As filed with the Securities and Exchange Commission on March 11, 2005
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1933 Act File No. 333-
1940 Act File No. 811-21727
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM N-2
(Check appropriate box or boxes)
[X] REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933
[ ] Pre-Effective Amendment No. __
[ ] Post-Effective Amendment No. __
and
[X] REGISTRATION STATEMENT UNDER THE INVESTMENT COMPANY ACT OF 1940
[ ] Amendment No. __
First Trust/FIDAC Mortgage Income Fund
Exact Name of Registrant as Specified in Declaration of Trust
1001 Warrenville Road, Suite 300, Lisle, Illinois 60532
Address of Principal Executive Offices (Number, Street, City, State, Zip Code)
(630) 241-4141
Registrant's Telephone Number, including Area Code
W. Scott Jardine, Esq.
First Trust Portfolios L.P.
1001 Warrenville Road, Suite 300
Lisle, Illinois 60532
Name and Address (Number, Street, City, State, Zip Code) of Agent for Service
Copies of Communications to:
Eric F. Fess, Esq.
Chapman and Cutler LLP
111 West Monroe Street
Chicago, Illinois 60603
Approximate Date of Proposed Public Offering: As soon as practicable after the
effective date of this Registration Statement
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If any of the securities being registered on this form are offered on a delayed
or continuous basis in reliance on Rule 415 under the Securities Act of 1933,
other than securities offered in connection with a dividend reinvestment plan,
check the following box. [ ]
It is proposed that this filing will become effective (check appropriate box)
[ ] when declared effective pursuant to section 8(c)
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CALCULATION OF REGISTRATION FEE UNDER THE SECURITIES ACT OF 1933
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---------------- ------------ ---------------- ----------------- --------------
Title of Proposed Proposed
Securities Amount Maximum Maximum Amount of
Being Being Offering Price Aggregate Registration
Registered Registered Per Unit Offering Price(1) Fee
---------------- ------------ ---------------- ----------------- --------------
Common Shares, 1,000 $20.00 $20,000 $2.35
$0.01 par value
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(1) Estimated solely for the purpose of calculating the registration fee.
The Registrant hereby amends this Registration Statement on such date or dates
as may be necessary to delay its effective date until the Registrant shall file
a further amendment which specifically states this Registration Statement shall
thereafter become effective in accordance with Section 8(a) of the Securities
Act of 1933 or until the Registration Statement shall become effective on such
dates as the Commission, acting pursuant to said Section 8(a), may determine.
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SUBJECT TO COMPLETION
PRELIMINARY PROSPECTUS DATED MARCH 11, 2005
THE INFORMATION IN THIS PROSPECTUS IS NOT COMPLETE AND MAY BE CHANGED. WE MAY
NOT SELL THESE SECURITIES UNTIL THE REGISTRATION STATEMENT FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION IS EFFECTIVE. THIS PROSPECTUS IS NOT AN OFFER
TO SELL THESE SECURITIES AND IT IS NOT SOLICITING AN OFFER TO BUY THESE
SECURITIES IN ANY STATE WHERE THE OFFER OR SALE IS NOT PERMITTED.
PROSPECTUS
----------
SHARES
FIRST TRUST/FIDAC MORTGAGE INCOME FUND
COMMON SHARES
$20.00 PER SHARE
----------------
The Fund. First Trust/FIDAC Mortgage Income Fund (the "Fund") is a newly
organized, diversified, closed-end management investment company.
Investment Objectives. The Fund's primary investment objective is to seek a
high level of current income. As a secondary objective, the Fund will seek to
preserve capital. There can be no assurance that the Fund's investment
objectives will be achieved.
The Fund will pursue its objectives by investing primarily in investment
securities consisting of mortgage-backed securities, which include agency
mortgage pass-through certificates, agency collateralized mortgage obligations,
non-agency mortgage-backed securities and commercial mortgage-backed securities
(collectively, "MBS"), that, in the opinion of the Fund's sub-adviser, offer an
attractive combination of credit quality, yield and maturity.
Under normal market conditions, the Fund will invest at least 80% of its
managed assets in MBS. In addition, the Fund may invest up to 20% of its managed
assets in U.S. government securities, or cash or other short-term instruments,
and may invest up to 10% of its managed assets in other mortgage-related assets
that are secured by pools of assets that represent interests in real estate. The
Fund will invest all of its managed assets in securities that at the time of
investment are investment grade quality and rated within the three highest
investment grades by at least one rating agency or are unrated but judged to be
of comparable quality by the sub-adviser.
No Prior History. BECAUSE THE FUND IS NEWLY ORGANIZED, ITS SHARES HAVE NO
HISTORY OF PUBLIC TRADING. SHARES OF CLOSED-END INVESTMENT COMPANIES FREQUENTLY
TRADE AT A DISCOUNT FROM THEIR NET ASSET VALUE. THIS RISK MAY BE GREATER FOR
INVESTORS EXPECTING TO SELL THEIR SHARES IN A RELATIVELY SHORT PERIOD AFTER
COMPLETION OF THE PUBLIC OFFERING. The Fund intends to apply to list the common
shares on the Exchange. The trading or "ticker" symbol of the common shares
is expected to be " ."
Investment Adviser and Sub-Adviser. First Trust Advisors L.P. ("First Trust
Advisors" or the "Adviser") will be the Fund's investment adviser and will be
responsible for selecting and supervising the Sub-Adviser (as defined below),
the ongoing monitoring of the Fund's investment portfolio, managing the Fund's
business affairs and providing certain clerical and bookkeeping and other
administrative services. The Adviser, in consultation with the Sub-Adviser, is
also responsible for determining the Fund's overall investment strategy and
overseeing its implementation. Fixed Income Discount Advisory Company ("FIDAC"
or the "Sub-Adviser") will be the Fund's sub-adviser.
(continued on the following page)
INVESTING IN THE FUND'S COMMON SHARES INVOLVES CERTAIN RISKS THAT ARE
DESCRIBED IN THE "RISKS" SECTION BEGINNING ON PAGE 23 OF THIS PROSPECTUS.
----------------
PER SHARE TOTAL(1)
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Public offering price $20.00 $
Sales load $.90 $
Estimated offering costs (2) (3) $.04 $
Proceeds, after expenses, to the Fund $19.06 $
(notes on following page)
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.
The common shares will be ready for delivery on or about , 2005.
----------------
----------------
The date of this prospectus is , 2005.
Front Cover
(continued from previous page)
First Trust Advisors serves as investment adviser or portfolio supervisor to
investment portfolios with approximately $17.1 billion in assets which it
managed or supervised as of February 28, 2005. FIDAC is a wholly owned
subsidiary of Annaly Mortgage Management, Inc. ("Annaly"), a New York Stock
Exchange-listed real estate investment trust. As of December 31, 2004, FIDAC and
its parent Annaly collectively had approximately $36 billion of gross assets
under management. See "Management of the Fund" in this prospectus and
"Investment Adviser" and "Sub-Adviser" in the Fund's Statement of Additional
Information (the "SAI").
Leverage. Within approximately two months after the completion of the
offering of common shares described in this prospectus, the Fund intends,
subject to then favorable market conditions, to utilize leverage primarily
through the use of reverse repurchase agreements. The Fund may also utilize
leverage through the issuance of preferred shares of beneficial interest
("Preferred Shares"), commercial paper or notes and/or borrowings. The Fund will
limit its use of leverage to an aggregate amount of up to 33-1/3% of the Fund's
Managed Assets after such issuance and/or borrowing. "Managed Assets" means the
average daily gross asset value of the Fund (including assets attributable to
the Fund's Preferred Shares, if any, and the principal amount of borrowings)
minus the sum of the Fund's accrued and unpaid dividends on any outstanding
Preferred Shares and accrued liabilities (other than the principal amount of any
repurchase agreements, other borrowings or of commercial paper or notes issued
by the Fund). For purposes of determining Managed Assets, the liquidation
preference of the Preferred Shares is not treated as a liability. The use of
repurchase agreements and the issuance of other borrowings, the repayment of
which would be senior to the common shares, will result in the financial
leveraging of the common shares. Whether to offer Preferred Shares or engage in
another form of leveraging, and, if offered, the terms of such shares or
leveraging and the timing and other terms of their offering or arrangement will
be determined by the Fund's board of trustees ("Board of Trustees"). Through
leveraging, the Fund will seek to obtain a higher return for the holders of
common shares than if the Fund did not use leverage. Leverage is a speculative
technique and investors should note that there are special risks and costs
associated with the leveraging of the common shares. There can be no assurance
that a leveraging strategy will be successful during any period in which it is
employed. See "Borrowings and Preferred Shares--Effects of Leverage,"
"Risks--Leverage Risk" and "Description of Shares."
You should read this prospectus, which contains important information about
the Fund, before deciding whether to invest in the common shares, and retain it
for future reference. This prospectus sets forth concisely the information about
the Fund that a prospective investor ought to know before investing. The SAI,
dated , 2005, 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. You may request a free copy of the SAI, the
table of contents of which is on page 41 of this prospectus, annual and
semi-annual reports to shareholders when available, and other information about
the Fund, and make shareholder inquiries by calling (800) 988-5891, by writing
to the Fund or from the Fund's website (http://www.ftportfolios.com). You also
may obtain a copy of the SAI (and other information regarding the Fund) from the
Securities and Exchange Commission's web site (http:// www.sec.gov).
The Fund's common shares 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 "FDIC"), the Federal Reserve Board or any other government
agency.
(notes from previous page)
(1) The Fund has granted the underwriters an option to purchase up to
additional common shares at the public offering price, less the sales
load, within 45 days of the date of this prospectus solely to cover
overallotments, if any. If such option is exercised in full, the total
price to the public, sales load, estimated offering costs and proceeds,
after expenses, to the Fund will be $ , $ , $ and $ , respectively. See
"Underwriting."
(2) Total expenses of the offering of the common shares of the Fund paid by
the Fund (other than sales load, but including the partial
reimbursement of certain underwriter expenses described below) are
estimated to be $ , which represents .2% (or $.04 per common share) of
the Fund's offering price. The Fund's investment adviser, First Trust
Advisors L.P., has agreed to pay (i) all organizational expenses and
(ii) all offering costs of the Fund (other than sales load, but
including the partial reimbursement of expenses described below) that
exceed .2% (or $.04 per common share) of the Fund's offering price. The
Fund's Sub-Adviser, FIDAC, has agreed to reimburse the Fund's
investment adviser for one-half of such organizational expenses and
offering costs of the Fund that exceed .2% (or $.04 per common share)
of the Fund's offering price.
(3) The Fund has agreed to pay the underwriters $ per common share as a
partial reimbursement of expenses incurred in connection with the
offering and to pay certain fees to counsel to the underwriters. The
Fund's investment adviser (not the Fund) will pay additional
compensation and will pay an incentive fee. The total amount of the
foregoing payments, together with any reimbursement to First Trust
Portfolios, L.P. for distribution services, will not exceed 4.5% (or
$.90 per common share) of the total price to the public of the common
shares sold in this offering, but is in addition to the 4.5% (or $.90
per common share) sales load described in the table. See
"Underwriting."
Page 2
TABLE OF CONTENTS
PAGE
Prospectus Summary ......................................................... 4
Summary of Fund Expenses ................................................... 15
The Fund ................................................................... 16
Use of Proceeds ............................................................ 16
The Fund's Investments ..................................................... 16
Borrowings and Preferred Shares ............................................ 21
Risks ...................................................................... 23
Management of the Fund ..................................................... 29
Net Asset Value ............................................................ 30
Distributions .............................................................. 31
Dividend Reinvestment Plan ................................................. 31
Description of Shares ...................................................... 32
Certain Provisions in the Declaration of Trust ............................. 34
Structure of the Fund; Common Share Repurchases and
Conversion to Open-End Fund ............................................ 35
Tax Matters ................................................................ 36
Underwriting ............................................................... 38
Administrator, Custodian and Transfer Agent ................................ 40
Legal Opinions ............................................................. 40
Table of Contents for the Statement of Additional Information .............. 41
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YOU SHOULD RELY ONLY ON THE INFORMATION CONTAINED IN THIS PROSPECTUS.
NEITHER THE FUND NOR THE UNDERWRITERS HAVE AUTHORIZED ANY OTHER PERSON TO
PROVIDE YOU WITH DIFFERENT INFORMATION. IF ANYONE PROVIDES YOU WITH DIFFERENT OR
INCONSISTENT INFORMATION, YOU SHOULD NOT RELY ON IT. NEITHER THE FUND NOR THE
UNDERWRITERS ARE MAKING AN OFFER TO SELL THESE SECURITIES IN ANY JURISDICTION
WHERE THE OFFER OR SALE IS NOT PERMITTED. YOU SHOULD ASSUME THAT THE INFORMATION
APPEARING IN THIS PROSPECTUS IS ACCURATE AS OF THE DATE ON THE FRONT COVER ONLY.
Page 3
PROSPECTUS SUMMARY
This is only a summary. This summary does not contain all of the
information that you should consider before investing in the Fund's common
shares. You should review the more detailed information contained in this
prospectus and in the SAI, especially the information set forth in this
prospectus under the heading "Risks."
THE FUND......................... First Trust/FIDAC Mortgage Income Fund (the
"Fund") is a newly organized, diversified,
closed-end management investment company.
See "The Fund."
