage loans, including savings and loan associations, mortgage banks, commercial banks, investment banks and special purpose subsidiaries of the foregoing. Stripped mortgage securities not issued by Federal Agencies will be treated
by the Fund as illiquid securities so long as the staff of the SEC maintains its position that such securities are illiquid. Stripped mortgage securities issued by Federal Agencies generally will be treated by the Fund as liquid securities under
procedures adopted by the Fund and approved by the Funds Board.
Stripped mortgage securities usually are structured with two classes
that receive different proportions of the interest and principal distribution of a pool of mortgage assets. A common type of stripped mortgage security will have one class receiving some of the interest and most of the principal from the mortgage
assets, while the other class will receive most of the interest and the remainder of the principal. In the most extreme case, one class will receive all of the interest (the interest-only or
IO
class), while the other class will
receive all of the principal (the principal-only or
PO
class). PO classes generate income through the accretion of the deep discount at which such securities are purchased, and, while PO classes do not receive periodic payments of
interest, they receive monthly payments associated with scheduled amortization and principal prepayment from the mortgage assets underlying the PO class. The yield to maturity on a PO or an IO class security is extremely sensitive to the rate of
principal payments (including prepayments) on the related underlying mortgage assets. A slower than expected rate of principal payments may have an adverse effect on a PO class securitys yield to maturity. If the underlying mortgage assets
experience slower than anticipated principal repayment, the Fund may fail to fully recoup its initial investment in these securities. Conversely, a rapid rate of principal payments may have a material adverse effect on an IO class securitys
yield to maturity. If the underlying mortgage assets experience greater than anticipated prepayments or principal, the Fund may fail to fully recoup its initial investment in these securities.
-24-
The Fund may purchase stripped mortgage securities for income, or for hedging purposes to protect the
Funds portfolio against interest rate fluctuations. For example, since an IO class will tend to increase in value as interest rates rise, it may be utilized to hedge against a decrease in value of other fixed-income securities in a rising
interest rate environment.
Yankee Dollar Obligations, Eurobonds, Global Bonds.
Certain debt securities purchased by
the Fund may take the forms of Yankee dollar obligations, Eurobonds or global bonds. Yankee dollar obligations are U.S. dollar-denominated obligations issued in the U.S. capital markets by foreign issuers, such as corporations and banks. A Eurobond
is a bond issued in a currency other than the currency of the country or market in which it is issued. Global bonds are bonds that can be offered within multiple markets simultaneously. Unlike Eurobonds, global bonds can be issued in the local
currency of the country of issuance.
Collateralized Debt Obligations
. Collateralized debt obligations
(
CDOs
) include, among other things, collateralized bond obligations (
CBOs
), collateralized loan obligations (
CLOs
) and other similarly structured securities. CBOs and CLOs are types of
asset-backed securities. A CBO is a trust which is backed by a diversified pool of high risk, below investment grade fixed income securities. A CLO is a trust typically collateralized by a pool of loans, which may include, among others, domestic and
foreign senior secured loans, senior unsecured loans and subordinate corporate loans, including loans that may be rated below investment grade or equivalent unrated loans. CDOs may charge management fees and administrative expenses. For both CBOs
and CLOs, the cash flows from the trust are split into two or more portions, called tranches, varying in risk and yield. The riskiest portion is the equity tranche which bears the bulk of defaults from the bonds or loans in the trust and
serves to protect the other, more senior tranches from default in all but the most severe circumstances. Since it is partially protected from defaults, a senior tranche from a CBO trust or CLO trust typically has higher ratings and lower yields than
the underlying securities, and can be rated investment grade. Despite the protection from the equity tranche, CBO or CLO tranches can experience substantial losses due to actual defaults, increased sensitivity to defaults due to collateral default
and disappearance of protecting tranches, market anticipation of defaults and aversion to CBO or CLO securities as a class. The risks of an investment in a CDO depend largely on the type of the collateral securities and the class of the CDO in which
the Fund invests. Normally, CBOs, CLOs and other CDOs are privately offered and sold, and thus are not registered under the securities laws. As a result, investments in CDOs may be characterized by the Fund as illiquid securities; however, an active
dealer market, or other relevant measures of liquidity, may exist for CDOs allowing a CDO potentially to be deemed liquid by the Adviser under liquidity policies approved by the Board. In addition to the risks associated with debt instruments
(
e.g.,
interest rate risk and credit risk), CDOs carry additional risks including, but not limited to: (i) the possibility that distributions from collateral securities will not be adequate to make interest or other payments;
(ii) the quality of the collateral may decline in value or default; (iii) the possibility that the Fund may invest in CDOs that are subordinate to other classes; and (iv) the complex structure of the security may not be fully
understood at the time of investment and may produce disputes with the issuer or unexpected investment results.
Consistent with the
Funds investment objective and policies, the Adviser may also cause the Fund to invest in other types of mortgage- and asset-backed securities offered currently or in the future, including certain yet-to-be-developed types of mortgage- and
asset-backed securities which may be created as the market evolves.
Foreign Currency Transactions.
The Fund may
engage in currency exchange transactions to protect against uncertainty in the level of future foreign currency exchange rates and to increase current return. There can be no assurance that appropriate foreign currency transactions will be available
for the Fund at any time or that the Fund will enter into such transactions at any time or under any circumstances even if appropriate transactions are available to it.
The Fund may engage in both transaction hedging and position hedging. When it engages in transaction hedging, the Fund enters into foreign currency transactions with respect to specific receivables or
payables of the Fund generally arising in connection with the purchase or sale of its portfolio securities. The Fund may engage in transaction hedging when it desires to lock in the U.S. dollar price of a security it has agreed to purchase or sell,
or the U.S. dollar equivalent of a dividend or interest payment in a foreign currency. By transaction hedging, the Fund may attempt to protect against a possible loss resulting from an adverse change in the relationship between the U.S. dollar and
the applicable foreign currency during the period between the date on which the security is purchased or sold or on which the dividend or interest payment is declared, and the date on which such payments are made or received.
The Fund may purchase or sell a foreign currency on a spot (
i.e.
, cash) basis at the prevailing spot rate in connection with transaction hedging.
The Fund may also enter into contracts to purchase or sell foreign currencies at a future date (
forward contracts
) and purchase and sell foreign currency futures contracts.
For transaction hedging purposes, the Fund may also purchase exchange-listed and over-the-counter call and put options on foreign currency futures contracts and on foreign currencies. A put option on a
futures contract gives the Fund the right to assume a short position in the futures contract until expiration of the option. A put option on currency gives the Fund the right to sell a currency at a specified exercise price until the expiration of
the option. A call option on a futures contract gives the Fund the right to assume a long
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position in the futures contract until the expiration of the option. A call option on currency gives the Fund the right to purchase a currency at the exercise price until the expiration of the
option. The Fund will engage in over-the-counter transactions only when appropriate exchange-traded transactions are unavailable and when, in the opinion of the Adviser, the pricing mechanism and liquidity are satisfactory and the participants are
responsible parties likely to meet their contractual obligations.
When it engages in position hedging, the Fund enters into foreign currency
exchange transactions to protect against a decline in the values of the foreign currencies in which securities held by the Fund are denominated or are quoted in their principle trading markets or an increase in the value of currency for securities
which the Fund expects to purchase. In connection with position hedging, the Fund may purchase put or call options on foreign currency and foreign currency futures contracts and buy or sell forward contracts and foreign currency futures contracts.
The Fund may also purchase or sell foreign currency on a spot basis.
The precise matching of the amounts of foreign currency exchange
transactions and the value of the portfolio securities involved will not generally be possible since the future value of such securities in foreign currencies will change as a consequence of market movements in the values of those securities between
the dates the currency exchange transactions are entered into and the dates they mature.
It is impossible to forecast with precision the
market value of the Funds portfolio securities at the expiration or maturity of a forward or futures contract. Accordingly, it may be necessary for the Fund to purchase additional foreign currency on the spot market (and bear the expense of
such purchase) if the market value of the security or securities being hedged is less than the amount of foreign currency the Fund is obligated to deliver and if a decision is made to sell the security or securities and make delivery of the foreign
currency. Conversely, it may be necessary to sell on the spot market some of the foreign currency received upon the sale of the portfolio security or securities of the Fund if the market value of such security or securities exceeds the amount of
foreign currency the Fund is obligated to deliver. To offset some of the costs of hedging against fluctuations in currency exchange rates, the Fund may write covered call options on those currencies.
Transaction and position hedging do not eliminate fluctuations in the underlying prices of the securities that the Fund owns or intends to purchase or
sell. They simply establish a rate of exchange that one can achieve at some future point in time. Additionally, although these techniques tend to minimize the risk of loss due to a decline in the value of the hedged currency, they tend to limit any
potential gain which might result from the increase in the value of such currency.
The Fund may also seek to increase its current return by
purchasing and selling foreign currency on a spot basis, by purchasing and selling futures contracts on foreign currencies and options on foreign currencies and on foreign currency futures contracts, and by purchasing and selling foreign currency
forward contracts.
The value of any currency, including U.S. dollars and foreign currencies, may be affected by complex political, social,
and economic factors applicable to the issuing country. In addition, the exchange rates of foreign currencies (and therefore the values of foreign currency options, forward contracts, and futures contracts) may be affected significantly, fixed, or
supported directly or indirectly by U.S. and foreign government actions. Government intervention may increase risks involved in purchasing or selling foreign currency options, forward contracts, and futures contracts, since exchange rates may not be
free to fluctuate in response to other market forces. Foreign governmental restrictions or taxes could result in adverse changes in the cost of acquiring or disposing of foreign currencies.
Currency Forward and Futures Contracts
. A forward foreign currency exchange contract involves an obligation to purchase or sell a specific currency at a future date, which may be any
fixed number of days from the date of the contract as agreed by the parties, at a price set at the time of the contract. In the case of a cancelable forward contract, the holder has the unilateral right to cancel the contract at maturity by paying a
specified fee. The contracts are traded in the interbank market conducted directly between currency traders (usually large commercial banks) and their customers. A forward contract generally has no deposit requirement, and no commissions are charged
at any stage for trades. A foreign currency futures contract is a standardized contract for the future delivery of a specified amount of a foreign currency at a future date at a price set at the time of the contract. Foreign currency futures
contracts traded in the United States are designed by and traded on exchanges regulated by the CFTC, such as the New York Mercantile Exchange.
The Fund may enter into foreign currency forward contracts in order to protect against the risk that the U.S. dollar value of the Funds dividends,
interest, net realized capital gains, sales proceeds or investments denominated in foreign currency will decline, including to the extent of any devaluation of the currency during the intervals between (a) (i) the time the Fund becomes
entitled to receive or receives dividends, interest, net realized capital gains or sales proceeds or (ii) the time an investor gives notice of a requested redemption of a certain amount and (b) the time such amount(s) are converted into
U.S. dollars for remittance out of the particular country or countries.
-26-
Forward foreign currency exchange contracts differ from foreign currency futures contracts in certain
respects. For example, the maturity date of a forward contract may be any fixed number of days from the date of the contract agreed upon by the parties, rather than a predetermined date in a given month. Forward contracts may be in any amounts
agreed upon by the parties rather than predetermined amounts. Also, forward foreign exchange contracts are traded directly between currency traders so that no intermediary is required. A forward contract generally requires no margin or other
deposit.
At the maturity of a forward or futures contract, the Fund may either accept or make delivery of the currency specified in the
contract, or at or prior to maturity enter into a closing transaction involving the purchase or sale of an offsetting contract. Closing transactions with respect to forward contracts are usually effected with the currency trader who is a party to
the original forward contract. Closing transactions with respect to futures contracts are effected on a commodities exchange; a clearing corporation associated with the exchange assumes responsibility for closing out such contracts.
Positions in foreign currency futures contracts and related options may be closed out only on an exchange or board of trade which provides a secondary
market in such contracts or options. Although the Fund will normally purchase or sell foreign currency futures contracts and related options only on exchanges or boards of trade where there appears to be an active secondary market, there is no
assurance that a secondary market on an exchange or board of trade will exist for any particular contract or option or at any particular time. In such event, it may not be possible to close a futures or related option position and, in the event of
adverse price movements, the Fund would continue to be required to make daily cash payments of variation margin on its futures positions.
Foreign Currency Options
. Options on foreign currencies operate similarly to options on securities, and are traded primarily in the
over-the-counter market, although options on foreign currencies have recently been listed on several exchanges. Such options will be purchased or written only when the Adviser believes that a liquid secondary market exists for such options. There
can be no assurance that a liquid secondary market will exist for a particular option at any specific time. Options on foreign currencies are affected by all of those factors which influence exchange rates and investments generally.
The value of a foreign currency option is dependent upon the value of the foreign currency and the U.S. dollar, and may have no relationship to the
investment merits of a foreign security. Because foreign currency transactions occurring in the interbank market involve substantially larger amounts than those that may be involved in the use of foreign currency options, investors may be
disadvantaged by having to deal in an odd lot market (generally consisting of transactions of less than $1 million) for the underlying foreign currencies at prices that are less favorable than for round lots.
There is no systematic reporting of last-sale information for foreign currencies and there is no regulatory requirement that quotations available through
dealers or other market sources be firm or revised on a timely basis. Available quotation information is generally representative of very large transactions in the interbank market and thus may not reflect relatively smaller transactions (less than
$1 million) where rates may be less favorable. The interbank market in foreign currencies is a global, around-the-clock market. To the extent that the U.S. options markets are closed while the markets for the underlying currencies remain open,
significant price and rate movements may take place in the underlying markets that cannot be reflected in the U.S. options markets.
Foreign Currency Conversion
. Although foreign exchange dealers do not charge a fee for currency conversion, they do realize a profit
based on the difference (the
spread
) between prices at which they buy and sell various currencies. Thus, a dealer may offer to sell a foreign currency to the Fund at one rate, while offering a lesser rate of exchange should the
Fund desire to resell that currency to the dealer.
Foreign Investments and Related Risks.
The Fund may invest in
securities issued by a foreign issuer or by an issuer with significant revenue or other exposure to foreign markets. There may be less information publicly available about a foreign market, issuer, or security than about U.S. markets or a U.S.
issuer or security, and foreign issuers may not be subject to accounting, auditing and financial reporting standards and practices comparable to those in the United States. In addition, there may be less (or less effective) regulation of exchanges,
brokers and listed companies in some foreign countries. The securities of some foreign issuers are less liquid and at times more volatile than securities of comparable U.S. issuers. Foreign brokerage commissions, custodial expenses and other fees
are also generally higher than in the United States.
Foreign settlement procedures and trade regulations may be more complex and involve
certain risks (such as delay in payment or delivery of securities or in the recovery of the Funds assets held abroad) and expenses not present in the settlement of investments in U.S. markets. For example, settlement of transactions involving
foreign securities or foreign currencies (see below) may occur within a foreign country, and the Fund may accept or make delivery of the underlying securities or currency in conformity with any applicable U.S. or foreign restrictions or regulations,
and may pay fees, taxes or charges associated with such delivery. Such investments may also involve the risk that an entity involved in the settlement may not meet its obligations.
-27-
In addition, foreign securities may be subject to the risk of nationalization or expropriation of assets,
imposition of currency exchange controls, foreign withholding taxes or restrictions on the repatriation of foreign currency, confiscatory taxation, political, social or financial instability and diplomatic developments which could affect the value
of the Funds investments in certain foreign countries. Dividends or interest on, or proceeds from the sale of, foreign securities may be subject to foreign withholding taxes, and special U.S. tax considerations may apply.
Legal remedies available to investors in certain foreign countries may be more limited than those available with respect to investments in the United
States or in other foreign countries. The laws of some foreign countries may limit the Funds ability to invest in securities of certain issuers organized under the laws of those foreign countries.
The risks described above, including the risks of nationalization or expropriation of assets, typically are increased in connection with investments in
developing countries, also known as emerging markets. For example, political and economic structures in these countries may be in their infancy and developing rapidly, and such countries may lack the social, political and economic stability
characteristic of more developed countries. Certain of these countries have in the past failed to recognize private property rights and have at times nationalized and expropriated the assets of private companies. High rates of inflation or currency
devaluations may adversely affect the economies and securities markets of such countries. Investments in emerging markets may be considered speculative.
Foreign securities are normally denominated and traded in foreign currencies. As a result, the value of the Funds foreign investments and the value of its shares may be affected favorably or
unfavorably by changes in currency exchange rates relative to the U.S. dollar. In addition, the Fund is required to compute and distribute its income in U.S. dollars. Therefore, if the exchange rate for a foreign currency declines after the
Funds income has been earned and translated into U.S. dollars (but before payment), the Fund could be required to liquidate portfolio securities to make such distributions. Similarly, if an exchange rate declines between the time the Fund
incurs expenses in U.S. dollars and the time such expenses are paid, the amount of such currency required to be converted into U.S. dollars in order to pay such expenses in U.S. dollars will be greater than the equivalent amount in any such currency
of such expenses at the time they were incurred.
As the European debt crisis has progressed, the possibility of one or more Eurozone
countries exiting the European Monetary Union (the
EMU
), or even the collapse of the euro as a common currency, has persisted, creating significant volatility at times in currency and financial markets generally. Any partial or
complete dissolution of the EMU could have significant adverse effects on currency and financial markets, and on the values of the Funds portfolio investments. If one or more EMU countries were to stop using the euro as its primary currency,
the Funds investments in such countries may be redenominated into a different or newly adopted currency. As a result, the value of those investments could decline significantly and unpredictably. In addition, securities or other investments
that are redenominated may be subject to liquidity risk and the risk that the Fund may not be able to value investments accurately to a greater extent than similar investments currently denominated in euros. To the extent a currency used for
redenomination purposes is not specified in respect of certain EMU-related investments, or should the euro cease to be used entirely, the currency in which such investments are denominated may be unclear, making such investments particularly
difficult to value or dispose of. The Fund may incur additional expenses to the extent it is required to seek judicial or other clarification of the denomination or value of such securities.
The currencies of certain emerging market countries have experienced devaluations relative to the U.S. dollar, and future devaluations may adversely affect the value of assets denominated in such
currencies. Many emerging market countries have experienced substantial, and in some periods extremely high, rates of inflation or deflation for many years, and future inflation may adversely affect the economies and securities markets of such
countries.
In addition, unanticipated political or social developments may affect the value of investments in emerging markets and the
availability of additional investments in these markets. The small size, limited trading volume and relative inexperience of the securities markets in these countries may make investments in securities traded in emerging markets illiquid and more
volatile than investments in securities traded in more developed countries, and the Fund may be required to establish special custodial or other arrangements before making investments in securities traded in emerging markets. There may be little
financial or accounting information available with respect to issuers of emerging market securities, and it may be difficult as a result to assess the value or prospects of an investment in such securities.
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American Depositary Receipts (
ADRs
) as well as other hybrid forms of ADRs, including
European Depositary Receipts (
EDRs
) and Global Depositary Receipts (
GDRs
), are certificates evidencing ownership of shares of a foreign issuer. These certificates are issued by depositary banks and generally
trade on an established market in the United States or elsewhere. The underlying shares are held in trust by a custodian bank or similar financial institution in the issuers home country. The depositary bank may not have physical custody of
the underlying securities at all times and may charge fees for various services, including forwarding dividends and interest and corporate actions. ADRs are alternatives to directly purchasing the underlying foreign securities in their national
markets and currencies. However, ADRs continue to be subject to many of the risks associated with investing in foreign securities.
Certain of
the foregoing risks may also apply to some extent to securities of U.S. issuers that are denominated in foreign currencies or that are traded in foreign markets, or securities of U.S. issuers having significant foreign operations or other exposure
to foreign markets.
Forward Commitments and Dollar Rolls.
The Fund may enter into contracts to purchase securities
for a fixed price at a future date beyond customary settlement time (
forward commitments
) if the Fund sets aside on its books liquid assets in an amount sufficient to meet the purchase price, or if the Fund enters into offsetting
contracts for the forward sale of other securities it owns. In the case of to-be-announced (
TBA
) purchase commitments, the unit price and the estimated principal amount are established when the Fund enters into a contract, with
the actual principal amount being within a specified range of the estimate. Forward commitments may be considered securities in themselves, and involve a risk of loss if the value of the security to be purchased declines prior to the settlement
date, which risk is in addition to the risk of decline in the value of the Funds other assets. Where such purchases are made through dealers, the Fund relies on the dealer to consummate the sale. The dealers failure to do so may result
in the loss to the Fund of an advantageous yield or price. Although the Fund will generally enter into forward commitments with the intention of acquiring securities for its portfolio or for delivery pursuant to options contracts it has entered
into, the Fund may dispose of a commitment prior to settlement if the Adviser deems it appropriate to do so. The Fund may realize short-term profits or losses upon the sale of forward commitments.
The Fund may enter into TBA sale commitments to hedge its portfolio positions or to sell securities it owns under delayed delivery arrangements. Proceeds
of TBA sale commitments are not received until the contractual settlement date. Unsettled TBA sale commitments are valued at current market value of the underlying securities. If the TBA sale commitment is closed through the acquisition of an
offsetting purchase commitment, the Fund realizes a gain or loss on the commitment without regard to any unrealized gain or loss on the underlying security. If the Fund delivers securities under the commitment, the Fund realizes a gain or loss from
the sale of the securities based upon the unit price established at the date the commitment was entered into.
The Fund may enter into dollar
roll transactions (generally using TBAs) in which it sells a fixed income security for delivery in the current month and simultaneously contracts to purchase similar securities (for example, same type, coupon and maturity) at an agreed upon future
time. By engaging in a dollar roll transaction, the Fund foregoes principal and interest paid on the security that is sold, but receives the difference between the current sales price and the forward price for the future purchase. The Fund would
also be able to earn interest on the proceeds of the sale before they are reinvested. The Fund accounts for dollar rolls as purchases and sales. Dollar rolls may be used to create investment leverage and may increase the Funds risk and
volatility.
The obligation to purchase securities on a specified future date involves the risk that the market value of the securities that
the Fund is obligated to purchase may decline below the purchase price. In addition, in the event the other party to the transaction files for bankruptcy, becomes insolvent or defaults on its obligation, the Fund may be adversely affected.
Hybrid Securities.
The Fund may acquire hybrid securities. A third party or Adviser may create a hybrid security by
combining an income-producing debt security (
income producing component
) and the right to receive payment based on the change in the price of an equity security (
equity component
). The income-producing component
is achieved by investing in non-convertible, income-producing securities such as bonds, preferred stocks and money market instruments, which may be represented by derivative instruments. The equity component is achieved by investing in securities or
instruments such as cash-settled warrants or options to receive a payment based on whether the price of a common stock surpasses a certain exercise price, or options on a stock index. A hybrid security comprises two or more separate securities, each
with its own market value. Therefore, the market value of a hybrid security is the sum of the values of its income-producing component and its equity component.
A holder of a hybrid security faces the risk of a decline in the price of the security or the level of the index involved in the equity component, causing a decline in the value of the security or
instrument, such as a call option or warrant, purchased to create the hybrid security. The equity component has risks typical to a purchased call option. Should the price of the stock fall below the exercise price and remain there throughout the
exercise period, the entire amount paid for the call option or warrant would be lost. Because a hybrid security includes the income-producing component as well, the holder of a hybrid security also faces risks typical to all debt securities.
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Sovereign Debt Obligations.
The Fund may invest in sovereign debt, including of
emerging market countries. Investors should be aware that the sovereign debt instruments in which the Fund may invest may involve great risk and may be deemed to be the equivalent in terms of quality to securities rated below investment grade by
Moodys and S&P.
