Filed pursuant to Rule 497(h)
Registration No. 333-91744
PROSPECTUS August 16, 2002
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$505,000,000
[LOGO] PIMCO
FUNDS
[LOGO] PIMCO Municipal Income Fund II
4,040 Shares Series A
4,040 Shares Series B
4,040 Shares Series C
4,040 Shares Series D
4,040 Shares Series E
Auction Preferred Shares
Liquidation Preference $25,000 Per Share
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Investment Objective. The Fund is a recently organized, diversified,
closed-end management investment company. The Fund's investment objective is to
provide current income exempt from federal income tax. In pursuing this
objective, the portfolio manager also seeks to preserve and enhance the value
of the Fund's holdings relative to the municipal bond market generally, using
proprietary analytical models that test and evaluate the sensitivity of those
holdings to changes in interest rates and yield relationships.
Portfolio Contents. Under normal market conditions, the Fund will invest its
net assets in a portfolio of municipal bonds the interest from which is exempt
from federal income taxes. Under normal market conditions, the Fund expects to
be fully invested (at least 90% of its total assets) in tax-exempt municipal
bonds. The Fund will at all times seek to avoid bonds generating interest
potentially subjecting individuals to the alternative minimum tax. The Fund
will invest at least 80% of its net assets in investment grade quality
municipal bonds, including bonds that are unrated but judged to be of
investment grade quality by the Fund's portfolio manager. The Fund may invest
up to 20% of its net assets in municipal bonds that are rated Ba/BB or B or
that are unrated but judged to be of comparable quality by the Fund's portfolio
manager. The Fund cannot assure you that it will achieve its investment
objective.
Certain capitalized terms used in this Prospectus are defined in the Glossary
that appears at the end of this Prospectus.
Before buying any preferred shares you should read the discussion of the
material risks of investing in the Fund in "Risks" beginning on page 18.
Certain of these risks are summarized in "Prospectus summary--Special Risk
Considerations" beginning on page 3.
Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if
this Prospectus is truthful or complete. Any representation to the contrary is
a criminal offense.
Proceeds
Price to Public Sales Load to Fund/(1)/
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Per Share $ 25,000 $ 250 $ 24,750
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Total $505,000,000 $5,050,000 $499,950,000
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(1) Plus accumulated dividends, if any, from the date the Auction Preferred
Shares are issued, but before offering expenses payable by the Fund
estimated to be $375,000.
Auction Preferred Shares, Series A, Auction Preferred Shares, Series B, Auction
Preferred Shares, Series C, Auction Preferred Shares, Series D and Auction
Preferred Shares, Series E (together, "APS") are being offered by the
underwriters subject to certain conditions. The underwriters reserve the right
to withdraw, cancel or modify the offering in whole or in part. It is expected
that the APS will be delivered to the nominee of The Depository Trust Company
on or about August 20, 2002.
UBS Warburg Merrill Lynch & Co.
A.G. Edwards & Sons, Inc. Prudential Securities
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(continued from previous page)
Investors in APS will be entitled to receive cash dividends at an annual rate
that may vary for the successive dividend periods for such shares. The dividend
rate on the Series A APS for the initial period from and including the date of
issue to, but excluding, August 27, 2002 will be 1.20% per year. The dividend
rate on the Series B APS for the initial period from and including the date of
issue to, but excluding, August 28, 2002 will be 1.20% per year. The dividend
rate on the Series C APS for the initial period from and including the date of
issue to, but excluding, August 29, 2002 will be 1.20% per year. The dividend
rate on the Series D APS for the initial period from and including the date of
issue to, but excluding, August 30, 2002 will be 1.20% per year. The dividend
rate on the Series E APS for the initial period from and including the date of
issue to, but excluding, September 3, 2002 will be 1.20% per year. For each
subsequent period, the auction agent will determine the dividend rate for a
particular period by an auction conducted in accordance with the procedures
described in this Prospectus and, in further detail, in Appendix A to the
Statement of Additional Information (each, an "Auction").
The APS, which have no history of public trading, will not be listed on an
exchange or automated quotation system. Broker-Dealers may maintain a secondary
trading market in the APS outside of Auctions; however, they have no obligation
to do so, and there can be no assurance that a secondary market for the APS
will develop or, if it does develop, that it will provide holders with a liquid
trading market (i.e., trading will depend on the presence of willing buyers and
sellers and the trading price will be subject to variables to be determined at
the time of the trade by such Broker-Dealers). A general increase in the level
of interest rates may have an adverse effect on the secondary market price of
the APS, and a selling shareholder that sells APS between Auctions may receive
a price per share of less than $25,000. The Fund may redeem APS as described
under "Description of APS--Redemption."
The APS will be senior in liquidation and distribution rights to the Fund's
outstanding common shares. The Fund's common shares are traded on the New York
Stock Exchange under the symbol "PML." This offering is conditioned upon the
APS receiving a rating of "Aaa" from Moody's Investors Service, Inc.
("Moody's").
You should read this Prospectus, which contains important information about the
Fund, before deciding whether to invest and retain it for future reference.
A Statement of Additional Information, dated August 16, 2002, containing
additional information about the Fund, has been filed with the Securities and
Exchange Commission and is incorporated by reference in its entirety into this
Prospectus, which means that it is part of the Prospectus for legal purposes.
You can review the table of contents of the Statement of Additional Information
on page 60 of this Prospectus. You may request a free copy of the Statement of
Additional Information by calling (877) 819-2224 or by writing to the Fund, or
obtain a copy (and other information regarding the Fund) from the Securities
and Exchange Commission web site (http://www.sec.gov).
The APS do not represent a deposit or obligation of, and are not guaranteed or
endorsed by, any bank or other insured depository institution and are not
federally insured by the Federal Deposit Insurance Corporation, the Federal
Reserve Board or any other government agency.
You should rely only on the information contained or incorporated by reference
in this Prospectus. The Fund has not, and the underwriters have not, authorized
anyone to provide you with different information. If anyone provides you with
different or inconsistent information, you should not rely on it. The Fund is
not, and the underwriters are not, making an offer of the APS in any state
where the offer is not permitted. You should not assume that the information
contained in this Prospectus is accurate as of any date other than the date on
the front of this Prospectus. The Fund's business, financial condition, results
of operations and prospects may have changed since that date.
TABLE OF CONTENTS
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Prospectus summary....... 1
The Fund................. 12
Use of proceeds.......... 12
Capitalization........... 12
Portfolio composition.... 13
The Fund's investments... 14
Risks.................... 18
How the Fund manages risk 23
Rating agency guidelines. 25
Description of APS....... 26
Management of the Fund... 49
Net asset value.......... 51
Taxes.................... 51
Description of capital structure................... 54
Anti-takeover and other provisions in the
Declaration of Trust............................. 56
Repurchase of Common Shares; conversion to open-
end fund......................................... 57
Underwriting....................................... 58
Shareholder servicing agent, custodian and transfer
agents........................................... 58
Legal matters...................................... 59
Table of contents for the Statement of
Additional Information........................... 60
Glossary........................................... 61
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Prospectus summary
This is only a summary. You should review the more detailed information
contained in this Prospectus and in the Statement of Additional Information.
Certain capitalized terms used in this Prospectus are defined in the Glossary
that appears at the end of this Prospectus.
THE FUND
PIMCO Municipal Income Fund II (the "Fund") is a recently organized,
diversified, closed-end management investment company registered under the
Investment Company Act of 1940, as amended (the "1940 Act"). See "The Fund."
The Fund's common shares ("Common Shares") are traded on the New York Stock
Exchange under the symbol "PML." As of August 7, 2002, the Fund had 57,508,129
Common Shares outstanding and net assets of $832,467,998.
THE OFFERING
The Fund is offering an aggregate of 4,040 Series A APS, 4,040 Series B APS,
4,040 Series C APS, 4,040 Series D APS and 4,040 Series E APS, each at a
purchase price of $25,000 per share plus accumulated dividends, if any, from
the date of original issue. The APS are being offered through a group of
underwriters led by UBS Warburg LLC and Merrill Lynch, Pierce, Fenner & Smith
Incorporated (collectively, the "Underwriters"). See "Underwriting."
The APS will entitle their holders to receive cash dividends at an annual rate
that may vary for successive Dividend Periods. In general, except as described
under "Description of APS--Dividends," each Dividend Period will be seven days.
The Auction Agent will determine the Applicable Rate for a particular period by
an Auction conducted on the Business Day immediately prior to the start of that
Dividend Period.
The APS are not listed on an exchange. Instead, investors may buy or sell APS
at an auction that normally is held weekly, by submitting orders to
Broker-Dealers that have entered into an agreement with the Auction Agent and
the Fund or to certain other Broker-Dealers. Deutsche Bank Trust Company
Americas, the Auction Agent, reviews orders from Broker-Dealers on behalf of
Existing Holders that wish to sell, or hold at the auction rate, or hold only
at a specified Applicable Rate, and on behalf of Potential Holders that wish to
buy, APS. The Auction Agent then determines the lowest Applicable Rate that
will result in all of the outstanding APS continuing to be held. The first
Auction Date for Series A APS will be August 26, 2002, for Series B APS will be
August 27, 2002, for Series C APS will be August 28, 2002, for Series D APS
will be August 29, 2002 and for Series E APS will be August 30, 2002, each
being the Business Day before the Initial Dividend Payment Date for the Initial
Dividend Period for the relevant series of APS (August 27, 2002 for Series A,
August 28, 2002 for Series B, August 29, 2002 for Series C, August 30, 2002 for
Series D and September 3, 2002 for Series E). The auction day for Series A APS
generally will be Monday, for Series B APS generally will be Tuesday, for
Series C APS generally will be Wednesday, for Series D APS generally will be
Thursday and for Series E APS generally will be Friday, unless the then-current
Dividend Period is a Special Dividend Period, or the day that normally would be
the Auction Date or the first day of the subsequent Dividend Period is not a
Business Day.
INVESTMENT OBJECTIVE AND POLICIES
The Fund's investment objective is to provide current income exempt from
federal income tax. In pursuing this objective, the portfolio manager also
seeks to preserve and enhance the value of the Fund's holdings relative to the
municipal bond market generally, using proprietary analytical models that test
and evaluate the sensitivity of those holdings to changes in interest rates and
yield relationships. Under normal market conditions, the Fund expects to be
fully invested (at least 90% of its total assets) in a portfolio of municipal
bonds the interest from which is exempt from federal income taxes. The Fund will
1
invest at least 80% of its net assets in municipal bonds that at the time of
investment are investment grade quality. Investment grade quality bonds are
bonds rated, at the time of investment, within the four highest grades (Baa or
BBB or better by Moody's, Standard & Poor's ("S&P") or Fitch, Inc. ("Fitch")),
or bonds that are unrated but judged to be of comparable quality by the Fund's
portfolio manager. The Fund may invest up to 20% of its net assets in municipal
bonds that, at the time of investment, are rated Ba/BB or B by Moody's, S&P or
Fitch, or bonds that are unrated but judged to be of comparable quality by the
Fund's portfolio manager. Bonds of below investment grade quality are regarded
as having predominantly speculative characteristics with respect to capacity to
pay interest and repay principal and are commonly referred to as "junk bonds."
Bonds in the lowest investment grade category may also be considered to possess
some speculative characteristics by certain rating agencies. The Fund will at
all times seek to avoid bonds generating interest potentially subjecting
individuals to the alternative minimum tax.
The Fund may invest in "structured" notes, which are privately negotiated debt
obligations where the principal and/or interest is determined by reference to
the performance of a benchmark asset, market or interest rate, such as selected
securities, an index of securities or specified interest rates, or the
differential performance of two assets or markets, such as indices reflecting
taxable and tax-exempt bonds. The Fund currently intends that any use of
structured notes will be for the purpose of reducing the interest rate
sensitivity of the Fund's portfolio (and thereby decreasing the Fund's exposure
to interest rate risk) and, in any event, that the interest income on the notes
will normally be exempt from federal income tax. The Fund may utilize a variety
of other derivative instruments, including residual interest municipal bonds
("RIBS"), to add leverage to the portfolio or for investment or risk management
purposes. See "Risks--Leverage Risk" and "Risks--Derivatives Risk."
The Fund will invest primarily in municipal bonds with long-term maturities in
order to maintain a weighted average maturity of 15-30 years, but the weighted
average maturity of obligations held by the Fund may be shortened, depending on
market conditions.
The Fund cannot assure you that it will attain its investment objective. See
"The Fund's investments."
INVESTMENT MANAGER
PIMCO Funds Advisors LLC (the "Manager") serves as the investment manager of
the Fund. Subject to the supervision of the Board of Trustees, the Manager is
responsible for managing, either directly or through others selected by it, the
investment activities of the Fund and the Fund's business affairs and other
administrative matters. The Manager is located at 1345 Avenue of the Americas,
New York, New York 10105. Organized in 2000, the Manager provides investment
management and advisory services to several closed-end and open-end investment
company clients. As of June 30, 2002, the Manager had approximately $7 billion
in assets under management. Allianz Dresdner Asset Management of America L.P.
is the direct parent company of PIMCO Advisory Services Holdings LLC, of which
the Manager is a wholly-owned subsidiary. As of June 30, 2002, Allianz Dresdner
Asset Management of America L.P. and its subsidiary partnerships, including
Pacific Investment Management Company LLC ("PIMCO"), had approximately $346
billion in assets under management.
The Manager has retained its affiliate, PIMCO, as a sub-adviser to manage the
Fund's portfolio investments. See "--Portfolio Manager" below.
PORTFOLIO MANAGER
PIMCO serves as the Fund's sub-adviser responsible for managing the Fund's
portfolio investments and is sometimes referred to herein as the "portfolio
manager." Subject to the supervision of the Manager,
2
PIMCO has full investment discretion and makes all determinations with respect
to the investment of the Fund's assets.
PIMCO is located at 840 Newport Center Drive, Newport Beach, California 92660.
Organized in 1971, PIMCO provides investment management and advisory services
to private accounts of institutional and individual clients and to mutual
funds. As of June 30, 2002, PIMCO had approximately $275 billion in assets
under management.
The Manager (and not the Fund) will pay a portion of the fees it receives to
PIMCO in return for PIMCO's services.
LEVERAGE
The Fund expects to utilize financial leverage on an ongoing basis for
investment purposes. After completion of the offering of APS, the Fund
anticipates its total leverage from the issuance of APS will be approximately
38%. This amount may change, but total leverage will not exceed 50% of the
Fund's total assets. Although the Fund may in the future offer other Preferred
Shares, the Fund does not currently intend to offer Preferred Shares other than
Series A APS, Series B APS, Series C APS, Series D APS and Series E APS. The
Fund may also invest in RIBS and other derivative instruments, each of which
may amplify the effects of leverage in the Fund's portfolio.
The Fund generally will not utilize leverage if it anticipates that it would
result in a lower return to Common Shareholders over time. Use of financial
leverage creates an opportunity for increased income for Common Shareholders
but, at the same time, creates the possibility for greater loss (including the
likelihood of greater volatility of net asset value and market price of the
shares and of dividends), and there can be no assurance that a leveraging
strategy will be successful during any period in which it is employed. Because
the fees paid to the Manager and PIMCO will be calculated on the basis of the
Fund's managed assets, the fees will be higher when leverage (including the
APS) is utilized, giving the Manager and PIMCO an incentive to utilize
leverage. See "Risks--Leverage Risk."
SPECIAL RISK CONSIDERATIONS
Risks of investing in APS include:
Auction Risk
You may not be able to sell your APS at an Auction if the Auction fails, that
is, if there are more APS offered for sale than there are buyers for those
shares. As a result, your investment in APS may be illiquid. Neither the
Broker-Dealers nor the Fund are obligated to purchase APS in an Auction or
otherwise, nor is the Fund required to redeem APS in the event of a failed
Auction.
Ratings and Asset Coverage Risk
A Rating Agency could downgrade the APS, which could affect their liquidity and
value. In addition, the Fund may be forced to redeem your APS to meet
regulatory or Rating Agency requirements. The Fund may also voluntarily redeem
APS under certain circumstances.
Secondary Market Risk
You could receive less than the price you paid for your APS if you sell them
outside of an Auction, especially when market interest rates are rising.
Although the Broker-Dealers may maintain a secondary trading market in the APS
outside of Auctions, they are not obligated to do so, and no secondary market
may develop or exist at any time for the APS.
3
General risks of investing in the Fund include:
Limited Operating History
The Fund is a recently organized, diversified, closed-end management investment
company which has been operational for less than two months.
Market Discount Risk
Shares of closed-end management investment companies like the Fund frequently
trade at a discount from their net asset value.
Interest Rate Risk
Interest rate risk is the risk that the municipal bonds in the Fund's portfolio
will decline in value because of increases in market interest rates. The prices
of longer-term bonds generally fluctuate more than prices of shorter-term bonds
as interest rates change. Because the Fund will invest primarily in long-term
bonds, the Fund's net asset value will fluctuate more in response to changes in
market interest rates than if the Fund invested primarily in short-term bonds.
If long-term rates rise, the value of the Fund's investment portfolio may
decline, reducing asset coverage on the APS. See "Risks--Interest Rate Risk"
for additional information.
Credit Risk
Credit risk is the risk that one or more debt obligations in the Fund's
portfolio will decline in price, or fail to pay interest or principal when due,
because the issuer of the obligation experiences a decline in its financial
status. Any default by an issuer of a debt obligation could have a negative
impact on the Fund's ability to pay dividends on the APS and could result in
the redemption of some or all of the APS.
Municipal Bond Market Risk
The amount of public information available about the municipal bonds in the
Fund's portfolio is generally less than that for corporate equities or bonds,
and the investment performance of the Fund may therefore be more dependent on
the analytical abilities of PIMCO than would be a stock fund or taxable bond
fund. The secondary market for municipal bonds, particularly below investment
grade bonds in which the Fund may invest, also tends to be less well-developed
and less liquid than many other securities markets, which may adversely affect
the Fund's ability to sell its bonds at attractive prices.
Reinvestment Risk
Income from the Fund's municipal bond portfolio will decline if and when the
Fund invests the proceeds from matured, traded or called bonds at market
interest rates that are below the portfolio's then-current earnings rate. This
could impact the Fund's net asset value and reduce asset coverage on the APS.
Leverage Risk
The Fund utilizes financial leverage for investment purposes. Leverage risk
includes the risk associated with the issuance of APS to leverage the Fund's
Common Shares. The Fund may also invest in RIBS and other derivative
instruments, which will amplify the effects of leverage. If the dividend rate
on the APS exceeds the net rate of return on the Fund's portfolio, the leverage
will result in a lower net asset value than if the Fund were not leveraged, and
the Fund's ability to pay dividends and to meet its asset coverage requirements
on the APS would be reduced.
Because the fees received by the Manager and PIMCO are based on the Fund's
managed assets, the fees will be higher when leverage (including the APS) is
utilized, giving the Manager and PIMCO an incentive to utilize leverage.
4
Inflation Risk
Inflation risk is the risk that the value of assets or income from the Fund's
investments will be worth less in the future as inflation decreases the present
value of payments at future dates. As inflation increases, the real value of
the APS and distributions, as well as the value of the Fund's portfolio, could
decline.
Liquidity Risk
The Fund may invest up to 20% of its net assets in securities which are
illiquid at the time of investment, which means a security that cannot be sold
within seven days at a price which approximates fair value. Illiquid securities
may trade at a discount from comparable, more liquid investments and may be
subject to wide fluctuations in market value. Also, the Fund may not be able to
dispose of illiquid securities when that would be beneficial at a favorable
time or price.
Derivatives Risk
The Fund may utilize a variety of derivative instruments for investment or risk
management purposes, such as RIBS, structured notes, options contracts, futures
contracts, options on futures contracts, swap agreements, short sales and
delayed delivery and forward commitment transactions. Derivatives are subject
to a number of risks described elsewhere in this Prospectus, such as liquidity
risk, interest rate risk, credit risk and management risk. In addition,
investment by the Fund in RIBS and other derivative instruments may increase
the Fund's leverage. Derivatives also involve the risk of mispricing or
improper valuation, the risk of ambiguous documentation and physical custody
and the risk that changes in the value of a derivative may not correlate
perfectly with an underlying asset, interest rate or index. Suitable derivative
transactions may not be available in all circumstances and there can be no
assurance that the Fund will engage in these transactions to reduce exposure to
other risks when that would be beneficial.
Management Risk
The Fund is subject to management risk because it is an actively managed
investment portfolio. PIMCO and the individual portfolio manager will apply
investment techniques and risk analyses in making investment decisions for the
Fund, but there can be no guarantee that these will produce the desired results.
Anti-Takeover Provisions
The Fund's Amended and Restated Agreement and Declaration of Trust (as amended
to date, the "Declaration") and Amended By-Laws include provisions that could
have the effect of limiting the ability of other entities or persons to acquire
control of the Fund, to convert the Fund to open-end status or to change the
composition of the Board of Trustees.
Certain Affiliations
Because certain broker-dealers may be considered affiliated persons of the
Fund, the Manager and/or PIMCO, the Fund's ability to utilize such
broker-dealers is subject to restrictions and, in some cases, is prohibited.
This could limit the Fund's ability to engage in securities transactions and
take advantage of market opportunities.
For additional information about the risks of investing in APS and in the Fund,
see "Risks."
DIVIDENDS ON APS
The APS will entitle their holders to receive cash dividends at a rate per
annum that may vary for the successive Dividend Periods for such shares. In
general, except as described below, each Dividend Period for each series of APS
subsequent to the Initial Dividend Period will be seven days in length. The
Applicable Rate for a particular Dividend Period will be determined by an
Auction conducted on the Business Day next preceding the start of such Dividend
Period.
5
Through their Broker-Dealers, Beneficial Owners and Potential Beneficial Owners
of APS may participate in Auctions, although, except in the case of Special
Dividend Periods of longer than 91 days, Beneficial Owners desiring to continue
to hold all of their APS regardless of the Applicable Rate resulting from
Auctions need not participate. For an explanation of Auctions and the method of
determining the Applicable Rate, see "Description of APS--The Auction."
Except as described herein, investors in APS will not receive certificates
representing ownership of their shares. Ownership of APS will be maintained in
book-entry form by the Securities Depository or its nominee for the account of
the investor's Agent Member. The investor's Agent Member, in turn, will
maintain records of such investor's beneficial ownership of APS. Accordingly,
references herein to an investor's investment in or purchase, sale or ownership
of APS are to purchases, sales or ownership of those shares by Beneficial
Owners.
After the Initial Dividend Period, each Subsequent Dividend Period for each
series of APS will generally consist of seven days (a "7-Day Dividend Period");
provided, however, that prior to any Auction, the Fund may elect, subject to
certain limitations described herein, upon giving notice to holders thereof, a
Special Dividend Period for any or all series. A "Special Dividend Period" is a
Dividend Period consisting of a specified number of days, evenly divisible by
seven and not fewer than 14 nor more than 364 (a "Short Term Dividend Period")
or a Dividend Period consisting of a specified period of one whole year or more
but not greater than five years (a "Long Term Dividend Period"). Dividends on
the APS offered hereby are cumulative from the Date of Original Issue and are
payable when, as and if declared by the Board of Trustees of the Fund, out of
funds legally available therefor, commencing on the Initial Dividend Payment
Date. In the case of Dividend Periods that are not Special Dividend Periods,
dividends will be payable generally on each succeeding Tuesday for Series A
APS, on each succeeding Wednesday for Series B APS, on each succeeding Thursday
for Series C APS, on each succeeding Friday for Series D APS and on each
succeeding Monday for Series E APS, subject to certain exceptions.
Dividends for the APS will be paid through the Securities Depository on each
Dividend Payment Date. The Securities Depository's normal procedures provide
for it to distribute dividends in same-day funds to Agent Members, who are in
turn expected to distribute such dividends to the person for whom they are
acting as agent in accordance with the instructions of such person. See
"Description of APS--Dividends."
For each Subsequent Dividend Period, the cash dividend rate on each series of
APS will be the Applicable Rate that the Auction Agent advises the Fund has
resulted from an Auction. See "Description of APS--Dividends." The first
Auction for each series of the APS is scheduled to be held on the ending date
for the Initial Dividend Period as set forth above.
The Amended By-Laws provide that until the Fund gives a Request for Special
Dividend Period and the related Notice of Special Dividend Period, only 7-Day
Dividend Periods will be applicable to each series of APS. While the Fund does
not currently intend to give a Request for Special Dividend Period with respect
to any series of APS, it may so elect in the future subject to, and on, the
conditions discussed under "Description of the APS--Dividends--Notification of
Dividend Period."
A Special Dividend Period will not be effective for a series of APS unless
Sufficient Clearing Bids exist at the Auction in respect of such Special
Dividend Period. If Sufficient Clearing Bids do not exist at such Auction, the
Dividend Period commencing on the Business Day succeeding such Auction will be
a 7-Day Dividend Period, and the holders of the APS outstanding immediately
prior to such Auction will be required to continue to hold some or all of such
shares for such Dividend Period. In addition, the Fund may not give a Notice of
Special Dividend Period with respect to the APS, or if the Fund has given a
Notice of Special Dividend Period for the APS, the Fund will be required to
give a Notice of Revocation
6
in respect thereof, if (i) either the 1940 Act APS Asset Coverage is not
satisfied or the Fund fails to maintain Moody's Eligible Assets with an
aggregate Discounted Value at least equal to the APS Basic Maintenance Amount,
in each case on each of the two Valuation Dates immediately preceding the
Business Day prior to the related Auction Date for the APS, or (ii) sufficient
funds for the payment of dividends payable on the immediately succeeding
Dividend Payment Date have not been irrevocably deposited with the Auction
Agent by the close of business on the third Business Day preceding the related
Auction Date. In such event, the next succeeding Dividend Period will be a
7-Day Dividend Period.
ADVANCE NOTICE OF ALLOCATION OF TAXABLE INCOME; INCLUSION OF TAXABLE INCOME IN
DIVIDENDS
Dividends paid by the Fund, to the extent paid from tax-exempt income earned on
municipal bonds, will be exempt from federal income tax, although a portion of
those dividends may be a tax preference item for individuals for purposes of
the federal alternative minimum tax. In addition, for corporations, interest on
all tax-exempt obligations is taken into account in the computation of income
subject to the federal alternative minimum tax. Although the Fund will at all
times seek to avoid portfolio investments that pay interest that is taxable to
individuals under the federal alternative minimum tax, the Fund may not succeed
in this regard. The Fund is required to allocate net capital gains and other
income subject to federal income tax, if any, proportionately among the Common
Shares and APS. Except as noted below and under "Description of APS--Auction
Procedures," whenever the Fund is aware that it will include any net capital
gains or other income that is subject to federal income tax, but not including
for this purpose income that is exempt for regular federal income tax purposes
but subject to the alternative minimum tax ("Taxable Income"), in any dividend
on the APS, the Fund will notify the Auction Agent prior to the Auction
establishing the Applicable Rate for such dividend. The Auction Agent in turn
will notify each Broker-Dealer whenever it receives any such notice from the
Fund, and each Broker-Dealer will notify its Beneficial Owners and Potential
Beneficial Owners, as provided in its Broker-Dealer Agreement. In the
alternative, the Fund also may include such Taxable Income in a dividend on the
APS without giving advance notice thereof if it increases the dividend by an
amount sufficient to offset substantially the tax effect thereof or, in certain
circumstances, makes a Gross-up Dividend, as described in the next section. The
amount of Taxable Income otherwise allocable to the APS will depend upon the
amount of such income realized by the Fund and other factors but generally is
not expected to be significant. See "Taxes" and "Description of APS--Auction
Procedures--Auction Date; Advance Notice of Allocation of Taxable Income;
Inclusion of Taxable Income in Dividends."
GROSS-UP DIVIDENDS
The Fund may retroactively allocate any net capital gains or other Taxable
Income to the APS without giving the advance notice described in the preceding
section. If the Fund does so solely by reason of the fact that such allocation
is made as a result of the redemption of all or a portion of the outstanding
APS or the liquidation of the Fund, the Fund will make certain payments to
holders of the APS to which such allocation was made to offset substantially
the tax effect thereof. Otherwise, the Fund does not expect to make payments to
holders of the APS to offset the tax effect of any reallocation of net capital
gains or other taxable income. See "Description of APS--Dividends--Gross-up
Dividends" and "Taxes."
DETERMINATION OF MAXIMUM APPLICABLE RATES
Except during a Non-Payment Period, the Applicable Rate for any Dividend Period
for APS will not be more than the Maximum Applicable Rate applicable to such
shares. The Maximum Applicable Rate for each series of APS will depend on the
credit rating assigned to such series and on the duration of the Dividend
Period. The Maximum Applicable Rate will be the Applicable Percentage of the
Reference Rate. The Reference Rate is (i) with respect to any 7-Day Dividend
Period or any Short Term Dividend
7
Period having 28 or fewer days, the higher of the applicable "AA" Composite
Commercial Paper Rate and the Taxable Equivalent of the Short-Term Municipal
Obligation Rate, (ii) with respect to any Short Term Dividend Period having
more than 28 but fewer than 183 days, the applicable "AA" Composite Commercial
Paper Rate, (iii) with respect to any Short Term Dividend Period having 183 or
more but fewer than 364 days, the applicable U.S. Treasury Bill Rate and (iv)
with respect to any Long Term Dividend Period, the applicable U.S. Treasury
Note Rate. The Applicable Percentage will be determined based on (i) the credit
rating assigned on such date to the APS by Moody's (or, if Moody's shall not
make such rating available, the equivalent of such rating by a Substitute
Rating Agency) and (ii) whether the Fund has provided notification to the
Auction Agent prior to the Auction establishing the Applicable Rate for any
dividend that net capital gains or other taxable income will be included in
such dividend on the APS, as follows:
Applicable Applicable
Percentage of Percentage of
Reference Rate-- Reference Rate --
Moody's Credit Ratings on APS No Notification Notification
---------------------------------------------------------------------------
Aa3 or higher........................... 110% 150%
A....................................... 125 160
Baa..................................... 150 250
Below Baa............................... 200 275
There is no minimum Applicable Rate in respect of any Dividend Period. The
Applicable Rate for any Dividend Period commencing during any Non-Payment
Period, and the rate used to calculate the late charge described under
"Description of APS--Dividends--Non-Payment Period; Late Charge," initially
will be 200% of the Reference Rate (or 275% of such rate if the Fund has
provided notification to the Auction Agent prior to the Auction establishing
the Applicable Rate for any dividend that net capital gains or other taxable
income will be included in such dividend on APS).
AUCTION PROCEDURES
Separate Auctions will be conducted for each series of APS. Unless otherwise
permitted by the Fund, Beneficial Owners and Potential Beneficial Owners of APS
may only participate in Auctions through their Broker-Dealers. Broker-Dealers
will submit the Orders of their respective customers who are Beneficial Owners
and Potential Beneficial Owners to the Auction Agent, designating themselves as
Existing Holders in respect of shares subject to Orders submitted or deemed
submitted to them by Beneficial Owners and as Potential Holders in respect of
shares subject to Orders submitted to them by Potential Beneficial Owners. On
or prior to each Auction Date for the APS (the Business Day next preceding the
first day of each Dividend Period), each Beneficial Owner may submit Orders to
its Broker-Dealer as follows:
.. Hold Order--indicating its desire to hold the APS without regard to the
Applicable Rate for the next Dividend Period for such shares.
.. Bid--indicating its desire to hold the APS, provided that the Applicable Rate
for the next Dividend Period for such shares is not less than the rate per
annum specified in such Bid.
.. Sell Order--indicating its desire to sell the APS without regard to the
Applicable Rate for the next Dividend Period for such shares.
A Beneficial Owner may submit different types of Orders to its Broker-Dealer
with respect to the APS then held by such Beneficial Owner, provided that the
total number of APS covered by such Orders does
8
not exceed the number of APS held by such Beneficial Owner. If, however, a
Beneficial Owner offers through its Broker-Dealer to purchase additional APS in
such Auction, such Beneficial Owner, for purposes of such offer to purchase
additional shares, will be treated as a Potential Beneficial Owner as described
below. Bids by Beneficial Owners through their Broker-Dealers with rates per
annum higher than the Maximum Applicable Rate will be treated as Sell Orders. A
Hold Order (in the case of an Auction relating to a Dividend Period of 91 days
or less) or a Sell Order (in the case of an Auction relating to a Special
Dividend Period of longer than 91 days) shall be deemed to have been submitted
on behalf of a Beneficial Owner if an Order with respect to the APS then held
by such Beneficial Owner is not submitted on behalf of such Beneficial Owner
for any reason, including the failure of a Broker-Dealer to submit such
Beneficial Owner's Order to the Auction Agent.
Potential Beneficial Owners of APS may submit Bids through their Broker-Dealers
in which they offer to purchase APS, provided that the Applicable Rate for the
next Dividend Period for such shares is not less than the rate per annum
specified in such Bid. A Bid by a Potential Beneficial Owner with a rate per
annum higher than the Maximum Applicable Rate will not be considered.
Neither the Fund nor the Auction Agent will be responsible for a
Broker-Dealer's failure to act in accordance with the instructions of
Beneficial Owners or Potential Beneficial Owners or failure to comply with any
of the foregoing.
A Broker-Dealer also may hold APS for its own account as a Beneficial Owner. A
Broker-Dealer thus may submit Orders to the Auction Agent as a Beneficial Owner
or a Potential Beneficial Owner and therefore participate in an Auction as an
Existing Holder or Potential Holder on behalf of both itself and its customers.
Any Order placed with the Auction Agent by a Broker-Dealer as or on behalf of a
Beneficial Owner or a Potential Beneficial Owner will be treated in the same
manner as an Order placed with a Broker-Dealer by a Beneficial Owner or a
Potential Beneficial Owner. Similarly, any failure by a Broker-Dealer to submit
to the Auction Agent an Order in respect of any APS held by it or its customers
who are Beneficial Owners will be treated in the same manner as a Beneficial
Owner's failure to submit to its Broker-Dealer an Order in respect of APS held
by it, as described above. Inasmuch as a Broker-Dealer participates in an
Auction as an Existing Holder or a Potential Holder only to represent the
interests of a Beneficial Owner or Potential Beneficial Owner, whether it be a
customer or itself, all discussion herein relating to the consequences of an
Auction for Existing Holders and Potential Holders also applies to the
underlying beneficial ownership interests represented thereby.
If Sufficient Clearing Bids exist in an Auction for a series of APS (that is,
in general, the number of APS subject to Bids by Potential Holders with rates
equal to or lower than the Maximum Applicable Rate is at least equal to the
number of APS subject to Sell Orders by Existing Holders), the Applicable Rate
will be the lowest rate per annum specified in the Submitted Bids which, taking
into account such rate per annum and all lower rates per annum bid by Existing
Holders and Potential Holders, would result in Existing Holders and Potential
Holders owning all of the APS available for purchase in the Auction. If
Sufficient Clearing Bids do not exist, the Dividend Period next following the
Auction automatically will be a 7-Day Dividend Period and the Applicable Rate
will be the Maximum Applicable Rate, and in such event, Existing Holders that
have submitted Sell Orders will not be able to sell in the Auction all, and may
not be able to sell any, APS subject to such Sell Orders. Thus, in certain
circumstances, Existing Holders and, thus, the Beneficial Owners they represent
may not have liquidity of investment. If all Existing Holders submit (or are
deemed to have submitted) Hold Orders in an Auction, the Dividend Period next
following the Auction automatically shall be the same length as the immediately
preceding Dividend Period, and the Applicable Rate will be 40% of the Reference
Rate (as defined under "Determination of Maximum Applicable Rates" above) in
effect on the date of the Auction (or 60% of such rate if the Fund has provided
notification to the Auction Agent prior to the Auction establishing the
9
Applicable Rate for any dividend that net capital gains or other taxable income
will be included in such dividend on APS). The Auction Procedures include a pro
rata allocation of shares for purchase and sale, which may result in an
Existing Holder selling or holding, or a Potential Holder purchasing, a number
of APS that is less than the number of APS specified in its Order. To the
extent the allocation has this result, a Broker-Dealer will be required to make
appropriate pro rata allocations among its customers and itself.
A Sell Order by an Existing Holder will constitute an irrevocable offer to sell
the APS subject thereto, and a Bid placed by an Existing Holder also will
constitute an irrevocable offer to sell the APS subject thereto if the rate per
annum specified in the Bid is higher than the Applicable Rate determined in the
Auction, in each case at a price per share equal to $25,000. A Bid placed by a
Potential Holder will constitute an irrevocable offer to purchase the APS
subject thereto at a price per share equal to $25,000 if the rate per annum
specified in such Bid is less than or equal to the Applicable Rate determined
in the Auction. Settlement of purchases and sales will be made on the next
Business Day (also a Dividend Payment Date) after the Auction Date through the
Securities Depository. Purchasers will make payment through their Agent Members
in same-day funds to the Securities Depository against delivery by book-entry
to their Agent Members. The Securities Depository will make payment to the
sellers' Agent Members in accordance with the Securities Depository's normal
procedures, which now provide for payment in same-day funds. See "Description
of APS--The Auction."
ASSET MAINTENANCE
Under the Amended By-Laws, the Fund must maintain (i) Moody's Eligible Assets
having, in the aggregate, a Discounted Value at least equal to the APS Basic
Maintenance Amount and (ii) 1940 Act APS Asset Coverage of at least 200%. See
"Description of APS--Asset Maintenance."
The Fund estimates that, based on the composition of its portfolio at August 7,
2002, 1940 Act APS Asset Coverage with respect to APS would be approximately
264% immediately after the issuance of the APS offered hereby in an amount
representing approximately 38% of the Fund's capital (including the capital
attributable to the APS).
The Discount Factors and guidelines for calculating the Discounted Value of the
Fund's portfolio for purposes of determining whether the APS Basic Maintenance
Amount has been satisfied have been established by Moody's in connection with
the Fund's receipt of a rating of "Aaa" on the APS on their Date of Original
Issue. See "Rating agency guidelines."
MANDATORY REDEMPTION
If the APS Basic Maintenance Amount or the 1940 Act APS Asset Coverage is not
maintained or restored as specified herein, the APS will be subject to
mandatory redemption, out of funds legally available therefor, at the Mandatory
Redemption Price of $25,000 per share plus an amount equal to dividends thereon
(whether or not earned or declared) accumulated but unpaid to the date fixed
for redemption. In addition, holders of APS may be entitled to receive Gross-up
Dividends in the event of redemption of such APS as described herein. See
"Description of APS--Dividends--Gross-up Dividends." Any such redemption will
be limited to the minimum number of APS necessary to restore the APS Basic
Maintenance Amount or the 1940 Act APS Asset Coverage, as the case may be. The
Fund's ability to make such a mandatory redemption may be restricted by the
provisions of the 1940 Act. See "Description of APS--Redemption--Mandatory
Redemption."
OPTIONAL REDEMPTION
The APS are redeemable at the option of the Fund, as a whole or in part, on any
Dividend Payment Date (except during the Initial Dividend Period or a Non-Call
Period) at the Optional Redemption Price of
10
$25,000 per share, plus an amount equal to dividends thereon (whether or not
earned or declared) accumulated but unpaid to the date fixed for redemption
plus the premium, if any, resulting from the designation of a Premium Call
Period. See "Description of APS--Redemption--Optional Redemption." In addition,
holders of APS may be entitled to receive Gross-up Dividends in the event of
redemption of such APS as described herein. See "Description of
APS--Dividends--Gross-up Dividends."
LIQUIDATION PREFERENCE
The liquidation preference of the APS will be $25,000 per share, plus an amount
equal to accumulated but unpaid dividends (whether or not earned or declared).
See "Description of APS--Liquidation Rights." In addition, holders of APS may
be entitled to receive Gross-up Dividends in the event of the liquidation of
the Fund as provided herein. See "Description of APS--Dividends--Gross-up
Dividends."
RATING
It is a condition to their issuance that the APS be issued with a credit
quality rating of "Aaa" from Moody's. The Fund may at some future time seek to
have the APS rated by an additional or Substitute Rating Agency. See "Rating
agency guidelines."
VOTING RIGHTS
The 1940 Act requires that the holders of APS and any other Preferred Shares,
voting as a class, have the right to elect at least two Trustees at all times
and to elect a majority of the Trustees at any time when two years' dividends
on the APS or any other Preferred Shares are unpaid. The holders of APS and any
other Preferred Shares will vote as a separate class on certain other matters
as required under the Declaration and Amended By-Laws and under the 1940 Act.
See "Description of APS--Voting Rights," "Description of capital structure" and
"Anti-takeover and other provisions in the Declaration of Trust."
TAX CONSIDERATIONS
Interest on certain "private activity" municipal bonds is treated as a tax
preference item for individuals for purposes of the federal alternative minimum
tax. In addition, for corporations, interest on all tax-exempt obligations is
taken into account in the computation of income subject to the federal
alternative minimum tax. The Fund will at all times seek to avoid portfolio
investments that pay interest that is taxable to individuals under the federal
alternative minimum tax. Nonetheless, the Fund may not be successful in this
regard. Therefore, if your goal is to avoid or limit your receipt of income
that is taxable under the federal alternative minimum tax, you should discuss
with your tax advisor whether the Fund is an appropriate investment for you.
Moreover, distributions of any taxable net investment income and net short-term
capital gain are taxable as ordinary income. See "Taxes."
11
--------------------------------------------------------------------------------
The Fund
The Fund is a recently organized, diversified, closed-end management investment
company registered under the 1940 Act. The Fund was organized as a
Massachusetts business trust on March 29, 2002 pursuant to the Declaration,
which is governed by the laws of The Commonwealth of Massachusetts. The Fund's
principal office is located at 1345 Avenue of the Americas, New York, New York
10105, and its telephone number is (212) 739-3369.
The Fund commenced operations on June 28, 2002 upon the closing of an initial
public offering of 50,500,000 of its Common Shares. The proceeds of such
offering were approximately $722,507,500 after the payment of organizational
and offering expenses. In connection with the initial public offering of the
Common Shares, the underwriters were granted an option to purchase up to
7,575,000 additional Common Shares to cover over-allotments. On July 15, 2002
and August 7, 2002, the underwriters purchased, at a price of $14.325 per
Common Share, an additional 4,400,000 and 2,601,148 Common Shares,
respectively, pursuant to the over-allotment option.
Use of proceeds
The net proceeds of the offering of APS will be approximately $499,575,000
after payment of the estimated offering costs (not expected to exceed
$375,000). The Fund will invest the net proceeds of the offering in accordance
with the Fund's investment objective and policies discussed below under "The
Fund's investments." It is presently anticipated that the Fund will be able to
invest substantially all of the net proceeds in municipal bonds that meet the
investment objective and policies within three months after the completion of
the offering. Pending such investment, it is anticipated that the proceeds will
be invested in high quality, short-term, tax-exempt securities, although the
Fund may, if necessary, also invest in other high quality, short-term
securities, including mortgage-backed and corporate debt securities, that may
be either tax-exempt or taxable.
Capitalization
The following table sets forth the unaudited capitalization of the Fund as of
August 7, 2002 and as adjusted to give effect to the issuance of the APS
offered hereby (including estimated offering expenses and sales load of
$5,425,000).
As of August 7, 2002
Actual As Adjusted
---------------------------------------------------------------------------------------------
Auction Preferred Shares, par value $0.00001 per share (no shares
issued; 20,200 shares issued, as adjusted, at $25,000 per share
liquidation preference)........................................ $ 0 $ 505,000,000
Common Shares, par value $0.00001 per share, 57,508,129 shares
outstanding.................................................... $822,898,948 $ 817,473,948
Undistributed net investment income.............................. $ 2,105,525 $ 2,105,525
Net realized gain on investments................................. $ 0 $ 0
Net unrealized appreciation of investments....................... $ 7,463,525 $ 7,463,525
Net assets applicable to Common Shares and Auction Preferred
Shares......................................................... $832,467,998 $1,332,042,998
--------------------------------------------------------------------------------
12
--------------------------------------------------------------------------------
Portfolio composition
As of August 7, 2002, approximately 95.5% of the market value of the Fund's
portfolio was invested in long-term municipal bonds, and approximately 4.5% of
the market value of the Fund's portfolio was invested in cash. The following
table sets forth certain information with respect to the composition of the
Fund's investment portfolio as of August 7, 2002.
Number of Value (in
S&P* Moody's* Issues Thousands) Percent
-------------------------------------------
AAA Aaa 56 $360,864 43.3%
AA Aa1, Aa 9 106,951 12.8
A A1 31 228,903 27.5
BBB Baa1 2 15,334 1.8
BB Ba1 0 0 0.0
B B1 2 8,286 1.0
NR+ NR+ 15 75,947 9.1
Cash 37,571 4.5
----- --- -------- -----
Total 115 833,856 100.0%
--------
* Ratings: Using the higher of S&P's or Moody's ratings on the Fund's
municipal bonds. S&P rating categories may be modified further by a plus (+)
or minus (-) in AA, A, BBB, BB, B and C ratings. Moody's rating categories
may be modified further by a 1, 2, or 3 in Aa, A, Baa, Ba and B ratings.
+ Securities that are not rated by S&P or Moody's. Such municipal bonds may be
rated by Rating Agencies other than S&P or Moody's or may not be rated by
any such Rating Agency. With respect to the percentage of the Fund's assets
invested in such securities, PIMCO believes that these are of comparable
quality to municipal bonds rated investment grade (that is, rated within the
four highest grades by Moody's, S&P or Fitch). This determination is based
on PIMCO's own internal evaluation and does not necessarily reflect how such
securities would be rated by Moody's, S&P or Fitch if they were to rate the
securities.
--------------------------------------------------------------------------------
13
--------------------------------------------------------------------------------
The Fund's investments
INVESTMENT OBJECTIVE AND POLICIES
The Fund's investment objective is to provide current income exempt from
federal income tax. In pursuing this objective, PIMCO also seeks to preserve
and enhance the value of the Fund's holdings relative to the municipal bond
market generally, using proprietary analytical models that test and evaluate
the sensitivity of those holdings to changes in interest rates and yield
relationships.
PIMCO may at times believe that bonds associated with a particular municipal
market sector (for example, electric utilities), issued by a particular
municipal issuer or having particular structural characteristics are
undervalued. PIMCO may purchase such a bond for the Fund's portfolio because it
represents a market sector or issuer that PIMCO considers undervalued, even if
the value of the particular bond appears to be consistent with the value of
similar bonds. Municipal bonds of particular types (e.g., hospital bonds,
industrial revenue bonds or bonds issued by a particular municipal issuer) may
be undervalued because there is a temporary excess of supply in that market
sector, or because of a general decline in the market price of municipal bonds
of the market sector for reasons that do not apply to the particular municipal
bonds that are considered undervalued. The Fund's investment in municipal bonds
may be based on PIMCO's belief that their yield and/or total return potential
is higher than that available on bonds bearing similar levels of interest rate
risk, credit risk and other forms of risk, or that their value relative to the
municipal bond market is less sensitive to these risks. The Fund attempts to
increase its portfolio value relative to the municipal bond market generally by
prudent selection of municipal bonds regardless of the direction the market may
move. Any capital appreciation realized by the Fund will generally result in
the distribution of taxable capital gains to holders of APS.
Under normal market conditions, the Fund will invest its net assets in a
portfolio of municipal bonds the interest from which is exempt from federal
income taxes. The Fund expects to be fully invested (at least 90% of its total
assets) in tax-exempt municipal bonds.
Under normal market conditions, the Fund will invest at least 80% of its net
assets in municipal bonds which are of investment grade quality at the time of
investment, including bonds that are unrated but judged to be of investment
grade quality by PIMCO. Investment grade quality means that such bonds are
rated, at the time of investment, within the four highest grades (Baa or BBB or
better by Moody's, S&P or Fitch) or are unrated but judged to be of comparable
quality by PIMCO. The Fund may invest up to 20% of its net assets in municipal
bonds that are rated, at the time of investment, Ba/BB or B by Moody's, S&P or
Fitch or bonds that are unrated but judged to be of comparable quality by
PIMCO. Bonds of below investment grade quality (Ba/BB or below) are commonly
referred to as "junk bonds." Bonds of below investment grade quality are
regarded as having predominantly speculative characteristics with respect to
capacity to pay interest and repay principal. Bonds in the lowest investment
grade category may also be considered to possess some speculative
characteristics by certain rating agencies. The foregoing credit quality
policies apply only at the time a security is purchased, and the Fund is not
required to dispose of a security in the event that a rating agency or PIMCO
downgrades its assessment of the credit characteristics of a particular issue.
In determining whether to retain or sell such a security, PIMCO may consider
such factors as PIMCO's assessment of the credit quality of the issuer of such
security, the price at which such security could be sold and the rating, if
any, assigned to such security by other rating agencies. A general description
of Moody's, S&P's and Fitch's ratings of municipal bonds is set forth in
Appendix A to the Statement of Additional Information. The Fund may also invest
up to 10% of its net assets in securities of other open- or closed-end
investment companies that invest primarily in municipal bonds of the types in
which the Fund may invest directly. As a stockholder in an investment company,
the Fund would bear its ratable share of that investment
--------------------------------------------------------------------------------
14
The Fund's investments
--------------------------------------------------------------------------------
company's expenses in addition to the Fund's own expenses. See "--Other
Investment Companies" below.
The Fund may purchase municipal bonds that are additionally secured by
insurance, bank credit agreements or escrow accounts. The credit quality of
companies which provide such credit enhancements will affect the value of those
securities. Although the insurance feature reduces certain financial risks, the
premiums for insurance and the higher market price paid for insured obligations
may reduce the Fund's income. Insurance generally will be obtained from
insurers with a claims-paying ability rated Aaa by Moody's or AAA by S&P or
Fitch. The insurance feature does not guarantee the market value of the insured
obligations or the net asset value of the APS or the Common Shares.
Upon PIMCO's recommendation, for temporary defensive purposes, the Fund may
invest up to 100% of its net assets in high quality, short-term investments,
including mortgage-backed and corporate debt securities, that may be either
tax-exempt or taxable. The Fund may also invest without limit in these
securities temporarily in order to keep the Fund's cash fully invested,
including during the period in which the net proceeds of this offering are
being invested. The Fund intends to invest in taxable short-term investments
only in the event that suitable tax-exempt short-term investments are not
available at reasonable prices and yields. Investment in taxable short-term
investments would result in a portion of your dividends being subject to
federal income taxes. However, as discussed below under "Description of
APS--Auction Procedures--Auction Date; Advance Notice of Allocation of Taxable
Income; Inclusion of Taxable Income in Dividends," dividends on APS will
generally increase if Taxable Income is included in a dividend.
The Fund cannot change its investment objective without the approval of the
holders of a "majority of the outstanding" Common Shares and any Preferred
Shares (including the APS) voting together as a single class and of the holders
of a "majority of the outstanding" Preferred Shares (including the APS) voting
as a separate class. A "majority of the outstanding" shares (whether voting
together as a single class or voting as a separate class) means (i) 67% or more
of such shares present at a meeting, if the holders of more than 50% of those
shares are present or represented by proxy, or (ii) more than 50% of such
shares, whichever is less. See "Description of APS--Voting Rights" for
additional information with respect to the voting rights of holders of APS.
The Fund will at all times seek to avoid bonds generating interest potentially
subjecting individuals to the federal alternative minimum tax. Nonetheless, the
Fund may not be successful in this regard and if you are, or as a result of an
investment in the Fund would become, subject to the federal alternative minimum
tax, the APS may not be a suitable investment for you. Special alternative
minimum tax rules apply to corporate holders. In addition, capital gain
dividends will be subject to capital gains taxes. See "Tax Matters."
The following provides additional information regarding the types of securities
and other instruments in which the Fund will ordinarily invest. A more detailed
discussion of these and other instruments and investment techniques that may be
used by the Fund is provided under "Investment Objective and Policies" in the
Statement of Additional Information.
MUNICIPAL BONDS
Municipal bonds are either general obligation or revenue bonds and typically
are issued to finance public projects (such as roads or public buildings), to
pay general operating expenses or to refinance outstanding debt. General
obligation bonds are backed by the full faith and credit, or taxing authority,
of the issuer and may be repaid from any revenue source; revenue bonds may be
repaid only from the
--------------------------------------------------------------------------------
15
The Fund's investments
--------------------------------------------------------------------------------
revenues of a specific facility or source. The Fund also may purchase municipal
bonds that represent lease obligations. These carry special risks because the
issuer of the bonds may not be obligated to appropriate money annually to make
payments under the lease. In order to reduce this risk, the Fund will only
purchase municipal bonds representing lease obligations where PIMCO believes
the issuer has a strong incentive to continue making appropriations until
maturity.
The municipal bonds in which the Fund will invest are generally issued by
states, cities or local authorities, or certain possessions and territories of
the United States (such as Puerto Rico or Guam), and pay interest that, in the
opinion of bond counsel to the issuer (or on the basis of other authority
believed by PIMCO to be reliable), is exempt from federal income taxes.
The yields on municipal bonds depend on a variety of factors, including
prevailing interest rates and the condition of the general money market and the
municipal bond market, the size of a particular offering, the maturity of the
obligation and the rating of the issue. The market value of municipal bonds
will vary with changes in interest rate levels and as a result of changing
evaluations of the ability of their issuers to meet interest and principal
payments.
The Fund will invest primarily in municipal bonds with long-term maturities in
order to maintain a weighted average maturity of 15-30 years, but the weighted
average maturity of obligations held by the Fund may be shortened, depending on
market conditions.
WHEN-ISSUED, DELAYED DELIVERY AND FORWARD COMMITMENT TRANSACTIONS
The Fund may purchase securities which it is eligible to purchase on a
when-issued basis, may purchase and sell such securities for delayed delivery
and may make contracts to purchase such securities for a fixed price at a
future date beyond normal settlement time (forward commitments). When-issued
transactions, delayed delivery purchases and forward commitments involve a risk
of loss if the value of the securities declines prior to the settlement date.
The risk is in addition to the risk that the Fund's other assets will decline
in value. Therefore, these transactions may result in a form of leverage and
increase the Fund's overall investment exposure. Typically, no income accrues
on securities the Fund has committed to purchase prior to the time delivery of
the securities is made, although the Fund may earn income on securities it has
segregated to cover these positions.
STRUCTURED NOTES
The Fund may invest in "structured" notes, which are privately negotiated debt
obligations where the principal and/or interest is determined by reference to
the performance of a benchmark asset, market or interest rate, such as selected
securities, an index of securities or specified interest rates, or the
differential performance of two assets or markets, such as indices reflecting
taxable and tax-exempt bonds. Depending on the terms of the note, the Fund may
forgo all or part of the interest and principal that would be payable on a
comparable conventional note. The rate of return on structured notes may be
determined by applying a multiplier to the performance or differential
performance of the referenced index(es) or other asset(s). Application of a
multiplier involves leverage that will serve to magnify the potential for gain
and the risk of loss.
The Fund currently intends that any use of structured notes will be for the
purpose of reducing the interest rate sensitivity of the Fund's portfolio (and
thereby decreasing the Fund's exposure to interest rate risk) and, in any
event, that the interest income on the notes will normally be exempt from
federal income tax. The Fund will only invest in structured notes if it has
received an opinion of counsel for the issuer (or the advice of another
authority believed by PIMCO to be reliable) that the interest income on the
notes will be exempt from federal income tax. Like other sophisticated
strategies, the Fund's use of
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16
The Fund's investments
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structured notes may not work as intended; for example, the change in value of
the structured notes may not match very closely the change in the value of
bonds that the structured notes were purchased to hedge.
VARIABLE AND FLOATING RATE SECURITIES
Variable and floating rate securities provide for a periodic adjustment in the
interest rate paid on the obligations. The Fund may invest in floating rate
debt instruments ("floaters") and engage in credit spread trades. While
floaters provide a certain degree of protection against rising interest rates,
the Fund will participate in any decline in interest rates as well, although
this is no guarantee that the interest rates earned by the Fund on its
investments will be greater than the dividend rate payable with respect to the
APS. A credit spread trade is an investment position relating to a difference
in the prices or interest rates of two bonds or other securities, where the
value of the investment position is determined by changes in the difference
between such prices or interest rates, as the case may be, of the respective
securities.
RESIDUAL INTEREST MUNICIPAL BONDS (RIBS)
The Fund may also invest up to 10% of its total assets in RIBS, whose interest
rates bear an inverse relationship to the interest rate on another security or
the value of an index. An investment in RIBS typically will involve greater
risk than an investment in a fixed rate bond. Because increases in the interest
rate on the other security or index reduce the residual interest paid on a RIB,
the value of a RIB is generally more volatile than that of a fixed rate bond.
RIBS have interest rate adjustment formulas that generally reduce or, in the
extreme, eliminate the interest paid to the Fund when short-term interest rates
rise and increase the interest paid to the Fund when short-term interest rates
fall. RIBS have varying degrees of liquidity that approximate the liquidity of
the underlying bond(s), and the market price for these securities is volatile.
These securities generally will underperform the market of fixed rate bonds in
a rising interest rate environment but tend to outperform the market of fixed
rate bonds when interest rates decline or remain relatively stable. Although
volatile, RIBS typically offer the potential for yields exceeding the yields
available on fixed rate bonds with comparable credit quality, coupon, call
provisions and maturity. The Fund may also invest in RIBS for the purpose of
increasing the Fund's leverage. Should short-term and long-term interest rates
rise, the combination of the Fund's investment in RIBS and its use of other
forms of leverage (including through the issuance of APS or the use of other
derivative instruments) likely will adversely affect the Fund's net asset
value. Trusts in which RIBS may be held could be terminated, in which case the
residual bond holder would take possession of the underlying bond(s) on an
unleveraged basis.