THE OFFERING..................... The Fund is offering common
shares of beneficial interest at $20.00 per
share through a group of underwriters (the
"Underwriters") led by (" "). The common
shares of beneficial interest are called
"Common Shares" in this prospectus. You must
purchase at least 100 Common Shares in this
offering. The Fund has given the
Underwriters an option to purchase up to
additional Common Shares to cover orders in
excess of Common Shares. The Adviser has
agreed to pay (i) all organizational
expenses and (ii) all offering costs of the
Fund (other than sales load, but including a
partial reimbursement of certain underwriter
expenses) that exceed .2% (or $.04 per
Common Share) of the Fund's offering price.
The Sub-Adviser has agreed to reimburse the
Adviser for one-half of such organizational
expenses and offering costs of the Fund that
exceed .2% (or $.04 per Common Share) of the
Fund's offering price.
LISTING.......................... The Fund intends to apply to list the Common
Shares on the Exchange. The trading or
"ticker" symbol of the Common Shares is
expected to be " ."
INVESTMENT OBJECTIVES
AND POLICIES..................... The Fund's primary investment objective is
to seek a high level of current income. As a
secondary objective, the Fund will seek to
preserve capital. There can be no assurance
that the Fund's investment objectives will
be achieved.
The Fund will pursue its objectives by
investing primarily in MBS that, in the
opinion of the Fund's Sub-Adviser, offer an
attractive combination of credit quality,
yield and maturity. The Fund's investment
securities will include:
o mortgage pass-through certificates
issued or guaranteed by the
Government National Mortgage
Association ("GNMA" or "Ginnie Mae"),
the Federal National Mortgage
Association ("FNMA" or "Fannie Mae"),
and/or the Federal Home Loan Mortgage
Corporation ("FHLMC" or "Freddie
Mac") (collectively, "Agency Mortgage
Pass-through Certificates");
o collateralized mortgage obligations
issued by GNMA, FNMA or FHLMC
("Agency CMOs" and collectively with
Agency Mortgage Pass-through
Certificates, "Agency MBS");
o debt obligations issued by private
originators or investors backed by
residential mortgage loans
("Non-Agency RMBS");
o multi-class debt or pass-through or
pay-through securities backed by a
mortgage loan or pool of mortgage
loans on commercial real estate
("CMBS");
o U.S. government securities, or cash
or other short-term instruments; and
o real estate-related assets
collateralized by pools of assets
such as home equity loans and lines
of credit ("Other MBS").
Under normal market conditions, the Fund
will invest at least 80% of its Managed
Assets in Agency MBS, Non-Agency RMBS, and
CMBS (collectively, "MBS"). In addition, the
Fund may invest up to 20% of its Managed
Assets in U.S. government securities, or
cash or other short-term instruments, and
may invest up to 10% of its Managed Assets
in Other MBS. Under normal market
conditions, the Fund will be fully invested
in Agency MBS, Non-Agency RMBS, CMBS, and
Other MBS.
Page 4
The Fund will invest all of its Managed
Assets in securities that at the time of
investment are investment grade quality. The
Fund will only invest in securities which
are:
o issued or guaranteed by the U.S.
government or any agency or
instrumentality thereof,
o rated within the three highest
investment grades by at least one
rating agency (A or better by Moody's
Investors Service, Inc. ("Moody's"),
Standard & Poor's Ratings Group
("S&P") or Fitch IBCA, Inc.
("Fitch")), or
o unrated but judged to be of
comparable quality by the
Sub-Adviser.
The MBS in which the Fund may invest include
those with fixed, floating or variable
interest rates, those with interest rates
that change based on multiples of changes in
a specified index of interest rates and
those with interest rates that change
inversely to changes in interest rates, as
well as those that do not bear interest. The
Fund will not invest in corporate bonds,
other than those primarily secured by
interests in real estate.
The Fund will attempt to reduce portfolio
prepayment risk by investing in MBS, such as
certain Non-Agency RMBS, whose returns may
be enhanced by faster prepayments, and also
by investing in MBS, such as certain Agency
MBS, whose returns may be enhanced by slower
prepayments. The Fund may invest a portion
of its Managed Assets in subordinated
classes of MBS, including Non-Agency RMBS
and CMBS.
Percentage limitations described in this
prospectus are as of the time of investment
by the Fund and may be exceeded on a
going-forward basis as a result of market
value fluctuations of the Fund's portfolio.
While the majority of the Fund's investments
are expected initially to consist of fixed-
rate investment securities, the Fund may
also invest in adjustable-rate MBS. In
selecting MBS and Other MBS, the Sub-Adviser
will also consider the liquidity of the
market for the different MBS. Unlike most
fixed-income products, MBS are sold and
traded based on the average life of the
security rather than the stated maturity.
The average life of a mortgage is the
average number of years that each dollar of
unpaid principal due on the security remains
outstanding. If prepayment rates are faster
than expected (typical in declining rate
environments), the average life of the
security will be shorter than the original
estimate. If prepayment rates are slower
(typical in rising rate environments), the
security's average life will be extended.
The Sub-Adviser will manage the Fund's
portfolio's prepayment characteristics to
take advantage of observed interest rate
trends. In a rising rate environment, it is
expected that the Fund would purchase
securities that will benefit from a slowdown
in mortgage prepayment rates. Conversely, in
a falling rate environment, it is
anticipated that the Fund would add
securities to the portfolio that would
benefit from increasing prepayment rates.
The Fund's investment objectives are
considered fundamental and may not be
changed without shareholder approval. The
remainder of the Fund's investment policies
(other than its investment restrictions
which are described in the SAI), including
its investment strategy, are considered
non-fundamental and may be changed by the
Board of Trustees without shareholder
approval. The Fund will provide investors
with at least 60 days' prior notice of any
change in the Fund's investment strategy.
There can be no assurance that the Fund's
investment objectives will be achieved. See
"The Fund's Investments" and "Risks" in this
prospectus and "Investment Policies and
Techniques" and "Additional Information
About the Fund's Investments and Investment
Risks" in the SAI.
INVESTMENT ADVISER
AND SUB-ADVISER.................. First Trust Advisors L.P. will be the Fund's
investment adviser and will be responsible
for supervising the Fund's Sub-Adviser,
monitoring the Fund's investment portfolio,
managing the Fund's business affairs and
providing certain clerical and bookkeeping
and other administrative services. The
Adviser, in consultation with the
Sub-Adviser, is also responsible for
determining the Fund's overall investment
strategy and overseeing its implementation.
Page 5
Fixed Income Discount Advisory Company will
be the Fund's Sub-Adviser.
First Trust Advisors, a registered
investment adviser, is an Illinois limited
partnership formed in 1991. It serves as
investment adviser or portfolio supervisor
to investment portfolios with approximately
$17.1 billion in assets which it managed or
supervised as of February 28, 2005. See the
SAI under "Adviser."
FIDAC, a registered investment adviser, is a
wholly owned subsidiary of Annaly Mortgage
Management, Inc., a New York Stock
Exchange-listed real estate investment
trust. As of December 31, 2004, FIDAC and
its parent Annaly collectively had
approximately $36 billion of gross assets
under management. See the SAI under
"Sub-Adviser."
STRATEGIC TRANSACTIONS........... The Fund may, but is not required to, use
various strategic transactions (1) to seek
to reduce interest rate risks arising from
any use of financial leverage, (2) to
facilitate portfolio management and (3) to
mitigate risks, including interest rate and
credit risks. The Fund may purchase and sell
derivative investments such as
exchange-listed and over-the-counter put and
call options on securities, fixed-income and
interest rate indices and other financial
instruments, purchase and sell financial
futures contracts and options thereon, and
enter into various interest rate
transactions such as swaps, caps, floors or
collars or credit transactions, total rate
of return swap transactions and credit
derivative instruments. The Fund also may
purchase derivative instruments that combine
features of these instruments. Collectively,
all of the above are referred to as
"Strategic Transactions." The Fund generally
seeks to use these instruments and
transactions as a portfolio management or
hedging technique to protect against
possible adverse changes in the market value
of securities held in or to be purchased for
the Fund's portfolio, protect the value of
the Fund's portfolio, facilitate the sale of
certain securities for investment purposes,
manage the effective interest rate exposure
of the Fund, or establish positions in the
derivatives markets as a substitute for
purchasing or selling particular securities.
BORROWINGS AND
PREFERRED SHARES................. The Fund intends to use leverage through the
use of reverse repurchase agreements, and,
to a lesser extent, through the issuance of
Preferred Shares, commercial paper or notes
and/or borrowings (each a "Leverage
Instrument" and collectively, the "Leverage
Instruments") in an aggregate amount of up
to 33-1/3% of the Fund's Managed Assets
after such issuance and/or borrowing. The
Fund intends to borrow primarily using
reverse repurchase agreements. Leverage
creates a greater risk of loss, as well as
potential for more gain, for the Common
Shares than if leverage is not used. The
Fund's leveraging strategy may not be
successful. See "Risks--Leverage Risk."
Subject to market conditions, approximately
two months after completion of this
offering, the Fund intends to establish a
leverage program. Investors should
understand that Leverage Instruments will
have seniority over the Common Shares. The
use of Leverage Instruments will leverage
your investment in the Common Shares. A
reverse repurchase agreement, although
structured as a sale and repurchase
obligation, acts as a financing under which
the Fund will effectively pledge its assets
as collateral to secure a short-term loan.
Generally, the other party to the agreement
makes the loan in an amount equal to a
percentage of the market value of the
pledged collateral. At the maturity of the
reverse repurchase agreement, the Fund will
be required to repay the loan and
correspondingly receive back its collateral.
While used as collateral, the assets
continue to pay principal and interest which
are for the benefit of the Fund. The Fund
may also issue commercial paper or notes or
obtain other loans from banks and other
financial institutions. If the Fund uses
Leverage Instruments, associated costs will
be borne immediately by holders of Common
Shares ("Common Shareholders") and result in
a reduction of the net asset value ("NAV")
of the Common Shares.
Preferred Shares, if issued, will pay
dividends based on short-term rates, which
will be reset frequently. Borrowings may be
at a fixed or floating rate and generally
will be based upon short-term rates. So long
as the rate of return, net of applicable
Fund expenses, on the Fund's portfolio
investments purchased with leverage exceeds
Page 6
the then current interest rate or dividend
rate on the Leverage Instruments, the Fund
will generate more return or income than
will be needed to pay such dividends or
interest payments. In this event, the excess
will be available to pay higher dividends to
Common Shareholders. When leverage is
employed, the NAV and market prices of the
Common Shares and the yield to Common
Shareholders will be more volatile.
DISTRIBUTIONS.................... The Fund's present distribution policy,
which may be changed at any time by the
Fund's Board of Trustees, is to distribute
monthly all or a portion of its net
investment income to Common Shareholders
(after the payment of interest and/or
dividends in connection with leverage). In
addition, the Fund intends to distribute any
net long-term capital gains to Common
Shareholders as long-term capital gain
dividends at least annually. Unless an
election is made to receive dividends in
cash, Common Shareholders will automatically
have all dividends and distributions
reinvested in Common Shares through the
Fund's Dividend Reinvestment Plan. See
"Dividend Reinvestment Plan."
If the Fund realizes a long-term capital
gain, it will be required to allocate such
gain between the Common Shares and the
Preferred Shares, if any, issued by the Fund
in proportion to the total dividends paid to
each class of shares for the year in which
the income is realized. See "Distributions"
and "Borrowings and Preferred Shares."
ADMINISTRATOR,
CUSTODIAN AND
TRANSFER AGENT................... The Fund has retained PFPC Trust Company as
custodian, and PFPC Inc. as administrator,
fund accountant and transfer agent for the
Fund. The Adviser and the Board of Trustees
will be responsible for monitoring the
activities of the custodian, administrator,
fund accountant and transfer agent. See
"Administrator, Custodian and Transfer
Agent."
CLOSED-END STRUCTURE............. Closed-end funds differ from open-end
management investment companies (commonly
referred to as mutual funds) in that
closed-end funds generally list their shares
for trading on a securities exchange and do
not redeem their shares at the option of the
shareholder. By comparison, mutual funds
issue securities redeemable at net asset
value at the option of the shareholder and
typically engage in a continuous offering of
their shares. Mutual funds are subject to
continuous asset in-flows and out-flows that
can complicate portfolio management, whereas
closed-end funds generally can stay more
fully invested in securities consistent with
the closed-end fund's investment objective
and policies. In addition, in comparison to
open-end funds, closed-end funds have
greater flexibility in their ability to make
certain types of investments, including
investments in illiquid securities.
Shares of closed-end funds listed for
trading on a securities exchange frequently
trade at a discount from NAV. The market
price of such shares may be affected by NAV,
dividend or distribution levels (which are
dependent, in part, on expenses), supply of
and demand for the shares, stability of
dividends or distributions, trading volume
of the shares, general market and economic
conditions and other factors beyond the
control of a closed-end fund. The foregoing
factors may result in the market price of
the Common Shares being greater than, less
than or equal to, NAV.
The Board of Trustees has reviewed the
structure of the Fund in light of its
investment objectives and policies and
believes that the closed-end fund structure
is appropriate. As described in this
prospectus, however, the Board of Trustees
may review periodically the trading range
and activity of the Common Shares with
respect to its NAV and the Board of Trustees
may take certain actions to seek to reduce
or eliminate any such discount. Such actions
may include open market repurchases or
tender offers for the Common Shares or the
possible conversion of the Fund to an
open-end fund. There can be no assurance
that the Board of Trustees will decide to
undertake any of these actions or that, if
undertaken, such actions would result in the
Common Shares trading at a price equal to or
close to NAV per Common Share. Investors
should assume that it is highly unlikely
that the Board of Trustees would vote to
convert the Fund to an open-end management
investment company. See "Structure of the
Fund; Common Share Repurchases and
Conversion to Open-End Fund."