Sovereign debt may be issued by foreign developed and emerging market governments and their respective
sub-divisions, agencies or instrumentalities, government sponsored enterprises and supranational government entities. Supranational entities include international organizations that are organized or supported by one or more government entities to
promote economic reconstruction or development and by international banking institutions and related governmental agencies. Investment in sovereign debt can involve a high degree of risk. The governmental entity that controls the repayment of
sovereign debt may not be able or willing to repay the principal and/or interest when due in accordance with the terms of the debt. A governmental entitys willingness or ability to repay principal and interest due in a timely manner may be
affected by, among other factors, its cash flow situation, the extent of its foreign reserves, the availability of sufficient foreign exchange on the date a payment is due, the relative size of the debt service burden to the economy as a whole, the
governmental entitys policy toward the International Monetary Fund, and the political constraints to which a governmental entity may be subject. Governmental entities also may depend on expected disbursements from foreign governments,
multilateral agencies and others to reduce principal and interest arrearages on their debt. The commitment on the part of these governments, agencies and others to make such disbursements may be conditioned on a governmental entitys
implementation of economic reforms and/or economic performance and the timely service of such debtors obligations. Failure to implement such reforms, achieve such levels of economic performance or repay principal or interest when due may
result in the cancellation of such third parties commitments to lend funds to the governmental entity, which may further impair such debtors ability or willingness to service its debts in a timely manner. Consequently, governmental
entities may decide to default on their sovereign debt in whole or in part. Holders of sovereign debt (including the Fund) may be requested to participate in the rescheduling of such debt and to extend further loans to governmental entities. There
is no known bankruptcy proceeding by which sovereign debt on which governmental entities have defaulted may be collected in whole or in part.
The Funds investments in foreign currency denominated debt obligations and hedging activities will likely produce a difference between its book
income and its taxable income. This difference may cause a portion of the Funds income distributions to constitute returns of capital for tax purposes or require the Fund to make distributions exceeding book income to qualify as a RIC for
federal tax purposes. See Distributions and Taxes below.
In recent years, some of the countries in which the Fund may invest have
encountered difficulties in servicing their sovereign debt. Some of these countries have withheld payments of interest and/or principal of sovereign debt. These difficulties have also led to agreements to restructure external debt obligations; in
particular, commercial bank loans, typically by rescheduling principal payments, reducing interest rates and extending new credits to finance interest payments on existing debt. In the future, holders of sovereign debt may be requested to
participate in similar rescheduling of such debt.
The ability or willingness of foreign governments to make timely payments on their
sovereign debt is likely to be influenced strongly by a countrys balance of trade and its access to trade and other international credits. A country whose exports are concentrated in a few commodities could be vulnerable to a decline in the
international prices of one or more of such commodities. Increased protectionism on the part of a countrys trading partners could also adversely affect its exports. Such events could extinguish a countrys trade account surplus, if any.
To the extent that a country receives payment for its exports in currencies other than hard currencies, its ability to make hard currency payments could be affected.
The occurrence of political, social, economic and diplomatic changes in one or more of the countries issuing sovereign debt could adversely affect the Funds investments. The countries issuing such
instruments are faced with social and political issues and some of them have experienced high rates of inflation in recent years and have extensive internal debt. Among other effects, high inflation and internal debt service requirements may
adversely affect the cost and availability of future domestic sovereign borrowing to finance governmental programs, and may have other adverse social, political and economic consequences. Political changes or a deterioration of a countrys
domestic economy or balance of trade may affect the willingness of countries to services their sovereign debt. There can be no assurance that adverse political changes will not cause the Fund to suffer a loss of interest or principal on any of its
holdings.
As a result of all of the foregoing, a government obligor may default on its obligations. If such an event occurs, the Fund may
have limited legal recourse against the issuer and/or guarantor. Remedies must, in some cases, be pursued in the courts of the defaulting party itself, and the ability of the holder of foreign government debt securities to obtain recourse may be
subject to the political climate in the relevant country. Bankruptcy, moratorium and other similar laws applicable to issuers of sovereign debt obligations may be substantially different from those applicable to issuers of private debt obligations.
In addition, no assurance can be given that the holders of commercial bank debt will not contest payments to the holders of other foreign government debt obligations in the event of default under their commercial bank loan agreements.
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Periods of economic uncertainty may result in the volatility of market prices of sovereign debt and in turn,
the Funds net asset value, to a greater extent than the volatility inherent in domestic securities. The value of sovereign debt will likely vary inversely with changes in prevailing interest rates, which are subject to considerable variance in
the international market.
Commodities.
The Fund may invest directly or indirectly in commodities (such as precious
metals or natural gas). Commodity prices can be more volatile than prices of other types of investments and can be affected by a wide range of factors, including changes in overall market movements, speculative investors, real or perceived
inflationary trends, commodity index volatility, changes in interest rates or currency exchange rates, population growth and changing demographics, nationalization, expropriation, or other confiscation, international or local regulatory, political,
and economic developments (for example, regime changes and changes in economic activity levels), and developments affecting a particular industry or commodity, such as drought, floods, or other weather conditions, livestock disease, trade embargoes,
competition from substitute products, transportation bottlenecks or shortages, fluctuations in supply and demand, and tariffs.
The Fund may
also directly or indirectly use commodity-related derivatives. The values of these derivatives may fluctuate more than the relevant underlying commodity or commodities or commodity index. The requirements for qualification as a RIC can limit the
manner in or extent to which the Fund may enter into certain commodity-related derivatives, such as commodities futures contracts discussed above. See Distributions and Taxes below.
Convertible Securities
. The Fund may invest in convertible securities. Convertible securities include bonds, debentures, notes,
preferred stock and other securities that may be converted into or exchanged for, at a specific price or formula within a particular period of time, a prescribed amount of common stock or other equity securities of the same or a different issuer.
Convertible securities may entitle the holder to receive interest paid or accrued on debt or dividends paid or accrued on preferred stock until the security matures or is redeemed, converted or exchanged. The Fund may invest in convertible bonds and
debentures of any credit quality and maturity.
The market value of a convertible security is a function of its investment value and its
conversion value. A securitys investment value represents the value of the security without its conversion feature (
i.e.
, a nonconvertible fixed income security). The investment value may be determined by reference to its credit quality
and the current value of its yield to maturity or probable call date. At any given time, investment value is dependent upon such factors as the general level of interest rates, the yield of similar nonconvertible securities, the financial strength
of the issuer and the seniority of the security in the issuers capital structure. A securitys conversion value is determined by multiplying the number of shares the holder is entitled to receive upon conversion or exchange by the current
price of the underlying security.
If the conversion value of a convertible security is significantly below its investment value, the
convertible security generally trades like nonconvertible debt or preferred stock and its market value will not be influenced greatly by fluctuations in the market price of the underlying security. Conversely, if the conversion value of a
convertible security is near or above its investment value, the market value of the convertible security is typically more heavily influenced by fluctuations in the market price of the underlying security. Convertible securities generally have less
potential for gain than common stocks.
The Funds investments in convertible securities may at times include securities that have a
mandatory conversion feature, pursuant to which the securities convert automatically into common stock or other equity securities at a specified date and a specified conversion ratio, or that are convertible at the option of the issuer. Because
conversion of the security is not at the option of the holder, the Fund may be required to convert the security into the underlying common stock even at times when to do so is not in the best interests of the shareholders.
The Funds investments in convertible securities, particularly securities that are convertible into securities of an issuer other than the issuer of
the convertible security, may be illiquid, in which case the Fund may not be able to dispose of such securities in a timely fashion or for a fair price, which could result in losses to the Fund.
Exchange-Traded Notes (ETNs)
. The Fund may invest in ETNs. ETNs have many features of senior, unsecured,
unsubordinated debt securities. Their returns are linked to the performance of a particular asset, such as a market index, less applicable fees and expenses. ETNs are listed on an exchange and traded in the secondary market. The Fund may hold the
ETN until maturity, at which time the issuer is obligated to pay a return linked to the performance of the relevant asset. ETNs do not typically make periodic interest payments and principal is not protected.
-31-
The market value of an ETN may be influenced by, among other things, time to maturity, level of supply and
demand of the ETN, volatility and lack of liquidity in the underlying assets, changes in the applicable interest rates, the current performance of the asset to which the ETN is linked, and the credit rating of the ETN issuer. The market value of an
ETN may differ from the performance of the applicable asset and there may be times when an ETN trades at a premium or discount to the underlying assets value. This difference in price may be due to the fact that the supply and demand in the
market for ETNs at any point in time is not always identical to the supply and demand in the market for the assets on which the ETNs return is based. A change in the issuers credit rating may also affect the value of an ETN despite the
underlying asset remaining unchanged. ETNs are also subject to tax risk. For tax purposes, no assurance can be given that the Internal Revenue Service (
IRS
) will accept, or a court will uphold, how the Fund characterizes and
treats ETNs or amounts realized thereon; further, the requirements for qualification as a RIC may limit the extent to which the Fund may invest in certain ETNs. See Distributions and Taxes below.
An ETN that is tied to a specific market index may not be able to replicate and maintain exactly the composition and relative weighting of securities,
commodities or other components in the applicable market index. ETNs also incur certain expenses not incurred by their applicable market index, and the Fund would bear a proportionate share of any fees and expenses borne by the ETN in which it
invests.
The Funds decision to sell its ETN holdings may be limited by the availability of a secondary market. In addition, although an
ETN may be listed on an exchange, the issuer may not be required to maintain the listing and there can be no assurance that a secondary market will exist for an ETN. Some ETNs that use leverage in an effort to amplify the returns of an underlying
market index can, at times, be relatively illiquid and may therefore be difficult to purchase or sell at a fair price. Leveraged ETNs may offer the potential for greater return, but the potential for loss and speed at which losses can be realized
also are greater.
ETNs are generally similar to structured investments and hybrid instruments. For discussion of these investments and the
risks generally associated with them, see Hybrid Securities and Structured Investments in this Statement of Additional Information.
Floating Rate and Variable Rate Demand Notes.
The Fund may purchase taxable or tax-exempt floating rate and variable rate demand notes for short-term cash management or other
investment purposes. Floating rate and variable rate demand notes and bonds may have a stated maturity in excess of one year, but may have features that permit a holder to demand payment of principal plus accrued interest upon a specified number of
days notice. Frequently, such obligations are secured by letters of credit or other credit support arrangements provided by banks. The issuer has a corresponding right, after a given period, to prepay in its discretion the outstanding principal of
the obligation plus accrued interest upon a specific number of days notice to the holders. The interest rate of a floating rate instrument may be based on a known lending rate, such as a banks prime rate, and is reset whenever such rate is
adjusted. The interest rate on a variable rate demand note is reset at specified intervals at a market rate.
Inflation-Protected
Securities
. The Fund may invest in U.S. Treasury Inflation Protected Securities (
U.S. TIPS
), which are fixed income securities issued by the U.S. Department of Treasury, the principal amounts of which are
adjusted daily based upon changes in the rate of inflation. The Fund may also invest in other inflation-protected securities issued by non-U.S. governments or by private issuers. U.S. TIPS pay interest on a semi-annual basis, equal to a fixed
percentage of the inflation-adjusted principal amount. The interest rate on these bonds is fixed at issuance, but over the life of the bond this interest may be paid on an increasing or decreasing principal value that has been adjusted for
inflation.
Repayment of the original bond principal upon maturity (as adjusted for inflation) is guaranteed for U.S. TIPS, even during a
period of deflation. However, because the principal amount of U.S. TIPS would be adjusted downward during a period of deflation, the Fund will be subject to deflation risk with respect to its investments in these securities. In addition, the current
market value of the bonds is not guaranteed, and will fluctuate. If the Fund purchases in the secondary market U.S. TIPS whose principal values have been adjusted upward due to inflation since issuance, the Fund may experience a loss if there is a
subsequent period of deflation. The Fund may also invest in other inflation-related bonds which may or may not provide a guarantee of principal. If a guarantee of principal is not provided, the adjusted principal value of the bond repaid at maturity
may be less than the original principal amount.
The periodic adjustment of U.S. TIPS is currently tied to the CPI-U, which is calculated by
the U.S. Department of Treasury. The CPI-U is a measurement of changes in the cost of living, made up of components such as housing, food, transportation and energy. Inflation-protected bonds issued by a non-U.S. government are generally adjusted to
reflect a comparable inflation index, calculated by that government. There can no assurance that the CPI-U or any non-U.S. inflation index will accurately measure the real rate of inflation in the prices of goods and services. If interest rates rise
due to reasons other than inflation (for example, due to changes in currency exchange rates), investors in these securities may not be protected to the extent that the increase is not reflected in the bonds inflation measure. In addition,
there can be no assurance that the rate of inflation in a non-U.S. country will be correlated to the rate of inflation in the United States.
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In general, the value of inflation-protected bonds is expected to fluctuate in response to changes in real
interest rates, which are in turn tied to the relationship between nominal interest rates and the rate of inflation. Therefore, if inflation were to rise at a faster rate than nominal interest rates, real interest rates might decline, leading to an
increase in value of inflation-protected bonds. In contrast, if nominal interest rates increased at a faster rate than inflation, real interest rates might rise, leading to a decrease in value of inflation-protected bonds. If inflation is lower than
expected during the period the Fund holds the security, the Fund may earn less on the security than on a conventional bond. Any increase in principal value is taxable in the year the increase occurs, even though holders do not receive cash
representing the increase at that time. As a result, if the Fund invests in inflation-protected securities, it could be required at times to liquidate other investments, including when it is not advantageous to do so, in order to satisfy its
distribution requirements as a RIC and to eliminate any fund-level income tax liability under the Code.
Infrastructure
Investments.
The Fund may invest in securities and other obligations of U.S. and non-U.S. issuers providing exposure to infrastructure investment. Infrastructure investments may be related to physical structures and networks that
provide necessary services to society, such as transportation and communications networks, water and energy utilities, and public service facilities. Securities, instruments and obligations of infrastructure-related companies and projects are more
susceptible to adverse economic or regulatory occurrences affecting their industries. Infrastructure companies may be subject to a variety of factors that may adversely affect their business or operations, including high interest costs in connection
with capital construction programs, high leverage, costs associated with environmental and other regulations, the effects of economic slowdown, surplus capacity, increased competition from other providers of services, uncertainties concerning the
availability of fuel at reasonable prices, the effects of energy conservation policies and other factors. Infrastructure companies and projects also may be affected by or subject to (i) regulation by various government authorities, including
rate regulation; (ii) service interruption due to environmental, operational or other mishaps; (iii) the imposition of special tariffs and changes in tax laws, regulatory policies and accounting standards; and (iv) general changes in
market sentiment towards infrastructure and utilities assets.
Initial Public Offerings.
The Fund may purchase debt
or equity securities in initial public offerings (
IPOs
). These securities, which are often issued by unseasoned companies, may be subject to many of the same risks of investing in companies with smaller market capitalizations.
Securities issued in IPOs have no trading history, and information about the companies may be available for very limited periods. Securities issued in an IPO frequently are very volatile in price, and the Fund may hold securities purchased in an IPO
for a very short period of time. As a result, the Funds investments in IPOs may increase portfolio turnover, which increases brokerage and administrative costs and may result in taxable distributions to shareholders.
At any particular time or from time to time the Fund may not be able to invest in securities issued in IPOs, or invest to the extent desired because, for
example, only a small portion (if any) of the securities being offered in an IPO may be made available to the Fund. In addition, under certain market conditions a relatively small number of companies may issue securities in IPOs. Similarly, as the
number of funds advised by the Adviser to which IPO securities are allocated increases, the number of securities issued to any one fund may decrease. The investment performance of the Fund during periods when it is unable to invest significantly or
at all in IPOs may be lower than during periods when the Fund is able to do so. In addition, as the Fund increases in size, the impact of IPOs on the Funds performance will generally decrease. There can be no assurance that investments in IPOs
will be available to the Fund or improve the Funds performance.
Municipal Bonds.
Municipal bonds are
investments of any maturity issued by states, public authorities or political subdivisions to raise money for public purposes; they include, for example, general obligations of a state or other government entity supported by its taxing powers to
acquire and construct public facilities, or to provide temporary financing in anticipation of the receipt of taxes and other revenue. They also include obligations of states, public authorities or political subdivisions to finance privately owned or
operated facilities or public facilities financed solely by enterprise revenues. Changes in law or adverse determinations by the IRS or a state tax authority could cause the income from some of these obligations to become taxable.
Short-term municipal bonds are generally issued by state and local governments and public authorities as interim financing in anticipation of tax
collections, revenue receipts or bond sales to finance such public purposes.
Certain types of private activity bonds may be issued by public
authorities to finance projects such as privately operated housing facilities; certain local facilities for supplying water, gas or electricity; sewage or solid waste disposal facilities; student loans; or public or private institutions for the
construction of educational, hospital, housing and other facilities. Such obligations are included within the term municipal bonds if the interest paid thereon is, in the opinion of bond counsel, exempt from federal income tax and state personal
income tax (such interest may, however, be subject to federal alternative minimum tax). Other types of private activity bonds, the proceeds of which are used for the construction, repair or improvement of, or to obtain equipment for, privately
operated industrial or commercial facilities, may also constitute municipal bonds, although current federal tax laws place substantial limitations on the size of such issues.
-33-
The Fund does not expect to qualify to pass through to shareholders the tax-exempt character of interest on
municipal bonds.
Participation interests
. The Fund may invest in municipal bonds either by purchasing them directly or by
purchasing certificates of accrual or similar instruments evidencing direct ownership of interest payments or principal payments, or both, on municipal bonds, provided that, in the opinion of counsel, any discount accruing on a certificate or
instrument that is purchased at a yield not greater than the coupon rate of interest on the related municipal bonds will be exempt from federal income tax to the same extent as interest on the municipal bonds. The Fund may also invest in municipal
bonds by purchasing from banks participation interests in all or part of specific holdings of municipal bonds. These participations may be backed in whole or in part by an irrevocable letter of credit or guarantee of the selling bank. The selling
bank may receive a fee from the Fund in connection with the arrangement.
Stand-by commitments
. If the Fund purchases
municipal bonds, it has the authority to acquire stand-by commitments from banks and broker-dealers with respect to those municipal bonds. A stand-by commitment may be considered a security independent of the municipal bond to which it relates. The
amount payable by a bank or dealer during the time a stand-by commitment is exercisable, absent unusual circumstances, would be substantially the same as the market value of the underlying municipal bond to a third party at any time. It is expected
that stand-by commitments generally will be available without the payment of direct or indirect consideration.
Yields
. The
yields on municipal bonds depend on a variety of factors, including general money market conditions, effective marginal tax rates, the financial condition of the issuer, general conditions of the municipal bond market, the size of a particular
offering, the maturity of the obligation and the rating of the issue. The ratings assigned by NRSROs represent their opinions as to the credit quality of the municipal bonds that they undertake to rate. It should be emphasized, however, that ratings
are general and are not absolute standards of quality. Consequently, municipal bonds with the same maturity and interest rate but with different ratings may have the same yield. Yield disparities may occur for reasons not directly related to the
investment quality of particular issues or the general movement of interest rates and may be due to such factors as changes in the overall demand or supply of various types of municipal bonds or changes in the investment objectives of investors.
Subsequent to purchase by the Fund, an issue of municipal bonds or other investments may cease to be rated, or its rating may be reduced below the minimum rating required for purchase by the Fund. Neither event will require the elimination of an
investment from the Funds portfolio, but the Adviser will consider such an event in its determination of whether the Fund should continue to hold an investment in its portfolio.
Moral obligation bonds
. The Fund may invest in so-called moral obligation bonds, where repayment is backed by a moral commitment of an entity other than the issuer, if the credit of the
issuer itself, without regard to the moral obligation, meets the investment criteria established for investments by the Fund.
Municipal
leases
. The Fund may acquire participations in lease obligations or installment purchase contract obligations (collectively,
lease obligations
) of municipal authorities or entities. Lease obligations do not
constitute general obligations of the municipality for which the municipalitys taxing power is pledged. Certain of these lease obligations contain non-appropriation clauses, which provide that the municipality has no obligation to make lease
or installment purchase payments in future years unless money is appropriated for such purpose on a yearly basis. In the case of a non-appropriation lease, the Funds ability to recover under the lease in the event of non-appropriation or
default will be limited solely to the repossession of the leased property, and in any event, foreclosure of that property might prove difficult.
Additional risks
. Securities in which the Fund may invest, including municipal bonds, are subject to the provisions of bankruptcy, insolvency and other laws affecting the rights and
remedies of creditors, such as the federal Bankruptcy Code (including special provisions related to municipalities and other public entities), and laws, if any, that may be enacted by Congress or state legislatures extending the time for payment of
principal or interest, or both, or imposing other constraints upon enforcement of such obligations. There is also the possibility that, as a result of litigation or other conditions, the power, ability or willingness of issuers to meet their
obligations for the payment of interest and principal on their municipal bonds may be materially affected or their obligations may be found to be invalid or unenforceable. Such litigation or conditions may from time to time have the effect of
introducing uncertainties in the market for municipal bonds or certain segments thereof, or of materially affecting the credit risk with respect to particular bonds. Adverse economic, business, legal or political developments might affect all or a
substantial portion of the Funds municipal bonds in the same manner.
From time to time, proposals have been introduced before Congress
for the purpose of restricting or eliminating the federal income tax exemption for interest on debt obligations issued by states and their political subdivisions. Federal tax laws limit the types and amounts of tax-exempt bonds issuable for certain
purposes, especially industrial development bonds and private activity bonds. Such limits may affect the future supply and yields of these types of municipal bonds. Further proposals limiting the issuance of municipal bonds may well be introduced in
the future.
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Private Investment Vehicles.
The Fund may also invest in private investment funds,
pools, vehicles, or other structures such as, without limitation, hedge funds, private equity funds or other pooled investment vehicles, which may take the form of corporations, partnerships, trusts, limited partnerships, limited liability
companies, or any other form of business organization (collectively,
private funds
), including those sponsored or advised by the Adviser or its affiliates. Private funds may utilize leverage without limit and, to the extent the
Fund invests in private funds that utilize leverage, the Fund will indirectly be exposed to the risks associated with that leverage and the values of its shares may be more volatile as a result. If a private fund in which the Fund invests is not
publicly offered or there is no public market for its shares, the Fund may be prohibited by the terms of its investment from selling its shares in the private fund, or may not be able to find a buyer for those shares at an acceptable price.
Securities issued by private funds are generally issued in private placements and are restricted securities. An investment in a private fund may be highly volatile and difficult to value. The Fund would bear its pro rata share of the expenses of any
private fund in which it invests. See Private Placement and Restricted Securities below.
An investment in private funds sponsored
or advised by the Adviser or its affiliates presents certain conflicts of interest. Private funds may pay the Adviser (or its affiliates) different levels of fees, each based on the amount of assets invested in them. Accordingly, the Adviser or its
affiliates may earn fees if the Adviser invests the Funds assets in private funds that pay fees to the Adviser or its affiliates, and may earn more in payments if the Funds assets are allocated to those private funds paying fees at the
highest rates. This provides the Adviser an incentive to allocate the Funds assets into those private funds that pay the highest rate of fees to the Adviser and its affiliates; however, the Adviser has a duty to disregard that incentive and
allocate the Funds assets based on the best interest of the Fund.
Private Placement and Restricted
Securities
. The Fund may invest in securities that are purchased in private placements and, accordingly, are subject to restrictions on resale as a matter of contract or under federal securities laws. Because there may be
relatively few potential purchasers for such investments, especially under adverse market or economic conditions or in the event of adverse changes in the financial condition of the issuer, the Fund could find it more difficult to sell such
securities when the Adviser believes it advisable to do so or may be able to sell such securities only at prices lower than if such securities were more widely held. At times, it may also be more difficult to determine the fair value of such
securities for purposes of computing the Funds net asset value.
While such private placements may offer attractive opportunities for
investment not otherwise available on the open market, the securities so purchased are often restricted securities,
i.e.
, securities which cannot be sold to the public without registration under the Securities Act or the availability of an
exemption from registration (such as Rules 144 or 144A), or which are not readily marketable because they are subject to other legal or contractual delays in or restrictions on resale.