OTHER INVESTMENT COMPANIES
The Fund may invest up to 10% of its net assets in securities of other open- or
closed-end investment companies that invest primarily in municipal bonds of the
types in which the Fund may invest directly. The Fund may invest in other
investment companies either during periods when it has large amounts of
uninvested cash, such as the period shortly after the Fund receives the
proceeds of the offering of the APS, during periods when there is a shortage of
attractive, high-yielding municipal bonds available in the market, or when
PIMCO believes share prices of other investment companies offer attractive
values. The Fund may invest in investment companies that are advised by PIMCO
or its affiliates to the extent permitted by applicable law and/or pursuant to
exemptive relief from the Securities and Exchange Commission. As a stockholder
in an investment company, the Fund will bear its ratable share of that
investment company's expenses and would remain subject to payment of the Fund's
management fees and other expenses with respect to assets so invested. PIMCO
will take expenses into account when evaluating the investment merits of an
investment in an investment company relative to available municipal bond
investments. In addition, the securities of other investment companies may also
be
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17
The Fund's investments
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leveraged and will therefore be subject to the risks associated with leverage.
The net asset value and market value of leveraged shares will be more volatile,
and the yield to shareholders will tend to fluctuate more than the yield
generated by unleveraged shares.
DERIVATIVES
The Fund may, but is not required to, use a variety of derivative instruments
to add leverage to the portfolio, for risk management purposes or as part of
its investment strategies. Generally, derivatives are financial contracts whose
value depends upon, or is derived from, the value of an underlying asset,
reference rate or index and may relate to individual debt instruments, interest
rates and related indexes. Examples of derivative instruments that the Fund may
use include RIBS, structured notes, options contracts, futures contracts,
options on futures contracts, swap agreements, short sales and delayed delivery
and forward commitment transactions. The Fund's use of derivative instruments
involves risks different from, or possibly greater than, the risks associated
with investments directly in securities and other more traditional investments.
See "Risks--Derivatives Risk." Certain types of derivative instruments that the
Fund may utilize with some frequency are described elsewhere in this section,
including those described under "--Structured Notes" and "--Residual Interest
Municipal Bonds (RIBS)" above. Please see "Investment Objective and
Policies--Derivative Instruments" in the Statement of Additional Information
for additional information about these and other derivative instruments that
the Fund may use and the risks associated with such instruments. Income earned
by the Fund from many derivatives transactions will be treated as capital gain
and, if not offset by net realized capital loss, will be distributed to
shareholders in taxable distributions. There is no assurance that derivative
strategies will be available at any time or that PIMCO will determine to use
them for the Fund or, if used, that the strategies will be successful. In
addition, the Fund's use of derivative instruments will be limited by the
Rating Agency guidelines described below. See "Rating agency guidelines."
Please see "Investment Objective and Policies" in the Statement of Additional
Information for additional information regarding the investments of the Fund
and their related risks.
Risks
Risk is inherent in all investing. Investing in any investment company security
involves risk, including the risk that you may receive little or no return on
your investment or even that you may lose part or all of your investment.
Therefore, before purchasing APS, you should consider carefully the following
risks that you assume when you invest in the Fund.
AUCTION RISK
You may not be able to sell your APS at an Auction if the Auction fails; that
is, if there are more APS offered for sale than there are buyers for those
shares. If Sufficient Clearing Bids do not exist in an Auction, the Applicable
Rate will be the Maximum Applicable Rate, and in such event, owners of APS
wishing to sell will not be able to sell all, and may not be able to sell any,
of such shares in the Auction. As a result, your investment in APS may be
illiquid. Neither the Broker-Dealers nor the Fund is obligated to purchase APS
in an Auction or otherwise, nor is the Fund required to redeem APS in the event
of a failed Auction. Also, if you place bid orders (orders to retain APS) at an
Auction only at a specified rate and that bid rate exceeds the Applicable Rate
set at the Auction, you will not retain your APS. Finally, if you elect to
retain APS without specifying a rate below which you would not wish to continue
to hold those APS and the Auction sets a below-market rate, you may receive a
lower rate of return on your APS than the market rate. See "Description of
APS--The Auction" and "Description of APS--Auction Procedures."
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18
Risks
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RATINGS AND ASSET COVERAGE RISK
While Moody's is expected to assign a rating of "Aaa" to the APS, the ratings
would not eliminate or necessarily mitigate the risks of investing in the APS.
A Rating Agency could downgrade the APS, which may make your shares less liquid
at an Auction or in the secondary market. In addition, the Fund may be forced
to redeem your APS to meet regulatory or Rating Agency requirements. The Fund
may also voluntarily redeem APS under certain circumstances. See "Description
of APS--Redemption." The Fund may not redeem APS if such a redemption would
cause the Fund to fail to meet regulatory or Rating Agency asset coverage
requirements, and the Fund may not declare, pay or set apart for payment any
dividend or other distribution if immediately thereafter the Fund would fail to
meet regulatory asset coverage requirements. In addition, as a condition to its
receipt of an "Aaa" rating on the APS, the Fund has agreed to certain
investment limitations, which may restrict the Fund from making investments
that PIMCO believes would benefit the Fund. See "Rating agency guidelines" for
descriptions of the significance and limitations of the ratings on the APS and
of the asset maintenance and other tests the Fund must meet.
SECONDARY MARKET RISK
The Broker-Dealers may maintain a secondary trading market in the APS outside
of Auctions; however, they have no obligation to do so, and there can be no
assurance that a secondary market for the APS will develop or, if it does
develop, that it will provide holders with a liquid trading market (i.e.,
trading will depend on the presence of willing buyers and sellers and the
trading price is subject to variables to be determined at the time of the trade
by the Broker-Dealers). The APS will not be registered on any stock exchange or
on any automated quotation system. If you try to sell your APS between
Auctions, you may not be able to sell any or all of your shares, or you may
receive a purchase price of less than $25,000 per share. An increase in the
level of interest rates, particularly during any Long Term Dividend Period,
likely will have an adverse effect on the secondary market price of the APS.
LIMITED OPERATING HISTORY
The Fund is a recently organized, diversified, closed-end management investment
company which has been operational for less than two months.
INTEREST RATE RISK
Interest rate risk is the risk that bonds (and the Fund's net assets) will
decline in value because of changes in interest rates. Generally, municipal
bonds will decrease in value when interest rates rise and increase in value
when interest rates decline. The value of the longer-term bonds in which the
Fund generally invests normally fluctuates more in response to changes in
interest rates than does the value of shorter-term bonds. Because the Fund will
invest primarily in long-term bonds, the Fund's net asset value will fluctuate
more in response to changes in market interest rates than if the Fund invested
primarily in shorter-term bonds. The Fund may invest up to 10% of its total
assets in RIBS. Compared to similar fixed rate municipal obligations, the value
of RIBS will fluctuate to a greater extent in response to changes in prevailing
long-term interest rates. Moreover, the income earned on RIBS will fluctuate in
response to changes in prevailing short-term interest rates. Thus, when RIBS
are held by the Fund, an increase in short- or long-term market interest rates
will adversely affect the income received from such bonds or the net asset
value of the Fund's shares.
The APS pay dividends based on short-term interest rates. The Fund will use the
proceeds from the issuance of APS to buy municipal bonds, which generally pay
interest based on longer-term yields. Long-term municipal bond yields are
typically, although not always, higher than short-term interest rates. If
short-term interest rates rise, the dividend rate on the APS may rise so that
the amount of dividends payable to APS shareholders exceeds the income from the
portfolio securities purchased with the
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19
Risks
--------------------------------------------------------------------------------
proceeds from the APS. Because income from the Fund's entire investment
portfolio (not just the portion of the portfolio purchased with the proceeds of
the APS offering) is available to pay APS dividends, however, APS dividend
rates would need to greatly exceed the Fund's net portfolio income before the
Fund's ability to pay APS dividends would be jeopardized. If long-term rates
rise, the value of the Fund's investment portfolio will decline, reducing the
amount of assets serving as asset coverage for the APS.
The Fund may utilize certain strategies, including investments in structured
notes, for the purpose of reducing the interest rate sensitivity of the
portfolio and decreasing the Fund's exposure to interest rate risk, although
there is no assurance that it will do so or that such strategies will be
successful. See "How the Fund manages risk--Hedging and Related Strategies."
CREDIT RISK
The Fund could lose money if the issuer of a municipal bond, or the
counterparty to a derivatives contract or other obligation, is unable or
unwilling to make timely principal and/or interest payments, or to otherwise
honor its obligations. Because the primary source of income for the Fund is the
interest and principal payments on the municipal bonds in which it invests, any
default by an issuer of a municipal bond could have a negative impact on the
Fund's ability to pay dividends on the APS and could result in the redemption
of some or all of the APS. In general, lower-rated municipal bonds carry a
greater degree of risk that the issuer will lose its ability to make interest
and principal payments, which could have a negative impact on the Fund's net
asset value or dividends. The Fund may invest up to 20% of its net assets in
municipal bonds that are rated Ba/BB or B by Moody's, S&P or Fitch or bonds
that are unrated but judged to be of comparable quality by PIMCO. Bonds rated
Ba/BB or B are regarded as having predominantly speculative characteristics
with respect to capacity to pay interest and repay principal, and these bonds
are commonly referred to as "junk bonds." The prices of these lower-grade bonds
are more sensitive to negative developments, such as a decline in the issuer's
revenues or a general economic downturn, than are the prices of higher-grade
securities. Municipal bonds in the lowest investment grade category may also be
considered to possess some speculative characteristics by certain Rating
Agencies.
MUNICIPAL BOND MARKET RISK
Investing in the municipal bond market involves certain risks. The amount of
public information available about the municipal bonds in the Fund's portfolio
is generally less than that for corporate equities or bonds, and the investment
performance of the Fund may therefore be more dependent on the analytical
abilities of PIMCO than would be a stock fund or taxable bond fund. The
secondary market for municipal bonds, particularly the below investment grade
bonds in which the Fund may invest, also tends to be less well developed or
liquid than many other securities markets, which may adversely affect the
Fund's ability to sell its bonds at attractive prices.
The ability of municipal issuers to make timely payments of interest and
principal may be diminished during general economic downturns and as
governmental cost burdens are reallocated among federal, state and local
governments. In addition, laws enacted in the future by Congress or state
legislatures or referenda could extend the time for payment of principal and/or
interest, or impose other constraints on enforcement of such obligations, or on
the ability of municipal issuers to levy taxes. Issuers of municipal securities
might seek protection under the bankruptcy laws. In the event of bankruptcy of
such an issuer, the Fund could experience delays in collecting principal and
interest and the Fund may not, in all circumstances, be able to collect all
principal and interest to which it is entitled. To enforce its rights in the
event of a default in the payment of interest or repayment of principal, or
both, the Fund may take possession of and manage the assets securing the
issuer's obligations on such securities, which may increase the Fund's
operating expenses. Any income derived from the Fund's ownership or operation
of such assets may not be tax exempt.
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20
Risks
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REINVESTMENT RISK
Reinvestment risk is the risk that income from the Fund's municipal bond
portfolio will decline if and when the Fund invests the proceeds from matured,
traded or called bonds at market interest rates that are below the portfolio's
then-current earnings rate. A decline in income could affect the Fund's net
asset value or reduce asset coverage on the APS.
LEVERAGE RISK
The Fund expects to utilize financial leverage on an ongoing basis for
investment purposes. Leverage risk includes the risk associated with the
issuance of APS to leverage the Common Shares. If the dividend rate on the APS
exceeds the net rate of return on the Fund's portfolio, the leverage will
result in a lower net asset value than if the Fund were not leveraged, and the
Fund's ability to pay dividends and meet its asset coverage requirements on the
APS would be reduced. Because the long-term bonds included in the Fund's
portfolio will typically pay fixed rates of interest while the dividend rate on
the APS will be adjusted periodically, this could occur even when both
long-term and short-term municipal rates rise. Similarly, any decline in the
net asset value of the Fund's investments could result in the Fund being in
danger of failing to meet its asset coverage requirements or of losing its
expected "Aaa" rating on the APS or, in an extreme case, the Fund's current
investment income might not be sufficient to meet the dividend requirements on
the APS. In order to counteract such an event, the Fund might need to liquidate
investments in order to fund a redemption of some or all of the APS.
While the Fund may from time to time consider reducing leverage in response to
actual or anticipated changes in interest rates in an effort to mitigate the
increased volatility of current income and net asset value associated with
leverage, there can be no assurance that the Fund will actually reduce leverage
in the future or that any reduction, if undertaken, will be effective. Changes
in the future direction of interest rates are very difficult to predict
accurately. If the Fund were to reduce leverage based on a prediction about
future changes to interest rates and that prediction turned out to be
incorrect, the reduction in leverage would likely operate to reduce the Fund's
net asset value relative to the circumstance where the Fund had not reduced
leverage. The Fund may decide that this risk outweighs the likelihood of
achieving the desired reduction to volatility in income and net asset value if
the prediction were to turn out to be correct, and determine not to reduce
leverage as described above.
The Fund may invest in securities of other investment companies. Such
securities may also be leveraged and will therefore be subject to the leverage
risks described above.
The Fund may also invest up to 10% of its assets in RIBS and invest in other
derivative instruments, which may amplify the effects of leverage and, during
periods of rising short-term interest rates, may adversely affect the Fund's
net asset value. See "Residual Interest Municipal Bonds (RIBS)" and
"Derivatives" under "The Fund's investments" and the Statement of Additional
Information under "Investment Objective and Policies--Derivative Instruments."
Because the fees paid to the Manager and PIMCO will be calculated on the basis
of the Fund's managed assets, the fees will be higher when leverage is
utilized, giving the Manager and PIMCO an incentive to utilize leverage.
INFLATION RISK
Inflation risk is the risk that the value of assets or income from the Fund's
investments will be worth less in the future as inflation decreases the value
of money. As inflation increases, the real, or inflation-adjusted, value of the
APS and distributions can decline. However, during any periods of rising
inflation, APS dividend payments, if any, may increase, which would tend to
offset this risk.
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21
Risks
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LIQUIDITY RISK
The Fund may invest up to 20% of its net assets in securities which are
illiquid at the time of investment. The term "illiquid securities" for this
purpose means securities that cannot be disposed of within seven days in the
ordinary course of business at approximately the value at which the Fund has
valued the securities. Illiquid securities may be subject to wide fluctuations
in market value. The Fund may be subject to significant delays in disposing of
illiquid securities. Accordingly, the Fund may be forced to sell these
securities at less than fair market value or may not be able to sell them when
PIMCO believes it is desirable to do so. Illiquid securities also may entail
registration expenses and other transaction costs that are higher than those
for liquid securities. Restricted securities, i.e., securities subject to legal
or contractual restrictions on resale, may be illiquid. However, some
restricted securities (such as securities issued pursuant to Rule 144A under
the Securities Act of 1933, as amended, and certain commercial paper) may be
treated as liquid for these purposes.
DERIVATIVES RISK
Derivatives are financial contracts whose value depends on, or is derived from,
the value of an underlying asset, reference rate or index (or relationship
between two indices). The Fund may invest in a variety of derivative
instruments, such as RIBS, structured notes, options contracts, futures
contracts, options on futures contracts, swap agreements, short sales and
delayed delivery and forward commitment transactions. The Fund may use
derivatives as a substitute for taking a position in an underlying portfolio
security or other asset and/or as part of a strategy designed to reduce
exposure to other risks, such as interest rate risk. The Fund also may use
derivatives to add leverage to the portfolio. The Fund's use of derivative
instruments involves risks different from, and possibly greater than, the risks
associated with investing directly in securities and other traditional
investments. Derivatives are subject to a number of risks described elsewhere
in this Prospectus, such as liquidity risk, interest rate risk, credit risk,
leveraging risk and management risk, and are also subject to the risk of
ambiguous documentation and physical custody. They also involve the risk of
mispricing or improper valuation and the risk that changes in the value of the
derivative may not correlate perfectly with the underlying asset, rate or
index. If the Fund invests in a derivative instrument, it could lose more than
the principal amount invested. Also, suitable derivative transactions may not
be available in all circumstances, and there can be no assurance that the Fund
will engage in these transactions to reduce exposure to other risks when that
would be beneficial. Income earned by the Fund from many derivatives
transactions will be treated as capital gain and, if not offset by net realized
capital loss, will be distributed to shareholders in taxable distributions.
There is no assurance that derivative strategies will be available at any time
or that PIMCO will determine to use them for the Fund or, if used, that the
strategies will be successful. In addition, the Fund's use of derivative
instruments will be limited by the Rating Agency guidelines described below.
See "Rating agency guidelines."
MANAGEMENT RISK
The Fund is subject to management risk because it is an actively managed
investment portfolio. PIMCO and the individual portfolio manager will apply
investment techniques and risk analyses in making investment decisions for the
Fund, but there can be no guarantee that these will produce the desired results.
ANTI-TAKEOVER PROVISIONS
The Declaration and Amended By-Laws include provisions that could have the
effect of limiting the ability of other entities or persons to acquire control
of the Fund, to convert the Fund to open-end status or to change the
composition of the Board of Trustees. See "Anti-takeover and other provisions
in the Declaration of Trust."
CERTAIN AFFILIATIONS
Certain broker-dealers may be considered to be affiliated persons of the Fund,
the Manager and/or PIMCO due to their possible affiliations with Allianz AG,
the ultimate parent of the Manager and
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22
Risks
--------------------------------------------------------------------------------
PIMCO. Absent an exemption from the Securities and Exchange Commission or other
regulatory relief, the Fund is generally precluded from effecting certain
principal transactions with affiliated brokers, and its ability to purchase
securities being underwritten by an affiliated broker or a syndicate including
an affiliated broker or to utilize affiliated brokers for agency transactions
is subject to restrictions. This could limit the Fund's ability to engage in
securities transactions and take advantage of market opportunities. Similar
prohibitions apply to trades with the Underwriters or their affiliates during
the offering of APS.
How the Fund manages risk
INVESTMENT LIMITATIONS
The Fund has adopted certain investment limitations designed to limit
investment risk and maintain portfolio diversification. These limitations (two
of which are listed below) are fundamental and may not be changed without the
approval of the holders of a majority of the outstanding Common Shares and any
Preferred Shares (including APS) voting together as a single class, and the
approval of the holders of a majority of any Preferred Shares (including APS)
voting as a separate class. The Fund may not:
.. Concentrate its investments in a particular industry, as that term is used in
the 1940 Act and as interpreted, modified or otherwise permitted by
regulatory authority having jurisdiction, from time to time; and
.. With respect to 75% of the Fund's total assets, purchase the securities of
any issuer, except securities issued or guaranteed by the U.S. government or
any of its agencies or instrumentalities or securities of other investment
companies, if, as a result, (i) more than 5% of the Fund's total assets would
be invested in the securities of that issuer or (ii) the Fund would hold more
than 10% of the outstanding voting securities of that issuer. For the purpose
of this restriction, each state and each separate political subdivision,
agency, authority or instrumentality of such state, each multi-state agency
or authority, and each guarantor, if any, are treated as separate issuers of
municipal bonds.
The Fund would be deemed to "concentrate" its investments in a particular
industry if it invested 25% or more of its net assets in that industry.
The Fund's industry concentration policy does not preclude it from focusing
investments in issuers in a group of related industrial sectors (such as
different types of utilities).
The Fund is subject to guidelines that are more limiting than the investment
restrictions set forth above and other restrictions set forth in the Statement
of Additional Information in order to obtain and maintain a rating of "Aaa"
from Moody's on the APS and may become subject to additional guidelines in the
future. The Fund does not anticipate that such guidelines will have a material
adverse effect on the Fund's ability to achieve its investment objective. See
"Rating agency guidelines" and "Investment Objective and Policies" and
"Investment Restrictions" in the Statement of Additional Information for
information about these guidelines and a complete list of the fundamental
investment policies of the Fund.
QUALITY OF INVESTMENTS
The Fund will invest at least 80% of its net assets in municipal bonds that at
the time of investment are investment grade quality. Investment grade quality
means that such bonds are rated, at the time of
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23
How the Fund manages risk
--------------------------------------------------------------------------------
investment, by Rating Agencies within the four highest grades (Baa or BBB or
better by Moody's, S&P or Fitch) or bonds that are unrated but judged to be of
comparable quality by PIMCO. Bonds in the lowest investment grade category may
be considered to possess some speculative characteristics by certain Rating
Agencies.
MANAGEMENT OF INVESTMENT PORTFOLIO AND CAPITAL STRUCTURE TO LIMIT LEVERAGE RISK
The Fund may take certain actions if short-term interest rates increase or
market conditions otherwise change (or the Fund anticipates such an increase or
change) and the Fund's leverage begins (or is expected) to adversely affect
Common Shareholders. In order to attempt to offset such a negative impact of
leverage on Common Shareholders, the Fund may shorten the average maturity or
duration of its investment portfolio (by investing in short-term, high-quality
securities or implementing certain hedging strategies) or may extend the
maturity of outstanding Preferred Shares (including the APS). The Fund also may
attempt to reduce leverage by redeeming or otherwise purchasing Preferred
Shares (subject to any restrictions discussed under "Description of
APS--Redemption") or by reducing any holdings in RIBS or other instruments that
create leverage. The success of any such attempt to limit leverage risk depends
on PIMCO's ability to accurately predict interest rate or other market changes.
Because of the difficulty of making such predictions, the Fund may not be
successful in managing its interest rate exposure in the manner described above.
If market conditions suggest that additional leverage would be beneficial, the
Fund may issue additional Preferred Shares or utilize other forms of leverage,
such as RIBS and other derivative instruments.
HEDGING AND RELATED STRATEGIES
The Fund may use various investment strategies designed to limit the risk of
price fluctuations of its portfolio securities and to preserve capital. For
instance, the Fund may invest in structured notes for the purpose of reducing
the interest rate sensitivity of the Fund's portfolio, thereby decreasing the
Fund's exposure to interest rate risk. The Fund currently intends that the
income from structured notes will normally be exempt from federal income tax.
See "The Fund's investments--Structured Notes." Other hedging strategies that
the Fund may use include: financial futures contracts; short sales; swap
agreements or options thereon; options on financial futures; and options based
on either an index of municipal securities or on taxable debt securities whose
prices, PIMCO believes, correlate with the prices of the Fund's investments.
Income earned by the Fund from many hedging activities will be treated as
capital gain and, if not offset by net realized capital loss, will be
distributed to shareholders in taxable distributions. If effectively used,
hedging strategies will offset in varying percentages losses incurred on the
Fund's investments due to adverse interest rate changes. There is no assurance
that these hedging strategies will be available at any time or that PIMCO will
determine to use them for the Fund or, if used, that the strategies will be
successful. In addition, the Fund's use of hedging transactions is restricted
in accordance with the Rating Agency guidelines described below and further
specified in the Amended By-Laws. For instance, the Fund's use of the types of
investments and transactions defined as "Moody's Hedging Transactions" in the
Glossary is limited as specified in that definition. From time to time, certain
restrictions in the definition of "Moody's Hedging Transactions" may be changed
with the approval of Moody's.
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24
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Rating agency guidelines
The Fund is required under Moody's guidelines to maintain assets having in the
aggregate a Discounted Value at least equal to the APS Basic Maintenance
Amount. Moody's has established guidelines for determining Discounted Value. To
the extent any particular portfolio holding does not satisfy Moody's
guidelines, all or a portion of such holding's value will not be included in
the calculation of Discounted Value (as defined by Moody's). The amount of such
assets included in the portfolio at any time may vary depending upon the
rating, diversification and other characteristics of the eligible assets
included in the portfolio, although it is not anticipated that in the normal
course of business the value of such assets would exceed 20% of the Fund's
total assets. The Moody's guidelines also impose limitations on the Fund's
investments.
The Fund is also required under the 1940 Act and Rating Agency guidelines to
maintain, with respect to shares of APS, asset coverage of at least 200% with
respect to senior securities that are stock (as that term is used in the 1940
Act), including APS (or such other asset coverage as may in the future be
specified in or under the 1940 Act as the minimum asset coverage for senior
securities that are stock (as used in the 1940 Act) of a closed-end investment
company as a condition of declaring dividends on its common shares) ("1940 Act
APS Asset Coverage").
In the event the Fund does not timely cure a failure to maintain (a) a
Discounted Value of its portfolio equal to the APS Basic Maintenance Amount or
(b) the 1940 Act APS Asset Coverage, in each case in accordance with the
requirements of the Rating Agency or Agencies then rating the shares of APS,
the Fund will be required by the Amended By-Laws to redeem shares of APS as
described under "Description of APS--Redemption--Mandatory Redemption."
The Moody's guidelines restrict the Fund's use of some types of investment
strategies. For example, the guidelines, among other restrictions, limit the
Fund's use of futures, options and other derivative transactions for hedging,
leveraging or investment purposes, restrict the use of forward commitments and
similar transactions and limit the percentage of the Fund's assets that may be
invested in any one issuer or type or class of issuer.
The Moody's guidelines also prohibit the Fund from taking certain types of
actions unless it has received written confirmation from Moody's that such
actions would not impair the ratings then assigned to the APS. These include
restrictions on borrowing money, engaging in short sales, lending portfolio
securities, issuing any class or series of shares ranking prior to or on a
parity with the APS with respect to the payment of dividends or the
distribution of assets upon dissolution, liquidation or winding up of the Fund
or merging or consolidating into or with any other entity.
The restrictions in the Moody's guidelines may limit the Fund's ability to make
investments that PIMCO believes would benefit the Fund. The descriptions of the
Moody's guidelines in this section and in "Description of APS--Asset
Maintenance" are summaries only and are not complete. The Moody's guidelines
are set forth in their entirety in the Amended By-Laws, which have been filed
as an exhibit to the Registration Statement of which this Prospectus is a part.
The Fund may, but is not required to, adopt any modifications to the guidelines
that may hereafter be established by Moody's. Failure to adopt any such
modifications, however, may result in a change in the ratings described above
or a withdrawal of ratings altogether. In addition, any Rating Agency providing
a rating for the APS may, at any time, change or withdraw any such rating. The
Board may, without shareholder approval, amend, alter or repeal certain of the
definitions and related provisions which have
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25
Rating agency guidelines
--------------------------------------------------------------------------------
been adopted by the Fund in the Amended By-Laws pursuant to the Rating Agency
guidelines only in the event the Fund receives written confirmation from such
Rating Agency or Agencies that any such amendment, alteration or repeal would
not impair the ratings then assigned by such Rating Agency or Agencies to the
APS.
As described by Moody's, a preferred stock rating is an assessment of the
capacity and willingness of an issuer to pay preferred stock obligations. The
ratings on the APS are not recommendations to purchase, hold or sell those
shares, inasmuch as the ratings do not comment as to market price or
suitability for a particular investor. The Rating Agency guidelines described
above also do not address the likelihood that an owner of APS will be able to
sell such shares in an Auction or otherwise. The ratings are based on current
information furnished to Moody's by the Fund and/or the Manager and its
affiliates and information obtained from other sources. The ratings may be
changed, suspended or withdrawn as a result of changes in, or the
unavailability of, such information. The Common Shares have not been rated by a
Rating Agency.
A Rating Agency's guidelines will apply to the APS only so long as such Rating
Agency is rating such shares. The Fund will pay certain fees to Moody's for
rating the APS. The Fund may at some future time seek to have the APS rated by
an additional or Substitute Rating Agency.
Description of APS
The following is a brief description of the terms of the APS. This description
does not purport to be complete and is subject to, and qualified in its
entirety by reference to, the Declaration and Amended By-Laws, including the
provisions thereof establishing the APS. The Declaration and the Amended
By-Laws establishing the terms of the APS have been filed as exhibits to the
Registration Statement of which this Prospectus is a part.
Each series of APS will be Preferred Shares that entitle their holders to
receive dividends when, as and if declared by the Board of Trustees, out of
funds legally available therefor, at a rate per annum that may vary for the
successive Dividend Periods for each such series. After the Initial Dividend
Period, each Subsequent Dividend Period for each series of APS generally will
be a 7-Day Dividend Period; provided, however, that prior to any Auction, the
Fund may elect, subject to certain limitations described herein, upon giving
notice to holders thereof, a Special Dividend Period. The Applicable Rate for a
particular Dividend Period for a series of APS will be determined by an Auction
conducted on the Business Day before the start of such Dividend Period.
Beneficial Owners and Potential Beneficial Owners of APS may participate in
Auctions therefor, although, except in the case of Special Dividend Periods of
longer than 91 days, Beneficial Owners desiring to continue to hold all of
their APS regardless of the Applicable Rate resulting from Auctions need not
participate. For an explanation of Auctions and the method of determining the
Applicable Rate, see "--The Auction."
The nominee of the Securities Depository is expected to be the sole holder of
record of each series of APS. Accordingly, each purchaser of APS must rely on
(i) the procedures of the Securities Depository and, if such purchaser is not a
member of the Securities Depository, such purchaser's Agent Member, to receive
dividends, distributions and notices and to exercise voting rights (if and when
applicable) and (ii) the records of the Securities Depository and, if such
purchaser is not a member of the Securities Depository, such purchaser's Agent
Member, to evidence its beneficial ownership of the APS.
When issued and sold, the APS of each series will have a liquidation preference
of $25,000 per share plus an amount equal to accumulated but unpaid dividends
(whether or not earned or declared) and will be
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26
Description of APS
--------------------------------------------------------------------------------
fully paid and, except as discussed under "Anti-takeover and other provisions
in the Declaration of Trust," non-assessable. See "--Liquidation Rights." The
APS will not be convertible into Common Shares or other shares of beneficial
interest of the Fund, and the holders thereof will have no preemptive rights.
The APS will not be subject to any sinking fund but will be subject to
redemption at the option of the Fund at the Optional Redemption Price on any
Dividend Payment Date for such series (except during the Initial Dividend
Period and during a Non-Call Period) and, in certain circumstances, will be
subject to mandatory redemption by the Fund at the Mandatory Redemption Price
stated herein. See "--Redemption."
In addition to serving as the Auction Agent in connection with the Auction
Procedures described below, Deutsche Bank Trust Company Americas will be the
transfer agent, registrar, dividend paying agent and redemption agent for each
series of APS. The Auction Agent, however, will serve merely as the agent of
the Fund, acting in accordance with the Fund's instructions, and will not be
responsible for any evaluation or verification of any matters certified to it.
Except in an Auction, the Fund will have the right (to the extent permitted by
applicable law) to purchase or otherwise acquire any APS so long as the Fund is
current in the payment of dividends on APS and on any other shares of
beneficial interest of the Fund ranking on a parity with the APS with respect
to the payment of dividends or upon liquidation.
THE AUCTION
General
Holders of the APS of each series will be entitled to receive cumulative cash
dividends on their shares when, as and if declared by the Board of Trustees,
out of the funds legally available therefor, on the Initial Dividend Payment
Date with respect to the Initial Dividend Period for each series and,
thereafter, on each Dividend Payment Date with respect to a Subsequent Dividend
Period for each series (generally a period of seven days subject to certain
exceptions set forth under "--Dividends--General") at the rate per annum equal
to the Applicable Rate for each such Dividend Period.
The provisions of the Amended By-Laws establishing the terms of the APS offered
hereby will provide that the Applicable Rate for each Dividend Period after the
Initial Dividend Period for each series will be equal to the rate per annum
that the Auction Agent advises has resulted on the Business Day preceding the
first day of such Dividend Period due to implementation of the Auction
Procedures set forth in the Amended By-Laws in which persons determine to hold
or offer to purchase or sell the APS. The Auction Procedures are attached as
Appendix C to the Statement of Additional Information. Each periodic operation
of such procedures with respect to the APS is referred to herein as an
"Auction." If, however, the Fund should fail to pay or duly provide for the
full amount of any dividend on or the redemption price of the APS called for
redemption, the Applicable Rate for the APS will be determined as set forth
under "--Dividends--Non-Payment Period; Late Charge."
Auction Agency Agreement
The Fund will enter into the Auction Agency Agreement with the Auction Agent,
which provides, among other things, that the Auction Agent will follow the
Auction Procedures for the purpose of determining the Applicable Rate for each
series of APS. The Fund will pay the Auction Agent compensation for its
services under the Auction Agency Agreement.
The Auction Agent will act as agent for the Fund in connection with Auctions.
In the absence of bad faith or negligence on its part, the Auction Agent will
not be liable for any action taken, suffered or omitted, or for any error of
judgment made, by it in the performance of its duties under the Auction
--------------------------------------------------------------------------------
27
Description of APS
--------------------------------------------------------------------------------
Agency Agreement and will not be liable for any error of judgment made in good
faith unless the Auction Agent shall have been negligent in ascertaining the
pertinent facts. Pursuant to the Auction Agency Agreement, the Fund is required
to indemnify the Auction Agent for certain losses and liabilities incurred by
the Auction Agent without negligence or bad faith on its part in connection
with the performance of its duties under such agreement.
The Auction Agent may terminate the Auction Agency Agreement upon notice to the
Fund, which termination may be no earlier than 60 days following delivery of
such notice. If the Auction Agent resigns, the Fund will use its best efforts
to enter into an agreement with a successor Auction Agent containing
substantially the same terms and conditions as the Auction Agency Agreement.
The Fund may terminate the Auction Agency Agreement, provided that prior to
such termination the Fund shall have entered into such an agreement with
respect thereto with a successor Auction Agent.
Broker-Dealer Agreements
The Auctions require the participation of one or more broker-dealers. The
Auction Agent will enter into agreements (collectively, the "Broker-Dealer
Agreements") with one or more broker-dealers, or other entities permitted by
law to perform the functions required of a Broker-Dealer in the Auction
Procedures (collectively, the "Broker-Dealers"), selected by the Fund, which
provide for the participation of such Broker-Dealers in Auctions and pursuant
to which such Broker-Dealers agree to follow the Auction Procedures. A
Broker-Dealer Agreement may be terminated by the Auction Agent or a
Broker-Dealer on five days' notice to the other party, provided that neither
the Broker-Dealer Agreement with UBS Warburg LLC nor the Broker-Dealer
Agreement with Merrill Lynch, Pierce, Fenner & Smith Incorporated may be
terminated without the prior written consent of the Fund, which consent may not
be unreasonably withheld.
Securities Depository
The Depository Trust Company initially will act as the Securities Depository
for the Agent Members with respect to the APS. All of the shares of each series
of APS initially will be registered in the name of Cede & Co., as nominee of
the Securities Depository. Such shares will be subject to the provisions
restricting transfers of the APS contained in the Amended By-Laws. Cede & Co.
initially will be the holder of record of all shares of APS, and Beneficial
Owners will not be entitled to receive certificates representing their
ownership interest in such shares. See Appendix C (Auction Procedures) to the
Statement of Additional Information. The Securities Depository will maintain
lists of its participants and will maintain the positions (ownership interests)
of the APS held by each Agent Member, whether as the Beneficial Owner thereof
for its own account or as nominee for the Beneficial Owner thereof. Payments
made by the Fund to holders of APS will be duly made by making payments to the
nominee of the Securities Depository.
AUCTION PROCEDURES
The following is a brief summary of the procedures to be used in conducting
Auctions. This summary is qualified by reference to the Auction Procedures set
forth in Appendix C to the Statement of Additional Information. The Settlement
Procedures to be used with respect to Auctions are set forth in Appendix B to
the Statement of Additional Information.
Auction Date; Advance Notice of Allocation of Taxable Income; Inclusion of
Taxable Income in Dividends
An Auction to determine the Applicable Rate for the APS offered hereby for each
Dividend Period for such shares (other than the Initial Dividend Period
therefor) will be held on the last Business Day preceding the first day of such
Dividend Period, which first day is also the Dividend Payment Date for
--------------------------------------------------------------------------------
28
Description of APS
--------------------------------------------------------------------------------
the preceding Dividend Period (the date of each Auction being referred to
herein as an "Auction Date"). The initial Auction Date will be August 26, 2002
for Series A APS, August 27, 2002 for Series B APS, August 28, 2002 for Series
C APS, August 29, 2002 for Series D APS and August 30, 2002 for Series E APS.
Auctions for the APS for Dividend Periods after the Initial Dividend Period
normally will be held every Monday after the preceding Dividend Payment Date
for Series A APS, every such Tuesday for Series B APS, every such Wednesday for
Series C APS, every such Thursday for Series D APS and every such Friday for
Series E APS; and each subsequent Dividend Period normally will begin on the
following Tuesday for Series A APS, on the following Wednesday for Series B
APS, on the following Thursday for Series C APS, on the following Friday for
Series D APS and on the following Monday for Series E APS (also a Dividend
Payment Date). The Auction Date and the first day of the related Dividend
Period for a series of APS (both of which must be Business Days) need not be
consecutive calendar days. See "--Dividends" for information concerning the
circumstances under which a Dividend Payment Date may fall on a date other than
the days specified above, which may affect the Auction Date.
Except as noted below and under "--Dividends--Gross-up Dividends," whenever the
Fund is aware that it will include any net capital gain or other income subject
to federal income tax in any dividend on the APS, the Fund will notify the
Auction Agent of the amount to be so included at least five Business Days prior
to the Auction Date on which the Applicable Rate for such dividend is to be
established. Whenever the Auction Agent receives such notice from the Fund, it
will in turn notify each Broker-Dealer, who, on or prior to such Auction Date,
in accordance with its Broker-Dealer Agreement, will notify its customers who
are Beneficial Owners and Potential Beneficial Owners believed to be interested
in submitting an Order in the Auction to be held on such Auction Date. The Fund
also may include such income in a dividend on the APS without giving advance
notice thereof if it increases the dividend by an additional amount calculated
as if such income were a Retroactive Taxable Allocation and the additional
amount were a Gross-up Dividend; provided that the Fund will notify the Auction
Agent of the additional amounts to be included in such dividend at least five
Business Days prior to the applicable Dividend Payment Date. See
"--Dividends--Gross-up Dividends."
Orders by Beneficial Owners, Potential Beneficial Owners, Existing Holders and
Potential Holders
On or prior to the Submission Deadline on each Auction Date for a series of APS:
(a) each Beneficial Owner may submit to its Broker-Dealer by telephone a:
(i) "Hold Order"--indicating the number of outstanding APS, if any, such
Beneficial Owner desires to continue to hold without regard to the
Applicable Rate for the next Dividend Period for such shares;
(ii) "Bid"--indicating the number of outstanding APS, if any, such
Beneficial Owner desires to continue to hold, provided that the
Applicable Rate for the next Dividend Period for such shares is not
less than the rate per annum then specified by such Beneficial Owner;
and/or
(iii) "Sell Order"--indicating the number of outstanding APS, if any, such
Beneficial Owner offers to sell without regard to the Applicable Rate
for the next Dividend Period for such shares; and
(b) Broker-Dealers will contact customers who are Potential Beneficial Owners
of APS to determine whether such Potential Beneficial Owners desire to
submit Bids indicating the number of APS which they offer to purchase
provided that the Applicable Rate for the next Dividend Period is not less
than the rates per annum specified in such Bids.
The communication by a Beneficial Owner or Potential Beneficial Owner to a
Broker-Dealer and the communication by a Broker-Dealer, whether or not acting
for its own account, to the Auction Agent of
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29
Description of APS
--------------------------------------------------------------------------------
the foregoing information is hereinafter referred to as an "Order" and
collectively as "Orders." A Beneficial Owner or a Potential Beneficial Owner
placing an Order, including a Broker-Dealer acting in such capacity for its own
account, is hereinafter referred to as a "Bidder" and collectively as
"Bidders." Any Order submitted by a Beneficial Owner or a Potential Beneficial
Owner to its Broker-Dealer, or by a Broker-Dealer to the Auction Agent, prior
to the Submission Deadline on any Auction Date shall be irrevocable.
In an Auction, a Beneficial Owner may submit different types of Orders with
respect to APS then held by such Beneficial Owner, as well as Bids for
additional APS. If, however, a Beneficial Owner offers through its
Broker-Dealer to purchase additional APS in such Auction, such Beneficial
Owner, for purposes of such offer to purchase additional shares, will be
treated as a Potential Beneficial Owner as described below. For information
concerning the priority given to different types of Orders placed by Beneficial
Owners, see "--Submission of Orders by Broker-Dealers to Auction Agent" below.
The "Maximum Applicable Rate" for a series of APS will be the Applicable
Percentage of the Reference Rate. The Auction Agent will round each applicable
Maximum Applicable Rate to the nearest one-thousandth (0.001) of one percent
per annum, with any such number ending in five ten-thousandths of one percent
being rounded upwards to the nearest one-thousandth (0.001) of one percent. The
Auction Agent will not round the applicable Reference Rate as part of its
calculation of the Maximum Applicable Rate.
The Maximum Applicable Rate for a series of APS will depend on the credit
rating assigned to such series. The "Applicable Percentage" will be determined
based on (i) the credit rating assigned on such date to such shares by Moody's
(or if Moody's shall not make such rating available, the equivalent of such
rating by a Substitute Rating Agency), and (ii) whether the Fund has provided
notification to the Auction Agent prior to the Auction establishing the
Applicable Rate for any dividend that net capital gains or other taxable income
will be included in such dividend on the APS as follows:
Applicable Applicable
Percentage of Percentage of
Reference Rate-- Reference Rate--
Moody's Credit Ratings on APS No Notification Notification
---------------------------------------------------------------
Aa3 or higher........ 110 % 150 %
A.................... 125 160
Baa.................. 150 250
Below Baa............ 200 275
There is no minimum Applicable Rate in respect of any Dividend Period.
The Fund will take all reasonable action necessary to enable Moody's to provide
a rating for each series of APS. If Moody's does not make such a rating
available, the Underwriters or their affiliates and successors, after
consultation with the Fund, will select another Rating Agency to act as a
Substitute Rating Agency.
Any Bid by a Beneficial Owner specifying a rate per annum higher than the
Maximum Applicable Rate will be treated as a Sell Order, and any Bid by a
Potential Beneficial Owner specifying a rate per annum higher than the Maximum
Applicable Rate will not be considered. See "--Determination of Sufficient
Clearing Bids, Winning Bid Rate and Applicable Rate" and "--Acceptance and
Rejection of Submitted Bids and Submitted Sell Orders and Allocation of Shares."
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30
Description of APS
--------------------------------------------------------------------------------
A Broker-Dealer also may hold APS in its own account as a Beneficial Owner. A
Broker-Dealer thus may submit Orders to the Auction Agent as a Beneficial Owner
or a Potential Beneficial Owner and therefore participate in an Auction as an
Existing Holder or Potential Holder on behalf of both itself and its customers.
Any Order placed with the Auction Agent by a Broker-Dealer as or on behalf of a
Beneficial Owner or a Potential Beneficial Owner will be treated in the same
manner as an Order placed with a Broker-Dealer by a Beneficial Owner or a
Potential Beneficial Owner. Similarly, any failure by a Broker-Dealer to submit
to the Auction Agent an Order in respect of any APS held by it or its customers
who are Beneficial Owners will be treated in the same manner as a Beneficial
Owner's failure to submit to its Broker-Dealer an Order in respect of APS held
by it, as described in the next paragraph. If a Broker-Dealer participates in
an Auction as an Existing Holder or a Potential Holder only to represent the
interests of a Beneficial Owner or Potential Beneficial Owner, whether it be
its customers or itself, all discussion herein relating to the consequences of
an Auction for Existing Holders and Potential Holders also applies to the
underlying beneficial ownership interests represented thereby. For information
concerning the priority given to different types of Orders placed by Existing
Holders, see "--Submission of Orders by Broker-Dealers to Auction Agent." Each
purchase or sale in an Auction will be settled on the Business Day next
succeeding the Auction Date at a price per share equal to $25,000.
See "--Notification of Results; Settlement."
If one or more Orders covering in the aggregate all of the outstanding APS held
by a Beneficial Owner are not submitted to the Auction Agent prior to the
Submission Deadline, either because a Broker-Dealer failed to contact such
Beneficial Owner or otherwise, the Auction Agent will deem a Hold Order (in the
case of an Auction relating to a Special Dividend Period of 91 days or less) or
a Sell Order (in the case of an Auction relating to a Special Dividend Period
of longer than 91 days) to have been submitted on behalf of such Beneficial
Owner covering the number of outstanding APS held by such Beneficial Owner and
not subject to Orders submitted to the Auction Agent.
If all of the outstanding APS are subject to Submitted Hold Orders, the
Dividend Period next succeeding the Auction automatically will be the same
length as the immediately preceding Dividend Period, and the Applicable Rate
for the next Dividend Period for all the APS will be 40% of the Reference Rate
on the date of the applicable Auction (or 60% of such rate if the Fund has
provided notification to the Auction Agent prior to the Auction establishing
the Applicable Rate for any dividend that net capital gains or other taxable
income will be included in such dividend on the APS).
For the purposes of an Auction, the APS for which the Fund shall have given
notice of redemption and deposited moneys therefor with the Auction Agent in
trust or segregated in an account at the Fund's custodian bank for the benefit
of the Auction Agent, as set forth under "--Redemption," will not be considered
as outstanding and will not be included in such Auction. The Fund may not
submit an Order in any Auction.
Neither the Fund nor the Auction Agent will be responsible for a
Broker-Dealer's failure to act in accordance with the instructions of
Beneficial Owners or Potential Beneficial Owners or failure to comply with the
foregoing.
Submission of Orders by Broker-Dealers to Auction Agent
Prior to 1:00 p.m., New York City time, on each Auction Date, or such other
time on the Auction Date as may be specified by the Auction Agent (the
"Submission Deadline"), each Broker-Dealer will submit to the Auction Agent in
writing or through the Auction Agent's auction processing system all Orders
obtained by it for the Auction for a series of APS to be conducted on such
Auction Date, designating itself (unless otherwise permitted by the Fund) as
the Existing Holder or Potential Holder in respect of the APS subject to such
Orders. Any Order submitted by a Beneficial Owner or a Potential Beneficial
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31
Description of APS
--------------------------------------------------------------------------------
Owner to its Broker-Dealer, or by a Broker-Dealer to the Auction Agent, prior
to the Submission Deadline for any Auction Date, shall be irrevocable.
If the rate per annum specified in any Bid contains more than three figures to
the right of the decimal point, the Auction Agent will round such rate per
annum up to the next highest one-thousandth (.001) of one-percent. If one or
more Orders of an Existing Holder are submitted to the Auction Agent and such
Orders cover in the aggregate more than the number of outstanding shares of APS
held by such Existing Holder, such Orders will be considered valid in the
following order of priority:
(i) any Hold Order will be considered valid up to and including the number of
outstanding APS held by such Existing Holder, provided that if more than
one Hold Order is submitted by such Existing Holder and the number of APS
subject to such Hold Orders exceeds the number of outstanding APS held by
such Existing Holder, the number of APS subject to each of such Hold Orders
will be reduced pro rata so that such Hold Orders, in the aggregate, will
cover exactly the number of outstanding APS held by such Existing Holder;
(ii) any Bids will be considered valid, in the ascending order of their
respective rates per annum if more than one Bid is submitted by such
Existing Holder, up to and including the excess of the number of
outstanding APS held by such Existing Holder over the number of
outstanding APS subject to any Hold Order referred to in clause (i) above
(and if more than one Bid submitted by such Existing Holder specifies the
same rate per annum and together they cover more than the remaining number
of shares that can be the subject of valid Bids after application of
clause (i) above and of the foregoing portion of this clause (ii) to any
Bid or Bids specifying a lower rate or rates per annum, the number of
shares subject to each of such Bids will be reduced pro rata so that such
Bids, in the aggregate, cover exactly such remaining number of outstanding
shares); and the number of outstanding shares, if any, subject to Bids not
valid under this clause (ii) shall be treated as the subject of a Bid by a
Potential Holder; and
(iii) any Sell Order will be considered valid up to and including the excess of
the number of outstanding APS held by such Existing Holder over the sum
of the number of APS subject to Hold Orders referred to in clause (i)
above and the number of APS subject to valid Bids by such Existing Holder
referred to in clause (ii) above; provided that, if more than one Sell
Order is submitted by any Existing Holder and the number of APS subject
to such Sell Orders is greater than such excess, the number of APS
subject to each of such Sell Orders will be reduced pro rata so that such
Sell Orders, in the aggregate, will cover exactly the number of APS equal
to such excess.
If more than one Bid of any Potential Holder is submitted in any Auction, each
Bid submitted in such Auction will be considered a separate Bid with the rate
per annum and number of APS therein specified.
Determination of Sufficient Clearing Bids, Winning Bid Rate and Applicable Rate
Not earlier than the Submission Deadline for each Auction, the Auction Agent
will assemble all Orders submitted or deemed submitted to it by the
Broker-Dealers (each such "Hold Order," "Bid" or "Sell Order" as submitted or
deemed submitted by a Broker-Dealer hereinafter being referred to as a
"Submitted Hold Order," a "Submitted Bid" or a "Submitted Sell Order," as the
case may be, or as a "Submitted Order") and will determine the excess of the
number of outstanding APS over the number of outstanding APS subject to
Submitted Hold Orders (such excess being referred to as the "Available APS")
and whether Sufficient Clearing Bids have been made in such Auction. Sufficient
Clearing Bids will have been made if the number of outstanding APS that are the
subject of Submitted Bids of Potential Holders with rates per annum not higher
than the Maximum Applicable Rate equals or exceeds the number of outstanding
shares that are the subject of Submitted Sell Orders (including the number of
--------------------------------------------------------------------------------
32
Description of APS
--------------------------------------------------------------------------------
shares subject to Bids of Existing Holders specifying rates per annum higher
than the Maximum Applicable Rate). If Sufficient Clearing Bids have been made,
the Auction Agent will determine the lowest rate per annum specified in the
Submitted Bids (the "Winning Bid Rate") which would result in the number of
shares subject to Submitted Bids specifying such rate per annum or a lower rate
per annum being at least equal to the Available APS. If Sufficient Clearing
Bids have been made, the Winning Bid Rate will be the Applicable Rate for the
next Dividend Period for the APS then outstanding. If Sufficient Clearing Bids
have not been made (other than because all outstanding APS are the subject of
Submitted Hold Orders), the Dividend Period next following the Auction
automatically will be a 7-Day Dividend Period, and the Applicable Rate for such
Dividend Period will be equal to the Maximum Applicable Rate.
If Sufficient Clearing Bids have not been made, Beneficial Owners that have
Submitted Sell Orders will not be able to sell in the Auction all, and may not
be able to sell any, of their APS subject to such Submitted Sell Orders. See
"--Acceptance and Rejection of Submitted Bids and Submitted Sell Orders and
Allocation of Shares." Thus, under some circumstances, Beneficial Owners may
not have liquidity of investment.
Acceptance and Rejection of Submitted Bids and Submitted Sell Orders and
Allocation of Shares
Based on the determinations described under "--Determination of Sufficient
Clearing Bids, Winning Bid Rate and Applicable Rate" and subject to the
discretion of the Auction Agent to round as described below, Submitted Bids and
Submitted Sell Orders will be accepted or rejected in the order of priority set
forth in the Auction Procedures with the result that Existing Holders and
Potential Holders of a series of APS will sell, continue to hold and/or
purchase APS as set forth below. Existing Holders that submit or are deemed to
have submitted Hold Orders will continue to hold the APS subject to such Hold
Orders.
If Sufficient Clearing Bids have been made:
(a) each Existing Holder that placed a Submitted Bid specifying a rate per
annum higher than the Winning Bid Rate or a Submitted Sell Order will sell
the outstanding APS subject to such Submitted Bid or Submitted Sell Order;
(b) each Existing Holder that placed a Submitted Bid specifying a rate per
annum lower than the Winning Bid Rate will continue to hold the outstanding
APS subject to such Submitted Bid;
(c) each Potential Holder that placed a Submitted Bid specifying a rate per
annum lower than the Winning Bid Rate will purchase the number of APS
subject to such Submitted Bid;
(d) each Existing Holder that placed a Submitted Bid specifying a rate per
annum equal to the Winning Bid Rate will continue to hold the outstanding
shares of APS subject to such Submitted Bids, unless the number of
outstanding APS subject to all such Submitted Bids of Existing Holders is
greater than the excess of the Available APS over the number of APS
accounted for in clauses (b) and (c) above, in which event each Existing
Holder with such a Submitted Bid will sell a number of outstanding APS
determined on a pro rata basis based on the number of outstanding APS
subject to all such Submitted Bids of such Existing Holders; and
(e) each Potential Holder that placed a Submitted Bid specifying a rate per
annum equal to the Winning Bid Rate will purchase any Available APS not
accounted for in clause (b), (c) or (d) above on a pro rata basis based on
the APS subject to all such Submitted Bids of Potential Holders.
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33
Description of APS
--------------------------------------------------------------------------------
If Sufficient Clearing Bids have not been made (other than because all
outstanding APS are the subject of Submitted Hold Orders):
(a) each Existing Holder that placed a Submitted Bid specifying a rate per
annum equal to or lower than the Maximum Applicable Rate will continue to
hold the outstanding APS subject to such Submitted Bid;
(b) each Potential Holder that placed a Submitted Bid specifying a rate per
annum equal to or lower than the Maximum Applicable Rate will purchase the
number of APS subject to such Submitted Bid; and
(c) each Existing Holder that placed a Submitted Bid specifying a rate per
annum higher than the Maximum Applicable Rate or a Submitted Sell Order
will sell a number of outstanding APS determined on a pro rata basis based
on the outstanding APS subject to all such Submitted Bids and Submitted
Sell Orders.
If as a result of the Auction Procedures described above any Existing Holder
would be entitled or required to sell, or any Potential Holder would be
entitled or required to purchase, a fraction of APS, the Auction Agent, in such
manner as, in its sole discretion, it shall determine, will round up or down
the number of APS being sold or purchased on such Auction Date so that each
share sold or purchased by each Existing Holder or Potential Holder will be a
whole APS. If any Potential Holder would be entitled or required to purchase
less than a whole APS, the Auction Agent, in such manner as, in its sole
discretion, it shall determine, will allocate APS for purchase among Potential
Holders so that only whole APS are purchased by any such Potential Holder, even
if such allocation results in one or more of such Potential Holders not
purchasing any APS.
Notification of Results; Settlement
The Auction Agent will advise each Broker-Dealer who submitted a Bid or Sell
Order in an Auction whether such Bid or Sell Order was accepted or rejected in
whole or in part and of the Applicable Rate for the next Dividend Period for
the related APS by telephone or through the Auction Agent's auction processing
system at approximately 3:00 p.m., New York City time, on the Auction Date for
such Auction. Each such Broker-Dealer that submitted an Order for the account
of a customer then will advise such customer whether such Bid or Sell Order was
accepted or rejected, will confirm purchases and sales with each customer
purchasing or selling APS as a result of the Auction and will advise each
customer purchasing or selling APS to give instructions to its Agent Member of
the Securities Depository to pay the purchase price against delivery of such
shares or to deliver such shares against payment therefor as appropriate. If a
customer selling APS as a result of an Auction fails to instruct its Agent
Member to deliver such shares, the Broker-Dealer that submitted such customer's
Bid or Sell Order will instruct such Agent Member to deliver such shares
against payment therefor. Each Broker-Dealer that submitted a Hold Order in an
Auction on behalf of a customer also will advise such customer of the
Applicable Rate for the next Dividend Period for the APS. The Auction Agent
will record each transfer of APS on the record book of Existing Holders to be
maintained by the Auction Agent.
In accordance with the Securities Depository's normal procedures, on the day
after each Auction Date, the transactions described above will be executed
through the Securities Depository, and the accounts of the respective Agent
Members at the Securities Depository will be debited and credited as necessary
to effect the purchases and sales of APS as determined in such Auction.
Purchasers will make payment through their Agent Members in same-day funds to
the Securities Depository against delivery through their Agent Members; the
Securities Depository will make payment in accordance with its normal
procedures, which now provide for payment in same-day funds. If the procedures
of the Securities Depository applicable to APS shall be changed to provide for
payment in next-day funds, then purchasers may be required to make payment in
next-day funds. If the certificates for the APS are not held by the
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34
Description of APS
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Securities Depository or its nominee, payment will be made in same-day funds to
the Auction Agent against delivery of such certificates.
If any Existing Holder selling APS in an Auction fails to deliver such shares,
the Broker-Dealer of any person that was to have purchased APS in such Auction
may deliver to such person a number of whole APS that is less than the number
of shares that otherwise was to be purchased by such person. In such event, the
number of APS to be so delivered will be determined by such Broker-Dealer.
Delivery of such lesser number of shares will constitute good delivery. Each
Broker-Dealer Agreement also will provide that neither the Fund nor the Auction
Agent will have responsibility or liability with respect to the failure of a
Potential Beneficial Owner, Potential Beneficial Owner or their respective
Agent Members to deliver APS or to pay for APS purchased or sold pursuant to an
Auction or otherwise.