Page 7
TAX MATTERS...................... Distributions with respect to the Common
Shares will constitute dividends to the
extent of the Fund's current and accumulated
earnings and profits, as calculated for U.S.
federal income tax purposes. Such dividends
generally will be taxable as ordinary income
to Common Shareholders. Distributions of net
capital gain that are designated by the Fund
as capital gain dividends will be treated as
long-term capital gains in the hands of
Common Shareholders receiving such
distributions. In addition, distributions
generally will not constitute "qualified
dividends" for federal income tax purposes
and thus will not be eligible for the new
lower tax rates on qualified dividends. See
"Tax Matters."
SPECIAL RISK
CONSIDERATIONS................... Risk is inherent in all investing. The
following discussion summarizes the
principal risks that you should consider
before deciding whether to invest in the
Fund. For additional information about the
risks associated with investing in the Fund,
see "Risks."
No Operating History. The Fund is a newly
organized, diversified, closed-end
management investment company with no
operating history.
Investment and Market Risk. An investment in
Common Shares is subject to investment risk,
including the possible loss of the entire
principal amount that you invest. Your
investment in Common Shares represents an
indirect investment in the securities owned
by the Fund. The value of these securities,
like other market investments, may move up
or down, sometimes rapidly and
unpredictably. The value of the securities
in which the Fund invests will affect the
value of the Common Shares. Your Common
Shares at any point in time may be worth
less than your original investment, even
after taking into account the reinvestment
of Fund dividends and distributions.
Management Risk. The Fund is subject to
management risk because it is an actively
managed portfolio. The Adviser and the
Sub-Adviser will apply investment techniques
and risk analyses in making investment
decisions for the Fund, but there can be no
guarantee that these will produce the
desired results.
Credit Risk. Credit risk is the risk that
one or more securities in the Fund's
portfolio will (1) decline in price due to
deterioration of the issuer's or underlying
pool's financial condition or other events
or (2) fail to pay interest or principal
when due. Although the Fund will invest all
of its Managed Assets in investment grade
securities, or if unrated, judged to be of
comparable quality by the Sub-Adviser, no
assurance can be given that the value of the
securities will not decline.
The Fund may invest a portion of its Managed
Assets in subordinated classes of MBS,
including Non-Agency RMBS and CMBS. Such
subordinated classes are subject to a
greater degree of non-payment than are
senior classes of the same issuer or Agency
MBS. In addition, under certain market
conditions, the market for subordinated
classes of MBS may not be as liquid as the
market for other fixed-income securities.
Prepayment Risk. MBS are backed by pools of
mortgage loans. The Fund will receive
payments from the payments that are made on
these underlying mortgage loans. If
borrowers prepay their mortgage loans at
rates that are faster than expected, this
results in prepayments that are faster than
expected on the MBS. These faster than
expected prepayments may adversely affect
the Fund's profitability. The Fund may
purchase MBS that have a higher interest
rate than the market interest rate at the
time. In exchange for this higher interest
rate, the Fund will be required to pay a
premium over the market value to acquire the
security. If a mortgage-backed security is
prepaid in whole or in part prior to its
maturity date, the Fund's profitability will
be adversely affected.
Prepayment rates generally increase when
interest rates fall and decrease when
interest rates rise, but changes in
prepayment rates are difficult to predict.
Prepayment rates also may be affected by
conditions in the housing and financial
markets, general economic conditions and the
relative interest rates on fixed-rate and
adjustable-rate mortgage loans.
Page 8
The Fund may also invest in MBS which are
interest only ("IO") securities and
principal-only ("PO") securities. An IO
security receives some or all of the
interest portion of the underlying
collateral and little or no principal. A
reference principal value called a notional
value is used to calculate the amount of
interest due. IOs are sold at a deep
discount to their notional principal amount.
A PO security does not receive any interest,
is priced at a deep discount to its
redemption value and ultimately receives the
redemption value. Generally speaking, when
interest rates are falling and prepayment
rates are increasing, the value of a PO
security will rise and the value of an IO
security will fall. Conversely, when
interest rates are rising and prepayment
rates are decreasing, generally the value of
a PO security will fall and the value of an
IO security will rise.
The Fund may also acquire MBS that are less
affected by prepayments. For example, CMOs
divide a pool of mortgage loans into
multiple tranches that allow for shifting of
prepayment risks from slower-paying tranches
to faster-paying tranches. This is in
contrast to pass-through or pay-through MBS,
where all investors share equally in all
payments, including all prepayments. While
the Fund will seek to minimize prepayment
risk to the extent practical, the Fund must
balance prepayment risk against other risks
and the potential returns of each investment
in selecting investments. No strategy can
completely insulate the Fund from prepayment
risk.
Reinvestment Risk. Reinvestment risk is the
risk that income from the Fund's portfolio
will decline if the Fund invests the
proceeds from matured, traded or called
bonds at market interest rates that are
below the Fund portfolio's current earnings
rate. A decline in income could affect the
Common Shares' market price or their overall
returns.
Interest Rate Risk. Interest rate risk is
the risk that fixed-income securities will
decline in value because of changes in
market interest rates. When market interest
rates rise, the market value of such
securities generally will fall. Under
current market conditions, the Fund will
primarily invest in securities that pay a
fixed rate of return, therefore, the NAV and
market price of the Common Shares will tend
to decline if the market interest rates
applicable to such investments were to rise.
During periods of rising interest rates, the
average life of certain types of securities
may be extended because of slower than
expected prepayments. This may lock in a
below market yield, increase the security's
duration and reduce the value of the
security. Investments in debt securities
with long-term maturities may experience
significant price declines if long-term
interest rates increase. Market interest
rates in the United States currently are
near historically low levels.
An increase in the interest payments on the
Fund's borrowings relative to the interest
it earns on its investment securities may
adversely affect the Fund's profitability.
The Fund earns money based upon the spread
between the interest payments it earns on
its investment securities and the interest
payments it must make on its borrowings.
The Fund relies primarily on short-term
borrowings to acquire investment securities
with long-term maturities. Accordingly, if
short-term interest rates increase, this may
adversely affect its profitability. Some of
the investment securities the Fund may
acquire are adjustable-rate securities. This
means that their interest rates may vary
over time based upon changes in an objective
index, such as:
o LIBOR. The interest rate that banks
in London offer for deposits in
London of U.S. dollars.
o Treasury Rate. A monthly or weekly
average yield of benchmark U.S.
Treasury securities, as published by
the Federal Reserve Board.
o CD Rate. The weekly average of
secondary market interest rates on
six-month negotiable certificates of
deposit, as published by the Federal
Reserve Board.
These indices generally reflect short-term
interest rates.
Page 9
The interest rates on the Fund's borrowings
similarly vary with changes in an objective
index. Nevertheless, the interest rates on
the Fund's borrowings generally adjust more
frequently than the interest rates on its
adjustable-rate investment securities. In a
period of rising interest rates, the Fund
could experience a decrease in net income or
a net loss because the interest rates on its
borrowings adjust faster than the interest
rates on its adjustable-rate investment
securities.
In a period of rising interest rates, the
Fund's interest payments could increase
while the interest it earns on its
fixed-rate MBS would not change. This would
adversely affect the Fund's profitability.
While the majority of the Fund's investments
are expected initially to consist of fixed-
rate investment securities, the Fund may
also invest in adjustable-rate MBS. The Fund
may acquire adjustable-rate investment
securities, which typically are subject to
periodic and lifetime interest rate caps.
Periodic interest rate caps limit the amount
an interest rate can increase during any
given period. Lifetime interest rate caps
limit the amount an interest rate can
increase through maturity of an investment
security. The Fund's borrowings are not
subject to similar restrictions.
Accordingly, in a period of rapidly
increasing interest rates, the Fund could
experience a decrease in net income or
experience a net loss because the interest
rates on its borrowings could increase
without limitation while the interest rates
on its adjustable-rate investment securities
would be limited by caps. The Fund may also
invest in MBS whose interests move in a
direction opposite to the changes in the
designated index.
Floating Rate CMOs/Inverse Floating Rate
CMOs Risk. The Fund may invest in tranches
of CMOs which have coupon rates which reset
periodically at a specified increment over
an index, such as LIBOR (or sometimes more
than one index). These floating rate CMOs
typically are issued with lifetime caps on
the coupon rate thereon. In a falling
interest rate environment, coupon rates on
floating rate CMOs will generally fall,
adversely affecting the amount of income
received by the Fund as well as the value of
the security. The Fund also may invest in
inverse floating rate CMOs. Inverse floating
rate CMOs constitute a tranche of a CMO with
a coupon rate that moves in the reverse
direction to an applicable index such as
LIBOR. Accordingly, the coupon rate thereon
will increase as interest rates decrease.
Inverse floating rate CMOs are typically
more volatile than fixed or floating rate
tranches of CMOs. Many inverse floating rate
CMOs have coupons that move inversely to a
multiple of the applicable indexes. The
effect of the coupon varying inversely to a
multiple of an applicable index creates a
leverage situation. Inverse floaters based
on multiples of a stated index are designed
to be highly sensitive to changes in
interest rates and can subject the holders
thereof to extreme reductions of yield and
loss of principal. The markets for inverse
floating rate CMOs with highly leveraged
characteristics at times may be very thin.
Bond Market Risk. The yield spreads of the
Fund's portfolio securities, or yield
differentials between the Fund's portfolio
securities and Treasury securities with
comparable maturities, may widen, causing
the value of the Fund's portfolio securities
to underperform Treasury securities. The
amount of public information available about
the MBS and Other MBS 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 capabilities of the Sub-Adviser
than if the Fund were a stock fund or a
corporate bond fund. The secondary market
for certain types of MBS, including Other
MBS, may be less well-developed or liquid
than many other securities markets, which
may affect the Fund's ability to sell its
portfolio securities at attractive prices.
Economic Sector Risk. Under normal market
conditions, the Fund will be fully invested
in Agency MBS, Non-Agency RMBS, CMBS or
Other MBS. This may make the Fund more
susceptible to adverse economic, political
or regulatory events that affect the value
of real estate, and increase the potential
for fluctuation in the net asset value of
the Fund's Common Shares.
Page 10
Inflation Risk. Inflation risk is the risk
that the value of assets or income from
investments will be worth less in the future
as inflation decreases the value of money.
As inflation increases, the real value of
the Common Shares and distributions can
decline. In addition, during any periods of
rising inflation, the dividend rates or
borrowing costs associated with the Fund's
use of financial leverage would likely
increase, which would tend to further reduce
returns to Common Shareholders.
Market Discount From Net Asset Value. Shares
of closed-end investment companies
frequently trade at a discount from their
NAV. This characteristic is a risk separate
and distinct from the risk that the Fund's
NAV could decrease as a result of its
investment activities and may be greater for
investors expecting to sell their Common
Shares in a relatively short period
following completion of this offering. The
NAV of the Common Shares will be reduced
immediately following the offering as a
result of the payment of certain offering
costs. Although the value of the Fund's net
assets is generally considered by market
participants in determining whether to
purchase or sell Common Shares, whether
investors will realize gains or losses upon
the sale of the Common Shares will depend
entirely upon whether the market price of
the Common Shares at the time of sale is
above or below the investor's purchase price
for the Common Shares. Because the market
price of the Common Shares will be
determined by factors such as NAV, dividend
and distribution levels (which are
dependent, in part, on expenses), supply of
and demand for the Common Shares, stability
of dividends or distributions, trading
volume of the Common Shares, general market
and economic conditions and other factors
beyond the control of the Fund, the Fund
cannot predict whether the Common Shares
will trade at, below or above NAV or at,
below or above the initial public offering
price.
Leverage Risk. The Fund may borrow an amount
up to 33-1/3% (or such other percentage as
permitted by law) of its Managed Assets
(including the amount borrowed) less all
liabilities other than borrowings. The Fund
may also issue Preferred Shares in an amount
up to 50% of the Fund's Managed Assets
(including the proceeds from Leverage
Instruments). However, the Fund intends,
under normal circumstances, to utilize
leverage in an amount up to 33-1/3% of the
Fund's Managed Assets. The Fund intends to
use leverage through the use of reverse
repurchase agreements. Repurchase agreements
and the issuance of Preferred Shares,
commercial paper or notes or incurring other
indebtedness is referred to in this
prospectus collectively as "leverage." The
Fund may use leverage for investment
purposes, to finance the repurchase of its
Common Shares and to meet cash requirements.
Although the use of leverage by the Fund may
create an opportunity for increased return
for the Common Shares, it also results in
additional risks and can magnify the effect
of any losses. If the income and gains
earned on the securities and investments
purchased with leverage proceeds are greater
than the cost of the leverage, the Common
Shares' return will be greater than if
leverage had not been used. Conversely, if
the income and gains from the securities and
investments purchased with such proceeds
does not cover the cost of leverage, the
return to the Common Shares will be less
than if leverage had not been used. Reverse
repurchase agreements are also subject to
the risks that the market value of the
securities sold by the Fund may decline
below the price of the securities the Fund
is obligated to repurchase, and that the
securities may not be returned to the Fund.