The absence of a trading market can make it difficult to ascertain a market value for illiquid investments. Disposing of illiquid investments may involve time-consuming negotiation and legal expenses, and
it may be difficult or impossible for the Fund to sell them promptly at an acceptable price. The Fund may have to bear the extra expense of registering such securities for resale and the risk of substantial delay in effecting such registration. In
addition, market quotations are less readily available. The judgment of the Adviser may at times play a greater role in valuing these securities than in the case of publicly traded securities.
Generally speaking, restricted securities may be sold only to qualified institutional buyers, or in a privately negotiated transaction to a limited
number of purchasers, or in limited quantities after they have been held for a specified period of time and other conditions are met pursuant to an exemption from registration, or in a public offering for which a registration statement is in effect
under the Securities Act. The Fund may be deemed to be an underwriter for purposes of the Securities Act when selling restricted securities to the public, and in such event the Fund may be liable to purchasers of such securities if the registration
statement prepared by the issuer, or the Prospectus forming a part of it, is materially inaccurate or misleading.
Real Estate
Investment Trusts (
REITs
)
. The Fund may invest in REITs. REITs are pooled investment vehicles that own, and typically operate, income-producing real estate. If a REIT meets
certain requirements, including distributing to shareholders substantially all of its taxable income (other than net capital gains), then it is not taxed on the income distributed to shareholders. REITs are subject to management fees and other
expenses, and so the Fund will bear its proportionate share of the costs of the REITs operations. There are three general categories of REITs: Equity REITs, Mortgage REITs and Hybrid REITs. Equity REITs invest primarily in direct fee ownership
or leasehold ownership of real property and derive most of their income from rents. Mortgage REITs invest mostly in mortgages on real estate, which may secure, for example, construction, development or long-term loans, and the main
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source of their income is mortgage interest payments. Equity REITs are generally affected by changes in the values of and incomes from the properties they own, while mortgage REITs may be
affected by the credit quality of the mortgage loans they hold. A hybrid REIT combines the characteristics of equity REITs and mortgage REITs, generally by holding both ownership interests and mortgage interests in real estate, and thus may be
subject to risks associated with both real estate ownership and investments in mortgage-related securities. Along with the risks common to different types of real estate-related securities, REITs, no matter the type, involve additional risk factors.
These include poor performance by the REITs manager, adverse changes to the tax laws, and the possible failure by the REIT to qualify for tax-free distribution of income or exemption under the 1940 Act. Furthermore, REITs are not diversified
and are heavily dependent on cash flow.
The Funds investment in a REIT may result in the Fund making distributions that constitute a
return of capital to Fund shareholders for federal income tax purposes or may require the Fund to accrue and distribute income not yet received. In addition, distributions attributable to REITs made by the Fund to Fund shareholders will not qualify
for the corporate dividends-received deduction, or, generally, for treatment as qualified dividend income.
Redeemable
Securities.
Certain securities held by the Fund may permit the issuer at its option to call or redeem its securities. If an issuer were to redeem securities held by the Fund during a time of declining interest rates, the Fund may
not be able to reinvest the proceeds in securities providing the same investment return as the securities redeemed.
Short
Sales
. Short sales are transactions in which the Fund sells a security it does not own, in anticipation of a decline in the market value of that security. To complete such a transaction, the Fund must borrow the security to make
delivery to the buyer. The Fund then is obligated to replace the security borrowed by purchasing it at the market price at or prior to the time of replacement. The price at such time may be more or less than the price at which the security was sold
by the Fund. Until the security is replaced, the Fund is required to repay the lender any dividends or interest that accrue during the period of the loan. To borrow the security, the Fund also may be required to pay a premium, which would increase
the cost of the security sold. The net proceeds of the short sale will be retained by the broker (or by the Funds custodian in a special custody account), to the extent necessary to meet margin requirements, until the short position is closed
out. The Fund also will incur transaction costs in effecting short sales.
The Fund will incur a loss as a result of the short sale if the
price of the security increases between the date of the short sale and the date on which the Fund replaces the borrowed security. The Fund will generally realize a gain if the security declines in price between those dates. The amount of any gain
will be decreased, and the amount of any loss increased, by the amount of the premium, dividends, interest, or expenses the Fund may be required to pay in connection with a short sale. An increase in the value of a security sold short by the Fund
over the price at which it was sold short will result in a loss to the Fund. There can be no assurance that the Fund will be able to close out the position at any particular time or at an acceptable price. The Funds ability to engage in short
sales may from time to time be limited or prohibited because of the inability to borrow certain securities in the market, legal restrictions on short sales, or other reasons.
Short-Term Investments
. Short-term, high quality investments, including, for example, commercial paper, bankers acceptances, certificates of deposit, bank time deposits,
repurchase agreements, and investments in money market mutual funds or similar pooled investments.
Special Purpose Acquisition
Companies
. The Fund may invest in stock, warrants, and other securities of special purpose acquisition companies (
SPACs
) or similar special purpose entities that pool funds to seek potential acquisition
opportunities. Unless and until an acquisition meeting the SPACs requirements is completed, a SPAC generally invests its assets (less a portion retained to cover expenses) in U.S. Government securities, money market securities and cash; if an
acquisition that meets the requirements for the SPAC is not completed within a pre-established period of time, the invested funds are returned to the entitys shareholders. Because SPACs and similar entities have no operating history or ongoing
business other than seeking acquisitions, the value of their securities is particularly dependent on the ability of the entitys management to identify and complete a profitable acquisition. Some SPACs may pursue acquisitions only within
certain industries or regions, which may increase the volatility of their prices. In addition, these securities, which are typically traded in the over-the-counter market, may be considered illiquid and/or be subject to restrictions on resale. The
Funds affiliates may create a SPAC for purchase by the Fund to assist the Fund in purchasing certain assets not otherwise available to the Fund.
Structured Investments.
A structured investment is a security having a return tied to an underlying index or other security or asset class. Structured investments generally are
individually negotiated agreements and may be traded over-the-counter. Structured investments are organized and operated to restructure the investment characteristics of the underlying security. This restructuring involves the deposit with or
purchase by an entity, such as a corporation or trust, or specified instruments (such as commercial bank loans) and the issuance by that entity or one or more classes of securities (
structured securities
) backed by, or
representing
-36-
interests in, the underlying instruments. The cash flow on the underlying instruments may be apportioned among the newly issued structured securities to create securities with different
investment characteristics, such as varying maturities, payment priorities and interest rate provisions, and the extent of such payments made with respect to structured securities is dependent on the extent of the cash flow on the underlying
instruments. Because structured securities typically involve no credit enhancement, their credit risk generally will be equivalent to that of the underlying instruments. Investments in structured securities are generally of a class of structured
securities that is either subordinated or unsubordinated to the right of payment of another class. Subordinated structured securities typically have higher yields and present greater risks than unsubordinated structured securities. Structured
securities are typically sold in private placement transactions, and there currently is no active trading market for structured securities. Investments in government and government-related and restructured debt instruments are subject to special
risks, including the inability or unwillingness to repay principal and interest, requests to reschedule or restructure outstanding debt and requests to extend additional loan amounts.
Warrants
. The Fund may invest in warrants, which are instruments that give the Fund the right to purchase certain securities from an issuer at a specific price (the
strike price
) for a limited period of time. The strike price of warrants typically is much lower than the current market price of the underlying securities, yet they are subject to similar price fluctuations. As a result, warrants
may be more volatile investments than the underlying securities and may offer greater potential for capital appreciation as well as capital loss. Warrants do not entitle a holder to dividends or voting rights with respect to the underlying
securities and do not represent any rights in the assets of the issuing company. Also, the value of the warrant does not necessarily change with the value of the underlying securities and a warrant ceases to have value if it is not exercised prior
to the expiration date. These factors can make warrants more speculative than other types of investments.
In addition to warrants on
securities, the Fund may purchase put warrants and call warrants whose values vary depending on the change in the value of one or more specified securities indices (
index warrants
). Index warrants are generally issued by banks or
other financial institutions and give the holder the right, at any time during the term of the warrant, to receive upon exercise of the warrant a cash payment from the issuer based on the value of the underlying index at the time of exercise. In
general, if the value of the underlying index rises above the exercise price of the index warrant, the holder of a call warrant will be entitled to receive a cash payment from the issuer upon exercise based on the difference between the value of the
index and the exercise price of the warrant; if the value of the underlying index falls, the holder of a put warrant will be entitled to receive a cash payment from the issuer upon exercise based on the difference between the exercise price of the
warrant and the value of the index. The holder of a warrant would not be entitled to any payments from the issuer at any time when, in the case of a call warrant, the exercise price is greater than the value of the underlying index, or, in the case
of a put warrant, the exercise price is less than the value of the underlying index. If the Fund were not to exercise an index warrant prior to its expiration, then the Fund would lose the amount of the purchase price paid by it for the warrant.
The Fund will normally use index warrants in a manner similar to its use of options on securities indices. The risks of the Funds use
of index warrants are generally similar to those relating to its use of index options. Unlike most index options, however, index warrants are issued in limited amounts and are not obligations of a regulated clearing agency, but are backed only by
the credit of the bank or other institution which issues the warrant. Also, index warrants generally have longer terms than index options. Index warrants are not likely to be as liquid as certain index options backed by a recognized clearing agency.
In addition, the terms of index warrants may limit the Funds ability to exercise the warrants at such time, or in such quantities, as the Fund would otherwise wish to do.
Commercial Real Estate Loans.
The Fund may acquire and originate performing commercial whole mortgage loans secured by a first mortgage lien on commercial property, which may be
structured to either permit the Fund to retain the entire loan, or sell the lower yielding senior portions of the loans and retain the higher yielding subordinate investment. Typically, borrowers of these loans are institutions and real estate
operating companies and investors. These loans are generally secured by commercial real estate assets in a variety of industries with a variety of characteristics. The Fund may originate and own entire whole loans or in some cases may choose to
originate and syndicate a portion of the risk or participate in syndications led by other institutions. In some cases, the Fund may originate and fund a first mortgage loan with the intention of selling the senior tranche, or an A-Note, and
retaining the subordinated tranche, or a B-Note, or mezzanine loan tranche. The Fund may seek, in the future, to enhance the returns of all or a senior portion of its commercial mortgage loans through securitizations, should the market to securitize
commercial mortgage loans recover. In addition to interest, the Fund may receive origination fees, extension fees, modification or similar fees in connection with our whole mortgage loans.
B-Notes.
The Fund may originate or invest in B-Notes. A B-Note is a mortgage loan typically (i) secured by a first mortgage on a single large commercial property or group of
related properties and (ii) subordinated to an A-Note secured by the same first mortgage on the same collateral. As a result, if a borrower defaults, there may not be sufficient funds remaining for B-Note holders after payment to the A-Note
holders. Since each transaction is privately negotiated, B-Notes can vary in their structural characteristics and
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risks. For example, the rights of holders of B-Notes to control the process following a borrower default may be limited in certain investments. The Fund cannot predict the terms of each B-Note
investment and does not have control over the terms of the investments held by an Investment Fund. Further, B-Notes typically are secured by a single property, and so reflect the increased risks associated with a single property compared to a pool
of properties.
Mezzanine Loans.
The Fund may also originate or invest in mezzanine loans, which are loans that are
subordinate in the capital structure of the borrower, meaning that there may be significant indebtedness ranking ahead of the borrowers obligation to the Fund in the event of the borrowers insolvency. Such loans may be collateralized
with tangible fixed assets such as real property or interests in real property, or may be uncollateralized. As with other loans to corporate borrowers, repayment of a mezzanine loan is dependent on the successful operation of the borrower. Mezzanine
loans may also be affected by the successful operation of other properties, the interests in which are not pledged to secure the mezzanine loan. While mezzanine investments may benefit from the same or similar financial and other covenants as those
enjoyed by the indebtedness ranking ahead of the mezzanine investments and may benefit from cross-default provisions and security over the borrowers assets, some or all of such terms may not apply to particular mezzanine investments. Mezzanine
investments generally are subject to various risks including, without limitation, (i) a subsequent characterization of an investment as a fraudulent conveyance; (ii) the recovery as a preference of liens perfected
or payments made on account of a debt incurred in the 90 days before a bankruptcy filing; (iii) equitable subordination claims by other creditors; (iv) so-called lender liability claims by the issuer of the obligations; and
(v) environmental liabilities that may arise with respect to collateral securing the obligations. In addition to interest, the Fund may receive origination fees, extension fees, modification or similar fees in connection with investments in
mezzanine loans.
Income Deposit Securities.
The Fund may purchase income deposit securities
(
IDSs
). Each IDS represents two separate securities, shares of common stock and subordinated notes issued by the same company, that are combined into one unit that trades like a stock on an exchange. Holders of IDSs receive
dividends on the common shares and interest at a fixed rate on the subordinated notes to produce a blended yield. An IDS is typically listed on a stock exchange, but the underlying securities typically are not listed on the exchange until a period
of time after the listing of the IDS or upon the occurrence of certain events (e.g., a change of control of the issuer of the IDS). When the underlying securities are listed, the holders of IDSs generally have the right to separate the components of
the IDSs and trade them separately.
There may be a thinner and less active market for IDSs than that available for other securities. The
value of an IDS will be affected by factors generally affecting common stock and subordinated debt securities, including the issuers actual or perceived ability to pay interest and principal on the notes and pay dividends on the stock.
The U.S. federal income tax treatment of IDSs is not entirely clear and there is no authority that directly addresses the tax treatment of
securities with terms substantially similar to IDSs. Among other things, although it is expected that the subordinated notes portion of an IDS will be treated as debt, if it is characterized as equity rather than debt, then interest paid on the
notes could be treated as dividends (to the extent paid out of the issuers earnings and profits). Such dividends would not likely qualify for favorable long-term capital gains rates currently available to dividends on other types of equity.
Indexed Securities.
The Fund may purchase securities whose prices are indexed to the prices of other securities,
securities indices, currencies, precious metals or other commodities, or other financial indicators. Indexed securities typically, but not always, are debt securities or deposits whose value at maturity or coupon rate is determined by reference to a
specific instrument or statistic. Gold-indexed securities, for example, typically provide for a maturity value that depends on the price of gold, resulting in a security whose price tends to rise and fall together with gold prices. Currency-indexed
securities typically are short-term to intermediate-term debt securities whose maturity values or interest rates are determined by reference to the values of one or more specified foreign currencies, and may offer higher yields than U.S.
dollar-denominated securities of equivalent issuers. Currency-indexed securities may be positively or negatively indexed; that is, their maturity value may increase when the specified currency value increases, resulting in a security whose price
characteristics are similar to a put option on the underlying currency. Currency-indexed securities also may have prices that depend on the values of a number of different foreign currencies relative to each other.
The performance of indexed securities depends to a great extent on the performance of the security, currency, commodity or other instrument to which they
are indexed, and also may be influenced by interest rate changes in the United States and abroad. At the same time, indexed securities are subject to the credit risks associated with the issuer of the security, and their values may decline
substantially if the issuers creditworthiness deteriorates. Recent issuers of indexed securities have included banks, corporations, and certain U.S. Government agencies.
Master Limited Partnerships.
The Fund may invest in master limited partnerships (
MLPs
), which are limited partnerships in which ownership units are publicly
traded. MLPs often own or own interests in properties or businesses that are related to oil and gas industries, including pipelines, although MLPs may invest in other types of investments, including credit-related investments. Generally, an MLP is
operated under the supervision of one or more managing general partners. Limited partners (like the Fund when it invests in an MLP) are not involved in the day-to-day management of the partnership. The Fund also may invest in companies who serve (or
whose affiliates serve) as the general partner of an MLP.
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Investments in MLPs are generally subject to many of the risks that apply to partnerships. For example,
holders of the units of MLPs may have limited control and limited voting rights on matters affecting the partnership. There may be fewer corporate protections afforded investors in an MLP than investors in a corporation. Conflicts of interest may
exist among unit holders, subordinated unit holders and the general partner of an MLP, including those arising from incentive distribution payments. MLPs that concentrate in a particular industry or region are subject to risks associated with such
industry or region. MLPs holding credit-related investments are subject to interest rate risk and the risk of default on payment obligations by debt issuers. Investments held by MLPs may be illiquid. MLP units may trade infrequently and in limited
volume, and they may be subject to more abrupt or erratic price movements than securities of larger or more broadly based companies.
The Fund
may also hold investments in limited liability companies that have many of the same characteristics and are subject to many of the same risks as master limited partnerships.
The manner and extent of the Funds investments in MLPs and limited liability companies may be limited by its intention to qualify as a RIC under the Code, and any such investments by the Fund may
adversely affect the ability of the Fund to so qualify.
Zero-Coupon and Payment-in-Kind Bonds.
The Fund may invest
without limit in so-called zero-coupon bonds and payment-in-kind bonds. Zero-coupon bonds are issued at a significant discount from their principal amount in lieu of paying interest periodically. Payment-in-kind bonds allow the issuer, at its
option, to make current interest payments on the bonds either in cash or in additional bonds. Because zero-coupon and payment-in-kind bonds do not pay current interest in cash, their value is subject to greater fluctuation in response to changes in
market interest rates than bonds that pay interest currently. Both zero-coupon and payment-in-kind bonds allow an issuer to avoid the need to generate cash to meet current interest payments. Accordingly, such bonds may involve greater credit risks
than bonds paying interest currently in cash. The Fund is required to accrue interest income on such investments and to distribute such amounts at least annually to shareholders even though the investments do not make any current interest payments.
Thus, it may be necessary at times for the Fund to liquidate other investments in order to satisfy its distribution requirements under the Code.
Perpetual Bonds.
Perpetual bonds offer a fixed return with no maturity date. Because they never mature, perpetual bonds can be more volatile than other types of bonds that have a
maturity date and may have heightened sensitivity to changes in interest rates. An issuer of perpetual bonds is responsible for coupon payments in perpetuity but does not have to redeem the securities. Perpetual bonds are often callable after a set
period of time, typically between 5 and 10 years.
RISK CONSIDERATIONS
The following risk considerations relate to investment practices undertaken by the Fund. Generally, since shares of the Fund represent an investment
in securities with fluctuating market prices, shareholders should understand that the value of Fund shares will vary as the value of the Funds portfolio securities increases or decreases. Therefore, the value of an investment in the Fund could
go down as well as up. You can lose money by investing in the Fund. There is no guarantee of successful performance, that the Funds objective can be achieved or that an investment in the Fund will achieve a positive return. An investment in
the Fund should be considered as a means of diversifying an investment portfolio and is not in itself a balanced investment program.
Prospective investors should consider the following risks. Please see the Funds Prospectus for more information on the principal risks and
investment strategies associated with the Fund.
General
Various market risks can affect the price or liquidity of an issuers securities. Adverse events occurring with respect to an issuers performance or financial position can depress the value of
the issuers securities. The liquidity in a market for a particular security will affect its value and may be affected by factors relating to the issuer, as well as the depth of the market for that security. Other market risks that can affect
value include a markets current attitudes about type of security, market reactions to political or economic events, and tax and regulatory effects (including lack of adequate regulations for a market or particular type of instrument). Market
restrictions on trading volume can also affect price and liquidity.
Certain risks exist because of the composition and investment horizon of
a particular portfolio of securities. Prices of many securities tend to be more volatile in the short-term and lack of diversification in a portfolio can also increase volatility.
-39-
Equity Issuer Risk
The market prices of common stocks and other equity securities may go up or down, sometimes rapidly or unpredictably. The values of equity securities may decline due to general market conditions that are
not especially related to a particular company, such as real or perceived adverse economic conditions, changes in the general outlook for corporate earnings, changes in interest or currency rates, or adverse investor sentiment generally. They also
may decline due to factors which affect a particular industry or industries, such as labor shortages or increased production costs and competitive conditions within an industry. In addition, the values of equity securities may decline for a number
of reasons that may directly relate to the issuer, such as management performance, financial leverage, non-compliance with regulatory requirements, and reduced demand for the issuers goods or services. Equity securities generally have greater
price volatility than bonds and other debt securities. The values of equity securities paying dividends at high rates may be more sensitive to change in interest rates than are other equity securities. The Fund may continue to accept new
subscriptions and to make additional investment in equity securities even under general market conditions that the Funds portfolio managers view as unfavorable for equity securities.
Debt Securities Risks
Debt securities are subject to various risks. Debt securities are
subject to, among others, two primary (but not exclusive) types of risk: credit risk and interest rate risk. These risks can affect a securitys price volatility to varying degrees, depending upon the nature of the instrument. In addition, the
depth and liquidity of the market for an individual or class of fixed income security can also affect its price and, hence, the market value of the Fund.
Credit risk:
refers to the risk that an issuer or counterparty will fail to pay its obligations to the Fund when they are due. Financial strength and solvency of an issuer are the
primary factors influencing credit risk. Changes in the financial condition of an issuer or counterparty, changes in specific economic, social or political conditions that affect a particular type of security or issuer, and changes in economic,
social or political conditions generally can increase the risk of default by an issuer or counterparty, which can affect a securitys or instruments credit quality or value and an issuers or counterpartys ability to pay
interest and principal when due. The values of lower-quality debt securities, including floating rate loans, tend to be particularly sensitive to these changes. The values of securities also may decline for a number of other reasons that relate
directly to the issuer, such as management performance, financial leverage and reduced demand for the issuers goods and services, as well as the historical and prospective earnings of the issuer and the value of its assets. In addition, lack
of or inadequacy of collateral or credit enhancements for a fixed income security may affect its credit risk. Credit risk of a security may change over its life and securities which are rated by rating agencies are often reviewed and may be subject
to downgrade, which may have an indirect impact on the market price of securities. Ratings are only opinions of the agencies issuing them as to the likelihood of repayment. They are not guarantees as to quality and they do not reflect market risk.
If an issuer or counterparty fails to pay interest, the Funds income might be reduced and the value of the investment might fall, and if an issuer or counterparty fails to pay principal, the value of the investment might fall and the Fund
could lose the amount of its investment.
Extension risk:
refers to the risk that if interest rates rise, repayments
of principal on certain debt securities, including, but not limited to, floating rate loans and mortgage-related securities, may occur at a slower rate than expected and the expected maturity of those securities could lengthen as a result.
Securities that are subject to extension risk generally have a greater potential for loss when prevailing interest rates rise, which could cause their values to fall sharply. Interest-only and principal-only securities are especially sensitive to
interest rate changes, which can affect not only their prices but can also change the income flows and repayment assumptions about those investments.
Interest rate risk:
refers to the risks associated with market changes in interest rates. Interest rate changes may affect the value of a fixed income security directly
(especially in the case of fixed rate securities) and indirectly (especially in the case of adjustable rate securities). In general, rises in interest rates will negatively impact the price of fixed rate securities and falling interest rates will
have a positive effect on price. The degree to which a securitys price will change as a result of changes in interest rates is measured by its duration. For example, the price of a bond fund with an average duration of three years would be
generally expected to fall approximately 3% if interest rates rose by one percentage point. Generally, securities with longer maturities have a greater duration and thus are subject to greater price volatility from changes in interest rates.
Adjustable rate instruments also react to interest rate changes in a similar manner although generally to a lesser degree (depending, however, on the characteristics of the re-set terms, including the index chosen, frequency of reset and reset caps
or floors, among other things).