BROKER-DEALERS
General
The Auction Agent after each Auction will pay a service charge from funds
provided by the Fund to each Broker-Dealer on the basis of the purchase price
of APS placed by such Broker-Dealer at such Auction. The service charge (i) for
any 7-Day Dividend Period shall be payable at the annual rate of 0.25% of the
purchase price of the APS placed by such Broker-Dealer in any such Auction and
(ii) for any Special Dividend Period shall be determined by mutual consent of
the Fund and any such Broker-Dealer or Broker-Dealers and shall be based upon a
selling concession that would be applicable to an underwriting of fixed or
variable rate preferred shares with a similar final maturity or variable rate
dividend period, respectively, at the commencement of the Dividend Period with
respect to such Auction. For the purposes of the preceding sentence, the APS
will be placed by a Broker-Dealer if such shares were (i) the subject of Hold
Orders deemed to have been made by Beneficial Owners that were acquired by such
Beneficial Owners through such Broker-Dealer or (ii) the subject of the
following Orders submitted by such Broker-Dealer: (A) a Submitted Bid of a
Beneficial Owner that resulted in such Beneficial Owner continuing to hold such
shares as a result of the Auction, (B) a Submitted Bid of a Potential
Beneficial Owner that resulted in such Potential Beneficial Owner purchasing
such shares as a result of the Auction or (C) a Submitted Hold Order.
The Broker-Dealer Agreements provide that a Broker-Dealer may submit Orders in
Auctions for its own account, unless the Fund notifies all Broker-Dealers that
they no longer may do so; provided that Broker-Dealers may continue to submit
Hold Orders and Sell Orders. If a Broker-Dealer submits an Order for its own
account in any Auction of APS, it may have knowledge of Orders placed through
it in that Auction and therefore have an advantage over other Bidders, but such
Broker-Dealer would not have knowledge of Orders submitted by other
Broker-Dealers in that Auction.
Secondary Market Trading and Transfers of APS
The Broker-Dealers may maintain a secondary trading market in the APS outside
of Auctions; however, they have no obligation to do so, and may discontinue
such activity at any time. There can be no assurance that a secondary market
for the APS will develop or, if it does develop, that it will provide holders
with a liquid trading market (i.e., trading will depend on the presence of
willing buyers and sellers and the trading price is subject to variables to be
determined at the time of the trade by the Broker-Dealers). The APS will not be
registered on any stock exchange or on any automated quotation system. An
increase in the level of interest rates, particularly during any Long Term
Dividend Period for a series of APS, likely will have an adverse effect on the
secondary market price of such APS, and a selling shareholder may sell APS
between Auctions at a price per share of less than $25,000.
A Beneficial Owner or an Existing Holder may sell, transfer or otherwise
dispose of APS only in whole shares and only (1) pursuant to a Bid or Sell
Order placed with the Auction Agent in accordance with the
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35
Description of APS
--------------------------------------------------------------------------------
Auction Procedures, (2) to a Broker-Dealer or (3) to such other persons as may
be permitted by the Fund; provided, however, that (a) a sale, transfer or other
disposition of shares of APS from a customer of a Broker-Dealer who is listed
on the records of that Broker-Dealer as the holder of such shares to that
Broker-Dealer or another customer of that Broker-Dealer shall not be deemed to
be a sale, transfer or other disposition for purposes of the foregoing if such
Broker-Dealer remains the Existing Holder of the shares so sold, transferred or
disposed of immediately after such sale, transfer or disposition and (b) in the
case of all transfers other than pursuant to Auctions, such Beneficial Owner or
Existing Holder, its Broker-Dealer, if applicable, or its Agent Member advises
the Auction Agent of such transfer.
DIVIDENDS
General
The holders of APS of each series will be entitled to receive, when, as and if
declared by the Board of Trustees, out of funds legally available therefor,
cumulative cash dividends on their shares, at the Applicable Rate determined as
set forth below under "--Determination of Dividend Rate," payable on the dates
set forth below. Dividends on the APS so declared and payable will be paid (i)
in preference to and in priority over any dividends so declared and payable on
the Common Shares and (ii) to the extent permitted under the Code and to the
extent available, out of net tax-exempt income earned on the Fund's
investments. Dividends on the APS, to the extent that they are derived from
municipal bonds, generally will be exempt from federal income tax, although all
of those dividends will be a tax preference item for corporate taxpayers and a
portion of those dividends may be a tax preference item for purposes of the
federal alternative minimum tax for individuals ("Preference Item"). See
"Taxes."
Dividends on each series of APS will accumulate from the date on which the Fund
originally issues the APS (the "Date of Original Issue") and will be payable on
the APS on the dates described below. Dividends on a series of APS with respect
to the Initial Dividend Period shall be payable on the Initial Dividend Payment
Date for that series. Following the Initial Dividend Payment Date, dividends on
each series of APS will be payable, at the option of the Fund, either (i) with
respect to any 7-Day Dividend Period and any Short Term Dividend Period of 35
or fewer days, on the day next succeeding the last day thereof or (ii) with
respect to any Short Term Dividend Period of more than 35 days and with respect
to any Long Term Dividend Period, monthly on the first Business Day of each
calendar month during such Short Term Dividend Period or Long Term Dividend
Period and on the day next succeeding the last day thereof (each such date
referred to in clause (i) or (ii) being referred to herein as a "Normal
Dividend Payment Date"), except that if such Normal Dividend Payment Date is
not a Business Day, the Dividend Payment Date will be the first Business Day
next succeeding such Normal Dividend Payment Date. Although any particular
Dividend Payment Date may not occur on the originally scheduled date because of
the exceptions discussed above, the next succeeding Dividend Payment Date,
subject to such exceptions, will nonetheless occur on the next following
originally scheduled date. If for any reason a Dividend Period for a series of
APS is scheduled to begin on the same day and end on the same day as a Dividend
Period for another series of APS, then the last day of the Dividend Period for
such other series of APS shall be the second Business Day next succeeding such
scheduled day unless the Fund obtains the opinion of tax counsel referred to
below. Subject to the limitation in the next sentence, if for any reason a
Dividend Payment Date cannot be fixed as described above, then the Board of
Trustees will fix the Dividend Payment Date. However, Dividend Periods of any
series of APS shall not be co-extensive with the Dividend Period of any other
series of APS unless the Fund has received an opinion of tax counsel that
having such co-extensive periods will not affect the deductibility, for federal
income tax purposes, of dividends paid on the different series of APS. The
Board of Trustees before authorization of a dividend may change a Dividend
Payment Date if such change does not adversely affect the contract rights of
the holders of APS set forth in the Declaration or Amended By-Laws. The Initial
Dividend Period, 7-Day Dividend Periods and Special Dividend Periods are
hereinafter sometimes referred to as "Dividend
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36
Description of APS
--------------------------------------------------------------------------------
Periods." Each dividend payment date determined as provided above is
hereinafter referred to as a "Dividend Payment Date."
Prior to each Dividend Payment Date, the Fund is required to deposit with the
Auction Agent sufficient funds for the payment of declared dividends. The Fund
does not intend to establish any reserves for the payment of dividends.
Each dividend will be paid to the record holder of the APS as of 12:00 noon,
New York City time, on the Business Day preceding the Dividend Payment Date,
which holder is expected to be the nominee of the Securities Depository. See
"--The Auction--Securities Depository." The Securities Depository will credit
the accounts of the Agent Members of the Existing Holders in accordance with
the Securities Depository's normal procedures, which provide for payment in
same-day funds. The Agent Member of an Existing Holder will be responsible for
holding or disbursing such payments on the applicable Dividend Payment Date to
such Existing Holder in accordance with the instructions of such Existing
Holder. Dividends in arrears for any past Dividend Period may be declared and
paid at any time, without reference to any regular Dividend Payment Date, to
the nominee of the Securities Depository. Any dividend payment made on the APS
first shall be credited against the earliest declared but unpaid dividends
accumulated with respect to such shares.
Holders of the APS will not be entitled to any dividends, whether payable in
cash, property or stock, in excess of full cumulative dividends except as
described under "--Gross-up Dividends" and "--Non-Payment Period; Late Charge"
below. No interest will be payable in respect of any dividend payment or
payments on the APS which may be in arrears.
The amount of cash dividends per share of APS of each series payable (if
declared) on the Initial Dividend Payment Date, each 7-Day Dividend Period and
each Dividend Payment Date of each Short Term Dividend Period will be computed
by multiplying the Applicable Rate for such Dividend Period by a fraction, the
numerator of which will be the number of days in such Dividend Period or part
thereof that such share was outstanding and for which dividends are payable on
such Dividend Payment Date and the denominator of which will be 365,
multiplying the amount so obtained by $25,000, and rounding the amount so
obtained to the nearest cent. During any Long Term Dividend Period, the amount
of cash dividends per share of APS payable (if declared) on any Dividend
Payment Date will be computed by multiplying the Applicable Rate for such
Dividend Period by a fraction, the numerator of which will be such number of
days in such part of such Dividend Period that such share was outstanding and
for which dividends are payable on such Dividend Payment Date and the
denominator of which will be 360, multiplying the amount so obtained by
$25,000, and rounding the amount so obtained to the nearest cent.
Notification of Dividend Period
The Fund, at its sole option and to the extent permitted by law, by telephonic
and written notice (a "Request for Special Dividend Period") to the Auction
Agent and to each Broker-Dealer, may request that the next succeeding Dividend
Period for a series of APS will be a number of days (other than seven), evenly
divisible by seven, and not fewer than fourteen nor more than 364 in the case
of a Short Term Dividend Period or one whole year or more but not greater than
five years in the case of a Long Term Dividend Period, specified in such
notice, provided that the Fund may not give a Request for Special Dividend
Period for a Dividend Period of greater than 28 days (and any such request will
be null and void) unless, for any Auction occurring after the initial Auction,
Sufficient Clearing Bids were made in the last occurring Auction and unless
full cumulative dividends, any amounts due with respect to redemptions, and any
Gross-up Dividends payable prior to such date have been paid in full. Such
Request for Special Dividend Period, in the case of a Short Term Dividend
Period, shall be given on or
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37
Description of APS
--------------------------------------------------------------------------------
prior to the second Business Day but not more than seven Business Days prior to
an Auction Date for the APS of that series and, in the case of a Long Term
Dividend Period, shall be given on or prior to the second Business Day but not
more than 28 days prior to an Auction Date for the APS of that series. Upon
receiving such Request for Special Dividend Period, the Broker-Dealers jointly
shall determine the Optional Redemption Price of the APS of that series during
such Special Dividend Period and the Specific Redemption Provisions and shall
give the Fund and the Auction Agent written notice (a "Response") of such
determination by no later than the second Business Day prior to such Auction
Date. In making such determination, the Broker-Dealers will consider (i)
existing short-term and long-term market rates and indices of such short-term
and long-term rates, (ii) existing market supply and demand for short-term and
long-term securities, (iii) existing yield curves for short-term and long-term
securities comparable to the APS, (iv) industry and financial conditions which
may affect the APS of that series, (v) the investment objective of the Fund and
(vi) the Dividend Periods and dividend rates at which current and potential
beneficial holders of the APS would remain or become beneficial holders.
After providing the Request for Special Dividend Period to the Auction Agent
and each Broker-Dealer as set forth above, the Fund, by no later than the
second Business Day prior to such Auction Date, may give a notice (a "Notice of
Special Dividend Period") to the Auction Agent, the Securities Depository and
each Broker-Dealer, which notice will specify (i) the duration of the Special
Dividend Period, (ii) the Optional Redemption Price, if any, as specified in
the related Response and (iii) the Specific Redemption Provisions, if any, as
specified in the related Response. The Fund has agreed to provide a copy of
such Notice of Special Dividend Period to Moody's. The Fund will not give a
Notice of Special Dividend Period and, if such Notice of Special Dividend
Period was given already, will give telephonic and written notice of its
revocation (a "Notice of Revocation") to the Auction Agent, each Broker-Dealer
and the Securities Depository on or prior to the Business Day prior to the
relevant Auction Date if (x) either the 1940 Act APS Asset Coverage is not
satisfied or the Fund fails to maintain Moody's Eligible Assets with an
aggregate Discounted Value at least equal to the APS Basic Maintenance Amount,
on each of the two Valuation Dates immediately preceding the Business Day prior
to the relevant Auction Date on an actual basis and on a pro forma basis giving
effect to the proposed Special Dividend Period (using as a pro forma dividend
rate with respect to such Special Dividend Period the dividend rate which the
Broker-Dealers shall advise the Fund is an approximately equal rate for
securities similar to the APS with an equal dividend period) or (y) sufficient
funds for the payment of dividends payable on the immediately succeeding
Dividend Payment Date have not been irrevocably deposited with the Auction
Agent by the close of business on the third Business Day preceding the Auction
Date immediately preceding such Dividend Payment Date. The Fund also shall
provide a copy of such Notice of Revocation to Moody's. If the Fund is
prohibited from giving a Notice of Special Dividend Period as a result of the
factors enumerated in clause (x) or (y) above or if the Fund gives a Notice of
Revocation with respect to a Notice of Special Dividend Period, the next
succeeding Dividend Period for that series will be a 7-Day Dividend Period. In
addition, in the event Sufficient Clearing Bids are not made in an Auction, or
if an Auction is not held for any reason, the next succeeding Dividend Period
will be a 7-Day Dividend Period, and the Fund may not again give a Notice of
Special Dividend Period (and any such attempted notice will be null and void)
until Sufficient Clearing Bids have been made in an Auction with respect to a
7-Day Dividend Period. If an Auction is not held because an unforeseen event or
unforeseen events cause a day that otherwise would have been a Dividend Payment
Date or an Auction Date not to be a Business Day, then the length of the
Dividend Period relating to such Dividend Payment Date shall be extended by
seven days (or a multiple thereof if necessary because of such unforeseen event
or events) (an "Extension Period"), the Applicable Rate for such Extension
Period shall be the Applicable Rate for the Dividend Period so extended and the
Dividend Payment Date for such Dividend Period shall be the first Business Day
next succeeding the end of such Extension Period. Solely for purposes of (1)
the foregoing sentence, (2) the proviso in clause (i) of the definition of
"Non-Payment Period" under "--Non-Payment Period; Late Charge" below and (3)
the second parenthetical in the fifth sentence of the same paragraph in which
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38
Description of APS
--------------------------------------------------------------------------------
"Non-Payment Period" is defined, any day on which banks in New York City
generally are closed, for any reason, while the New York Stock Exchange remains
open for trading and any day which otherwise would be a Business Day as defined
in the Amended By-laws on which the Auction Agent is closed for business, for
any reason, shall not be considered a Business Day.
Determination of Dividend Rate
The dividend rate on a series of APS during the period from and including the
Date of Original Issue for the APS to but excluding the Initial Dividend
Payment Date for that series of APS (the "Initial Dividend Period") will be the
rate per annum set forth on the inside cover page hereof. Commencing on the
Initial Dividend Payment Date for a series of APS, the Applicable Rate on that
series of APS for each Subsequent Dividend Period, which Subsequent Dividend
Period shall be a period commencing on and including a Dividend Payment Date
and ending on and including the calendar day prior to the next Dividend Payment
Date (or last Dividend Payment Date in a Dividend Period if there is more than
one Dividend Payment Date), shall be equal to the rate per annum that results
from the Auction with respect to such Subsequent Dividend Period. Cash
dividends shall be calculated as set forth above under "--Dividends--General."
Non-Payment Period; Late Charge
A "Non-Payment Period" for a series of APS will commence if the Fund fails to
(i) declare, prior to the close of business on the second Business Day
preceding any Dividend Payment Date, for payment on or (to the extent permitted
as described below) within three Business Days after such Dividend Payment Date
to the persons who held such shares as of 12:00 noon, New York City time, on
the Business Day preceding such Dividend Payment Date, the full amount of any
dividend on the APS payable on such Dividend Payment Date, provided, however,
that if the Fund is not able to make such declaration in compliance with the
foregoing because an unforeseen event or unforeseen events causes or cause a
day that otherwise would have been a Business Day not to be a Business Day,
then the Fund may make such declaration on the Business Day immediately
preceding the Dividend Payment Date, if possible, or, if not possible, on the
Dividend Payment Date, and in such case the Fund shall not be deemed to have
failed to declare a dividend otherwise required to be declared, or (ii)
deposit, irrevocably in trust, in same-day funds, with the Auction Agent by
12:00 noon, New York City time, (A) on such Dividend Payment Date the full
amount of any cash dividend on such shares payable (if declared) on such
Dividend Payment Date or (B) on any redemption date for any APS called for
redemption, the Mandatory Redemption Price per share of such APS or, in the
case of an optional redemption, the Optional Redemption Price per share. Such
Non-Payment Period will consist of the period commencing on and including the
aforementioned Dividend Payment Date or redemption date, as the case may be,
and ending on and including the Business Day on which, by 12:00 noon, New York
City time, all unpaid cash dividends and unpaid redemption prices shall have
been so deposited or otherwise shall have been made available to the applicable
holders in same-day funds, provided that a Non-Payment Period for the APS will
not end unless the Fund shall have given at least five days' but no more than
30 days' written notice of such deposit or availability to the Auction Agent,
the Securities Depository and all holders of the APS of such series.
Notwithstanding the foregoing, the failure by the Fund to deposit funds as
provided for by clauses (ii) (A) or (ii) (B) above within three Business Days
after any Dividend Payment Date or redemption date, as the case may be, in each
case to the extent contemplated below, shall not constitute a "Non-Payment
Period." The Applicable Rate for each Dividend Period for the APS of any
series, commencing during a Non-Payment Period, will be equal to the
Non-Payment Period Rate; and each Dividend Period commencing after the first
day of, and during, but not after the end of, a Non-Payment Period shall be a
7-Day Dividend Period. Any dividend on the APS due on any Dividend Payment Date
for such shares (if, prior to the close of business on the second Business Day
preceding such Dividend Payment Date, the Fund has declared such dividend
payable on such Dividend Payment Date to the persons who held such shares as of
12:00 noon, New York City time, on the Business Day preceding such Dividend
Payment
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39
Description of APS
--------------------------------------------------------------------------------
Date) or redemption price with respect to such shares not paid to such persons
when due may be paid to such persons in the same form of funds by 12:00 noon,
New York City time, on any of the first three Business Days after such Dividend
Payment Date or due date, as the case may be, provided that such amount is
accompanied by a late charge calculated for such period of non-payment at the
Non-Payment Period Rate applied to the amount of such non-payment based on the
actual number of days comprising such period (excluding any days that would
have been Business Days but for the occurrence of any unforeseen event or
unforeseen events that caused such days not to be Business Days) divided by
365, and in such case such period shall not constitute a Non-Payment Period;
provided, however, that the Fund shall not be required to pay any late charge
if it declares a dividend on the Dividend Payment Date or the Business Day
immediately preceding such Dividend Payment Date in accordance with clause (i)
of the definition of "Non-Payment Period" and deposits payment for such
dividend as contemplated by clause (ii)(A) of the definition of "Non-Payment
Period" on or before the second Business Day succeeding the day on which the
dividend was declared. In the case of a willful failure of the Fund to pay a
dividend on a Dividend Payment Date or to redeem any APS on the date set for
such redemption, the preceding sentence shall not apply and the Applicable Rate
for the Dividend Period commencing during the Non-Payment Period resulting from
such failure shall be the Non-Payment Period Rate. For the purposes of the
foregoing, payment to a person in same-day funds on any Business Day at any
time will be considered equivalent to payment to that person in New York
Clearing House (next-day) funds at the same time on the preceding Business Day,
and any payment made after 12:00 noon, New York City time, on any Business Day
shall be considered to have been made instead in the same form of funds and to
the same person before 12:00 noon, New York City time, on the next Business
Day. The "Non-Payment Period Rate" initially will be 200% of the applicable
Reference Rate (or 275% of such rate if the Fund has provided notification to
the Auction Agent prior to the Auction establishing the Applicable Rate for any
dividend that net capital gains or other taxable income will be included in
such dividend on the APS), provided that the Board of Trustees shall have the
authority to adjust, modify, alter or change from time to time the initial
Non-Payment Period Rate if the Board of Trustees determines and Moody's (or any
Substitute Rating Agency in lieu of Moody's in the event Moody's shall not rate
the APS) advises the Fund in writing that such adjustment, modification,
alteration or change will not adversely affect its then-current rating on the
APS.
Restrictions on Dividends and Other Payments
Under the 1940 Act, the Fund may not declare dividends or make other
distributions on Common Shares or purchase any such shares if, at the time of
the declaration, distribution or purchase, as applicable (and after giving
effect thereto), asset coverage (as defined in the 1940 Act) with respect to
the outstanding APS would be less than 200% (or such other percentage as in the
future may be required by law). The foregoing limitations on dividends, other
distributions and purchases in certain circumstances may impair the Fund's
ability to maintain its qualification as a regulated investment company under
the Code. See "Taxes." Upon any failure to pay dividends on the APS for two
years or more, the holders of the APS will acquire certain additional voting
rights. See "--Voting Rights" below.
For so long as any APS are outstanding, the Fund will not declare, pay or set
apart for payment any dividend or other distribution (other than a dividend or
distribution paid in shares of, or options, warrants or rights to subscribe for
or purchase, Common Shares or other shares, if any, ranking junior to the APS
as to dividends or upon liquidation) in respect of Common Shares or any other
shares of the Fund ranking junior to or on a parity with the APS as to
dividends or upon liquidation, or call for redemption, redeem, purchase or
otherwise acquire for consideration any Common Shares or any other such junior
shares (except by conversion into or exchange for shares of the Fund ranking
junior to APS as to dividends and upon liquidation) or any such parity shares
(except by conversion into or exchange for shares of the Fund ranking junior to
or on a parity with APS as to dividends and upon liquidation), unless (A)
immediately after such transaction, the Fund would have Moody's Eligible Assets
with an
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40
Description of APS
--------------------------------------------------------------------------------
aggregate Discounted Value equal to or greater than the APS Basic Maintenance
Amount, and the 1940 Act APS Asset Coverage (see "--Asset Maintenance" and
"--Redemption" below) would be satisfied, (B) full cumulative dividends on the
APS due on or prior to the date of the transaction have been declared and paid
or shall have been declared and sufficient funds for the payment thereof
deposited with the Auction Agent, (C) any Gross-up Dividend required to be paid
on or before the date of such declaration or payment has been paid and (D) the
Fund has redeemed the full number of APS required to be redeemed by any
provision for mandatory redemption contained in the Amended By-Laws.
Inclusion of Taxable Income in Dividends
Where the Fund is aware that it will include any net capital gains or other
taxable income in any dividend on APS, the Fund will notify the Auction Agent
of the amount to be so included prior to the Auction Date on which the
Applicable Rate for the dividend is to be established. The Fund may also
include such income in a dividend on shares of APS without giving notice in
advance of the Auction Date if it increases the dividend by an additional
amount calculated as if such income were the subject of a Retroactive Taxable
Allocation and the additional amount were a Gross-up Dividend (as described
immediately below) and notifies the Auction Agent of such inclusion at least
five days prior to the applicable Dividend Payment Date.
Gross-up Dividends
The Fund may retroactively allocate net capital gains or other Taxable Income
to the APS without giving the advance notice to the Auction Agent described
above under "--The Auction--Auction Date; Advance Notice of Allocation of
Taxable Income; Inclusion of Taxable Income in Dividends." If the Fund does so
solely by reason of the fact that such allocation is made as a result of the
redemption of all or a portion of the outstanding shares of APS or the
liquidation of the Fund (a "Retroactive Taxable Allocation"), the Fund, within
90 days (and generally within 60 days) after the end of the Fund's fiscal year
for which a Retroactive Taxable Allocation is made, will provide notice thereof
to the Auction Agent and to each holder of APS (initially Cede & Co. as nominee
of the Securities Depository) during such fiscal year at such holder's address
as the same appears or last appeared on the share books of the Fund. Within 30
days after such notice is given to the Auction Agent, the Fund will pay to the
Auction Agent (who then will distribute to such holders of the APS), out of
funds legally available therefor, an amount equal to the aggregate Gross-up
Dividend (as defined below) with respect to all Retroactive Taxable Allocations
made to such holders during the fiscal year in question. The Fund will not
otherwise compensate the holders of the APS for any tax liability caused by the
retroactive allocation of net capital gains or other taxable income to the APS.
See "Taxes."
A "Gross-up Dividend" means a payment to a present or former holder of the APS
of an amount which, when giving effect to the Retroactive Taxable Allocation
made to such holder with respect to the fiscal year in question, would cause
such holder's after-tax return (taking into account both the Retroactive
Taxable Allocation and the Gross-up Dividend) to be equal to the after-tax
return the holder would have received if there had been no Retroactive Taxable
Allocation. A Gross-up Dividend shall be calculated (i) without consideration
being given to the time value of money, (ii) assuming that none of the
dividends received from the Fund is a Preference Item and (iii) assuming that
each Retroactive Taxable Allocation would be taxable to each holder of APS at
the maximum marginal federal income tax rate (including any surtax) applicable
to the taxable character of the distribution (i.e., ordinary income or net
capital gain) in the hands of an individual or a corporation, whichever is
greater (disregarding the effect of any state and local taxes and the phase out
of, or provision limiting, personal exemptions, itemized deductions or the
benefit of lower tax brackets). The Fund generally intends to designate any
Gross-up Dividend as an "exempt-interest" dividend to the extent permitted by
applicable law. However, a portion or all of any Gross-up Dividend will be
taxable to the recipient thereof. See "Taxes." The Fund will not pay a further
Gross-up Dividend with respect to any taxable portion of a Gross-up Dividend.
The Fund shall not be
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41
Description of APS
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required to pay Gross-up Dividends with respect to any net capital gain or
other taxable income determined by the IRS to be allocable in a manner
different from that allocated by the Fund.
ASSET MAINTENANCE
The Fund will be required to satisfy two separate asset maintenance
requirements under the terms of the Amended By-Laws. These requirements are
summarized below.
1940 Act APS Asset Coverage
The Fund will be required under the Amended By-Laws to maintain, with respect
to the APS, as of the last Business Day of each month in which any APS are
outstanding, asset coverage of at least 200% with respect to senior securities
which are shares of beneficial interest in the Fund, including the APS (or such
other asset coverage as in the future may be specified in or under the 1940 Act
as the minimum asset coverage for senior securities which are shares of
beneficial interest of a closed-end investment company as a condition of paying
dividends on its common stock) ("1940 Act APS Asset Coverage"). If the Fund
fails to maintain 1940 Act APS Asset Coverage and such failure is not cured as
of the last Business Day of the following month (the "1940 Act Cure Date"), the
Fund will be required under certain circumstances to redeem certain of the APS.
See "--Redemption" below.
The 1940 Act APS Asset Coverage immediately following the issuance of APS
offered hereby (after giving effect to the deduction of the sales load and
offering expenses for the APS), computed using the Fund's net assets as of
August 7, 2002, and assuming the APS had been issued as of such date, will be
as follows:
Value of Fund assets less liabilities not
constituting senior securities $1,332,042,998
-------------------------------------------- = ------------ = 264%
Senior securities representing indebtedness plus $ 505,000,000
liquidation value of the shares of APS
APS Basic Maintenance Amount
So long as the APS are outstanding, the Fund will be required under the Amended
By-Laws to maintain as of each Business Day (a "Valuation Date") Moody's
Eligible Assets having in the aggregate a Discounted Value at least equal to
the APS Basic Maintenance Amount. If the Fund fails to meet such requirement as
of any Valuation Date and such failure is not cured on or before the sixth
Business Day after such Valuation Date (the "APS Basic Maintenance Cure Date"),
the Fund will be required in certain circumstances to redeem certain of the
APS. Upon any failure to maintain the required Discounted Value, the Fund will
use its best efforts to alter the composition of its portfolio to retain a
Discounted Value at least equal to the APS Basic Maintenance Amount on or prior
to the APS Basic Maintenance Cure Date. See "--Redemption."
The "APS Basic Maintenance Amount" as of any Valuation Date is defined as the
dollar amount equal to the sum of (i)(A) the product of the number of shares of
APS outstanding on such date multiplied by $25,000 (plus the product of the
number of shares of any other series of Preferred Shares outstanding on such
date multiplied by the liquidation preference of such shares), plus any
redemption premium applicable to shares of APS (or other Preferred Shares) then
subject to redemption; (B) the aggregate amount of dividends that will have
accumulated at the respective Applicable Rates (whether or not earned or
declared) to (but not including) the first respective Dividend Payment Dates
for shares of APS outstanding that follow such Valuation Date (plus the
aggregate amount of dividends, whether or not earned or declared, that will
have accumulated in respect of other outstanding Preferred Shares to, but not
including, the first respective dividend payment dates for such other shares
that follow such Valuation Date); (C) the aggregate amount of dividends that
would accumulate on shares of each series
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42
Description of APS
--------------------------------------------------------------------------------
of APS outstanding from such first respective Dividend Payment Date therefor
through the 49th day after such Valuation Date, at the Maximum Applicable Rate
(calculated as if such Valuation Date were the Auction Date for the Dividend
Period commencing on such Dividend Payment Date) for a 7-Day Dividend Period of
shares of such series to commence on such Dividend Payment Date, assuming,
solely for purposes of the foregoing, that if on such Valuation Date the Fund
shall have delivered a Notice of Special Dividend Period to the Auction Agent
with respect to shares of such series, such Maximum Applicable Rate shall be
the higher of (a) the Maximum Applicable Rate for the Special Dividend Period
of shares of such series to commence on such Dividend Payment Date and (b) the
Maximum Applicable Rate for a 7-Day Rate Period of shares of such series to
commence on such Dividend Payment Date, multiplied by the Moody's Volatility
Factor applicable to a 7-Day Dividend Period, or, in the event the Fund shall
have delivered a Notice of Special Dividend Period to the Auction Agent with
respect to shares of such series designating a Special Dividend Period
consisting of 49 days or more, the Moody's Volatility Factor applicable to a
Special Dividend Period of that length (plus the aggregate amount of dividends
that would accumulate at the maximum dividend rate or rates on any other
Preferred Shares outstanding from such respective dividend payment dates
through the 49th day after such Valuation Date, as established by or pursuant
to the respective statements establishing and fixing the rights and preferences
of such other Preferred Shares) (except that (1) if such Valuation Date occurs
during a Non-Payment Period (or, in the case of Preferred Shares other than
APS, a period similar to a Non-Payment Period), the dividend for purposes of
calculation would accumulate at the current dividend rate then applicable to
the shares in respect of which such Non-Payment Period is applicable and (2)
for those days during the period described in this subparagraph (C) in respect
of which the Applicable Rate in effect immediately prior to such Dividend
Payment Date will remain in effect (or, in the case of Preferred Shares other
than APS, in respect of which the dividend rate or rates in effect immediately
prior to such respective dividend payment dates will remain in effect), the
dividend for purposes of calculation would accumulate at such Applicable Rate
(or other rate or rates, as the case may be) in respect of those days); (D) the
amount of anticipated expenses of the Fund for the 90 days subsequent to such
Valuation Date; (E) the amount of the Fund's Maximum Potential Gross-up
Dividend Liability in respect of shares of APS (and similar amounts payable in
respect of other Preferred Shares) as of such Valuation Date; and (F) any
current liabilities as of such Valuation Date to the extent not reflected in
any of (i)(A) through (i)(E) (including, without limitation, any payables for
Municipal Obligations purchased as of such Valuation Date and any liabilities
incurred for the purpose of clearing securities transactions) less (ii) the
value (i.e., the face value of cash, short-term Municipal Obligations rated
MIG-1, VMIG-1 or P-1, and short-term securities that are the direct obligation
of the U.S. government, provided in each case that such securities mature on or
prior to the date upon which any of (i)(A) through (i)(F) become payable,
otherwise the Moody's Discounted Value) of any of the Fund's assets irrevocably
deposited by the Fund for the payment of any of (i)(A) through (i)(F). For
purposes of the foregoing, "Maximum Potential Gross-up Dividend Liability"
means, as of any Valuation Date, the aggregate amount of Gross-up Dividends
that would be due if the Fund were to make Retroactive Taxable Allocations,
with respect to any fiscal year, estimated based upon dividends paid and the
amount of undistributed realized net capital gains and other taxable income
earned by the Fund, as of the end of the calendar month immediately preceding
such Valuation Date and assuming such Gross-up Dividends are fully taxable.
For purposes of determining whether the Fund has Moody's Eligible Assets with
an aggregate Discounted Value that equals or exceeds the APS Basic Maintenance
Amount, the Discounted Value of Moody's Eligible Assets that the Fund is
obligated to deliver or receive pursuant to an outstanding futures contract or
option shall be as follows: (i) assets subject to call options written by the
Fund that are either exchange-traded and "readily reversible" or that expire
within 49 days after the date as of which such valuation is made shall be
valued at the lesser of (A) Discounted Value and (B) the exercise price of the
call option written by the Fund; (ii) assets subject to call options written by
the Fund not meeting the requirements of clause (i) of this sentence shall have
no value; (iii) assets subject to put options written by
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43
Description of APS
--------------------------------------------------------------------------------
the Fund shall be valued at the lesser of (A) the exercise price and (B) the
Discounted Value of the assets subject to the option; (iv) futures contracts
shall be valued at the lesser of (A) settlement price and (B) the Discounted
Value of the assets subject to the futures contract, provided that, if a
contract matures within 49 days after the date as of which such valuation is
made, where the Fund is the seller the contract may be valued at the settlement
price and where the Fund is the buyer the contract may be valued at the
Discounted Value of the assets subject to the futures contract; and (v) where
delivery may be made to the Fund with any security of a class of securities,
the Fund shall assume that it will take delivery of the security with the
lowest Discounted Value.
In addition, for purposes of determining whether the Fund has Moody's Eligible
Assets with an aggregate Discounted Value that equals or exceeds the APS Basic
Maintenance Amount, the following amounts shall be subtracted from the
aggregate Discounted Value of the Moody's Eligible Assets held by the Fund to
the extent the relevant asset is a Moody's Eligible Asset: (i) 10% of the
exercise price of a written call option; (ii) the exercise price of any written
put option; (iii) where the Fund is the seller under a financial futures
contract, 10% of the settlement price of the financial futures contract; (iv)
where the Fund is the purchaser under a financial futures contract, any amounts
payable by the Fund under such financial futures contract; (v) the settlement
price of the underlying financial futures contract if the Fund writes put
options on a financial futures contract; and (vi) 105% of the Market Value of
the underlying financial futures contracts if the Fund writes call options on a
financial futures contract and does not own the underlying contract. The
Discounted Value of all forward commitments to which the Fund is a party and of
all securities deliverable to the Fund pursuant to such forward commitments
shall be zero.
The Discount Factors and guidelines for determining the market value of the
Fund's portfolio holdings have been based on criteria established in connection
with rating the APS. These factors include, but are not limited to, the
sensitivity of the market value of the relevant asset to changes in interest
rates, the liquidity and depth of the market for the relevant asset, the credit
quality of the relevant asset (for example, the lower the rating of a debt
obligation, the higher the related Discount Factor) and the frequency with
which the relevant asset is marked to market. In no event shall the Discounted
Value of any asset of the Fund exceed its unpaid principal balance or face
amount as of the date of calculation. The Discount Factor relating to any asset
of the Fund and the APS Basic Maintenance Amount, the assets eligible for
inclusion in the calculation of the Discounted Value of the Fund's portfolio
and certain definitions and methods of calculation relating thereto may be
changed from time to time by the Fund, without shareholder approval, but only
in the event the Fund receives written confirmation from Moody's, or any
Substitute Rating Agency, that any such changes would not impair the ratings
then assigned to the APS by Moody's or such Substitute Rating Agency.
On or before the third Business Day after a Valuation Date on which the Fund
fails to maintain Moody's Eligible Assets with an aggregate Discounted Value
equal to or greater than the APS Basic Maintenance Amount, the Fund is required
to deliver to the Auction Agent and Moody's a report with respect to the
calculation of the APS Basic Maintenance Amount and the value of its portfolio
holdings (an "APS Basic Maintenance Report") as of the date of such failure.
Additionally, on or before the third Business Day after the first day of a
Special Dividend Period, the Fund will deliver an APS Basic Maintenance Report
to Moody's and the Auction Agent. The Fund also will deliver an APS Basic
Maintenance Report as of the last Business Day of the last month of each fiscal
quarter of the Fund on or before the third Business Day after such day. Within
ten Business Days after delivery of such report relating to the last Business
Day of the last month of each fiscal quarter of the Fund, the Fund will deliver
a letter prepared by the Fund's independent accountants regarding the accuracy
of the calculations made by the Fund in its most recent APS Basic Maintenance
Report (and in another APS Basic Maintenance Report, randomly selected by the
Fund's independent accountants, that was delivered during such fiscal quarter).
Also, on or before 5:00 p.m., New York City time, on the first Business Day
after any Common Shares are repurchased by
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44
Description of APS
--------------------------------------------------------------------------------
the Fund, the Fund will complete and deliver to Moody's an APS Basic
Maintenance Report as of the close of business on such date that Common Shares
are repurchased. If any such letter prepared by the Fund's independent
accountants shows that an error was made in the most recent APS Basic
Maintenance Report, the calculation or determination made by the Fund's
independent accountants will be conclusive and binding on the Fund.
REDEMPTION
Optional Redemption
To the extent permitted under the 1940 Act and under Massachusetts law, upon
giving a notice of redemption, as provided below, the Fund, at its option, may
redeem the APS, in whole or in part, out of funds legally available therefor,
at the Optional Redemption Price per share on any Dividend Payment Date;
provided that no APS may be redeemed at the option of the Fund during (a) the
Initial Dividend Period with respect to the APS or (b) a Non-Call Period to
which such share is subject. "Optional Redemption Price" means $25,000 per
share of APS plus an amount equal to accumulated but unpaid dividends (whether
or not earned or declared) to the date fixed for redemption plus any applicable
redemption premium, if any, attributable to the designation of a Premium Call
Period, but excluding Gross-up Dividends. In addition, holders of APS may be
entitled to receive Gross-up Dividends in the event of redemption of such APS
to the extent provided herein. See "--Dividends--Gross-up Dividends." The Fund
has the authority to redeem the APS for any reason and may redeem all or part
of the outstanding APS if it anticipates that the Fund's leveraged capital
structure will result in a lower rate of return to holders of Common Shares for
any significant period of time than that obtainable if the Common Shares were
unleveraged.
Mandatory Redemption
Under the Fund's Amended By-Laws, the Fund will be required to redeem, out of
funds legally available therefor, at the Mandatory Redemption Price per share,
the APS to the extent permitted under the 1940 Act and Massachusetts law, on a
date fixed by the Board of Trustees, if the Fund fails to maintain Moody's
Eligible Assets with an aggregate Discounted Value equal to or greater than the
APS Basic Maintenance Amount or to satisfy the 1940 Act APS Asset Coverage and
such failure is not cured on or before the APS Basic Maintenance Cure Date or
the 1940 Act Cure Date (herein collectively referred to as a "Cure Date"), as
the case may be. "Mandatory Redemption Price" for each series of APS means
$25,000 per share plus an amount equal to accumulated but unpaid dividends
(whether or not earned or declared) to the date fixed for redemption, but
excluding Gross-up Dividends. In addition, holders of APS may be entitled to
receive Gross-up Dividends in the event of redemption of such APS to the extent
provided herein. See "--Dividends--Gross-up Dividends." The number of APS to be
redeemed will be equal to the lesser of (a) the minimum number of APS the
redemption of which, if deemed to have occurred immediately prior to the
opening of business on the Cure Date, together with all other Preferred Shares
subject to redemption or retirement, would result in the Fund having Moody's
Eligible Assets with an aggregate Discounted Value equal to or greater than the
APS Basic Maintenance Amount or satisfaction of the 1940 Act APS Asset
Coverage, as the case may be, on such Cure Date (provided that, if there is no
such minimum number of shares the redemption of which would have such result,
all APS then outstanding will be redeemed), and (b) the maximum number of APS,
together with all other shares of Preferred Shares subject to redemption or
retirement, that can be redeemed out of funds expected to be legally available
therefor on such redemption date. In determining the number of APS required to
be redeemed in accordance with the foregoing, the Fund shall allocate the
number required to be redeemed which would result in the Fund having Moody's
Eligible Assets with an aggregate Discounted Value equal to or greater than the
APS Basic Maintenance Amount or satisfaction of the 1940 Act APS Asset
Coverage, as the case may be, pro rata among APS and other Preferred Shares
subject to redemption pursuant to provisions similar to those set forth below;
provided that APS that may not be redeemed at
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45
Description of APS
--------------------------------------------------------------------------------
the option of the Fund due to the designation of a Non-Call Period applicable
to such shares (A) will be subject to mandatory redemption only to the extent
that other shares are not available to satisfy the number of shares required to
be redeemed and (B) will be selected for redemption in an ascending order of
outstanding number of days in the Non-Call Period (with shares with the lowest
number of days to be redeemed first) and by lot in the event of shares having
an equal number of days in such Non-Call Period. The Fund is required to effect
such a mandatory redemption not later than 35 days after such Cure Date, except
that if the Fund does not have funds legally available for the redemption of
all of the required number of APS which are subject to mandatory redemption or
the Fund otherwise is unable to effect such redemption on or prior to 35 days
after such Cure Date, the Fund will redeem those APS which it was unable to
redeem on the earliest practicable date on which it is able to effect such
redemption.
General
If the APS are to be redeemed, a notice of redemption will be mailed to each
record holder of such APS (initially Cede & Co. as nominee of the Securities
Depository) and to the Auction Agent not less than 17 nor more than 30 days
prior to the date fixed for the redemption thereof. Each notice of redemption
will include a statement setting forth: (i) the redemption date, (ii) the
aggregate number of APS to be redeemed, (iii) the redemption price, (iv) the
place or places where APS are to be surrendered for payment of the redemption
price, (v) a statement that dividends on the shares to be redeemed will cease
to accumulate on such redemption date (except that holders may be entitled to
Gross-up Dividends) and (vi) the provision of the Amended By-Laws pursuant to
which such shares are being redeemed. No defect in the notice of redemption or
in the mailing or publication thereof will affect the validity of the
redemption proceedings, except as required by applicable law.
If less than all of the outstanding APS are to be redeemed, the shares to be
redeemed will, unless otherwise required for the Amended By-Laws, be selected
by lot or such other method as the Fund deems fair and equitable, and the
results thereof will be communicated to the Auction Agent. The Auction Agent
will give notice to the Securities Depository, whose nominee will be the record
holder of all APS, and the Securities Depository will determine the number of
shares to be redeemed from the account of the Agent Member of each Existing
Holder. Each Agent Member will determine the number of shares to be redeemed
from the account of each Existing Holder for which it acts as agent. An Agent
Member may select for redemption shares from the accounts of some Existing
Holders without selecting for redemption any shares from the accounts of other
Existing Holders. Notwithstanding the foregoing, if neither the Securities
Depository nor its nominee is the record holder of all of the APS series, the
particular shares to be redeemed shall be selected by the Fund by lot or by
such other method as the Fund deems fair and equitable.
If the Fund gives notice of redemption, and concurrently or thereafter deposits
in trust with the Auction Agent, or segregates in an account at the Fund's
custodian bank for the benefit of the Auction Agent, Deposit Securities (with a
right of substitution) having an aggregate Discounted Value equal to the
redemption payment for the APS as to which notice of redemption has been given,
with irrevocable instructions and authority to pay the redemption price to the
record holders thereof, then upon the date of such deposit or, if no such
deposit is made, upon such date fixed for redemption (unless the Fund defaults
in making payment of the redemption price), all rights of the holders of such
shares called for redemption will cease and terminate, except the right of such
holders to receive the redemption price thereof and any Gross-up Dividends, but
without interest, and such shares no longer will be deemed to be outstanding.
The Fund will be entitled to receive, from time to time, the interest, if any,
earned on such Deposit Securities deposited with the Auction Agent, and the
holders of any shares so redeemed will have no claim to any such interest. Any
funds so deposited which are unclaimed at the end of one year
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46
Description of APS
--------------------------------------------------------------------------------
from such redemption date will be repaid, upon demand, to the Fund, after which
the holders of the APS of such series so called for redemption may look only to
the Fund for payment thereof.
So long as any APS are held of record by the nominee of the Securities
Depository (initially Cede & Co.), the redemption price for such shares will be
paid on the redemption date to the nominee of the Securities Depository. The
Securities Depository's normal procedures now provide for it to distribute the
amount of the redemption price to Agent Members who, in turn, are expected to
distribute such funds to the persons for whom they are acting as agent.
Notwithstanding the provisions for redemption described above, no APS shall be
subject to optional redemption (i) unless all dividends in arrears on the
outstanding APS, and all shares of beneficial interest of the Fund ranking on a
parity with the APS with respect to the payment of dividends or upon
liquidation, have been or are being contemporaneously paid or declared and set
aside for payment and (ii) if redemption thereof would result in the Fund's
failure to maintain Moody's Eligible Assets with an aggregate Discounted Value
equal to or greater than the APS Basic Maintenance Amount.
LIQUIDATION RIGHTS
Upon any liquidation, dissolution or winding up of the Fund, whether voluntary
or involuntary, the holders of APS of each series will be entitled to receive,
out of the assets of the Fund available for distribution to shareholders,
before any distribution or payment is made upon any Common Shares or any other
shares of beneficial interest of the Fund ranking junior in right of payment
upon liquidation of APS, $25,000 per share together with the amount of any
dividends accumulated but unpaid (whether or not earned or declared) thereon to
the date of distribution, and after such payment the holders of APS will be
entitled to no other payments except for any Gross-up Dividends. If such assets
of the Fund are insufficient to make the full liquidation payment on
outstanding APS and liquidation payments on any other outstanding class or
series of Preferred Shares of the Fund ranking on a parity with the APS as to
payment upon liquidation, then such assets will be distributed among the
holders of APS and the holders of shares of such other class or series ratably
in proportion to the respective preferential amounts to which they are
entitled. After payment of the full amount of liquidation distribution to which
they are entitled, the holders of APS will not be entitled to any further
participation in any distribution of assets by the Fund except for any Gross-up
Dividends. A consolidation, merger or share exchange of the Fund with or into
any other entity or entities or a sale, whether for cash, shares of stock,
securities or properties, of all or substantially all or any part of the assets
of the Fund shall not be deemed or construed to be a liquidation, dissolution
or winding up of the Fund.
VOTING RIGHTS
Except as otherwise indicated in this Prospectus and except as otherwise
required by applicable law, holders of APS will be entitled to one vote per
share on each matter submitted to a vote of shareholders and will vote together
with holders of Common Shares and other Preferred Shares as a single class.
In connection with the election of the Fund's Trustees, holders of the APS and
any other Preferred Shares, voting as a separate class, shall be entitled at
all times to elect two of the Fund's Trustees, and the remaining Trustees will
be elected by holders of Common Shares and APS and any other Preferred Shares,
voting together as a single class. In addition, if at any time dividends on
outstanding APS are unpaid in an amount equal to at least two full years'
dividends thereon and sufficient cash or securities shall not have been
deposited with the Auction Agent for the payment of such accumulated dividends,
or if at any time holders of any shares of Preferred Shares are entitled,
together with the holders of APS, to elect a majority of the Trustees of the
Fund under the 1940 Act, then the number of Trustees constituting the Board of
Trustees automatically shall be increased by the smallest number that, when
added to the
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47
Description of APS
--------------------------------------------------------------------------------
two Trustees elected exclusively by the holders of APS and any other Preferred
Shares as described above, would constitute a majority of the Board of Trustees
as so increased by such smallest number, and at a special meeting of
shareholders which will be called and held as soon as practicable, and at all
subsequent meetings at which Trustees are to be elected, the holders of the APS
and any other Preferred Shares, voting as a separate class, will be entitled to
elect the smallest number of additional Trustees that, together with the two
Trustees which such holders in any event will be entitled to elect, constitutes
a majority of the total number of Trustees of the Fund as so increased. The
terms of office of the persons who are Trustees at the time of that election
will continue. If the Fund thereafter shall pay, or declare and set apart for
payment in full, all dividends payable on all outstanding APS and any other
Preferred Shares for all past Dividend Periods, the additional voting rights of
the holders of APS and any other Preferred Shares as described above shall
cease, and the terms of office of all of the additional Trustees elected by the
holders of APS and any other Preferred Shares (but not of the Trustees with
respect to whose election the holders of Common Shares were entitled to vote or
the two Trustees the holders of APS and any other Preferred Shares have the
right to elect in any event) will terminate automatically.
The affirmative vote of a majority of the votes entitled to be cast by holders
of outstanding APS and any other Preferred Shares, voting together as one
class, will be required to (i) authorize, create or issue any class or series
of shares ranking prior to the APS or any other series of Preferred Shares with
respect to the payment of dividends or the distribution of assets on
liquidation; provided, however, that no vote is required to authorize the
issuance of another series of APS or another class of Preferred Shares which
are substantially identical in all respects to the APS or (ii) amend, alter or
repeal the provisions of the Declaration or the Amended By-Laws, whether by
merger, consolidation or otherwise, so as to adversely affect any of the
contract rights expressly set forth in the Declaration or the Amended By-Laws
of holders of APS or any other Preferred Shares. To the extent permitted under
the 1940 Act, in the event shares of more than one series of APS are
outstanding, the Fund shall not approve any of the actions set forth in clause
(i) or (ii) which adversely affects the contract rights expressly set forth in
the Declaration or the Amended By-Laws of a holder of shares of a series of APS
differently than those of a holder of shares of any other series of APS without
the affirmative vote of at least a majority of votes entitled to be cast by
holders of the APS of each series adversely affected and outstanding at such
time (each such adversely affected series voting separately as a class). The
Board of Trustees, however, without shareholder approval, may amend, alter or
repeal any or all of the various Rating Agency guidelines described herein in
the event the Fund receives confirmation from Moody's (or the applicable
Substitute Rating Agency) that any such amendment, alteration or repeal would
not impair the rating then assigned to the APS by such Rating Agency. Unless a
higher percentage is provided for under the Declaration, the affirmative vote
of a majority of the votes entitled to be cast by holders of outstanding APS
and any other Preferred Shares, voting as a separate class, will be required to
approve any plan of reorganization (including bankruptcy proceedings) adversely
affecting such shares or any action requiring a vote of security holders under
Section 13(a) of the 1940 Act including, among other things, changes in the
investment restrictions described as fundamental policies under "Investment
Restrictions" in the Statement of Additional Information. The class vote of
holders of APS and any other Preferred Shares described above in each case will
be in addition to a separate vote of the requisite percentage of Common Shares
and APS and any other Preferred Shares, voting together as a single class,
necessary to authorize the action in question.
The foregoing voting provisions will not apply to the APS if, at or prior to
the time when the act with respect to which such vote otherwise would be
required shall be effected, such shares shall have been (i) redeemed or (ii)
called for redemption and sufficient funds shall have been deposited in trust
to effect such redemption.
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48
--------------------------------------------------------------------------------
Management of the Fund
TRUSTEES AND OFFICERS
The Board of Trustees is responsible for the management of the Fund, including
supervision of the duties performed by the Manager and PIMCO. The names and
business addresses of the Trustees and officers of the Fund and their principal
occupations and other affiliations during the past five years are set forth
under "Management of the Fund" in the Statement of Additional Information.
INVESTMENT MANAGER
The Manager serves as the investment manager of the Fund. Subject to the
supervision of the Board of Trustees, the Manager is responsible for managing,
either directly or through others selected by it, the investment activities of
the Fund and the Fund's business affairs and other administrative matters. The
Manager is located at 1345 Avenue of the Americas, New York, New York 10105.
Organized in 2000, the Manager provides investment management and advisory
services to several closed-end and open-end investment company clients. As of
June 30, 2002, the Manager had approximately $7 billion in assets under
management. Allianz Dresdner Asset Management of America L.P. is the direct
parent company of PIMCO Advisory Services Holdings LLC, of which the Manager is
a wholly-owned subsidiary. As of June 30, 2002, Allianz Dresdner Asset
Management of America L.P. and its subsidiary partnerships, including PIMCO,
had approximately $346 billion in assets under management.
The Manager has retained its affiliate, PIMCO, to manage the Fund's
investments. See "--Portfolio Manager" below. The Manager and PIMCO are each
majority-owned indirect subsidiaries of Allianz AG, a publicly traded German
insurance and financial services company.
PORTFOLIO MANAGER
PIMCO serves as the portfolio manager for the Fund. Subject to the supervision
of the Manager, PIMCO has full investment discretion and makes all
determinations with respect to the investment of the Fund's assets.
PIMCO is located at 840 Newport Center Drive, Newport Beach, California 92660.
Organized in 1971, PIMCO provides investment management and advisory services
to private accounts of institutional and individual clients and to mutual
funds. As of June 30, 2002, PIMCO had approximately $275 billion in assets
under management. The Manager (and not the Fund) pays a portion of the fees it
receives to PIMCO in return for PIMCO's services.
Bill Gross, a founder of PIMCO, serves as Managing Director and Chief
Investment Officer of PIMCO. In his role as Chief Investment Officer, he serves
as the head of the Investment Committee, which oversees setting investment
policy decisions, including duration positioning, yield curve management,
sector rotation, credit quality and overall portfolio composition, for all
PIMCO portfolios and strategies, including the Fund. The following individual
at PIMCO has primary responsibility for the day-to-day portfolio management of
the Fund.
--------------------------------------------------------------------------------
49
Management of the Fund
--------------------------------------------------------------------------------
Since Recent Professional Experience
---------------------------------------------------------------------------------------
Mark V. McCray 2002 (Inception) Executive Vice President, PIMCO. Mr. McCray joined
PIMCO as a Portfolio Manager in 2000. Prior to that, he
was a bond trader from 1992-1999 at Goldman Sachs &
Co. where he was appointed Vice President in 1996 and
named co-head of municipal bond trading in 1997 with
responsibility for the firm's proprietary account and
supervised municipal bond traders.
Chris Dialynas, a Managing Director and senior member of PIMCO's investment
strategy group, oversees Mr. McCray regarding the management of the Fund.
INVESTMENT MANAGEMENT AGREEMENT
Pursuant to an investment management agreement between the Manager and the Fund
(the "Investment Management Agreement"), the Fund has agreed to pay the Manager
an annual management fee payable on a monthly basis at the annual rate of 0.65%
of the Fund's average daily net assets (including net assets attributable to
Preferred Shares, including the APS) for the services and facilities it
provides.
In addition to the fees of the Manager, the Fund pays all other costs and
expenses of its operations, including compensation of its Trustees (other than
those affiliated with the Manager), custodial expenses, shareholder servicing
expenses, transfer agency and dividend disbursing expenses, legal fees,
expenses of independent auditors, expenses of repurchasing shares, expenses of
issuing any Preferred Shares, expenses of preparing, printing and distributing
prospectuses, shareholder reports, notices, proxy statements and reports to
governmental agencies, and taxes, if any.
The Manager has contractually agreed to waive a portion of the management fees
it is entitled to receive from the Fund in the amounts, and for the time
periods, set forth below (covering commencement of Fund operations through June
30, 2009):
Percentage Waived
(contractual annual rate as a percentage of Percentage Waived
average daily net assets attributable to Common (annual rate as a percentage of average daily net
Period Ending Shares assuming no Preferred Shares are issued assets attributable to Common Shares-assuming
June 30, or outstanding) the issuance of Preferred Shares) (2)
---------------------------------------------------------------------------------------------------------------
2003(1)... 0.15% 0.24%
2004...... 0.15% 0.24%
2005...... 0.15% 0.24%
2006...... 0.15% 0.24%
2007...... 0.15% 0.24%
2008...... 0.10% 0.16%
2009...... 0.05% 0.08%
(1) From the commencement of the Fund's operations.
(2) Assumes the issuance of Preferred Shares in an amount equal to 38% of the
Fund's capital (after their issuance).
The Manager has not agreed to waive any portion of its fees beyond June 30,
2009.
Because the fees received by the Manager and PIMCO are based on the total net
assets of the Fund (including assets represented by APS and any leverage
created thereby), the Manager and PIMCO each
--------------------------------------------------------------------------------
50
Management of the Fund
--------------------------------------------------------------------------------
have a financial incentive for the Fund to issue APS, which may create a
conflict of interest between the Manager and/or PIMCO and the holders of the
Common Shares.
Net asset value
The net asset value ("NAV") of the Fund equals the total value of the Fund's
portfolio investments and other assets, less any liabilities. For purposes of
calculating NAV, portfolio securities and other assets for which market quotes
are available are stated at market value. Market value is generally determined
on the basis of the last reported sales price, or if no sales are reported,
based on quotes obtained from a quotation reporting system, established market
makers or pricing services. Certain securities or investments for which market
quotations are not readily available may be valued, pursuant to guidelines
established by the Board of Trustees, with reference to other securities or
indices. For instance, a pricing service may recommend a fair market value
based on prices of comparable municipal bonds. Short-term investments having a
maturity of 60 days or less are generally valued at amortized cost. Exchange
traded options, futures and options on futures are valued at the settlement
price determined by the exchange. Other securities for which market quotes are
not readily available are valued at fair value as determined in good faith by
the Board of Trustees or persons acting at their direction.
The NAV of the Fund will be determined as of the close of regular trading on
the New York Stock Exchange (normally 4:00 p.m., New York City time) (the "NYSE
Close") on each day the New York Stock Exchange is open. Domestic debt
securities are normally priced using data reflecting the earlier closing of the
principal markets for those securities. Information that becomes known to the
Fund or its agent after the Fund's NAV has been calculated on a particular day
will not be used to retroactively adjust the price of a security or the Fund's
NAV determined earlier that day.