There is no assurance that a leveraging
strategy will be successful. Leverage
involves risks and special considerations
for Common Shareholders including:
o the likelihood of greater volatility
of NAV and market price of the Common
Shares than a comparable portfolio
without leverage;
o the risk that fluctuations in
interest rates on repurchase
agreements, borrowings and short-term
debt or in the dividend rates on any
Preferred Shares that the Fund may
pay will reduce the return to the
Common Shareholders or will result in
fluctuations in the dividends paid on
the Common Shares;
o the effect of leverage in a declining
market, which is likely to cause a
greater decline in the NAV of the
Common Shares than if the Fund were
not leveraged, which may result in a
Page 11
greater decline in the market price
of the Common Shares; and
o when the Fund uses leverage, the
investment advisory fee payable to
the Adviser (and by the Adviser to
the Sub-Adviser) will be higher than
if the Fund did not use leverage.
The Sub-Adviser, in its judgment,
nevertheless may determine to continue to
use leverage if it expects that the benefits
to the Fund's shareholders of maintaining
the leveraged position will outweigh the
current reduced return.
Interest Rate Transactions Risk. In order to
reduce the variability of leverage borrowing
costs from short-term reverse repurchase
agreements, the Fund may enter into interest
rate swaps with the effect of fixing net
borrowing costs for longer periods of time.
The value of the Fund's interest rate swaps
could increase or decrease, with a
corresponding impact on the NAV of the Fund.
To the extent there is a decline in interest
rates, the value of the interest rate swap
could decrease, and could result in a
decrease in the Fund's NAV. In addition, if
the counterparty to an interest rate swap
defaults, the Fund would be obligated to
make the payments that it had intended to
avoid. Depending on whether the Fund would
be entitled to receive net payments from the
counterparty on the swap, which in turn
would depend on the general state of short-
term interest rates and the returns on the
Fund's portfolio securities at that point in
time, a default could adversely affect the
NAV of the Common Shares.
Derivatives Risk. The Fund's Strategic
Transactions have risks, including the
imperfect correlation between the value of
such instruments and the underlying assets
of the Fund, the possible default of the
other party to the transaction or
illiquidity of the derivative investments.
Furthermore, the ability to successfully use
hedging and interest rate transactions
depends on the Sub-Adviser's ability to
predict pertinent market movements, which
cannot be assured. Thus, the use of
derivatives for hedging and interest rate
management purposes may result in losses
greater than if they had not been used, may
require the Fund to sell or purchase
portfolio securities at inopportune times or
for prices other than current market values,
may limit the amount of appreciation the
Fund can realize on an investment or may
cause the Fund to hold a security that it
might otherwise sell. Additionally, amounts
paid by the Fund as premiums and cash or
other assets held in margin accounts with
respect to Strategic Transactions are not
otherwise available to the Fund for
investment purposes. See "Risks--Derivatives
Risk."
Portfolio Turnover Risk. The Fund's annual
portfolio turnover rate may vary greatly
from year to year. Although the Fund cannot
accurately predict its annual portfolio
turnover rate, it is not expected to exceed
100% under normal circumstances. However,
portfolio turnover rate is not considered a
limiting factor in the execution of
investment decisions for the Fund. High
portfolio turnover may result in the Fund's
recognition of gains that will be taxable as
ordinary income to the Fund. A high
portfolio turnover may increase the Fund's
current and accumulated earnings and
profits, resulting in a greater portion of
the Fund's distributions being treated as a
dividend to the Fund's Common Shareholders.
In addition, a higher portfolio turnover
rate results in correspondingly greater
brokerage commissions and other
transactional expenses that are borne by the
Fund. See "The Fund's
Investments--Investment Practices--Portfolio
Turnover" and "Tax Matters."
Market Disruption Risk. The terrorist
attacks in the United States on September
11, 2001 had a disruptive effect on the
securities markets. The ongoing U.S.
military and related action in Iraq and
events in the Middle East, as well as the
continuing threat of terrorist attacks,
could have significant adverse effects on
the U.S. economy, the stock market and world
economies and markets generally. The Fund
cannot predict the effects of similar events
in the future on the U.S. and world
economies, the value of the Common Shares or
the NAV of the Fund.
Page 12
Illiquid/Restricted Securities Risk. The
Fund may invest up to 10% of its Managed
Assets in securities that, at the time of
investment, are illiquid (determined using
the Securities and Exchange Commission's
standard applicable to investment companies,
i.e., 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). The
Fund may also invest, without limit, in
restricted securities. However, restricted
securities determined by the Sub-Adviser to
be illiquid are subject to the limitations
set forth above. The Sub-Adviser, under the
supervision of the Board of Trustees, will
determine whether restricted securities are
illiquid (that is, not readily marketable)
and thus subject to the Fund's limit of
investing no more than 10% of its Managed
Assets in illiquid securities. Investments
in restricted securities could have the
effect of increasing the amount of the
Fund's assets invested in illiquid
securities if qualified institutional buyers
are unwilling to purchase these securities.
Illiquid and restricted securities may be
difficult to dispose of at a fair price at
the times when the Fund believes it is
desirable to do so. The market price of
illiquid and restricted securities generally
is more volatile than that of more liquid
securities, which may adversely affect the
price that the Fund pays for or recovers
upon the sale of such securities. Illiquid
and restricted securities are also more
difficult to value and the Sub-Adviser's
judgment may play a greater role in the
valuation process. Investment of the Fund's
assets in illiquid and restricted securities
may restrict the Fund's ability to take
advantage of market opportunities. The risks
associated with illiquid and restricted
securities may be particularly acute in
situations in which the Fund's operations
require cash and could result in the Fund
borrowing to meet its short-term needs or
incurring losses on the sale of illiquid or
restricted securities. In order to dispose
of an unregistered security, the Fund, where
it has contractual rights to do so, may have
to cause such security to be registered. A
considerable period may elapse between the
time the decision is made to sell the
security and the time the security is
registered, therefore enabling the Fund to
sell it. Contractual restrictions on the
resale of securities vary in length and
scope and are generally the result of a
negotiation between the issuer and acquiror
of the securities. In either case, the Fund
would bear market risks during that period.
Certain Affiliations. Certain broker-dealers
may be considered to be affiliated persons
of the Fund or First Trust Advisors. 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
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. In
addition, unless and until the underwriting
syndicate is broken in connection with the
initial public offering of the Common
Shares, the Fund will be precluded from
effecting principal transactions with
brokers who are members of the syndicate.
Anti-Takeover Provisions. The Fund's
Declaration of Trust includes provisions
that could limit the ability of other
entities or persons to acquire control of
the Fund or convert the Fund to open-end
status. These provisions could have the
effect of depriving the Common Shareholders
of opportunities to sell their Common Shares
at a premium over the then current market
price of the Common Shares. See "Certain
Provisions in the Declaration of Trust" and
"Risks--Anti-Takeover Provisions."
Secondary Market for the Fund's Shares. The
issuance of Common Shares through the Fund's
Dividend Reinvestment Plan may have an
adverse effect on the secondary market for
the Fund's Common Shares. The increase in
the number of outstanding Common Shares
resulting from issuances pursuant to the
Fund's Dividend Reinvestment Plan and the
discount to the market price at which such
Common Shares may be issued, may put
downward pressure on the market price for
the Common Shares. Common Shares will not be
issued pursuant to the Dividend Reinvestment
Plan at any time when Common Shares are
trading at a lower price than the Fund's NAV
per Common Share. When the Fund's Common
Shares are trading at a premium, the Fund
may also issue Common Shares that may be
sold through private transactions effected
on the Exchange (" ") or through
Page 13
broker-dealers. The increase in the number
of outstanding Common Shares resulting from
these offerings may put downward pressure on
the market price for Common Shares.
Certain Other Risks. An investment in the
Fund is subject to certain other risks
described in the "Risks" section of this
prospectus.
Page 14
SUMMARY OF FUND EXPENSES
The following table assumes the issuance of leverage in the form of debt in
an amount equal to 33-1/3% of the Fund's Managed Assets (after their issuance),
and shows Fund expenses as a percentage of net assets attributable to Common
Shares. The "Other expenses" shown in the table and related footnotes are based
on estimated amounts.
SHAREHOLDER TRANSACTION EXPENSES
Sales load paid by you (as a percentage of offering price) .......................................... 4.50%
Offering expenses borne by the Fund (as a percentage of offering price).............................. .20%(1)
Dividend Reinvestment Plan fees...................................................................... None(2)
PERCENTAGE OF NET ASSETS ATTRIBUTABLE
TO COMMON SHARES (ASSUMES
DEBT IS USED)(3)
ANNUAL EXPENSES
Management fees(4) .................................................................................. %
Interest payments on borrowed funds.................................................................. %
Other expenses....................................................................................... %(5)
Total annual expenses........................................................................... %
(1) The Adviser has agreed to pay (i) all organizational expenses and (ii)
all offering costs of the Fund (other than sales load, but including a
partial reimbursement of certain underwriter expenses) that exceed .2%
(or $.04 per Common Share) of the Fund's offering price. The
Sub-Adviser has agreed to reimburse the Adviser for one-half of such
organizational expenses and offering costs of the Fund that exceed .2%
(or $.04 per Common Share) of the Fund's offering price.
(2) You will pay brokerage charges if you direct PFPC Inc., as agent for
the Common Shareholders (the "Plan Agent"), to sell your Common Shares
held in a dividend reinvestment account.
(3) The table presented below in this footnote estimates what the Fund's
annual expenses would be stated as percentages of the Fund's net assets
attributable to Common Shares. Unlike the table above, this table
assumes that no debt and no other leverage is used. This will be the
case, for instance, prior to the Fund's expected issuance of debt or
the use of other Leverage Instruments. In accordance with these
assumptions, the Fund's expenses would be estimated to be as follows:
PERCENTAGE OF NET ASSETS ATTRIBUTABLE
TO COMMON SHARES (ASSUMES NO
DEBT IS USED OR OTHER
LEVERAGE INSTRUMENTS ARE USED)
ANNUAL EXPENSES
Management fees (4)........................ %
Other expenses............................. %
Total annual expenses.................. %
(4) Represents the aggregate fee payable to the Adviser (and by the
Adviser to the Sub-Adviser).
(5) If the Fund uses Leverage Instruments in the form of debt, costs of
the issuance of debt, estimated to be approximately % of the total
dollar amount of the debt issuance, will be borne immediately by
the Common Shareholders and result in a reduction of the NAV of the
Common Shares. Assuming the issuance of debt in an amount equal to
33-1/3% of the Fund's Managed Assets (immediately after the issuance
of such debt), those offering costs of the debt issuance are estimated
to be approximately $ or $ per Common Share ( % of the offering
price of the Common Shares).
The purpose of the table above and the example below is to help you
understand all fees and expenses that you, as a holder of Common Shares, would
bear directly or indirectly. The expenses shown in the table under "Other
expenses" and "Total annual expenses" are based on estimated amounts for the
Fund's first full year of operations. See "Management of the Fund" and "Dividend
Reinvestment Plan."
The following example illustrates the expenses (including the sales load of
$45, estimated offering expenses of this offering of $2 and the estimated
offering costs of issuing debt assuming the Fund issues debt representing
33-1/3% of the Fund's capital (after their issuance) of $ ) that you would pay
on a $1,000 investment in Common Shares, assuming (1) total net annual expenses
of % of net assets attributable to Common Shares and (2) a 5% annual return*:
1 YEAR 3 YEARS 5 YEARS 10 YEARS
$ $ $ $
* THE EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF FUTURE
EXPENSES. ACTUAL EXPENSES MAY BE GREATER OR LESS THAN THOSE SHOWN. The
example assumes that the estimated "Other expenses" set forth in the
Annual Expenses table are accurate and that all dividends and
distributions are reinvested at net asset value. Moreover, the Fund's
actual rate of return may be greater or less than the hypothetical 5%
return shown in the example. In the event that the Fund does not
utilize any leverage, an investor would pay the following expenses
based on the assumptions in the example: one year, $ ; three years,
$ ; five years, $ ; and ten years, $ .
Page 15
THE FUND
The Fund is a newly organized, diversified, closed-end management
investment company registered under the Investment Company Act of 1940, as
amended (the "1940 Act"). The Fund was organized on February 22, 2005 as a
Massachusetts business trust pursuant to a Declaration of Trust (the
"Declaration of Trust"). As a newly organized entity, the Fund has no operating
history. The Fund's principal office is located at 1001 Warrenville Road, Suite
300, Lisle, Illinois 60532, and its telephone number is (630) 241-4141.
Investment in the Fund involves certain risks and special considerations,
including risks associated with the Fund's use of leverage. See "Risks."
USE OF PROCEEDS
The net proceeds of the offering of Common Shares will be approximately $
($ if the Underwriters exercise the overallotment option in full) after payment
of the estimated offering costs. The Adviser has agreed to pay (i) all
organizational expenses and (ii) all offering costs of the Fund (other than
sales load, but including a partial reimbursement of certain underwriter
expenses) that exceed .2% (or $.04 per Common Share) of the Fund's offering
price. The Sub-Adviser has agreed to reimburse the Adviser for one-half of such
organizational expenses and offering costs of the Fund that exceed .2% (or $.04
per Common Share) of the Fund's offering price. The Fund will invest the net
proceeds of the offering in accordance with the Fund's investment objectives and
policies as stated below. The Fund expects it will be able to invest
substantially all of the net proceeds in securities that meet the Fund's
investment objectives and policies within months after the completion of the
offering. Pending such investment, it is anticipated that the proceeds will be
invested in cash or cash equivalents.