Index Risk
There can be no assurance the Fund will achieve its investment objective. The Funds return may not match or exceed the return of the Shiller Barclays CAPE
®
US Sector USD Index (the
Index
) and it may deviate significantly from the return of the Index
for a number of reasons, including, for example, (i) the performance of derivatives in which the Fund invests and whose returns are based
-40-
on the performance of the Index may not correlate with the performance of the Index; (ii) certain indexed securities may create leverage to the extent that they increase or decrease in value
at a rate that is a multiple of the changes in the Index, which could result in increased risks associated with leverage; (iii) the Fund may not be able to find counterparties willing to enter into derivative instruments whose returns are based
on the return of the Index or find parties who are willing to do so at an acceptable cost or level of risk to the Fund; (iv) the Funds overall performance may be adversely affected by the performance of the Funds investments in debt
instruments; and (v) to the extent the Fund calculates its net asset value based on fair value prices and the value of the Index is not based on fair value prices. In addition, the Fund incurs a number of operating expenses not applicable to
the Index, including those it incurs in connection with its use of derivatives, when buying securities to invest cash received from subscriptions, and selling securities to raise cash to meet redemptions. Those costs may be significant and may cause
the Funds performance to deviate significantly from the Indexs performance.
It is anticipated that the Adviser will license the
exclusive right to use the Index as part of the principal investment strategies of one or more registered investment companies, including the Fund. Because the Index is not widely used and information regarding its component securities may not
generally be known to industry participants, it may be more difficult for the Fund to find willing counterparties to engage in total return swaps or other derivative instruments based on the return of that index. Barclays Bank PLC, the provider of
the Index, may provide model portfolios of securities in the Index to the Funds swap counterparties to facilitate the counterparties ability to provide excess return swaps whose returns are based on the Index. Because the Index is a
proprietary index, there may be a limited number of counterparties willing or able to serve as counterparties to a swap agreement, especially if Barclays Bank PLC fails to provide the model portfolios referred to above. If such swap agreements are
not available for any reason, the Fund may have to invest in other derivative instruments, baskets of stocks, or individual securities in an attempt to replicate the performance of the Index, whose performance may be significantly less
correlated to the performance of the Index and which would inhibit the Funds ability to invest in debt instruments. The Fund expects to remain invested in derivatives related to the Index or component stocks of the Index even when the Index is
declining or when the Adviser believes the values of its component securities may be overvalued.
While index sponsors generally provide
descriptions of what an index is designed to achieve, index providers do not generally provide any warranty or accept any liability in relation to the quality, accuracy or completeness of data in respect of their indexes, and do not guarantee that
the published indexes will be in line with their described index methodologies. Neither Barclays Bank PLC nor the Adviser provides any similar warranty, guarantee or acceptance of liability for the Index or the data used. Errors in respect of the
quality, accuracy and completeness of the data may occur from time to time and may not be identified and corrected for a period of time. This risk may be particularly prevalent where an index is less commonly used, as is the case with the Index. For
example, during a period where the Index contains incorrect constituents, the Fund would have market exposure to such constituents and would be underexposed to such Indexs other constituents. As such, errors may potentially result in a
negative or positive performance impact to the Fund and the shareholders. Further, apart from scheduled rebalances, index providers may carry out additional ad hoc rebalances to their underlying indexes in order, for example, to correct an error in
the selection of index constituents. Where the Index is rebalanced and the Fund in turn rebalances its portfolio to bring it in line with such Index, any transaction costs and market exposure arising from such portfolio rebalancing will be borne by
the Fund and, by extension, its shareholders. Therefore, errors and additional ad hoc rebalances carried out by Barclays Bank PLC to the Index may increase the costs and market exposure risk of the Fund. There can be no assurance that Barclays Bank
PLC will continue to maintain and calculate the Index indefinitely.
As noted above, in certain cases, the value of derivatives may not
correlate perfectly, or at all, with the value of the assets, reference rates or indexes they are designed to closely track. In this regard, the Fund seeks to achieve its investment objective, in part, by investing in derivatives positions that are
designed to closely track the performance of the Index on a daily basis. However, the overall investment strategy of the Fund is not necessarily designed or expected to produce returns which replicate the performance of the Index, and the degree of
variation could be substantial, particularly over longer periods. There are a number of factors which may prevent a mutual fund, or derivatives or other strategies used by a fund, from achieving a desired correlation with an index. These may
include, but are not limited to (i) the impact of fund fee, expenses and transaction costs, including borrowing and brokerage costs/bid-ask spreads, which are not reflected in index returns; (ii) differences in the timing of daily
calculations of the value of an index and the timing of the valuation of derivatives, securities and other assets held by a fund and the determination of the net asset value of fund shares; (iii) disruptions or illiquidity in the markets for
derivative instruments or securities in which a fund invests; (iv) a fund having exposure to or holding less than all of the securities in the underlying index and/or having exposure to or holding securities not included in the underlying
index; (v) large or unexpected movements of assets into and out of a fund (due to share purchases or redemptions, for example), potentially resulting in the fund being over- or under-exposed to the index; (vi) the impact of accounting
standards or changes thereto; (vii) changes to the applicable index that are not disseminated in advance; (viii) a possible need to conform a funds portfolio holdings to comply with investment restrictions or policies or regulatory
or tax law requirements; and (ix) fluctuations in currency exchange rates.
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Lower Rated Securities
The Fund may invest in fixed income instruments that are at the time of investment unrated or rated BB+ or lower by S&P or Ba1 or lower by Moodys or the equivalent by any other nationally
recognized statistical rating organization. Fixed income instruments rated below investment grade, or unrated securities that are determined by the Adviser to be of comparable quality, are high yield, high risk bonds, commonly known as junk bonds.
High yield securities or junk bonds can be classified into two categories: (a) securities issued without an investment grade rating and
(b) securities whose credit ratings have been downgraded below investment grade because of declining investment fundamentals. The first category includes securities issued by emerging credit companies and companies which have experienced a
leveraged buyout or recapitalization. Although the small and medium size companies that constitute emerging credit issuers typically have significant operating histories, these companies generally do not have strong enough operating results to
secure investment grade ratings from the rating agencies. In addition, in recent years there has been a substantial volume of high yield securities issued by companies that have converted from public to private ownership through leveraged buyout
transactions and by companies that have restructured their balance sheets through leveraged recapitalizations. High yield securities issued in these situations are used primarily to pay existing stockholders for their shares or to finance special
dividend distributions to shareholders. The indebtedness incurred in connection with these transactions is often substantial and, as a result, often produces highly leveraged capital structures which present special risks for the holders of such
securities. Also, the market price of such securities may be more volatile to the extent that expected benefits from the restructuring do not materialize. The second category of high yield securities consists of securities of former investment grade
companies that have experienced poor operating performance due to such factors as cyclical downtrends in their industry, poor management or increased foreign competition.
Generally, lower-rated debt securities provide a higher yield than higher rated debt securities of similar maturity but are subject to greater risk of loss of principal and interest than higher rated
securities of similar maturity. They are generally considered to be subject to greater risk than securities with higher ratings particularly in the event of a deterioration of general economic conditions. The lower ratings of the high yield
securities which the Fund will purchase reflect a greater possibility that the financial condition of the issuers, or adverse changes in general economic conditions, or both, may impair the ability of the issuers to make payments of principal and
interest. The market value of a single lower-rated debt security may fluctuate more than the market value of higher rated securities, since changes in the creditworthiness of lower rated issuers and in market perceptions of the issuers
creditworthiness tend to occur more frequently and in a more pronounced manner than in the case of higher rated issuers. High yield debt securities also tend to reflect individual corporate developments to a greater extent than higher rated
securities. The securities in which the Fund invests are frequently subordinated to senior indebtedness.
The economy and interest rates
affect high yield securities differently from other securities. The prices of high yield bonds have been found to be less sensitive to interest rate changes than higher-rated investments, but more sensitive to adverse economic changes or individual
corporate developments. During an economic downturn or substantial period of rising interest rates, highly leveraged issuers may experience financial stress which would adversely affect their ability to service their principal and interest payment
obligations, to meet projected business goals, and to obtain additional financing. If the issuer of a bond owned by the Fund defaults, the Fund may incur additional expenses to seek recovery. In addition, periods of economic uncertainty and changes
can be expected to result in increased volatility of market prices of high yield bonds and the Funds asset value. Furthermore, the market prices of high yield bonds structured as zero coupon or pay-in-kind securities are affected to a greater
extent by interest rate changes and thereby tend to be more volatile than securities which pay interest periodically and in cash.
To the
extent there is a limited retail secondary market for particular high yield bonds, these bonds may be thinly-traded and the Advisers ability to accurately value high yield bonds and the Funds assets may be more difficult because there is
less reliable, objective data available. In addition, the Funds ability to acquire or dispose of the bonds may be negatively-impacted. Adverse publicity and investor perceptions, whether or not based on fundamental analysis, may decrease the
values and liquidity of high yield bonds, especially in a thinly-traded market. To the extent the Fund owns or may acquire illiquid or restricted high yield bonds, these securities may involve special registration responsibilities, liabilities and
costs, and liquidity and valuation difficulties.
Special tax considerations are associated with investing in lower rated debt securities
structured as zero coupon or pay-in-kind securities. The Fund accrues income on these securities prior to the receipt of cash payments. The Fund must distribute substantially all of its income to its shareholders to qualify for pass-through
treatment under the tax laws and may, therefore, have to dispose of its portfolio securities to satisfy distribution requirements.
Underwriting and dealer spreads associated with the purchase of lower rated bonds are typically higher than those associated with the purchase of high
grade bonds.
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Loan Risk
Investments in loans are generally subject to the same risks as investments in other types of debt securities, including, among others, credit risk, interest rate risk, prepayment risk, and extension
risk. In addition, in many cases loans are subject to the risks associated with below-investment grade securities. This means loans are often subject to significant credit risks, including a greater possibility that the borrower will be adversely
affected by changes in market or economic conditions and may default or enter bankruptcy. This risk of default will increase in the event of an economic downturn or a substantial increase in interest rates (which will increase the cost of the
borrowers debt service).
The interest rates on floating rate loans typically adjust only periodically. Accordingly, adjustments in the
interest rate payable under a loan may trail prevailing interest rates significantly, especially if there are limitations placed on the amount the interest rate on a loan may adjust in a given period. Certain floating rate loans have a feature that
prevents their interest rates from adjusting below a specified minimum level. When short-term interest rates are low, this feature could result in the interest rates of those loans becoming fixed at the applicable minimum level until short-term
interest rates rise above that level. Although this feature is intended to result in these loans yielding more than they otherwise would when short-term interest rates are low, the feature might also result in the prices of these loans becoming more
sensitive to changes in interest rates should short-term interest rates rise but remain below the applicable minimum level.
In addition,
investments in loans may be difficult to value and may be illiquid. Floating rate loans generally are subject to legal or contractual restrictions on resale. The liquidity of floating rate loans, including the volume and frequency of secondary
market trading in such loans, varies significantly over time and among individual floating rate loans. For example, if the credit quality of the borrower related to a floating rate loan unexpectedly declines significantly, secondary market trading
in that floating rate loan can also decline. The secondary market for loans may be subject to irregular trading activity, wide bid/ask spreads, and extended trade settlement periods, which may increase the expenses of the Fund or cause the Fund to
be unable to realize the full value of its investment in the loan, resulting in a material decline in the Funds net asset value.
Opportunities to invest in loans or certain types of loans, such as Senior Loans, may be limited. Alternative investments may provide lower yields and
may, in the Advisers view, offer less attractive investment characteristics. The limited availability of loans may be due to a number of reasons, including that direct lenders may allocate only a small number of loans to new investors,
including the Fund. There may also be fewer loans made or available that the Adviser finds attractive investment opportunities, particularly during economic downturns. Also, lenders or agents may have an incentive to market only the least desirable
loans to investors such as the Fund. If the market demand for loans increases, the availably of loans for purchase and the interest paid by borrowers may decrease.
Additional risks of investments in loans may include:
Agent/Intermediary
Risk.
If the Fund holds a loan through another financial institution, or relies on another financial institution to administer the loan, the Funds receipt of principal and interest on the loan is subject to the credit risk
of the financial institution. If the Fund holds its interest in a loan through another financial institution, the Fund likely would not be able to exercise its rights directly against the borrower and may not be able to cause the financial
institution to take what it considers to be appropriate action. If the Fund relies on a financial institution to administer a loan, the Fund is subject to the risk that the financial institution may be unwilling or unable to demand and receive
payments from the borrower in respect of the loan, or otherwise unwilling or unable to perform its administrative obligations.
Collateral Impairment Risk.
The terms of certain loans in which the Fund may invest require that collateral be
maintained to support payment of the borrowers obligations under the loan. However, the value of the collateral may decline after the Fund invests, and the value of the collateral may not be sufficient to cover the amount owed to the Fund. In
addition, the Funds interest in collateral securing a loan may be found invalid or may be used to pay other outstanding obligations of the borrower under applicable law. In the event that a borrower defaults, the Funds access to the
collateral may be limited by bankruptcy and other insolvency laws. There is also the risk that the collateral may be difficult to liquidate, or that all or some of the collateral may be illiquid. The Fund may have to participate in legal proceedings
or take possession of and manage assets that secure the issuers obligations. This could increase the Funds operating expenses and decrease its net asset value.
Equity Securities and Warrants.
The acquisition of equity securities may generally be incidental to the Funds purchase of a loan. The Fund may acquire equity securities as
part of an instrument combining a loan and equity securities of a borrower or its affiliates. The Fund also may acquire equity securities issued in exchange for a loan or in connection with the default and/or restructuring of a loan, including
subordinated and unsecured loans, and high-yield securities. Equity securities include common stocks, preferred stocks and securities convertible into common stock. Equity securities are subject to market risks and the risks of changes to the
financial condition of the issuer, and fluctuations in value.
Highly Leveraged Transactions.
The Fund
may invest in loans made in connection with highly leveraged transactions. These transactions may include operating loans, leveraged buyout loans, leveraged capitalization loans and other types of acquisition financing. Those loans are subject to
greater credit and liquidity risks than other types of loans. If the Fund voluntarily or involuntarily sold those types of loans, it might not receive the full value it expected.
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Stressed, Distressed or Defaulted Borrowers
.
The Fund can
also invest in loans of borrowers that are experiencing, or are likely to experience, financial difficulty. These loans are subject to greater credit and liquidity risks than other types of loans. In addition, the Fund can invest in loans of
borrowers that have filed for bankruptcy protection or that have had involuntary bankruptcy petitions filed against them by creditors. Various laws enacted for the protection of debtors may apply to loans. A bankruptcy proceeding or other court
proceeding could delay or limit the ability of the Fund to collect the principal and interest payments on that borrowers loans or adversely affect the Funds rights in collateral relating to a loan. If a lawsuit is brought by creditors of
a borrower under a loan, a court or a trustee in bankruptcy could take certain actions that would be adverse to the Fund. For example:
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Other creditors might convince the court to set aside a loan or the collateralization of the loan as a fraudulent conveyance or
preferential transfer. In that event, the court could recover from the Fund the interest and principal payments that the borrower made before becoming insolvent. There can be no assurance that the Fund would be able to prevent that
recapture.
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A bankruptcy court may restructure the payment obligations under the loan so as to reduce the amount to which the Fund would be entitled.
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The court might discharge the amount of the loan that exceeds the value of the collateral.
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The court could subordinate the Funds rights to the rights of other creditors of the borrower under applicable law, decreasing, potentially
significantly, the likelihood of any recovery on the Funds investment.
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Limited Information
Risk.
Because there is limited public information available regarding loan investments, the Fund is particularly dependent on the analytical abilities of the Funds portfolio managers.
Interest Rate Benchmarks.
Interest rates on loans typically adjust periodically often based on a benchmark rate
plus a premium or spread over the benchmark rate. The benchmark rate usually is the Prime Rate, LIBOR, the Federal Reserve federal funds rate, or other base lending rates used by commercial lenders (each as defined in the applicable loan agreement).
The interest rate on Prime Rate-based loans floats daily as the Prime Rate changes, while the interest rate on LIBOR based
loans is reset periodically, typically between 30 days and one year. Certain floating or variable rate loans may permit the borrower to select an interest rate reset period of up to one year or longer. Investing in loans with longer interest rate
reset periods or fixed interest rates may increase fluctuations in the Funds net asset value as a result of changes in interest rates.
Certain loans may permit the borrower to change the base lending rate during the term of the loan. In recent years, the differential between the lower LIBOR base rates and the higher Prime Rate base rates
prevailing in the commercial bank markets has widened to the point that the payments paid by borrowers with LIBOR based interest rates do not currently compensate for the differential between the Prime Rate and the LIBOR base rates. Consequently,
borrowers have increasingly selected the LIBOR-based pricing option, resulting in a yield on loans that is consistently lower than the yield available from the Prime Rate-based pricing option. If this trend continues, it may significantly limit the
ability of the Fund to achieve a net return to shareholders that approximates the average published Prime Rate of leading U.S. banks. The Adviser cannot predict whether this trend will continue.
Restrictive Loan Covenants.
Borrowers must comply with various restrictive covenants typically contained in loan
agreements. They may include restrictions on dividend payments and other distributions to stockholders, provisions requiring the borrower to maintain specific financial ratios, and limits on total debt. They may include requirements that the
borrower prepay the loan with any free cash flow. A break of a covenant that is not waived by the agent bank (or the lenders) is normally an event of default that provides the agent bank or the lenders the right to call the outstanding amount on the
loan. If a lender accelerates the repayment of a loan because of the borrowers violation of a restrictive covenant under the loan agreement, the borrower might default in payment of the loan.
Senior Loan and Subordination Risk.
In addition to the risks typically associated with debt securities and loans
generally, Senior Loans are also subject to the risk that a court could subordinate a Senior Loan, which typically holds a senior position in the capital structure of a borrower, to presently existing or future indebtedness or take other action
detrimental to the holders of Senior Loans.
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The Funds investments in Senior Loans may be collateralized with one or more of
(1) working capital assets, such as accounts receivable and inventory, (2) tangible fixed assets, such as real property, buildings and equipment, (3) intangible assets such as trademarks or patents, or (4) security interests in
shares of stock of the borrower or its subsidiaries or affiliates. In the case of loans to a non-public company, the companys shareholders or owners may provide collateral in the form of secured guarantees and/or security interests in assets
they own. However, the value of the collateral may decline after the Fund buys the Senior Loan, particularly if the collateral consists of equity securities of the borrower or its affiliates. If a borrower defaults, insolvency laws may limit the
Funds access to the collateral, or the lenders may be unable to liquidate the collateral. A bankruptcy court might find that the collateral securing the Senior Loan is invalid or require the borrower to use the collateral to pay other
outstanding obligations. If the collateral consists of stock of the borrower or its subsidiaries, the stock may lose all of its value in the event of a bankruptcy, which would leave the Fund exposed to greater potential loss. As a result, a
collateralized Senior Loan may not be fully collateralized and can decline significantly in value.
If a borrower defaults on
a collateralized Senior Loan, the Fund may receive assets other than cash or securities in full or partial satisfaction of the borrowers obligation under the Senior Loan. Those assets may be illiquid, and the Fund might not be able to realize
the benefit of the assets for legal, practical or other reasons. The Fund might hold those assets until the adviser determined it was appropriate to dispose of them. If the collateral becomes illiquid or loses some or all of its value, the
collateral may not be sufficient to protect the Fund in the event of a default of scheduled interest or principal payments.
The Fund can invest in Senior Loans that are not secured by any specific collateral of the borrower. If the borrower is unable to pay
interest or defaults in the payment of principal, there will be no collateral on which the Fund can foreclose. Therefore, these loans typically present greater risks than collateralized Senior Loans.
Due to restrictions on transfers in loan agreements and the nature of the private syndication of Senior Loans including, for example, the
lack of publicly-available information, some Senior Loans are not as easily purchased or sold as publicly-traded securities. Some Senior Loans and other Fund investments are illiquid, which may make it difficult for the Fund to value them or dispose
of them at an acceptable price. Direct investments in Senior Loans and investments in participation interests in or assignments of Senior Loans may be limited.
Settlement Risk.
Transactions in many loans settle on a delayed basis, and the Fund may not receive the proceeds from the sale of a loan for a substantial period after the sale.
As a result, sale proceeds related to the sale of loans will not be available to make additional investments or to meet the Funds redemption obligations until potentially a substantial period after the sale of the loans.
Reliance on the Adviser
The
Funds ability to achieve its investment objective is dependent upon the Advisers ability to identify profitable investment opportunities for the Fund. While the portfolio managers of the Fund may have considerable experience in managing
other portfolios with investment objectives, policies and strategies that are similar, the past experience of the portfolio managers does not guarantee future results for the Fund.
Options Transactions
The effective use of options depends on the Funds ability to
terminate option positions at times when the Adviser deems it desirable to do so. Prior to exercise or expiration, an option position can only be terminated by entering into a closing purchase or sale transaction. If a covered call option writer is
unable to effect a closing purchase transaction or to purchase an offsetting OTC Option, it cannot sell the underlying security until the option expires or the option is exercised. Accordingly, a covered call option writer may not be able to sell an
underlying security at a time when it might otherwise be advantageous to do so. A covered put option writer who is unable to effect a closing purchase transaction or to purchase an offsetting OTC Option would continue to bear the risk of decline in
the market price of the underlying security until the option expires or is exercised.
In addition, a covered put or call writer would be
unable to utilize the amount held in cash, U.S. Government Securities, or other liquid securities as security for the option for other investment purposes until the exercise or expiration of the option.
The Funds ability to close out its position as a writer of an option is dependent upon the existence of a liquid secondary market. There is no
assurance that such a market will exist, particularly in the case of OTC Options, as such options will generally only be closed out by entering into a closing purchase transaction with the purchasing dealer. However, the Fund may be able to purchase
an offsetting option which does not close out its position as a writer but constitutes an asset of equal value to the obligation under the option
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written. If the Fund is not able to either enter into a closing purchase transaction or purchase an offsetting position, it will be required to maintain the securities subject to the call, or the
collateral underlying the put, even though it might not be advantageous to do so, until a closing transaction can be entered into (or the option is exercised or expires).
There can be no assurance that a liquid market will exist when the Fund seeks to close out an option position. Reasons for the absence of a liquid secondary market on an exchange include the following:
(i) there may be insufficient trading interest in certain options; (ii) restrictions may be imposed by an exchange on opening transactions or closing transactions or both; (iii) trading halts, suspensions or other restrictions may be
imposed with respect to particular classes or series of options; (iv) unusual or unforeseen circumstances may interrupt normal operations on an exchange; (v) the facilities of an exchange clearinghouse may not at all times be adequate to
handle current trading volume; or (vi) one or more exchanges could, for economic or other reasons, decide or be compelled at some future date to discontinue the trading of options (or a particular class or series of options). If trading were
discontinued, the secondary market on that exchange (or in that class or series of options) would cease to exist.
In addition, the hours of
trading for options may not conform to the hours during which securities held by the Fund are traded. To the extent that the options markets close before the markets for underlying securities, significant price and rate movements can take place in
the underlying markets that cannot be reflected in the options markets. In addition, the Funds listed options transactions will be subject to limitations established by each of the exchanges, boards of trade or other trading facilities on
which the options are traded. These limitations govern the maximum number of options in each class which may be written or purchased by a single investor or group of investors acting in concert, regardless of whether the options are written or
purchased on the same or different exchanges, boards of trade or other trading facilities or are held or written in one or more accounts or through one or more brokers. Thus, the number of options which the Fund may write (sell) or purchase may be
affected by options written or purchased by other investment advisory clients of the Adviser. An exchange, board of trade or other trading facility may order the liquidation of positions found to be in excess of these limits, and it may impose other
sanctions or restrictions. These position limits may restrict the number of listed options which the Fund may write.
In the event of the
bankruptcy of a broker through which the Fund engages in transactions in options, the Fund could experience delays and/or losses in liquidating open positions purchased or sold through the broker and/or incur a loss of all or part of its margin
deposits with the broker. Similarly, in the event of the bankruptcy of the writer of an OTC Option purchased by the Fund, the Fund could experience a loss of all or part of the value of the option.