In unusual circumstances, instead of valuing securities in the usual manner,
the Fund may value securities at fair value as determined in good faith by the
Board of Trustees, generally based upon recommendations provided by PIMCO. Fair
valuation also may be required due to material events that occur after the
close of the relevant market but prior to the NYSE Close.
Taxes
FEDERAL INCOME TAX MATTERS
The following federal income tax discussion is based on the advice of Ropes &
Gray, counsel to the Fund, and reflects provisions of the Internal Revenue Code
of 1986, as amended (the "Code"), existing Treasury regulations, rulings
published by the IRS and other applicable authority, as of the date of this
Prospectus. 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 tax considerations
generally applicable to investments in the Fund. For more detailed information
regarding tax considerations, see the Statement of Additional Information.
There may be other tax considerations applicable to particular investors. In
addition, income earned through an investment in the Fund may be subject to
state and local taxes.
The Fund intends to qualify each year for taxation as a regulated investment
company eligible for treatment under the provisions of Subchapter M of the
Code. If the Fund so qualifies and satisfies certain distribution requirements,
the Fund will not be subject to federal income tax on income distributed in a
timely manner to its shareholders in the form of dividends or capital gain
distributions.
--------------------------------------------------------------------------------
51
Taxes
--------------------------------------------------------------------------------
In order for any distributions to holders of APS to be eligible to be treated
as exempt interest dividends, the APS must be treated as equity for federal
income tax purposes. Based in part on certain representations made by the Fund
to Ropes & Gray relating to the lack of any present intention to redeem or
purchase APS at any time in the future, it is the opinion of Ropes & Gray that
the APS will constitute equity for federal income tax purposes. This opinion
relies in part on a published ruling of the IRS stating that certain auction
rate preferred stock similar in many material respects to the APS represents
equity. The opinion of Ropes & Gray represents only its best legal judgment and
is not binding on the IRS or the courts. If the IRS were successfully to assert
that variable rate preferred stock such as the APS should be treated as debt
for federal income tax purposes, dividends on APS would not be increased by the
Fund and holders of APS would not be entitled to any additional distributions
to offset the effect of paying federal income tax on the Fund's distributions
so recharacterized as interest. Ropes & Gray has advised the Fund that, should
the IRS pursue in court the position that the APS should be treated as debt for
federal income tax purposes, the IRS would be unlikely to prevail.
To satisfy the distribution requirement applicable to regulated investment
companies, amounts paid as dividends by the Fund to its shareholders, including
holders of the APS, must qualify for the dividends-paid deduction. In certain
circumstances, the IRS could take the position that dividends paid on the APS
constitute preferential dividends under Section 562(c) of the Code, and thus do
not qualify for the dividends-paid deduction.
If at any time when APS are outstanding the Fund does not meet applicable asset
coverage requirements, it will be required to suspend distributions to Common
Shareholders until the requisite asset coverage is restored. Any such
suspension may cause the Fund to pay a 4% federal excise tax (imposed on
regulated investment companies that fail to distribute for a given calendar
year, generally, at least 98% of their net investment income and capital gain
net income) and income tax on undistributed income or gains, and may, in
certain circumstances, prevent the Fund from qualifying for treatment as a
regulated investment company. The Fund may redeem APS in an effort to comply
with the distribution requirement applicable to regulated investment companies
and to avoid income and excise taxes.
The Fund primarily invests in municipal bonds issued by states, cities and
local authorities and certain possessions and territories of the United States
(such as Puerto Rico or Guam) or in municipal bonds the income on which is, in
the opinion of bond counsel to the issuer (or on the basis of other authority
believed by PIMCO to be reliable), otherwise exempt from federal income taxes.
Thus, substantially all of the Fund's dividends to you will qualify as
"exempt-interest dividends," which are not generally subject to federal income
tax. An investment in the Fund may result in liability for federal alternative
minimum tax for both individual and corporate shareholders. The Fund will at
all times seek to avoid portfolio investments that pay interest that is taxable
to individuals under the federal alternative minimum tax. Nonetheless, the Fund
may not be successful in this regard. Therefore, if your goal is to avoid or
limit your receipt of income that is taxable under the federal alternative
minimum tax, you should discuss with your tax advisor whether the Fund is an
appropriate investment for you.
The IRS has taken the position in a published ruling that the Fund is required
for each taxable year to allocate net capital gain and other income subject to
regular federal income tax, if any, proportionately among its Common Shares and
each series of APS in accordance with the percentage of total Fund
distributions received by each such class of shares with respect to such year.
As described above in the section entitled "Description of
APS--Dividends--Gross-up Dividends," if the Fund retroactively allocates any
net capital gains or other taxable income to the APS, in certain circumstances,
it will pay Gross-up Dividends to the holders of the APS. There are other
circumstances where, even if it is determined after the payment of a dividend
that a portion of that dividend was subject to federal income
--------------------------------------------------------------------------------
52
Taxes
--------------------------------------------------------------------------------
tax, the Fund will not be required to pay any additional amount to compensate
for any tax payable on the dividend.
The federal income tax consequences of Gross-up Dividends under existing law
are uncertain. For example, it is unclear how Gross-up Dividends will be
treated under the rules in Subchapter M of the Code applicable to dividends
paid following the close of a taxable year in respect of a prior year's income.
The Fund intends to treat such Gross-up Dividends as paid during such prior
taxable year for purposes of the rules governing the Fund's treatment of such
dividends, and to treat a holder as receiving a dividend distribution in the
amount of any Gross-up Dividend only as and when such Gross-up Dividend is paid.
Existing authorities do not specifically address whether dividends (including
possible Gross-up Dividends) that are paid following the close of a taxable
year, but that are treated for tax purposes as derived from the income of such
prior taxable year, are treated as dividends paid during such prior taxable
year for purposes of determining each class's proportionate share of a
particular type of income. The Fund currently intends to treat such dividends
as having been paid in the prior taxable year for purposes of determining each
class's proportionate share of a particular type of income with respect to such
prior taxable year. Existing authorities also do not specifically address the
allocation of taxable income among the dividends paid to holders of a class of
shares during or with respect to a taxable year. It is possible that the IRS
could disagree with the Fund's position concerning the treatment of dividends
paid after the close of a taxable year or with the Fund's method of allocation,
in which case the IRS could attempt to recharacterize a portion of the
dividends paid to the holders of APS and designated by the Fund as exempt
interest dividends as consisting instead of capital gains or other taxable
income. If the IRS were to prevail with respect to any such attempted
recharacterization, holders of APS could be subject to tax on amounts so
recharacterized and the Fund could be subject to federal income and excise tax.
In such event, no additional amounts (including Gross-up Dividends) would be
paid by the Fund with respect to dividends so recharacterized to compensate for
any additional tax owed by holders of APS.
If, in connection with the selection of a Long-Term Dividend Period, (i) the
Fund provides that a Premium Call Period will follow a Non-Call Period, (ii)
based on all the facts and circumstances at the time of the designation of the
Long-Term Dividend Period the Fund is more likely than not to redeem the
Preferred Shares during the Premium Call Period, and (iii) the premium to be
paid upon redemption during the Premium Call Period exceeds a reasonable
penalty for early redemption, it is possible that the holders of APS will be
required to accrue such premium as a dividend (to the extent of the Fund's
earnings and profits) over the term of the Non-Call Period.
The Fund will generally designate Gross-up Dividends as exempt-interest
dividends to the extent it determines such designation is consistent with the
allocation principles, as described in "Description of APS--Dividends--Gross-up
Dividends." However, a portion or all of a Gross-up Dividend will be taxable
either in the taxable year in which the dividend or dividends to which the
Gross-up Dividend relates was paid or in the taxable year in which the Gross-up
Dividend is paid. The Fund will not be required to pay any additional amount if
it is determined that its treatment of Gross-up Dividends was improper.
The Fund may at times buy tax-exempt investments at a discount from the price
at which they were originally issued, especially during periods of rising
interest rates. For federal income tax purposes, some or all of any market
discount that is other than de minimis will be included in the Fund's ordinary
income and will be taxable to shareholders as such when such income is
distributed. The Fund's investments in these and certain other debt obligations
may cause the Fund to recognize taxable income
--------------------------------------------------------------------------------
53
Taxes
--------------------------------------------------------------------------------
in excess of the cash generated by such obligations. Thus, the Fund could be
required at times to liquidate other investments in order to satisfy its
distribution requirements.
For federal income tax purposes, distributions of investment income other than
exempt interest dividends are taxable as ordinary income. Generally, gains
realized by the Fund on the sale or exchange of investments will be taxable to
its shareholders, even though interest income from such investments generally
will be tax-exempt. Whether distributions of capital gains are taxed as
ordinary income or capital gains is determined by how long the Fund owned the
investments that generated such capital gains, rather than how long a
shareholder has owned his or her shares. Distributions are taxable to
shareholders even if they are paid from income or gains earned by the Fund
before a shareholder's investment (and thus were included in the price the
shareholder paid). Distributions of gains from the sale of investments that the
Fund owned for more than one year will be taxable as capital gains.
Distributions of gains from the sale of investments that the Fund owned for one
year or less will be taxable as ordinary income. Distributions of capital gains
and investment income other than exempt interest dividends are taxable whether
shareholders receive them in cash or reinvest them in additional shares through
the Fund's Dividend Reinvestment Plan for Common Shares.
Any gain resulting from the sale or exchange of Fund shares will generally also
be subject to tax. In addition, the exemption from federal income tax for
exempt-interest dividends does not necessarily result in exemption for such
dividends under the income or other tax laws of any state or local taxing
authority. You should consult your tax advisor for more information on your own
tax situation, including possible state and local taxes.
The backup withholding tax rate is 30% for amounts paid during 2002 and 2003 if
the Fund is required to apply backup withholding to taxable distributions
payable to a shareholder. Please see "Tax Matters" in the Statement of
Additional Information for additional information about the backup withholding
tax rates for subsequent years.
Description of capital structure
The Fund is an unincorporated business trust established under the laws of The
Commonwealth of Massachusetts by the Declaration. The Declaration provides that
the Trustees of the Fund may authorize separate classes of shares of beneficial
interest. The Trustees have authorized an unlimited number of Common Shares and
Preferred Shares. Preferred Shares (such as the APS) may be issued in one or
more series, with such par value and with such rights as determined by the
Board of Trustees, by action of the Board of Trustees without the approval of
the Common Shareholders. For a description of the APS, see "Description of
APS." The following table shows the amount of (i) shares authorized and (ii)
shares outstanding, for each class of authorized securities of the Fund as of
August 15, 2002.
Amount Amount
Title of Class Authorized Outstanding
------------------------------------------------------------------------------
Common Shares.......................................... Unlimited 57,508,129
Auction Preferred Shares
Series A............................................ 4,040 -0-
Series B............................................ 4,040 -0-
Series C............................................ 4,040 -0-
Series D............................................ 4,040 -0-
Series E............................................ 4,040 -0-
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54
Description of capital structure
--------------------------------------------------------------------------------
Holders of Common Shares are entitled to share equally in dividends declared by
the Board of Trustees payable to holders of Common Shares and in the net assets
of the Fund available for distribution to holders of Common Shares after
payment of the preferential amounts payable to holders of any outstanding
Preferred Shares. Neither holders of Common Shares nor holders of Preferred
Shares have pre-emptive or conversion rights or give shareholders the right to
cause the Fund to redeem their shares. Upon liquidation of the Fund, after
paying or adequately providing for the payment of all liabilities of the Fund
and the liquidation preference with respect to any outstanding Preferred
Shares, and upon receipt of such releases, indemnities and refunding agreements
as they deem necessary for their protection, the Trustees may distribute the
remaining assets of the Fund among the holders of the Common Shares.
Pursuant to the Fund's Dividend Reinvestment Plan, all Common Shareholders
whose shares are registered in their own names will have all dividends,
including any capital gain dividends, reinvested automatically in additional
Common Shares by PFPC Inc., as agent for the Common Shareholders, unless the
shareholder elects to receive cash. The Fund and PFPC Inc. reserve the right to
amend or terminate the Dividend Reinvestment Plan.
Holders of Common Shares are entitled to one vote for each share held and will
vote with the holders of any outstanding APS or other Preferred Shares on each
matter submitted to a vote of holders of Common Shares, except as described
under "Description of APS--Voting Rights."
Shareholders are entitled to one vote for each share held. Except as provided
under "Description of APS--Voting Rights," holders of APS are (voting as a
separate class) entitled to elect two Trustees, and the remaining Trustees will
be elected by holders of Common Shares and APS, voting as a single class.
So long as any APS or any other Preferred Shares are outstanding, holders of
Common Shares will not be entitled to receive any dividends of or other
distributions from the Fund, unless at the time of such declaration, (1) all
accrued dividends on Preferred Shares or accrued interest on borrowings has
been paid and (2) the value of the Fund's total assets (determined after
deducting the amount of such dividend or other distribution), less all
liabilities and indebtedness of the Fund not represented by senior securities,
is at least 300% of the aggregate amount of such securities representing
indebtedness and at least 200% of the aggregate amount of securities
representing indebtedness plus the aggregate liquidation value of the
outstanding Preferred Shares (expected to equal the aggregate original purchase
price of the outstanding Preferred Shares plus redemption premium, if any,
together with any accrued and unpaid dividends thereon, whether or not earned
or declared and on a cumulative basis). In addition to the requirements of the
1940 Act, the Fund is required to comply with other asset coverage requirements
as a condition of the Fund obtaining a rating of the Preferred Shares from a
Rating Agency. These requirements include an asset coverage test more stringent
than under the 1940 Act. See "Description of APS--Dividends--Restrictions on
Dividends and Other Payments."
The Fund will send unaudited reports at least semi-annually and audited
financial statements annually to all of its shareholders.
The Common Shares commenced trading on the NYSE on June 26, 2002. At August 7,
2002, the net asset value per Common Share was $14.48, and the closing price
per Common Share on the NYSE was $15.09.
OTHER ISSUES RELATING TO PREFERRED SHARES
Under the 1940 Act, the Fund is permitted to have outstanding more than one
series of Preferred Shares as long as no single series has priority over
another series as to the distribution of assets of the Fund or
--------------------------------------------------------------------------------
55
Description of capital structure
--------------------------------------------------------------------------------
the payment of dividends. Neither holders of Common Shares nor holders of
Preferred Shares have pre-emptive rights to purchase any APS or any other
Preferred Shares that might be issued. It is anticipated that the net asset
value per share of the APS will equal its original purchase price per share
plus accumulated dividends per share.
Anti-takeover and other provisions in the Declaration of Trust
The Declaration includes provisions that could limit the ability of other
entities or persons to acquire control of the Fund or to convert the Fund to
open-end status. The Fund's Trustees are divided into three classes. At each
annual meeting of shareholders, the term of one class will expire, and each
Trustee elected to that class will hold office for a term of three years. The
classification of the Board of Trustees in this manner could delay for an
additional year the replacement of a majority of the Board of Trustees. In
addition, the Declaration provides that a Trustee may be removed only for cause
and only (i) by action of at least seventy-five percent (75%) of the
outstanding shares of the classes or series of shares entitled to vote for the
election of such Trustee or (ii) by at least seventy-five percent (75%) of the
remaining Trustees.
As described below, the Declaration grants special approval rights with respect
to certain matters to members of the Board who qualify as "Continuing
Trustees," which term means a Trustee who either (i) has been a member of the
Board for a period of at least 36 months (or since the commencement of the
Fund's operations, if less than 36 months) or (ii) was nominated to serve as a
member of the Board of Trustees by a majority of the Continuing Trustees then
members of the Board.
The Declaration requires the affirmative vote or consent of at least
seventy-five percent (75%) of the Board of Trustees and holders of at least
seventy-five percent (75%) of the Fund's shares (including Common and Preferred
Shares) to authorize certain Fund transactions not in the ordinary course of
business, including a merger or consolidation or a sale or transfer of Fund
assets, unless the transaction is authorized by both a majority of the Trustees
and seventy-five percent (75%) of the Continuing Trustees (in which case no
shareholder authorization would be required by the Declaration, but may be
required in certain cases under the 1940 Act). The Declaration also requires
the affirmative vote or consent of holders of at least seventy-five percent
(75%) of each class of the Fund's shares entitled to vote on the matter to
authorize a conversion of the Fund from a closed-end to an open-end investment
company, unless the conversion is authorized by both a majority of the Trustees
and seventy-five percent (75%) of the Continuing Trustees (in which case
shareholders would have only the minimum voting rights required by the 1940 Act
with respect to the conversion). Also, the Declaration provides that the Fund
may be terminated at any time by vote or consent of at least seventy-five
percent (75%) of the Fund's shares or, alternatively, by vote or consent of
both a majority of the Trustees and seventy-five percent (75%) of the
Continuing Trustees. See "Anti-Takeover and Other Provisions in the Declaration
of Trust" in the Statement of Additional Information for a more detailed
summary of these provisions.
The Trustees may from time to time grant other voting rights to shareholders
with respect to these and other matters in the Amended By-Laws, certain of
which are required by the 1940 Act. For example, the Amended By-Laws grant
holders of the APS and any other Preferred Shares special voting rights with
respect to certain matters described in the preceding paragraph. See
"Description of APS--Voting Rights."
The overall effect of these provisions is to render more difficult the
accomplishment of a merger, conversion of the Fund to open-end status or the
assumption of control by a third party. They provide,
--------------------------------------------------------------------------------
56
Anti-takeover and other provisions in the Declaration of Trust
--------------------------------------------------------------------------------
however, the advantage of potentially requiring persons seeking control of the
Fund to negotiate with its management regarding the price to be paid and
facilitating the continuity of the Fund's investment objective and policies.
The provisions of the Declaration described above could have the effect of
discouraging a third party from seeking to obtain control of the Fund in a
tender offer or similar transaction. The Board of Trustees of the Fund has
considered the foregoing anti-takeover provisions and concluded that they are
in the best interests of the Fund.
The foregoing is intended only as a summary and is qualified in its entirety by
reference to the full text of the Declaration and the Amended By-Laws, both of
which are on file with the Securities and Exchange Commission.
Under Massachusetts law, shareholders could, in certain circumstances, be held
personally liable for the obligations of the Fund. However, the Declaration
contains an express disclaimer of shareholder liability for debts or
obligations of the Fund and requires that notice of such limited liability be
given in each agreement, obligation or instrument entered into or executed by
the Fund or the Trustees. The Declaration further provides for indemnification
out of the assets and property of the Fund for all loss and expense of any
shareholder held personally liable for the obligations of the Fund. Thus, the
risk of a shareholder incurring financial loss on account of shareholder
liability is limited to circumstances in which the Fund would be unable to meet
its obligations. The Fund believes that the likelihood of such circumstances is
remote.
Repurchase of Common Shares; conversion to open-end fund
The Fund is a closed-end investment company, and, as such, its shareholders
will not have the right to cause the Fund to redeem their shares. Shares of a
closed-end investment company may frequently trade at prices lower than net
asset value. The Fund's Board of Trustees regularly monitors the relationship
between the market price and net asset value of the Common Shares. If the
Common Shares were to trade at a substantial discount to net asset value for an
extended period of time, the Board may consider the repurchase of the Common
Shares on the open market or in private transactions, the making of a tender
offer for such shares or the conversion of the Fund to an open-end investment
company.
If the Fund converted to an open-end company, it would be required to redeem
all Preferred Shares then outstanding (requiring in turn that it liquidate a
portion of its investment portfolio), and the Common Shares would no longer be
listed on the New York Stock Exchange. In contrast to a closed-end investment
company, shareholders of an open-end investment company may require the company
to redeem their shares at any time (except in certain circumstances as
authorized by or under the 1940 Act) at their net asset value, less any
redemption charge that is in effect at the time of redemption.
Before deciding whether to take any action to convert the Fund to an open-end
investment company, the Board would consider all relevant factors, including
the extent and duration of the discount, the liquidity of the Fund's portfolio,
the impact of any action that might be taken on the Fund or its shareholders
and market considerations. Based on these considerations, even if the Fund's
shares should trade at a discount, the Board of Trustees may determine that, in
the interest of the Fund and its shareholders, no action should be taken. See
the Statement of Additional Information under "Repurchase of Common Shares;
Conversion to Open-End Fund" for a further discussion of possible action to
reduce or eliminate such discount to net asset value.
--------------------------------------------------------------------------------
57
--------------------------------------------------------------------------------
Underwriting
The underwriters named below (the "Underwriters"), acting through UBS Warburg
LLC, 299 Park Avenue, New York, New York, and Merrill Lynch, Pierce, Fenner &
Smith Incorporated, 4 World Financial Center, New York, New York, as lead
managers, and A.G. Edwards & Sons, Inc. and Prudential Securities Incorporated
as their representatives (together with the lead managers, the
"Representatives"), have severally agreed, subject to the terms and conditions
of the Underwriting Agreement with the Fund and the Manager, to purchase from
the Fund the number of APS set forth opposite their respective names. The
Underwriters are committed to purchase and pay for all of such APS if any are
purchased.
Number
Underwriters of APS
-----------------------------------------------------------------------------------
UBS Warburg LLC............................................................. 8,080
Merrill Lynch, Pierce, Fenner & Smith
Incorporated...................................................... 8,080
A.G. Edwards & Sons, Inc.................................................... 2,020
Prudential Securities Incorporated.......................................... 2,020
------
Total.................................................................... 20,200
======
The Underwriters have advised the Fund that they propose initially to offer the
APS to the public at the public offering price set forth on the cover page of
this Prospectus, and to certain dealers at such price less a concession not in
excess of $150 per share. The Underwriters may allow, and such dealers may
reallow, a discount not in excess of $100 per share to other dealers. After the
initial public offering, the public offering price, concession and discount may
be changed. Investors must pay for any APS purchased in the initial public
offering on or before August 20, 2002.
The Underwriters will act in Auctions as Broker-Dealers as set forth under
"Description of APS--The Auction--Broker-Dealer Agreements" and will be
entitled to fees for services as Broker-Dealers as set forth under "Description
of APS--Broker-Dealers." The Underwriters also may provide information to be
used in ascertaining the Reference Rate.
The Fund anticipates that the Representatives and certain other Underwriters
may from time to time act as brokers and dealers in connection with the
execution of the Fund's portfolio transactions after they have ceased to be
principal underwriters of the Fund under the 1940 Act and, subject to certain
conditions, may act as such brokers while they are principal underwriters.
The Fund and the Manager have agreed to indemnify the Underwriters against
certain liabilities including liabilities under the Securities Act of 1933, as
amended.
Shareholder servicing agent, custodian and transfer agents
The Manager (and not the Fund) has agreed to pay from its own assets to UBS
Warburg LLC a shareholder servicing fee at an annual rate equal to 0.10% of the
average daily net asset value of the Fund (including assets attributable to any
Preferred Shares that may be outstanding, including the APS) pursuant to a
shareholder servicing agreement between the Manager and UBS Warburg LLC (the
"Shareholder Servicing Agreement"). Pursuant to the Shareholder Servicing
Agreement, UBS Warburg LLC will: (i) undertake to make public information
pertaining to the Fund on an ongoing basis
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58
Shareholder servicing agent, custodian and transfer agents
--------------------------------------------------------------------------------
and to communicate to investors and prospective investors the Fund's features
and benefits (including periodic seminars or conference calls, responses to
questions from current or prospective shareholders and specific shareholder
contact where appropriate); (ii) make available to investors and prospective
investors market price, net asset value, yield and other information regarding
the Fund, if reasonably obtainable, for the purpose of maintaining the
visibility of the Fund in the investor community; (iii) at the request of the
Manager, provide certain economic research and statistical information and
reports, if reasonably obtainable, on behalf of the Fund, and consult with
representatives and Trustees of the Fund in connection therewith, which
information and reports shall include: (a) statistical and financial market
information with respect to the Fund's market performance and (b) comparative
information regarding the Fund and other closed-end management investment
companies with respect to (1) the net asset value of their respective shares,
(2) the respective market performance of the Fund and such other companies, and
(3) other relevant performance indicators; and (iv) at the request of the
Manager, provide information to and consult with the Board of Trustees with
respect to applicable modifications to dividend policies or capital structure,
repositioning or restructuring of the Fund, conversion of the Fund to an
open-end investment company, or a Fund liquidation or merger; provided,
however, that under the terms of the Shareholder Servicing Agreement, UBS
Warburg LLC is not obligated to render any opinions, valuations or
recommendations of any kind or to perform any such similar services. Under the
terms of the Shareholder Servicing Agreement, UBS Warburg LLC is relieved from
liability to the Manager for any act or omission in the course of its
performance under the Shareholder Servicing Agreement in the absence of gross
negligence or willful misconduct. The Shareholder Servicing Agreement will
remain in effect so long as the Investment Management Agreement remains in
effect between the Fund and the Manager or any successor in interest or
affiliate of the Manager, as and to the extent that such Investment Management
Agreement is renewed periodically in accordance with the 1940 Act.
The custodian of the Fund's assets is State Street Bank and Trust Co., 225
Franklin Street, Boston, MA 02110. The Custodian performs custodial and fund
accounting services.
Deutsche Bank Trust Company Americas, 100 Plaza One, 6th Floor, Jersey City,
New Jersey 07311, serves as Auction Agent, transfer agent, registrar, dividend
paying agent and redemption agent for the APS. PFPC Inc., 400 Bellevue Parkway,
Wilmington, Delaware 19809, serves as the transfer agent, registrar and
dividend disbursement agent for the Common Shares, as well as agent for the
Fund's Dividend Reinvestment Plan for Common Shares.
Legal matters
Certain legal matters in connection with the APS will be passed upon for the
Fund by Ropes & Gray, Boston, Massachusetts and for the Underwriters by
Skadden, Arps, Slate, Meagher & Flom (Illinois), Chicago, Illinois and its
affiliated entities.
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59
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Table of contents for the
Statement of Additional Information
Use of Proceeds............................................... 3
Investment Objective and Policies............................. 3
Investment Restrictions....................................... 26
Management of the Fund........................................ 28
Investment Manager and Portfolio Manager...................... 40
Portfolio Transactions........................................ 44
Distributions................................................. 46
Description of Shares......................................... 47
Anti-Takeover and Other Provisions in the Declaration of Trust 48
Repurchase of Fund Shares; Conversion to Open-End Fund........ 50
Tax Matters................................................... 52
Performance Related and Comparative Information............... 58
Custodian, Transfer Agents and Dividend Disbursement Agents... 58
Independent Accountants....................................... 59
Counsel....................................................... 59
Registration Statement........................................ 59
Financial Statements.......................................... 60
Appendix A--Description of Securities Ratings................. A-1
Appendix B--Settlement Procedures............................. B-1
Appendix C--Auction Procedures................................ C-1
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60
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Glossary
"'AA' Composite Commercial Paper Rate" on any Valuation Date, means (i) the
Interest Equivalent of the rate on commercial paper placed on behalf of issuers
whose corporate bonds are rated "AA" by S&P or "Aa" by Moody's or the
equivalent of such rating by another nationally recognized statistical rating
organization, as such rate is made available on a discount basis or otherwise
by the Federal Reserve Bank of New York for the Business Day immediately
preceding such date, or (ii) in the event that the Federal Reserve Bank of New
York does not make available such a rate, then the arithmetic average of the
Interest Equivalent of the rate on commercial paper placed on behalf of such
issuers, as quoted on a discount basis or otherwise by UBS Warburg LLC or
Merrill Lynch, Pierce, Fenner & Smith Incorporated or their respective
successors that are Commercial Paper Dealers, to the Auction Agent for the
close of business on the Business Day immediately preceding such date. If one
of the Commercial Paper Dealers does not quote a rate required to determine the
"AA" Composite Commercial Paper Rate, the "AA" Composite Commercial Paper Rate
will be determined on the basis of the quotation or quotations furnished by any
Substitute Commercial Paper Dealer or Substitute Commercial Paper Dealers
selected by the Fund to provide such rate or rates not being supplied by the
Commercial Paper Dealer. If the number of Dividend Period days shall be (i) 7
or more but fewer than 49 days, such rate shall be the Interest Equivalent of
the 30-day rate on such commercial paper; (ii) 49 or more but fewer than 70
days, such rate shall be the Interest Equivalent of the 60-day rate on such
commercial paper; (iii) 70 or more days but fewer than 85 days, such rate shall
be the arithmetic average of the Interest Equivalent of the 60-day and 90-day
rates on such commercial paper; (iv) 85 or more days but fewer than 99 days,
such rate shall be the Interest Equivalent of the 90-day rate on such
commercial paper; (v) 99 or more days but fewer than 120 days, such rate shall
be the arithmetic average of the Interest Equivalent of the 90-day and 120-day
rates on such commercial paper; (vi) 120 or more days but fewer than 141 days,
such rate shall be the Interest Equivalent of the 120-day rate on such
commercial paper; (vii) 141 or more days but fewer than 162 days, such rate
shall be the arithmetic average of the Interest Equivalent of the 120-day and
180-day rates on such commercial paper; and (viii) 162 or more days but fewer
than 183 days, such rate shall be the Interest Equivalent of the 180-day rate
on such commercial paper.
"Agent Member" means a member of the Securities Depository that will act on
behalf of a Beneficial Owner of one or more APS or on behalf of a Potential
Beneficial Owner.
"Amended By-Laws" means the By-Laws of the Fund as amended August 15, 2002,
specifying, in part, the powers, preferences and rights of the APS.
"Applicable Percentage" has the meaning specified under "Description of
APS--Auction Procedures--Orders by Beneficial Owners, Potential Beneficial
Owners, Existing Holders and Potential Holders" in this Prospectus.
"Applicable Rate" means the rate per annum at which cash dividends are payable
on APS for any Dividend Period.
"APS" means the Auction Preferred Shares with par value $0.00001 per share and
a liquidation preference of $25,000 per share plus an amount equal to
accumulated but unpaid dividends thereon (whether or not earned or declared) of
the Fund.
"APS Basic Maintenance Amount" has the meaning specified under "Description of
APS--Asset Maintenance--APS Basic Maintenance Amount" in this Prospectus.
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61
Glossary
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"APS Basic Maintenance Cure Date" has the meaning specified under "Description
of APS--Asset Maintenance--APS Basic Maintenance Amount" in this Prospectus.
"APS Basic Maintenance Report" has the meaning specified under "Description of
APS--Asset Maintenance--APS Basic Maintenance Amount" in this Prospectus.
"Auction" means a periodic operation of the Auction Procedures.
"Auction Agency Agreement" means the agreement entered into between the Fund
and the Auction Agent which provides, among other things, that the Auction
Agent will follow the Auction Procedures for the purpose of determining the
Applicable Rate.
"Auction Agent" means Deutsche Bank Trust Company Americas unless and until
another commercial bank, trust company or other financial institution appointed
by a resolution of the Board of Trustees of the Fund or a duly authorized
committee thereof enters into an agreement with the Fund to follow the Auction
Procedures for the purpose of determining the Applicable Rate and to act as
transfer agent, registrar, dividend disbursing agent and redemption agent for
the APS.
"Auction Date" has the meaning specified under "Description of APS--Auction
Procedures--Auction Date; Advance Notice of Allocation of Taxable Income;
Inclusion of Taxable Income in Dividends" in this Prospectus.
"Auction Procedures" means the procedures for conducting Auctions set forth in
Appendix C to the Statement of Additional Information.
"Available APS" has the meaning specified under "Description of APS--Auction
Procedures--Determination of Sufficient Clearing Bids, Winning Bid Rate and
Applicable Rate" in this Prospectus.
"Beneficial Owner" means a customer of a Broker-Dealer who is listed on the
records of that Broker-Dealer (or if applicable, the Auction Agent) as a holder
of APS or a Broker-Dealer that holds APS for its own account.
"Bid" has the meaning specified under "Description of APS--Auction
Procedures--Orders by Beneficial Owners, Potential Beneficial Owners, Existing
Holders and Potential Holders" in this Prospectus.
"Bidder" has the meaning specified under "Description of APS--Auction
Procedures--Orders by Beneficial Owners, Potential Beneficial Owners, Existing
Holders and Potential Holders" in this Prospectus.
"Board of Trustees" or "Board" means the Board of Trustees of the Fund.
"Broker-Dealer" has the meaning specified under "Description of APS--The
Auction--Broker-Dealer Agreements" in this Prospectus.
"Broker-Dealer Agreement" has the meaning specified under "Description of
APS--The Auction--Broker-Dealer Agreements" in this Prospectus.
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62
Glossary
--------------------------------------------------------------------------------
"Business Day" means a day on which the New York Stock Exchange is open for
trading and which is not a Saturday, Sunday or other day on which banks in New
York City are authorized or obligated by law to close.
"Closing Transactions" has the meaning set forth in the definition of "Moody's
Hedging Transactions" below.
"Code" has the meaning specified under "Taxes--Federal Income Tax Matters" in
this Prospectus.
"Commercial Paper Dealers" means UBS Warburg LLC, Merrill Lynch, Pierce, Fenner
& Smith Incorporated and such other commercial paper dealer or dealers as the
Fund from time to time may appoint or, in lieu thereof, their respective
affiliates and successors.
"Common Shares" means the common shares of beneficial interest, par value
$0.00001 per share, of the Fund.
"Cure Date" has the meaning specified under "Description of
APS--Redemption--Mandatory Redemption" in this Prospectus.
"Date of Original Issue" means, with respect to any share of APS, the date on
which such share first is issued by the Fund.
"Declaration" has the meaning specified under "Prospectus summary--Special Risk
Considerations--Anti-Takeover Provisions" in this Prospectus.
"Deposit Securities" means cash and Municipal Obligations rated at least A2
(having a remaining maturity of 12 months or less), P-1, VMIG-1 or MIG-1 by
Moody's or A (having a remaining maturity of 12 months or less), A-1+ or SP-1+
by S&P.
"Discount Factor" means a Moody's Discount Factor.
"Discounted Value" of any asset of the Fund means with respect to a Moody's
Eligible Asset, the quotient of the market value thereof divided by the
applicable Moody's Discount Factor.
"Dividend Payment Date" has the meaning specified under "Description of
APS--Dividends--General" in this Prospectus.
"Dividend Period" has the meaning specified under "Description of
APS--Dividends--General" in this Prospectus.
"Existing Holder" means a Broker-Dealer or any such other person as may be
permitted by the Fund that is listed as the holder of record of APS in the
records of the Auction Agent.
"Extension Period" has the meaning specified under "Description of
APS--Dividends--Notification of Dividend Period" in this Prospectus.
"Federal Tax Rate Increase" has the meaning set forth in the definition of
"Moody's Volatility Factor" below.
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63
Glossary
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"Fitch" means Fitch, Inc., doing business as Fitch Ratings, or its successors.
"Fund" means PIMCO Municipal Income Fund II, a Massachusetts business trust
that is the issuer of the APS.
"Gross-up Dividend" has the meaning specified under "Description of
APS--Dividends--Gross-up Dividends" in this Prospectus.
"Hold Order" has the meaning specified under "Description of APS--Auction
Procedures--Orders By Beneficial Owners, Potential Beneficial Owners, Existing
Holders and Potential Holders" in this Prospectus.
"Initial Dividend Payment Date" means, with respect to a series of APS, the
Initial Dividend Payment Date as determined by the Board of Trustees or
pursuant to their delegated authority with respect to such series.
"Initial Dividend Period" means, for each series of APS, the period from and
including the Date of Original Issue but excluding the Initial Dividend Payment
Date.
"Interest Equivalent" means a yield on a 360-day basis of a discount basis
security which is equal to the yield on an equivalent interest-bearing security.
"Investment Management Agreement" has the meaning set forth under "Management
of the Fund--Investment Management Agreement" in this Prospectus.
"IRS" means the United States Internal Revenue Service.
"Issue Type Category" means, with respect to a Municipal Obligation acquired by
the Fund, for purposes of calculating Moody's Eligible Assets as of any
Valuation Date, one of the following categories into which such Municipal
Obligation falls based upon a good faith determination by the Fund: health care
issues (including issues related to teaching and non-teaching hospitals, public
or private, and elder-care facilities, including nursing homes); housing issues
(including issues related to single- and multi-family housing projects);
educational facilities issues (including issues related to public and private
schools); student loan issues; resource recovery issues; transportation issues
(including issues related to mass transit, airports and highways); industrial
development bond issues (including issues related to pollution control
facilities); utility issues (including issues related to the provision of gas,
water, sewers and electricity); general obligation issues; lease obligations
(including certificates of participation); escrowed bonds; and other issues
("Other Issues") not falling within one of the aforementioned categories. The
general obligation issue category includes any issue that is directly or
indirectly guaranteed by any state or any political subdivision of a state.
Utility issues are included in the general obligation issue category if the
issue is directly or indirectly guaranteed by a state or any political
subdivision of a state. Municipal Obligations in the utility issue category
will be classified within one of the three following sub-categories: (i)
electric, gas and combination issues (if the combination issue includes an
electric issue); (ii) water and sewer utilities and combination issues (if the
combination issues does not include an electric issue); and (iii) irrigation,
resource recovery, solid waste and other utilities. Municipal Obligations in
the transportation issue category will be classified within one of the two
following sub-categories: (i) streets and highways, toll roads, bridges and
tunnels, airports and multi-purpose port authorities (multiple revenue streams
generated by toll roads, airports, real estate, bridges); and (ii) mass
transit, parking seaports and others.
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64
Glossary
--------------------------------------------------------------------------------
"Kenny Index" shall have the meaning set forth in the definition of "Taxable
Equivalent of the Short-Term Municipal Obligations Rate" below.
"Liens" shall have the meaning set forth in the definition of "Moody's Eligible
Asset" below.
"Long Term Dividend Period" has the meaning specified under "Prospectus
summary--Dividends on APS" in this Prospectus.
"Manager" means PIMCO Funds Advisors LLC.
"Mandatory Redemption Price" has the meaning specified under "Description of
APS--Redemption--Mandatory Redemption" in this Prospectus.
"Marginal Tax Rate" means the maximum marginal federal individual income tax
rate applicable to an individual's or a corporation's ordinary income,
whichever is greater.
"Market Value" of any asset of the Fund shall be the market value thereof
determined by the Pricing Service. Market Value of any asset shall include any
interest accrued thereon. The Pricing Service shall value portfolio securities
at the quoted bid prices or the mean between the quoted bid and asked price or
the yield equivalent when quotations are not readily available. Securities for
which quotations are not readily available shall be valued at fair value as
determined by the Pricing Service using methods which include consideration of:
yields or prices of municipal obligations of comparable quality, type of issue,
coupon, maturity and rating; indications as to value from dealers; and general
market conditions. The Pricing Service may employ electronic data processing
techniques and/or a matrix system to determine valuations. In the event the
Pricing Service is unable to value a security, the security shall be valued at
the lower of two dealer bids obtained by the Fund from dealers who are members
of the National Association of Securities Dealers, Inc. and who make a market
in the security, at least one of which shall be in writing. Futures contracts
and options are valued at closing prices for such instruments established by
the exchange or board of trade on which they are traded, or if market
quotations are not readily available, are valued at fair value on a consistent
basis using methods determined in good faith by the Board of Trustees.
"Maximum Applicable Rate" has the meaning specified under "Description of
APS--Auction Procedures--Orders by Beneficial Owners, Potential Beneficial
Owners, Existing Holders and Potential Holders" in this Prospectus.
"Maximum Potential Gross-up Dividend Liability" has the meaning specified under
"Description of APS--Asset Maintenance--APS Basic Maintenance Amount" in this
Prospectus.
"Moody's" means Moody's Investors Service, Inc. or its successors.
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65
Glossary
--------------------------------------------------------------------------------
"Moody's Discount Factor" shall mean, for purposes of determining the
Discounted Value of any Moody's Eligible Asset, the percentage determined by
reference to the rating on such asset and the shortest Exposure Period set
forth opposite such rating that is the same length as or is longer than the
Moody's Exposure Period, in accordance with the table set forth below:
Rating Category
Exposure Period Aaa* Aa* A* Baa* Other** (V)MIG-1*** SP-1+**** Unrated*****
------------------------------------------------------------------------------------------
7 weeks.................... 151% 159% 166% 173% 187% 136% 148% 225%
8 weeks or less but greater
than seven weeks......... 154 161 168 176 190 137 149 231
9 weeks or less but greater
than eight weeks......... 158 163 170 177 192 138 150 240
* Moody's rating.
** Municipal Obligations not rated by Moody's but rated BBB by S&P.
*** Municipal Obligations rated MIG-1 or VMIG-1, which do not mature or have
a demand feature at par exercisable in 30 days and which do not have a
long-term rating.
**** Municipal Obligations not rated by Moody's but rated SP-1+ by S&P, which
do not mature or have a demand feature at par exercisable in 30 days and
which do not have a long-term rating.
***** Municipal Obligations rated less than Baa3 or not rated by Moody's and
less than BBB or not rated by S&P, not to exceed 10% of Moody's Eligible
Assets.
Notwithstanding the foregoing, (i) except as provided in clause (ii) below, the
Moody's Discount Factor for short-term Municipal Obligations will be 115%, so
long as such Municipal Obligations are rated at least MIG-1, VMIG-l or P-1 by
Moody's and mature or have a demand feature at par exercisable in 30 days or
less, or 125%, as long as such Municipal Obligations are rated at least A-1+/AA
or SP-1+/AA by S&P and mature or have a demand feature at par exercisable in 30
days or less, (ii) the Moody's Discount Factor for RIBS and structured notes
shall be the product of (x) the percentage determined by reference to the
rating on the security underlying such RIBS multiplied by (y) 1.25 (provided
that the trust in which such RIBS are held may be terminated within five
business days), and (iii) except as provided in clause (ii) above, no Moody's
Discount Factor will be applied to cash, Receivables for Municipal Obligations
Sold, or futures, options and similar instruments (to the extent such
securities are Moody's Eligible Assets); provided, however, that for purposes
of determining the Moody's Discount Factor applicable to a Municipal
Obligation, any Municipal Obligation (excluding any short-term Municipal
Obligation) not rated by Moody's but rated by S&P shall be deemed to have a
Moody's rating which is one full rating category lower than its S&P rating.
"Moody's Eligible Asset" shall mean cash, Receivables for Municipal Obligations
Sold, futures and options (to the extent entered into in Moody's Hedging
Transactions) and similar instruments (including RIBS (provided that the trusts
in which such RIBS are held may be terminated within five business days) and
structured notes), or a Municipal Obligation that (i) pays interest in cash,
(ii) does not have its Moody's rating, as applicable, suspended by Moody's, and
(iii) is part of an issue of Municipal Obligations of at least $5,000,000,
except for Municipal Obligations rated below A by Moody's or Municipal
Obligations within the healthcare Issue Type Category, in which case the
minimum issue size is $10,000,000. Except for general obligation bonds,
Municipal Obligations issued by any one issuer and rated BBB or lower or not
rated by S&P and rated Ba or B or not rated by Moody's ("Other Securities") may
comprise no more than 4% of total Moody's Eligible Assets; such Other
Securities, if any, together with any Municipal Obligations issued by the same
issuer and rated Baa by Moody's or A by S&P, may comprise no more than 6% of
total Moody's Eligible Assets; such Other Securities, Baa and A-rated Municipal
Obligations, if any, together with any Municipal Obligations issued by the same
issuer and
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66
Glossary
--------------------------------------------------------------------------------
rated A by Moody's or AA by S&P, may comprise no more than 10% of total Moody's
Eligible Assets; and such Other Securities, Baa, A and AA-rated Municipal
Obligations, if any, together with any Municipal Obligations issued by the same
issuer and rated Aa by Moody's or AAA by S&P, may comprise no more than 20% of
total Moody's Eligible Assets. For purposes of the foregoing sentence, any
Municipal Obligation backed by the guaranty, letter of credit or insurance
issued by a third party shall be deemed to be issued by such third party if the
issuance of such third party credit is the sole determinant of the rating on
such Municipal Obligation. Other Securities falling within a particular Issue
Type Category may comprise no more than 12% of total Moody's Eligible Assets;
such Other Securities, if any, together with any Municipal Obligations falling
within a particular Issue Type Category and rated Baa by Moody's or A by S&P,
may comprise no more than 20% of total Moody's Eligible Assets; such Other
Securities, Baa and A-rated Municipal Obligations, if any, together with any
Municipal Obligations falling within a particular Issue Type Category and rated
A by Moody's or AA by S&P, may comprise no more than 40% of total Moody's
Eligible Assets; and such Other Securities, Baa, A and AA- rated Municipal
Obligations, if any, together with any Municipal Obligations falling within a
particular Issue Type Category and rated Aa by Moody's or AAA by S&P, may
comprise no more than 60% of total Moody's Eligible Assets. For purposes of
this definition, a Municipal Obligation shall be deemed to be rated BBB by S&P
if rated BBB-, BBB or BBB+ by S&P. Notwithstanding any other provision of this
definition, (A) in the case of general obligation Municipal Obligations only,
Other Securities issued by issuers located within any one county may comprise
no more than 4% of Moody's Eligible Assets; such Other Securities, if any,
together with any Municipal Obligations issued by issuers located within the
same county and rated Baa by Moody's or A by S&P, may comprise no more than 6%
of Moody's Eligible Assets; such Other Securities, Baa and A-rated Municipal
Obligations, if any, together with any Municipal Obligations issued by issuers
located within the same county and rated A by Moody's or AA by S&P, may
comprise no more than 10% of Moody's Eligible Assets; and such Other
Securities, Baa, A and AA-rated Municipal Obligations, if any, together with
any Municipal Obligations issued by issuers located within the same county and
rated Aa by Moody's or AAA by S&P, may comprise no more than 20% of Moody's
Eligible Assets; and (B) in no event may (i) student loan Municipal Obligations
comprise more than 10% of Moody's Eligible Assets; (ii) resource recovery
Municipal Obligations comprise more than 10% of Moody's Eligible Assets; and
(iii) Other Issues comprise more than 10% of Moody's Eligible Assets. For
purposes of applying the foregoing requirements, Municipal Obligations rated
MIG-1, VMIG-1 or P-1 or, if not rated by Moody's, rated A-1+/AA or SP-1+/AA by
S&P, shall be considered to have a long-term rating of A. When the Fund sells a
Municipal Obligation and agrees to repurchase such Municipal Obligation at a
future date, such Municipal Obligation shall be valued at its Discounted Value
for purposes of determining Moody's Eligible Assets, and the amount of the
repurchase price of such Municipal Obligation shall be included as a liability
for purposes of calculating the APS Basic Maintenance Amount. When the Fund
purchases a Moody's Eligible Asset and agrees to sell it at a future date, such
Eligible Asset shall be valued at the amount of cash to be received by the Fund
upon such future date, provided that the counterparty to the transaction has a
long-term debt rating of at least A2 from Moody's and the transaction has a
term of no more than 30 days, otherwise such Eligible Asset shall be valued at
the Discounted Value of such Eligible Asset.
Notwithstanding the foregoing, an asset will not be considered a Moody's
Eligible Asset to the extent it is (i) subject to any material lien, mortgage,
pledge, security interest or security agreement of any kind (collectively,
"Liens"), except for (a) Liens which are being contested in good faith by
appropriate proceedings and which Moody's has indicated to the Fund will not
affect the status of such asset as a Moody's Eligible Asset, (b) Liens for
taxes that are not then due and payable or that can be paid thereafter without
penalty, (c) Liens to secure payment for services rendered or cash advanced to
the Fund by the Manager, PIMCO, State Street Bank and Trust Company, its
transfer agent or registrar or the Auction Agent and (d) Liens arising by
virtue of any repurchase agreement; (ii) deposited irrevocably
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67
Glossary
--------------------------------------------------------------------------------
for the payment of any liabilities for purposes of determining the APS Basic
Maintenance Amount; or (iii) held in a margin account.
"Moody's Exposure Period" means the period commencing on a given Valuation Date
and ending 49 days thereafter.
"Moody's Hedging Transactions" means purchases or sales of exchange-traded
financial futures contracts based on the Municipal Index or Treasury Bonds, and
purchases, writings or sales of exchange-traded put options on such financial
futures contracts, the Municipal Index or Treasury Bonds, and purchases,
writings or sales of exchange-traded call options on such financial futures
contracts, the Municipal Index or Treasury Bonds, subject to the following
limitations:
(i) the Fund will not engage in any Moody's Hedging Transaction based on the
Municipal Index (other than transactions that terminate a futures contract
or option held by the Fund by the Fund's taking the opposite position
thereto ("Closing Transactions")) that would cause the Fund at the time of
such transaction to own or have sold:
(A) outstanding financial futures contracts based on the Municipal Index
exceeding in number 10% (or such higher percentage as Moody's may
approve) of the average number of daily traded financial futures
contracts based on the Municipal Index in the 30 days preceding the
time of effecting such transaction as reported by The Wall Street
Journal; or
(B) outstanding financial futures contracts based on the Municipal Index
having a Market Value exceeding 50% (or such higher percentage as
Moody's may approve) of the Market Value of all Municipal Obligations
constituting Moody's Eligible Assets owned by the Fund (other than
Moody's Eligible Assets already subject to a Moody's Hedging
Transaction);
(ii) the Fund will not engage in any Moody's Hedging Transaction based on
Treasury Bonds (other than Closing Transactions) that would cause the Fund
at the time of such transaction to own or have sold:
(A) outstanding financial futures contracts based on Treasury Bonds with
such contracts having an aggregate Market Value exceeding 20% (or such
higher percentage as Moody's may approve) of the aggregate Market Value
of Moody's Eligible Assets owned by the Fund and rated Aa or higher by
Moody's (or, if not rated by Moody's but rated by S&P, rated AAA by
S&P); or
(B) outstanding financial futures contracts based on Treasury Bonds with
such contracts having an aggregate Market Value exceeding 80% of the
aggregate Market Value of all Municipal Obligations constituting
Moody's Eligible Assets owned by the Fund (other than Moody's Eligible
Assets already subject to a Moody's Hedging Transaction) and rated Baa
or A by Moody's (or, if not rated by Moody's but rated by S&P, rated A
or AA by S&P)
(for purposes of the foregoing clauses (i) and (ii), the Fund shall be
deemed to own the number of financial futures contracts that underlie any
outstanding options written by the Fund);
(iii) the Fund will engage in Closing Transactions to close out any outstanding
financial futures contract based on the Municipal Index if the amount of
open interest in the Municipal Index as reported by The Wall Street
Journal is less than 5,000 (or such lower number as Moody's may approve);
(as contemplated under "How the Fund manages risk--Hedging and Related
Strategies," the Fund is currently seeking to increase the percentage in
clause (i)(A) above to 33 1/3% and the percentage in clause (ii)(A) above
to 50% and to decrease the number in clause (iii) above to zero; however,
there can be no assurance that Moody's will agree to any of these changes);
(iv) the Fund will engage in a Closing Transaction to close out any outstanding
financial futures contract by no later than the fifth Business Day of the
month in which such contract expires and
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68
Glossary
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will engage in a Closing Transaction to close out any outstanding option on
a financial futures contract by no later than the first Business Day of the
month in which such option expires;
(v) the Fund will engage in Moody's Hedging Transactions only with respect to
financial futures contracts or options thereon having the next settlement
date or the settlement date immediately thereafter;
(vi) while the Fund may use options and futures transactions for hedging and
risk management purposes, it will not engage in options and futures
transactions for leveraging or speculative purposes and will not write any
call options or sell any financial futures contracts for the purpose of
hedging the anticipated purchase of an asset prior to completion of such
purchase; and
(vii) the Fund will not enter into an option or futures transaction unless,
after giving effect thereto, the Fund would continue to have Moody's
Eligible Assets with an aggregate Discounted Value equal to or greater
than the APS Basic Maintenance Amount.
"Moody's Volatility Factor" means, as of any Valuation Date, (i) in the case of
any 7-Day Dividend Period, any Special Dividend Period of 28 days or fewer, or
any Special Dividend Period of 57 days or more, a multiplicative factor equal
to 275%, except as otherwise provided in the last sentence of this definition;
(ii) in the case of any Special Dividend Period of more than 28 but fewer than
36 days, a multiplicative factor equal to 203%; (iii) in the case of any
Special Dividend Period of more than 35 but fewer than 43 days, a
multiplicative factor equal to 217%; (iv) in the case of any Special Dividend
Period of more than 42 but fewer than 50 days, a multiplicative factor equal to
226%; and (v) in the case of any Special Dividend Period of more than 49 but
fewer than 57 days, a multiplicative factor equal to 235%. If, as a result of
the enactment of changes to the Code, the Marginal Tax Rate will increase, such
increase being rounded up to the next five percentage points (the "Federal Tax
Rate Increase"), until the effective date of such increase, the Moody's
Volatility Factor in the case of any Dividend Period described in (i) above in
this definition instead shall be determined by reference to the following table:
Volatility
Federal Tax Rate Increase Factor
------------------------------------
5%............ 295%
10%........... 317%
15%........... 341%
20%........... 369%
25%........... 400%
30%........... 436%
35%........... 477%
40%........... 525%
"Municipal Index" means the Bond Buyer Municipal Bond Index or any successor
index approved by Moody's.
"Municipal Obligations" means municipal obligations, including municipal bonds
and short-term municipal obligations, the interest from which is exempt from
federal income taxes.
"NAV" has the meaning specified under "Net asset value" in this Prospectus.
"1940 Act" means the Investment Company Act of 1940, and the regulations
thereunder, each as amended from time to time.
"1940 Act APS Asset Coverage" has the meaning specified under "Rating agency
guidelines" in this Prospectus.
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69
Glossary
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"1940 Act Cure Date" has the meaning specified under "Description of APS--Asset
Maintenance--1940 Act APS Asset Coverage" in this Prospectus.
"Non-Call Period" has the meaning set forth in the definition of "Specific
Redemption Provisions" below.
"Non-Payment Period" has the meaning specified under "Description of
APS--Dividends--Non-Payment Period; Late Charge" in this Prospectus.
"Non-Payment Period Rate" has the meaning specified under "Description of
APS--Dividends--Non-Payment Period; Late Charge" in this Prospectus.
"Normal Dividend Payment Date" has the meaning specified under "Description of
APS--Dividends--General" in this Prospectus.
"Notice of Revocation" has the meaning specified under "Description of
APS--Dividends--Notification of Dividend Period" in this Prospectus.
"Notice of Special Dividend Period" has the meaning. specified under
"Description of APS--Dividends--Notification of Dividend Period" in this
Prospectus.
"NYSE Close" has the meaning set forth under "Net Asset Value" in this
Prospectus.
"Optional Redemption Price" has the meaning specified under "Description of
APS--Redemption--Optional Redemption" in this Prospectus.
"Order" has the meaning specified under "Description of APS--Auction
Procedures--Orders by Beneficial Owners, Potential Beneficial Owners, Existing
Holders and Potential Holders" in this Prospectus.
"Other Issues" has the meaning set forth in the definition of "Issue Type
Category" above.
"Other Securities" has the meaning set forth in the definition of "Moody's
Eligible Asset" above.
"PIMCO" means Pacific Investment Management Company LLC.
"Potential Beneficial Owner" means a customer of a Broker-Dealer or a
Broker-Dealer that is not a Beneficial Owner of APS but that wishes to purchase
such shares, or that is a Beneficial Owner that wishes to purchase additional
APS.
"Potential Holder" means any Broker-Dealer or any such other person as may be
permitted by the Fund, including any Existing Holder, who may be interested in
acquiring APS (or, in the case of an Existing Holder, additional APS).
"Preference Item" has the meaning specified under "Description of
APS--Dividends--General" in this Prospectus.
"Preferred Shares" means preferred shares of beneficial interest of the Fund,
and includes APS.
"Premium Call Period" has the meaning set forth in the definition of "Specific
Redemption Provisions" below.
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70
Glossary
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"Pricing Service" means Standard & Poor's/J.J. Kenny or any other pricing
service designated by the Board of Trustees for purposes of determining whether
the Fund has Moody's Eligible Assets with an aggregate Discounted Value that
equals or exceeds the APS Basic Maintenance Amount.
"Rating Agency" means a nationally recognized statistical rating organization.
"Receivables For Municipal Obligations Sold" means for purposes of calculation
of Moody's Eligible Assets as of any Valuation Date, no more than the aggregate
of the following: (i) the book value of receivables for Municipal Obligations
sold as of or prior to such Valuation Date if such receivables are due within
five business days of such Valuation Date, and if the trades which generated
such receivables are (x) settled through clearing house firms with respect to
which the Fund has received prior written authorization from Moody's or (y)
with counterparties having a Moody's long-term debt rating of at least Baa3;
and (ii) the Moody's Discounted Value of Municipal Obligations sold as of or
prior to such Valuation Date which generated receivables, if such receivables
are due within five business days of such Valuation Date but do not comply with
either of the conditions specified in (i) above.
"Reference Rate" means: (i) with respect to any 7-Day Dividend Period or any
Short Term Dividend Period having 28 or fewer days, the higher of the
applicable "AA" Composite Commercial Paper Rate and the Taxable Equivalent of
the Short Term Municipal Obligation Rate, (ii) with respect to any Short Term
Dividend Period having more than 28 but fewer than 183 days, the applicable
"AA" Composite Commercial Paper Rate, (iii) with respect to any Short Term
Dividend Period having 183 or more but fewer than 364 days, the applicable U.S.
Treasury Bill Rate and (iv) with respect to any Long Term Dividend Period, the
applicable U.S. Treasury Note Rate.
"Representatives" has the meaning specified under "Underwriting" in this
Prospectus.