THE FUND'S INVESTMENTS
INVESTMENT OBJECTIVES AND POLICIES
The Fund's primary investment objective is to seek a high level of current
income. As a secondary objective, the Fund will seek to preserve capital. The
Fund will pursue its objectives by investing primarily in MBS that, in the
opinion of the Fund's Sub-Adviser, offer an attractive combination of credit
quality, yield and maturity. There can be no assurance that the Fund's
investment objectives will be achieved.
The Fund's investment objectives and the investment restrictions listed in
the SAI are considered fundamental and may not be changed without approval by
holders of a majority of the outstanding voting securities of the Fund, as
defined in the 1940 Act, which includes Common Shares and Preferred Shares, if
any, voting together as a single class, and the holders of the outstanding
Preferred Shares voting as a single class. The remainder of the Fund's
investment policies, including its investment strategy, are considered
non-fundamental and may be changed by the Board of Trustees without shareholder
approval, provided that shareholders receive at least 60 days' prior written
notice of any change. As defined in the 1940 Act, when used with respect to
particular shares of the Fund, a "majority of the outstanding" shares means (i)
67% or more of the shares present at a meeting, if the holders of more than 50%
of the shares are present or represented by proxy, or (ii) more than 50% of the
shares, whichever is less.
INVESTMENT PHILOSOPHY AND PROCESS
Under normal market conditions, the Fund will invest substantially all of
its Managed Assets in a diversified portfolio of MBS. The Fund will acquire
investment securities that the Sub-Adviser has the necessary expertise to
evaluate and manage. For example, each individual MBS has a unique cash flow
that can change in different interest rate environments. The Sub-Adviser
believes that future interest rates and mortgage prepayment rates are very
difficult to predict. Therefore, the Sub-Adviser will seek to minimize
prepayment risk by structuring a diversified portfolio with a variety of
prepayment characteristics and through other means which it believes will
provide acceptable returns over a broad range of interest rate and prepayment
scenarios.
Unlike most fixed-income products, MBS are sold and traded based on the
average life of the security rather than the stated maturity. The average life
is the average number of years that each dollar of unpaid principal due on the
security remains outstanding. If prepayment rates are faster than expected
(typical in declining rate environments), the average life of the security will
be shorter than the original estimate. If prepayment rates are slower (typical
in rising rate environments), the security's average life will be extended. The
total return of a MBS is highly dependent on the underlying cash flows which
determine the average life. Constructing a diversified MBS portfolio means
exposure to securities that can benefit from both increasing and declining
prepayment environments.
In constructing a diversified MBS portfolio, the Sub-Adviser utilizes a
disciplined investment process that identifies assets that it expects will
provide income in a wide range of interest rate environments. The investment
process is designed to consistently evaluate five sources of portfolio
performance: yield curve, duration, prepayment performance, credit and leverage.
Page 16
The Sub-Adviser's research process is internally driven and is
predominantly top down in nature. The Sub-Adviser analyzes the fixed-income
market from the perspectives of (1) long-term structural trends, (2) medium-term
bond market valuations and (3) short-term tactical views.
Generally, the Sub-Adviser views long-term structural trends as being
driven by an understanding of demographics, political systems/cycles, fiscal
sustainability, international trade, capital market structures, global growth
rates and regulatory regimes. The Sub-Adviser believes these factors influence
the demand/supply for capital, and therefore have a structural impact on
long-term yield patterns. Opportunities are identified by comparative sector
analysis, determining which sectors are likely to benefit or suffer as economic
and political cycles change.
The Sub-Adviser examines medium-term bond market valuations in order to
judge whether they are consistent with economic and political environments, and
how they are likely to change in the context of the Sub-Adviser's forecasts over
a 3 to 12 month period. This analysis determines the overall composition of the
Fund's portfolio.
The Sub-Adviser determines tactical views through continuous monitoring of
market developments. Relative value, cash flow analysis, market positioning
intelligence and portfolio flow data are used to determine the timing,
implementation and scale of positions suggested by the Sub-Adviser's strategic
views.
Underlying the investment process is consistent risk management and stress
testing of the portfolio using risk modeling and attribution techniques. The
quantitative techniques are used to identify and test market observations and
are a tool to assist in portfolio construction.
The Sub-Adviser's investment team follows a disciplined investment process
that applies daily information flow into portfolio construction, liability
management and risk management. The process is designed to highlight investment
opportunities that provide current income and capital protection across the MBS
market, and the underlying philosophy is to invest in a "balanced portfolio"
that provides income in a wide range of market environments.
Mortgage cash flow characteristics can vary greatly between different
securities. The building block for an investment decision is to gauge prepayment
exposure by examining such underlying loan characteristics as geographic
information, servicer information, FICO credit scores, loan balance and
prepayment penalties.
Although analysis focuses on portfolio cash flow, there are other factors
(such as interest rates, swap spreads, currency moves, and risk appetite
indicators) that will also contribute to performance irrespective of underlying
yield performance. The portfolio is constructed to reflect the Sub-Adviser's
investment team's views, and in a manner to optimize returns according to market
conditions. Each investment idea is monitored on a daily basis using risk
modeling and attribution techniques to determine that the risk/reward ratio is
acceptable.
PORTFOLIO COMPOSITION
The Fund's portfolio will be composed principally of the following
investments. A more detailed description of the Fund's investment policies and
restrictions and more detailed information about the Fund's portfolio
investments are contained in the SAI.
Under normal market conditions, the Fund will invest at least 80% of its
Managed Assets in MBS. In addition, the Fund may invest up to 20% of its Managed
Assets in U.S. government securities, or cash or other short-term instruments
and may invest up to 10% of its Managed Assets in Other MBS. Under normal market
conditions, the Fund will be fully invested in Agency MBS, Non-Agency RMBS,
CMBS, and Other MBS.
The Fund will invest all of its Managed Assets in securities that at the
time of investment are investment grade quality. The Fund will only invest in
securities which are:
o issued or guaranteed by the U.S. government or any agency or
instrumentality thereof,
o rated within the three highest investment grades by at least one
rating agency (A or better by Moody's, S&P or Fitch), or
o unrated but judged to be of comparable quality by the Sub-Adviser.
The MBS in which the Fund may invest include those with fixed, floating or
variable interest rates, those with interest rates that change based on
multiples of changes in a specified index of interest rates and those with
interest rates that change inversely to changes in interest rates, as well as
those that do not bear interest. The Fund will not invest in corporate bonds,
other than those primarily secured by interests in real estate.
Page 17
The Fund will attempt to reduce portfolio prepayment risk by investing in
MBS, such as certain Non-Agency RMBS, whose returns may be enhanced by faster
prepayments, and also by investing in MBS, such as certain Agency MBS, whose
returns may be enhanced by slower prepayments. The Fund may invest a portion of
its Managed Assets in subordinated classes of MBS, including Non-Agency RMBS and
CMBS.
The discussion below describes the principal categories of securities in
which the Fund intends to invest.
Agency MBS. Agency MBS are securities that represent participations in, are
secured by or payable from, mortgage loans secured by real residential property.
Agency MBS include the following:
AGENCY MORTGAGE PASS-THROUGH CERTIFICATES. The agency mortgage
pass-through certificates in which the Fund will invest include those
issued or guaranteed by GNMA, FNMA and/or FHLMC.
These mortgage pass-through certificates provide for the pass-through
to investors of their pro rata share of monthly payments (including any
prepayments) made by the individual borrowers on the pooled mortgage
loans, net of any fees paid to the guarantor of such securities and the
servicer of the underlying loans. GNMA, FNMA and FHLMC guarantee timely
distributions of interest and principal to shareholders.
GNMA is a wholly-owned corporate instrumentality of the U.S. Department
of Housing and Urban Development. The full faith and credit of the U.S.
government is pledged to payment of all amounts that may be required to
be paid under GNMA's guaranty. FNMA and FHLMC are federally chartered
and privately owned corporations created pursuant to the Federal
National Mortgage Association Charter Act of 1938 and the Emergency
Home Finance Act of 1970, respectively. The obligations of FNMA and
FHLMC are obligations solely of those respective corporations, and are
not backed by the full faith and credit of the U.S. government.
AGENCY COLLATERALIZED MORTGAGE OBLIGATIONS. Agency CMOs are debt
obligations issued by GNMA, FNMA or FHLMC. CMOs, which may be Agency or
Non-Agency, are backed by mortgage pass-through certificates (discussed
above) and are evidenced by a series of bonds or certificates issued in
multiple "classes." The principal and interest on the underlying
mortgage assets may be allocated among the several classes of a series
of CMOs in many ways.
In a CMO, a series of bonds or certificates are issued in multiple
classes. Each class of CMOs, often referred to as a "tranche," is
issued at a specific coupon rate and has a stated maturity or final
distribution date. Principal prepayments on collateral underlying a CMO
may cause it to be retired substantially earlier than the stated
maturities or final distribution dates. The principal and interest on
the underlying mortgages may be allocated among the several tranches of
a series of a CMO in many ways. As a result of this allocation process,
certain tranches of a CMO may have more predictable cash flows, while
the cash flows of other tranches may be less predictable. CMO tranches
with less predictable cash flows will generally exhibit more volatile
market prices and yields. One or more tranches of a CMO may have coupon
rates which reset periodically at a specified increment over an index,
such as LIBOR (or sometimes more than one index). These floating rate
CMOs typically are issued with lifetime caps on the coupon rate
thereon. The Fund also may invest in inverse floating rate CMOs.
Inverse floating rate CMOs constitute a tranche of a CMO with a coupon
rate that moves in the reverse direction to an applicable index such as
LIBOR. Accordingly, the coupon rate thereon will increase as interest
rates decrease. Inverse floating rate CMOs are typically more volatile
than fixed or floating rate tranches of CMOs. Many inverse floating
rate CMOs have coupons that move inversely to a multiple of the
applicable indexes. The effect of the coupon varying inversely to a
multiple of an applicable index creates a leverage situation. Inverse
floaters based on multiples of a stated index are designed to be highly
sensitive to changes in interest rates and can subject the holders
thereof to extreme reductions of yield and loss of principal. The
markets for inverse floating rate CMOs with highly leveraged
characteristics at times may be very thin.
Agency CMOs issued after 1991 have generally elected to be treated, for
federal income tax purposes, as a Real Estate Mortgage Investment
Conduit (a "REMIC"). A Non-Agency issuer of CMOs issued after 1991 must
elect to be treated as a REMIC or it will be taxable as a corporation
under rules regarding taxable mortgage pools.
STRIPPED MORTGAGE-BACKED SECURITIES. The Fund also may invest in
stripped mortgage-backed securities ("Stripped Mortgage-Backed
Securities"). Stripped Mortgage-Backed Securities are created by
segregating the cash flows from underlying mortgage loans or mortgage
securities to create two or more new securities, each with a specified
percentage of the underlying security's principal or interest payments.
Mortgage securities may be partially stripped so that each investor
class receives some interest and some principal. When securities are
completely stripped, however, all of the interest is distributed to
holders of one type of securities, known as an interest-only or IO
security, and all of the principal is distributed to holders of another
type of security known as a principal-only or PO security. Strips can
be created in a pass-through structure or as tranches of a CMO. The
yields to maturity on IOs and POs are very sensitive to the rate of
principal payments (including prepayments) on the related underlying
mortgage assets. If the underlying mortgage assets experience greater
Page 18
than anticipated prepayments of principal, the Fund may not fully
recoup its initial investment in IOs. Conversely, if the underlying
mortgage assets experience less than anticipated prepayments of
principal, the yield on POs could be materially and adversely affected.
Non-Agency RMBS. Non-Agency RMBS are debt obligations issued by private
originators or investors in residential mortgage loans. Non-Agency RMBS
generally are issued as CMOs, and are backed by pools of whole mortgage loans or
by mortgage pass-through certificates.
Non-Agency RMBS generally are securitized in senior/subordinated
structures, or structured with one or more of the types of credit enhancement
described below under "Credit Support." In senior/subordinated structures, the
senior class investors have greater protection against potential losses on the
underlying mortgage loans or assets than the subordinated class investors, who
assume the first losses if there are defaults on the underlying loans.
CMBS. CMBS are multi-class debt or pass-through or pay-through securities
backed by a mortgage loan or pool of mortgage loans on commercial real estate,
such as industrial and warehouse properties, office buildings, retail space and
shopping malls, multifamily properties, hotels and motels, nursing homes, and
medical facilities. Assets underlying CMBS may relate to many properties, only a
few properties, or to a single property. Each commercial mortgage loan that
underlies a CMBS has certain distinct characteristics.
Commercial mortgage loans are sometimes non-amortizing and often not fully
amortizing. At their maturity date, repayment of the remaining principal balance
or "balloon" is due and is repaid through the attainment of an additional loan,
the sale of the property or the contribution of additional capital.
Unlike most single family residential mortgages, commercial real estate
loans often contain provisions that substantially reduce the likelihood that
they will be prepaid. The provisions generally impose significant prepayment
penalties on loans and, in some cases, there may be prohibitions on principal
prepayments for several years following origination.
Changing real estate markets may adversely affect both the value of the
underlying collateral and the borrower's ability to meet contractual
obligations, either of which may lead to delinquencies, defaults, modifications
or foreclosure that in turn may lead to the realization of losses in CMBS.
CMBS have been issued in public and private transactions by a variety of
public and private issuers. The Fund may from time to time purchase CMBS
directly from issuers in negotiated or non-negotiated transactions or from a
holder of such CMBS in the secondary market.