The writer of an option has no control over the time when it may be required to fulfill its obligation as a writer of an option. Once an option writer
has received an exercise notice, it cannot effect a closing purchase transaction in order to terminate its obligation under the option and must deliver the underlying security or the contract value of the relevant index at the exercise price. If a
put or call option purchased by the Fund is not sold when it has remaining value, and if the market price of the underlying security or the value of the index remains equal to or greater than the exercise price (in the case of a put), or remains
less than or equal to the exercise price (in the case of a call), the Fund will lose its entire investment in the option. Also, where a put or call option on a particular security or index is purchased to hedge against price movements in a related
security or securities, the price of the put or call option may move more or less than the price of the related security or securities.
To
the extent that the Fund utilizes unlisted (or over-the-counter) options, the Funds ability to terminate these options may be more limited than with exchange-traded options and may involve enhanced risk that counterparties
participating in such transactions will not fulfill their obligations.
Each of the exchanges has established limitations governing the
maximum number of options on the same underlying security or futures contract (whether or not covered) which may be written by a single investor, whether acting alone or in concert with others (regardless of whether such options are written on the
same or different exchanges or are held or written on one or more accounts or through one or more brokers). An exchange may order the liquidation of positions found to be in violation of these limits and it may impose other sanctions or
restrictions. These position limits may restrict the number of listed options which the Fund may write.
Futures Contracts and Options on
Futures
There are certain risks inherent in the use of futures contracts and options on futures contracts. Successful use of futures
contracts by the Fund is subject to the ability of the Adviser to correctly predict movements in the direction of interest rates or changes in market conditions. In addition, there can be no assurance that there will be a correlation between price
movements in the underlying securities, currencies or index and the price movements in the securities which are the subject of the hedge.
Positions in futures contracts and options on futures contracts may be closed out only on the exchange or board of trade on which they were entered into,
and there can be no assurance that an active market will exist for a particular contract or option at any particular time. If the Fund has hedged against the possibility of an increase in interest rates or a decrease in the value of portfolio
securities and
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interest rates fall or the value of portfolio securities increase instead, the Fund will lose part or all of the benefit of the increased value of securities that it has hedged because it will
have offsetting losses in its futures positions. In addition, in such situations, if the Fund has insufficient cash, it may have to sell securities to meet daily variation margin requirements at a time when it may be disadvantageous to do so. These
sales of securities may, but will not necessarily be at increased prices that reflect the decline in interest rates. While utilization of futures contracts and options on futures contracts may be advantageous to the Fund, if the Fund is not
successful in employing such instruments in managing the Funds investments, the Funds performance will be worse than if the Fund did not make such investments.
Exchanges limit the amount by which the price of a futures contract may move on any day. If the price moves equal the daily limit on successive days, then it may prove impossible to liquidate a futures
position until the daily limit moves have ceased. In the event of adverse price movements, the Fund would continue to be required to make daily cash payments of variation margin on open futures positions. In such situations, if the Fund has
insufficient cash, it may have to sell portfolio securities to meet daily variation margin requirements at a time when it may be disadvantageous to do so. In addition, the Fund may be required to take or make delivery of the instruments underlying
interest rate futures contracts it holds at a time when it is disadvantageous to do so. The inability to close out options and futures positions could also have an adverse impact on the Funds ability to effectively hedge its portfolio.
Futures contracts and options thereon which are purchased or sold on foreign commodities exchanges may have greater price volatility than
their U.S. counterparts. Furthermore, foreign commodities exchanges may be less regulated and under less governmental scrutiny than U.S. exchanges. Brokerage commissions and dealer mark-ups, clearing costs and other transaction costs may be higher
on foreign exchanges. Greater margin requirements may limit the Funds ability to enter into certain commodity transactions on foreign exchanges. Moreover, differences in clearance and delivery requirements on foreign exchanges may occasion
delays in the settlement of the Funds transactions effected on foreign exchanges.
In the event of the bankruptcy of a broker through
which the Fund engages in transactions in futures or options thereon, the Fund could experience delays and/or losses in liquidating open positions purchased or sold through the broker and/or incur a loss of all or part of its margin deposits with
the broker. Similarly, in the event of the bankruptcy, of the writer of an OTC option purchased by the Fund, the Fund could experience a loss of all or part of the value of the option. Transactions are entered into by the Fund only with brokers or
financial institutions deemed creditworthy by the Adviser.
There is no assurance that a liquid secondary market will exist for futures
contracts and related options in which the Fund may invest. In the event a liquid market does not exist, it may not be possible to close out a futures position, and in the event of adverse price movements, the Fund would continue to be required to
make daily cash payments of variation margin. In addition, limitations imposed by an exchange or board of trade on which futures contracts are traded may compel or prevent the Fund from closing out a contract which may result in reduced gain or
increased loss to the Fund. The absence of a liquid market in futures contracts might cause the Fund to make or take delivery of the underlying securities (currencies) at a time when it may be disadvantageous to do so.
Compared to the purchase or sale of futures contracts, the purchase of call or put options on futures contracts involves less potential risk to the Fund
because the maximum amount at risk is the premium paid for the options (plus transaction costs). However, there may be circumstances when the purchase of a call or put option on a futures contract would result in a loss to the Fund notwithstanding
that the purchase or sale of a futures contract would not result in a loss, as in the instance where there is no movement in the prices of the futures contract or underlying securities (currencies).
Options on foreign currency futures contracts may involve certain additional risks. Trading options on foreign currency futures contracts is relatively
new. The ability to establish and close out positions on such options is subject to the maintenance of a liquid secondary market. To reduce this risk, the Fund will not purchase or write options on foreign currency futures contracts unless and
until, in the Advisers opinion, the market for such options has developed sufficiently that the risks in connection with such options are not greater than the risks in connection with transactions in the underlying foreign currency futures
contracts.
Risk of Potential Government Regulation of Derivatives
Recent legislative and regulatory reforms, including the Dodd-Frank Wall Street Reform and Consumer Protection Act (the
Dodd-Frank Act
), are expected to result in new regulation of swap
agreements, including clearing, margin, reporting, recordkeeping and registration requirements for certain types of swaps contracts and other derivatives, including among others interest rate swaps and credit default swaps. Because the legislation
leaves much to rule making, which is not yet completed, its ultimate impact remains unclear. New regulations could, among other things, restrict the Funds ability to engage in swap transactions (for example, by making certain types of swap
transactions no longer available to the Fund) and/or increase the costs of such swap transactions (for example, by increasing margin or capital requirements), and the Fund may as a result be unable to execute its investment strategies in a manner
the Funds Adviser might otherwise choose. New rules under the Dodd-Frank Act will require certain over-the-counter derivatives, including certain interest rate swaps and certain credit default swaps, to be executed on a regulated market and
cleared through a central counterparty, which may result in increased margin requirements and costs for the Fund. It is also unclear how the regulatory changes will affect counterparty risk.
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Risks Related to the Funds Clearing Broker and Central Clearing Counterparty
The Fund will be required to deposit margin and other assets with its swaps and futures clearing brokers. There is a risk that assets deposited by the
Fund with any swaps or futures clearing broker as margin for futures contracts or cleared swaps may, in certain circumstances, be used to satisfy losses of other clients of the Funds clearing broker. In addition, the assets of the Fund might
not be fully protected in the event of the clearing brokers bankruptcy, as the Fund would be limited to recovering only a pro rata share of all available funds segregated on behalf of the clearing brokers customers for the relevant
account class. Similarly, all customer funds held at a clearing organization in connection with any futures contracts are held in a commingled omnibus account and are not identified to the name of the clearing members individual customers. All
customer funds held at a clearing organization with respect to cleared swaps of customers of a clearing broker are also held in an omnibus account, but CFTC rules require that the clearing broker notify the clearing organization of the amount of the
initial margin provided by the clearing broker to the clearing organization that is attributable to each customer. With respect to futures and options contracts, a clearing organization may use assets of a non-defaulting customer held in an omnibus
account at the clearing organization to satisfy payment obligations of a defaulting customer of the clearing member to the clearing organization. With respect to cleared swaps, a clearing organization generally cannot do so, but may do so if the
clearing member does not provide accurate reporting to the clearing organization as to the attribution of margin among its clients. Also, since clearing brokers generally provide to clearing organizations the net amount of variation margin required
for cleared swaps for all of its customers in the aggregate, rather than the gross amount of each customer, the Fund is subject to the risk that a clearing organization will not make variation margin payments owed to the Fund if another customer of
the clearing member has suffered a loss and is in default. As a result, in the event of a default or the clearing brokers other clients or the clearing brokers failure to extend its own funds in connection with any such default, the Fund
may not be able to recover the full amount of assets deposited by the clearing broker on behalf of the Fund with the clearing organization.
Repurchase Agreements
In the event of
a default or bankruptcy by a selling financial institution under a repurchase agreement, the Fund will seek to sell the underlying security serving as collateral. However, this could involve certain costs or delays, and, to the extent that proceeds
from any sale were less than the repurchase price, the Fund could suffer a loss. The Fund follows procedures designed to minimize the risks associated with repurchase agreements, including effecting repurchase transactions only with large,
well-capitalized and well-established financial institutions and specifying the required value of the collateral underlying the agreement.
Reverse Repurchase Agreements
A
reverse repurchase agreement involves the sale of a portfolio-eligible security by the Fund, coupled with its agreement to repurchase the instrument at a specified time and price. Under a reverse repurchase agreement, the Fund continues to be
entitled to receive any principal and interest payments on the underlying security during the term of the agreement. Reverse repurchase agreements involve leverage risk
;
the Fund may lose money as a result of declines in the values both of
the security subject to the reverse repurchase agreement and the instruments in which the Fund invested the proceeds of the reverse repurchase agreement. Reverse repurchase agreements are considered borrowings by the Fund. Under the requirements of
the 1940 Act, the Fund is required to maintain an asset coverage (including the proceeds of the borrowings) of a least 300% of all borrowings or otherwise segregate sufficient cash or other liquid assets to cover the repurchase obligation.
Preferred Securities Risk
In addition to many of the risks associated with both fixed income securities (
e.g.
, interest rate risk and credit risk) and common shares or
other equity securities (see Investment PracticesEquity Securities above), preferred securities are also subject to deferral risk. Preferred securities typically contain provisions that allow an issuer, at its discretion, to defer
distributions for an extended period. Preferred securities may also contain provisions that allow an issuer, under certain conditions, to skip (in the case of noncumulative preferred securities) or defer (in the case of cumulative preferred
securities), dividend payments. If the Fund owns a preferred security that is deferring its distributions, the Fund may be required to report income for tax purposes while it is not receiving any distributions. Preferred stock in some instances is
convertible into common shares or other securities.
Preferred securities typically contain provisions that allow for redemption in the event
of tax or security law changes in addition to call features at the option of the issuer. In the event of a redemption, the Fund may not be able to reinvest the proceeds at comparable or favorable rates of return.
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Preferred securities typically do not provide any voting rights, except in cases in which dividends are in
arrears beyond a certain time period, which varies by issue. Preferred securities are generally subordinated to bonds and other debt instruments in a companys capital structure in terms of priority to corporate income and liquidation payments,
and therefore will be subject to greater credit risk than those debt instruments. Preferred securities may be substantially less liquid than many other securities.
Restricted Securities
The Fund may invest in securities which are subject to restrictions
on resale because they have not been registered under the Securities Act or which are otherwise not readily marketable. These securities are generally referred to as private placements or restricted securities. The Adviser, pursuant to procedures
adopted by the Board of Trustees, will make a determination as to the liquidity of each restricted security purchased by the Fund. If a restricted security is determined to be liquid, it will not be included within the category illiquid securities,
which under the Funds current policies may not exceed 15% of the Funds net assets.
Securities eligible for resale pursuant to
Rule 144A under the Securities Act, and determined to be liquid pursuant to the procedures discussed in the following paragraph, are not subject to the foregoing restriction. Limitations on the resale of restricted securities may have an adverse
effect on their marketability, and may prevent the Fund from disposing of them promptly at reasonable prices. The Fund may have to bear the expense of registering such securities for resale and the risk of substantial delays in effecting such
registration.
Rule 144A permits the Fund to sell restricted securities to qualified institutional buyers without limitation. The Adviser,
pursuant to procedures adopted by the Board of Trustees, will make a determination as to the liquidity of each restricted security purchased by the Fund. If a restricted security is determined to be liquid, the security will not be included within
the category illiquid securities. However, investing in Rule 144A securities could have the effect of increasing the level of the Funds illiquidity to the extent the Fund, at a particular point in time, may be unable to find qualified
institutional buyers interested in purchasing such securities.
Ratings Categories Use of Credit Ratings by the Fund
A description of the rating categories as published by Moodys and S&P is set forth in the Appendix to this Statement of Additional Information.
(Other NRSROs use different categorizations, which may also be utilized by the Adviser.) Ratings assigned by Moodys and/or S&P to securities acquired by the Fund reflect only the views of those agencies as to the quality of the securities
they have undertaken to rate. It should be emphasized, however, that ratings are relative and subjective and are not absolute standards of quality. There is no assurance that a rating assigned initially will not change.
When an investment is rated by more than one NRSRO, the Adviser will utilize the highest rating for that security for purposes of applying any investment
policies that incorporate credit ratings (
e.g.
, a policy to invest a certain percentage of the Funds assets in securities rated investment grade) except where the Fund has a policy to invest a certain percentage of its assets in
securities that are rated below investment grade, in which case the Fund will utilize the lowest rating that applies to that investment.
Risks of Unrated Securities
The Fund
may purchase unrated securities (which are not rated by a rating agency) if the Adviser determines that the security is of comparable quality to a rated security that the Fund may purchase. Unrated securities may be less liquid than comparable rated
securities and involve the risk that the Adviser may not accurately evaluate the securitys comparative credit rating. Analysis of creditworthiness of issuers of high yield securities may be more complex than for issuers of higher-quality fixed
income securities. To the extent that the Fund invests in high yield and/or unrated securities, the Funds success in achieving its investment objective may depend more heavily on the Advisers creditworthiness analysis than if the Fund
invested exclusively in higher-quality and rated securities.
Securities Lending
The Fund may lend portfolio securities with a value up to 33
1
/3% of its total assets, including collateral received for securities lent. If the Fund lends securities, there is
a risk that the securities will not be available to the Fund on a timely basis, and the Fund, therefore, may lose the opportunity to sell the securities at a desirable price. In addition, as with other extensions of credit, there is the risk of
possible delay in receiving additional collateral or in the recovery of the securities or possible loss of rights in the collateral should the borrower fail financially. Also, there is the risk that the value of the investment of the collateral
could decline causing the Fund to lose money.
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Service Providers
The Fund may be subject to credit risk with respect to the custodian. In the event of the custodians bankruptcy, even if the Funds custodian does have sufficient assets to meet all claims,
there could be a delay before the Fund receives assets to satisfy their claims. In addition, in the event of the bankruptcy of the Funds administrator, transfer agent or custodian there are likely to be operational and other delays and
additional costs and expenses associated with changes in service provider arrangements.
Large Shareholder Redemptions
Certain account holders may from time to time own (beneficially or of record) or control a significant percentage of the Funds shares. Redemptions
by these account holders of their shares in the Fund may impact the Funds liquidity and net asset value. These redemptions may also force the Fund to sell securities at a time when the Adviser would otherwise not choose to sell, which may
negatively impact the Funds performance, as well as increase the Funds trading costs and its taxable distributions to shareholders.
Mortgage-Backed Securities Risks
Credit and Market Risks of Mortgage-Backed Securities.
Investments by the Fund in fixed rate and floating rate mortgage-backed
securities will entail normal credit risks (i.e., the risk of non-payment of interest and principal) and market risks (i.e., the risk that interest rates and other factors will cause the value of the instrument to decline). Many issuers or servicers
of mortgage-backed securities guarantee timely payment of interest and principal on the securities, whether or not payments are made when due on the underlying mortgages. This kind of guarantee generally increases the quality of a security, but does
not mean that the securitys market value and yield will not change. Like other bond investments, the value of fixed rate mortgage-backed securities will tend to rise when interest rates fall, and fall when rates rise. Floating rate
mortgage-backed securities will generally tend to have minimal changes in price when interest rates rise or fall. The value of all mortgage-backed securities may also change because of changes in the markets perception of the creditworthiness
of the organization that issued or guarantees them. In addition, the mortgage-backed securities market in general may be adversely affected by changes in governmental legislation or regulation. Fluctuations in the market value of mortgage-backed
securities after their acquisition usually do not affect cash income from such securities but are reflected in the Funds net asset value. The liquidity of mortgage-backed securities varies by type of security; at certain times the Fund may
encounter difficulty in disposing of investments. Other factors that could affect the value of a mortgage-backed security include, among other things, the types and amounts of insurance which a mortgagor carries, the amount of time the mortgage loan
has been outstanding, the loan-to-value ratio of each mortgage and the amount of overcollateralization of a mortgage pool.
Ongoing
developments in the residential mortgage market may have additional consequences to mortgage-backed securities. Delinquencies and losses generally have been increasing with respect to securitizations involving residential mortgage loans and may
continue to increase as a result of the weakening housing market and the seasoning of securitized pools of mortgage loans.
Additionally,
mortgage lenders recently have adjusted their loan programs and underwriting standards, which has reduced the availability of mortgage credit to prospective mortgagors. This has resulted in reduced availability of financing alternatives for
mortgagors seeking to refinance their mortgage loans. The reduced availability of refinancing options for mortgagors has resulted in higher rates of delinquencies, defaults and losses on mortgage loans, particularly in the case of, but not limited
to, mortgagors with adjustable rate mortgage loans or interest-only mortgage loans that experience significant increases in their monthly payments following the adjustment date or the end of the interest-only period (see Adjustable Rate
Mortgages below for further discussion of adjustable rate mortgage risks). These events, alone or in combination with each other and with deteriorating economic conditions in the general economy, may continue to contribute to higher
delinquency and default rates on mortgage loans. The tighter underwriting guidelines for residential mortgage loans, together with lower levels of home sales and reduced refinance activity, also may have contributed to a reduction in the prepayment
rate for mortgage loans generally and this may continue.
Alternative A mortgage loans may experience greater rates of delinquency and
foreclosure due to underwriting standards. These mortgage loans may not meet the sponsors general underwriting policies for prime mortgage loans due to borrower credit characteristics. In addition, the underwriting program may permit less
restrictive underwriting criteria as compared to general underwriting criteria, including additional types of mortgaged properties, categories of borrowers and/or reduced documentation requirements, such as no verification of income or no
verification of assets. As a consequence, delinquencies, foreclosures and cumulative losses may be expected to be greater with respect to these mortgage loans than with respect to mortgage loans originated in conformity with the general underwriting
standards.
The conservatorship of Fannie Mae and Freddie Mac in September 2008 may adversely affect the real estate market and the value of
real estate assets generally. It is unclear at this time to what extent these conservatorships will curtail the ability of Fannie Mae and Freddie Mac to continue to act as the primary sources of liquidity in the residential mortgage markets, both by
purchasing mortgage loans for portfolio and by guaranteeing mortgage-backed securities. A reduction in the ability of mortgage loan originators to access Fannie Mae and Freddie Mac to sell their mortgage loans may adversely affect the financial
condition of mortgage loan originators.
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Liquidity Risk of Mortgage-Backed Securities.
The liquidity of mortgage-backed
securities varies by type of security; at certain times the Fund may encounter difficulty in disposing of such investments. Because mortgage-backed securities may be less liquid than other securities, the Fund may be more susceptible to liquidity
risks than funds that invest in other securities. In the past, in stressed markets, certain types of mortgage-backed securities suffered periods of illiquidity if disfavored by the market.
Commercial Mortgage-Backed Securities (CMBS)
. CMBSs include securities that reflect an interest in, and are secured by, mortgage loans on commercial real property.
Many of the risks of investing in commercial mortgage-backed securities reflect the risks of investing in the real estate securing the underlying mortgage loans. These risks reflect the effects of local and other economic conditions on real estate
markets, the ability of tenants to make loan payments and the ability of a property to attract and retain tenants. Commercial mortgage-backed securities may be less liquid and exhibit greater price volatility than other types of mortgage- or
asset-backed securities.
Prepayment, Extension, and Redemption Risks of Mortgage-Backed Securities.
Mortgage-backed
securities reflect an interest in monthly payments made by the borrowers who receive the underlying mortgage loans. Although the underlying mortgage loans are for specified periods of time, such as 20 or 30 years, the borrowers can, and typically
do, pay them off sooner. In such an event, the mortgage-backed security which represents an interest in such underlying mortgage loan will be prepaid. A borrower is more likely to prepay a mortgage which bears a relatively high rate of interest.
This means that in times of declining interest rates, a portion of the Funds higher yielding securities are likely to be redeemed and the Fund will probably be unable to replace them with securities having as great a yield. Prepayments can
result in lower yields to shareholders. The increased likelihood of prepayments when interest rates decline also limits market price appreciation. Mortgage-backed securities are also subject to extension risk. Extension risk is the possibility that
rising interest rates may cause prepayments to occur at a slower than expected rate. This particular risk may effectively change a security which was considered short or intermediate term into a long-term security. Long-term securities generally
fluctuate more widely in response to changes in interest rates than short or intermediate-term securities. In addition, a mortgage-backed security may be subject to redemption at the option of the issuer. If a mortgage-backed security held by the
Fund is called for redemption, the Fund will be required to permit the issuer to redeem the security, which could have an adverse effect on the Funds ability to achieve its investment objective.
Collateralized Mortgage Obligations.
There are certain risks associated specifically with CMOs. CMOs issued by private entities
are not obligations issued or guaranteed by the United States Government, its agencies or instrumentalities and are not guaranteed by any government agency, although the securities underlying a CMO may be subject to a guarantee. Therefore, if the
collateral securing the CMO, as well as any third party credit support or guarantees, is insufficient to make payment, the holder could sustain a loss. In addition, the average life of CMOs is determined using mathematical models that incorporate
prepayment assumptions and other factors that involve estimates of future economic and market conditions. These estimates may vary from actual future results, particularly during periods of extreme market volatility. Further, under certain market
conditions, such as those that occurred in 1994 and 2008, the average weighted life of certain CMOs may not accurately reflect the price volatility of such securities. For example, in periods of supply and demands imbalances in the market for such
securities and/or in periods of sharp interest rate movements, the prices of CMOs may fluctuate to a greater extent than would be expected from interest rate movements alone.
Adjustable Rate Mortgages.
ARMs contain maximum and minimum rates beyond which the mortgage interest rate may not vary over the lifetime of the security. In addition, certain ARMs
provide for additional limitations on the minimum amount by which the mortgage interest rate may adjust for any single adjustment period. Alternatively, certain ARMs contain limitations on changes in the required monthly payment. In the event that a
monthly payment is not sufficient to pay the interest accruing on an ARM, any such excess interest is added to the principal balance of the mortgage loan, which is repaid through future monthly payments. If the monthly payment for such an instrument
exceeds the sum of the interest accrued at the applicable mortgage interest rate and the principal payment required at such point to amortize the outstanding principal balance over the remaining term of the loan, the excess is utilized to reduce the
then outstanding principal balance of the ARM.
In addition, certain ARMs may provide for an initial fixed, below-market or teaser interest
rate. During this initial fixed-rate period, the payment due from the related mortgagor may be less than that of a traditional loan. However, after the teaser rate expires, the monthly payment required to be made by the mortgagor may increase
dramatically when the interest rate on the mortgage loan adjusts. This increased burden on the mortgagor may increase the risk of delinquency or default on the mortgage loan and in turn, losses on the mortgage-backed securities.
Stripped Mortgage Securities.
Part of the investment strategy of the Fund may involve the purchase of interest-only or
principal-only Stripped Mortgage Securities. The yield to maturity on a PO or an IO class security is extremely sensitive to the rate of principal payments (including prepayments) on the related underlying mortgage assets. A slower than expected
rate of principal payments may have an adverse effect on a PO class securitys yield to maturity. If the underlying mortgage assets experience slower than anticipated principal repayment, the Fund may fail to fully recoup its initial investment
in these securities. Conversely, a rapid rate of principal
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payments may have a material adverse effect on an IO class securitys yield to maturity. If the underlying mortgage assets experience greater than anticipated prepayments or principal, the
Fund may fail to fully recoup its initial investment in these securities. These investments are highly sensitive to changes in interest and prepayment rates and tend to be less liquid than other CMOs.