"Request for Special Dividend Period" has the meaning specified under
"Description of APS--Dividends--Notification of Dividend Period" in this
Prospectus.
"Response" has the meaning specified under "Description of
APS--Dividends--Notification of Dividend Period" in this Prospectus.
"Retroactive Taxable Allocation" has the meaning specified under "Description
of APS--Dividends--Gross-up Dividends" in this Prospectus.
"RIBS" means residual interest municipal bonds.
"S&P" means Standard & Poor's, a division of The McGraw-Hill Companies, Inc.,
or its successors.
"Securities Depository" means The Depository Trust Company and its successors
and assigns or any successor securities depository selected by the Fund that
agrees to follow the procedures required to be followed by such securities
depository in connection with the APS.
"Sell Order" has the meaning specified under "Description of APS--Auction
Procedures--Orders by Beneficial Owners, Potential Beneficial Owners, Existing
Holders and Potential Holders" in this Prospectus.
"7-Day Dividend Period" has the meaning specified under "Prospectus
summary--Dividends on APS" in this Prospectus.
"Shareholder Servicing Agreement" has the meaning specified under "Shareholder
servicing agent, custodian and transfer agent" in this Prospectus.
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71
Glossary
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"Short Term Dividend Period" has the meaning specified under "Prospectus
summary--Dividends on APS" in this Prospectus.
"Special Dividend Period" has the meaning specified under "Prospectus
summary--Dividends on APS" in this Prospectus.
"Specific Redemption Provisions" means, with respect to a Special Dividend
Period, either, or both of, (i) a period (a "Non-Call Period") determined by
the Board of Trustees of the Fund, after consultation with the Auction Agent
and the Broker-Dealers, during which the APS subject to such Dividend Period
shall not be subject to redemption at the option of the Fund and (ii) a period
(a "Premium Call Period"), consisting of a number of whole years and determined
by the Board of Trustees of the Fund, after consultation with the Auction Agent
and the Broker-Dealers, during each year of which the APS subject to such
Dividend Period shall be redeemable at the Fund's option at a price per share
equal to $25,000 plus accumulated but unpaid dividends plus a premium expressed
as a percentage of $25,000, as determined by the Board of Trustees of the Fund
after consultation with the Auction Agent and the Broker-Dealers.
"Submission Deadline" has the meaning specified under "Description of
APS--Auction Procedures--Submission of Orders by Broker-Dealers to Auction
Agent" in this Prospectus.
"Submitted Bid" has the meaning specified under "Description of APS--Auction
Procedures--Determination of Sufficient Clearing Bids, Winning Bid Rate and
Applicable Rate" in this Prospectus.
"Submitted Hold Order" has the meaning specified under "Description of
APS--Auction Procedures--Determination of Sufficient Clearing Bids, Winning Bid
Rate and Applicable Rate" in this Prospectus.
"Submitted Order" has the meaning specified under "Description of APS--Auction
Procedures--Determination of Sufficient Clearing Bids, Winning Bid Rate and
Applicable Rate" in this Prospectus.
"Submitted Sell Order" has the meaning specified under "Description of
APS--Auction Procedures--Determination of Sufficient Clearing Bids, Winning Bid
Rate and Applicable Rate" in this Prospectus.
"Substitute Commercial Paper Dealer" means such substitute Commercial Paper
Dealer or Dealers as the Fund may from time to time appoint or their respective
affiliates and successors.
"Subsequent Dividend Period" means each Dividend Period after the Initial
Dividend Period.
"Substitute Rating Agency" shall mean a nationally recognized statistical
rating organization selected by UBS Warburg LLC and Merrill Lynch, Pierce,
Fenner & Smith Incorporated, or their respective affiliates and successors,
after consultation with the Fund, to act as a substitute rating agency to
determine the credit ratings of the APS.
"Sufficient Clearing Bids" has the meaning specified in Subsection 11.4(i) of
the Auction Procedures.
"Taxable Equivalent of the Short-Term Municipal Obligations Rate" on any date
means 90% of the quotient of (A) the per annum rate expressed on an interest
equivalent basis equal to the Kenny S&P 30 day High Grade Index or any
successor index (the "Kenny Index") made available for the Business Day
immediately preceding such date but in any event not later than 8:30 a.m., New
York City time, on such date by Kenny Information Systems Inc. or any successor
thereto, based upon 30-day yield evaluations at par of short term bonds the
interest on which is excludable for federal income tax purposes under the Code
of "high grade" component issuers selected by Kenny Information Systems Inc. or
any such
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72
Glossary
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successor from time to time in its discretion, which component issuers shall
include, without limitation, issuers of general obligation bonds but shall
exclude any bonds the interest on which constitutes a Preference Item, divided
by (B) 1.00 minus the Marginal Tax Rate (expressed as a decimal); provided,
however, that if the Kenny Index is not made so available by 8:30 a.m., New
York City time, on such date by Kenny Information Systems Inc. or any
successor, the Taxable Equivalent of the Short-Term Municipal Obligations Rate
shall mean the quotient of (A) the per annum rate expressed on an interest
equivalent basis equal to the most recent Kenny Index so made available for any
preceding Business Day, divided by (B) 1.00 minus the Marginal Tax Rate noted
above (expressed as a decimal). The Fund may not utilize a successor index to
the Kenny Index unless Moody's provides the Fund with written confirmation that
the use of such successor index will not adversely affect the then-current
Moody's rating of the APS.
"Taxable Income" has the meaning specified under "Prospectus summary--Advance
Notice of Allocation of Taxable Income; Inclusion of Taxable Income in
Dividends" in this Prospectus.
"Treasury Bonds" means United States Treasury Bonds or Notes.
"Underwriters" has the meaning specified under "Prospectus summary--The
Offering" in this Prospectus.
"U.S. Treasury Bill Rate" on any date means (i) the Interest Equivalent of the
rate on the actively traded Treasury Bill with a maturity most nearly
comparable to the length of the related Dividend Period, as such rate is made
available on a discount basis or otherwise by the Federal Reserve Bank of New
York in its Composite 3:30 p.m. Quotations for U.S. Government Securities
report for such Business Day, or (ii) if such yield as so calculated is not
available, the Alternate Treasury Bill Rate on such date. "Alternate Treasury
Bill Rate" on any date means the Interest Equivalent of the yield as calculated
by reference to the arithmetic average of the bid price quotations of the
actively traded Treasury Bill with a maturity most nearly comparable to the
length of the related Dividend Period, as determined by bid price quotations as
of any time on the Business Day immediately preceding such date, obtained from
at least three recognized primary U.S. Government securities dealers selected
by the Auction Agent.
"U.S. Treasury Note Rate" on any date means (i) the yield as calculated by
reference to the bid price quotation of the actively traded, current coupon
Treasury Note with a maturity most nearly comparable to the length of the
related Dividend Period, as such bid price quotation is published on the
Business Day immediately preceding such date by the Federal Reserve Bank of New
York in its Composite 3:30 p.m. Quotations for U.S. Government Securities
report for such Business Day, or (ii) if such yield as so calculated is not
available, the Alternate Treasury Note Rate on such date. "Alternate Treasury
Note Rate" on any date means the yield as calculated by reference to the
arithmetic average of the bid price quotations of the actively traded, current
coupon Treasury Note with a maturity most nearly comparable to the length of
the related Dividend Period, as determined by the bid price quotations as of
any time on the Business Day immediately preceding such date, obtained from at
least three recognized primary U.S. Government securities dealers selected by
the Auction Agent.
"Valuation Date" has the meaning specified under "Description of APS--Asset
Maintenance--APS Basic Maintenance Amount" in this Prospectus.
"Winning Bid Rate" has the meaning specified under "Description of APS--Auction
Procedures--Determination of Sufficient Clearing Bids, Winning Bid Rate and
Applicable Rate" in this Prospectus.
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[LOGO] PIMCO
FUNDS
PIMCO MUNICIPAL INCOME FUND II
STATEMENT OF ADDITIONAL INFORMATION
August 16, 2002
PIMCO Municipal Income Fund II (the "Fund") is a newly organized,
diversified closed-end management investment company.
This Statement of Additional Information relating to auction preferred
shares of the Fund ("Preferred Shares" or "APS") is not a prospectus, and should
be read in conjunction with the Fund's prospectus relating thereto dated
August 16, 2002 (the "Prospectus"). This Statement of Additional Information
does not include all information that a prospective investor should consider
before purchasing Preferred Shares, and investors should obtain and read the
Prospectus prior to purchasing such shares. A copy of the Prospectus may be
obtained without charge by calling (877) 819-2224. You may also obtain a copy of
the Prospectus on the web site (http://www.sec.gov) of the Securities and
Exchange Commission ("SEC"). Capitalized terms used but not defined in this
Statement of Additional Information have the meanings ascribed to them in the
Prospectus.
1
TABLE OF CONTENTS
USE OF PROCEEDS .......................................................... 3
INVESTMENT OBJECTIVE AND POLICIES ........................................ 3
INVESTMENT RESTRICTIONS .................................................. 26
MANAGEMENT OF THE FUND ................................................... 28
INVESTMENT MANAGER AND PORTFOLIO MANAGER ................................. 41
PORTFOLIO TRANSACTIONS ................................................... 45
DISTRIBUTIONS ............................................................ 47
DESCRIPTION OF SHARES .................................................... 48
ANTI-TAKEOVER AND OTHER PROVISIONS IN THE DECLARATION OF TRUST ........... 49
REPURCHASE OF FUND SHARES; CONVERSION TO OPEN-END FUND ................... 51
TAX MATTERS .............................................................. 53
PERFORMANCE RELATED AND COMPARATIVE INFORMATION .......................... 59
CUSTODIAN, TRANSFER AGENTS AND DIVIDEND DISBURSEMENT AGENTS .............. 59
INDEPENDENT ACCOUNTANTS .................................................. 60
COUNSEL .................................................................. 60
REGISTRATION STATEMENT ................................................... 60
FINANCIAL STATEMENTS ..................................................... 61
APPENDIX A -Description of Securities Ratings ............................ A-1
APPENDIX B - Settlement Procedures ....................................... B-1
APPENDIX C - Auction Procedures .......................................... C-1
This Statement of Additional Information is dated August 16, 2002.
2
USE OF PROCEEDS
The net proceeds of the offering of Preferred Shares will be
approximately $499,575,000 after payment of offering costs and the sales load.
Pending investment in Municipal Bonds (as hereinafter defined) that
meet the Fund's investment objective and policies, it is anticipated that the
net proceeds of the offering will be invested in high quality, short-term,
tax-exempt securities. If necessary to invest fully the net proceeds of the
offering immediately, the Fund may also purchase high quality, short-term
securities, including mortgage-backed and corporate debt securities, the income
on which is subject to regular federal income tax.
INVESTMENT OBJECTIVE AND POLICIES
The investment objective and general investment policies of the Fund
are described in the Prospectus. Additional information concerning the
characteristics of certain of the Fund's investments is set forth below.
Municipal Bonds
Under normal market conditions, the Fund will invest its net assets in
a portfolio of municipal bonds the interest from which, in the opinion of bond
counsel to the issuer (or on the basis of other authority believed by the Fund's
portfolio manager to be reliable), is exempt from federal income taxes
("Municipal Bonds"). Under normal market conditions, the Fund expects to be
fully invested (at least 90% of its total assets) in Municipal Bonds. The Fund
will at all times seek to avoid bonds generating interest potentially subjecting
individuals to the alternative minimum tax.
Municipal Bonds share the attributes of debt/fixed income securities in
general, but are generally issued by states, municipalities and other political
subdivisions, agencies, authorities and instrumentalities of states and
multi-state agencies or authorities. The Municipal Bonds that the Fund may
purchase include general obligation bonds and limited obligation bonds (or
revenue bonds), including industrial development bonds issued pursuant to former
federal tax law. General obligation bonds are obligations involving the credit
of an issuer possessing taxing power and are payable from such issuer's general
revenues and not from any particular source. Limited obligation bonds are
payable only from the revenues derived from a particular facility or class of
facilities or, in some cases, from the proceeds of a special excise or other
specific revenue source. Tax-exempt private activity bonds and industrial
development bonds generally are also revenue bonds and thus are not payable from
the issuer's general revenues. The credit and quality of private activity bonds
and industrial development bonds are usually related to the credit of the
corporate user of the facilities. Payment of interest on and repayment of
principal of such bonds is the responsibility of the corporate user (and/or any
guarantor).
The Fund will invest at least 80% of its net assets in Municipal Bonds
that at the time of investment are investment grade quality. Investment grade
quality bonds are bonds rated within the four highest grades (Baa or BBB or
better by Moody's Investors Service, Inc. ("Moody's"), Standard & Poor's ("S&P")
or Fitch, Inc. ("Fitch")) or bonds that are unrated but judged to be of
comparable quality by the Fund's portfolio manager, Pacific Investment
Management Company
3
LLC ("PIMCO"). The Fund may invest up to 20% of its net assets in Municipal
Bonds that, at the time of investment, are rated Ba/BB or B by Moody's, S&P or
Fitch or unrated but judged to be of comparable quality by PIMCO. Bonds of below
investment grade quality (Ba/BB or below) are commonly referred to as "junk
bonds." For a description of the risks associated with lower quality securities,
see "--High Yield Securities ("Junk Bonds")" below.
The Fund will primarily invest in Municipal Bonds with long-term
maturities in order to maintain a weighted average maturity of 15-30 years, but
the average weighted maturity of obligations held by the Fund may be shortened,
depending on market conditions. As a result, the Fund's portfolio at any given
time may include both long-term and intermediate-term Municipal Bonds. Moreover,
for temporary defensive purposes (e.g., during times when PIMCO believes that
temporary imbalances of supply and demand or other temporary dislocations in the
tax-exempt bond market adversely affect the price at which long-term or
intermediate-term Municipal Bonds are available), the Fund may invest any
percentage of its net assets in high quality, short-term investments, including
mortgage-backed and corporate debt securities, that may be either tax-exempt or
taxable, and up to 10% of its net assets in securities of open- or closed-end
investment companies that invest primarily in Municipal Bonds of the type in
which the Fund may invest directly. The Fund may also invest without limit in
these securities temporarily in order to keep the Fund's cash fully invested,
including periods during which the net proceeds of the offering are being
invested. The Fund intends to invest in taxable short-term investments only in
the event that suitable tax-exempt short-term investments are not available at
reasonable prices and yields. See "Tax Matters" for information relating to the
allocation of taxable income between and among the Fund's common shares (called
"Common Shares" herein) and the Preferred Shares. Tax-exempt short-term
investments include various obligations issued by state and local governmental
issuers, such as tax-exempt notes (bond anticipation notes, tax anticipation
notes and revenue anticipation notes or other such Municipal Bonds maturing in
three years or less from the date of issuance) and municipal commercial paper.
The Fund will invest only in taxable short-term investments that are U.S.
government securities or securities rated within the four highest grade by
Moody's, S&P or Fitch, and which mature within one year from the date of
purchase or carry a variable or floating rate of interest. See Appendix A for a
general description of Moody's, S&P's and Fitch's ratings of securities in such
categories. Taxable short-term investments of the Fund may include certificates
of deposit issued by U.S. banks with assets of at least $1 billion, or
commercial paper or corporate notes, bonds or debentures with a remaining
maturity of one year or less, or repurchase agreements. See "--Short-Term
Investments/Temporary Defensive Strategies." To the extent the Fund invests in
taxable investments, the Fund will not at such times be in a position to achieve
its investment objective.
Also included within the general category of Municipal Bonds in which
the Fund may invest are participations in lease obligations or installment
purchase contract obligations of municipal authorities or entities ("Municipal
Lease Obligations"). Although a Municipal Lease Obligation does not constitute a
general obligation of the municipality for which the municipality's taxing power
is pledged, a Municipal Lease Obligation is ordinarily backed by the
municipality's covenant to budget for, appropriate and make the payments due
under the Municipal Lease Obligation. However, certain Municipal Lease
Obligations contain "non-appropriation" clauses that 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 Fund's ability to recover under the
4
lease in the event of non-appropriation or default will be limited solely to the
repossession of the leased property, without recourse to the general credit of
the lessee, and disposition or releasing of the property might prove difficult.
There have been challenges to the legality of lease financing in numerous
states, and, from time to time, certain municipalities have considered not
appropriating money for lease payments. In deciding whether to purchase a
Municipal Lease Obligation, PIMCO will assess the financial condition of the
borrower, the merits of the project, the level of public support for the
project, and the legislative history of lease financing in the state. These
securities may be less readily marketable than other Municipal Bonds. The Fund
may also purchase unrated lease obligations if determined by PIMCO to be of
comparable quality to rated securities in which the Fund is permitted to invest.
The Fund may seek to enhance its yield through the purchase of private
placements. These securities are sold through private negotiations, usually to
institutions or mutual funds, and may have resale restrictions. Their yields are
usually higher than comparable public securities to compensate the investor for
their limited marketability. The Fund may invest up to 20% of its net assets in
securities which are illiquid at the time of investment, including unmarketable
private placements.
Some longer-term Municipal Bonds give the investor the right to "put"
or sell the security at par (face value) within a specified number of days
following the investor's request--usually one to seven days. This demand feature
enhances a security's liquidity by shortening its effective maturity and enables
it to trade at a price equal to or very close to par. If a demand feature
terminates prior to being exercised, the Fund would hold the longer-term
security, which could experience substantially more volatility.
The Fund may invest in Municipal Bonds with credit enhancements such as
letters of credit, municipal bond insurance and Standby Bond Purchase Agreements
("SBPAs"). Letters of credit are issued by a third party, usually a bank, to
enhance liquidity and ensure repayment of principal and any accrued interest if
the underlying Municipal Bond should default. Municipal bond insurance, which is
usually purchased by the bond issuer from a private, non-governmental insurance
company, provides an unconditional and irrevocable guarantee that the insured
bond's principal and interest will be paid when due. Insurance does not
guarantee the price of the bond or the share price of the Fund. The credit
rating of an insured bond reflects the credit rating of the insurer, based on
its claims-paying ability. The obligation of a municipal bond insurance company
to pay a claim extends over the life of each insured bond. Although defaults on
insured Municipal Bonds have been low to date and municipal bond insurers have
ordinarily met their claims, there is no assurance this will continue. A
higher-than-expected default rate could strain the insurer's loss reserves and
adversely affect its ability to pay claims to bondholders. The number of
municipal bond insurers is relatively small, and not all of them have the
highest rating. An SBPA is a liquidity facility provided to pay the purchase
price of bonds that cannot be re-marketed. The obligation of the liquidity
provider (usually a bank) is only to advance funds to purchase tendered bonds
that cannot be remarketed and does not cover principal or interest under any
other circumstances. The liquidity provider's obligations under the SBPA are
usually subject to numerous conditions, including the continued creditworthiness
of the underlying borrower.
5
The Fund also may invest in participation interests. Participation
interests are various types of securities created by converting fixed rate bonds
into short-term, variable rate certificates. These securities have been
developed in the secondary market to meet the demand for short-term, tax-exempt
securities. The Fund will invest in such securities only if they are deemed
tax-exempt by a nationally recognized bond counsel, but there is no guarantee
the interest will be exempt.
The Fund may also invest up to 10% of its total assets in residual
interest municipal bonds, which may involve leverage and related risks. See
"--Residual Interest Municipal Bonds (RIBS)" below.
The Fund may purchase custodial receipts representing the right to
receive either the principal amount or the periodic interest payments or both
with respect to specific underlying Municipal Bonds. In a typical custodial
receipt arrangement, an issuer or third party owner of Municipal Bonds deposits
the bonds with a custodian in exchange for two classes of custodial receipts.
The two classes have different characteristics, but, in each case, payments on
the two classes are based on payments received on the underlying Municipal
Bonds. In no event will the aggregate interest paid with respect to the two
classes exceed the interest paid by the underlying Municipal Bond. Custodial
receipts are sold in private placements. The value of a custodial receipt may
fluctuate more than the value of a Municipal Bond of comparable quality and
maturity.
Municipal Bonds are subject to credit and market risk. Generally,
prices of higher quality issues tend to fluctuate less with changes in market
interest rates than prices of lower quality issues and prices of longer maturity
issues tend to fluctuate more than prices of shorter maturity issues.
The Fund may purchase and sell portfolio investments to take advantage
of changes or anticipated changes in yield relationships, markets or economic
conditions. The Fund may also sell Municipal Bonds due to changes in PIMCO's
evaluation of the issuer. The secondary market for Municipal Bonds typically has
been less liquid than that for taxable debt/fixed income securities, and this
may affect the Fund's ability to sell particular Municipal Bonds at then-current
market prices, especially in periods when other investors are attempting to sell
the same securities.
Prices and yields on Municipal Bonds are dependent on a variety of
factors, including general money-market conditions, 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.
A number of these factors, including the ratings of particular issues, are
subject to change from time to time. Information about the financial condition
of an issuer of Municipal Bonds may not be as extensive as that made available
by corporations whose securities are publicly traded.
Obligations of issuers of Municipal Bonds are subject to the provisions
of bankruptcy, insolvency and other laws, such as the Federal Bankruptcy Reform
Act of 1978, affecting the rights and remedies of creditors. Congress or state
legislatures may seek to extend the time for payment of principal or interest,
or both, or to impose other constraints upon enforcement of such obligations.
There is also the possibility that as a result of litigation or other
conditions,
6
the power or ability 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 Fund's Municipal Bonds in the same manner. The Fund will be
particularly subject to these risks to the extent that it focuses its
investments in a particular state or region.
Residual Interest Municipal Bonds (RIBS)
The Fund may also invest up to 10% of its total assets in residual
interest Municipal Bonds ("RIBS") whose interest rates bear an inverse
relationship to the interest rate on another security or the value of an index.
RIBS are created by dividing the income stream provided by the underlying bonds
to create two securities, one short-term and one long-term. The interest rate on
the short-term component is reset by an index or auction process normally every
seven to 35 days. After income is paid on the short-term securities at current
rates, the residual income from the underlying bond(s) goes to the long-term
securities. Therefore, rising short-term interest rates result in lower income
for the longer-term portion, and vice versa. The longer-term bonds can be very
volatile and may be less liquid than other Municipal Bonds of comparable
maturity. An investment in RIBS typically will involve greater risk than an
investment in a fixed rate bond. Because increases in the interest rate on the
other security or index reduce the residual interest paid on a RIB, the value of
a RIB is generally more volatile than that of a fixed rate bond. RIBS have
interest rate adjustment formulas that generally reduce or, in the extreme,
eliminate the interest paid to the Fund when short-term interest rates rise, and
increase the interest paid to the Fund when short-term interest rates fall. RIBS
have varying degrees of liquidity that approximate the liquidity of the
underlying bond(s), and the market price for these securities is volatile. These
securities generally will underperform the market of fixed rate bonds in a
rising interest rate environment, but tend to outperform the market of fixed
rate bonds when interest rates decline or remain relatively stable. Although
volatile, RIBS typically offer the potential for yields exceeding the yields
available on fixed rate bonds with comparable credit quality, coupon, call
provisions and maturity. The Fund may also invest in RIBS for the purpose of
increasing the Fund's leverage as a more flexible alternative to the issuance of
Preferred Shares. Should short-term and long-term interest rates rise, the
combination of the Fund's investment in RIBS and its use of other forms of
leverage (including through the issuance of Preferred Shares or the use of other
derivative instruments) likely will adversely affect the Fund's net asset value
per share and income, distributions and total returns to shareholders. Trusts in
which RIBS may be held could be terminated, in which case the residual bond
holder would take possession of the underlying bond(s) on an unleveraged basis.
Short-Term Investments / Temporary Defensive Strategies
Upon PIMCO's recommendation, for temporary defensive purposes, the Fund
may invest up to 100% of its net assets in high quality, short-term investments,
including mortgage-backed and corporate debt securities, that may be either
tax-exempt or taxable. The Fund may also invest without limit in these
securities temporarily in order to keep the Fund's cash fully invested,
including during the period in which the net proceeds of the offering are being
invested. The Fund intends to invest in taxable short-term investments only in
the event that
7
suitable tax-exempt short-term investments are not available at reasonable
prices and yields. To the extent the Fund invests in taxable short-term
investments, the Fund will not at such times be in a position to achieve its
investment objective of providing current income exempt from federal income tax.
Short-Term Taxable Fixed Income Securities
Short-term taxable fixed income investments are defined to include,
without limitation, the following:
(1) U.S. government securities, including bills, notes and
bonds differing as to maturity and rates of interest that are either
issued or guaranteed by the U.S. Treasury or by U.S. government
agencies or instrumentalities. U.S. government agency securities
include, without limitation, securities issued by (a) the Federal
Housing Administration, Farmers Home Administration, Export-Import Bank
of the United States, Small Business Administration, and the Government
National Mortgage Association, whose securities are supported by the
full faith and credit of the United States; (b) the Federal Home Loan
Banks, Federal Intermediate Credit Banks, and the Tennessee Valley
Authority, whose securities are supported by the right of the agency to
borrow from the U.S. Treasury; (c) the Federal National Mortgage
Association, whose securities are supported by the discretionary
authority of the U.S. government to purchase certain obligations of the
agency or instrumentality; and (d) the Student Loan Marketing
Association, whose securities are supported only by its credit. While
the U.S. government provides financial support to such U.S.
government-sponsored agencies or instrumentalities, no assurance can be
given that it always will do so since it is not so obligated by law.
The U.S. government, its agencies, and instrumentalities do not
guarantee the market value of their securities. Consequently, the value
of such securities may fluctuate.
(2) Certificates of deposit issued against funds deposited in
a bank or a savings and loan association. Such certificates are for a
definite period of time, earn a specified rate of return, and are
normally negotiable. The issuer of a certificate of deposit agrees to
pay the amount deposited plus interest to the bearer of the certificate
on the date specified thereon. Certificates of deposit purchased by the
Fund may not be fully insured.
(3) Repurchase agreements, which involve purchases of debt
securities. A repurchase agreement is a contractual agreement whereby
the seller of securities (e.g., U.S. government securities) agrees to
repurchase the same security at a specified price on a future date
agreed upon by the parties. The agreed-upon repurchase price determines
the yield during the Fund's holding period. Repurchase agreements are
considered to be loans collateralized by the underlying security that
is the subject of the repurchase contract. Income generated from
transactions in repurchase agreements will be taxable. The Fund will
only enter into repurchase agreements with registered securities
dealers or domestic banks that PIMCO believes present minimal credit
risk. The risk to the Fund is limited to the ability of the issuer to
pay the agreed-upon repurchase price on the delivery date; however,
although the value of the underlying collateral at the time the
transaction is entered into always equals or exceeds the agreed-upon
repurchase price, if the value of the collateral declines there is a
risk of loss of both principal and interest. In the event of default,
the collateral may be sold but the Fund might incur a loss if the value
of the
8
collateral declines, and might incur disposition costs or experience
delays in connection with liquidating the collateral. In addition, if
bankruptcy proceedings are commenced with respect to the seller of the
security, realization upon the collateral by the Fund may be delayed
or limited. PIMCO will monitor the value of the collateral at the time
the transaction is entered into and at all times subsequent during the
term of the repurchase agreement in an effort to determine that such
value always equals or exceeds the agreed-upon repurchase price.
(4) Commercial paper, which consists of short-term unsecured
promissory notes, including variable rate master demand notes issued by
corporations to finance their current operations. Master demand notes
are direct lending arrangements between the Fund and a corporation.
There is no secondary market for such notes. However, they are
redeemable by the Fund at any time. PIMCO will consider the financial
condition of the corporation (e.g., earning power, cash flow, and other
liquidity ratios) and will continuously monitor the corporation's
ability to meet all of its financial obligations, because the Fund's
liquidity might be impaired if the corporation were unable to pay
principal and interest on demand. Investments in commercial paper will
be limited to commercial paper rated investment grade by a major rating
agency, or unrated but determined by PIMCO to be of comparable quality,
and which mature within one year of the date of purchase or carry a
variable or floating rate of interest.
Short-Term Tax-Exempt Fixed Income Securities
Short-term tax-exempt fixed-income securities are securities that are
exempt from regular federal income tax and mature within three years or less
from the date of issuance. Short-term tax-exempt fixed income securities are
defined to include, without limitation, the following:
Bond Anticipation Notes ("BANs") are usually general obligations of
state and local governmental issuers that are sold to obtain interim financing
for projects that will eventually be funded through the sale of long-term debt
obligations or bonds. The ability of an issuer to meet its obligations on its
BANs is primarily dependent on the issuer's access to the long-term Municipal
Bond market and the likelihood that the proceeds of such bond sales will be used
to pay the principal and interest on the BANs.
Tax Anticipation Notes ("TANs") are issued by state and local
governments to finance the current operations of such governments. Repayment is
generally to be derived from specific future tax revenues. TANs are usually
general obligations of the issuer. A weakness in an issuer's capacity to raise
taxes due to, among other things, a decline in its tax base or a rise in
delinquencies, could adversely affect the issuer's ability to meet its
obligations on outstanding TANs.
Revenue Anticipation Notes ("RANs") are issued by governments or
governmental bodies with the expectation that future revenues from a designated
source will be used to repay the notes. In general, they also constitute general
obligations of the issuer. A decline in the receipt of projected revenues, such
as anticipated revenues from another level of government, could adversely affect
an issuer's ability to meet its obligations on outstanding RANs. In addition,
the possibility that the revenues would, when received, be used to meet other
obligations could affect the ability of the issuer to pay the principal and
interest on RANs.
9
Construction Loan Notes are issued to provide construction financing
for specific projects. Frequently, these notes are redeemed with funds obtained
from the Federal Housing Administration.
Bank Notes are notes issued by local government bodies and agencies,
such as those described above to commercial banks as evidence of borrowings. The
purposes for which the notes are issued are varied but they are frequently
issued to meet short-term working capital or capital-project needs. These notes
may have risks similar to the risks associated with TANs and RANs.
Tax-Exempt Commercial Paper ("Municipal Paper") represents very
short-term unsecured, negotiable promissory notes issued by states,
municipalities and their agencies. Payment of principal and interest on issues
of Municipal Paper may be made from various sources, to the extent the funds are
available therefrom. Maturities of Municipal Paper generally will be shorter
than the maturities of TANs, BANs or RANs. There is a limited secondary market
for issues of Municipal Paper.
Certain Municipal Bonds may carry variable or floating rates of
interest whereby the rate of interest is not fixed but varies with changes in
specified market rates or indices, such as a bank prime rate or a tax-exempt
money market index.
While the various types of notes described above as a group currently
represent the major portion of the tax-exempt note market, other types of notes
are or may become available in the marketplace and the Fund may invest in such
other types of notes to the extent permitted under its investment objective,
policies and limitations. Such notes may be issued for different purposes and
may be secured differently from those mentioned above.
High Yield Securities ("Junk Bonds")
The Fund may invest up to 20% of its net assets in Municipal Bonds
that, at the time of investment, are rated Ba/BB or B by Moody's, S&P or Fitch
or unrated but judged to be of comparable quality by PIMCO. Bonds of below
investment grade quality (Ba/BB or below) are commonly referred to as "high
yield securities" or "junk bonds." Issuers of bonds rated Ba/BB or B are
regarded as having current capacity to make principal and interest payments but
are subject to business, financial or economic conditions which could adversely
affect such payment capacity. Municipal bonds rated Baa or BBB are considered
"investment grade" securities, although such bonds may be considered to possess
some speculative characteristics. Municipal Bonds rated AAA in which the Fund
may invest may have been so rated on the basis of the existence of insurance
guaranteeing the timely payment, when due, of all principal and interest.
High yield securities are regarded as predominantly speculative with
respect to the issuer's continuing ability to meet principal and interest
payments and, therefore, carry greater price volatility and principal and income
risk, including the possibility of issuer default and bankruptcy and increased
market price volatility.
High yield securities may be more susceptible to real or perceived
adverse economic and competitive industry conditions than investment grade
securities. A projection of an economic downturn or of a period of rising
interest rates, for example, could cause a decline in high yield security prices
because the advent of a recession could lessen the ability of an issuer to make
10
principal and interest payments on its debt securities. If an issuer of high
yield securities defaults, in addition to risking payment of all or a portion of
interest and principal, the Fund may incur additional expenses to seek recovery.
In the case of high yield securities structured as zero-coupon, their market
prices are affected to a greater extent by interest rate changes, and therefore
tend to be more volatile than securities which pay interest periodically and in
cash. PIMCO seeks to reduce these risks through diversification, credit analysis
and attention to current developments and trends in both the economy and
financial markets.
The secondary market on which high yield securities are traded may be
less liquid than the market for higher grade securities. Less liquidity in the
secondary trading market could adversely affect the price at which the Fund
could sell a high yield security, and could adversely affect the daily net asset
value of the shares. Adverse publicity and investor perceptions, whether or not
based on fundamental analysis, may decrease the values and liquidity of high
yield securities, especially in a thinly traded market. When secondary markets
for high yield securities are less liquid than the market for higher grade
securities, it may be more difficult to value the securities because such
valuation may require more research, and elements of judgment may play a greater
role in the valuation because there is less reliable, objective data available.
During periods of thin trading in these markets, the spread between bid and
asked prices is likely to increase significantly and the Fund may have greater
difficulty selling its portfolio securities. The Fund will be more dependent on
PIMCO's research and analysis when investing in high yield securities. PIMCO
seeks to minimize the risks of investing in all securities through
diversification, in-depth credit analysis and attention to current developments
in interest rates and market conditions.
A general description of Moody's, S&P's and Fitch's ratings of
securities (including Municipal Bonds) is set forth in Appendix A hereto. The
ratings of Moody's, S&P and Fitch represent their opinions as to the quality of
the securities they rate. It should be emphasized, however, that ratings are
general and are not absolute standards of quality. Consequently, debt
obligations with the same maturity, coupon and rating may have different yields
while obligations with the same maturity and coupon with different ratings may
have the same yield. For these reasons, the use of credit ratings as the sole
method of evaluating high yield securities can involve certain risks. For
example, credit ratings evaluate the safety of principal and interest payments,
not the market value risk of high yield securities. Also, credit rating agencies
may fail to change credit ratings in a timely fashion to reflect events since
the security was last rated. PIMCO does not rely solely on credit ratings when
selecting securities for the Fund, and develops its own independent analysis of
issuer credit quality.
The Fund's credit quality policies apply only at the time a security is
purchased, and the Fund is not required to dispose of a security in the event
that a rating agency or PIMCO downgrades its assessment of the credit
characteristics of a particular issue. In determining whether to retain or sell
such a security, PIMCO may consider such factors as PIMCO's assessment of the
credit quality of the issuer of such security, the price at which such security
could be sold and the rating, if any, assigned to such security by other rating
agencies. However, analysis of the creditworthiness of issuers of high yield
securities may be more complex than for issuers of higher quality debt
securities.
11
Municipal Warrants
The Fund may invest in municipal warrants, which are essentially call
options on Municipal Bonds. In exchange for a premium, they give the purchaser
the right, but not the obligation, to purchase a Municipal Bond in the future.
The Fund might purchase a warrant to lock in forward supply in an environment
where the current issuance of bonds is sharply reduced. Like options, warrants
may expire worthless and they may have reduced liquidity.
Mortgage-Backed Securities
The Fund may invest in mortgage-backed securities. Mortgage-backed
securities in which the Fund may invest include fixed and adjustable rate
mortgage pass-through securities and other securities that directly or
indirectly represent a participation in, or are secured by and payable from,
mortgage loans on real property.
The value of mortgage-backed securities may be particularly sensitive
to changes in prevailing interest rates. Early repayment of principal on some
mortgage-backed securities may expose the Fund to a lower rate of return upon
reinvestment of principal. When interest rates rise, the value of a
mortgage-backed security generally will decline; however, when interest rates
are declining, the value of mortgage-backed securities with prepayment features
may not increase as much as other fixed income securities without such
prepayment features. The rate of prepayments on underlying mortgages will affect
the price and volatility of a mortgage-backed security, and may shorten or
extend the effective maturity of the security beyond what was anticipated at the
time of purchase. If unanticipated rates of prepayment on underlying mortgages
increase the effective maturity of a mortgage-related security, the volatility
of the security can be expected to increase. The value of these securities may
fluctuate in response to the market's perception of the creditworthiness of the
issuers. Additionally, although mortgages and mortgage-backed securities are
generally supported by some form of government or private guarantee and/or
insurance, there is no assurance that private guarantors or insurers will meet
their obligations.
Variable and Floating Rate Securities
Variable and floating rate securities provide for a periodic adjustment
in the interest rate paid on the obligations. The terms of such obligations must
provide that interest rates are adjusted periodically based upon an interest
rate adjustment index as provided in the respective obligations. The adjustment
intervals may be regular, and range from daily up to annually, or may be event
based, such as based on a change in the prime rate.
The Fund may invest in floating rate debt instruments ("floaters") and
engage in credit spread trades. The interest rate on a floater is a variable
rate that is tied to another interest rate, such as a municipal bond index or
Treasury bill rate. The interest rate on a floater resets periodically,
typically every six months. While, because of the interest rate reset feature,
floaters provide the Fund with a certain degree of protection against rising
interest rates, the Fund will participate in any declines in interest rates as
well. A credit spread trade is an investment position relating to a difference
in the prices or interest rates of two bonds or other securities, where the
value of the investment position is determined by movements in the difference
between the prices or interest rates, as the case may be, of the respective
securities or currencies.
12
The Fund may also invest in inverse floating rate debt instruments
("inverse floaters"). The interest rate on an inverse floater resets in the
opposite direction from the market rate of interest to which the inverse floater
is indexed. An inverse floating rate security may exhibit greater price
volatility than a fixed rate obligation of similar credit quality.
Structured Notes and Other Hybrid Instruments
The Fund may invest in "structured" notes, which are privately
negotiated debt obligations where the principal and/or interest is determined by
reference to the performance of a benchmark asset, market or interest rate, such
as selected securities, an index of securities or specified interest rates, or
the differential performance of two assets or markets, such as indices
reflecting taxable and tax-exempt bonds. Depending on the terms of the note, the
Fund may forgo all or part of the interest and principal that would be payable
on a comparable conventional note. The rate of return on structured notes may be
determined by applying a multiplier to the performance or differential
performance of the referenced index(es) or other asset(s). Application of a
multiplier involves leverage that will serve to magnify the potential for gain
and the risk of loss. The Fund currently intends that any use of structured
notes will be for the purpose of reducing the interest rate sensitivity of the
Fund's portfolio (and, thereby, decreasing the Fund's exposure to interest rate
risk) and, in any event, that the interest income on the notes will normally be
exempt from federal income tax. Like other sophisticated strategies, the Fund's
use of structured notes may not work as intended; for example, the change in the
value of the structured notes may not match very closely the change in the value
of bonds that the structured notes were purchased to hedge.
The Fund may invest in other types of "hybrid" instruments that combine
the characteristics of securities, futures, and options. For example, the
principal amount or interest rate of a hybrid could be tied (positively or
negatively) to the price of some securities index or another interest rate (each
a "benchmark"). The interest rate or (unlike most debt obligations) the
principal amount payable at maturity of a hybrid security may be increased or
decreased, depending on changes in the value of the benchmark. Hybrids can be
used as an efficient means of pursuing a variety of investment goals, including
duration management and increased total return. Hybrids may not bear interest or
pay dividends. The value of a hybrid or its interest rate may be a multiple of a
benchmark and, as a result, may be leveraged and move (up or down) more steeply
and rapidly than the benchmark. These benchmarks may be sensitive to economic
and political events that cannot be readily foreseen by the purchaser of a
hybrid. Under certain conditions, the redemption value of a hybrid could be
zero. Thus, an investment in a hybrid may entail significant market risks that
are not associated with a similar investment in a traditional, U.S.
dollar-denominated bond that has a fixed principal amount and pays a fixed rate
or floating rate of interest. The purchase of hybrids also exposes the Fund to
the credit risk of the issuer of the hybrids. These risks may cause significant
fluctuations in the net asset value of the Fund.
Certain issuers of structured products, such as hybrid instruments, may
be deemed to be investment companies as defined in the 1940 Act. As a result,
the Fund's investments in these products may be subject to limits applicable to
investments in investment companies and may be subject to restrictions contained
in the 1940 Act.
13
Municipal Market Data Rate Locks
The Fund may purchase and sell Municipal Market Data Rate Locks ("MMD
Rate Locks"). An MMD Rate Lock permits the Fund to lock in a specified municipal
interest rate for a portion of its portfolio to preserve a return on a
particular investment or a portion of its portfolio as a duration management
technique or to protect against any increase in the price of securities to be
purchased at a later date. The Fund will ordinarily use these transactions as a
hedge or for duration or risk management although it is permitted to enter into
them to enhance income or gain. An MMD Rate Lock is a contract between the Fund
and an MMD Rate Lock provider pursuant to which the parties agree to make
payments to each other on a notional amount, contingent upon whether the
Municipal Market Data AAA General Obligation Scale is above or below a specified
level on the expiration date of the contract. For example, if the Fund buys an
MMD Rate Lock and the Municipal Market Data AAA General Obligation Scale is
below the specified level on the expiration date, the counterparty to the
contract will make a payment to the Fund equal to the specified level minus the
actual level, multiplied by the notional amount of the contract. If the
Municipal Market Data AAA General Obligation Scale is above the specified level
on the expiration date, the Fund will make a payment to the counterparty equal
to the actual level minus the specified level, multiplied by the notional amount
of the contract. In entering into MMD Rate Locks, there is a risk that municipal
yields will move in the direction opposite of the direction anticipated by the
Fund.
Borrowing
The Fund may borrow money to the extent permitted under the 1940 Act,
as interpreted, modified or otherwise permitted by regulatory authority having
jurisdiction from time to time. The Fund may from time to time borrow money to
add leverage to the portfolio. The Fund may also borrow money for temporary
administrative purposes.
Under the 1940 Act, the Fund generally is not permitted to engage in
borrowings unless immediately after a borrowing the value of the Fund's total
assets less liabilities (other than the borrowing) is at least 300% of the
principal amount of such borrowing (i.e., such principal amount may not exceed
33 1/3% of the Fund's total assets). In addition, the Fund is not permitted to
declare any cash dividend or other distribution on Common Shares unless, at the
time of such declaration, the value of the Fund's total assets, less liabilities
other than borrowing, is at least 300% of such principal amount. If the Fund
borrows, it intends, to the extent possible, to prepay all or a portion of the
principal amount of the borrowing to the extent necessary in order to maintain
the required asset coverage. Failure to maintain certain asset coverage
requirements could result in an event of default and entitle holders of
Preferred Shares ("Preferred Shareholders") to elect a majority of the Trustees
of the Fund.
As described elsewhere in this section, the Fund also may enter into
certain transactions, including RIBS and other derivative instruments that can
constitute a form of borrowing or financing transaction by the Fund. The Fund
may enter into these transactions in order to add leverage to the portfolio. The
Fund may (but is not required to) cover its commitment under these instruments
by the segregation of assets determined to be liquid by PIMCO in accordance with
procedures adopted by the Trustees, equal in value to the amount of the Fund's
commitment, or by entering into offsetting transactions or owning positions
covering its obligations. In that case, the instruments will not be considered
"senior securities" under the
14
1940 Act for purposes of the asset coverage requirements otherwise applicable to
borrowings by the Fund or the Fund's issuance of Preferred Shares. Borrowing
will tend to exaggerate the effect on net asset value of any increase or
decrease in the market value of the Fund's portfolio. Money borrowed will be
subject to interest costs that may or may not be recovered by appreciation of
the securities purchased. The Fund also may be required to maintain minimum
average balances in connection with such borrowing or to pay a commitment or
other fee to maintain a line of credit; either of these requirements would
increase the cost of borrowing over the stated interest rate.
Derivative Instruments
In pursuing its investment objective, the Fund may purchase and sell
(write) both put options and call options on securities, swap agreements, and
securities indexes, and enter into interest rate and index futures contracts and
purchase and sell options on such futures contracts ("futures options") to add
leverage to the portfolio, for hedging purposes or as part of its overall
investment strategy. The Fund also may enter into swap agreements with respect
to interest rates, securities indexes and other assets and measures of risk or
return. If other types of financial instruments, including other types of
options, futures contracts, or futures options are traded in the future, the
Fund may also use those instruments, provided that the Trustees determine that
their use is consistent with the Fund's investment objective.
The value of some derivative instruments in which the Fund may invest
may be particularly sensitive to changes in prevailing interest rates, and, like
the other investments of the Fund, the ability of the Fund to successfully
utilize these instruments may depend in part upon the ability of PIMCO to
forecast interest rates and other economic factors correctly. If PIMCO
incorrectly forecasts such factors and has taken positions in derivative
instruments contrary to prevailing market trends, the Fund could be exposed to
the risk of loss.
The Fund might not employ any of the strategies described below, and no
assurance can be given that any strategy used will succeed. If PIMCO incorrectly
forecasts interest rates, market values or other economic factors in utilizing a
derivatives strategy for the Fund, the Fund might have been in a better position
if it had not entered into the transaction at all. Also, suitable derivative
transactions may not be available in all circumstances. The use of these
strategies involves certain special risks, including a possible imperfect
correlation, or even no correlation, between price movements of derivative
instruments and price movements of related investments. While some strategies
involving derivative instruments 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 related investments or otherwise, due to the possible
inability of the Fund to purchase or sell a portfolio security at a time that
otherwise would be favorable or the possible need to sell a portfolio security
at a disadvantageous time because the Fund is required to maintain asset
coverage or offsetting positions in connection with transactions in derivative
instruments, and the possible inability of the Fund to close out or to liquidate
its derivatives positions. Income earned by the Fund from many derivative
strategies will be treated as capital gain and, if not offset by net realized
capital loss, will be distributed to shareholders in taxable distributions.
15
Options on Securities, Swap Agreements and Indexes. The Fund may
purchase and sell both put and call options on securities, swap agreements or
indexes in standardized contracts traded on domestic or other securities
exchanges, boards of trade, or similar entities, or quoted on NASDAQ or on an
over-the-counter market, and agreements, sometimes called cash puts, which may
accompany the purchase of a new issue of debt obligations from a dealer.
An option on a security (or an index) is a contract that gives the
holder of the option, in return for a premium, the right to buy from (in the
case of a call) or sell to (in the case of a put) the writer of the option the
security underlying the option (or the cash value of the index) at a specified
exercise price at any time during the term of the option. The writer of an
option on a security has the obligation upon exercise of the option to deliver
the underlying security upon payment of the exercise price or to pay the
exercise price upon delivery of the underlying security. Upon exercise, the
writer of an option on an index is obligated to pay the difference between the
cash value of the index and the exercise price multiplied by the specified
multiplier for the index option. (An index is designed to reflect features of a
particular securities market, a specific group of financial instruments or
securities, or certain economic indicators.)
The Fund will write call options and put options only if they are
"covered." In the case of a call option on a security, the option is "covered"
if the Fund owns the security underlying the call or has an absolute and
immediate right to acquire that security without additional cash consideration
(or, if additional cash consideration is required, cash or other assets
determined to be liquid by PIMCO in accordance with procedures established by
the Board of Trustees, in such amount are segregated by its custodian) upon
conversion or exchange of other securities held by the Fund. For a call option
on an index, the option is covered if the Fund maintains with its custodian
assets determined to be liquid by PIMCO in accordance with procedures
established by the Board of Trustees, in an amount equal to the contract value
of the index. A call option is also covered if the Fund holds a call on the same
security or index as the call written where the exercise price of the call held
is (i) equal to or less than the exercise price of the call written, or (ii)
greater than the exercise price of the call written, provided the difference is
maintained by the Fund in segregated assets determined to be liquid by PIMCO in
accordance with procedures established by the Board of Trustees. A put option on
a security or an index is "covered" if the Fund segregates assets determined to
be liquid by PIMCO in accordance with procedures established by the Board of
Trustees equal to the exercise price. A put option is also covered if the Fund
holds a put on the same security or index as the put written where the exercise
price of the put held is (i) equal to or greater than the exercise price of the
put written, or (ii) less than the exercise price of the put written, provided
the difference is maintained by the Fund in segregated assets determined to be
liquid by PIMCO in accordance with procedures established by the Board of
Trustees.
If an option written by the Fund expires unexercised, the Fund realizes
a capital gain equal to the premium received at the time the option was written.
If an option purchased by the Fund expires unexercised, the Fund realizes a
capital loss equal to the premium paid. Prior to the earlier of exercise or
expiration, an exchange-traded option may be closed out by an offsetting
purchase or sale of an option of the same series (type, exchange, underlying
security or index, exercise price, and expiration). There can be no assurance,
however, that a closing purchase or sale transaction can be effected when the
Fund desires.
16
The Fund may sell put or call options it has previously purchased,
which could result in a net gain or loss depending on whether the amount
realized on the sale is more or less than the premium and other transaction
costs paid on the put or call option which is sold. Prior to exercise or
expiration, an option may be closed out by an offsetting purchase or sale of an
option of the same series. The Fund will realize a capital gain from a closing
purchase transaction if the cost of the closing option is less than the premium
received from writing the option, or, if it is more, the Fund will realize a
capital loss. If the premium received from a closing sale transaction is more
than the premium paid to purchase the option, the Fund will realize a capital
gain or, if it is less, the Fund will realize a capital loss. The principal
factors affecting the market value of a put or a call option include supply and
demand, interest rates, the current market price of the underlying security or
index in relation to the exercise price of the option, the volatility of the
underlying security or index, and the time remaining until the expiration date.
The premium paid for a put or call option purchased by the Fund is an
asset of the Fund. The premium received for an option written by the Fund is
recorded as a deferred credit. The value of an option purchased or written is
marked to market daily and is valued at the closing price on the exchange on
which it is traded or, if not traded on an exchange or no closing price is
available, at the mean between the last bid and asked prices.
The Fund may write covered straddles consisting of a combination of a
call and a put written on the same underlying security. A straddle will be
covered when sufficient assets are deposited to meet the Fund's immediate
obligations. The Fund may use the same liquid assets to cover both the call and
put options where the exercise price of the call and put are the same, or the
exercise price of the call is higher than that of the put. In such cases, the
Fund will also segregate liquid assets equivalent to the amount, if any, by
which the put is "in the money."
Risks Associated with Options on Securities and Indexes. There are
several risks associated with transactions in options on securities and on
indexes. For example, there are significant differences between the securities
and options markets that could result in an imperfect correlation between these
markets, causing a given transaction not to achieve its objectives. A decision
as to whether, when and how to use options involves the exercise of skill and
judgment, and even a well-conceived transaction may be unsuccessful to some
degree because of market behavior or unexpected events.
During the option period, the covered call writer has, in return for
the premium on the option, given up the opportunity to profit from a price
increase in the underlying security above the exercise price, but, as long as
its obligation as a writer continues, has retained the risk of loss should the
price of the underlying security decline. The writer of an option has no control
over the time when it may be required to fulfill its obligation as a writer of
the 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 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 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 is purchased to hedge against price movements in a related
security, the price of the put or call option may move more or less than the
price of the related security.
17
There can be no assurance that a liquid market will exist when the Fund
seeks to close out an option position. If the Fund were unable to close out an
option that it had purchased on a security, it would have to exercise the option
in order to realize any profit or the option may expire worthless. If the Fund
were unable to close out a covered call option that it had written on a
security, it would not be able to sell the underlying security unless the option
expired without exercise. As the writer of a covered call option, the Fund
forgoes, during the option's life, the opportunity to profit from increases in
the market value of the security covering the call option above the sum of the
premium and the exercise price of the call.
If trading were suspended in an option purchased by the Fund, the Fund
would not be able to close out the option. If restrictions on exercise were
imposed, the Fund might be unable to exercise an option it has purchased. Except
to the extent that a call option on an index written by the Fund is covered by
an option on the same index purchased by the Fund, movements in the index may
result in a loss to the Fund; however, such losses may be mitigated by changes
in the value of the Fund's securities during the period the option was
outstanding.
Futures Contracts and Options on Futures Contracts. The Fund may invest
in interest rate futures contracts and options thereon ("futures options"). The
Fund may also purchase and sell futures contracts on Municipal Bonds and U.S.
government and agency securities, as well as purchase put and call options on
such futures contracts.
A securities or interest rate futures contract provides for the future
sale by one party and purchase by another party of a specified quantity of the
security or financial instrument representative of interest rate fluctuations at
a specified price and time. A futures contract on an index is an agreement
pursuant to which two parties agree to take or make delivery of an amount of
cash equal to the difference between the value of the index at the close of the
last trading day of the contract and the price at which the index contract was
originally written. Although the value of an index might be a function of the
value of certain specified securities, physical delivery of these securities is
not always made. A public market exists in futures contracts covering a number
of indexes as well as financial instruments, including, without limitation: U.S.
Treasury bonds; U.S. Treasury notes; three-month U.S. Treasury bills; 90-day
commercial paper; bank certificates of deposit; and the Bond Buyer 40 Bond
Index. It is expected that other futures contracts will be developed and traded
in the future.
The Fund may purchase and write call and put futures options. Futures
options possess many of the same characteristics as options on securities and
indexes (discussed above). A futures option gives the holder the right, in
return for the premium paid, to assume a long position (call) or short position
(put) in a futures contract at a specified exercise price at any time during the
period of the option. Upon exercise of a call option, the holder acquires a long
position in the futures contract and the writer is assigned the opposite short
position. In the case of a put option, the opposite is true.
To comply with applicable rules of the Commodity Futures Trading
Commission ("CFTC") under which the Fund avoids being deemed a "commodity pool"
or a "commodity pool operator," the Fund intends generally to limit its use of
futures contracts and futures options to "bona fide hedging" transactions, as
such term is defined in applicable regulations, interpretations and practice.
For example, the Fund might use futures contracts to hedge against anticipated
changes in interest rates that might adversely affect either the value of the
Fund's
18
Municipal Bonds or the price of the bonds that the Fund intends to purchase. The
Fund's hedging activities may include sales of futures contracts as an offset
against the effect of expected increases in interest rates, and purchases of
futures contracts as an offset against the effect of expected declines in
interest rates. Although other techniques could be used to reduce the Fund's
exposure to interest rate fluctuations, the Fund may be able to hedge its
exposure more effectively and perhaps at a lower cost by using futures contracts
and futures options.
The Fund will only enter into futures contracts and futures options
that are standardized and traded on a U.S. or other exchange, board of trade, or
similar entity, or quoted on an automated quotation system. The Fund may also
enter into OTC options on futures contracts.
When a purchase or sale of a futures contract is made by the Fund, the
Fund is required to deposit with its custodian (or broker, if legally permitted)
a specified amount of assets determined to be liquid by PIMCO in accordance with
procedures established by the Board of Trustees ("initial margin"). The margin
required for a futures contract is set by the exchange on which the contract is
traded and may be modified during the term of the contract. The initial margin
is in the nature of a performance bond or good faith deposit on the futures
contract that is returned to the Fund upon termination of the contract, assuming
all contractual obligations have been satisfied. The Fund expects to earn
taxable interest income on its initial margin deposits. A futures contract held
by the Fund is valued daily at the official settlement price of the exchange on
which it is traded. Each day the Fund pays or receives cash, called "variation
margin," equal to the daily change in value of the futures contract. This
process is known as "marking to market." Variation margin does not represent a
borrowing or loan by the Fund but is instead a settlement between the Fund and
the broker of the amount one would owe the other if the futures contract
expired. In computing daily net asset value, the Fund will mark to market its
open futures positions.
The Fund is also required to deposit and maintain margin with respect
to put and call options on futures contracts written by it. Such margin deposits
will vary depending on the nature of the underlying futures contract (and the
related initial margin requirements), the current market value of the option,
and other futures positions held by the Fund.
Although some futures contracts call for making or taking delivery of
the underlying securities, generally these obligations are closed out prior to
delivery by offsetting purchases or sales of matching futures contracts
(involving the same exchange, underlying security or index, and delivery month).
If an offsetting purchase price is less than the original sale price, the Fund
realizes a capital gain, or if it is more, the Fund realizes a capital loss.
Conversely, if an offsetting sale price is more than the original purchase
price, the Fund realizes a capital gain, or if it is less, the Fund realizes a
capital loss. The transaction costs must also be included in these calculations.
The Fund may write covered straddles consisting of a call and a put
written on the same underlying futures contract. A straddle will be covered when
sufficient assets are deposited to meet the Fund's immediate obligations. The
Fund may use the same liquid assets to cover both the call and put options where
the exercise price of the call and put are the same, or the exercise price of
the call is higher than that of the put. In such cases, the Fund will also
segregate liquid assets equivalent to the amount, if any, by which the put is
"in the money."
19
Limitations on Use of Futures and Futures Options. As noted above, the
Fund generally intends to enter into positions in futures contracts and related
options only for "bona fide hedging" purposes. With respect to positions in
futures and related options that do not constitute bona fide hedging positions,
the Fund will not enter into a futures contract or futures option contract if,
immediately thereafter, the aggregate initial margin deposits relating to such
positions plus premiums paid by it for open futures option positions, less the
amount by which any such options are "in-the-money," would exceed 5% of the
Fund's liquidation value, after taking into account unrealized profits and
unrealized losses on any such contracts into which the Fund has entered. A call
option is "in-the-money" if the value of the futures contract that is the
subject of the option exceeds the exercise price. A put option is "in-the-money"
if the exercise price exceeds the value of the futures contract that is the
subject of the option.