Commercial mortgage securitizations generally are senior/subordinated
structures. The senior class investors have greater protection against potential
losses on the underlying mortgage loans or assets than the subordinated class
investors who take the first loss if there are defaults on the underlying
commercial mortgage loans. Other protections, which may benefit all of the
classes including the subordinated classes, may include issuer guarantees,
additional subordinated securities, cross-collateralization, over-
collateralization and the equity in the underlying properties.
Other MBS. Other MBS, which will be mortgage-related assets, are
collateralized by pools of assets such as home equity loans and lines of credit.
Other MBS include pools of loans generally secured by property and other forms
of residential dwellings such as manufactured housing and by loans used to
finance the building and establishment of franchise businesses. Other MBS
includes securities secured by second liens on residential property, commonly
referred to as "home equity loans" and "home equity lines-of-credit."
Credit Support. Many of the Non-Agency RMBS, CMBS and Other MBS in which
the Fund will invest are issued in a senior/ subordinated structure. In these
structures, the senior class investors have greater protection against potential
losses on the underlying loans or assets than do the subordinated class
investors. In senior/subordinated structures, Non-Agency RMBS, CMBS and Other
MBS are often backed by a pool of assets representing the obligations of a
number of different parties. To lessen the effect of a failure by obligors on
underlying assets to make payments, such securities may contain elements of
credit support. Such credit support falls into two categories: (1) liquidity
protection and (2) protection against losses resulting from ultimate default by
an obligor on the underlying assets. Liquidity protection generally refers to
the provision of advances, typically by the entity administering the pool of
assets, to ensure that the pass-through of payments due on the underlying pool
occurs in a timely fashion. Protection against losses resulting from ultimate
default enhances the likelihood of ultimate payment of the obligations on at
least a portion of the assets in the pool. Such protection may be provided
through guarantees, insurance policies or letters of credit obtained by the
issuer or sponsor from third parties (referred to herein as "third party credit
support"), through various means of structuring the transaction or through a
combination of such approaches. The Fund will not pay any additional fees for
such credit support, although the existence of credit support may increase the
price the Fund pays for a security.
Page 19
MBS Expected Average Maturity and Stated Final Maturity. The stated final
maturity of an MBS or Other MBS often corresponds to the last scheduled payment
of the longest maturity individual loan in the underlying pool of assets. The
expected average maturity of an MBS or Other MBS, often referred to as "weighted
average life," as described below, depends upon the expected timing of all the
return of principal from the security, which in turn depends upon assumptions
regarding the expected cash flow from the underlying pool, including scheduled
principal, prepayments and other factors that may affect cash flow.
Weighted average life is a measure of expected average maturity for an MBS
or Other MBS that pays principal to investors over a period of time, rather than
on a single maturity date. It is equal to the projected weighted average time to
return of principal from the MBS or Other MBS, based upon assumptions regarding
prepayments and other factors that may affect cash flow.
U.S. Government Securities. U.S. government securities include issues of
the U.S. Treasury, such as bills, certificates of indebtedness, notes and bonds,
as well as obligations of agencies and instrumentalities of the U.S. government.
U.S. Treasury securities are backed by the full faith and credit of the U.S.
government. Obligations of agencies and instrumentalities of the U.S. government
often are not backed by the full faith and credit of the U.S. government.
Illiquid/Restricted Securities. The Fund may invest up to 10% of its
Managed Assets in securities that, at the time of investment, are illiquid
(determined using the Securities and Exchange Commission's standard applicable
to investment companies, i.e., 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). The Fund may also invest, without
limit, in restricted securities. However, restricted securities determined by
the Sub-Adviser to be illiquid are subject to the limitations set forth above.
Short-Term Debt Securities; Temporary Defensive Position; Invest-Up Period.
During the period in which the net proceeds of the offering of Common Shares are
being invested, or during periods in which the Adviser or Sub-Adviser determines
that it is temporarily unable to follow the Fund's investment strategy or that
it is impractical to do so, the Fund may deviate from its investment strategy
and invest all or any portion of its Managed Assets in cash or cash equivalents.
The Adviser's or Sub-Adviser's determination that it is temporarily unable to
follow the Fund's investment strategy or that it is impractical to do so will
generally occur only in situations in which a market disruption event has
occurred and where trading in the securities selected through application of the
Fund's investment strategy is extremely limited or absent. In such a case,
Common Shares of the Fund may be adversely affected and the Fund may not pursue
or achieve its investment objectives. For a further description of these
temporary investments, see the SAI under "Investment Policies and Techniques."
INVESTMENT PRACTICES
Strategic Transactions. The Fund may, but is not required to, use various
Strategic Transactions (1) to seek to reduce interest rate risks arising from
any use of financial leverage, (2) to facilitate portfolio management and (3) to
mitigate risks, including interest rate and credit risks. Strategic Transactions
are generally accepted under modern portfolio management theory and are
regularly used by many mutual funds and other institutional investors. Although
the Sub-Adviser seeks to use such practices to further the Fund's investment
objectives, no assurance can be given that the Sub-Adviser will engage in any of
these practices or that these practices will achieve this result.
The Fund may purchase and sell derivative instruments such as
exchange-listed and over-the-counter put and call options on securities,
fixed-income and interest rate indices and other financial instruments, purchase
and sell financial futures contracts and options thereon and enter into various
interest rate transactions such as swaps, caps, floors or collars or credit
transactions, total rate of return swap transactions and credit derivative
instruments. The Fund also may purchase derivative instruments that combine
features of these instruments. The Fund generally seeks to use Strategic
Transactions as a portfolio management or hedging technique to protect against
possible adverse changes in the market value of securities held in or to be
purchased for the Fund's portfolio, protect the value of the Fund's portfolio,
facilitate the sale of certain securities for investment purposes, manage the
effective interest rate exposure of the Fund or establish positions in the
derivative markets as a substitute for purchasing or selling particular
securities.
Strategic Transactions have risks, including the imperfect correlation
between the value of such instruments and the underlying assets, the possible
default of the other party to the transactions or illiquidity of the derivative
investments. Furthermore, the ability to successfully use Strategic Transactions
depends on the Sub-Adviser's ability to predict pertinent market movements,
which cannot be assured. Thus, the use of Strategic Transactions may result in
losses greater than if they had not been used, may require the Fund to sell or
purchase portfolio securities at inopportune times or for prices other than
current market values, may limit the amount of appreciation the Fund can realize
on an investment, or may cause the Fund to hold a security that it might
otherwise sell. Additionally, amounts paid by the Fund as premiums and cash or
other assets held in margin accounts with respect to Strategic Transactions are
not otherwise available to the Fund for investment purposes. See
"Risks--Derivatives Risk" in this prospectus and "Other Investment Policies and
Techniques" in the SAI for further information on Strategic Transactions and
their risks.
Page 20
Portfolio Turnover. The Fund's annual portfolio turnover rate may vary
greatly from year to year. Although the Fund cannot accurately predict its
annual portfolio turnover rate, it is not expected to exceed 100% under normal
circumstances. Portfolio turnover rate is not considered a limiting factor in
the execution of investment decisions for the Fund. There are no limits on the
rate of portfolio turnover, and investments may be sold without regard to length
of time held when the Fund's investment strategy so dictates. A higher portfolio
turnover rate results in correspondingly greater brokerage commissions and other
transactional expenses that are borne by the Fund. High portfolio turnover may
result in the realization of net short-term capital gains by the Fund which,
when distributed to Common Shareholders, will be taxable as ordinary income. See
"Tax Matters."
BORROWINGS AND PREFERRED SHARES
The Fund anticipates that under current market conditions it will issue
Leverage Instruments representing no more than 33-1/3% of its Managed Assets
approximately two months after the completion of this offering. If as a result
of market conditions, or any other reason, the Fund does not issue Preferred
Shares, the Fund will limit its borrowings to 33-1/3% (or such other percentage
permitted by law) of its Managed Assets. Any use of Leverage Instruments by the
Fund will, however, be consistent with the provisions of the 1940 Act. The Fund
intends to borrow primarily using reverse repurchase agreements. A reverse
repurchase agreement, although structured as a sale and repurchase obligation,
acts as a financing under which the Fund will effectively pledge its securities
as collateral to secure a short-term loan. Generally, the other party to the
agreement makes the loan in an amount equal to a percentage of the market value
of the pledged collateral. At the maturity of the reverse repurchase agreement,
the Fund will be required to repay the loan and correspondingly receive back its
collateral. While used as collateral, the securities continue to pay principal
and interest which are for the benefit of the Fund. The Fund may borrow from
banks and other financial institutions.
The Leverage Instruments would have complete priority upon distribution of
assets over Common Shares. The issuance of Leverage Instruments would leverage
the Common Shares. Although the timing and other terms of the offering of
Leverage Instruments and the terms of the Leverage Instruments would be
determined by the Fund's Board of Trustees, the Fund expects to invest the
proceeds derived from any Leverage Instrument offering in securities consistent
with the Fund's investment objectives and policies. If Preferred Shares are
issued, they would pay adjustable rate dividends based on shorter-term interest
rates, which would be redetermined periodically by an auction process. The
adjustment period for Preferred Shares dividends could be as short as one day or
as long as a year or more. So long as the Fund's portfolio is invested in
securities that provide a higher rate of return than the dividend rate or
interest rate of the Leverage Instruments, after taking expenses into
consideration, the leverage will cause Common Shareholders to receive a higher
rate of income than if the Fund were not leveraged.
Leverage creates risk for the Common Shareholders, including the likelihood
of greater volatility of NAV and market price of the Common Shares, and the risk
that fluctuations in interest rates on repurchase agreements, borrowings and
debt or in the dividend rates on any Preferred Shares may affect the return to
the Common Shareholders or will result in fluctuations in the dividends paid on
the Common Shares. To the extent total return exceeds the cost of leverage, the
Fund's return will be greater than if leverage had not been used. Conversely, if
the total return derived from securities purchased with funds received from the
use of leverage is less than the cost of leverage, the Fund's return will be
less than if leverage had not been used, and therefore the amount available for
distribution to Common Shareholders as dividends and other distributions will be
reduced. In the latter case, the Sub-Adviser in its best judgment nevertheless
may determine to maintain the Fund's leveraged position if it expects that the
benefits to the Fund's Common Shareholders of maintaining the leveraged position
will outweigh the current reduced return. Under normal market conditions, the
Fund anticipates that it will be able to invest the proceeds from leverage at a
higher rate than the costs of leverage, which would enhance returns to Common
Shareholders. The fees paid to the Adviser (and by the Adviser to the
Sub-Adviser) will be calculated on the basis of the Managed Assets including
proceeds from repurchase agreements and other borrowings for leverage and the
issuance of Preferred Shares. During periods in which the Fund is utilizing
financial leverage, the investment advisory fee payable to the Adviser (and by
the Adviser to the Sub-Adviser) will be higher than if the Fund did not utilize
a leveraged capital structure. The use of leverage creates risks and involves
special considerations. See "Risks--Leverage Risk."
The Fund's Declaration of Trust authorizes the Fund, without prior approval
of the Common Shareholders, to borrow money. In this connection, the Fund may
enter into reverse repurchase agreements, issue notes or other evidence of
indebtedness (including bank borrowings or commercial paper) and may secure any
such borrowings by mortgaging, pledging or otherwise subjecting as security the
Fund's assets. In connection with such borrowing, the Fund may be required to
maintain minimum average balances with the lender or to pay a commitment or
other fee to maintain a line of credit. Any such requirements will increase the
cost of borrowing over the stated interest rate. Under the requirements of the
1940 Act, the Fund, immediately after any such borrowings, must have an "asset
coverage" of at least 300% (33-1/3% of Managed Assets after borrowings). With
respect to such borrowing, asset coverage means the ratio which the value of the
total assets of the Fund, less all liabilities and indebtedness not represented
by senior securities (as defined in the 1940 Act), bears to the aggregate amount
of such borrowing represented by senior securities issued by the Fund.
Page 21
The rights of lenders to the Fund to receive interest on and repayment of
principal of any such borrowings will be senior to those of the Common
Shareholders, and the terms of any such borrowings may contain provisions which
limit certain activities of the Fund, including the payment of dividends to
Common Shareholders in certain circumstances. Further, the 1940 Act does (in
certain circumstances) grant to the lenders to the Fund certain voting rights in
the event of default in the payment of interest on or repayment of principal. In
the event that such provisions would impair the Fund's status as a regulated
investment company under the Internal Revenue Code of 1986, as amended (the
"Code"), the Fund intends to repay the borrowings. Any borrowing will likely be
ranked senior or equal to all other existing and future borrowings of the Fund.
Certain types of borrowings may result in the Fund being subject to
covenants in credit agreements relating to asset coverage and portfolio
composition requirements. The Fund may be subject to certain restrictions on
investments imposed by guidelines of one or more rating agencies, which may
issue ratings for the short-term corporate debt securities or Preferred Shares
issued by the Fund. These guidelines may impose asset coverage or portfolio
composition requirements that are more stringent than those imposed by the 1940
Act. It is not anticipated that these covenants or guidelines will impede the
Sub-Adviser from managing the Fund's portfolio in accordance with the Fund's
investment objectives and policies.
If Preferred Shares are issued, they would pay adjustable rate dividends
based on shorter-term interest rates, which would be redetermined periodically
by an auction process. The adjustment period for Preferred Shares dividends
could be as short as one day or as long as a year or more.