Inverse Floaters.
Investments in inverse floaters and similar instruments expose the Fund to the same risks as investments in
debt securities and derivatives, as well as other risks, including those associated with leverage and increased volatility. An investment in these securities typically will involve greater risk than an investment in a fixed rate security.
Distributions on inverse floaters and similar instruments will typically bear an inverse relationship to short term interest rates and typically will be reduced or, potentially, eliminated as interest rates rise. Inverse floaters may be considered
to be leveraged, including if their interest rates vary by a magnitude that exceeds the magnitude of the change in a reference rate of interest (typically a short term interest rate), and the market price of inverse floaters may as a result be
highly sensitive to changes in interest rates and in prepayment rates on the underlying securities, and may decrease significantly when interest rates increase or prepayment rates change. Investments in inverse floaters and similar instruments that
have mortgage-backed securities underlying them will expose the Fund to the risks associated with those mortgage-backed securities and the values of those investments may be especially sensitive to changes in prepayment rates on the underlying
mortgage-backed securities.
Collateralized Debt Obligations
. The Fund may invest in CDOs, which include CBOs, CLOs
and other similarly structured securities. CBOs and CLOs are types of asset-backed securities. A CBO is a trust which is backed by a diversified pool of high risk, below investment grade fixed income securities. A CLO is a trust typically
collateralized by a pool of loans, which may include, among others, domestic and foreign senior secured loans, senior unsecured loans and subordinate corporate loans, including loans that may be rated below investment grade or equivalent unrated
loans. CDOs may charge management fees and administrative expenses. For both CBOs and CLOs, the cash flows from the trust are split into two or more portions, called tranches, varying in risk and yield. The riskiest portion is the equity tranche
which bears the bulk of defaults from the bonds or loans in the trust and serves to protect the other, more senior tranches from default in all but the most severe circumstances. Since it is partially protected from defaults, a senior tranche from a
CBO trust or CLO trust typically has higher ratings and lower yields than the underlying securities, and can be rated investment grade. Despite the protection from the equity tranche, CBO or CLO tranches can experience substantial losses due to
actual defaults, increased sensitivity to defaults due to collateral default and disappearance of protecting tranches, market anticipation of defaults and aversion to CBO or CLO securities as a class. The risks of an investment in a CDO depend
largely on the type of the collateral securities and the class of the CDO in which the Fund invests. Normally, CBOs, CLOs and other CDOs are privately offered and sold, and thus are not registered under the securities laws. As a result, investments
in CDOs may be characterized by the Fund as illiquid securities; however, an active dealer market may exist for CDOs allowing a CDO to qualify under Rule 144A under the Securities Act. In addition to the normal risks associated with debt instruments
(e.g., interest rate risk and credit risk), CDOs carry additional risks including, but not limited to: (i) the possibility that distributions from collateral securities will not be adequate to make interest or other payments; (ii) the
quality of the collateral may decline in value or default; (iii) the Fund may invest in CDOs that are subordinate to other classes; and (iv) the complex structure of the security may not be fully understood at the time of investment and
may produce disputes with the issuer or unexpected investment results.
Mortgage Dollar Rolls.
Mortgage dollar rolls
involve the risk that the market value of the securities the Fund is obligated to repurchase under an agreement may decline below the price of the security the Fund sold for immediate settlement. Mortgage dollar rolls are speculative techniques
involving leverage, and are considered borrowings by the Fund. Under the requirements of the 1940 Act, the Fund is required to maintain an asset coverage (including the proceeds of the borrowings) of a least 300% of all borrowings.
Affiliated Fund Risk
Investing in
other investment companies or private investment vehicles sponsored or managed by the Adviser or affiliates of the Adviser, including other series of the Trust and DoubleLine Equity Funds (each, a
DoubleLine Fund
and,
collectively, the
DoubleLine Funds
), involves potential conflicts of interest. For example, the Adviser or its affiliates may receive fees based on the amount of assets invested in those vehicles, which fees may be higher than the
fees the Adviser receives for managing the Fund. Investment by the Fund in those other vehicles may be beneficial in the management of those other vehicles, by helping to achieve economies of scale or enhancing cash flows. Due to its own financial
interest or other business considerations, the Adviser may choose to invest a portion of the Funds assets in investment companies sponsored or managed by the Adviser or its affiliates in lieu of investments by the Fund directly in portfolio
securities, or may choose to invest in such investment companies over investment companies sponsored or managed by others. Similarly, the Adviser may delay or decide against the sale of interests held by the Fund in investment companies sponsored or
managed by the Adviser or its affiliates. To reduce this potential conflict of interest, the Adviser has agreed to reduce its advisory fee to the extent of advisory fees paid to the Adviser by other investment vehicles sponsored by the Adviser in
respect of assets of the Fund invested in those other vehicles.
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Asset-Backed Securities
Certain asset-backed securities do not have the benefit of the same security interest in the related collateral as do mortgage-backed securities. Credit card receivables are generally unsecured, and the
debtors are entitled to the protection of a number of state and federal consumer credit laws, many of which give such debtors the right to set off certain amounts owned on the credit cards, thereby reducing the balance due. In addition, some issuers
of automobile receivables permit the servicers to retain possession of the underlying obligations. If the servicer were to sell these obligations to another party, there is a risk that the purchaser would acquire an interest superior to that of the
holders of the related automobile receivables.
Foreign Securities
Investment in foreign securities involves special risks in addition to the usual risks inherent in domestic investments. These include: political or economic instability; the unpredictability of
international trade patterns; the possibility of foreign governmental actions such as expropriation, nationalization or confiscatory taxation; the imposition or modification of foreign currency or foreign investment controls; the imposition of
withholding taxes on dividends, interest and gains; price volatility; and fluctuations in currency exchange rates. As compared to United States companies, foreign issuers generally disclose less financial and other information publicly and are
subject to less stringent and less uniform accounting, auditing and financial reporting standards. Foreign countries typically impose less thorough regulations on brokers, dealers, stock exchanges, insiders and listed companies than does the United
States, and foreign securities markets may be less liquid and more volatile than domestic markets. Investment in foreign securities involves higher costs than investment in U.S. securities, including higher transaction and custody costs as well as
the imposition of additional taxes by foreign governments. In addition, security trading practices abroad may offer less protection to investors such as the Fund. Settlement of transactions in some foreign markets may be delayed or may be less
frequent than in the U.S., which could affect the liquidity of the Funds portfolio. Also, it may be more difficult to obtain and enforce legal judgments against foreign corporate issuers than against domestic issuers and it may be impossible
to obtain and enforce judgments against foreign governmental issues.
Foreign Currency
Because foreign securities generally are denominated and pay dividends or interest in foreign currencies, the value of the net assets of those Funds as
measured in United States dollars will be affected favorably or unfavorably by changes in exchange rates. Currency exchange transactions may be conducted on a spot (i.e., cash) basis at the spot rate prevailing in the currency exchange market. The
cost of currency exchange transactions will generally be the difference between the bid and offer spot rate of the currency being purchased or sold. In order to protect against uncertainty in the level of future foreign currency exchange rates, the
Fund is authorized to enter into certain foreign currency future and forward and options contracts. However, it is not obligated to do so and, depending on the availability and cost of these devices, the Fund may be unable to use them to protect
against currency risk. While foreign currency future, forward and options contracts may be available, the cost of these instruments may be prohibitively expensive so that the Fund may not to be able to effectively use them.
Emerging Market Countries
Investing in
securities of emerging market countries through investment in the Fund involves certain risks, and considerations, including those set forth below, which are not typically associated with investing in the United States or other developed countries.
Political and economic structures in many emerging markets countries may be undergoing significant evolution and rapid development, and such
countries may lack the social, political and economic stability characteristics of more developed countries. Some of these countries may have in the past failed to recognize private property rights and have at times nationalized or expropriated the
assets of private companies.
The securities markets of emerging market countries are substantially smaller, less developed, less liquid and
more volatile than the major securities markets in the United States and other developed nations. The limited size of many emerging securities markets and limited trading volume in issuers compared to volume of trading in U.S. securities or
securities of issuers in other developed countries could cause prices to be erratic for reasons apart from factors that affect the quality of the securities. For example, limited market size may cause prices to be unduly influenced by traders who
control large positions. Adverse publicity and investors perceptions, whether or not based on fundamental analysis, may decrease the value and liquidity of portfolio securities, especially in these markets.
In addition, emerging market countries exchanges and broker-dealers are generally subject to less government and exchange regulation than
their counterparts in developed countries. Brokerage commissions, dealer concessions, custodial expenses and other transaction costs may be higher in emerging markets than in developed countries. As a result, Funds investing in emerging market
countries have operating expenses that are expected to be higher than other funds investing in more established market regions.
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Many of the emerging market countries may be subject to greater degree of economic, political and social
instability than is the case in the United States, Canada, Australia, New Zealand, Japan and Western European and certain Asian countries.
Such instability may result from, among other things, (i) popular unrest associated with demands for improved political, economic and social
conditions, and (ii) internal insurgencies. Such social, political and economic instability could disrupt the financial markets in which the Fund invests and adversely affect the value of the Funds assets.
In certain emerging market countries governments participate to a significant degree, through ownership or regulation, in their respective economies.
Action by these governments could have a significant adverse effect on market prices of securities and payment of dividends. In addition, most emerging market countries have experienced substantial, and in some periods extremely high, rates of
inflation. Inflation and rapid fluctuation in inflation rates have had and may continue to have very negative effects on the economies and securities markets of certain emerging market countries.
Many of the currencies of emerging market countries have experienced devaluations relative to the U.S. dollar, and major devaluations have historically
occurred in certain countries. Any devaluations in the currencies in which portfolio securities are denominated will have a detrimental impact on the Fund to the extent it invests in emerging market countries. Many emerging market countries are
experiencing currency exchange problems. Countries have and may in the future impose foreign currency controls and repatriation control.
Defaulted Securities
The Fund may
invest in securities in default. Defaulted securities risk refers to the uncertainty of repayment of defaulted securities and obligations of distressed issuers. Repayment of defaulted securities and obligations of distressed issuers (including
insolvent issuers or issuers in payment or covenant default, in workout or restructuring or in bankruptcy or in solvency proceedings) is subject to significant uncertainties. Insolvency laws and practices in emerging market countries are different
than those in the U.S. and the effect of these laws and practices cannot be predicted with certainty. Investments in defaulted securities and obligations of distressed issuers are considered speculative.
Counterparty Risk
The Fund will be
subject to the credit risk presented by another party (whether a clearing corporation in the case of exchange-traded instruments or another third party in the case of over-the-counter instruments) to the extent it engages in transactions, such as
securities loans, repurchase agreements or certain derivatives (including swaps), which involve a promise by the counterparty to honor an obligation to the Fund. That Funds ability to realize a profit from such transactions will depend on the
ability of the counterparty (the obligor) with which it enters into the transaction to meet its obligations to the Fund. If a counterparty becomes bankrupt or insolvent or otherwise fails to perform its obligations to the Fund due to financial
difficulties, the Fund may experience significant losses or delays in obtaining any recovery (including recovery of any collateral it has provided to the counterparty), including in a dissolution, assignment for the benefit of creditors,
liquidation, winding-up, bankruptcy, or other analogous proceeding. If a counterpartys creditworthiness declines, the value of the agreement would be likely to decline, potentially resulting in losses.
In addition, in the event of the bankruptcy or insolvency of a counterparty to a derivative transaction, the derivative transaction would typically be
terminated at its fair market value. If the Fund is owed this fair market value in the termination of the derivative transaction and its claim is unsecured, the Fund will be treated as a general creditor of such counterparty, and will not have any
claim with respect to any underlying security or asset. The Fund may obtain only a limited recovery or may obtain no recovery in such circumstances. Counterparty risk with respect to certain exchange-traded and over-the-counter derivatives may be
further complicated by U.S. financial reform legislation (see Legal and Regulatory Risk).
Cyclical Opportunities Risk
The Fund may seek to take advantage of changes in the business cycle by investing in companies that are sensitive to those changes if the
Adviser believes they have growth potential. The Fund might sometimes seek to take tactical advantage of short-term market movements or events affecting particular issuers or industries. There is a risk that if the event does not occur as expected,
the value of the stock could fall, which in turn could depress the Funds share prices.
Investing in Special Situations
Periodically, the Fund might use aggressive investment techniques. These might include seeking to benefit from what the Adviser perceives
to be special situations, such as mergers, reorganizations, restructurings or other unusual events expected to affect a particular issuer. However, there is a risk that the change or event might not occur as expected by the Adviser, which could have
a negative impact on the price of the issuers securities. The Funds investment might not produce the expected gains or could incur a loss.
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Sector Risk
To the extent that the Fund has significant investments in one or a few sectors, it bears more risk than a fund that maintains broad sector diversification because, for example, a decline in values of the
securities of issuers in that sector (due to, for example, an issue affecting companies in that sector) will affect the performance of the Fund greater than a fund that invests more broadly or evenly across sectors. Specific types of sector risk
include the following:
Financial Services Risk:
The Fund may invest a significant portion of its assets in the
financial services sector. Risks of investing in the financial services sector include: (i) Regulatory actions: financial services companies may suffer setbacks if regulators change the rules under which such companies operate;
(ii) Changes in interest rates: unstable and/or rising interest rates may have a disproportionate effect on companies in the financial services sector; (iii) Non-diversified loan portfolios: financial services companies, whose securities
the Fund purchases, may themselves have concentrated portfolios, such as a high level of loans to real estate developers, which makes them vulnerable to economic conditions that affect that industry; (iv) Credit: financial services companies
may have exposure to investments or agreements which, under certain circumstances, may lead to losses, for example sub-prime loans; and (v) Competition: the financial services sector has become increasingly competitive.
Natural Resource Risk:
The Fund may invest in companies that derive their value from natural resources, and therefore may be
particularly subject to risks affecting those companies. Natural resources may include, without limitation, energy (including gas, petroleum, petrochemicals and other hydrocarbons), precious metals (including gold), base and industrial metals,
timber and forest products, agriculture and commodities.
Natural resource prices can swing sharply in response to cyclical economic
conditions, political events or the monetary policies of various countries. In addition, political and economic conditions in a limited number of natural-resource-producing countries may have a direct effect on the commercialization of natural
resources, and consequently, on their prices. For example, the vast majority of gold producers are domiciled in just five countries: South Africa, the United States, Australia, Canada and Russia.
Technology Risk
: Equities Technology Fund may invest in companies which utilize innovative technologies and therefore may be
subject to risks affecting those companies. Technology company stocks can be subject to abrupt or erratic price movements and have been volatile, especially over the short term, due to the rapid pace of product change and development affecting such
companies. Technology companies are subject to significant competitive pressures, such as new market entrants, aggressive pricing and tight profit margins. Electronic technology and technology service companies also face the risks that new services,
equipment or technologies will not be accepted by consumers and businesses or will become rapidly obsolete. These factors can affect the profitability of technology companies and, as a result, the value of their securities. In addition, many
Internet-related companies in an emerging stage of development are particularly vulnerable to the risks that their business plans will not develop as anticipated and of rapidly changing technologies.
DISTRIBUTION AND TAXES
The following discussion of U.S.
federal income tax consequences is based on the Code, existing U.S. Treasury regulations, and other applicable authority, as of the date of this Statement of Additional Information. These authorities are subject to change by legislative or
administrative action, possibly with retroactive effect. The following discussion is only a summary of some of the important U.S. federal tax considerations generally applicable to investments in the Fund. It does not address special tax rules
applicable to certain classes of investors, such as investors holding Fund shares through tax-advantaged accounts (such as 401(k) plan accounts or IRAs), tax-exempt entities, foreign investors, insurance companies, financial institutions and
investors making in-kind contributions to the Fund. You should consult your tax advisor for more information about your own tax situation, including possible other federal, state, local, and, where applicable, foreign tax consequences of investing
in the Fund.
Taxation of the Fund
The Fund has elected or intends to elect to be treated as a RIC under Subchapter M of the Code and intends each year to qualify and to be eligible to be treated as such. In order to qualify for the
special tax treatment accorded RICs and their shareholders, the Fund must, among other things: (a) derive at least 90% of its gross income for each taxable year from (i) dividends, interest, payments with respect to certain securities
loans, and gains from the sale or other disposition of stock, securities or foreign currencies, or other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to its business of investing in
such stock, securities, or currencies, and (ii) net income derived from interests in qualified publicly traded partnerships (as defined below); (b) diversify its holdings so that, at the close of each quarter of the Funds
taxable year, (i) at least 50% of the market value of the Funds total assets consists of cash, cash items, U.S. Government securities, securities of other RICs and other securities limited in respect of any one issuer to a value not
greater than 5% of the value of the Funds total assets and not more than 10% of the outstanding voting securities of such issuer, and (ii) not more than 25% of the value of the Funds total assets is invested (x) in the
securities (other than those of the U.S. Government or other RICs) of any one issuer or of two or more issuers that the Fund controls and that are engaged in the same, similar or related trades or businesses, or (y) in the securities of one or
more qualified publicly traded partnerships (as defined below); and (c) distribute with respect to each taxable year at least 90% of the sum of its investment company taxable income (as that term is defined in the Code without regard to the
deduction for dividends paid generally, taxable ordinary income and the excess, if any, of net short-term capital gains over net long-term capital losses) and net tax-exempt interest income, for such year.
In general, for purposes of the 90% gross income requirement described in (a) above, income derived from a partnership will be treated as qualifying
income only to the extent such income is attributable to items of income of the partnership that would be qualifying income if realized directly by the RIC. However, 100% of the net income derived from an interest in a qualified publicly traded
partnership (a partnership (x) the interests in which are traded on an established securities market or are readily tradable on a secondary market or the substantial equivalent thereof, and (y) that derives less than 90% of its income from
the qualifying income described in (a)(i) above) will be treated as qualifying income. In general, such entities will be treated as partnerships for federal income tax purposes because they meet the passive income requirement under Code section
7704(c)(2). In addition, although in general the passive loss rules of the Code do not apply to RICs, such rules do apply to a RIC with respect to items attributable to an interest in a qualified publicly traded partnership. MLPs, if any, in which
the Fund invests generally will qualify as qualified publicly traded partnerships.
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For purposes of the diversification test in (b) above, the term outstanding voting securities of
such issuer will include the equity securities of a qualified publicly traded partnership. Also, for purposes of the diversification test in (b) above, the identification of the issuer (or, in some cases, issuers) of a particular Fund
investment can depend on the terms and conditions of that investment. In some cases, identification of the issuer (or issuers) is uncertain under current law, and an adverse determination or future guidance by the IRS with respect to issuer
identification for a particular type of investment may adversely affect the Funds ability to meet the diversification test in (b) above.
If the Fund qualifies as a RIC that is accorded special tax treatment, the Fund will not be subject to U.S. federal income tax on income distributed in a timely manner to its shareholders in the form of
dividends (including Capital Gain Dividends, as defined below).
If the Fund were to fail to meet the income, diversification or distribution
test described above, the Fund could in some cases cure such failure, including by paying the Fund-level tax, paying interest, making additional distributions, or disposing of certain assets. If the Fund were ineligible to or otherwise did not cure
such failure for any year, or if the Fund were otherwise to fail to qualify as a RIC accorded special tax treatment for such year, the Fund would be subject to tax on its taxable income at corporate rates, and all distributions from earnings and
profits, including any distributions of net tax-exempt income and net long-term capital gains would be taxable to shareholders as ordinary income. Some portions of such distributions may be eligible for the dividends-received deduction in the case
of corporate shareholders and may be eligible to be treated as qualified dividend income in the case of shareholders taxed as individuals, provided, in both cases, the shareholder meets certain holding period and other requirements in respect of the
Funds shares (as described below). In addition, the Fund may be required to recognize unrealized gains, pay substantial taxes and interest, and make substantial distributions before re-qualifying as a RIC that is accorded special tax
treatment.
The Fund intends to distribute at least annually to its shareholders all or substantially all of its investment company taxable
income (computed without regard to the dividends-paid deduction), its net tax-exempt income (if any) and its net capital gain (that is, the excess of net long-term capital gain over net short-term capital loss, in each case determined with reference
to any loss carryforwards). Any taxable income including any net capital gain retained by the Fund will be subject to tax at the Fund level at regular corporate rates. In the case of net capital gain, the Fund is permitted to designate the retained
amount as undistributed capital gain in a timely notice to its shareholders who would then, in turn, be (i) required to include in income for U.S. federal income tax purposes, as long-term capital gain, their shares of such undistributed
amount, and (ii) entitled to credit their proportionate shares of the tax paid by the Fund on such undistributed amount against their U.S. federal income tax liabilities, if any, and to claim refunds on a properly-filed U.S. tax return to the
extent the credit exceeds such liabilities. If the Fund makes this designation, for U.S. federal income tax purposes, the tax basis of shares owned by a shareholder of the Fund would be increased by an amount equal under current law to the
difference between the amount of undistributed capital gains included in the shareholders gross income under clause (i) of the preceding sentence and the tax deemed paid by the shareholder under clause (ii) of the preceding sentence.
The Fund is not required to, and there can be no assurance the Fund will, make this designation if it retains all or a portion of its net capital gain in a taxable year.
In determining its net capital gain, including in connection with determining the amount available to support a Capital Gain Dividend (as defined below), its taxable income, and its earnings and profits,
a RIC generally may elect to treat part or all of any post-October capital loss (defined as the greatest of net capital loss, net long-term capital loss, or net short-term capital loss, in each case attributable to the portion of the taxable year
after October 31) or late-year ordinary loss (generally, (i) net ordinary loss from the sale, exchange or other taxable disposition of property, attributable to the portion of the taxable year after October 31, plus (ii) other
net ordinary loss attributable to the portion of the taxable year after December 31) as if incurred in the succeeding taxable year.
If
the Fund were to fail to distribute in a calendar year at least an amount generally equal to the sum of 98% of its ordinary income for such year and 98.2% of its capital gain net income for the one-year period ending October 31 of such year,
plus any such amounts retained from the prior year, the Fund would be subject to a nondeductible 4% excise tax on the undistributed amounts. For purposes of the required excise tax distribution, a RICs ordinary gains and losses from the sale,
exchange or other taxable disposition of property that would otherwise be taken into account after October 31 of a calendar year generally are treated as arising on January 1 of the following calendar year. Also, for these purposes, the
Fund will be treated as having distributed any amount on which it has been subject to corporate income tax for the taxable year ending within the calendar year. The Fund intends generally to make distributions sufficient to avoid imposition of the
4% excise tax, although there can be no assurance that it will be able to do so.
Capital losses in excess of capital gains (
net
capital losses
) are not permitted to be deducted against the Funds net investment income. Instead, potentially subject to certain limitations, the Fund may carry net capital losses from any taxable year forward to subsequent taxable
years to offset capital gains, if any, realized during such subsequent taxable year. If the Fund incurs net capital losses in a taxable year, those losses will be carried forward to one or more subsequent taxable years without expiration; any such
carryforward losses will retain their character as short-term or long-term.
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Fund Distributions.
For U.S. federal income tax purposes, distributions of investment income are generally taxable to shareholders as ordinary income. Taxes on distributions of capital gains are determined by how long the
Fund owned the investments that generated the gains, rather than how long a shareholder has owned his or her shares. In general, the Fund will recognize long-term capital gain or loss on investments it has owned (or is deemed to have owned) for more
than one year, and short-term capital gain or loss on investments it has owned (or is deemed to have owned) for one year or less. Distributions of net capital gain (that is, the excess of net long-term capital gain over net short-term capital loss,
in each case determined with reference to any loss carryforwards) that are properly reported by the Fund to its shareholders as capital gain dividends (
Capital Gain Dividends
) will be taxable to shareholders as long-term capital
gains includible in net capital gain and taxed to individuals at reduced rates. Distributions from capital gains are generally made after applying any available capital loss carryovers. Distributions of net short-term capital gain (as reduced by any
net long-term capital loss for the taxable year) will be taxable to shareholders as ordinary income.