When purchasing a futures contract, the Fund will maintain with its
custodian (and mark-to-market on a daily basis) assets determined to be liquid
by PIMCO in accordance with procedures established by the Board of Trustees,
that, when added to the amounts deposited with a futures commission merchant as
margin, are equal to the market value of the futures contract. Alternatively,
the Fund may "cover" its position by purchasing a put option on the same futures
contract with a strike price as high or higher than the price of the contract
held by the Fund.
When selling a futures contract, the Fund will maintain with its
custodian (and mark-to-market on a daily basis) assets determined to be liquid
by PIMCO in accordance with procedures established by the Board of Trustees,
that are equal to the market value of the instruments underlying the contract.
Alternatively, the Fund may "cover" its position by owning the instruments
underlying the contract (or, in the case of an index futures contract, a
portfolio with a volatility substantially similar to that of the index on which
the futures contract is based), or by holding a call option permitting the Fund
to purchase the same futures contract at a price no higher than the price of the
contract written by the Fund (or at a higher price if the difference is
maintained in liquid assets with the Fund's custodian).
When selling a call option on a futures contract, the Fund will
maintain with its custodian (and mark-to-market on a daily basis) assets
determined to be liquid by PIMCO in accordance with procedures established by
the Board of Trustees, that, when added to the amounts deposited with a futures
commission merchant as margin, equal the total market value of the futures
contract underlying the call option. Alternatively, the Fund may cover its
position by entering into a long position in the same futures contract at a
price no higher than the strike price of the call option, by owning the
instruments underlying the futures contract, or by holding a separate call
option permitting the Fund to purchase the same futures contract at a price not
higher than the strike price of the call option sold by the Fund.
When selling a put option on a futures contract, the Fund will maintain
with its custodian (and mark-to-market on a daily basis) assets determined to be
liquid by PIMCO in accordance with procedures established by the Board of
Trustees, that equal the purchase price of the futures contract, less any margin
on deposit. Alternatively, the Fund may cover the position either by entering
into a short position in the same futures contract, or by owning a separate put
option permitting it to sell the same futures contract so long as the strike
price of the purchased put option is the same or higher than the strike price of
the put option sold by the Fund.
20
To the extent that securities with maturities greater than one year are
used to segregate assets to cover the Fund's obligations under futures contracts
and related options, such use will not eliminate the leverage risk arising from
such use, which may tend to exaggerate the effect on net asset value of any
increase or decrease in the market value of the Fund's portfolio, and may
require liquidation of portfolio positions when it is not advantageous to do so.
The requirements for qualification as a regulated investment company
also may limit the extent to which the Fund may enter into futures, futures
options or forward contracts. See "Tax Matters."
Risks Associated with Futures and Futures Options. There are several
risks associated with the use of futures contracts and futures options as
hedging techniques. A purchase or sale of a futures contract may result in
losses in excess of the amount invested in the futures contract. There can be no
guarantee that there will be a correlation between price movements in the
hedging vehicle and in the Fund securities being hedged. In addition, there are
significant differences between the securities and futures markets that could
result in an imperfect correlation between the markets, causing a given hedge
not to achieve its objectives. The degree of imperfection of correlation depends
on circumstances such as variations in speculative market demand for futures and
futures options on securities, including technical influences in futures trading
and futures options, and differences between the financial instruments being
hedged and the instruments underlying the standard contracts available for
trading in such respects as interest rate levels, maturities, and
creditworthiness of issuers. A decision as to whether, when and how to hedge
involves the exercise of skill and judgment, and even a well-conceived hedge may
be unsuccessful to some degree because of market behavior or unexpected interest
rate trends.
Futures contracts on U.S. government securities historically have
reacted to an increase or decrease in interest rates in a manner similar to that
in which the underlying U.S. government securities reacted. To the extent,
however, that the Fund enters into such futures contracts, the value of such
futures will not vary in direct proportion to the value of the Fund's holdings
of Municipal Bonds. Thus, the anticipated spread between the price of the
futures contract and the hedged security may be distorted due to differences in
the nature of the markets. The spread also may be distorted by differences in
initial and variation margin requirements, the liquidity of such markets and the
participation of speculators in such markets.
Futures exchanges may limit the amount of fluctuation permitted in
certain futures contract prices during a single trading day. The daily limit
establishes the maximum amount that the price of a futures contract may vary
either up or down from the previous day's settlement price at the end of the
current trading session. Once the daily limit has been reached in a futures
contract subject to the limit, no more trades may be made on that day at a price
beyond that limit. The daily limit governs only price movements during a
particular trading day and therefore does not limit potential losses because the
limit may work to prevent the liquidation of unfavorable positions. For example,
futures prices have occasionally moved to the daily limit for several
consecutive trading days with little or no trading, thereby preventing prompt
liquidation of positions and subjecting some holders of futures contracts to
substantial losses.
21
There can be no assurance that a liquid market will exist at a time
when the Fund seeks to close out a futures contract or a futures option
position, and the Fund would remain obligated to meet margin requirements until
the position is closed. In addition, many of the contracts discussed above are
relatively new instruments without a significant trading history. As a result,
there can be no assurance that an active secondary market will develop or
continue to exist.
Swap Agreements. The Fund may enter into swap agreements with respect
to interest rates, indexes of securities and other assets or measures of risk or
return. The Fund may also enter into options on swap agreements ("swaptions").
These transactions are entered into in an attempt to obtain a particular return
when it is considered desirable to do so, possibly at a lower cost to the Fund
than if the Fund had invested directly in an instrument that yielded that
desired return. Swap agreements are two-party contracts entered into primarily
by institutional investors for periods ranging from a few weeks to more than one
year. In a standard "swap" transaction, two parties agree to exchange the
returns (or differentials in rates of return) earned or realized on particular
predetermined investments or instruments, which may be adjusted for an interest
factor. The gross returns to be exchanged or "swapped" between the parties are
generally calculated with respect to a "notional amount," i.e., the return on or
increase in value of a particular dollar amount invested at a particular
interest rate or in a "basket" of securities representing a particular index.
Forms of swap agreements include interest rate caps, under which, in return for
a premium, one party agrees to make payments to the other to the extent that
interest rates exceed a specified rate, or "cap"; interest rate floors, under
which, in return for a premium, one party agrees to make payments to the other
to the extent that interest rates fall below a specified rate, or "floor"; and
interest rate collars, under which a party sells a cap and purchases a floor or
vice versa in an attempt to protect itself against interest rate movements
exceeding given minimum or maximum levels. 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.
Most swap agreements entered into by the Fund would calculate the
obligations of the parties to the agreement on a "net basis." Consequently, the
Fund's current obligations (or rights) under a swap agreement will generally be
equal only to the net amount to be paid or received under the agreement based on
the relative values of the positions held by each party to the agreement (the
"net amount"). The Fund's current obligations under a swap agreement will be
accrued daily (offset against any amounts owed to the Fund). The Fund may use
swap agreements to add leverage to the portfolio. The Fund may (but is not
required to) cover any accrued but unpaid net amounts owed to a swap
counterparty through the segregation of assets determined to be liquid by PIMCO
in accordance with procedures established by the Board of Trustees. Obligations
under swap agreements so covered will not be construed to be "senior securities"
for purposes of the Fund's investment restriction concerning senior securities
and borrowings.
Whether the Fund's use of swap agreements or swaptions will be
successful in furthering its investment objective will depend on PIMCO's ability
to predict correctly whether certain types of investments are likely to produce
greater returns than other investments. Because they are two-party contracts and
because they may have terms of greater than seven days, swap agreements may be
considered to be illiquid. Moreover, the Fund bears the risk of loss of the
amount expected to be received under a swap agreement in the event of the
default or bankruptcy
22
of a swap agreement counterparty. The Fund will enter into swap agreements only
with counterparties that meet certain standards of creditworthiness. The swaps
market is a relatively new market and is largely unregulated. It is possible
that developments in the swaps market, including potential government
regulation, could adversely affect the Fund's ability to terminate existing swap
agreements or to realize amounts to be received under such agreements.
Depending on the terms of the particular option agreement, the Fund
will generally incur a greater degree of risk when it writes a swaption than it
will incur when it purchases a swaption. When the Fund purchases a swaption, it
risks losing only the amount of the premium it has paid should it decide to let
the option expire unexercised. However, when the Fund writes a swaption, upon
exercise of the option the Fund will become obligated according to the terms of
the underlying agreement.
Certain swap agreements are exempt from most provisions of the
Commodity Exchange Act ("CEA") and, therefore, are not regulated as futures or
commodity option transactions under the CEA.
Short Sales
The Fund may make short sales of securities as part of its overall
portfolio management strategy and to offset potential declines in long positions
in securities in the Fund's portfolio. A short sale is a transaction in which
the Fund sells a security it does not own in anticipation that the market price
of that security will decline. Although short sale transactions are not
currently available with respect to Municipal Bonds, the Fund may engage in
short sales on taxable bonds and on futures contracts with respect to Municipal
Bonds and taxable bonds.
When the Fund makes a short sale on a security, it must borrow the
security sold short and deliver it to the broker-dealer through which it made
the short sale as collateral for its obligation to deliver the security upon
conclusion of the sale. The Fund may have to pay a fee to borrow particular
securities and is often obligated to pay over any accrued interest and dividends
on such borrowed securities.
If the price of the security sold short increases between the time of
the short sale and the time the Fund replaces the borrowed security, the Fund
will incur a loss; conversely, if the price declines, the Fund will realize a
capital gain. Any gain will be decreased, and any loss increased, by the
transaction costs described above. The successful use of short selling may be
adversely affected by imperfect correlation between movements in the price of
the security sold short and the securities being hedged.
To the extent that the Fund engages in short sales, it will provide
collateral to the broker-dealer. A short sale is "against the box" to the extent
that the Fund contemporaneously owns, or has the right to obtain at no added
cost, securities identical to those sold short. The Fund may also engage in
so-called "naked" short sales (i.e., short sales that are not "against the
box"), in which case the Fund's losses could theoretically be unlimited, in
cases where the Fund is unable for whatever reason to close out its short
position. The Fund has the flexibility to engage in short selling to the extent
permitted by the 1940 Act and rules and interpretations thereunder.
23
Illiquid Securities
The Fund may invest up to 20% of its net assets in securities which are
illiquid at the time of investment. The term "illiquid securities" for this
purpose means securities that cannot be disposed of within seven days in the
ordinary course of business at approximately the amount at which the Fund has
valued the securities. Illiquid securities are considered to include, among
other things, written over-the-counter options, securities or other liquid
assets being used as cover for such options, repurchase agreements with
maturities in excess of seven days, certain loan participation interests, fixed
time deposits which are not subject to prepayment or provide for withdrawal
penalties upon prepayment (other than overnight deposits), and other securities
whose disposition is restricted under the federal securities laws (other than
securities issued pursuant to Rule 144A under the 1933 Act and certain
commercial paper that PIMCO has determined to be liquid under procedures
approved by the Board of Trustees).
Illiquid securities may include privately placed securities, which are
sold directly to a small number of investors, usually institutions. Unlike
public offerings, such securities are not registered under the federal
securities laws. Although certain of these securities may be readily sold,
others may be illiquid, and their sale may involve substantial delays and
additional costs.
Portfolio Trading and Turnover Rate
Portfolio trading may be undertaken to accomplish the investment
objective of the Fund in relation to actual and anticipated movements in
interest rates. In addition, a security may be sold and another of comparable
quality purchased at approximately the same time to take advantage of what PIMCO
believes to be a temporary price disparity between the two securities. Temporary
price disparities between two comparable securities may result from supply and
demand imbalances where, for example, a temporary oversupply of certain bonds
may cause a temporarily low price for such bonds, as compared with other bonds
of like quality and characteristics. The Fund may also engage in short-term
trading consistent with its investment objective. Securities may be sold in
anticipation of a market decline (a rise in interest rates) or purchased in
anticipation of a market rise (a decline in interest rates) and later sold, or
to recognize a gain.
A change in the securities held by the Fund is known as "portfolio
turnover." PIMCO manages the Fund without regard generally to restrictions on
portfolio turnover. The use of certain derivative instruments with relatively
short maturities may tend to exaggerate the portfolio turnover rate for the
Fund. Trading in debt obligations does not generally involve the payment of
brokerage commissions, but does involve indirect transaction costs. The use of
futures contracts may involve the payment of commissions to futures commission
merchants. High portfolio turnover (e.g., greater than 100%) involves
correspondingly greater expenses to the Fund, including brokerage commissions or
dealer mark-ups and other transaction costs on the sale of securities and
reinvestments in other securities. The higher the rate of portfolio turnover of
the Fund, the higher these transaction costs borne by the Fund generally will
be. Transactions in the Fund's portfolio securities may result in realization of
taxable capital gains (including short-term capital gains which are generally
taxed to shareholders at ordinary income tax rates). The trading costs and tax
effects associated with portfolio turnover may adversely affect the Fund's
performance.
24
The portfolio turnover rate of the Fund is calculated by dividing (a)
the lesser of purchases or sales of portfolio securities for the particular
fiscal year by (b) the monthly average of the value of the portfolio securities
owned by the Fund during the particular fiscal year. In calculating the rate of
portfolio turnover, there is excluded from both (a) and (b) all securities,
including options, whose maturities or expiration dates at the time of
acquisition were one year or less.
Other Investment Companies
The Fund may invest up to 10% of its net assets in securities of open-
or closed-end investment companies that invest primarily in Municipal Bonds of
the types in which the Fund may invest directly. The Fund may invest in other
investment companies either during periods when it has large amounts of
uninvested cash, such as the period shortly after the Fund receives the proceeds
of the offering of its Common Shares or Preferred Shares, during periods when
there is a shortage of attractive, high-yielding Municipal Bonds available in
the market, or when PIMCO believes share prices of other investment companies
offer attractive values. The Fund may invest in investment companies that are
advised by PIMCO or its affiliates to the extent permitted by applicable law
and/or pursuant to exemptive relief from the SEC. As a stockholder in an
investment company, the Fund will bear its ratable share of that investment
company's expenses and would remain subject to payment of the Fund's management
fees with respect to assets so invested. PIMCO will take expenses into account
when evaluating the investment merits of an investment in an investment company
relative to available Municipal Bond investments. In addition, the securities of
other investment companies may also be leveraged and will therefore be subject
to the same leverage risks described in the Prospectus and herein. As described
in the Prospectus in the section entitled "Risks--Leverage Risk," the net asset
value and market value of leveraged shares will be more volatile and the yield
to shareholders will tend to fluctuate more than the yield generated by
unleveraged shares.
When-Issued, Delayed Delivery and Forward Commitment Transactions
The Fund may purchase or sell securities on a when-issued, delayed
delivery, or forward commitment basis. Typically, no income accrues on
securities the Fund has committed to purchase prior to the time delivery of the
securities is made, although the Fund may earn income on securities it has
segregated.
When purchasing a security on a when-issued, delayed delivery, or
forward commitment basis, the Fund assumes the rights and risks of ownership of
the security, including the risk of price and yield fluctuations, and takes such
fluctuations into account when determining its net asset value. Because the Fund
is not required to pay for the security until the delivery date, these risks are
in addition to the risks associated with the Fund's other investments. If the
Fund remains substantially fully invested at a time when when-issued, delayed
delivery, or forward commitment purchases are outstanding, the purchases may
result in a form of 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. If the other party to a transaction fails
to deliver or pay for the securities, the Fund could miss a favorable price or
yield opportunity or could suffer a loss. The Fund may dispose of or renegotiate
a transaction after it is entered into, and may sell when-issued, delayed
delivery
25
or forward commitment securities before they are delivered, which may
result in a capital gain or loss. There is no percentage limitation on the
extent to which the Fund may purchase or sell securities on a when-issued,
delayed delivery, or forward commitment basis.
Zero-Coupon Bonds and Step-Ups
Zero-coupon securities are debt obligations that do not entitle the
holder to any periodic payments of interest either for the entire life of the
obligation or for an initial period after the issuance of the obligations. Like
zero-coupon bonds, "step-up" bonds pay no interest initially but eventually
begin to pay a coupon rate prior to maturity, which rate may increase at stated
intervals during the life of the security. Each of these instruments is
typically issued and traded at a deep discount from its face amount. The amount
of the discount varies depending on such factors as the time remaining until
maturity of the securities, prevailing interest rates, the liquidity of the
security and the perceived credit quality of the issuer. The market prices of
zero-coupon bonds and step-ups generally are more volatile than the market
prices of debt instruments that pay interest currently and in cash and are
likely to respond to changes in interest rates to a greater degree than do other
types of securities having similar maturities and credit quality. In order to
satisfy a requirement for qualification as a "regulated investment company"
under the Internal Revenue Code of 1986, as amended (the "Code"), an investment
company, such as the Fund, must distribute each year at least 90% of its net
investment income, including the original issue discount accrued on zero-coupon
bonds and step-ups. Because the Fund will not on a current basis receive cash
payments from the issuer of these securities in respect of any accrued original
issue discount, in some years the Fund may have to distribute cash obtained from
selling other portfolio holdings of the Fund. In some circumstances, such sales
might be necessary in order to satisfy cash distribution requirements even
though investment considerations might otherwise make it undesirable for the
Fund to sell securities at such time. Under many market conditions, investments
in zero-coupon bonds and step-ups may be illiquid, making it difficult for the
Fund to dispose of them or determine their current value.
INVESTMENT RESTRICTIONS
Fundamental Investment Restrictions
Except as described below, the Fund, as a fundamental policy, may not,
without the approval of the holders of a majority of the outstanding Common
Shares and any outstanding preferred shares of beneficial interest of the Fund
(including the Preferred Shares) voting together as a single class, and of the
holders of a majority of any outstanding preferred shares of beneficial interest
of the Fund (including the Preferred Shares) voting as a separate class:
(1) Concentrate its investments in a particular "industry," as
that term is used in the Investment Company Act of 1940, as amended,
and as interpreted, modified, or otherwise permitted by regulatory
authority having jurisdiction, from time to time.
(2) With respect to 75% of the Fund's total assets, purchase
the securities of any issuer, except securities issued or guaranteed by
the U.S. government or any of its agencies or instrumentalities or
securities issued by other investment companies, if, as a result, (i)
more than 5% of the Fund's total assets would be invested in the
securities of
26
that issuer, or (ii) the Fund would hold more than 10% of the
outstanding voting securities of that issuer. For the purpose of this
restriction, each state and each separate political subdivision,
agency, authority or instrumentality of such state, each multi-state
agency or authority, and each obligor, if any, are treated as separate
issuers of Municipal Bonds.
(3) Purchase or sell real estate, although it may purchase
securities (including Municipal Bonds) secured by real estate or
interests therein, or securities issued by companies which invest in
real estate, or interests therein.
(4) Purchase or sell commodities or commodities contracts or
oil, gas or mineral programs. This restriction shall not prohibit the
Fund, subject to restrictions described in the Prospectus and elsewhere
in this Statement of Additional Information, from purchasing, selling
or entering into futures contracts, options on futures contracts,
forward contracts, or any interest rate, securities-related or other
hedging instrument, including swap agreements and other derivative
instruments, subject to compliance with any applicable provisions of
the federal securities or commodities laws.
(5) Borrow money or issue any senior security, except to the
extent permitted under the Investment Company Act of 1940, as amended,
and as interpreted, modified, or otherwise permitted by regulatory
authority having jurisdiction, from time to time.
(6) Make loans, except to the extent permitted under the
Investment Company Act of 1940, as amended, and as interpreted,
modified, or otherwise permitted by regulatory authority having
jurisdiction, from time to time.
(7) Act as an underwriter of securities of other issuers,
except to the extent that in connection with the disposition of
portfolio securities, it may be deemed to be an underwriter under the
federal securities laws.
(8) Make an investment if, at the time of such investment, the
Fund has invested less than 80% of its "assets" (as that term is
defined in Rule 35d-1 under the Investment Company Act of 1940, as
amended) in investments the income from which is, in the opinion of
bond counsel to the issuer (or on the basis of other authority believed
by the Fund's portfolio manager to be reliable), exempt from federal
income tax (not including, for these purposes, the federal alternative
minimum tax).
For purposes of the foregoing, "majority of the outstanding," when used
with respect to particular shares of the Fund (whether voting together as a
single class or voting as separate classes), means (i) 67% or more of such
shares present at a meeting, if the holders of more than 50% of such shares are
present or represented by proxy, or (ii) more than 50% of such shares, whichever
is less.
Unless otherwise indicated, all limitations applicable to the Fund's
investments (as stated above and elsewhere in this Statement of Additional
Information) apply only at the time a transaction is entered into. Any
subsequent change in a rating assigned by any rating service to a security (or,
if unrated, deemed by PIMCO to be of comparable quality), or change in the
percentage of the Fund's total assets invested in certain securities or other
instruments, or change
27
in the average maturity or duration of the Fund's investment portfolio,
resulting from market fluctuations or other changes in the Fund's total assets,
will not require the Fund to dispose of an investment until PIMCO determines
that it is practicable to sell or close out the investment without undue market
or tax consequences to the Fund. In the event that rating agencies assign
different ratings to the same security, PIMCO will determine which rating it
believes best reflects the security's quality and risk at that time, which may
be the higher of the several assigned ratings.
Under the 1940 Act, a "senior security" does not include any promissory
note or evidence of indebtedness where such loan is for temporary purposes only
and in an amount not exceeding 5% of the value of the total assets of the issuer
at the time the loan is made. A loan is presumed to be for temporary purposes if
it is repaid within sixty days and is not extended or renewed.
The Fund would be deemed to "concentrate" in a particular industry if
it invested 25% or more of its net assets in that industry. The Fund's industry
concentration policy does not preclude it from focusing investments in issuers
in a group of related industrial sectors (such as different types of utilities).
To the extent the Fund covers its commitment under a derivative
instrument by the segregation of assets determined by PIMCO to be liquid in
accordance with procedures adopted by the Trustees, equal in value to the amount
of the Fund's commitment, such instrument will not be considered a "senior
security" for purposes of the asset coverage requirements otherwise applicable
to borrowings by the Fund or the Fund's issuance of Preferred Shares.
The Fund interprets its policies with respect to borrowing and lending
to permit such activities as may be lawful for the Fund, to the full extent
permitted by the 1940 Act or by exemption from the provisions therefrom pursuant
to exemptive order of the SEC.
It is a condition of the issuance of the Preferred Shares that they be
issued with a credit quality rating of "Aaa" from Moody's. In order to obtain
and maintain the required ratings, the Fund will be required to comply with
investment quality, diversification and other guidelines established by Moody's.
Such guidelines will likely be more restrictive than the restrictions set forth
above. The Fund does not anticipate that such guidelines would have a material
adverse effect on its holders of Common Shares ("Common Shareholders") or its
ability to achieve its investment objective. Moody's receives fees in connection
with its ratings issuances.
MANAGEMENT OF THE FUND
Trustees and Officers
The business of the Fund is managed under the direction of the Fund's
Board of Trustees. Subject to the provisions of the Fund's Amended and Restated
Agreement and Declaration of Trust (the "Declaration"), its Amended By-Laws and
Massachusetts law, the Trustees have all powers necessary and convenient to
carry out this responsibility, including the election and removal of the Fund's
officers.
The Trustees and officers of the Fund, their ages, the position they
hold with the Fund, their term of office and length of time served, a
description of their principal occupations during the past five years, the
number of portfolios in the fund complex that the Trustee oversees and
28
any other directorships held by the Trustee are listed in the two tables
immediately following. Except as shown, each Trustee's and officer's principal
occupation and business experience for the last five years has been with the
employer(s) indicated, although in some cases the Trustee may have held
different positions with such employer(s). Unless otherwise indicated, the
business address of the persons listed below is c/o PIMCO Funds Advisors LLC,
1345 Avenue of the Americas, New York, New York 10105.
29
Independent Trustees*
(1) (2) (3) (4) (5) (6)
Number of
Term of Portfolios
Office and in Fund Other
Position(s) Length of Complex Directorships
Name, Address Held Time Served Principal Occupation(s) Overseen by Held by Trustee
and Age with Fund During the Past 5 Years Trustee
Paul Belica Trustee Since Trustee, Fixed Income 8 None.
Age 80 inception SHares, PIMCO Corporate
(June, 2002). Income Fund, PIMCO Municipal
Income Fund, PIMCO
California Municipal Income
Fund and PIMCO New York
Municipal Income Fund;
Manager, Stratigos Fund,
LLC, Whistler Fund, LLC,
Xanthus Fund, LLC and
Wynstone Fund, LLC;
Director, Student Loan
Finance Corp., Education
Loans, Inc., Goal Funding,
Inc., Surety Loan Funding,
Inc. Formerly, Advisor,
Salomon Smith Barney Inc.;
Director, Central European
Value Fund, Inc., Deck House
Inc., The Czech Republic
Fund, Inc.
Robert E. Connor Trustee Since Trustee, Fixed Income 9 None.
Age 68 inception SHares, PIMCO Corporate
(June, 2002). Income Fund, PIMCO Municipal
Income Fund, PIMCO
California Municipal Income
Fund and PIMCO New York
Municipal Income Fund;
Director, Municipal
Advantage Fund, Inc.;
Corporate Affairs
Consultant. Formerly,
Senior Vice President,
Corporate Office, Salomon
Smith Barney Inc.
John J. Dalessandro II Trustee Since President and Director, J.J. 7 None.
Age 65 inception Dalessandro II Ltd.,
(June, 2002). registered
broker-dealer and member
of the New York Stock
Exchange; Trustee, PIMCO
Corporate Income Fund,
PIMCO Municipal Income
Fund, PIMCO California
Municipal Income Fund
and PIMCO New York
Municipal Income Fund.
30
(1) (2) (3) (4) (5) (6)
Number of
Term of Portfolios
Office and in Fund Other
Position(s) Length of Complex Directorships
Name, Address Held Time Served Principal Occupation(s) Overseen by Held by Trustee
and Age with Fund During the Past 5 Years Trustee
Hans W. Kertess Trustee Since Consultant, Dain Rauscher 7 None.
Age 62 inception Inc.; Trustee, PIMCO
(June, 2002). Corporate Income Fund, PIMCO
Municipal Income Fund, PIMCO
California Municipal Income
Fund and PIMCO New York
Municipal Income Fund.
Formerly, Managing Director,
Salomon Brothers; Managing
Director, Dain Rauscher Inc.
Interested Trustees**
(1) (2) (3) (4) (5) (6)
Number of
Term of Portfolios
Office and in Fund Other
Position(s) Length of Complex Directorships
Name, Address Held Time Served Principal Occupation(s) Overseen by Held by Trustee
and Age with Fund During the Past 5 Years Trustee
R. Peter Sullivan III Trustee Since Trustee, PIMCO Corporate 7 None.
Age 60 inception Income Fund, PIMCO Municipal
(June, 2002). Income Fund, PIMCO California
Municipal Income Fund and
PIMCO New York Municipal
Income Fund. Formerly,
Managing Partner, Bear
Wagner Specialists LLC.
_________________
* Mr. Dalessandro is treated by the Fund as not being an "interested
person" (as defined in Section 2(a)(19) of the 1940 Act) of the Fund, the
Manager, PIMCO or the Underwriters, despite his affiliation with J.J.
Dalessandro II Ltd., a member of the New York Stock Exchange, Inc. (the
"Exchange") that operates as a floor broker and does not effect portfolio
transactions for entities other than other members of the Exchange. Mr. Kertess
retired from Dain Rauscher Inc. (a broker-dealer that within the last 6 months
may have executed portfolio transactions for the PIMCO Funds) effective January
1, 2002. He currently serves as a consultant and independent contractor to Dain
Rauscher Inc. and is no longer treated as an "interested person" of the Fund as
a result of his position with Dain Rauscher Inc.
** Mr. Sullivan owns shares of Merrill Lynch, one of the underwriters
of the Fund's Preferred Share offering. Mr. Sullivan will be treated by the Fund
as an "interested person" of the Fund through his ownership of
31
shares of Merrill Lynch, until such time as Merrill Lynch completes its
participation in the distribution of the Preferred Shares.
In accordance with the Fund's staggered board (see "Anti-Takeover and
Other Provisions in the Declaration of Trust"), the Common Shareholders will
elect Trustees to fill the vacancies of Trustees whose terms expire at each
annual meeting of Common Shareholders, unless any preferred shares of beneficial
interest are outstanding, in which event the holders of preferred shares, voting
as a separate class, will elect two Trustees and the remaining Trustees shall be
elected by Common Shareholders and the holders of preferred shares, voting
together as a single class. The holders of preferred shares will be entitled to
elect a majority of the Fund's Trustees under certain circumstances.
Officers
(1) (2) (3) (4) (5) (6)
Number of
Term of Portfolios
Office and in Fund Other
Position(s) Length of Complex Directorships
Name, Address Held Time Served Principal Occupation(s) Overseen by Held by Officer
and Age with Fund During the Past 5 Years Officer
Stephen J. Treadway President Since Managing Director, Allianz N/A N/A
2187 Atlantic Street inception Dresdner Asset Management of
Stamford, CT 06902 (June, 2002). America L.P.; Managing
Age 54 Director and Chief Executive
Officer, PIMCO Funds
Advisors LLC; Managing
Director and Chief Executive
Officer, PIMCO Funds
Distributors LLC ("PFD");
Trustee, President and Chief
Executive Officer, PIMCO
Funds: Multi-Manager Series;
Chairman, Fixed Income
SHares; Trustee, Chairman
and President, OCC Cash
Reserves, Inc., OCC
Accumulation Trust, PIMCO
Corporate Income Fund, PIMCO
Municipal Income Fund, PIMCO
California Municipal Income
Fund and PIMCO New York
Municipal Income Fund;
Chairman and Trustee,
Municipal Advantage Fund,
Inc.; President, The
Emerging Markets Income
Fund, Inc., The Emerging
Markets Income Fund II,
Inc., The Emerging Markets
Floating Rate Fund, Inc.,
Global Partners Income Fund,
Inc., Municipal Partners
Fund, Inc. and Municipal
Partners
Fund II, Inc. Formerly,
Executive
Vice President, Smith Barney
Inc.
32
(1) (2) (3) (4) (5) (6)
Number of
Term of Portfolios
Office and in Fund Other
Position(s) Length of Complex Directorships
Name, Address Held Time Served Principal Occupation(s) Overseen by Held by Officer
and Age with Fund During the Past 5 Years Officer
Newton B. Schott, Jr. Vice Since Managing Director, Chief N/A N/A
2187 Atlantic Street President, inception Administrative Officer,
Stamford, CT 06902 Secretary (June, 2002). Secretary and General
Age 59 Counsel, PFD; Managing
Director, Chief Legal
Officer and Secretary, PIMCO
Funds Advisors LLC;
President, Municipal
Advantage Fund, Inc.; Vice
President and Secretary,
PIMCO Funds: Multi-Manager
Series, PIMCO Corporate
Income Fund, PIMCO Municipal
Income Fund, PIMCO
California Municipal Income
Fund, PIMCO New York
Municipal Income Fund;
Executive Vice President,
The Emerging
Markets Income Fund, Inc.,
The Emerging Markets
Income Fund II, Inc.,
The Emerging Markets
Floating Rate Fund, Inc.,
Global Partners Income Fund,
Inc., Municipal Partners
Fund, Inc. and Municipal
Partners Fund II, Inc.;
Secretary, Fixed Income
SHares. Formerly, Vice
President and Clerk, PIMCO
Advisors Funds.
Brian S. Shlissel Treasurer; Since Senior Vice President, PIMCO N/A N/A
Age 37 Principal inception Funds Advisors LLC;
Financial (June, 2002). Executive Vice President and
and Treasurer, OCC Cash
Accounting Reserves, Inc. and OCC
Officer Accumulation Trust;
President, Chief Executive
Officer and Treasurer, Fixed
Income SHares; Treasurer,
Municipal Advantage Fund
Inc.; Treasurer and
Principal Financial and
Accounting Officer, PIMCO
Corporate Income Fund, PIMCO
Municipal Income Fund, PIMCO
California Municipal Income
Fund and PIMCO New York
Municipal Income Fund; Vice
President, Emerging Markets
Income Fund, Inc., Emerging
Markets Income Fund II,
Inc., Emerging Markets
Floating Rate Fund, Inc.,
Global Partners Income Fund,
Inc., Municipal Partners
Fund, Inc., and Municipal
Partners Fund II, Inc.
Formerly, Vice President,
Mitchell Hutchins Asset
Management Inc.
33
(1) (2) (3) (4) (5) (6)
Number of
Term of Portfolios
Office and in Fund Other
Position(s) Length of Complex Directorships
Name, Address Held Time Served Principal Occupation(s) Overseen by Held by Officer
and Age with Fund During the Past 5 Years Officer
Mark V. McCray Vice Since Executive Vice President, N/A N/A
840 Newport Center Drive President inception PIMCO; Vice President, PIMCO
Newport Beach, CA 92660 (June, 2002). Municipal Income Fund, PIMCO
Age 34 California Municipal Income
Fund and PIMCO New York
Municipal Income Fund.
Formerly, Vice President
and co-head of municipal
bond trading, Goldman
Sachs & Co.
Michael B. Zuckerman Assistant Since Vice President, PIMCO Funds N/A N/A
Age 36 Secretary inception Advisors LLC; Secretary,
(June, 2002). Municipal Advantage Fund,
Inc., OCC Accumulation Trust
and OCC Cash Reserves, Inc.;
Assistant Secretary, Fixed
Income SHares, PIMCO
Corporate Income Fund, PIMCO
Municipal Income Fund, PIMCO
California Municipal Income
Fund and PIMCO New York
Municipal Income Fund.
Formerly, Associate, Dechert
Price and Rhoads; Associate
Counsel, Metropolitan Life
Insurance Company.
For interested Trustees and officers, positions held with affiliated
persons or principal underwriters of the Fund are listed in the following table:
(1) (2)
Name Positions Held with Affiliated Persons or Principal Underwriters of the Fund
Stephen J. Treadway See above.
Hans W. Kertess See above.
R. Peter Sullivan III See above.
Newton B. Schott, Jr. See above.
Brian S. Shlissel See above.
Mark V. McCray See above.
Michael B. Zuckerman See above.
34
Committees of the Board of Trustees
Audit Oversight Committee
Provides oversight with respect to the internal and external accounting
and auditing procedures of the Fund and, among other things, considers the
selection of independent public accountants for the Fund and the scope of the
audit, approves all significant services proposed to be performed by those
accountants on behalf of the Fund, and considers other services provided by
those accountants to the Fund, the Manager and PIMCO and the possible effect of
those services on the independence of those accountants. Messrs. Belica, Connor,
Kertess and Sullivan serve on this committee.
Nominating Committee
Responsible for reviewing and recommending qualified candidates to the
Board in the event that a position is vacated or created. Messrs. Belica,
Connor, Kertess and Sullivan serve on this committee. The Nominating Committee
will review and consider nominees recommended by shareholders to serve as
Trustee, provided any such recommendation is submitted in writing to the Fund,
c/o Newton B. Schott, Jr., Secretary, at the address of the principal executive
offices of the Fund. The Nominating Committee has full discretion to reject
nominees recommended by shareholders, and there is no assurance that any such
person so recommended and considered by a committee will be nominated for
election to the Board.
Valuation Committee
Reviews procedures for the valuation of securities and periodically
reviews information from the Manager and PIMCO regarding fair value and
liquidity determination made pursuant to the Board-approved procedures, and
makes related recommendations to the full Board and assists the full Board in
resolving particular valuation matters. Messrs. Belica, Connor and Sullivan
serve on this committee.
Securities Ownership
For each Trustee, the following table discloses the dollar range of
equity securities beneficially owned by the Trustee in the Fund and, on an
aggregate basis, in any registered investment companies overseen by the Trustee
within the Fund's family of investment companies as of December 31, 2001:
35
(1) (2) (3)
Dollar Range of Aggregate Dollar Range of Equity Securities in
Equity Securities All Registered Investment Companies Overseen
Name of Trustee in the Fund by Trustee in Family of Investment Companies
Hans W. Kertess None. None.
John J. Dalessandro II None. None.
Paul Belica None. **$100,000
Robert E. Connor None. None.
R. Peter Sullivan III None. None.
For independent Trustees and their immediate family members, the
following table provides information regarding each class of securities owned
beneficially in an investment adviser or principal underwriter of the Fund, or a
person (other than a registered investment company) directly or indirectly
controlling, controlled by, or under common control with an investment adviser
or principal underwriter of the Fund as of December 31, 2001:
** Greater than.
36
(1) (2) (3) (4) (5) (6)
Name of Owners
and
Relationships Value of
Name of Trustee to Trustee Company Title of Class Securities Percent of Class
Paul Belica None - - - -
Robert E. Connor None - - - -
John J. Dalessandro None - - - -
As of August 7, 2002, the Fund's officers and Trustees as a group owned
less than 1% of the outstanding Common Shares.
37
As of August 7, 2002, the following persons owned of record the number
of Common Shares noted below, representing the indicated percentage of the
Fund's outstanding shares as of such date.
Percentage of the Fund's
Number of Common outstanding shares
Shareholder Shares as of August 7, 2002
----------- ------ ------------------------
A.G. Edwards & Sons, Inc. 5,489,467 9.60%
2801 Clark Street
St. Louis, MO 63103
First Clearing Corporation 4,661,398 8.15
10700 Wheat First Drive
Glen Allen, WV 23060
Merrill Lynch, Pierce, Fenner & Smith Safekeeping 6,609,457 11.55
4 Corporate Place
Piscataway, NJ 08854
Prudential Securities Incorporated 7,070,592 12.36
c/o ADP Proxy Services
51 Mercedes Way
Edgewood, NY 11717
UBS PaineWebber Inc. 10,417,049 18.21
1000 Harbor Blvd.
Weekhawken, NJ 07087
38
Compensation
Messrs. Belica, Connor, Dalessandro, Kertess and Sullivan also serve as
Trustees of PIMCO California Municipal Income Fund, PIMCO New York Municipal
Income Fund, PIMCO Municipal Income Fund, PIMCO California Municipal Income Fund
II and PIMCO New York Municipal Income Fund II (together with the Fund, the
"Municipal Funds") and PIMCO Corporate Income Fund, six closed-end funds for
which the Manager serves as investment manager and PIMCO serves as portfolio
manager. In addition to the Municipal Funds and PIMCO Corporate Income Fund, Mr.
Belica is a director or trustee, as the case may be, of one open-end investment
company (comprising two separate investment portfolios) advised by the Manager;
and Mr. Connor is a director or trustee, as the case may be, of one open-end
investment company (comprising two separate investment portfolios) and one
closed-end investment company advised by the Manager. To the best of the Fund's
knowledge, none of the "independent" Trustees has ever been a director, officer,
or employee of, or a consultant to, the Manager, PIMCO, any one or more of the
Underwriters or any one or more affiliates of any of the foregoing, except that
Mr. Connor provides occasional editorial consulting services as an independent
contractor to an administrative unit of Salomon Smith Barney Inc. As indicated
above, certain of the officers and Trustees of the Fund are affiliated with the
Manager and/or PIMCO.
The Municipal Funds and PIMCO Corporate Income Fund (together, the
"PIMCO Closed-End Funds") are expected to hold joint meetings of their Boards of
Trustees whenever possible. Each Trustee, other than any Trustee who is a
director, officer, partner or employee of the Manager, PIMCO or any entity
controlling, controlled by or under common control with the Manager or PIMCO,
receives $14,000 for each joint meeting for the first four joint meetings in
each year and $7,000 for each additional joint meeting in such year if the
meetings are attended in person. Trustees receive $3,500 per joint meeting if
the meetings are attended telephonically. Members of the Audit Oversight
Committee will receive $3,500 per joint meeting of the PIMCO Closed-End Funds'
Audit Oversight Committees if the meeting takes place on a day other than the
day of a regularly scheduled Board meeting. Trustees will also be reimbursed for
meeting-related expenses.
The PIMCO Closed-End Funds will allocate the Trustees' compensation and
other costs of their joint meetings pro rata based on each PIMCO Closed-End
Fund's net assets, including assets attributable to any preferred shares.
It is estimated that the Trustees will receive the amounts set forth in
the following table from the Fund for its initial fiscal year ending March 31,
2003. For the calendar year ended December 31, 2001, the Trustees received the
compensation set forth in the following table for serving as trustees of other
funds in the "Fund Complex." Each officer and Trustee who is a director,
officer, partner or employee of the Manager, PIMCO or any entity controlling,
controlled by or under common control with the Manager or PIMCO serves without
any compensation from the Fund.
39
(1) (2) (3)
Aggregate Compensation from Fund Total Compensation from Fund and Fund Complex
for the Fiscal Year Ending March Paid to Trustees for the Calendar Year Ending
Name of Person, Position 31, 2003* December 31, 2001**
Paul Belica $10,000 $26,000
Robert E. Connor $10,000 $36,500
Hans W. Kertess $10,000 $ 6,000
John J. Dalessandro II $10,000 $13,500
R. Peter Sullivan III $10,000 $ 0
_________________
* Since the Fund has not completed its first full fiscal year,
compensation is estimated based upon future payments to be made by the Fund
during the current fiscal year and upon estimated relative net assets of the
PIMCO Closed-End Funds. The estimate is for the fiscal year ending March 31,
2003.
** In addition to the PIMCO Closed-End Funds, during the year ended
December 31, 2001, Mr. Belica served as a Trustee of one open-end investment
company (comprising two separate investment portfolios) advised by the Manager,
and Mr. Connor served as a director or Trustee of one open-end investment
company (comprising two separate investment portfolios) and one closed-end
investment company advised by the Manager. These investment companies are
considered to be in the same "Fund Complex" as the Fund.
The Fund has no employees. Its officers are compensated by the Manager
and/or PIMCO.
Codes of Ethics
The Fund, the Manager and PIMCO have each adopted a separate code of
ethics governing personal trading activities of, as applicable, all Trustees and
officers of the Fund, and directors, officers and employees of the Manager and
PIMCO, who, in connection with their regular functions, play a role in the
recommendation of any purchase or sale of a security by the Fund or obtain
information pertaining to such purchase or sale or who have the power to
influence the management or policies of the Fund, the Manager or PIMCO, as
applicable. Such persons are prohibited from effecting certain transactions,
allowed to effect certain exempt transactions (including with respect to
securities that may be purchased or held by the Fund), and are required to
preclear certain security transactions with the applicable compliance officer or
his designee and to report certain transactions on a regular basis. The Fund,
the Manager and PIMCO have each developed procedures for administration of their
respective codes. Text-only versions of the codes of ethics can be viewed online
or downloaded from the EDGAR Database on the SEC's internet web site at
www.sec.gov. You may also review and copy those documents by visiting the SEC's
Public Reference Room in Washington, DC. Information on the operation of the
Public Reference Room may be obtained by calling the SEC at 202-942-8090. In
addition, copies of the codes of ethics may be obtained, after mailing the
appropriate duplicating fee, by writing to the SEC's Public Reference Section,
450 5th Street, N.W., Washington, DC 20549-0102 or by e-mail request at
publicinfo@sec.gov.
40
INVESTMENT MANAGER AND PORTFOLIO MANAGER
Investment Manager
The Manager serves as investment manager to the Fund pursuant to an
investment management agreement (the "Investment Management Agreement") between
it and the Fund. The Manager, a Delaware limited liability company organized in
2000, is wholly-owned by PIMCO Advisory Services Holdings LLC, a wholly-owned
subsidiary of Allianz Dresdner Asset Management of America L.P. ("ADAM of
America", formerly PIMCO Advisors, L.P.). ADAM of America was organized as a
limited partnership under Delaware law in 1987. ADAM of America's sole general
partner is Allianz Paclife Partners LLC. Allianz Paclife Partners LLC is a
Delaware limited liability company with two members, ADAM U.S. Holding LLC, a
Delaware limited liability company, and Pacific Asset Management LLC, a Delaware
limited liability company. ADAM U.S. Holdings LLC is a wholly-owned subsidiary
of Allianz Dresdner Asset Management of America LLC, a wholly-owned subsidiary
of Allianz of America, Inc., which is a wholly-owned subsidiary of Allianz AG.
Pacific Asset Management LLC is a wholly-owned subsidiary of Pacific Life
Insurance Company ("Pacific Life"), which is a wholly-owned subsidiary of
Pacific Mutual Holding Company. Pacific Mutual Holding Company is a Newport
Beach, California-based insurance holding company. Pacific Life Insurance
Company's address is 700 Newport Center Drive, Newport Beach, California.
The general partner of ADAM of America has substantially delegated its
management and control of ADAM of America to an Executive Committee. The
Executive Committee of ADAM of America is comprised of Udo Frank, William S.
Thompson, Jr. and Marcus Riess.
The Manager is located at 1345 Avenue of the Americas, New York, New
York 10105. As of December 31, 2001, the Manager had approximately $80 billion
in assets under management. As of June 30, 2002, ADAM of America and its
subsidiary partnerships had approximately $346 billion in assets under
management.
Allianz of America has entered into a put/call arrangement for the
possible disposition of Pacific Life's indirect interest in the Manager. The put
option held by Pacific Life will allow it to require Allianz of America, on the
last business day of each calendar quarter following May 5, 2000, to purchase at
a formula-based price all units of the Manager owned directly or indirectly by
Pacific Life. The call option held by Allianz of America will allow it,
beginning January 31, 2003 or upon a change in control of Pacific Life, to
require Pacific Life to sell or cause to be sold to Allianz of America, at the
same formula-based price, all units of the Manager owned directly or indirectly
by Pacific Life.
As of the date of this Statement of Additional Information, significant
institutional shareholders of Allianz AG currently include Munchener
Ruckversicherungs-Gesellschaft AG ("Munich Re") and HypoVereinsbank. Allianz AG
in turn owns more than 95% of Dresdner Bank AG. Credit Lyonnais, Munich Re and
HypoVereinsbank, as well as certain broker-dealers that might be controlled by
or affiliated with these entities or Dresdner Bank AG, such as Dresdner
Klienwort Benson North America LLC may be considered to be affiliated persons of
the Manager and PIMCO. (Broker-dealer affiliates of such significant
institutional shareholders are sometimes referred to herein as "Affiliated
Brokers.") Absent an SEC exemption or other relief, the Fund generally is
precluded from effecting principal transactions with the Affiliated
41
Brokers, and its ability to purchase securities being underwritten by an
Affiliated Broker or a syndicate including an Affiliated Broker is subject to
restrictions. Similarly, the Fund's ability to utilize the Affiliated Brokers
for agency transactions is subject to the restrictions of Rule 17e-1 under the
1940 Act. PIMCO does not believe that the restrictions on transactions with the
Affiliated Brokers described above will materially adversely affect its ability
to provide services to the Fund, the Fund's ability to take advantage of market
opportunities, or the Fund's overall performance.
Allianz AG's address is Koniginstrasse 28, D-80802, Munich, Germany.
Pacific Life's address is 700 Newport Center Drive, Newport Beach, CA 92660.
The Manager, subject to the supervision of the Board of Trustees, is
responsible for managing, either directly or through others selected by the
Manager, the investments of the Fund. The Manager also furnishes to the Board of
Trustees periodic reports on the investment performance of the Fund. As more
fully discussed below, the Manager has retained PIMCO, its affiliate, to serve
as the Fund's portfolio manager.
Under the terms of the Investment Management Agreement, subject to such
policies as the Trustees of the Fund may determine, the Manager, at its expense,
will furnish continuously an investment program for the Fund and will make
investment decisions on behalf of the Fund and place all orders for the purchase
and sale of portfolio securities subject always to the Fund's investment
objective, policies and restrictions; provided that, so long as PIMCO serves as
the portfolio manager for the Fund, the Manager's obligation under the
Investment Management Agreement with respect to the Fund is, subject always to
the control of the Trustees, to determine and review with PIMCO the investment
policies of the Fund.
Subject to the control of the Trustees, the Manager also manages,
supervises and conducts the other affairs and business of the Fund, furnishes
office space and equipment, provides bookkeeping and certain clerical services
(excluding determination of the net asset value of the Fund, shareholder
accounting services and the accounting services for the Fund) and pays all
salaries, fees and expenses of officers and Trustees of the Fund who are
affiliated with the Manager. As indicated under "Portfolio
Transactions--Brokerage and Research Services," the Fund's portfolio
transactions may be placed with broker-dealers which furnish the Manager and
PIMCO, without cost, certain research, statistical and quotation services of
value to them or their respective affiliates in advising the Fund or their other
clients. In so doing, the Fund may incur greater brokerage commissions and other
transactions costs than it might otherwise pay.
Pursuant to the Investment Management Agreement, the Fund has agreed to
pay the Manager an annual management fee, payable on a monthly basis, at the
annual rate of 0.65% of the Fund's average daily net assets (including net
assets attributable to Preferred Shares) for the services and facilities it
provides. All fees and expenses are accrued daily and deducted before payment of
dividends to investors.
From the commencement of the Fund's operations through June 30, 2009,
the Manager has contractually agreed to waive a portion of the management fees
it is entitled to receive from the Fund in the amounts, and for the time
periods, set forth below:
42
Percentage Waived Percentage Waived
(contractual annual rate as a (annual rate as a percentage of
Period Ending June 30, percentage of average daily net average daily net assets
----------------------
assets attributable to Common attributable to Common Shares -
Shares - assuming no Preferred assuming the issuance of
Shares are issued or outstanding) Preferred Shares)(2)
----------------------------------------------------------------------
2003(1) ................................ 0.15% 0.24%
2004 ................................... 0.15% 0.24%
2005 ................................... 0.15% 0.24%
2006 ................................... 0.15% 0.24%
2007 ................................... 0.15% 0.24%
2008 ................................... 0.10% 0.16%
2009 ................................... 0.05% 0.08%
________________
(1) From the commencement of the Fund's operations.
(2) Assumes the issuance of Preferred Shares in an amount equal to 38% of the
Fund's capital (after their issuance).
The Manager has not agreed to waive any portion of its fees beyond June
30, 2009.
Except as otherwise described in the Prospectus, the Fund pays, in
addition to the investment management fee described above, all expenses not
assumed by the Manager, including, without limitation, fees and expenses of
Trustees who are not "interested persons" of the Manager or the Fund, interest
charges, taxes, brokerage commissions, expenses of issue of shares, fees and
expenses of registering and qualifying the Fund and its classes of shares for
distribution under federal and state laws and regulations, charges of
custodians, auditing and legal expenses, expenses of determining net asset value
of the Fund, reports to shareholders, expenses of meetings of shareholders,
expenses of printing and mailing prospectuses, proxy statements and proxies to
existing shareholders, and its proportionate share of insurance premiums and
professional association dues or assessments. The Fund is also responsible for
such nonrecurring expenses as may arise, including litigation in which the Fund
may be a party, and other expenses as determined by the Trustees. The Fund may
have an obligation to indemnify its officers and Trustees with respect to such
litigation.
Portfolio Manager
PIMCO serves as portfolio manager for the Fund pursuant to a portfolio
management agreement (the "Portfolio Management Agreement") between PIMCO and
the Manager. Under the Portfolio Management Agreement, subject always to the
control of the Trustees and the supervision of the Manager, PIMCO's obligation
is to furnish continuously an investment program for the Fund, to make
investment decisions on behalf of the Fund and to place all orders for the
purchase and sale of portfolio securities and all other investments for the
Fund.
Under the Portfolio Management Agreement, the Manager pays a portion of
the fees it receives from the Fund to PIMCO in return for PIMCO's services, at
the maximum annual rate of 0.50% of the Fund's average daily net assets
(including assets attributable to the Preferred Shares). PIMCO has contractually
agreed to waive a portion of the fee it is entitled to receive from the Manager
such that PIMCO will receive 0.26% of the Fund's average daily net assets from
the commencement of Fund operations through June 30, 2007 (i.e., roughly the
first 5 years of Fund operations), 0.40% of average daily net assets in year 6,
0.45% in year 7 and 0.50% in each year thereafter.
43
Originally organized in 1971, reorganized as a Delaware general
partnership in 1994 and reorganized as a Delaware limited liability company in
2000, PIMCO provides investment management and advisory services to private
accounts of institutional and individual clients and to mutual funds. The
membership interests of PIMCO as of January 10, 2002, were held 94% by ADAM of
America and 6% by the managing directors of PIMCO. As of June 30, 2002, PIMCO
had approximately $7 billion in assets under management. PIMCO is located at
840 Newport Center Drive, Newport Beach, California 92660.
Certain Terms of the Investment Management Agreement and Portfolio
Management Agreement. The Investment Management Agreement and the Portfolio
Management Agreement were each approved by the Trustees of the Fund (including
all of the Trustees who are not "interested persons" of the Manager or PIMCO).
The Investment Management Agreement and Portfolio Management Agreement will each
continue in force with respect to the Fund for two years from their respective
dates, and from year to year thereafter, but only so long as their continuance
is approved at least annually by (i) vote, cast in person at a meeting called
for that purpose, of a majority of those Trustees who are not "interested
persons" of the Manager, PIMCO or the Fund, and by (ii) the majority vote of
either the full Board of Trustees or the vote of a majority of the outstanding
shares of all classes of the Fund. Each of the Investment Management Agreement
and Portfolio Management Agreement automatically terminates on assignment. The
Investment Management Agreement may be terminated on not less than 60 days'
notice by the Manager to the Fund or by the Fund to the Manager. The Portfolio
Management Agreement may be terminated on not less than 60 days' notice by the
Manager to PIMCO or by PIMCO to the Manager, or by the Fund at any time by
notice to the Manager and PIMCO.
The Investment Management Agreement and the Portfolio Management
Agreement each provide that the Manager or PIMCO, as applicable, shall not be
subject to any liability in connection with the performance of its services
thereunder in the absence of willful misfeasance, bad faith, gross negligence or
reckless disregard of its obligations and duties.
Basis for Approval of the Investment Management Agreement and Portfolio
Management Agreement. In determining to approve the Investment Management
Agreement and the Portfolio Management Agreement, the Trustees met with the
relevant investment advisory personnel from the Manager and PIMCO and considered
information relating to the education, experience and number of investment
professionals and other personnel who would provide services under the
applicable agreement. See "Management of the Fund" in the Prospectus and this
Statement of Additional Information. The Trustees also took into account the
time and attention to be devoted by senior management to the Fund and the other
funds in the complex. The Trustees evaluated the level of skill required to
manage the Fund and concluded that the human resources to be available at the
Manager and PIMCO were appropriate to fulfill effectively the duties of the
Manager and PIMCO on behalf of the Fund under the applicable agreement. The
Trustees also considered the business reputation of the Manager and PIMCO, their
financial resources and professional liability insurance coverage and concluded
that they would be able to meet any reasonably foreseeable obligations under the
applicable agreement.
The Trustees received information concerning the investment philosophy
and investment process to be applied by PIMCO in managing the Fund. In this
connection, the Trustees considered PIMCO's in-house research capabilities as
well as other resources available to
44
PIMCO's personnel, including research services available to PIMCO as a result of
securities transactions effected for the Fund and other investment advisory
clients. The Trustees concluded that PIMCO's investment process, research
capabilities and philosophy were well suited to the Fund, given the Fund's
investment objective and policies.
The Trustees considered the scope of the services provided by the
Manager and PIMCO to the Fund under the Investment Management Agreement and
Portfolio Management Agreement, respectively, relative to services provided by
third parties to other mutual funds. The Trustees noted that the Manager's and
PIMCO's standard of care was comparable to that found in most investment company
advisory agreements. See "--Certain Terms of the Investment Management Agreement
and the Portfolio Management Agreement" above. The Trustees concluded that the
scope of the Manager's and PIMCO's services to be provided to the Fund was
consistent with the Fund's operational requirements, including, in addition to
its investment objective, compliance with the Fund's investment restrictions,
tax and reporting requirements and related shareholder services.
The Trustees considered the quality of the services to be provided by
the Manager and PIMCO to the Fund. The Trustees also evaluated the procedures of
the Manager and PIMCO designed to fulfill the their fiduciary duty to the Fund
with respect to possible conflicts of interest, including their codes of ethics
(regulating the personal trading of their officers and employees) (see
"Management of the Fund--Code of Ethics" above), the procedures by which PIMCO
allocates trades among its various investment advisory clients, the integrity of
the systems in place to ensure compliance with the foregoing and the record of
PIMCO in these matters. The Trustees also received information concerning
standards of the Manager and PIMCO with respect to the execution of portfolio
transactions. See "Portfolio Transactions" below.
In approving the agreements, the Trustees also gave substantial
consideration to the fees payable under the agreements. The Trustees reviewed
information concerning fees paid to investment advisers of similar municipal
bond funds. The Trustees also considered the fees of the Fund as a percentage of
assets at different asset levels and possible economies of scale to the Manager.
The Trustees evaluated the Manager's profitability with respect to the Fund,
concluding that such profitability was not inconsistent with levels of
profitability that had been determined by courts not to be "excessive." In
evaluating the Fund's advisory fees, the Trustees also took into account the
complexity of investment management for the Fund relative to other types of
funds. The Trustees concluded that, generally, municipal bond funds require
greater intensity of research and trading acumen than more diversified funds.