Under the 1940 Act, the Fund is not permitted to issue Preferred Shares
unless immediately after such issuance the value of the Fund's Managed Assets is
at least 200% of the liquidation value of the outstanding Preferred Shares
(i.e., the liquidation value may not exceed 50% of the Fund's Managed Assets).
In addition, the Fund is not permitted to declare any cash dividend or other
distribution on its Common Shares unless, at the time of such declaration, the
value of the Fund's Managed Assets is at least 200% of such liquidation value.
If Preferred Shares are issued, the Fund intends, to the extent possible, to
purchase or redeem Preferred Shares from time to time to the extent necessary in
order to maintain coverage of any Preferred Shares of at least 200%. In
addition, as a condition to obtaining ratings on the Preferred Shares, the terms
of any Preferred Shares issued are expected to include asset coverage
maintenance provisions which will require the redemption of the Preferred Shares
in the event of non-compliance by the Fund and may also prohibit dividends and
other distributions on the Common Shares in such circumstances. In order to meet
redemption requirements, the Fund may have to liquidate portfolio securities.
Such liquidations and redemptions would cause the Fund to incur related
transaction costs and could result in capital losses to the Fund. Prohibitions
on dividends and other distributions on the Common Shares could impair the
Fund's ability to qualify as a regulated investment company under the Code. If
the Fund has Preferred Shares outstanding, two of the Fund's trustees will be
elected by the holders of Preferred Shares as a class. The remaining trustees of
the Fund will be elected by holders of Common Shares and Preferred Shares voting
together as a single class. In the event the Fund failed to pay dividends on
Preferred Shares for two years, holders of Preferred Shares would be entitled to
elect a majority of the trustees of the Fund.
The Fund may also borrow money as a temporary measure for extraordinary or
emergency purposes, including the payment of dividends and the settlement of
securities transactions which otherwise might require untimely dispositions of
Fund securities.
EFFECTS OF LEVERAGE
Assuming that the Leverage Instruments will represent approximately % of
the Fund's capital and pay dividends or interest at an annual combined average
rate of %, the income generated by the Fund's portfolio (net of estimated
expenses) must exceed
% in order to cover the dividend or interest payments specifically
related to the Leverage Instruments. Of course, these numbers are merely
estimates used for illustration. Actual dividend or interest rates on the
Leverage Instruments will vary frequently and may be significantly higher or
lower than the rate estimated above.
The following table is furnished in response to requirements of the
Securities and Exchange Commission. It is designed to illustrate the effect of
leverage on Common Share total return, assuming investment portfolio total
returns (comprised of income and changes in the value of securities held in the
Fund's portfolio) of (10%), (5%), 0%, 5% and 10%. These assumed investment
portfolio returns are hypothetical figures and are not necessarily indicative of
the investment portfolio returns experienced or expected to be experienced by
the Fund. See "Risks."
The table further reflects the issuance of Leverage Instruments
representing % of the Fund's capital, net of expenses, and the Fund's currently
projected annual dividend or interest on its Leverage Instruments of %.
Assumed Portfolio Total Return (Net of Expenses) .........(10)% (5)% 0% 5% 10%
Common Share Total Return .................................( )% ( )% ( )% % %
Common Share total return is composed of two elements: the Common Share
dividends paid by the Fund (the amount of which is largely determined by the net
investment income of the Fund after paying dividends or interest on its Leverage
Instruments) and gains or losses on the value of the securities the Fund owns.
As required by Securities and Exchange Commission rules, the table above assumes
Page 22
that the Fund is more likely to suffer capital losses than to enjoy capital
appreciation. For example, to assume a total return of 0% the Fund must assume
that the interest it receives on its debt security investments is entirely
offset by losses in the value of those bonds.
RISKS
Risk is inherent in all investing. The following discussion summarizes the
principal risks that you should consider before deciding whether to invest in
the Fund. For additional information about the risks associated with investing
in the Fund, see "Additional Information About the Fund's Investments" in the
SAI.
NO OPERATING HISTORY
The Fund is a newly organized, diversified, closed-end management
investment company with no operating history.
INVESTMENT AND MARKET RISK
An investment in Common Shares is subject to investment risk, including the
possible loss of the entire principal amount that you invest. Your investment in
Common Shares represents an indirect investment in the securities owned by the
Fund. The value of these securities, like other market investments, may move up
or down, sometimes rapidly and unpredictably. The value of the securities in
which the Fund invests will affect the value of the Common Shares. Your Common
Shares at any point in time may be worth less than your original investment,
even after taking into account the reinvestment of Fund dividends and
distributions.
MANAGEMENT RISK
The Fund is subject to management risk because it is an actively managed
portfolio. The Adviser and the Sub-Adviser will apply investment techniques and
risk analyses in making investment decisions for the Fund, but there can be no
guarantee that these will produce the desired results.
CREDIT RISK
Credit risk is the risk that one or more securities in the Fund's portfolio
will (1) decline in price due to deterioration of the issuer's or underlying
pool's financial condition or other events or (2) fail to pay interest or
principal when due. Although the Fund will invest all of its Managed Assets in
investment grade securities, or if unrated, judged to be of comparable quality
by the Sub-Adviser, no assurance can be given that the value of the securities
will not decline.
The Fund may invest a portion of its Managed Assets in subordinated classes
of MBS, including Non-Agency RMBS and CMBS. Such subordinated classes are
subject to a greater degree of non-payment than are senior classes of the same
issuer or Agency MBS. In addition, under certain market conditions, the market
for subordinated classes of MBS may not be as liquid as the market for other
fixed-income securities.
PREPAYMENT RISK
MBS are backed by pools of mortgage loans. The Fund will receive payments
from the payments that are made on these underlying mortgage loans. If borrowers
prepay their mortgage loans at rates that are faster than expected, this results
in prepayments that are faster than expected on the MBS. These faster than
expected prepayments may adversely affect the Fund's profitability. The Fund may
purchase MBS that have a higher interest rate than the market interest rate at
the time. In exchange for this higher interest rate, the Fund will be required
to pay a premium over the redemption value to acquire the security. If the
mortgage-backed security is prepaid in whole or in part prior to its maturity
date, the Fund's profitability will be adversely affected.
Prepayment rates generally increase when interest rates fall and decrease
when interest rates rise, but changes in prepayment rates are difficult to
predict. Prepayment rates also may be affected by conditions in the housing and
financial markets, general economic conditions and the relative interest rates
on fixed-rate and adjustable-rate mortgage loans.
The Fund may also invest in MBS which are IO securities and PO securities.
An IO security receives some or all of the interest portion of the underlying
collateral and little or no principal. A reference principal value called a
notional value is used to calculate the amount of interest due. IOs are sold at
a deep discount to their notional principal amount. A PO security does not
receive any interest, is priced at a deep discount to its redemption value and
ultimately receives the redemption value. Generally speaking, when interest
rates are falling and prepayment rates are increasing, the value of a PO
security will rise and the value of an IO security will fall. Conversely, when
interest rates are rising and prepayment rates are decreasing, generally the
value of a PO security will fall and the value of an IO security will rise.
Page 23
The Fund may also acquire MBS that are less affected by prepayments. For
example, CMOs divide a pool of mortgage loans into multiple tranches that allow
for shifting of prepayment risks from slower-paying tranches to faster-paying
tranches. This is in contrast to pass-through or pay-through MBS, where all
investors share equally in all payments, including all prepayments. While the
Fund will seek to minimize prepayment risk to the extent practical, the Fund
must balance prepayment risk against other risks and the potential returns of
each investment in selecting investments. No strategy can completely insulate
the Fund from prepayment risk.
REINVESTMENT RISK
Reinvestment risk is the risk that income from the Fund's portfolio will
decline if the Fund invests the proceeds from matured, traded or called bonds at
market interest rates that are below the Fund portfolio's current earnings rate.
A decline in income could affect the Common Shares' market price or their
overall returns.
INTEREST RATE RISK
Interest rate risk is the risk that fixed-income securities will decline in
value because of changes in market interest rates. When market interest rates
rise, the market value of such securities generally will fall. Under current
market conditions, the Fund will primarily invest in securities that pay a fixed
rate of return, therefore the NAV and market price of the Common Shares will
tend to decline if the market interest rates applicable to such investments were
to rise. During periods of rising interest rates, the average life of certain
types of securities may be extended because of slower than expected prepayments.
This may lock in a below market yield, increase the security's duration and
reduce the value of the security. Investments in debt securities with long-term
maturities may experience significant price declines if long-term interest rates
increase. Market interest rates in the United States currently are near
historically low levels.
An increase in the interest payments on the Fund's borrowings relative to
the interest it earns on its investment securities may adversely affect the
Fund's profitability. The Fund earns money based upon the spread between the
interest payments it earns on its investment securities and the interest
payments it must make on its borrowings.
The Fund relies primarily on short-term borrowings to acquire investment
securities with long-term maturities. Accordingly, if short-term interest rates
increase, this may adversely affect its profitability. Some of the investment
securities the Fund may acquire are adjustable-rate securities. This means that
their interest rates may vary over time based upon changes in an objective
index, such as:
o LIBOR. The interest rate that banks in London offer for deposits in
London of U.S. dollars.
o Treasury Rate. A monthly or weekly average yield of benchmark U.S.
Treasury securities, as published by the Federal Reserve Board.
o CD Rate. The weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the
Federal Reserve Board.
These indices generally reflect short-term interest rates.
The interest rates on the Fund's borrowings similarly vary with changes in
an objective index. Nevertheless, the interest rates on the Fund's borrowings
generally adjust more frequently than the interest rates on its adjustable-rate
investment securities. In a period of rising interest rates, the Fund could
experience a decrease in net income or a net loss because the interest rates on
its borrowings adjust faster than the interest rates on its adjustable-rate
investment securities.
In a period of rising interest rates, the Fund's interest payments could
increase while the interest it earns on its fixed-rate MBS would not change.
This would adversely affect the Fund's profitability.
While the majority of the Fund's investments are expected initially to
consist of fixed-rate investment securities, the Fund may also invest in
adjustable-rate MBS. The Fund may acquire adjustable-rate investment securities,
which typically are subject to periodic and lifetime interest rate caps.
Periodic interest rate caps limit the amount an interest rate can increase
during any given period. Lifetime interest rate caps limit the amount an
interest rate can increase through maturity of an investment security. The
Fund's borrowings are not subject to similar restrictions. Accordingly, in a
period of rapidly increasing interest rates, the Fund could experience a
decrease in net income or experience a net loss because the interest rates on
its borrowings could increase without limitation while the interest rates on its
adjustable-rate investment securities would be limited by caps. The Fund may
also invest in MBS whose interests move in a direction opposite to the changes
in the designated index.
Page 24
FLOATING RATE CMOS/INVERSE FLOATING RATE CMOS RISK
The Fund may invest in tranches of CMOs which have coupon rates which reset
periodically at a specified increment over an index, such as LIBOR (or sometimes
more than one index). These floating rate CMOs typically are issued with
lifetime caps on the coupon rate thereon. In a falling interest rate
environment, coupon rates on floating rate CMOs will generally fall, adversely
affecting the amount of income received by the Fund as well as the value of the
security. The Fund also may invest in inverse floating rate CMOs. Inverse
floating rate CMOs constitute a tranche of a CMO with a coupon rate that moves
in the reverse direction to an applicable index such as LIBOR. Accordingly, the
coupon rate thereon will increase as interest rates decrease. Inverse floating
rate CMOs are typically more volatile than fixed or floating rate tranches of
CMOs. Many inverse floating rate CMOs have coupons that move inversely to a
multiple of the applicable indexes. The effect of the coupon varying inversely
to a multiple of an applicable index creates a leverage situation. Inverse
floaters based on multiples of a stated index are designed to be highly
sensitive to changes in interest rates and can subject the holders thereof to
extreme reductions of yield and loss of principal. The markets for inverse
floating rate CMOs with highly leveraged characteristics at times may be very
thin.
BOND MARKET RISK
The yield spreads of the Fund's portfolio securities, or yield
differentials between the Fund's portfolio securities and Treasury securities
with comparable maturities, may widen, causing the value of the Fund's portfolio
securities to underperform Treasury securities. The amount of public information
available about the MBS and Other MBS 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 capabilities of the
Sub-Adviser than if the Fund were a stock fund or a corporate bond fund. The
secondary market for certain types of MBS, including Other MBS, may be less
well-developed or liquid than many other securities markets, which may affect
the Fund's ability to sell its portfolio securities at attractive prices.
ECONOMIC SECTOR RISK
Under normal market conditions, the Fund will be fully invested in Agency
MBS, Non-Agency RMBS, CMBS or Other MBS. This may make the Fund more susceptible
to adverse economic, political or regulatory events that affect the value of
real estate, and increase the potential for fluctuation in the net asset value
of the Fund's Common Shares.
INFLATION RISK
Inflation risk is the risk that the value of assets or income from
investments will be worth less in the future as inflation decreases the value of
money. As inflation increases, the real value of the Common Shares and
distributions can decline. In addition, during any periods of rising inflation,
the dividend rates or borrowing costs associated with the Fund's use of
financial leverage would likely increase, which would tend to further reduce
returns to Common Shareholders.