Distributions of investment income
reported by the Fund to its shareholders as derived from qualified dividend income are taxed in the hands of individuals at the rates applicable to net capital gain, provided holding period and other requirements are met at both the shareholder and
Fund level. In order for some portion of the dividends received by the Fund shareholder to be qualified dividend income that is eligible for taxation at long-term capital gain rates, the Fund must meet holding period and other
requirements with respect to some portion of the dividend-paying stocks in its portfolio and the shareholder must meet holding period and other requirements with respect to the Funds shares. A dividend will not be treated as qualified dividend
income (at either the Fund or shareholder level) (1) if the dividend is received with respect to any share of stock held for fewer than 61 days during the 121-day period beginning on the date which is 60 days before the date on which such share
becomes ex-dividend with respect to such dividend (or, in the case of certain preferred stock, 91 days during the 181-day period beginning 90 days before such date), (2) to the extent that the recipient is under an obligation (whether pursuant
to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property, (3) if the recipient elects to have the dividend income treated as investment income for purposes of the limitation
on deductibility of investment interest, or (4) if the dividend is received from a foreign corporation that is (a) not eligible for the benefits of a comprehensive income tax treaty with the United States (with the exception of dividends
paid on stock of such a foreign corporation readily tradable on an established securities market in the United States) or (b) treated as a passive foreign investment company. The Fund does not expect a significant portion of Fund distributions
to be derived from qualified dividend income.
In general, distributions of investment income reported by the Fund as derived from qualified
dividend income will be treated as qualified dividend income in the hands of a shareholder taxed as an individual, provided the shareholder meets the holding period and other requirements described above with respect to the Funds shares.
If the aggregate qualified dividends received by the Fund during a taxable year are 95% or more of its gross income (excluding net long-term
capital gain over net short-term capital loss), then 100% of the Funds dividends (other than dividends properly reported as Capital Gain Dividends) will be eligible to be treated as qualified dividend income.
In general, dividends of net investment income received by corporate shareholders of the Fund will qualify for the 70% dividends-received deduction
generally available to corporations to the extent of the amount of eligible dividends received by the Fund from domestic corporations for the taxable year. A dividend received by the Fund will not be treated as a dividend eligible for the
dividends-received deduction (1) if it has been received with respect to any share of stock that the Fund has held for less than 46 days (91 days in the case of certain preferred stock) during the 91-day period beginning on the date which is 45
days before the date on which such share becomes ex-dividend with respect to such dividend (during the 181-day period beginning 90 days before such date in the case of certain preferred stock) or (2) to the extent that the Fund is under an
obligation (pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property. Moreover, the dividends received deduction may otherwise be disallowed or reduced (1) if the
corporate shareholder fails to satisfy the foregoing requirements with respect to its shares of the Fund or (2) by application of various provisions of the Code (for instance, the dividends-received deduction is reduced in the case of a
dividend received on debt-financed portfolio stock (generally, stock acquired with borrowed funds)). The Fund does not expect that a significant portion of its distributions will be eligible for the corporate dividends-received deduction.
Any distribution of income that is attributable to (i) income received by the Fund in lieu of dividends with respect to securities on
loan pursuant to a securities lending transaction or (ii) dividend income received by the Fund on securities it temporarily purchased from a counterparty pursuant to a repurchase agreement that is treated for U.S. federal income tax purposes as
a loan by the Fund, will not constitute qualified dividend income to individual shareholders and will not be eligible for the dividends-received deduction for corporate shareholders.
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If, in and with respect to any taxable year, the Fund makes a distribution to a shareholder in excess of the
Funds current and accumulated earnings and profits, the excess distribution will be treated as a return of capital to the extent of such shareholders tax basis in its shares, and thereafter as capital gain. A return of capital is not
taxable, but it reduces a shareholders tax basis in its shares, thus reducing any loss or increasing any gain on a subsequent taxable disposition by the shareholder of its shares.
Section 1411 of the Code generally imposes a 3.8% Medicare contribution tax on the net investment income of certain individuals whose income exceeds certain threshold amounts, and of certain trusts
and estates under similar rules. The details of the implementation of this tax and of the calculation of net investment income, among other issues, are currently unclear and remain subject to future guidance. For these purposes, net investment
income generally includes, among other things, (i) distributions paid by the Fund of net investment income and capital gains as described above, and (ii) any net gain from the sale, redemption or exchange of Fund shares. Shareholders
are advised to consult their tax advisors regarding the possible implications of this tax on their investment in the Fund.
As required by
federal law, detailed federal tax information with respect to each calendar year will be furnished to shareholders early in the succeeding year.
Distributions are taxable as described herein whether shareholders receive them in cash or reinvest them in additional shares.
A dividend paid to shareholders by the Fund in January generally is deemed to have been paid by the Fund on December 31 of the preceding year, if the dividend was declared and payable to shareholders
of record on a date in October, November, or December of that preceding year.
Distributions on the Funds shares are generally subject
to U.S. federal income tax as described herein to the extent they do not exceed the Funds realized income and gains, even though such distributions may economically represent a return of a particular shareholders investment. Such
distributions are likely to occur in respect of shares purchased at a time when the Funds net asset value reflects either unrealized gains, or realized but undistributed income or gains, that were therefore included in the price the
shareholder paid. Such distributions may reduce the fair market value of the Funds shares below the shareholders cost basis in those shares. As described above, the Fund is required to distribute realized income and gains regardless of
whether the Funds net asset value also reflects unrealized losses.
Tax Implications of Certain Fund Investments.
Special Rules for Debt Obligations.
Some debt obligations with a fixed maturity date of more than one year from the
date of issuance (and zero-coupon debt obligations with a fixed maturity date of more than one year from the date of issuance) will be treated as debt obligations that are issued originally at a discount. Generally, the amount of the OID is treated
as interest income and is included in the Funds income (and required to be distributed by the Fund) over the term of the debt security, even though payment of that amount is not received until a later time, upon partial or full repayment or
disposition of the debt security. In addition, payment-in-kind securities will give rise to income which is required to be distributed and is taxable even though the Fund holding the security receives no interest payment in cash on the security
during the year.
Some debt obligations with a fixed maturity date of more than one year from the date of issuance that are acquired by the
Fund in the secondary market may be treated as having market discount. Very generally, market discount is the excess of the stated redemption price of a debt obligation (or in the case of an obligation issued with OID, its revised issue price) over
the purchase price of such obligation. Generally, any gain recognized on the disposition of, and any partial payment of principal on, a debt security having market discount is treated as ordinary income to the extent the gain, or principal payment,
does not exceed the accrued market discount on such debt security. Alternatively, the Fund may elect to accrue market discount currently, in which case the Fund will be required to include the accrued market discount in the Funds income (as
ordinary income) and thus distribute it over the term of the debt security, even though payment of that amount is not received until a later time, upon partial or full repayment or disposition of the debt security. The rate at which the market
discount accrues, and thus is included in the Funds income, will depend upon which of the permitted accrual methods the Fund elects.
Some debt obligations with a fixed maturity date of one year or less from the date of issuance may be treated as having OID or, in certain cases,
acquisition discount (very generally, the excess of the stated redemption price over the purchase price). The Fund will be required to include the OID or acquisition discount in income (as ordinary income) and thus distribute it over the term of the
debt security, even though payment of that amount is not received until a later time, upon partial or full repayment or disposition of the debt security. The rate at which OID or acquisition discount accrues, and thus is included in the Funds
income, will depend upon which of the permitted accrual methods the Fund elects.
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If the Fund holds the foregoing kinds of securities, it may be required to pay out as an income distribution
each year an amount which is greater than the total amount of cash interest the Fund actually received. Such distributions may be made from the cash assets of the Fund or, if necessary, by liquidation of portfolio securities including at a time when
it may not be advantageous to do so. These dispositions may cause the Fund to realize higher amounts of short-term capital gains (generally taxed to shareholders at ordinary income tax rates) and, in the event the Fund realizes net capital gains
from such transactions, its shareholders may receive a larger Capital Gain Dividend than if the Fund had not held such securities.
A portion
of the OID accrued on certain high yield discount obligations may not be deductible to the issuer and will instead be treated as a dividend paid by the issuer for purposes of the dividends received deduction. In such cases, if the issuer of the high
yield discount obligations is a domestic corporation, dividend payments by the Fund may be eligible for the dividends received deduction to the extent attributable to the deemed dividend portion of such OID.
Securities Purchased at a Premium
. Very generally, where the Fund purchases a bond at a price that exceeds the redemption price at
maturity (
i.e.
, a premium), the premium is amortizable over the remaining term of the bond. In the case of a taxable bond, if the Fund makes an election applicable to all such bonds it purchases, which election is irrevocable without consent
of the IRS, the Fund reduces the current taxable income from the bond by the amortized premium and reduces its tax basis in the bond by the amount of such offset; upon the disposition or maturity of such bonds acquired on or after January 4,
2013, the Fund is permitted to deduct any remaining premium allocable to a prior period. In the case of a tax-exempt bond, tax rules require the Fund to reduce its tax basis by the amount of amortized premium.
At-risk or Defaulted Securities
. Investments in debt obligations that are at risk of or in default present special tax issues for the
Fund. Tax rules are not entirely clear about issues such as whether or to what extent the Fund should recognize market discount on a debt obligation, when the Fund may cease to accrue interest, OID or market discount, when and to what extent the
Fund may take deductions for bad debts or worthless securities and how the Fund should allocate payments received on obligations in default between principal and income. These and other related issues will be addressed by the Fund when, as and if it
invests in such securities, in order to seek to ensure that it distributes sufficient income to preserve its status as a RIC and does not become subject to U.S. federal income or excise tax.
Certain Investments in REITs
. Any investment by the Fund in equity securities of REITs qualifying as such under Subchapter M of the Code may result in the Funds receipt of cash in
excess of the REITs earnings; if the Fund distributes these amounts, these distributions could constitute a return of capital to Fund shareholders for U.S. federal income tax purposes. Investments in REIT equity securities also may require the
Fund to accrue and distribute income not yet received. To generate sufficient cash to make the requisite distributions, the Fund may be required to sell securities in its portfolio (including when it is not advantageous to do so) that it otherwise
would have continued to hold. Dividends received by the Fund from a REIT will not qualify for the corporate dividends-received deduction and generally will not constitute qualified dividend income.
Mortgage-Related Securities.
The Fund may invest, including through investments in REITs or other pass-through entities, in residual
interests in REMICs or equity interests in taxable mortgage pools (
TMPs
). Under a notice issued by the IRS in October 2006 and Treasury regulations that have yet to be issued but may apply retroactively, a portion of the
Funds income (including income allocated to the Fund from a REIT or other pass-through entity) that is attributable to a residual interest in a REMIC or an equity interest in a TMP (referred to in the Code as an
excess
inclusion
) will be subject to U.S. federal income tax in all events. This notice also provides, and the regulations are expected to provide, that excess inclusion income of a RIC will be allocated to shareholders of the RIC in proportion
to the dividends received by such shareholders, with the same consequences as if the shareholders held the related interest directly. As a result, the Fund investing in such interests may not be a suitable investment for certain tax-exempt
investors, as noted below.
In general, excess inclusion income allocated to shareholders (i) cannot be offset by net operating losses
(subject to a limited exception for certain thrift institutions), (ii) will constitute unrelated business taxable income (
UBTI
) to entities (including a qualified pension plan, an individual retirement account, a 401(k) plan,
a Keogh plan or other tax-exempt entity) subject to tax on UBTI, thereby potentially requiring such an entity that is allocated excess inclusion income, and otherwise might not be required to file a tax return, to file a tax return and pay tax on
such income, and (iii) in the case of a non-U.S. shareholder, will not qualify for any reduction in U.S. federal withholding tax. A shareholder will be subject to U.S. federal income tax on such inclusions notwithstanding any exemption from
such income tax otherwise available under the Code.
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Foreign Currency Transactions.
Any transaction by the Fund in foreign currencies, foreign
currency-denominated debt obligations or certain foreign currency options, futures contracts or forward contracts (or similar instruments) may give rise to ordinary income or loss to the extent such income or loss results from fluctuations in the
value of the foreign currency concerned. Any such net gains could require a larger dividend toward the end of the calendar year. Any such net losses will generally reduce and potentially require the recharacterization of prior ordinary income
distributions. Such ordinary income treatment may accelerate Fund distributions to shareholders and increase the distributions taxed to shareholders as ordinary income. Any net ordinary losses so created cannot be carried forward by the Fund to
offset income or gains earned in subsequent taxable years.
Passive Foreign Investment Companies
. Equity investments by the
Fund in certain passive foreign investment companies (
PFICs
) could potentially subject the Fund to a U.S. federal income tax (including interest charges) on distributions received from the company or on proceeds
received from the disposition of shares in the company. This tax cannot be eliminated by making distributions to Fund shareholders. However, the Fund may elect to avoid the imposition of that tax. For example, the Fund may elect to treat a PFIC as a
qualified electing fund (
i.e.
, make a
QEF election
), in which case the Fund will be required to include its share of the PFIC s income and net capital gains annually, regardless of whether it receives any distribution
from the PFIC. The Fund also may make an election to mark the gains (and to a limited extent losses) in such holdings to the market as though it had sold (and, solely for purposes of this mark-to-market election, repurchased) its holdings in those
PFICs on the last day of the Funds taxable year. Such gains and losses are treated as ordinary income and loss. The QEF and mark-to-market elections may accelerate the recognition of income (without the receipt of cash) and increase the amount
required to be distributed by the Fund to avoid taxation. Making either of these elections therefore may require the Fund to liquidate other investments (including when it is not advantageous to do so) to meet its distribution requirement, which
also may accelerate the recognition of gain and affect the Funds total return. Dividends paid by PFICs will not be eligible to be treated as qualified dividend income. If the Fund indirectly invests in PFICs by virtue of the Funds
investment in other funds, it may not make such PFIC elections; rather, the underlying funds directly investing in the PFICs would decide whether to make such elections.
Because it is not always possible to identify a foreign corporation as a PFIC, the Fund may incur the tax and interest charges described above in some instances.
Options and Futures.
In general, option premiums received by the Fund are not immediately included in the income of the Fund. Instead,
the premiums are recognized when the option contract expires, the option is exercised by the holder, or the Fund transfers or otherwise terminates the option (for example, through a closing transaction). If a call option written by the Fund is
exercised and the Fund sells or delivers the underlying stock, the Fund generally will recognize capital gain or loss equal to (a) sum of the strike price and the option premium received by the Fund minus (b) the Funds basis in the
stock. Such gain or loss generally will be short-term or long-term depending upon the holding period of the underlying stock. If securities are purchased by the Fund pursuant to the exercise of a put option written by it, the Fund generally will
subtract the premium received for purposes of computing its cost basis in the securities purchased. Gain or loss arising in respect of a termination of the Funds obligation under an option other than through the exercise of the option will be
short-term gain or loss depending on whether the premium income received by the Fund is greater or less than the amount paid by the Fund (if any) in terminating the transaction. Thus, for example, if an option written by the Fund expires
unexercised, the Fund generally will recognize short-term gain equal to the premium received.
Certain covered call writing activities of the
Fund may trigger the U.S. federal income tax straddle rules of Section 1092 of the Code, requiring that losses be deferred and holding periods be tolled on offsetting positions in options and stocks deemed to constitute substantially similar or
related property. Options on single stocks that are not deep in the money may constitute qualified covered calls, which generally are not subject to the straddle rules; the holding period on stock underlying qualified covered calls that are in the
money although not deep in the money will be suspended during the period that such calls are outstanding. Thus, the straddle rules and the rules governing qualified covered calls could cause gains that would otherwise constitute long-term capital
gains to be treated as short-term capital gains, and distributions that would otherwise constitute qualified dividend income or qualify for the dividends-received deduction to fail to satisfy the holding period requirements and therefore to be taxed
as ordinary income or to fail to qualify for the 70% dividends-received deduction, as the case may be.
The tax treatment of certain contracts
(including regulated futures contracts) entered into by the Fund as well as listed non-equity options written or purchased by the Fund on U.S. exchanges (including options on futures contracts, equity indices and debt securities) will be governed by
section 1256 of the Code (
section 1256 contracts
). Gains or losses on section 1256 contracts generally are considered 60% long-term and 40% short-term capital gains or losses (
60/40
), although certain foreign
currency gains and losses from such contracts may be treated as ordinary in character. Also, section 1256 contracts held by the Fund at the end of each taxable year (and, for purposes of the 4% excise tax, on certain other dates as prescribed under
the Code) are marked to market with the result that unrealized gains or losses are treated as though they were realized and the resulting gain or loss is treated as ordinary or 60/40 gain or loss, as applicable.
Other Derivatives, Hedging, and Related Transactions.
In addition to the special rules described above in respect of futures and
options transactions, the Funds transactions in other derivative instruments (for example, forward contracts and swap agreements), as well as any of its other hedging, short sale or similar transactions, may be subject to one or more special
tax rules (for example,
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notional principal contract, straddle, constructive sale, wash sale and short sale rules). These rules may affect whether gains and losses recognized by the Fund are treated as ordinary or
capital or as short-term or long-term, accelerate the recognition of income or gains to the Fund, defer losses to the Fund, and cause adjustments in the holding periods of the Funds securities. These rules could therefore affect the amount,
timing and/or character of distributions to shareholders.
Because these and other tax rules applicable to these types of transactions are in
some cases uncertain under current law, an adverse determination or future guidance by the IRS with respect to these rules (which determination or guidance could be retroactive) may affect whether the Fund has made sufficient distributions, and
otherwise satisfied the relevant requirements, to maintain its qualification as a RIC and avoid the Fund-level tax.
Commodity-Related
Investments.
The Funds use of commodity-linked instruments can be limited by the Funds intention to qualify as a RIC, and can bear on the Funds ability to so qualify. Income and gains from certain commodity-linked
instruments and from direct investments, if any, in commodities do not constitute qualifying income to a RIC for purposes of the 90% gross income test described above. The tax treatment of certain other commodity-linked instruments in which the Fund
might invest is not certain, in particular with respect to whether income or gains from such instruments constitute qualifying income to a RIC. If the Fund were to treat income or gain from a particular instrument as qualifying income and the income
or gain were later determined not to constitute qualifying income and, together with any other non-qualifying income, caused the Funds non-qualifying income to exceed 10% of its gross income in any taxable year, the Fund would fail to qualify
as a RIC unless it is eligible to and does pay a tax at the Fund level.
Exchange-Traded Notes.
The tax rules are uncertain
with respect to the treatment, including timing, of income or gains arising in respect of ETNs. An adverse determination or future guidance by the IRS with respect to these rules (which determination or guidance could be retroactive) may affect the
Funds ability to satisfy the requirements for qualifying for treatment as a RIC and to avoid a Fund-level tax.
Book-Tax
Differences.
Certain of the Funds investments in derivative instruments and foreign currency-denominated instruments, and any of the Funds transactions in foreign currencies and hedging activities, are likely to produce a
difference between its book income and the sum of its taxable income and net tax-exempt income (if any). If such a difference arises, and the Funds book income is less than the sum of its taxable income and net tax-exempt income, the Fund
could be required to make distributions exceeding book income to qualify as a RIC that is accorded special tax treatment. In the alternative, if the Funds book income exceeds the sum of its taxable income (including realized capital gains) and
net tax-exempt income, the distribution (if any) of such excess generally will be treated as (i) a dividend to the extent of the Funds remaining earnings and profits (including earnings and profits arising from tax-exempt income),
(ii) thereafter, as a return of capital to the extent of the recipients basis in its shares, and (iii) thereafter as gain from the sale or exchange of a capital asset.
Investments in Other RICs.
The Funds investments in shares of another mutual fund, ETF or another company that qualifies as a RIC (each, an
investment company
)
can cause the Fund to be required to distribute greater amounts of net investment income or net capital gain than the Fund would have distributed had it invested directly in the securities held by the investment company, rather than in shares of the
investment company. Further, the amount or timing of distributions from the Fund qualifying for treatment as a particular character (for example, long-term capital gain, exempt interest, eligibility for dividends-received deduction, etc.) will not
necessarily be the same as it would have been had the Fund invested directly in the securities held by the investment company. If the Fund receives dividends from an investment company and the investment company reports such dividends as qualified
dividend income, then the Fund is permitted in turn to report to its shareholders a portion of its distributions as qualified dividend income, provided the Fund meets holding period and other requirements with respect to shares of the investment
company.
If the Fund receives dividends from an investment company and the investment company reports such dividends as eligible for the
dividends-received deduction, then the Fund is permitted in turn to report to its shareholders its distributions derived from those dividends as eligible for the dividends-received deduction as well, provided the Fund meets holding period and other
requirements with respect to shares of the investment company.
If at the close of each quarter of the Funds taxable year, at least 50%
of its total assets were to consist of interests in other RICs, the Fund would be a qualified fund of funds. In that case, the Fund would be permitted to elect to pass through to its shareholders foreign income and other similar taxes paid by the
Fund in respect of foreign securities held directly by the Fund or by an underlying fund in which it invests that itself elected to pass such taxes through to shareholders, so that shareholders of the Fund would be eligible to claim a tax credit or
deduction for such taxes. However, even if the Fund were to qualify to make such election for any year, it may determine not to do so. See Foreign Taxation below for more information. Additionally, if the Fund were a qualified fund of
funds, the Fund would be permitted to distribute exempt-interest dividends and thereby pass through to its shareholders the tax-exempt character of any exempt-interest dividends it receives from underlying funds in which it invests, or interest on
any tax-exempt obligations in which it directly invests, if any. The Fund does not expect to be able to distribute exempt-interest dividends under any other circumstances. Furthermore, even if the Fund were eligible to report any distributions as
exempt-interest dividends, it provides no assurance that it would do so.
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Investment in a Wholly-Owned Subsidiary
. The Fund may organize and invest in one or more
wholly-owned subsidiaries in order to achieve optimal exposure to certain asset classes without violating the 90% gross income requirement applicable to RICs, as described above. If the Fund were to invest in a wholly-owned foreign subsidiary
(treated as a controlled foreign corporation (
CFC
) for U.S. federal income tax purposes), each year it would generally be required to include in gross income all of the CFCs subpart F income. Subpart F income would be
treated as ordinary income, regardless of the character of the CFCs underlying income. Net losses incurred by the CFC during a tax year would not flow through to the Fund and thus would not be available to offset the Funds other income
or capital gains. If the Fund were to recognize subpart F income in excess of actual distributions from the CFC in a particular year, it may be required to liquidate other investments in order to satisfy its distribution requirements. There is no
assurance, however, that the Fund will invest in one or more wholly-owned subsidiaries to limit its exposure to non-qualifying income; not doing so may limit the Funds exposure to certain assets, or increase the risk of disqualification as a
RIC.
Backup Withholding
The Fund generally is required to withhold and remit to the U.S. Treasury a percentage of the taxable distributions and redemption proceeds paid to any individual shareholder who fails to properly furnish
the Fund with a correct taxpayer identification number, who has under-reported dividend or interest income, or who fails to certify to the Fund that he or she is not subject to such withholding. The backup withholding rules may also apply to any
distributions that the Fund properly reports as exempt-interest dividends. The backup withholding tax rate is 28%.
Backup withholding is not
an additional tax. Any amounts withheld may be credited against the shareholders U.S. federal income tax liability, provided the appropriate information is furnished to the IRS.
Tax-Exempt Shareholders.