PORTFOLIO TRANSACTIONS
Investment Decisions and Portfolio Transactions
Investment decisions for the Fund and for the other investment advisory
clients of the Manager and PIMCO are made with a view to achieving their
respective investment objectives. Investment decisions are the product of many
factors in addition to basic suitability for the particular client involved
(including the Fund). Some securities considered for investments by the Fund may
also be appropriate for other clients served by the Manager and PIMCO. Thus, a
particular security may be bought or sold for certain clients even though it
could have been
45
bought or sold for other clients at the same time. If a purchase or sale of
securities consistent with the investment policies of the Fund and one or more
of these clients served by the Manager or PIMCO is considered at or about the
same time, transactions in such securities will be allocated among the Fund and
clients in a manner deemed fair and reasonable by the Manager or PIMCO, as
applicable. The Manager or PIMCO may aggregate orders for the Fund with
simultaneous transactions entered into on behalf of its other clients so long as
price and transaction expenses are averaged either for that transaction or for
the day. Likewise, a particular security may be bought for one or more clients
when one or more clients are selling the security. In some instances, one client
may sell a particular security to another client. It also sometimes happens that
two or more clients simultaneously purchase or sell the same security, in which
event each day's transactions in such security are, insofar as possible,
averaged as to price and allocated between such clients in a manner which the
Manager or PIMCO believes is equitable to each and in accordance with the amount
being purchased or sold by each. There may be circumstances when purchases or
sales of portfolio securities for one or more clients will have an adverse
effect on other clients.
Brokerage and Research Services
There is generally no stated commission in the case of debt securities,
which are traded in the over-the-counter markets, but the price paid by the Fund
usually includes an undisclosed dealer commission or mark-up. In underwritten
offerings, the price paid by the Fund includes a disclosed, fixed commission or
discount retained by the underwriter or dealer. Transactions on U.S. stock
exchanges and other agency transactions involve the payment by the Fund of
negotiated brokerage commissions. Such commissions vary among different brokers.
Also, a particular broker may charge different commissions according to such
factors as the difficulty and size of the transaction.
Subject to the supervision of the Manager, PIMCO places all orders for
the purchase and sale of portfolio securities, options, futures contracts and
other instruments for the Fund and buys and sells such securities, options,
futures and other instruments for the Fund through a substantial number of
brokers and dealers. In so doing, PIMCO uses its best efforts to obtain for the
Fund the most favorable price and execution available, except to the extent it
may be permitted to pay higher brokerage commissions as described below. In
seeking the most favorable price and execution, PIMCO, having in mind the Fund's
best interests, considers all factors it deems relevant, including, by way of
illustration, price, the size of the transaction, the nature of the market for
the security, the amount of the commission, the timing of the transaction taking
into account market prices and trends, the reputation, experience and financial
stability of the broker-dealer involved and the quality of service rendered by
the broker-dealer in other transactions.
Subject to the supervision of the Manager, PIMCO places orders for the
purchase and sale of portfolio investments for the Fund's account with brokers
or dealers selected by it in its discretion. In effecting purchases and sales of
portfolio securities for the account of the Fund, PIMCO will seek the best price
and execution of the Fund's orders. In doing so, the Fund may pay higher
commission rates than the lowest available when PIMCO believes it is reasonable
to do so in light of the value of the brokerage and research services provided
by the broker effecting the transaction, as discussed below.
46
It has for many years been a common practice in the investment advisory
business for advisers of investment companies and other institutional investors
to receive research services from broker-dealers which execute portfolio
transactions for the clients of such advisers. Consistent with this practice,
PIMCO may receive research services from many broker-dealers with which PIMCO
places the Fund's portfolio transactions. PIMCO may also receive research or
research credits from brokers which are generated from underwriting commissions
when purchasing new issues of debt securities or other assets for the Fund.
These services, which in some cases may also be purchased for cash, include such
matters as general economic and security market reviews, industry and company
reviews, evaluations of securities and recommendations as to the purchase and
sale of securities. Some of these services are of value to PIMCO in advising
various of its clients (including the Fund), although not all of these services
are necessarily useful and of value in managing the Fund. Neither the management
fee paid by the Fund to the Manager nor the portfolio management fee paid by the
Manager to PIMCO is reduced because PIMCO and its affiliates receive such
services.
As permitted by Section 28(e) of the Securities Exchange Act of 1934,
PIMCO may cause the Fund to pay a broker-dealer which provides "brokerage and
research services" (as defined in such Act) to PIMCO an amount of disclosed
commission for effecting a securities transaction for the Fund in excess of the
commission which another broker-dealer would have charged for effecting that
transaction.
The Fund may use broker-dealers that are affiliates (or affiliates of
affiliates) of the Fund, the Manager and/or PIMCO, subject to certain
restrictions discussed above under "Investment Manager and Portfolio
Manager--Investment Advisor."
References to PIMCO in this section would apply equally to the Manager
if the Manager were to assume portfolio management responsibilities for the Fund
and place orders for the purchase and sale of the Fund's portfolio investments.
DISTRIBUTIONS
See "Description of APS -- Dividends" and "Description of
capital structure" in the Prospectus for information relating to distributions
made to Fund shareholders.
For tax purposes, the Fund is currently required to allocate net
capital gain and other taxable income, if any, between and among the Common
Shares, the Series A Preferred Shares, the Series B Preferred Shares, the
Series C Preferred Shares, the Series D Preferred Shares, and the Series E
Preferred Shares in proportion to total distributions paid to each class for the
year in which such net capital gain or other taxable income is realized.
While any Preferred Shares are outstanding, the Fund may not declare
any cash dividend or other distribution on its Common Shares unless at the time
of such declaration (1) all accumulated dividends on the Preferred Shares have
been paid and (2) the net asset value of the Fund's portfolio (determined after
deducting the amount of such dividend or other distribution) is at least 200% of
the liquidation value of any outstanding Preferred Shares. This latter
limitation on the Fund's ability to make distributions on its Common Shares
could cause the Fund to incur income and excise tax and, under certain
circumstances, impair the ability of the Fund to maintain its qualification for
taxation as a regulated investment company. See "Tax Matters."
47
The Board of Trustees has declared a dividend of $0.084375 per common
share payable on September 9, 2002.
DESCRIPTION OF SHARES
Common Shares
The Declaration authorizes the issuance of an unlimited number of
Common Shares. The Common Shares currently outstanding have been issued with a
par value of $0.00001 per share. All Common Shares have equal rights as to the
payment of dividends and the distribution of assets upon liquidation of the
Fund. The Common Shares currently outstanding have been fully paid and, subject
to matters discussed in "Anti-Takeover and Other Provisions in the Declaration
of Trust--Shareholder Liability" below, non-assessable, and will have no
pre-emptive or conversion rights or rights to cumulative voting. At any time
when the Preferred Shares are outstanding, Common Shareholders will not be
entitled to receive any distributions from the Fund unless all accrued dividends
on Preferred Shares have been paid, and unless asset coverage (as defined in the
1940 Act) with respect to Preferred Shares would be at least 200% after giving
effect to such distributions. See "Description of APS - Dividends - Restrictions
on Dividends and Other Payments" and "Description of capital structure" in the
Prospectus.
The Common Shares are listed on the New York Stock Exchange, subject to
notice of issuance. The Fund intends to hold annual meetings of shareholders so
long as the Common Shares are listed on a national securities exchange and such
meetings are required as a condition to such listing.
Shares of closed-end investment companies may frequently trade at
prices lower than net asset value. Shares of closed-end investment companies
like the Fund that invest predominantly in investment grade Municipal Bonds have
during some periods traded at prices higher than net asset value and during
other periods traded at prices lower than net asset value. There can be no
assurance that Common Shares or shares of other municipal funds will trade at a
price higher than net asset value in the future. Net asset value generally
increases when interest rates decline, and decreases when interest rates rise,
and these changes are likely to be greater in the case of a fund, such as the
Fund, having a leveraged capital structure. Whether investors realize gains or
losses upon the sale of Common Shares does not depend upon the Fund's net asset
value but depends entirely upon whether the market price of the Common Shares at
the time of sale is above or below the original purchase price for the shares.
Since the market price of the Common Shares is determined by factors beyond the
control of the Fund, the Fund cannot predict whether the Common Shares will
trade at, below, or above net asset value or at, below or above the initial
public offering price. Accordingly, the Common Shares are designed primarily for
long-term investors, and investors in the Common Shares should not view the Fund
as a vehicle for trading purposes.
Preferred Shares
See "Description of APS" and "Description of capital structure" in
the Prospectus for information relating to the Preferred Shares.
48
issuances of securities of the Fund or such series or class upon the exercise of
any stock subscription rights distributed by the Fund; or (3) a sale, lease,
exchange, mortgage, pledge,
ANTI-TAKEOVER AND OTHER PROVISIONS IN THE DECLARATION OF TRUST
Shareholder Liability
Under Massachusetts law, shareholders could, under certain
circumstances, be held personally liable for the obligations of the Fund.
However, the Declaration contains an express disclaimer of shareholder liability
for acts or obligations of the Fund and requires that notice of such disclaimer
be given in each agreement, obligation or instrument entered into or executed by
the Fund or the Trustees. The Declaration also provides for indemnification out
of the Fund's property for all loss and expense of any shareholder held
personally liable on account of being or having been a shareholder. Thus, the
risk of a shareholder incurring financial loss on account of shareholder
liability is limited to circumstances in which such disclaimer is inoperative or
the Fund is unable to meet its obligations, and thus should be considered
remote.
Anti-Takeover Provisions
As described below, the Declaration includes provisions that could have
the effect of limiting the ability of other entities or persons to acquire
control of the Fund or to change the composition of its Board of Trustees, and
could have the effect of depriving shareholders of opportunities to sell their
shares at a premium over prevailing market prices by discouraging a third party
from seeking to obtain control of the Fund.
The Fund's Trustees are divided into three classes (Class I, Class II
and Class III), having initial terms of one, two and three years, respectively.
At each annual meeting of shareholders, the term of one class will expire and
each Trustee elected to that class will hold office for a term of three years.
The classification of the Board of Trustees in this manner could delay for an
additional year the replacement of a majority of the Board of Trustees. In
addition, the Declaration provides that a Trustee may be removed only for cause
and only (i) by action of at least seventy-five percent (75%) of the outstanding
shares of the classes or series of shares entitled to vote for the election of
such Trustee, or (ii) by at least seventy-five percent (75%) of the remaining
Trustees.
Except as provided in the next paragraph, the affirmative vote or
consent of at least seventy-five percent (75%) of the Board of Trustees and at
least seventy-five percent (75%) of the shares of the Fund outstanding and
entitled to vote thereon are required to authorize any of the following
transactions (each a "Material Transaction"): (1) a merger, consolidation or
share exchange of the Fund or any series or class of shares of the Fund with or
into any other person or company, or of any such person or company with or into
the Fund or any such series or class of shares; (2) the issuance or transfer by
the Fund or any series or class of shares (in one or a series of transactions in
any twelve-month period) of any securities of the Fund or such series or class
to any other person or entity for cash, securities or other property (or
combination thereof) having an aggregate fair market value of $1,000,000 or
more, excluding sales of securities of the Fund or such series or class in
connection with a public offering, issuances of securities of the Fund or such
series or class pursuant to a dividend reinvestment plan adopted by the Fund and
issuances of securities of the Fund or such series or class upon the exercise of
any stock subscription rights distributed by the Fund; or (3) a sale, lease,
exchange, mortgage, pledge,
49
transfer or other disposition by the Fund or any series or class of shares (in
one or a series of transactions in any twelve-month period) to or with any
person of any assets of the Fund or such series or class having an aggregate
fair market value of $1,000,000 or more, except for transactions in securities
effected by the Fund or such series or class in the ordinary course of its
business. The same affirmative votes are required with respect to any
shareholder proposal as to specific investment decisions made or to be made with
respect to the Fund's assets or the assets of any series or class of shares of
the Fund.
Notwithstanding the approval requirements specified in the preceding
paragraph, the Declaration requires no vote or consent of the Fund's
shareholders to authorize a Material Transaction if the transaction is approved
by a vote of both a majority of the Board of Trustees and seventy-five percent
(75%) of the Continuing Trustees (as defined below), so long as all other
conditions and requirements, if any, provided for in the Fund's Amended By-Laws
and applicable law (including any shareholder voting rights under the 1940 Act)
have been satisfied.
In addition, the Declaration provides that the Fund may be terminated
at any time by vote or consent of at least seventy-five percent (75%) of the
Fund's shares or, alternatively, by vote or consent of both a majority of the
Board of Trustees and seventy-five percent (75%) of the Continuing Trustees (as
defined below).
In certain circumstances, the Declaration also imposes shareholder
voting requirements that are more demanding than those required under the 1940
Act in order to authorize a conversion of the Fund from a closed-end to an
open-end investment company. See "Repurchase of Common Shares; Conversion to
Open-End Fund" below.
As noted, the voting provisions described above could have the effect
of depriving Common Shareholders of an opportunity to sell their Common Shares
at a premium over prevailing market prices by discouraging a third party from
seeking to obtain control of the Fund in a tender offer or similar transaction.
In the view of the Fund's Board of Trustees, however, these provisions offer
several possible advantages, including: (1) requiring persons seeking control of
the Fund to negotiate with its management regarding the price to be paid for the
amount of Common Shares required to obtain control; (2) promoting continuity and
stability; and (3) enhancing the Fund's ability to pursue long-term strategies
that are consistent with its investment objective and management policies. The
Board of Trustees has determined that the voting requirements described above,
which are generally greater than the minimum requirements under the 1940 Act,
are in the best interests of the Common Shareholders generally.
A "Continuing Trustee," as used in the discussion above, is any member
of the Fund's Board of Trustees who either (i) has been a member of the Board
for a period of at least thirty-six months (or since the commencement of the
Fund's operations, if less than thirty-six months) or (ii) was nominated to
serve as a member of the Board of Trustees by a majority of the Continuing
Trustees then members of the Board.
The foregoing is intended only as a summary and is qualified in its
entirety by reference to the full text of the Declaration and the Fund's Amended
By-Laws, both of which have been filed as exhibits to the Fund's registration
statement on file with the SEC.
50
Liability of Trustees
The Declaration provides that the obligations of the Fund are not
binding upon the Trustees of the Fund individually, but only upon the assets and
property of the Fund, and that the Trustees shall not be liable for errors of
judgment or mistakes of fact or law. Nothing in the Declaration, however,
protects a Trustee against any liability to which he would otherwise be subject
by reason of willful misfeasance, bad faith, gross negligence or reckless
disregard of the duties involved in the conduct of his office.
REPURCHASE OF FUND SHARES; CONVERSION TO OPEN-END FUND
The Fund is a closed-end investment company and as such its
shareholders will not have the right to cause the Fund to redeem their shares.
Instead, the Common Shares will trade in the open market at a price that will be
a function of several factors, including dividend levels (which are in turn
affected by expenses), net asset value, call protection, price, dividend
stability, relative demand for and supply of such shares in the market, general
market and economic conditions and other factors. Shares of a closed-end
investment company may frequently trade at prices lower than net asset value.
The Fund's Board of Trustees regularly monitors the relationship between the
market price and net asset value of the Common Shares. If the Common Shares were
to trade at a substantial discount to net asset value for an extended period of
time, the Board may consider the repurchase of its Common Shares on the open
market or in private transactions, or the making of a tender offer for such
shares. There can be no assurance, however, that the Board of Trustees will
decide to take or propose any of these actions, or that share repurchases or
tender offers, if undertaken, will reduce market discount. The Fund has no
present intention to repurchase its Common Shares and would do so only in the
circumstances described in this section.
Notwithstanding the foregoing, at any time when the Preferred Shares
are outstanding, the Fund may not purchase, redeem or otherwise acquire any of
its Common Shares unless (1) all accrued dividends on Preferred Shares have been
paid and (2) at the time of such purchase, redemption or acquisition, the net
asset value of the Fund's portfolio (determined after deducting the acquisition
price of the Common Shares) is at least 200% of the liquidation value of the
outstanding Preferred Shares (expected to equal the original purchase price per
share plus any accrued and unpaid dividends thereon).
Subject to its investment limitations, the Fund may borrow to finance
the repurchase of shares or to make a tender offer. Interest on any borrowings
to finance share repurchase transactions or the accumulation of cash by the Fund
in anticipation of share repurchases or tenders will reduce the Fund's net
income. Any share repurchase, tender offer or borrowing that might be approved
by the Board of Trustees would have to comply with the Securities Exchange Act
of 1934, as amended, and the 1940 Act and the rules and regulations thereunder.
The Fund's Board of Trustees may also from time to time consider
submitting to the holders of the shares of beneficial interest of the Fund a
proposal to convert the Fund to an open-end investment company. In determining
whether to exercise its sole discretion to submit this issue to shareholders,
the Board of Trustees would consider all factors then relevant, including the
relationship of the market price of the Common Shares to net asset value, the
extent to which the Fund's capital structure is leveraged and the possibility of
re-leveraging, the spread, if any,
51
between the yields on securities in the Fund's portfolio and interest and
dividend charges on Preferred Shares issued by the Fund and general market and
economic conditions.
The Declaration requires the affirmative vote or consent of holders of
at least seventy-five percent (75%) of each class of the Fund's shares entitled
to vote on the matter to authorize a conversion of the Fund from a closed-end to
an open-end investment company, unless the conversion is authorized by both a
majority of the Board of Trustees and seventy-five percent (75%) of the
Continuing Trustees (as defined above under "Anti-Takeover and Other Provisions
in the Declaration of Trust--Anti-Takeover Provisions"). This seventy-five
percent (75%) shareholder approval requirement is higher than is required under
the 1940 Act. In the event that a conversion is approved by the Trustees and the
Continuing Trustees as described above, the minimum shareholder vote required
under the 1940 Act would be necessary to authorize the conversion. Currently,
the 1940 Act would require approval of the holders of a "majority of the
outstanding" Common Shares and, if issued, Preferred Shares voting together as a
single class, and the holders of a "majority of the outstanding" Preferred
Shares voting as a separate class, in order to authorize a conversion.
If the Fund converted to an open-end company, it would be required to
redeem all Preferred Shares then outstanding (requiring in turn that it
liquidate a portion of its investment portfolio), and the Common Shares likely
would no longer be listed on the New York Stock Exchange. Shareholders of an
open-end investment company may require the company to redeem their shares on
any business day (except in certain circumstances as authorized by or under the
1940 Act) at their net asset value, less such redemption charge, if any, as
might be in effect at the time of redemption. In order to avoid maintaining
large cash positions or liquidating favorable investments to meet redemptions,
open-end companies typically engage in a continuous offering of their shares.
Open-end companies are thus subject to periodic asset in-flows and out-flows
that can complicate portfolio management.
The repurchase by the Fund of its shares at prices below net asset
value will result in an increase in the net asset value of those shares that
remain outstanding. However, there can be no assurance that share repurchases or
tenders at or below net asset value will result in the Fund's shares trading at
a price equal to their net asset value. Nevertheless, the fact that the Fund's
shares may be the subject of repurchase or tender offers at net asset value from
time to time, or that the Fund may be converted to an open-end company, may
reduce any spread between market price and net asset value that might otherwise
exist.
In addition, a purchase by the Fund of the Common Shares will decrease
the Fund's total assets. This would likely have the effect of increasing the
Fund's expense ratio. Any purchase by the Fund of the Common Shares at a time
when Preferred Shares are outstanding will increase the leverage applicable to
the outstanding Common Shares then remaining. See the Prospectus under
"Risks--Leverage Risk."
Before deciding whether to take any action if the Common Shares trade
below net asset value, the Board of Trustees would consider all relevant
factors, including the extent and duration of the discount, the liquidity of the
Fund's portfolio, the impact of any action that might be taken on the Fund or
its shareholders and market considerations. Based on these considerations, even
if the Fund's shares should trade at a discount, the Board of Trustees may
determine that, in the interest of the Fund and its shareholders, no action
should be taken.
52
TAX MATTERS
Taxation of the Fund. The Fund intends to qualify each year as a
regulated investment company under Subchapter M of the Code. In order to qualify
for the special tax treatment accorded regulated investment companies and their
shareholders, the Fund must, among other things:
(a) derive at least 90% of its gross income from dividends, interest,
payments with respect to certain securities loans, and gains from the
sale 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;
(b) distribute with respect to each taxable year at least 90% of the
sum of its net tax-exempt income, taxable ordinary income and the
excess, if any, of net short-term capital gains over net long-term
capital losses for such year; and
(c) diversify its holdings so that, at the end of each quarter of the
Fund's taxable year, (i) at least 50% of the market value of the Fund's
total assets is represented by cash and cash items, U.S. government
securities, securities of other regulated investment companies, and
other securities limited in respect of any one issuer to a value not
greater than 5% of the value of the Fund's 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 Fund's total assets is invested
in the securities (other than those of the U.S. government or other
regulated investment companies) of any one issuer or of two or more
issuers which the Fund controls and which are engaged in the same,
similar, or related trades or businesses.
If the Fund qualifies as a regulated investment company that is accorded special
tax treatment, the Fund will not be subject to 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 failed to qualify as a regulated investment company
accorded special tax treatment in any taxable 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. Such distributions generally would be eligible for the dividends
received deduction in the case of corporate shareholders. In addition, the Fund
could be required to recognize unrealized gains, pay substantial taxes and
interest and make substantial distributions before requalifying as a regulated
investment company that is accorded special tax treatment.
The Fund intends to distribute at least annually to its shareholders
all or substantially all of its net tax-exempt interest and any investment
company taxable income, and may distribute its net capital gain. The Fund may
also retain for investment its net capital gain. If the Fund does retain any net
capital gain or any investment company taxable income, it will be subject to tax
at regular corporate rates on the amount retained. If the Fund retains any net
capital gain, it may designate the retained amount as undistributed capital
gains in a notice to its shareholders who, if subject to federal income tax on
long-term capital gains, (i) will be required to include in income for federal
income tax purposes, as long-term capital gain, their shares of such
undistributed
53
amount, and (ii) will be entitled to credit their proportionate shares of the
tax paid by the Fund on such undistributed amount against their federal income
tax liabilities, if any, and to claim refunds to the extent the credit exceeds
such liabilities. For federal income tax purposes, the tax basis of shares owned
by a shareholder of the Fund will be increased by an amount equal under current
law to the difference between the amount of undistributed capital gains included
in the shareholder's gross income and the tax deemed paid by the shareholder
under clause (ii) of the preceding sentence.
Treasury regulations permit a regulated investment company, in
determining its investment company taxable income and net capital gain, to elect
to treat all or part of any net capital loss, any net long-term capital loss or
any net foreign currency loss incurred after October 31 as if it had been
incurred in the succeeding year.
If the Fund fails to distribute in a calendar year at least an amount
equal to the sum of 98% of its ordinary income for such year and 98% of its
capital gain net income for the one-year period ending October 31 of such year,
plus any retained amount from the prior year, the Fund will be subject to a 4%
excise tax on the undistributed amounts. For these purposes, the Fund will be
treated as having distributed any amount for which it is subject to income tax.
A dividend paid to shareholders in January of a year 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. The Fund intends generally to make
distributions sufficient to avoid imposition of the 4% excise tax.
Fund Distributions. Distributions from the Fund (other than
exempt-interest dividends, as discussed below) will be taxable to shareholders
as ordinary income to the extent derived from investment income and net
short-term capital gains. Distributions of net capital gains (that is, the
excess of net gains from the sale of capital assets held more than one year over
net losses from the sale of capital assets held for not more than one year)
properly designated as capital gain dividends ("Capital Gain Dividends") will be
taxable to shareholders as long-term gain, regardless of how long a shareholder
has held the shares in the Fund.
The Fund's expenses attributable to earning tax-exempt income do not
reduce its current earnings and profits; therefore, distributions in excess of
the sum of the Fund's net tax-exempt and taxable income may be treated as
taxable dividends to the extent of the Fund's remaining earnings and profits
(which provides the measure of the Fund's dividend-paying capacity for tax
purposes). Distributions in excess of the sum of the Fund's net tax-exempt and
taxable income could occur, for example, if the Fund's book income exceeded the
sum of its net tax-exempt and taxable income. Differences in the Fund's book
income and its net tax-exempt and taxable income may arise from certain of the
Fund's hedging and investment activities. See "--Hedging Transactions" below.
Exempt-interest dividends. The Fund will be qualified to pay
exempt-interest dividends to its shareholders only if, at the close of each
quarter of the Fund's taxable year, at least 50% of the total value of the
Fund's assets consists of obligations the interest on which is exempt from
federal income tax under Code Section 103(a). Distributions that the Fund
properly designates as exempt-interest dividends are treated as interest
excludable from shareholders' gross income for federal income tax purposes but
may be taxable for federal alternative minimum tax ("AMT") purposes and for
state and local purposes. Because the Fund intends to qualify to pay
54
exempt-interest dividends, the Fund may be limited in its ability to enter into
taxable transactions involving forward commitments, repurchase agreements,
financial futures and options contracts on financial futures, tax-exempt bond
indices and other assets.
The receipt of exempt-interest dividends may affect the portion, if
any, of a person's Social Security and Railroad Retirement benefits that will be
includable in gross income subject to federal income tax. Up to 85% of Social
Security and Railroad Retirement benefits may be included in gross income in
cases where the recipient's combined income, consisting of adjusted gross income
(with certain adjustments), tax-exempt interest income and one-half of any
Social Security and Railroad Retirement benefits, exceeds an adjusted base
amount ($34,000 for a single individual and $44,000 for individuals filing a
joint return). Shareholders receiving Social Security or Railroad Retirement
benefits should consult their tax advisers.
Under the Code, the interest on certain "private activity bonds" issued
after August 7, 1986 is treated as a preference item and is (after reduction by
applicable expenses) included in federal alternative minimum taxable income. The
Fund will furnish to shareholders annually a report indicating the percentage of
Fund income treated as a preference item for federal AMT purposes. In addition,
for corporations, alternative minimum taxable income is increased by a
percentage of the excess of an alternative measure of income that includes
interest on all tax-exempt securities over the amount otherwise determined to be
alternative minimum taxable income. Accordingly, the portion of the Fund's
dividends that would otherwise be tax-exempt to the shareholders may cause an
investor to be subject to the AMT or may increase the tax liability of an
investor who is subject to such tax. As described above, the portfolio manager
will normally avoid investments in bonds potentially subjecting individuals to
the AMT, which generally includes private activity bonds.
Legislation has been introduced in recent years that would reinstate a
deductible tax (the "Environmental Tax") imposed through tax years beginning
before 1996 at a rate of 0.12% on a corporation's alternative minimum taxable
income (computed without regard to the AMT net operating loss deduction) in
excess of $2 million. If the Environmental Tax is reinstated, exempt-interest
dividends that are included in a corporate shareholder's alternative minimum
taxable income may subject corporate shareholders of the Fund to the
Environmental Tax.
The Fund designates distributions made to the share classes as
consisting of a portion of each type of income distributed by the Fund. The
portion of each type of income deemed received by each class of shareholders is
equal to the portion of total Fund distributions received by such class. Thus,
the Fund will designate dividends paid as exempt-interest dividends in a manner
that allocates such dividends between and among the Common Shares, the Series A
Preferred Shares, the Series B Preferred Shares, the Series C Preferred
Shares, the Series D Preferred Shares and the Series E Preferred Shares in
proportion to the total dividends paid to each class during or with respect to
the taxable year or otherwise as required by applicable law. Long-term capital
gain distributions and other income subject to regular federal income tax will
similarly be allocated between and among the two (or more) classes.
55
Dividends (including Capital Gain Dividends) will be taxable as
described above whether received in cash or in shares. A shareholder whose
distributions are reinvested in shares will be treated as having received a
dividend equal to either (i) the fair market value of the new shares issued to
the shareholder, or (ii) if the shares are trading below net asset value, the
amount of cash allocated to the shareholder for the purchase of shares on its
behalf in the open market.
Part or all of the interest on indebtedness, if any, incurred or
continued by a shareholder to purchase or carry shares of the Fund paying
exempt-interest dividends is not deductible. The portion of interest that is not
deductible is equal to the total interest paid or accrued on the indebtedness,
multiplied by the percentage of the Fund's total distributions (not including
distributions from net long-term capital gains) paid to the shareholder that are
exempt-interest dividends. Under rules used by the Internal Revenue Service (the
"Service") to determine when borrowed funds are considered used for the purpose
of purchasing or carrying particular assets, the purchase of shares may be
considered to have been made with borrowed funds even though such funds are not
directly traceable to the purchase of shares.
Under a published position of the Service, a shareholder's interest
deduction generally will not be disallowed if the average adjusted basis of the
shareholder's tax-exempt obligations (including shares of preferred stock) does
not exceed two percent of the average adjusted basis of the shareholder's trade
or business assets (in the case of most corporations) or portfolio investments
(in the case of individuals). Legislation has been introduced in recent years
that would further limit or repeal this two-percent de minimis exception, thus
reducing the total after-tax yield of a shareholder.
In general, exempt-interest dividends, if any, attributable to interest
received on certain private activity obligations and certain industrial
development bonds will not be tax-exempt to any shareholders who are
"substantial users," within the meaning of Section 147(a) of the Code, of the
facilities financed by such obligations or bonds or who are "related persons" of
such substantial users.
The Fund will inform investors within 60 days of the Fund's fiscal
year-end of the percentage of its income distributions designated as tax-exempt.
The percentage is applied uniformly to all distributions made in respect of
Common Shares during the year; percentages may differ among distributions to
holders of Preferred Shares. The percentage of income designated as tax-exempt
for any particular distribution, whether to holders of Common Shares or holders
of Preferred Shares, may be substantially different from the percentage of the
Fund's income that was tax-exempt during the period covered by the distribution.
Hedging Transactions. If the Fund engages in hedging transactions,
including hedging transactions in options, futures contracts, and straddles, or
other similar transactions, it will be subject to special tax rules (including
constructive sale, mark-to-market, straddle, wash sale, and short sale rules),
the effect of which may be to accelerate income to the Fund, defer losses to the
Fund, cause adjustments in the holding periods of the Fund's securities, convert
long-term capital gains into short-term capital gains or convert short-term
capital losses into long-term capital losses. These rules could therefore affect
the amount, timing and character of distributions to shareholders. Income earned
as a result of the Fund's hedging activities will not be eligible to be treated
as exempt-interest dividends when distributed to shareholders. The Fund will
endeavor to make any available elections pertaining to such transactions in a
manner
56
believed to be in the best interests of the Fund.
Certain of the Fund's hedging activities are likely to produce a
difference between its book income and the sum of its net tax-exempt and taxable
income. If the Fund's book income exceeds its net tax-exempt and taxable income,
the distribution (if any) of such excess will be treated as (i) a taxable
dividend to the extent of the Fund's 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 recipient's basis in the shares, and
(iii) thereafter as gain from the sale or exchange of a capital asset. If the
Fund's book income is less than its taxable income, the Fund could be required
to make distributions exceeding book income to qualify as a regulated investment
company that is accorded special tax treatment.
Return of Capital Distributions. If the Fund makes a distribution to a
shareholder in excess of the Fund's current and accumulated earnings and profits
in any taxable year, the excess distribution will be treated as a return of
capital to the extent of such shareholder's tax basis in its shares, and
thereafter as capital gain. A return of capital is not taxable, but it reduces a
shareholder's tax basis in its shares, thus reducing any loss or increasing any
gain on a subsequent taxable disposition by the shareholder of its shares. Where
one or more such distributions occur in any taxable year of the Fund, the
available earnings and profits will be allocated, first, to the distributions
made to the holders of Preferred Shares, and only thereafter to distributions
made to holders of Common Shares. As a result, the holders of Preferred Shares
will receive a disproportionate share of the distributions treated as dividends,
and the holders of the Common Shares will receive a disproportionate share of
the distributions treated as a return of capital.
Dividends and distributions on the Fund's shares are generally subject
to federal income tax as described herein to the extent they do not exceed the
Fund's realized income and gains, even though such dividends and distributions
may economically represent a return of a particular shareholder's investment.
Such distributions are likely to occur in respect of shares purchased at a time
when the Fund's net asset value reflects gains that are either unrealized, or
realized but not distributed. Such realized gains may be required to be
distributed even when the Fund's net asset value also reflects unrealized
losses. Distributions are taxable to a shareholder even if they are paid from
income or gains earned by the Fund prior to the shareholder's investment (and
thus included in the price paid by the shareholders).
Securities Issued or Purchased at a Discount. The Fund's investment in
securities issued at a discount and certain other obligations will (and
investments in securities purchased at a market discount may) require the Fund
to accrue and distribute income not yet received. In order to generate
sufficient cash to make the requisite distributions, the Fund may be required to
sell securities in its portfolio that it otherwise would have continued to hold.
Capital Loss Carryover. Distributions from capital gains are generally
made after applying any available capital loss carryovers.
Sale 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
57
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, if a shareholder
sells shares at a loss within six months of purchase, any loss will be
disallowed for federal income tax purposes to the extent of any exempt-interest
dividends received on such shares. In addition, any loss realized upon a taxable
disposition of shares held for six months or less but not disallowed as provided
in the preceding sentence will be treated as long-term, rather than short-term,
to the extent of any long-term capital gain distributions received by the
shareholder with respect to the shares. All or a portion of any loss realized
upon a taxable disposition of Fund shares will be disallowed if other shares of
the Fund are purchased 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.
From time to time the Fund may make a tender offer for its Common
Shares. It is expected that the terms of any such offer will require a tendering
shareholder to tender all Common Shares and dispose of all Preferred Shares
held, or considered under certain attribution rules of the Code to be held, by
such shareholder. Shareholders who tender all Common Shares and dispose of all
Preferred Shares held, or considered to be held, by them will be treated as
having sold their shares and generally will realize a capital gain or loss. If a
shareholder tenders fewer than all of its Common Shares, or retains a
substantial portion of its Preferred Shares, such shareholder may be treated as
having received a taxable dividend upon the tender of its Common Shares. In such
a case, there is a remote risk that non-tendering shareholders will be treated
as having received taxable distributions from the Fund. Likewise, if the Fund
redeems some but not all of the Preferred Shares held by a Preferred Shareholder
and such shareholder is treated as having received a taxable dividend upon such
redemption, there is a remote risk that Common Shareholders and non-redeeming
Preferred Shareholders will be treated as having received taxable distributions
from the Fund. To the extent that the Fund recognizes net gains on the
liquidation of portfolio securities to meet such tenders of Common Shares, the
Fund will be required to make taxable distributions to its shareholders, which
may in turn require the Fund to make additional distributions to its Common
Shareholders, and a higher percentage of its distributions to holders of
Preferred Shares will be taxable.
Backup Withholding. The Fund generally is required to withhold and
remit to the U.S. Treasury a percentage of the taxable dividends and other
distributions paid to any individual shareholder who fails to properly furnish
the Fund with a correct taxpayer identification number ("TIN"), 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 tax
rate is (i) 30% for amounts paid during 2002 and 2003, (ii) 29% for amounts paid
during 2004 and 2005, and (iii) 28% for amounts paid during 2006 through 2010.
The backup withholding rate will be 31% for amounts paid after December 31,
2010, unless Congress enacts tax legislation providing otherwise.
In order for a foreign investor to qualify for exemption from the
back-up withholding tax rates under income tax treaties, the foreign investor
must comply with special certification and filing requirements. Foreign
investors in the Fund should consult their tax advisers in this regard.
General. The 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 and
foreign tax law and any proposed tax law changes.
58
PERFORMANCE RELATED AND COMPARATIVE INFORMATION
The Fund may be a suitable investment for a shareholder who is thinking
of adding bond investments to his portfolio to balance the appreciated stocks
that the shareholder is holding. Although the Fund currently intends at all
times to avoid investments generating income potentially subjecting individuals
to the federal alternative minimum tax, it may not be successful in doing so.
Therefore, Preferred Shares may not be a suitable investment for investors who
are subject to the federal alternative minimum tax or who would become subject
to such tax by purchasing Preferred Shares. The suitability of an investment in
Preferred Shares will depend upon a comparison of the after-tax yield likely to
be provided from the Fund with that from comparable tax-exempt investments
(including those not subject to the alternative minimum tax), and from
comparable fully taxable investments, in light of each such investor's tax
position.
The Fund may quote certain performance-related information and may
compare certain aspects of its portfolio and structure to other substantially
similar closed-end funds as categorized by Lipper, Inc. ("Lipper"), Morningstar
Inc. or other independent services. Comparison of the Fund to an alternative
investment should be made with consideration of differences in features and
expected performance. The Fund may obtain data from sources or reporting
services, such as Bloomberg Financial ("Bloomberg") and Lipper, that the Fund
believes to be generally accurate.
The Fund, in its advertisements, may refer to pending legislation from
time to time and the possible impact of such legislation on investors,
investment strategy and related matters. This would include any tax proposals
and their effect on marginal tax rates and tax-equivalent yields. At any time in
the future, yields and total return may be higher or lower than past yields and
there can be no assurance that any historical results will continue.
For the period from June 28, 2002 (the commencement of the Fund's
operations) through July 31, 2002, the Fund's net increase in net assets
resulting from investment operations was $5,500,578.
Past performance is not indicative of future results.
CUSTODIAN, TRANSFER AGENTS AND DIVIDEND DISBURSEMENT AGENTS
State Street Bank and Trust Company, 225 Franklin Street, Boston,
Massachusetts 02110, serves as custodian for assets of the Fund. The custodian
performs custodial and fund accounting services.
PFPC Inc., 400 Bellevue Parkway, Wilmington, Delaware 19809, serves as
the transfer agent, registrar and dividend disbursement agent for the Common
Shares, as well as agent for the Dividend Reinvestment Plan relating to the
Common Shares.
Deutsche Bank Trust Company Americas, 100 Plaza One, 6th Floor, Jersey
City, New Jersey 07311, serves as auction agent, transfer agent, registrar,
dividend paying agent and redemption agent for the Preferred Shares.
59
INDEPENDENT ACCOUNTANTS
PricewaterhouseCoopers LLP, 1177 Avenue of the Americas, New York, New
York 10036, serves as independent accountants for the Fund.
PricewaterhouseCoopers LLP provides audit services, tax return preparation and
assistance and consultation in connection with review of SEC filings to the
Fund.
COUNSEL
Ropes & Gray, One International Place, Boston, MA 02110, passes upon
certain legal matters in connection with shares offered by the Fund and also
acts as counsel to the Fund.
REGISTRATION STATEMENT
A Registration Statement on Form N-2, including any amendments thereto,
relating to the shares of the Fund offered hereby, has been filed by the Fund
with the Securities and Exchange Commission (the "SEC"), Washington, D.C. The
Prospectus and this Statement of Additional Information do not contain all of
the information set forth in the Registration Statement, including any exhibits
and schedules thereto. For further information with respect to the Fund and the
shares offered or to be offered hereby, reference is made to the Fund's
Registration Statement. Statements contained in the Prospectus and this
Statement of Additional Information as to the contents of any contract or other
document referred to are not necessarily complete and in each instance reference
is made to the copy of such contract or other document filed as an exhibit to
the Registration Statement, each such statement being qualified in all respects
by such reference. Copies of the Registration Statement may be inspected without
charge at the SEC's principal office in Washington, D.C., and copies of all or
any part thereof may be obtained from the SEC upon the payment of certain fees
prescribed by the SEC.
60
FINANCIAL STATEMENTS
The Statement of Assets and Liabilities of the Fund dated as of June 19,
2002, and the Statement of Operations for the one-day period ending June 19,
2002, including the Notes thereto, and the report of PricewaterhouseCoopers LLP
thereon dated June 20, 2002, as included in the Fund's Statement of Additional
Information dated June 25, 2002, relating to the Common Shares, is hereby
incorporated by reference into this Statement of Additional Information, which
means that such Statement of Assets and Liabilities, Statement of Operations and
the Notes thereto are considered to be a part of this Statement of Additional
Information. The Statement of Additional Information for the Common Shares was
filed electronically with the SEC on June 27, 2002 (Accession No.
0000927016-02-003450).
61
PIMCO MUNICIPAL INCOME FUND II
STATEMENT OF ASSETS AND LIABILITIES
July 31, 2002
(unaudited)
Assets:
Investments, at value (cost-$710,749,821) ................... $714,850,726
Cash ........................................................ 57,327
Receivable for investments sold ............................. 158,823,388
Interest receivable ......................................... 6,627,397
Prepaid expenses ............................................ 24,310
------------
Total Assets ............................................ 880,383,148
------------
Liabilities:
Payable for investments purchased ........................... 88,756,575
Investment management fee payable ........................... 341,623
Common stock offering expenses payable ...................... 128,200
Accrued expenses ............................................ 18,669
------------
Total Liabilities ....................................... 89,245,067
------------
Net Assets ....................................... $791,138,081
============
Composition of Net Assets:
Par value ($0.00001 per share, applicable to 54,906,981
shares of common stock issued and outstanding) ............. 549
Paid-in-capital in excess of par ............................ 785,636,954
Undistributed net investment income ......................... 1,399,673
Net unrealized appreciation of investments .................. 4,100,905
------------
Net Assets ..................................... $791,138,081
============
Net asset value per share ...................... $14.41
======
See accompanying notes to financial information.
62
PIMCO MUNICIPAL INCOME FUND II
STATEMENT OF OPERATIONS
For the period June 28, 2002* through July 31, 2002
(unaudited)
Investment Income:
Interest ....................................................... $1,779,927
----------
Expenses:
Investment management fees ..................................... 341,623
Custodian fees ................................................. 13,600
Trustees' fees and expenses .................................... 5,440
Legal fees ..................................................... 5,100
Audit and tax service fees ..................................... 4,590
Reports to shareholders ........................................ 3,400
Transfer agent fees ............................................ 2,720
Miscellaneous .................................................. 3,781
----------
Total expenses .............................................. 380,254
----------
Net investment income .................................... 1,399,673
----------
Unrealized Gain on Investments:
Net unrealized appreciation of investments .................. 4,100,905
----------
Net increase in net assets resulting from investment operations .. $5,500,578
==========
--------------------------------------------------------------------------------
STATEMENT OF CHANGES IN NET ASSETS
For the period June 28, 2002* through July 31, 2002
(unaudited)
Income from Investment Operations:
Net investment income .......................................... $ 1,399,673
Net unrealized appreciation of investments ..................... 4,100,905
------------
Net increase in net assets resulting from investment
operations ............................................... 5,500,578
------------
Share Transactions:
Net proceeds from the sale of shares ........................... 786,442,500
Common stock offering costs charged to paid-in-capital in
excess of par ............................................... (905,000)
------------
Total share transactions .................................... 785,537,500
------------
Total increase in net assets ............................. 791,038,078
------------
Net Assets:
Beginning of period ............................................ 100,003
------------
End of period (including undistributed net investment
income of $1,399,673) ....................................... $791,138,081
============
63
Shares Issued:
Issued ...................................................... 54,900,000
------------
---------------------------
* Commencement of operations
See accompanying notes to financial information.
64
PIMCO MUNICIPAL INCOME FUND II
NOTES TO FINANCIAL INFORMATION
July 31, 2002
(unaudited)
1. Organization
PIMCO Municipal Income Fund II, (the "Fund") was organized as a Massachusetts
business trust on March 29, 2002. Prior to commencing operations on June 28,
2002, the Fund had no operations other than matters relating to its organization
and registration as a diversified, closed-end management investment company
under the Investment Company Act of 1940, as amended, and the sale and issuance
to PIMCO Funds Advisors LLC (the "Investment Manager"), an indirect,
majority-owned subsidiary of Allianz AG, of 6,981 shares of beneficial interest
at an aggregate purchase price of $100,003. The Investment Manager has agreed to
reimburse the amount by which the aggregate of all the Fund's organizational
expenses and offering costs (other than the sales load) exceeds $0.03 per share.
There are an unlimited number of $0.00001 par value common stock authorized.
2. Accounting Policies
(a) Valuation of Investments
Debt securities are valued daily by an independent pricing service approved by
the Board of Trustees. Any security or other asset for which market quotations
are not readily available is valued at fair value as determined in good faith
under procedures established by the Board of Trustees. The Fund invests
substantially all of its assets in municipal bonds the interest from which is
exempt from federal income taxes. The Fund will seek to avoid bonds generating
interest income which could potentially subject individuals to alternative
minimum tax. The Fund is susceptible to political, economic, regulatory and
other factors affecting issues of a specific state or region. The issuers'
ability to meet its obligations may be affected by the economic condition of the
facility or specific revenue source from whose revenue payments of obligations
may be made.
(b) Investment Transactions and Investment Income
Investment transactions are accounted for on the trade date. Realized gains and
losses on investments are determined on the identified cost basis. Interest
income is recorded on an accrual basis. Original issue discounts or premiums on
debt securities purchased are accreted or amortized daily to non-taxable
interest income. Market discounts, if any, are accreted daily to taxable income.
65
PIMCO MUNICIPAL INCOME FUND II
NOTES TO FINANCIAL INFORMATION
July 31, 2002
(unaudited) (concluded)
(c) Expense Offset
The Fund benefits from an expense offset arrangement with its custodian bank
whereby uninvested cash balances earn credits which reduce monthly custodian
expenses. Had these cash balances been invested in income producing securities,
they would have generated income for the Fund.
(d) Federal Income Taxes
The Fund intends to distribute all of its taxable income and comply with the
requirements of the U.S. Internal Revenue Code of 1986, as amended, applicable
to regulated investment companies. Accordingly, no provision for U.S. federal
income taxes is required. In addition, by distributing substantially all of its
taxable ordinary income and long-term capital gains, if any, during each
calendar year, the Fund intends not to be subject to U. S. federal excise tax.
3. Investment Manager and Related Parties
Pursuant to the Investment Management Agreement, the Fund pays the Investment
Manager an annual management fee, payable monthly, at the annual rate of 0.65%
of the Fund's average daily net assets, inclusive of net assets attributable to
any preferred shares that may be issued. The Investment Manager has retained its
affiliate, Pacific Investment Management Company LLC ("PIMCO"), to manage the
Fund's investments. The Investment Manager (not the Fund) will pay a portion of
the fees it receives as Investment Manager to PIMCO in return for its services,
at the maximum annual rate of 0.50% of the Fund's average daily net assets,
inclusive of net assets attributable to any preferred shares that may be issued.
In order to reduce Fund expenses, the Investment Manager has contractually
agreed to waive a portion of its investment management fees at the annual rate
of 0.15% of the Fund's average daily net assets, inclusive of net assets
attributable to any preferred shares that may be issued, from the commencement
of operations through June 30, 2007, and for a declining amount thereafter
through June 30, 2009. PIMCO has contractually agreed to waive a portion of the
fees it is entitled to receive from the Investment Manager such that it will
receive 0.26% of Fund's average daily net assets, inclusive of any net assets
attributable to any preferred shares issued from the commencement of operations
through June 30, 2007, and an increasing amount thereafter through June 30,
2009.
66
PIMCO MUNICIPAL INCOME FUND II
SCHEDULE OF INVESTMENTS
July 31, 2002
(unaudited)
Principal
Amount
(000) Cusip # Value*
-----------------------------------------------------------------------------------------------------------------------------
MUNICIPAL BONDS & NOTES - 55.6%
Alabama-0.2%
$1,750 44706HBN6 Huntsville Health Care Auth., Ser. B,
5.75%, 6/1/32 ..................................................... $ 1,763,860
------------
Colorado-2.9%
5,000 249183LZ5 Denver Co. City & Cnty. Cert. of Participation, Ser. B,
5.50%, 12/1/25 .................................................... 5,218,200
18,305 196474ZU7 Health Fac. Auth. Rev., Exempla Inc.,
5.625%, 1/1/33 .................................................... 18,184,004
------------
23,402,204
------------
District of Columbia-2.1%
17,500 93877MAS5 Washington DC Convention Ctr. Auth. Tax Rev.,
4.75%, 10/1/28 .................................................... 16,308,950
------------
Florida-3.2%
1,925 432320DN6 Hillsborough Cnty. Pollution Control Rev., Tampa
Electric Co. Proj.,
5.50%, 10/1/23 .................................................... 1,948,754
10,000 511665GT2 Lakeland Hosp. Sys. Rev., Regional Health Sys.,
5.50%, 11/15/32 ................................................... 9,897,200
1,410 585395C79 Melbourne Water & Sewer Rev., Ser. A,
5.00%, 10/1/32 .................................................... 1,390,443
4,610 342815KE6 Municipal Council Rev., North Miami Beach Water Proj., Ser. B,
5.00%, 8/1/32 ..................................................... 4,546,520
Orange Cnty. Health Fac. Adventist Health Sys.,
2,550 684503W27 5.625%, 11/15/32 .................................................. 2,547,909
5,000 684503V93 6.25%, 11/15/24 ................................................... 5,282,850
------------
25,613,676
------------
Georgia-1.1%
9,000 047870DA5 Atlanta Water & Wastewater, Ser. A,
5.00%, 11/1/39 .................................................... 8,718,660
------------
Hawaii-2.3%
19,170 438701BM5 Honolulu City & Cnty. First Board Resolution,
4.75%, 7/1/28 ..................................................... 17,949,063
------------
Illinois-3.8%
5,000 171646LL4 Cicero Corp. GO,
5.25%, 12/1/31 .................................................... 5,029,300
Chicago City Colleges GO,
32,670 167484RC0 0.00%, 1/1/37 ..................................................... 4,740,417
67
PIMCO MUNICIPAL INCOME FUND II
SCHEDULE OF INVESTMENTS
July 31, 2002
(unaudited) (continued)
Principal
Amount
(000) Cusip # Value*
----------------------------------------------------------------------------------------------------------------------------
MUNICIPAL BONDS & NOTES (continued)
29,145 167484RD8 0.00%, 1/1/38 ..................................................... $ 3,998,111
32,670 167484RE6 0.00%, 1/1/39 ..................................................... 4,237,299
1,000 167501UM5 Chicago Board of Education School Reform,
0.00%, 12/1/31 .................................................... 193,540
60,000 592247J50 Metropolitan Pier & Exposition Auth.,
0.00%, 12/15/30 ................................................... 11,986,800
-----------
30,185,467
-----------
Iowa-1.0%
8,850 888805AG3 Tobacco Settlement Auth., Ser. B,
5.60%, 6/1/35 ..................................................... 7,695,517
-----------
Louisiana-0.4%
3,575 88880PAC8 Tobacco Settlement Financing Corp., Ser. 2001B,
5.875%, 5/15/39 ................................................... 3,226,974
-----------
Massachusetts-7.6%
20,000 57582NDW2 State GO, Ser. C,
5.25%, 11/1/30 ..................................................... 20,156,000
20,000 57585KG93 State Health & Educational Fac. Auth. Rev.,
Harvard Univ., Ser. FF,
5.125%, 7/15/37 .................................................... 19,790,600
4,295 576018DN2 State Turnpike Auth., Ser. A,
Ser. A, 4.75%, 1/1/34 .............................................. 3,947,577
State Water Reserve Auth.,
2,300 576049KU3 Ser. B, 4.75%, 12/1/21 ............................................. 2,254,253
15,000 576049QF0 Ser. A 4.75%, 8/1/37 ............................................... 13,737,300
-----------
59,885,730
-----------
Michigan-2.0%
$7,775 955023KQ8 West Ottawa Pub. School Dist., Ser. A,
5.00%, 5/1/32 ..................................................... 7,609,393
8,000 965084FQ4 Whitehall Dist. Schools,
5.00%, 5/1/27 ..................................................... 7,909,840
-----------
15,519,233
-----------
Nebraska-1.4%
9,150 681793M28 Omaha Pub. Pwr. Dist., Ser. B,
6.20%, 2/1/17 ..................................................... 10,810,451
-----------
Nevada-2.6%
3,400 180847TJ4 Clark Cnty. GO,
5.00%, 6/1/31 ..................................................... 3,313,640
Reno Lien Transn.,
3,960 759858AK9 5.125%, 6/1/27 .................................................... 3,956,951
2,000 759858AL7 5.125%, 6/1/32 .................................................... 1,986,240
3,500 759858AM5 5.125%, 6/1/37 .................................................... 3,446,625
7,570 759858AN3 5.25%, 6/1/41 ..................................................... 7,544,489
-----------
20,247,945
-----------
68
PIMCO MUNICIPAL INCOME FUND II
SCHEDULE OF INVESTMENTS
July 31, 2002
(unaudited) (continued)
Principal
Amount
(000) Cusip # Value*
------------------------------------------------------------------------------------------------------------------
MUNICIPAL BONDS & NOTES (concluded)
New Jersey-1.9%
Economic Dev. Auth., Kapkowki Landfill Proj.,
4,000 64577HMF5 5.75%, 10/1/21 .................................................. 4,004,280
11,405 64577HMH1 5.75%, 4/1/31 ................................................... 11,309,084
-----------
15,313,364
-----------
New York-1.3%
10,600 59259RBE3 Metropolitan Trans. Auth., Ser. A,
5.00%, 11/15/30 ................................................. $ 10,457,006
------------
North Carolina-1.4%
11,105 65819GBK3 Cap. Facs. Fin. Agy. Rev., Duke Univ., Ser. A,
5.125%, 7/1/42 .................................................. 10,928,208
------------
Pennsylvania-0.3%
2,000 01728AWV4 Allegheny Cnty. Hosp. Dev. Auth. Rev., Ser. B,
9.25%, 11/15/30 ................................................. 2,155,800
500 72478PAP1 Pittsburgh & Allegheny Cnty. Pub. Auditorium,
5.00%, 2/1/29 ................................................... 494,210
------------
2,650,010
------------
Rhode Island-7.8%
65,000 888809AC4 Tobacco Settlement Financing. Corp., Ser. A,
6.25%, 6/1/42 ................................................... 61,980,100
------------
South Carolina-4.1%
27,745 396066AW2 Greenville Cnty. School District,
5.50%, 12/1/28 .................................................. 28,089,593
3,250 888806AC0 Tobacco Settlement Rev., Ser. B,
6.375%, 5/15/28 ................................................. 3,242,265
1,180 837152EQ6 Trans. Infrastructure Rev., Ser. A,
5.00%, 10/1/29 .................................................. 1,169,533
------------
32,501,391
------------
Texas-5.0%
19,750 414004MV0 Harris Cnty. GO,
5.125%, 8/15/31 ................................................. 19,646,312
6,250 662858CA5 North Dallas Thruway Auth.,
4.75%, 1/1/29 ................................................... 5,839,813
14,000 88271FCF8 State Affordable Housing, American
Housing Foundation, Ser. A,
5.40%, 9/1/22 ................................................... 14,451,080
------------
39,937,205
------------
Washington-1.2%
5,000 495289GE4 King Cnty. Sewer Rev., Ser. A,
5.00%, 1/1/35 ................................................... 4,828,700
5,000 873545EN3 Tacoma Sewer Rev., Ser. A,
5.00%, 12/1/31 .................................................. 4,872,050
------------
9,700,750
------------
69
PIMCO MUNICIPAL INCOME FUND II
SCHEDULE OF INVESTMENTS
July 31, 2002
(unaudited)
Principal
Amount
(000) Cusip # Value*
-------------------------------------------------------------------------------------------------------------------
SHORT-TERM VARIABLE RATE DEMAND NOTES** - 32.9%
Wisconsin-2.0%
$9,725 056559AK3 Badger Tobacco Asset Securitization Corp.,
6.125%, 6/1/27 ................................................... 9,511,731
5,685 977056F39 State Go, Ser. B,
5.00%, 5/1/16 .................................................... 5,917,289
-------------
15,429,020
-------------
Total Municipal Bonds & Notes (cost-$438,095,993) ...................... 440,224,784
=============
Alabama-1.8%
11,125 472682HQ9 Jefferson Cnty. Sewer Rev., Residual Ctfs., Ser. 352,
8.722%, 8/1/02 ................................................... $ 10,514,237
3,500 613041GL0 Montgomery Care Fac. Residual Ctfs., Ser. 435,
8.25%, 8/1/02 .................................................... 3,266,900
--------------
13,781,137
--------------
California-0.6%
4,500 544495DH4 Los Angeles Water & Power Rev.,
1.45%, 8/1/02 .................................................... 4,500,000
--------------
Colorado-0.7%
5,625 249181E46 Denver City & Cnty. Airpt Rev., Residual Ctfs., Ser. 425,
8.20%, 8/1/02 .................................................... 5,547,600
--------------
Connecticut-1.6%
13,000 20774LBN4 State Health & Educational Fac., Yale Univ., Ser. U,
1.25%, 8/7/02 .................................................... 13,000,000
--------------
Florida-1.9%
2,675 511678RK2 Lakeland Elec. & Water Rev., Residual Ctfs. Ser. 405,
8.23%, 8/1/02 .................................................... 2,620,698
4,455 684517CZ6 Orange Cnty. School Board Cert. of Participation, Ser. 328,
8.18%, 8/1/02 .................................................... 4,407,866
8,103 34281PCZ4 State Governmental Utilities Rev., Residual Ctfs., Ser. 327,
8.18%, 8/1/02 .................................................... 7,911,605
--------------
14,940,169
--------------
Illinois-2.4%
Chicago GO,
4,450 167484US1 Ser. 332, 8.43%, 8/1/02 .......................................... 4,430,776
2,525 168484F58 Ser. 526, 8.50%, 8/1/02 .......................................... 2,506,618
5,500 16748XM1 Ser. 426, 9.25%, 8/1/02 .......................................... 5,771,700
3,500 167562FK8 Chicago Midway Arpt. Rev., Residual Ctfs., Ser. 440,
8.23%, 8/1/02 .................................................... 3,293,080
3,220 213183P26 Cook Cnty., Residual Ctfs., Ser. 403,
8.25%, 8/1/02 .................................................... 3,090,298
--------------
19,092,472
--------------
Massachusetts-8.5%
3,500 101029LC8 Boston Water & Sewer Community Rev., Residual Ctfs., Ser. 434,
8.38%, 8/1/02 .................................................... 3,398,780
4,090 575827X47 State GO, Ser. B,
70
PIMCO MUNICIPAL INCOME FUND II
SCHEDULE OF INVESTMENTS
July 31, 2002
(unaudited) (concluded)
Principal
Amount
(000) Cusip # Value*
-------------------------------------------------------------------------------------------------------------------
1.45%, 8/1/02 .................................................... 4,090,000
20,000 57585KSW9 State Health & Educational Fac. Auth. Rev., Massachusetts
Institute of Technology,
1.40%, 8/1/02 .................................................... 20,000,000
State Turnpike Auth. Rev., Residual Ctfs.,
14,163 576018FB6 Ser. 335, 8.28%, 8/1/02 .......................................... 13,239,672
7,500 576018FQ3 Ser. 489, 8.38%, 8/1/02 .......................................... $ 7,021,050
18,415 576018FD2 Ser. 334, 8.38%, 8/1/02 .......................................... 17,239,018
2,150 576049WK2 State Water Reserve Auth., Residual Ctfs., Ser. 463,
7.88%, 8/1/02 .................................................... 1,788,026
--------------
66,776,546
--------------
Michigan-2.3%
10,000 59469CSE4 State Strategic Rev., Van Andel Research Inst.,
1.45%, 8/1/02 .................................................... 10,000,000
8,500 594712MZ1 State Univ. Rev., Ser. A,
1.25%, 8/7/02 .................................................... 8,500,000
--------------
18,500,000
--------------
Minnesota-2.5%
20,000 914460BV1 Univ. Minnesota, Ser. A,
1.35%, 8/7/02 .................................................... 20,000,000
--------------
Missouri-1.4%
$11,100 60635HUV9 State Health & Educational Fac. Auth. Rev., Stowers Inst.