Income of a RIC that would be UBTI if earned directly by
a tax-exempt entity will not generally be attributed as UBTI to a tax-exempt shareholder of the RIC. Notwithstanding this blocking effect, a tax-exempt shareholder could realize UBTI by virtue of its investment in the Fund if shares in the Fund
constitute debt-financed property in the hands of the tax-exempt shareholder within the meaning of Code Section 514(b).
A tax-exempt
shareholder may also recognize UBTI if the Fund recognizes excess inclusion income derived from direct or indirect investments in residual interests in REMICs or equity interests in TMPs as described above, if the amount of such income recognized by
the Fund exceeds the Funds investment company taxable income (after taking into account deductions for dividends paid by the Fund).
In
addition, special tax consequences apply to charitable remainder trusts (
CRTs
) that invest in RICs that invest directly or indirectly in residual interests in REMICs or equity interests in TMPs. Under legislation enacted in
December 2006, a CRT (as defined in section 664 of the Code) that realizes any UBTI for a taxable year must pay an excise tax annually of an amount equal to such UBTI. Under IRS guidance issued in October 2006, a CRT will not recognize UBTI as a
result of investing in a fund that recognizes excess inclusion income. Rather, if at any time during any taxable year a CRT (or one of certain other tax-exempt shareholders, such as the United States, a state or political subdivision, or an agency
or instrumentality thereof, and certain energy cooperatives) is a record holder of a share in a fund that recognizes excess inclusion income, then the Fund will be subject to a tax on that portion of its excess inclusion income for the taxable year
that is allocable to such shareholders at the highest federal corporate income tax rate. The extent to which this IRS guidance remains applicable in light of the December 2006 legislation is unclear. To the extent permitted under the 1940 Act, the
Fund may elect to specially allocate any such tax to the applicable CRT, or other shareholder, and thus reduce such shareholders distributions for the year by the amount of the tax that relates to such shareholders interest in the Fund.
CRTs and other tax-exempt investors are urged to consult their tax advisors concerning the consequences of investing in the Fund.
Sale, Exchange or Redemption of Shares
The sale, exchange, or redemption of Fund shares may give rise to a gain or loss. In general, any gain or loss realized upon a taxable disposition of shares will be treated as long-term capital gain or
loss if the shares have been held for more than 12 months. Otherwise, the gain or loss on the taxable disposition of Fund shares will be treated as short-term capital gain or loss. However, any loss realized upon a taxable disposition of Fund shares
held by a shareholder for six months or less will be treated as long-term, rather than short-term, to the extent of any Capital Gain Dividends received (or deemed received) by the shareholder with respect to the shares. In addition, any loss
realized upon a taxable disposition of Fund shares held by a shareholder for six months or less generally will be disallowed, to the extent of any exempt-interest dividends received by the shareholder with respect to the shares.
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Further, all or a portion of any loss realized upon a taxable disposition of Fund shares will be disallowed
under the Codes wash-sale rule if other substantially identical shares are purchased, including by means of dividend reinvestment, within 30 days before or after the disposition. In such a case, the basis of the newly purchased shares will be
adjusted to reflect the disallowed loss.
Upon the redemption or exchange of Fund shares, the Fund or, in the case of shares purchased through
a financial intermediary, the financial intermediary may be required to provide you and the IRS with cost basis and certain other related tax information about the Fund shares you redeemed or exchanged. See the Funds Prospectus for more
information.
Tax Shelter Reporting Regulations
Under Treasury regulations, if a shareholder recognizes a loss of $2 million or more for an individual shareholder or $10 million or more for a corporate shareholder, the shareholder must file with the
IRS a disclosure statement on Form 8886. Direct holders of portfolio securities are in many cases excepted from this reporting requirement, but under current guidance, shareholders of a RIC are not excepted. Future guidance may extend the current
exception from this reporting requirement to shareholders of most or all RICs. The fact that a loss is reportable under these regulations does not affect the legal determination of whether the taxpayers treatment of the loss is proper.
Shareholders should consult their tax advisers to determine the applicability of these regulations in light of their individual circumstances.
Foreign Taxation
Income
received by the Fund (or RICs in which the Fund has invested) from sources within foreign countries may be subject to withholding and other taxes imposed by such countries. Tax treaties between certain countries and the U.S. may reduce or eliminate
such taxes. This will decrease the Funds yield on securities subject to such taxes. If more than 50% of the value of the Funds total assets at the close of a taxable year consists of securities of foreign corporations, the Fund will be
eligible to elect to pass through to you foreign income taxes that it pays. If this election is made, you will be required to include your share of those taxes in gross income as a distribution from the Fund and you generally will be allowed to
claim a credit (or a deduction, if you itemize deductions) for such amounts on your federal U.S. income tax return, subject to certain limitations. The Fund generally does not expect to be eligible to elect to permit shareholders to claim a credit
or deduction with respect to foreign taxes incurred by the Fund. If the Fund were a qualified fund of funds, it would be permitted to elect to pass through to its shareholders foreign taxes it has paid or foreign taxes passed through to it by any
underlying fund that itself elected to pass through such taxes to shareholders (see Investments in Other RICs above). Even if the Fund were eligible to make such an election for a given year, it may determine not to do so.
Foreign Shareholders
.
Absent a specific statutory exemption, dividends other than Capital Gain Dividends paid by the Fund to a shareholder that is not a U.S. person within the meaning of the Code (a
foreign shareholder
) are subject to withholding of U.S. federal income tax at a rate of 30% (or lower applicable treaty rate) even if they are funded by income or gains (such as portfolio interest, short-term capital gains, or
foreign-source dividend and interest income) that, if paid to a foreign shareholder directly, would not be subject to withholding. Distributions properly designated as Capital Gain Dividends and exempt-interest dividends generally are not subject to
withholding of U.S. federal income tax (but may be subject to backup withholding).
For distributions with respect to taxable years of the
Fund beginning before January 1, 2014, the Fund is not required to withhold any amounts (i) with respect to distributions from U.S.-source interest income of types similar to those not subject to U.S. federal income tax if earned directly
by an individual foreign shareholder, to the extent such distributions are properly reported as such by the Fund in a written notice to shareholders (
interest-related dividends
), and (ii) with respect to distributions of net
short-term capital gains in excess of net long-term capital losses to the extent such distributions are properly reported by the Fund (
short-term capital gain dividends
). The exception to withholding for interest-related dividends
does not apply to distributions to a foreign shareholder (A) that has not provided a satisfactory statement that the beneficial owner is not a U.S. person, (B) to the extent that the dividend is attributable to certain interest on an
obligation if the foreign shareholder is the issuer or is a 10% shareholder of the issuer, (C) that is within certain foreign countries that have inadequate information exchange with the United States, or (D) to the extent the dividend is
attributable to interest paid by a person that is a related person of the foreign shareholder and the foreign shareholder is a controlled foreign corporation. The exception to withholding for short-term capital gain dividends does not apply to
(A) distributions to an individual foreign shareholder who is present in the United States for a period or periods aggregating 183 days or more during the year of the distribution and (B) distributions subject to special rules regarding
the disposition of U.S. real property interests as described below. If the Fund invests in another RIC that pays such distributions to the Fund, such distributions retain their character as not
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subject to withholding if properly reported when paid by the Fund to foreign shareholders. The Fund is permitted to report such part of its dividends as interest-related and/or short-term capital
gain dividends as are eligible, but is not required to do so. In the case of shares held through an intermediary, the intermediary may withhold even if the Fund reports all or a portion of a payment as an interest-related or short-term capital gain
dividend to shareholders.
It is currently unclear whether Congress will extend this exemption from withholding for interest-related and
short-term capital gain dividends for distributions with respect to taxable years of a RIC beginning on or after January 1, 2014, or what the terms of such an extension would be. Foreign shareholders should contact their intermediaries
regarding the application of these rules to their accounts.
A foreign shareholder is not, in general, subject to U.S. federal income tax on
gains (and is not allowed a deduction for losses) realized on the sale of shares of the Fund or on Capital Gain Dividends or exempt-interest dividends unless (i) such gain or dividend is effectively connected with the conduct by the foreign
shareholder of a trade or business within the United States, (ii) in the case of a foreign shareholder that is an individual, the shareholder is present in the United States for a period or periods aggregating 183 days or more during the year
of the sale or the receipt of the Capital Gain Dividend and certain other conditions are met, or (iii) the special rules relating to gain attributable to the sale or exchange of U.S. real property interests (
USRPIs
) apply to
the foreign shareholders sale of shares of the Fund or to the Capital Gain Dividend the foreign shareholder received (as described below).
Subject to certain exceptions (for example, for a fund that is a United States real property holding corporation as described below), the Fund is generally not required to withhold on the
amount of a non-dividend distribution (
i.e.
, a distribution that is not paid out of the Funds current or accumulated earnings and profits for the applicable taxable year) when paid to its foreign shareholders.
Foreign shareholders with respect to whom income from the Fund is effectively connected with a trade or business conducted by the foreign shareholder
within the United States will in general be subject to U.S. federal income tax on the income derived from the Fund at the graduated rates applicable to U.S. citizens, residents or domestic corporations, whether such income is received in cash or
reinvested in shares of the Fund and, in the case of a foreign corporation, may also be subject to a branch profits tax. If a foreign shareholder is eligible for the benefits of a tax treaty, any effectively connected income or gain will generally
be subject to U.S. federal income tax on a net basis only if it is also attributable to a permanent establishment maintained by the shareholder in the United States. More generally, foreign shareholders who are residents in a country with an income
tax treaty with the United States may obtain different tax results than those described herein, and are urged to consult their tax advisors.
Special rules would apply if the Fund were either a U.S. real property holding corporation (
USRPHC
) or would be a USRPHC but for the
operation of certain exceptions to the definition thereof. Very generally, a USRPHC is a domestic corporation that holds USRPIs the fair market value of which equals or exceeds 50% of the sum of the fair market values of the corporations
USRPIs, interests in real property located outside the United States, and other trade or business assets. USRPIs are generally defined as any interest in U.S. real property and any interest (other than solely as a creditor) in a USRPHC or former
USRPHC.
If the Fund were a USRPHC or would be a USRPHC but for the exceptions referred to above, under a special look-through
rule, any distributions by the Fund to a foreign shareholder (including, in certain cases, distributions made by the Fund in redemption of its shares) attributable to gains realized by the Fund on the disposition of USRPIs or to distributions
received by the Fund from a lower-tier RIC or REIT that the Fund is required to treat as USRPI gain in its hands generally would be subject to U.S. tax withholding. In addition, such distributions could result in the foreign shareholder being
required to file a U.S. tax return and pay tax on the distributions at regular U.S. federal income tax rates. The consequences to a foreign shareholder, including the rate of such withholding and character of such distributions (for example, as
ordinary income or USRPI gain), would vary depending upon the extent of the foreign shareholders current and past ownership of the Fund. On and after January 1, 2014, the look-through USRPI rule described above for
distributions by the Fund (which applies only if the Fund is either a USRPHC or would be a USRPHC but for the operation of the exceptions referred to above) applies only to those distributions that, in turn, are attributable directly or indirectly
to distributions received by the Fund from a lower-tier REIT, unless Congress enacts legislation providing otherwise.
In addition, if the
Fund were a USRPHC or former USRPHC, it could be required to withhold U.S. tax on the proceeds of a share redemption by a greater-than-5% foreign shareholder, in which case such foreign shareholder generally would also be required to file U.S. tax
returns and pay any additional taxes due in connection with the redemption.
Moreover, if the Fund were a USRPHC or former USRPHC, it could be
required to withhold on amounts distributed to a greater-than-5% foreign shareholder to the extent such amounts are in excess of the Funds current and accumulated earnings and profits for the applicable taxable year.
Foreign shareholders should consult their tax advisers and, if holding shares through intermediaries, their intermediaries, concerning the application of
these rules to their investment in the Fund.
-83-
In order to qualify for any exemptions from withholding described above or for lower withholding tax rates
under income tax treaties, or to establish an exemption from backup withholding, a foreign shareholder must comply with special certification and filing requirements relating to its non-U.S. status (including, in general, furnishing an IRS Form
W-8BEN or substitute form). Foreign shareholders should consult their tax advisers in this regard.
Special rules (including withholding and
reporting requirements) apply to foreign partnerships and those holding Fund shares through foreign partnerships. Additional considerations may apply to foreign trusts and estates. Investors holding Fund shares through foreign entities should
consult their tax advisers about their particular situation.
A foreign shareholder may be subject to state and local tax and to the U.S.
federal estate tax in addition to the U.S. federal income tax referred to above.
Shareholder Reporting Obligations With Respect to
Foreign Bank and Financial Accounts
Shareholders that are U.S. persons and own, directly or indirectly, more than 50% of the Fund by
vote or value could be required to report annually their financial interest in the Funds foreign financial accounts, if any, on Treasury Department Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (
FBAR
).
Shareholders should consult a tax advisor regarding the applicability to them of this reporting requirement.
Other Reporting and
Withholding Requirements
The Foreign Account Tax Compliance Act (FATCA) generally requires the Fund to obtain information
sufficient to identify the status of each of its shareholders under FATCA. If a shareholder fails to provide this information or otherwise fails to comply with FATCA, the Fund may be required to withhold under FATCA at a rate of 30% with respect to
that shareholder on dividends, including Capital Gain Dividends, and the proceeds of the sale, redemption or exchange of Fund shares. If a payment by the Fund is subject to FATCA withholding, the Fund is required to withhold even if such payment
would otherwise be exempt from withholding under the rules applicable to foreign shareholders described above (e.g., Capital Gain Dividends and short-term capital gain and interest-related dividends).
Each prospective investor is urged to consult its tax adviser regarding the applicability of FATCA and any other reporting requirements with respect to
the prospective investors own situation, including investments through an intermediary.
General Considerations
The U.S. federal income tax discussion set forth above is for general information only. Prospective investors should consult their
tax advisers regarding the specific federal tax consequences of purchasing, holding, and disposing of shares of the Fund, as well as the effects of state, local, foreign, and other tax law and any proposed tax law changes.
SHARES AND VOTING RIGHTS
Shares of each class of the Fund represent an equal proportionate share in the assets, liabilities, income and expenses of that class of the Fund. All shares issued will be fully paid and non-assessable
and will have no preemptive rights. Each whole share will be entitled to one vote as to any matter on which it is entitled to vote and each fractional share shall be entitled to a proportionate fractional vote. As a Delaware statutory trust, the
Trust is not required to hold an annual shareholder meeting in any year in which the selection of trustees is not required to be acted on under the 1940 Act. Shareholder approval will be sought only for certain changes in the operations of the Fund
and for the election of trustees under certain circumstances. Trustees may be removed with or without cause at any meeting of the shareholders of the Trust by a vote of shareholders owning at least a majority of the outstanding shares. There shall
be no cumulative voting in the election of Trustees. Generally, all shareholders of the Fund will vote together with all other shareholders of the Trust and with all shareholders of all other funds that the Trust may form in the future on all
matters affecting the Trust, including the election or removal of trustees, except when required by the 1940 Act or when the Trustees have determined that the matter affects one or more series of the Trust or classes of shares materially
differently, shares will be voted by an individual series or class; and when the Trustees have determined that the matter affects only the interests of one or more series or classes, only shareholders of such series or classes shall be entitled to
vote.
TRANSFER AGENT
U.S. Bancorp Fund Services, LLC, P.O. Box 701, Milwaukee, Wisconsin 53201, serves as transfer agent for the Trust.
-84-
CUSTODIAN
U.S. Bank National Association (the
Custodian
), 1555 N. River Center Drive, Suite 302, Milwaukee, Wisconsin 53212, serves as custodian for the Trust and is responsible for maintaining
custody of the Trusts cash and investments. Pursuant to the terms of the Custody Agreement between the Trust and the Custodian, the Custodian may delegate certain of its responsibilities, including its responsibility to establish and maintain
arrangements with foreign custodians, to a sub-custodian. Subject to its oversight, the Custodian has delegated to Bank of New York Mellon primary responsibility to review, establish, and monitor the Funds foreign custody arrangements. Certain
brokers may be engaged as futures commission merchants by the Fund from time to time and could be deemed to have custody over the Funds assets.
LEGAL COUNSEL
Ropes & Gray LLP, 800 Boylston Street,
Boston, Massachusetts 02199, serves as legal counsel to the Trust.
INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM AND FINANCIAL STATEMENTS
[ ],
[ ]. The independent registered public accounting firm is responsible for conducting the annual audit of the financial statements
of the Fund. The selection of the independent registered public accounting firm is approved annually by the Board of Trustees. As of the date of this Statement of Additional Information, the Fund does not have any operating history and, therefore,
does not have any audited financial statements.
DISCLAIMERS
Barclays Capital Inc and its affiliates (
Barclays
) is not the issuer, sponsor or promoter of DoubleLine Shiller
Enhanced CAPE
®
and Barclays has no responsibilities, obligations or duties to investors in DoubleLine Shiller
Enhanced CAPE
®
. The Shiller Barclays CAPE
®
US Sector TR USD Index consists of the respective trademarks of Barclays Bank PLC and trademarks owned by or licensed to RSBB-I, LLC and Barclays Bank PLC and that
are licensed for use by DoubleLine Funds Trust as the Issuer of DoubleLine Shiller Enhanced CAPE
®
.
Barclays only relationship with the Issuer in respect of Shiller Barclays CAPE
®
US Sector TR USD Index is
the licensing of these trademarks and the Shiller Barclays CAPE
®
US Sector TR USD Index which is determined,
composed and calculated by Barclays without regard to the Issuer or DoubleLine Shiller Enhanced CAPE
®
or the
owners of DoubleLine Shiller Enhanced CAPE
®
. Additionally, DoubleLine Capital LP may for DoubleLine Shiller
Enhanced CAPE
®
execute transaction(s) with Barclays in or relating to the Shiller Barclays CAPE
®
US Sector TR USD Index in connection with which DoubleLine Shiller Enhanced CAPE
®
investors acquire DoubleLine Shiller Enhanced CAPE
®
from DoubleLine Funds Trust and investors neither acquire any interest in Shiller Barclays CAPE
®
US Sector TR USD Index nor enter into any relationship of any kind whatsoever with Barclays upon making an investment in DoubleLine Shiller Enhanced CAPE
®
. DoubleLine Shiller Enhanced CAPE
®
is not sponsored, endorsed, sold or promoted by Barclays. Barclays does not make any representation or warranty, express or implied regarding the advisability of
investing in DoubleLine Shiller Enhanced CAPE
®
or the advisability of investing in securities generally or the
ability of the Shiller Barclays CAPE
®
US Sector TR USD Index to track corresponding or relative market
performance. Barclays has not passed on the legality or suitability of the DoubleLine Shiller Enhanced CAPE
®
name or the Index with respect to any person or entity. Barclays is not responsible for and has not participated in the determination of the timing of, prices of, or quantities of the shares of DoubleLine Shiller Enhanced CAPE
®
to be issued. Barclays has no obligation to take the needs of the Issuer or the owners of DoubleLine Shiller
Enhanced CAPE
®
or any other third party into consideration in determining, composing or calculating the Shiller
Barclays CAPE
®
US Sector TR USD Index. Barclays has no obligation or liability in connection with
administration, marketing or trading of DoubleLine Shiller Enhanced CAPE
®
.
The licensing agreement between DoubleLine Funds Trust and Barclays is solely for the benefit of DoubleLine Shiller
Enhanced CAPE
®
and Barclays and not for the benefit of the owners of DoubleLine Shiller Enhanced CAPE
®
, investors or other third parties.
BARCLAYS SHALL HAVE NO LIABILITY TO THE ISSUER, INVESTORS OR TO OTHER THIRD PARTIES FOR THE USE OF THE DOUBLELINE
SHILLER ENHANCED CAPE
®
NAME, OR THE QUALITY, ACCURACY AND/OR COMPLETENESS OF THE SHILLER BARCLAYS CAPE
®
US SECTOR TR USD INDEX OR ANY DATA INCLUDED THEREIN OR FOR INTERRUPTIONS IN THE DELIVERY OF THE SHILLER BARCLAYS
CAPE
®
US SECTOR TR USD INDEX. BARCLAYS MAKES NO WARRANTY, EXPRESS OR IMPLIED, AS TO RESULTS TO BE OBTAINED BY
THE ISSUER, THE INVESTORS OR ANY OTHER PERSON OR ENTITY FROM THE USE OF THE SHILLER BARCLAYS CAPE
®
US SECTOR TR
USD INDEX OR ANY DATA INCLUDED THEREIN. BARCLAYS MAKES NO EXPRESS OR IMPLIED WARRANTIES, AND HEREBY EXPRESSLY DISCLAIMS ALL WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE WITH RESPECT TO DOUBLELINE SHILLER ENHANCED CAPE
®
NAME, THE SHILLER BARCLAYS CAPE
®
US SECTOR TR USD INDEX OR ANY DATA INCLUDED THEREIN. BARCLAYS RESERVES THE RIGHT TO
-85-
CHANGE THE METHODS OF CALCULATION OR PUBLICATION, OR TO CEASE THE CALCULATION OR PUBLICATION OF THE SHILLER BARCLAYS CAPE
®
US SECTOR TR USD INDEX, AND BARCLAYS SHALL NOT BE LIABLE FOR ANY MISCALCULATION OF OR ANY INCORRECT, DELAYED OR INTERRUPTED PUBLICATION WITH RESPECT TO ANY OF THE
SHILLER BARCLAYS CAPE
®
US SECTOR TR USD INDEX. BARCLAYS SHALL NOT BE LIABLE FOR ANY DAMAGES, INCLUDING, WITHOUT
LIMITATION, ANY SPECIAL, INDIRECT OR CONSEQUENTIAL DAMAGES, OR ANY LOST PROFITS AND EVEN IF ADVISED OF THE POSSIBILITY OF SUCH, RESULTING FROM THE USE OF THE SHILLER BARCLAYS CAPE
®
US SECTOR TR USD INDEX OR ANY DATA INCLUDED THEREIN OR WITH RESPECT TO THE DOUBLELINE SHILLER ENHANCED CAPE
®
.
None of the information supplied by
Barclays Bank PLC and used in this publication may be reproduced in any manner without the prior written permission of Barclays Capital, the investment banking division of Barclays Bank PLC. Barclays Bank PLC is registered in England
No. 1026167. Registered office 1 Churchill Place London E14 5HP.
THE SHILLER BARCLAYS CAPE
®
US INDEX FAMILY HAS BEEN DEVELOPED IN PART BY RSBB, LLC, THE RESEARCH PRINCIPAL OF WHICH IS ROBERT J. SHILLER. RSBB,
LLC IS NOT AN INVESTMENT ADVISER AND DOES NOT GUARANTEE THE ACCURACY AND COMPLETENESS OF THE SHILLER BARCLAYS
CAPE
®
US INDEX FAMILY OR ANY DATA OR METHODOLOGY EITHER INCLUDED THEREIN OR UPON WHICH IT IS BASED. RSBB, LLC
SHALL HAVE NO LIABILITY FOR ANY ERRORS, OMISSIONS OR INTERRUPTIONS THEREIN AND MAKES NO WARRANTIES EXPRESSED OR IMPLIED, AS TO THE PERFORMANCE OR RESULTS EXPERIENCED BY ANY PARTY FROM THE USE OF ANY INFORMATION INCLUDED THEREIN OR UPON WHICH IT IS
BASED, AND EXPRESSLY DISCLAIMS ALL WARRANTIES OF THE MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE WITH RESPECT THERETO, AND SHALL NOT BE LIABLE FOR ANY CLAIMS OR LOSSES OF ANY NATURE IN CONNECTION WITH THE USE OF SUCH INFORMATION, INCLUDING
BUT NOT LIMITED TO, LOST PROFITS OR PUNITIVE OR CONSEQUENTIAL DAMAGES EVEN IF RSBB, LLC IS ADVISED OF THE POSSIBILITY OF SAME.