1.40%, 8/1/02 ...................................................... 11,100,000
--------------
Nevada-0.7%
5,500 6414598R6 State GO, Residual Ctfs., Ser. 344,
8.18%, 8/1/02 ...................................................... 5,234,460
--------------
New York-0.7%
5,610 73358EAM6 Port Auth. of New York & New Jersey, Versatile Structure,
1.45%, 8/1/02 ...................................................... 5,610,000
--------------
Ohio-1.9%
3,950 407287BY6 Hamilton Cnty. Sales Tax Residual Ctfs., Ser. 356,
8.25%, 8/1/02 ...................................................... 3,926,932
11,000 490728UQ3 Kent State Univ. Rev.,
1.25%, 8/7/02 ...................................................... 11,000,000
--------------
14,926,932
--------------
Pennsylvania-2.8%
2,500 71781QBU1 Philadelphia Auth. Indl. Dev. Lease Rev., Ser. 612,
8.68%, 8/1/02 ...................................................... 2,542,750
Philadelphia School Dist. Residual Ctfs.,
4,175 7178805A2 Ser. 345, 7.68%, 8/1/02 ............................................ 3,789,481
71
PIMCO MUNICIPAL INCOME FUND II
SCHEDULE OF INVESTMENTS
July 31, 2002
(unaudited) (concluded)
Principal
Amount
(000) Cusip # Value*
--------------------------------------------------------------------------------------------------------------------------------
6,693 7178806D5 Ser. 496, 7.78%, 8/1/02 ............................................ 6,074,515
Univ. of Pittsburgh, Commonwealth Sys. of Higher Education, Ser. A,
5,000 91335VBR6 1.25%, 8/7/02 ...................................................... 5,000,000
5,000 91335VBS4 1.25%, 8/7/02 ...................................................... 5,000,000
--------------
22,406,746
--------------
Texas-2.6%
6,150 249015QD3 Denton Util. Sys. Rev., Residual Ctfs., Ser. 428,
8.50%, 8/1/02 ...................................................... 6,050,739
2,750 442348F94 Houston Arpt. Sys. Rev., Ser. 404,
8.13%, 8/1/02 ...................................................... 2,610,630
Houston Water & Sewer Sys. Rev.,
5,500 442436U82 Ser. 427, 8.25%, 8/1/02 ............................................ 5,247,330
6,675 442436V24 Ser. 495, 8.75%, 8/1/02 ............................................ 6,727,599
--------------
20,636,298
--------------
Washington-0.5%
4,550 155048BL4 Central Puget Sound Regl. Tran. Auth. Sales Tax & Motor
Residual Ctfs., Ser. 360,
7.68%, 8/1/02 ...................................................... $ 3,975,244
--------------
Total Short-Term Variable Rate Demand Notes (cost-$258,055,490) .......... 260,027,604
--------------
TAX FREE MONEY MARKET FUND-1.9%
14,598 81799K944 State Street Global Advisors Fund, 1.07%, 8/31/02 (cost-$14,598,338) .... 14,598,338
--------------
Total Investments (cost-$710,749,821) .................................... 90.4 % $714,850,726
Other assets Less Liabilities ............................................ 9.6 76,287,355
----------- --------------
Net Assets ............................................................... 100.0 % $791,138,081
=========== ==============
----------------------------------
* Long-term debt securities are valued by an independent price service
authorized by the Board of Trustees.
** Variable Rate Demand Notes are instruments whose interest rates change on a
specified date (such as a coupon date or interest payment date) and/or
whose interest rates vary with changes in a designated base rate (such as
the prime interest rate). Maturity date shown is date of next rate change.
See accompanying notes to financial information.
72
APPENDIX A
DESCRIPTION OF SECURITIES RATINGS
The Fund's investments may range in quality from securities rated in
the lowest category to securities rated in the highest category (as rated by
Moody's, S&P or Fitch or, if unrated, determined by PIMCO to be of comparable
quality). The percentage of the Fund's assets invested in securities in a
particular rating category will vary. The following terms are generally used to
describe the credit quality of debt securities:
High Quality Debt Securities are those rated in one of the two highest
rating categories (the highest category for commercial paper) or, if unrated,
deemed comparable by PIMCO.
Investment Grade Debt Securities are those rated in one of the four
highest rating categories or, if unrated, deemed comparable by PIMCO.
Below Investment Grade, High Yield Securities (the "Junk Bonds") are
those rated lower than Baa by Moody's, BBB by S&P and BBB by Fitch and
comparable securities. They are deemed predominately speculative with respect to
the issuer's ability to repay principal and interest.
Following is a description of Moody's, S&P's and Fitch's rating
categories applicable to debt securities.
Moody's Investors Service, Inc.
Corporate and Municipal Bond Ratings
Aaa: Bonds which are rated Aaa are judged to be of the best quality.
They carry the smallest degree of investment risk and are generally referred to
as "gilt edge." Interest payments are protected by a large or by an
exceptionally stable margin and principal is secure. While the various
protective elements are likely to change, such changes as can be visualized are
most unlikely to impair the fundamentally strong position of such issues.
Aa: Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known as
high-grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of protective
elements may be of greater amplitude or there may be other elements present that
make the long-term risks appear somewhat larger than with Aaa securities.
A: Bonds which are rated A possess many favorable investment attributes
and are to be considered as upper-medium-grade obligations. Factors giving
security to principal and interest are considered adequate, but elements may be
present that suggest a susceptibility to impairment sometime in the future.
A-1
Baa: Bonds which are rated Baa are considered as medium-grade
obligations (i.e., they are neither highly protected nor poorly secured).
Interest payments and principal security appear adequate for the present but
certain protective elements may be lacking or may be characteristically
unreliable over any great length of time. Such bonds lack outstanding investment
characteristics and in fact have speculative characteristics as well.
Ba: Bonds which are rated Ba are judged to have speculative elements;
their future cannot be considered as well-assured. Often the protection of
interest and principal payments may be very moderate and thereby not well
safeguarded during both good and bad times over the future. Uncertainty of
position characterizes bonds in this class.
B: Bonds which are rated B generally lack characteristics of a
desirable investment. Assurance of interest and principal payments or of
maintenance of other terms of the contract over any long period of time may be
small.
Caa: Bonds which are rated Caa are of poor standing. Such issues may be
in default or there may be present elements of danger with respect to principal
or interest.
Ca: Bonds which are rated Ca represent obligations which are
speculative in a high degree. Such issues are often in default or have other
marked shortcomings.
C: Bonds which are rated C are the lowest rated class of bonds and
issues so rated can be regarded as having extremely poor prospects of ever
attaining any real investment standing.
Moody's bond ratings, where specified, are applicable to financial
contracts, senior bank obligations and insurance company senior policyholder and
claims obligations with an original maturity in excess of one year. Obligations
relying upon support mechanisms such as letter-of-credit and bonds of indemnity
are excluded unless explicitly rated. Obligations of a branch of a bank are
considered to be domiciled in the country in which the branch is located.
Unless noted as an exception, Moody's rating on a bank's ability to
repay senior obligations extends only to branches located in countries which
carry a Moody's Sovereign Rating for Bank Deposits. Such branch obligations are
rated at the lower of the bank's rating or Moody's Sovereign Rating for the Bank
Deposits for the country in which the branch is located. When the currency in
which an obligation is denominated is not the same as the currency of the
country in which the obligation is domiciled, Moody's ratings do not incorporate
an opinion as to whether payment of the obligation will be affected by the
actions of the government controlling the currency of denomination. In addition,
risk associated with bilateral conflicts between an investor's home country and
either the issuer's home country or the country where an issuer branch is
located are not incorporated into Moody's ratings.
A-2
Moody's makes no representation that rated bank obligations or
insurance company obligations are exempt from registration under the U.S.
Securities Act of 1933 or issued in conformity with any other applicable law or
regulation. Nor does Moody's represent any specific bank or insurance company
obligation is legally enforceable or a valid senior obligation of a rated
issuer.
Moody's applies numerical modifiers, 1, 2, and 3 in each generic rating
classified from Aa through Caa in its corporate bond rating system. The modifier
1 indicates that the security ranks in the higher end of its generic rating
category; the modifier 2 indicates a mid-range ranking; and the modifier 3
indicates that the issue ranks in the lower end of its generic rating category.
Corporate Short-Term Debt Ratings
Moody's short-term debt ratings are opinions of the ability of issuers
to repay punctually senior debt obligations. These obligations have an original
maturity not exceeding one year, unless explicitly noted.
Moody's employs the following three designations, all judged to be
investment grade, to indicate the relative repayment ability of rated issuers:
PRIME-1: Issuers rated Prime-1 (or supporting institutions) have a
superior ability for repayment of senior short-term debt obligations. Prime-1
repayment ability will often be evidenced by many of the following
characteristics: leading market positions in well-established industries; high
rates of return on funds employed; conservative capitalization structure with
moderate reliance on debt and ample asset protection; broad margins in earnings
coverage of fixed financial charges and high internal cash generation; and
well-established access to a range of financial markets and assured sources of
alternate liquidity.
PRIME-2: Issuers rated Prime-2 (or supporting institutions) have a
strong ability for repayment of senior short-term debt obligations. This will
normally be evidenced by many of the characteristics cited above but to a lesser
degree. Earnings trends and coverage ratios, while sound, may be more subject to
variation. Capitalization characteristics, while still appropriate, may be more
affected by external conditions. Ample alternate liquidity is maintained.
PRIME-3: Issuers rated Prime-3 (or supporting institutions) have an
acceptable ability for repayment of senior short-term obligations. The effect of
industry characteristics and market compositions may be more pronounced.
Variability in earnings and profitability may result in changes in the level of
debt protection measurements and may require relatively high financial leverage.
Adequate alternate liquidity is maintained.
NOT PRIME: Issuers rated Not Prime do not fall within any of the Prime
rating categories.
A-3
Standard & Poor's Ratings Services
Issue Credit Rating Definitions
A Standard & Poor's issue credit rating is a current opinion of the
creditworthiness of an obligor with respect to a specific financial obligation,
a specific class of financial obligations, or a specific financial program
(including ratings on medium term note programs and commercial paper programs).
It takes into consideration the creditworthiness of guarantors, insurers, or
other forms of credit enhancement on the obligation and takes into account the
currency in which the obligation is denominated. The issue credit rating is not
a recommendation to purchase, sell, or hold a financial obligation, inasmuch as
it does not comment as to market price or suitability for a particular investor.
Issue credit ratings are based on current information furnished by the
obligors or obtained by Standard & Poor's from other sources it considers
reliable. Standard & Poor's does not perform an audit in connection with any
credit rating and may, on occasion, rely on unaudited financial information.
Credit ratings may be changed, suspended, or withdrawn as a result of changes
in, or unavailability of, such information, or based on other circumstances.
Issue credit ratings can be either long-term or short-term. Short-term
ratings are generally assigned to those obligations considered short term in the
relevant market. In the U.S., for example, that means obligations with an
original maturity of no more than 365 days -- including commercial paper.
Short-term ratings are also used to indicate the creditworthiness of an obligor
with respect to put features on long-term obligations. The result is a dual
rating, in which the short-term rating addresses the put feature, in addition to
the usual long-term rating. Medium-term notes are assigned long-term ratings.
Issue credit ratings are based, in varying degrees, on the following
considerations: likelihood of payment -- capacity and willingness of the obligor
to meet its financial commitment on an obligation in accordance with the terms
of the obligation; nature of and provisions of the obligation; protection
afforded by, and relative position of, the obligation in the event of
bankruptcy, reorganization, or other arrangement under the laws of bankruptcy
and other laws affecting creditors' rights.
The issue rating definitions are expressed in terms of default risk. As
such, they pertain to senior obligations of an entity. Junior obligations are
typically rated lower than senior obligations, to reflect the lower priority in
bankruptcy, as noted above. (Such differentiation applies when an entity has
both senior and subordinated obligations, secured and unsecured obligations, or
operating company and holding company obligations.) Accordingly, in the case of
junior debt, the rating may not conform exactly with the category definition.
A-4
Corporate and Municipal Bond Ratings
Investment Grade
AAA: An obligation rated AAA has the highest rating assigned by
Standard & Poor's. The obligor's capacity to meet its financial commitment on
the obligation is extremely strong.
AA: An obligation rated AA differs from the highest rated obligations
only in small degree. The obligor's capacity to meet its financial commitment on
the obligation is very strong.
A: An obligation rated A is somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than obligations in
higher rated categories. However, the obligor's capacity to meet its financial
commitment on the obligation is still strong.
BBB: An obligation rated BBB exhibits adequate protection parameters.
However, adverse economic conditions or changing circumstances are more likely
to lead to a weakened capacity of the obligor to meet its financial commitment
on the obligation.
Speculative Grade
Obligations rated BB, B, CCC, CC, and C are regarded as having
predominantly speculative characteristics with respect to capacity to pay
interest and repay principal. BB indicates the least degree of speculation and C
the highest. While such debt will likely have some quality and protective
characteristics, these are outweighed by large uncertainties or major exposures
to adverse conditions.
BB: An obligation rated BB is less vulnerable to nonpayment than other
speculative issues. However, it faces major ongoing uncertainties or exposure to
adverse business, financial, or economic conditions which could lead to the
obligor's inadequate capacity to meet its financial commitment on the
obligation.
B: An obligation rated B is more vulnerable to nonpayment than
obligations rated BB, but the obligor currently has the capacity to meet its
financial commitment on the obligation. Adverse business, financial, or economic
conditions will likely impair the obligor's capacity or willingness to meet its
financial commitment on the obligation.
CCC: An obligation rated CCC is currently vulnerable to nonpayment, and
is dependent upon favorable business, financial, and economic conditions for the
obligor to meet its financial commitment on the obligation. In the event of
adverse business, financial, or economic conditions, the obligor is not likely
to have the capacity to meet its financial commitment on the obligation.
CC: An obligation rated CC is currently highly vulnerable to
nonpayment.
A-5
C: A subordinated debt or preferred stock obligation rated C is
CURRENTLY HIGHLY VULNERABLE to nonpayment. The C rating may be used to cover a
situation where a bankruptcy petition has been filed or similar action taken,
but payments on this obligation are being continued. A C also will be assigned
to a preferred stock issue in arrears on dividends or sinking fund payments, but
that is currently paying.
CI: The rating CI is reserved for income bonds on which no interest is
being paid.
D: An obligation rated D is in payment default. The D rating category
is used when payments on an obligation are not made on the date due even if the
applicable grace period has not expired, unless Standard & Poor's believes that
such payments will be made during such grace period. The D rating also will be
used upon the filing of a bankruptcy petition or the taking of a similar action
if payments on an obligation are jeopardized.
Plus (+) or Minus (-): The ratings from AA to CCC may be modified by
the addition of a plus or minus sign to show relative standing within the major
rating categories.
Provisional ratings: The letter "p" indicates that the rating is
provisional. A provisional rating assumes the successful completion of the
project being financed by the debt being rated and indicates that payment of
debt service requirements is largely or entirely dependent upon the successful
and timely completion of the project. This rating, however, while addressing
credit quality subsequent to completion of the project, makes no comment on the
likelihood of, or the risk of default upon failure of, such completion. The
investor should exercise his own judgment with respect to such likelihood and
risk.
r: This symbol is attached to the ratings of instruments with
significant noncredit risks. It highlights risks to principal or volatility of
expected returns which are not addressed in the credit rating. Examples include:
obligations linked or indexed to equities, currencies, or commodities;
obligations exposed to severe prepayment risk -- such as interest-only or
principal-only mortgage securities; and obligations with unusually risky
interest terms, such as inverse floaters.
The absence of an "r" symbol should not be taken as an indication that
an obligation will exhibit no volatility or variability in total return.
N.R.: This indicates that no rating has been requested, that there is
insufficient information on which to base a rating, or that Standard & Poor's
does not rate a particular obligation as a matter of policy.
Debt obligations of issuers outside the United States and its
territories are rated on the same basis as domestic corporate and municipal
issues. The ratings measure the creditworthiness of the obligor but do not take
into account currency exchange and related uncertainties.
A-6
Commercial Paper Rating Definitions
A Standard & Poor's commercial paper rating is a current assessment of
the likelihood of timely payment of debt having an original maturity of no more
than 365 days. Ratings are graded into several categories, ranging from A for
the highest quality obligations to D for the lowest. These categories are as
follows:
A-1: A short-term obligation rated A-1 is rated in the highest category
by Standard & Poor's. The obligor's capacity to meet its financial commitment on
the obligation is strong. Within this category, certain obligations are
designated with a plus sign (+). This indicates that the obligor's capacity to
meet its financial commitment on these obligations is extremely strong.
A-2: A short-term obligation rated A-2 is somewhat more susceptible to
the adverse effects of changes in circumstances and economic conditions than
obligations in higher rating categories. However, the obligor's capacity to meet
its financial commitment on the obligation is satisfactory.
A-3: A short-term obligation rated A-3 exhibits adequate protection
parameters. However, adverse economic conditions or changing circumstances are
more likely to lead to a weakened capacity of the obligor to meet its financial
commitment on the obligation.
B: A short-term obligation rated B is regarded as having significant
speculative characteristics. The obligor currently has the capacity to meet its
financial commitment on the obligation; however, it faces major ongoing
uncertainties which could lead to the obligor's inadequate capacity to meet its
financial commitment on the obligation.
C: A short-term obligation rated C is currently vulnerable to
nonpayment and is dependent upon favorable business, financial, and economic
conditions for the obligor to meet its financial commitment on the obligation.
D: A short-term obligation rated D is in payment default. The D rating
category is used when payments on an obligation are not made on the date due
even if the applicable grace period has not expired, unless Standard & Poor's
believes that such payments will be made during such grace period. The D rating
also will be used upon the filing of a bankruptcy petition or the taking of a
similar action if payments on an obligation are jeopardized.
A commercial paper rating is not a recommendation to purchase, sell or
hold a security inasmuch as it does not comment as to market price or
suitability for a particular investor. The ratings are based on current
information furnished to Standard & Poor's by the issuer or obtained from other
sources it considers reliable. Standard & Poor's does not perform an audit in
connection with any rating and may, on occasion, rely on unaudited financial
information. The ratings may be changed, suspended, or withdrawn as a result of
changes in or unavailability of such information.
A-7
Fitch, Inc.
A brief description of the applicable Fitch, Inc. ("Fitch") ratings
symbols and meanings (as published by Fitch) follows:
Long-Term Credit Ratings
Investment Grade
AAA: Highest credit quality. `AAA' ratings denote the lowest
expectation of credit risk. They are assigned only in case of exceptionally
strong capacity for timely payment of financial commitments. This capacity is
highly unlikely to be adversely affected by foreseeable events.
AA: Very high credit quality. `AA' ratings denote a very low
expectation of credit risk. They indicate very strong capacity for timely
payment of financial commitments. This capacity is not significantly vulnerable
to foreseeable events.
A: High credit quality. `A' ratings denote a low expectation of credit
risk. The capacity for timely payment of financial commitments is considered
strong. This capacity may, nevertheless, be more vulnerable to changes in
circumstances or in economic conditions than is the case for higher ratings.
BBB: Good credit quality. `BBB' ratings indicate that there is
currently a low expectation of credit risk. The capacity for timely payment of
financial commitments is considered adequate, but adverse changes in
circumstances and in economic conditions are more likely to impair this
capacity. This is the lowest investment-grade category.
Speculative Grade
BB: Speculative. `BB' ratings indicate that there is a possibility of
credit risk developing, particularly as the result of adverse economic change
over time; however, business or financial alternatives may be available to allow
financial commitments to be met. Securities rated in this category are not
investment grade. B: Highly speculative. `B' ratings indicate that significant
credit risk is present, but a limited margin of safety remains. Financial
commitments are currently being met; however, capacity for continued payment is
contingent upon a sustained, favorable business and economic environment.
CCC, CC, C: High default risk. Default is a real possibility. Capacity
for meeting financial commitments is solely reliant upon sustained, favorable
business or economic developments. A `CC' rating indicates that default of some
kind appears probable. `C' ratings signal imminent default.
A-8
DDD, DD, D: Default. The ratings of obligations in this category are
based on their prospects for achieving partial or full recovery in a
reorganization or liquidation of the obligor. While expected recovery values are
highly speculative and cannot be estimated with any precision, the following
serve as general guidelines. `DDD' obligations have the highest potential for
recovery, around 90%-100% of outstanding amounts and accrued interest. `DD'
indicates potential recoveries in the range of 50%-90%, and `D' the lowest
recovery potential, i.e., below 50%. Entities rated in this category have
defaulted on some or all of their obligations. Entities rated `DDD' have the
highest prospect for resumption of performance or continued operation with or
without a formal reorganization process. Entities rated `DD' and `D' are
generally undergoing a formal reorganization or liquidation process; those rated
`DD' are likely to satisfy a higher portion of their outstanding obligations,
while entities rated `D' have a poor prospect for repaying all obligations.
Short-Term Credit Ratings
A short-term rating has a time horizon of less than 12 months for most
obligations, or up to three years for U.S. public finance securities, and thus
places greater emphasis on the liquidity necessary to meet financial commitments
in a timely manner.
F1: Highest credit quality. Indicates the strongest capacity for timely
payment of financial commitments; may have an added "+" to denote any
exceptionally strong credit feature.
F2: Good credit quality. A satisfactory capacity for timely payment of
financial commitments, but the margin of safety is not as great as in the case
of the higher ratings.
F3: Fair credit quality. The capacity for timely payment of financial
commitments is adequate; however, near-term adverse changes could result in a
reduction to non-investment grade.
B: Speculative. Minimal capacity for timely payment of financial
commitments, plus vulnerability to near-term adverse changes in financial and
economic conditions.
C: High default risk. Default is a real possibility. Capacity for
meeting financial commitments is solely reliant upon a sustained, favorable
business and economic environment.
D: Default. Denotes actual or imminent payment default.
"+" or "-" may be appended to a rating to denote relative status within
major rating categories. Such suffixes are not added to the `AAA' long-term
rating category, to categories below `CCC', or to short-term ratings other than
`F1'.
`NR' indicates that Fitch does not rate the issuer or issue in
question.
`Withdrawn': A rating is withdrawn when Fitch deems the amount of
information available to be inadequate for rating purposes, or when an
obligation matures, is called, or refinanced.
A-9
`Rating Watch': Ratings are placed on RatingWatch to notify investors
that there is a reasonable probability of a rating change and the likely
direction of such change. These are designated as "Positive", indicating a
potential upgrade, "Negative", for a potential downgrade, or "Evolving", if
ratings may be raised, lowered or maintained. Rating Watch is typically resolved
over a relatively short period.
A Rating Outlook indicates the direction a rating is likely to move
over a one to two year period. Outlooks may be positive, stable, or negative. A
positive or negative Rating Outlook does not imply a rating change is
inevitable. Similarly, companies whose outlooks are 'stable' could be downgraded
before an outlook moves to positive or negative if circumstances warrant such an
action. Occasionally, Fitch may be unable to identify the fundamental trend. In
these cases, the Rating Outlook may be described as evolving.
A-10
APPENDIX B
SETTLEMENT PROCEDURES
The following summary of Settlement Procedures sets forth the
procedures expected to be followed in connection with the settlement of each
Auction and will be incorporated by reference in the Auction Agency Agreement
and each Broker-Dealer Agreement. Nothing contained in this Appendix B
constitutes a representation by the Fund that in each Auction each party
referred to herein actually will perform the procedures described herein to be
performed by such party. Capitalized terms used herein shall have the respective
meanings specified in the glossary of the Prospectus or Appendix A hereto, as
the case may be.
(a) On each Auction Date, the Auction Agent shall notify by telephone
or through the Auction Agent's auction processing system the Broker-Dealers that
participated in the Auction held on such Auction Date and submitted an Order on
behalf of any Beneficial Owner or Potential Beneficial Owner of:
(i) the Applicable Rate fixed for the next succeeding
Dividend Period;
(ii) whether Sufficient Clearing Bids existed for the
determination of the Applicable Rate;
(iii) if such Broker-Dealer (a "Seller's Broker-Dealer")
submitted a Bid or a Sell Order on behalf of a Beneficial Owner, the
number of Preferred Shares, if any, to be sold by such Beneficial
Owner;
(iv) if such Broker-Dealer (a "Buyer's Broker-Dealer")
submitted a Bid on behalf of a Potential Beneficial Owner, the number
of Preferred Shares, if any, to be purchased by such Potential
Beneficial Owner;
(v) if the aggregate number of Preferred Shares to be sold
by all Beneficial Owners on whose behalf such Broker-Dealer submitted a
Bid or a Sell Order exceeds the aggregate number of Preferred Shares to
be purchased by all Potential Beneficial Owners on whose behalf such
Broker-Dealer submitted a Bid, the name or names of one or more Buyer's
Broker-Dealers (and the name of the Agent Member, if any, of each such
Buyer's Broker-Dealer) acting for one or more purchasers of such excess
number of Preferred Shares and the number of such shares to be
purchased from one or more Beneficial Owners on whose behalf such
Broker-Dealer acted by one or more Potential Beneficial Owners on whose
behalf each of such Buyer's Broker-Dealers acted;
(vi) if the aggregate number of Preferred Shares to be
purchased by all Potential Beneficial Owners on whose behalf such
Broker-Dealer submitted a Bid exceeds the aggregate number of Preferred
Shares to be sold by all Beneficial Owners on whose behalf such
Broker-Dealer submitted a Bid or a Sell Order, the name or names of one
or more Seller's Broker-Dealers (and the name of the Agent Member, if
any, of each such Seller's Broker-Dealer) acting for one or more
sellers of such excess number of Preferred Shares and the number of
such shares to be sold to one or more Potential Beneficial Owners on
whose behalf such Broker-Dealer acted by one or more Beneficial Owners
on whose behalf each of such Seller's Broker-Dealers acted; and
B-1
(vii) the Auction Date of the next succeeding Auction with
respect to the Preferred Shares.
(b) On each Auction Date, each Broker-Dealer that submitted an Order on
behalf of any Beneficial Owner or Potential Beneficial Owner shall:
(i) in the case of a Broker-Dealer that is a Buyer's
Broker-Dealer, instruct each Potential Beneficial Owner on whose behalf
such Broker-Dealer submitted a Bid that was accepted, in whole or in
part, to instruct such Potential Beneficial Owner's Agent Member to pay
to such Broker-Dealer (or its Agent Member) through the Securities
Depository the amount necessary to purchase the number of Preferred
Shares to be purchased pursuant to such Bid against receipt of such
shares and advise such Potential Beneficial Owner of the Applicable
Rate for the next succeeding Dividend Period;
(ii) in the case of a Broker-Dealer that is a Seller's
Broker-Dealer, instruct each Beneficial Owner on whose behalf such
Broker-Dealer submitted a Sell Order that was accepted, in whole or in
part, or a Bid that was accepted, in whole or in part, to instruct such
Beneficial Owner's Agent Member to deliver to such Broker-Dealer (or
its Agent Member) through the Securities Depository the number of
Preferred Shares to be sold pursuant to such Order against payment
therefor and advise any such Beneficial Owner that will continue to
hold Preferred Shares of the Applicable Rate for the next succeeding
Dividend Period;
(iii) advise each Beneficial Owner on whose behalf such
Broker-Dealer submitted a Hold Order of the Applicable Rate for the
next succeeding Dividend Period;
(iv) advise each Beneficial Owner on whose behalf such
Broker-Dealer submitted an Order of the Auction Date for the next
succeeding Auction; and
(v) advise each Potential Beneficial Owner on whose behalf
such Broker-Dealer submitted a Bid that was accepted, in whole or in
part, of the Auction Date for the next succeeding Auction.
(c) On the basis of the information provided to it pursuant to (a)
above, each Broker-Dealer that submitted a Bid or a Sell Order on behalf of a
Potential Beneficial Owner or a Beneficial Owner shall, in such manner and at
such time or times as in its sole discretion it may determine, allocate any
funds received by it pursuant to (b)(i) above and any Preferred Shares received
by it pursuant to (b)(ii) above among the Potential Beneficial Owners, if any,
on whose behalf such Broker-Dealer submitted Bids, the Beneficial Owners, if
any, on whose behalf such Broker-Dealer submitted Bids that were accepted or
Sell Orders, and any Broker-Dealer or Broker-Dealers identified to it by the
Auction Agent pursuant to (a)(v) or (a)(vi) above.
(d) On each Auction Date:
(i) each Potential Beneficial Owner and Beneficial Owner
shall instruct its Agent Member as provided in (b)(i) or (ii) above, as
the case may be;
B-2
(ii) each Seller's Broker-Dealer which is not an Agent Member
of the Securities Depository shall instruct its Agent Member to (A) pay
through the Securities Depository to the Agent Member of the Beneficial
Owner delivering shares to such Broker-Dealer pursuant to (b)(ii) above
the amount necessary to purchase such shares against receipt of such
shares, and (B) deliver such shares through the Securities Depository
to a Buyer's Broker-Dealer (or its Agent Member) identified to such
Seller's Broker-Dealer pursuant to (a)(v) above against payment
therefor; and
(iii) each Buyer's Broker-Dealer which is not an Agent Member
of the Securities Depository shall instruct its Agent Member to (A) pay
through the Securities Depository to a Seller's Broker-Dealer (or its
Agent Member) identified pursuant to (a)(vi) above the amount necessary
to purchase the shares to be purchased pursuant to (b)(i) above against
receipt of such shares, and (B) deliver such shares through the
Securities Depository to the Agent Member of the purchaser thereof
against payment therefor.
(e) On the day after the Auction Date:
(i) each Bidder's Agent Member referred to in (d)(i) above
shall instruct the Securities Depository to execute the transactions
described in (b)(i) or (ii) above, and the Securities Depository shall
execute such transactions;
(ii) each Seller's Broker-Dealer or its Agent Member shall
instruct the Securities Depository to execute the transactions
described in (d)(ii) above, and the Securities Depository shall execute
such transactions; and
(iii) each Buyer's Broker-Dealer or its Agent Member shall
instruct the Securities Depository to execute the transactions
described in (d)(iii) above, and the Securities Depository shall
execute such transactions.
(f) If a Beneficial Owner selling Preferred Shares in an Auction fails
to deliver such shares (by authorized book-entry), a Broker-Dealer may deliver
to the Potential Beneficial Owner on behalf of which it submitted a Bid that was
accepted a number of whole Preferred Shares that is less than the number of
shares that otherwise was to be purchased by such Potential Beneficial Owner. In
such event, the number of Preferred Shares to be so delivered shall be
determined solely by such Broker-Dealer. Delivery of such lesser number of
shares shall constitute good delivery. Notwithstanding the foregoing terms of
this paragraph (f), any delivery or non-delivery of shares which shall represent
any departure from the results of an Auction, as determined by the Auction
Agent, shall be of no effect unless and until the Auction Agent shall have been
notified of such delivery or non-delivery in accordance with the provisions of
the Auction Agency Agreement and the Broker-Dealer Agreements.
B-3
APPENDIX C
AUCTION PROCEDURES
The following procedures following procedures will be set forth in
provisions of the Amended By-Laws relating to the Preferred Shares, and will be
incorporated by reference in the Auction Agency Agreement and each Broker-Dealer
Agreement. The terms not defined below are defined in the Prospectus. Nothing
contained in this Appendix C constitutes a representation by the Fund that in
each Auction each party referred to herein actually will perform the procedures
described herein to be performed by such party.
ARTICLE 11
* * *
11.10 Auction Procedures. (a) Certain definitions. As used in this
Section 11.10, the following terms shall have the following meanings, unless the
context otherwise requires:
(i) "APS" means the shares of APS being auctioned pursuant to this
Section 11.10.
(ii) "Auction Date" means the first Business Day preceding the first
day of a Dividend Period.
(iii) "Available APS" has the meaning specified in Section 11.10(d)(i)
below.
(iv) "Bid" has the meaning specified in Section 11.10(b)(i) below.
(v) "Bidder" has the meaning specified in Section 11.10(b)(i) below.
(vi) "Hold Order" has the meaning specified in Section 11.10(b)(i)
below.
(vii) "Maximum Applicable Rate" for any Dividend Period will be the
Applicable Percentage of the Reference Rate. The Auction Agent will round each
applicable Maximum Applicable Rate to the nearest one-thousandth (0.001) of one
percent per annum, with any such number ending in five ten-thousandths of one
percent being rounded upwards to the nearest one-thousandth (0.001) of one
percent. The Auction Agent will not round the applicable Reference Rate as part
of its calculation of the Maximum Applicable Rate. The Applicable Percentage
will be determined based on (i) the credit rating assigned on such date to such
shares by Moody's (or, if Moody's shall not make such rating available, the
equivalent of such rating by a Substitute Rating Agency) and (ii) whether the
Trust has provided notification to the Auction Agent prior to the Auction
establishing the Applicable Rate for any dividend that net capital gains or
other taxable income will be included in such dividend on shares of APS as
follows:
C-1
Percentage of Percentage of
Reference Rate - Reference Rate -
Moody's Credit Ratings on APS No Notification Notification
----------------------------- --------------- ------------
aa3 or higher 110% 150%
a 125% 160%
baa 150% 250%
Below baa 200% 275%
The Trust shall take all reasonable action necessary to enable Moody's
to provide a rating for each series of APS. If Moody's shall not make such a
rating available, UBS Warburg LLC and Merrill Lynch, Pierce, Fenner & Smith
Incorporated or their respective affiliates and successors, after consultation
with the Trust, shall select another Rating Agency to act as a Substitute Rating
Agency.
(viii) "Order" has the meaning specified in Section 11.10(b)(i) below.
(ix) "Sell Order" has the meaning specified in Section 11.10(b)(i)
below.
(x) "Submission Deadline" means 1:00 P.M., New York City time, on
any Auction Date or such other time on any Auction Date as may be specified by
the Auction Agent from time to time as the time by which each Broker-Dealer must
submit to the Auction Agent in writing all Orders obtained by it for the Auction
to be conducted on such Auction Date.
(xi) "Submitted Bid" has the meaning specified in Section 11.10(d)(i)
below.
(xii) "Submitted Hold Order" has the meaning specified in Section
11.10(d)(i) below.
(xiii) "Submitted Order" has the meaning specified in Section
11.10(d)(i) below.
(xiv) "Submitted Sell Order" has the meaning specified in Section
11.10(d)(i) below.
(xv) "Sufficient Clearing Bids" has the meaning specified in Section
11.10(d)(i) below.
(xvi) "Winning Bid Rate" has the meaning specified in Section
11.10(d)(i) below.
(b) Orders by Beneficial Owners, Potential Beneficial Owners, Existing
Holders and Potential Holders.
C-2
(i) Unless otherwise permitted by the Trust, Beneficial Owners and
Potential Beneficial Owners may only participate in Auctions through their
Broker-Dealers. Broker-Dealers will submit the Orders of their respective
customers who are Beneficial Owners and Potential Beneficial Owners to the
Auction Agent, designating themselves as Existing Holders in respect of shares
subject to Orders submitted or deemed submitted to them by Beneficial Owners and
as Potential Holders in respect of shares subject to Orders submitted to them by
Potential Beneficial Owners. A Broker-Dealer may also hold shares of APS in its
own account as a Beneficial Owner. A Broker-Dealer may thus submit Orders to the
Auction Agent as a Beneficial Owner or a Potential Beneficial Owner and
therefore participate in an Auction as an Existing Holder or Potential Holder on
behalf of both itself and its customers. On or prior to the Submission Deadline
on each Auction Date:
(A) each Beneficial Owner may submit to its Broker-Dealer information
as to:
(1) the number of Outstanding shares, if any, of APS held by such
Beneficial Owner which such Beneficial Owner desires to continue to hold without
regard to the Applicable Rate for the next succeeding Dividend Period for such
shares;
(2) the number of Outstanding shares, if any, of APS held by such
Beneficial Owner which such Beneficial Owner desires to continue to hold,
provided that the Applicable Rate for the next succeeding Dividend Period for
such shares shall not be less than the rate per annum specified by such
Beneficial Owner; and/or
(3) the number of Outstanding shares, if any, of APS held by such
Beneficial Owner which such Beneficial Owner offers to sell without regard to
the Applicable Rate for the next succeeding Dividend Period; and
(B) each Broker-Dealer, using a list of Potential Beneficial Owners
that shall be maintained in good faith for the purpose of conducting a
competitive Auction, shall contact Potential Beneficial Owners, including
Persons that are not Beneficial Owners, on such list to determine the number of
Outstanding shares, if any, of APS which each such Potential Beneficial Owner
offers to purchase, provided that the Applicable Rate for the next succeeding
Dividend Period shall not be less than the rate per annum specified by such
Potential Beneficial Owner.
For the purposes hereof, the communication by a Beneficial Owner or
Potential Beneficial Owner to a Broker-Dealer, or the communication by a
Broker-Dealer acting for its own account to the Auction Agent, of information
referred to in clause (A) or (B) of this Section 11.10(b)(i) is hereinafter
referred to as an "Order" and each Beneficial Owner and each Potential
Beneficial Owner placing an Order, including a Broker-Dealer acting in such
capacity for its own account, is hereinafter referred to as a "Bidder"; an Order
containing the information referred to in clause (A)(1) of this Section
11.10(b)(i) is hereinafter referred to as a "Hold Order"; an Order containing
the information referred to in clause (A)(2) or (B) of this Section 11.10(b)(i)
is hereinafter referred to as a "Bid"; and an Order containing the information
referred to in clause (A)(3) of this Section 11.10(b)(i) is hereinafter referred
to as a "Sell Order." Inasmuch as a Broker-Dealer participates in an Auction as
an Existing Holder or a Potential Holder only to represent the interests of a
Beneficial Owner or Potential Beneficial Owner, whether it be its customers or
itself, all discussion herein relating to the consequences of an Auction for
Existing Holders and Potential Holders also applies to the underlying beneficial
ownership interests represented.
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(ii) (A) A Bid by an Existing Holder shall constitute an irrevocable
offer to sell:
(1) the number of Outstanding shares of APS specified in such Bid if
the Applicable Rate determined on such Auction Date shall be less than the rate
per annum specified in such Bid; or
(2) such number or a lesser number of Outstanding shares of APS to be
determined as set forth in Section 11.10(e)(i)(D) if the Applicable Rate
determined on such Auction Date shall be equal to the rate per annum specified
therein; or
(3) a lesser number of Outstanding shares of APS to be determined as
set forth in Section 11.10(e)(ii)(C) if such specified rate per annum shall be
higher than the Maximum Applicable Rate and Sufficient Clearing Bids do not
exist.
(B) A Sell Order by an Existing Holder shall constitute an irrevocable
offer to sell:
(1) the number of Outstanding shares of APS specified in such Sell
Order; or
(2) such number or a lesser number of Outstanding shares of APS to be
determined as set forth in Section 11.10(e)(ii)(C) if Sufficient Clearing Bids
do not exist.
(C) A Bid by a Potential Holder shall constitute an irrevocable offer
to purchase:
(1) the number of Outstanding shares of APS specified in such Bid if
the Applicable Rate determined on such Auction Date shall be higher than the
rate per annum specified in such Bid; or
(2) such number or a lesser number of Outstanding shares of APS to be
determined as set forth in Section 11.10(e)(i)(E) if the Applicable Rate
determined on such Auction Date shall be equal to the rate per annum specified
therein.
(c) Submission of Orders by Broker-Dealers to Auction Agent.
(i) Each Broker-Dealer shall submit in writing or through the Auction
Agent's Auction Processing System to the Auction Agent prior to the Submission
Deadline on each Auction Date all Orders obtained by such Broker-Dealer,
designating itself (unless otherwise permitted by the Trust) as an Existing
Holder in respect of shares subject to Orders submitted or deemed submitted to
it by Beneficial Owners and as a Potential Holder in respect of shares subject
to Orders submitted to it by Potential Beneficial Owners, and specifying with
respect to each Order:
(A) the name of the Bidder placing such Order (which shall be the
Broker-Dealer unless otherwise permitted by the Trust);
(B) the aggregate number of Outstanding shares of APS that are the
subject of such Order;
(C) to the extent that such Bidder is an Existing Holder:
(1) the number of Outstanding shares, if any, of APS subject to any
Hold Order placed by such Existing Holder;
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(2) the number of Outstanding shares, if any, of APS subject to any Bid
placed by such Existing Holder and the rate per annum specified in such Bid; and
(3) the number of Outstanding shares, if any, of APS subject to any
Sell Order placed by such Existing Holder; and
(D) to the extent such Bidder is a Potential Holder, the rate per annum
specified in such Potential Holder's Bid.
(ii) If any rate per annum specified in any Bid contains more than
three figures to the right of the decimal point, the Auction Agent shall round
such rate up to the next highest one-thousandth (.001) of 1%.
(iii) If an Order or Orders covering all of the Outstanding shares of
APS held by an Existing Holder are not submitted to the Auction Agent prior to
the Submission Deadline, the Auction Agent shall deem a Hold Order (in the case
of an Auction relating to a Special Dividend Period of 91 days or less) or a
Sell Order (in the case of an Auction relating to a Special Dividend Period of
longer than 91 days) to have been submitted on behalf of such Existing Holder
covering the number of Outstanding shares of APS held by such Existing Holder
and not subject to Orders submitted to the Auction Agent.
(iv) If one or more Orders on behalf of an Existing Holder covering in
the aggregate more than the number of Outstanding shares of APS held by such
Existing Holder are submitted to the Auction Agent, such Order shall be
considered valid as follows and in the following order of priority:
(A) any Hold Order submitted on behalf of such Existing Holder shall be
considered valid up to and including the number of Outstanding shares of APS
held by such Existing Holder; provided that if more than one Hold Order is
submitted on behalf of such Existing Holder and the number of shares of APS
subject to such Hold Orders exceeds the number of Outstanding shares of APS held
by such Existing Holder, the number of shares of APS subject to each of such
Hold Orders shall be reduced pro rata so that such Hold Orders, in the
aggregate, will cover exactly the number of Outstanding shares of APS held by
such Existing Holder;
(B) any Bids submitted on behalf of such Existing Holder shall be
considered valid, in the ascending order of their respective rates per annum if
more than one Bid is submitted on behalf of such Existing Holder, up to and
including the excess of the number of Outstanding shares of APS held by such
Existing Holder over the number of shares of APS subject to any Hold Order
referred to in Section 11.10(c)(iv)(A) above (and if more than one Bid submitted
on behalf of such Existing Holder specifies the same rate per annum and together
they cover more than the remaining number of shares that can be the subject of
valid Bids after application of Section 11.10(c)(iv)(A) above and of the
foregoing portion of this Section 11.10(c)(iv)(B) to any Bid or Bids specifying
a lower rate or rates per annum, the number of shares subject to each of such
Bids shall be reduced pro rata so that such Bids, in the aggregate, cover
exactly such remaining number of shares); and the number of shares, if any,
subject to Bids not valid under this Section 11.10(c)(iv)(B) shall be treated as
the subject of a Bid by a Potential Holder; and
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(C) any Sell Order shall be considered valid up to and including the
excess of the number of Outstanding shares of APS held by such Existing Holder
over the number of shares of APS subject to Hold Orders referred to in Section
11.10(c)(iv)(A) and Bids referred to in Section 11.10(c)(iv)(B); provided that
if more than one Sell Order is submitted on behalf of any Existing Holder and
the number of shares of APS subject to such Sell Orders is greater than such
excess, the number of shares of APS subject to each of such Sell Orders shall be
reduced pro rata so that such Sell Orders, in the aggregate, cover exactly the
number of shares of APS equal to such excess.
(v) If more than one Bid is submitted on behalf of any Potential
Holder, each Bid submitted shall be a separate Bid with the rate per annum and
number of shares of APS therein specified.
(vi) Any Order submitted by a Beneficial Owner as a Potential
Beneficial Owner to its Broker-Dealer, or by a Broker-Dealer to the Auction
Agent, prior to the Submission Deadline on any Auction Date shall be
irrevocable.
(vii) The Trust shall not be responsible for a Broker-Dealer's failure
to act in accordance with the instructions of Beneficial Owners or Potential
Beneficial Owners or failure to comply with the provisions of this Section
11.10.
(d) Determination of Sufficient Clearing Bids, Winning Bid Rate and
Applicable Rate.
(i) Not earlier than the Submission Deadline on each Auction Date, the
Auction Agent shall assemble all Orders submitted or deemed submitted to it by
the Broker-Dealers (each such Order as submitted or deemed submitted by a
Broker-Dealer being hereinafter referred to individually as a "Submitted Hold
Order", a "Submitted Bid" or a "Submitted Sell Order", as the case may be, or as
a "Submitted Order") and shall determine:
(A) the excess of the total number of Outstanding shares of APS over
the number of Outstanding shares of APS that are the subject of Submitted Hold
Orders (such excess being hereinafter referred to as the "Available APS");
(B) from the Submitted Orders whether the number of Outstanding shares
of APS that are the subject of Submitted Bids by Potential Holders specifying
one or more rates per annum equal to or lower than the Maximum Applicable Rate
exceeds or is equal to the sum of:
(1) the number of Outstanding shares of APS that are the subject of
Submitted Bids by Existing Holders specifying one or more rates per annum higher
than the Maximum Applicable Rate, and
(2) the number of Outstanding shares of APS that are subject to
Submitted Sell Orders (if such excess or such equality exists (other than
because the number of Outstanding shares of APS in clause (1) above and this
clause (2) are each zero because all of the Outstanding shares of APS are the
subject of Submitted Hold Orders), such Submitted Bids by Potential Holders
being hereinafter referred to collectively as "Sufficient Clearing Bids"); and
(C) if Sufficient Clearing Bids exist, the lowest rate per annum
specified in the Submitted Bids (the "Winning Bid Rate") that if:
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(1) each Submitted Bid from Existing Holders specifying the Winning Bid
Rate and all other Submitted Bids from Existing Holders specifying lower rates
per annum were rejected, thus entitling such Existing Holders to continue to
hold the shares of APS that are the subject of such Submitted Bids, and
(2) each Submitted Bid from Potential Holders specifying the Winning
Bid Rate and all other Submitted Bids from Potential Holders specifying lower
rates per annum were accepted, thus entitling the Potential Holders to purchase
the shares of APS that are the subject of such Submitted Bids, would result in
the number of shares subject to all Submitted Bids specifying the Winning Bid
Rate or a lower rate per annum being at least equal to the Available APS.
(ii) Promptly after the Auction Agent has made the determinations
pursuant to Section 11.10(d)(i), the Auction Agent shall advise the Trust of the
Maximum Applicable Rate and, based on such determinations, the Applicable Rate
for the next succeeding Dividend Period as follows:
(A) if Sufficient Clearing Bids exist, that the Applicable Rate for the
next succeeding Dividend Period shall be equal to the Winning Bid Rate;
(B) if Sufficient Clearing Bids do not exist (other than because all of
the Outstanding shares of APS are the subject of Submitted Hold Orders), that
the Applicable Rate for the next succeeding Dividend Period shall be equal to
the Maximum Applicable Rate; or
(C) if all of the Outstanding shares of APS are the subject of
Submitted Hold Orders, that the Dividend Period next succeeding the Auction
shall automatically be the same length as the immediately preceding Dividend
Period and the Applicable Rate for the next succeeding Dividend Period shall be
equal to 40% of the Reference Rate (or 60% of such rate if the Trust has
provided notification to the Auction Agent prior to the Auction establishing the
Applicable Rate for any dividend pursuant to Section 11.2(f) hereof that net
capital gains or other taxable income will be included in such dividend on
shares of APS) on the date of the Auction.
(e) Acceptance and Rejection of Submitted Bids and Submitted Sell
Orders and Allocation of Shares. Based on the determinations made pursuant to
Section 11.10(d)(i), the Submitted Bids and Submitted Sell Orders shall be
accepted or rejected and the Auction Agent shall take such other action as set
forth below:
(i) If Sufficient Clearing Bids have been made, subject to the
provisions of Section 11.10(e)(iii) and Section 11.10(e)(iv), Submitted Bids and
Submitted Sell Orders shall be accepted or rejected in the following order of
priority and all other Submitted Bids shall be rejected:
(A) the Submitted Sell Orders of Existing Holders shall be accepted and
the Submitted Bid of each of the Existing Holders specifying any rate per annum
that is higher than the Winning Bid Rate shall be accepted, thus requiring each
such Existing Holder to sell the Outstanding shares of APS that are the subject
of such Submitted Sell Order or Submitted Bid;
(B) the Submitted Bid of each of the Existing Holders specifying any
rate per annum that is lower than the Winning Bid Rate shall be rejected, thus
entitling each such Existing Holder to continue to hold the Outstanding shares
of APS that are the subject of such Submitted Bid;
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(C) the Submitted Bid of each of the Potential Holders specifying any
rate per annum that is lower than the Winning Bid Rate shall be accepted;
(D) the Submitted Bid of each of the Existing Holders specifying a
rate per annum that is equal to the Winning Bid Rate shall be rejected, thus
entitling each such Existing Holder to continue to hold the Outstanding shares
of APS that are the subject of such Submitted Bid, unless the number of
Outstanding shares of APS subject to all such Submitted Bids shall be greater
than the number of Outstanding shares of APS ("Remaining Shares") equal to the
excess of the Available APS over the number of Outstanding shares of APS subject
to Submitted Bids described in Section 11.10(e)(i)(B) and Section
11.10(e)(i)(C), in which event the Submitted Bids of each such Existing Holder
shall be accepted, and each such Existing Holder shall be required to sell
Outstanding shares of APS, but only in an amount equal to the difference between
(1) the number of Outstanding shares of APS then held by such Existing Holder
subject to such Submitted Bid and (2) the number of shares of APS obtained by
multiplying (x) the number of Remaining Shares by (y) a fraction the numerator
of which shall be the number of Outstanding shares of APS held by such Existing
Holder subject to such Submitted Bid and the denominator of which shall be the
sum of the number of Outstanding shares of APS subject to such Submitted Bids
made by all such Existing Holders that specified a rate per annum equal to the
Winning Bid Rate; and
(E) the Submitted Bid of each of the Potential Holders specifying a
rate per annum that is equal to the Winning Bid Rate shall be accepted but only
in an amount equal to the number of Outstanding shares of APS obtained by
multiplying (x) the difference between the Available APS and the number of
Outstanding shares of APS subject to Submitted Bids described in Section
11.10(e)(i)(B), Section 11.10(e)(i)(C) and Section 11.10(e)(i)(D) by (y) a
fraction the numerator of which shall be the number of Outstanding shares of APS
subject to such Submitted Bid and the denominator of which shall be the sum of
the number of Outstanding shares of APS subject to such Submitted Bids made by
all such Potential Holders that specified rates per annum equal to the Winning
Bid Rate.
(ii) If Sufficient Clearing Bids have not been made (other than because
all of the Outstanding shares of APS are subject to Submitted Hold Orders),
subject to the provisions of Section 11.10(e)(iii), Submitted Orders shall be
accepted or rejected as follows in the following order of priority and all other
Submitted Bids shall be rejected:
(A) the Submitted Bid of each Existing Holder specifying any rate per
annum that is equal to or lower than the Maximum Applicable Rate shall be
rejected, thus entitling such Existing Holder to continue to hold the
Outstanding shares of APS that are the subject of such Submitted Bid;
(B) the Submitted Bid of each Potential Holder specifying any rate per
annum that is equal to or lower than the Maximum Applicable Rate shall be
accepted, thus requiring such Potential Holder to purchase the Outstanding
shares of APS that are the subject of such Submitted Bid; and
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(C) the Submitted Bids of each Existing Holder specifying any rate per
annum that is higher than the Maximum Applicable Rate shall be accepted and the
Submitted Sell Orders of each Existing Holder shall be accepted, in both cases
only in an amount equal to the difference between (1) the number of Outstanding
shares of APS then held by such Existing Holder subject to such Submitted Bid or
Submitted Sell Order and (2) the number of shares of APS obtained by multiplying
(x) the difference between the Available APS and the aggregate number of
Outstanding shares of APS subject to Submitted Bids described in Section
11.10(e)(ii)(A) and Section 11.10(e)(ii)(B) by (y) a fraction the numerator of
which shall be the number of Outstanding shares of APS held by such Existing
Holder subject to such Submitted Bid or Submitted Sell Order and the denominator
of which shall be the number of Outstanding shares of APS subject to all such
Submitted Bids and Submitted Sell Orders.
(iii) If, as a result of the procedures described in Section 11.10(e),
any Existing Holder would be entitled or required to sell, or any Potential
Holder would be entitled or required to purchase, a fraction of a share of APS
on any Auction Date, the Auction Agent shall, in such manner as in its sole
discretion it shall determine, round up or down the number of shares of APS to
be purchased or sold by any Existing Holder or Potential Holder on such Auction
Date so that each Outstanding share of APS purchased or sold by each Existing
Holder or Potential Holder on such Auction Date shall be a whole share of APS.
(iv) If, as a result of the procedures described in Section 11.10(e),
any Potential Holder would be entitled or required to purchase less than a whole
share of APS on any Auction Date, the Auction Agent shall, in such manner as in
its sole discretion it shall determine, allocate shares of APS for purchase
among Potential Holders so that only whole shares of APS are purchased on such
Auction Date by any Potential Holder, even if such allocation results in one or
more of such Potential Holders not purchasing any shares of APS on such Auction
Date.
(v) Based on the results of each Auction, the Auction Agent shall
determine, with respect to each Broker-Dealer that submitted Bids or Sell Orders
on behalf of Existing Holders or Potential Holders, the aggregate number of
Outstanding shares of APS to be purchased and the aggregate number of the
Outstanding shares of APS to be sold by such Potential Holders and Existing
Holders and, to the extent that such aggregate number of Outstanding shares to
be purchased and such aggregate number of Outstanding shares to be sold differ,
the Auction Agent shall determine to which other Broker-Dealer or Broker-Dealers
acting for one or more purchasers such Broker-Dealer shall deliver, or from
which other Broker-Dealer or Broker-Dealers acting for one or more sellers such
Broker-Dealer shall receive, as the case may be, Outstanding shares of APS.
(f) Miscellaneous.
(i) The Trust may interpret the provisions of this Section 11.10 to
resolve any inconsistency or ambiguity, remedy any formal defect or make any
other change or modification that does not substantially adversely affect the
rights of Beneficial Owners of APS.
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(ii) A Beneficial Owner or an Existing Holder (A) may sell, transfer or
otherwise dispose of shares of APS only pursuant to a Bid or Sell Order in
accordance with the procedures described in this Section 11.10 or to or through
a Broker-Dealer or to such other persons as may be permitted by the Fund,
provided that in the case of all transfers other than pursuant to Auctions such
Beneficial Owner or Existing Holder, its Broker-Dealer, if applicable, or its
Agent Member advises the Auction Agent of such transfer and (B) except as
otherwise required by law, shall have the ownership of the shares of APS held by
it maintained in book entry form by the Securities Depository in the account of
its Agent Member, which in turn will maintain records of such Beneficial Owner's
beneficial ownership. The Trust may not submit an Order in any Auction.
(iii) All of the Outstanding shares of APS of a series shall be
registered in the name of the nominee of the Securities Depository unless
otherwise required by law or unless there is no Securities Depository. If there
is no Securities Depository, at the Trust's option and upon its receipt of such
documents as it deems appropriate, any shares of APS may be registered in the
Stock Register in the name of the Beneficial Owner thereof and such Beneficial
Owner thereupon will be entitled to receive certificates therefor and required
to deliver certificates therefor upon transfer or exchange thereof.
C-10