MARKET DISCOUNT FROM NET ASSET VALUE
Shares of closed-end investment companies frequently trade at a discount
from their net asset value. This characteristic is a risk separate and distinct
from the risk that the Fund's NAV could decrease as a result of its investment
activities and may be greater for investors expecting to sell their Common
Shares in a relatively short period following completion of this offering. The
NAV of the Common Shares will be reduced immediately following the offering as a
result of the payment of certain offering costs. Although the value of the
Fund's net assets is generally considered by market participants in determining
whether to purchase or sell Common Shares, whether investors will realize gains
or losses upon the sale of the Common Shares will depend entirely upon whether
the market price of the Common Shares at the time of sale is above or below the
investor's purchase price for the Common Shares. Because the market price of the
Common Shares will be determined by factors such as net asset value, dividend
and distribution levels (which are dependent, in part, on expenses), supply of
and demand for the Common Shares, stability of dividends or distributions,
trading volume of the Common Shares, general market and economic conditions and
other factors beyond the control of the Fund, the Fund cannot predict whether
the Common Shares will trade at, below or above NAV or at, below or above the
initial public offering price.
LEVERAGE RISK
The Fund may borrow an amount up to 33-1/3% (or such other percentage as
permitted by law) of its Managed Assets (including the amounts borrowed pursuant
to reverse repurchase agreements) less all liabilities other than borrowings.
The Fund may also issue Preferred Shares in an amount up to 50% of the Fund's
Managed Assets (including the proceeds from Leverage Instruments). However, the
Fund intends, under normal circumstances, to utilize leverage in an amount up to
33-1/3% of the Fund's Managed Assets. Reverse repurchase agreements, borrowings
and the issuance of Preferred Shares are referred to in this prospectus
collectively as "leverage." The Fund may use leverage for investment purposes,
to finance the repurchase of its Common Shares, and to meet cash requirements.
Although the use of leverage by the Fund may create an opportunity for increased
return for the Common Shares, it also results in additional risks and can
magnify the effect of any losses. If the income and gains earned on the
securities and investments purchased with leverage proceeds are greater than the
cost of the leverage, the Common Shares' return will be greater than if leverage
Page 25
had not been used. Conversely, if the income and gains from the securities and
investments purchased with such proceeds does not cover the cost of leverage,
the return to the Common Shares will be less than if leverage had not been used.
Reverse repurchase agreements are also subject to the risks that the market
value of the securities sold by the Fund may decline below the price of the
securities the Fund is obligated to repurchase, and that the securities may not
be returned to the Fund. There is no assurance that a leveraging strategy will
be successful. Leverage involves risks and special considerations for Common
Shareholders including:
o the likelihood of greater volatility of NAV and market price of the
Common Shares than a comparable portfolio without leverage;
o the risk that fluctuations in interest rates on reverse repurchase
agreements, borrowings and short-term debt or in the dividend rates
on any Preferred Shares that the Fund may pay will reduce the
return to the Common Shareholders or will result in fluctuations in
the dividends paid on the Common Shares;
o the effect of leverage in a declining market, which is likely to
cause a greater decline in the NAV of the Common Shares than if the
Fund were not leveraged, which may result in a greater decline in
the market price of the Common Shares; and
o when the Fund uses financial leverage, the investment advisory fee
payable to the Adviser (and by the Adviser to the Sub-Adviser) will
be higher than if the Fund did not use leverage.
The Sub-Adviser, in its judgment, nevertheless may determine to continue to
use leverage if it expects that the benefits to the Fund's shareholders of
maintaining the leveraged position will outweigh the current reduced return.
The funds borrowed pursuant to a leverage borrowing program (such as a
reverse repurchase agreement, credit line or commercial paper program), or
obtained through the issuance of Preferred Shares, constitute a substantial lien
and burden by reason of their prior claim against the income of the Fund and
against the net assets of the Fund in liquidation. The rights of lenders to
receive payments of interest on and repayments of principal on any borrowings
made by the Fund under a leverage borrowing program are senior to the rights of
Common Shareholders and the holders of Preferred Shares, with respect to the
payment of dividends or upon liquidation. The Fund may not be permitted to
declare dividends or other distributions, including dividends and distributions
with respect to Common Shares or Preferred Shares or purchase Common Shares or
Preferred Shares, unless at the time thereof the Fund meets certain asset
coverage requirements and no event of default exists under any leverage program.
In addition, the Fund may not be permitted to pay dividends on Common Shares
unless all dividends on the Preferred Shares and/or accrued interest on
borrowings have been paid, or set aside for payment. In an event of default
under a leverage borrowing program, the lenders have the right to cause a
liquidation of collateral (i.e., sell securities and other assets of the Fund)
and, if any such default is not cured, the lenders may be able to control the
liquidation as well. Certain types of leverage may result in the Fund being
subject to covenants relating to asset coverage and Fund composition
requirements. The Fund may be subject to certain restrictions on investments
imposed by guidelines of one or more rating agencies, which may issue ratings
for the Preferred Shares or other leverage securities issued by the Fund. These
guidelines may impose asset coverage or Fund composition requirements that are
more stringent than those imposed by the 1940 Act. The Sub-Adviser does not
believe that these covenants or guidelines will impede it from managing the
Fund's portfolio in accordance with the Fund's investment objectives and
policies.
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 NAV 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 benefit the Common Shareholders. 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 income
and/or total returns to Common Shareholders relative to the circumstance if 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 Common
Share price if the prediction were to turn out to be correct, and determine not
to reduce leverage as described above.
INTEREST RATE TRANSACTIONS RISK
In order to reduce the variability of leverage borrowing costs from
short-term reverse repurchase agreements, the Fund may enter into interest rate
swaps with the effect of fixing net borrowing costs for longer periods of time.
The value of the Fund's interest rate swaps could increase or decrease,
with a corresponding impact on the NAV of the Fund. To the extent there is a
decline in interest rates, the value of the interest rate swap could decrease,
and could result in a decrease in the Fund's NAV. In addition, if the
counterparty to an interest rate swap defaults, the Fund would be obligated to
make the payments that it had intended to avoid. Depending on whether the Fund
would be entitled to receive net payments from the counterparty on the swap,
which in turn would depend on the general state of short-term interest rates and
the returns on the Fund's portfolio securities at that point in time, a default
could adversely affect the NAV of the Common Shares.
Page 26
DERIVATIVES RISK
Strategic Transactions have risks, including the imperfect correlation
between the value of such instruments and the underlying assets, the possible
default of the other party to the transaction or illiquidity of the derivative
investments. Furthermore, the ability to successfully use Strategic Transactions
depends on the Sub-Adviser's ability to predict pertinent market movements,
which cannot be assured. Thus, the use of Strategic Transactions may result in
losses greater than if they had not been used, may require the Fund to sell or
purchase portfolio securities at inopportune times or for prices other than
current market values, may limit the amount of appreciation the Fund can realize
on an investment or may cause the Fund to hold a security that it might
otherwise sell. Additionally, amounts paid by the Fund as premiums and cash or
other assets held in margin accounts with respect to Strategic Transactions will
not otherwise be available to the Fund for investment purposes.
There are several risks associated with transactions in options on
securities. 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.
There are several risks associated with the use of futures contracts and
futures options. The purchase or sale of a futures contract may result in losses
in excess of the amount invested in the futures contract. While the Fund may
enter into futures contracts and options on futures contracts for hedging
purposes, the use of futures contracts and options on futures contracts might
result in a poorer overall performance for the Fund than if it had not engaged
in any such transactions. There may be an imperfect correlation between the
Fund's portfolio holdings and futures contracts or options on futures contracts
entered into by the Fund, which may prevent the Fund from achieving the intended
hedge or expose the Fund to risk of loss. The degree of imperfection of
correlation depends on circumstances such as variations in market demand for
futures, options on futures and their related securities, including technical
influences in futures and futures options trading, and differences between the
securities markets and the securities underlying the standard contracts
available for trading. Further, the Fund's use of futures contracts and options
on futures contracts to reduce risk involves costs and will be subject to the
Sub-Adviser's ability to correctly predict changes in interest rate
relationships or other factors.
Depending on whether the Fund would be entitled to receive net payments
from the counterparty on a swap or cap, which in turn would depend on the
general state of short-term interest rates at that point in time, a default by a
counterparty could negatively impact the performance of the Common Shares. In
addition, at the time an interest rate swap or cap transaction reaches its
scheduled termination date, there is a risk that the Fund would not be able to
obtain a replacement transaction or that the terms of the replacement would not
be as favorable as on the expiring transaction. If this occurs, it could have a
negative impact on the performance of the Common Shares. If the Fund fails to
maintain any required asset coverage ratios in connection with any use by the
Fund of financial leverage, the Fund may be required to redeem or prepay some or
all of the financial leverage. Such redemption or prepayment would likely result
in the Fund seeking to terminate early all or a portion of any swap or cap
transaction. Early termination of a swap could result in a termination payment
by or to the Fund. Early termination of a cap could result in a termination
payment to the Fund. The Fund intends to maintain, in a segregated account, cash
or liquid securities having a value at least equal to the Fund's net payment
obligations under any swap transaction, marked to market daily. The Fund will
not enter into interest rate swap or cap transactions having a notional amount
that exceeds the outstanding amount of the Fund's leverage.
The Fund may purchase credit derivative instruments for the purposes of
hedging the Fund's credit risk exposure to certain issuers of securities that
the Fund owns. For example, the Fund may enter into credit swap default
contracts for hedging purposes where the Fund would be the buyer of such a
contract. The Fund would be entitled to receive the par (or other agreed-upon)
value of a referenced debt obligation from the counterparty to the contract in
the event of a default by a third party, such as a U.S. issuer, on the debt
obligation. In return, the Fund would pay to the counterparty a periodic stream
of payments over the term of the contract provided that no event of default has
occurred. If no default occurs, the Fund would have spent the stream of payments
and received no benefit from the contract.
The use of interest rate swaps and caps is a highly specialized activity
that involves investment techniques and risks different from those associated
with ordinary portfolio security transactions. Depending on market conditions in
general, the Fund's use of swaps or caps could enhance or harm the overall
performance of the Common Shares. To the extent there is a decline in interest
rates, the value of the interest rate swap or cap could decline, and could
result in a decline in the NAV of the Common Shares. In addition, if short-term
interest rates are lower than the Fund's fixed rate of payment on the interest
rate swap, the swap will reduce Common Share net earnings. If, on the other
hand, short-term interest rates are higher than the fixed rate of payment on the
interest rate swap, the swap will enhance Common Share net earnings. Buying
interest rate caps could decrease the net earnings of the Common Shares in the
event that the premium paid by the Fund to the counterparty exceeds the
additional amount the Fund would have been required to pay had it not entered
into the cap agreement. The Fund has no current intention of selling an interest
rate swap or cap.
Page 27
Interest rate swaps and caps do not involve the delivery of securities or
other underlying assets or principal. Accordingly, the risk of loss with respect
to interest rate swaps is limited to the net amount of interest payments that
the Fund is contractually obligated to make. If the counterparty defaults, the
Fund would not be able to use the anticipated net receipts under the swap or cap
to offset any declines in the value of the Fund's portfolio assets being hedged.
Depending on whether the Fund would be entitled to receive net payments from the
counterparty on the swap or cap, which in turn would depend on the general state
of the market rates at that point in time, such a default could negatively
impact the performance of the Common Shares.
PORTFOLIO TURNOVER RISK
The Fund's annual portfolio turnover rate may vary greatly from year to
year. Although the Fund cannot accurately predict its annual portfolio turnover
rate, it is not expected to exceed 100% under normal circumstances. However,
portfolio turnover rate is not considered a limiting factor in the execution of
investment decisions for the Fund. High portfolio turnover may result in the
Fund's recognition of gains that will be taxable as ordinary income to the Fund.
A high portfolio turnover may increase the Fund's current and accumulated
earnings and profits, resulting in a greater portion of the Fund's distributions
being treated as a dividend to the Fund's Common Shareholders. In addition, a
higher portfolio turnover rate results in correspondingly greater brokerage
commissions and other transactional expenses that are borne by the Fund. See
"The Fund's Investments--Investment Practices--Portfolio Turnover" and "Tax
Matters."
MARKET DISRUPTION RISK
The terrorist attacks in the United States on September 11, 2001 had a
disruptive effect on the securities markets. The ongoing U.S. military and
related action in Iraq and events in the Middle East, as well as the continuing
threat of terrorist attacks, could have significant adverse effects on the U.S.
economy, the stock market and world economies and markets generally. The Fund
cannot predict the effects of similar events in the future on the U.S. and world
economies, the value of the Common Shares or the NAV of the Fund.
ILLIQUID/RESTRICTED SECURITIES RISK
The Fund may invest up to 10% of its Managed Assets in securities that, at
the time of investment, are illiquid (determined using the Securities and
Exchange Commission's standard applicable to investment companies, i.e.,
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). The Fund may also invest, without limit, in restricted securities.
However, restricted securities determined by the Sub-Adviser to be illiquid are
subject to the limitations set forth above. The Sub-Adviser, under the
supervision of the Board of Trustees, will determine whether restricted
securities are illiquid (that is, not readily marketable) and thus subject to
the Fund's limit of investing no more than 10% of its Managed Assets in illiquid
securities. Investments in restricted securities could have the effect of
increasing the amount of the Fund's assets invested in illiquid securities if
qualified institutional buyers are unwilling to purchase these securities.
Illiquid and restricted securities may be difficult to dispose of at a fair
price at the times when the Fund believes it is desirable to do so. The market
price of illiquid and restricted securities generally is more volatile than that
of more liquid securities, which may adversely affect the price that the Fund
pays for or recovers upon the sale of such securities. Illiquid and restricted
securities are also more difficult to value and the Sub-Adviser's judgment may
play a greater role in the valuation process. Investment of the Fund's assets in
illiquid and restricted securities may restrict the Fund's ability to take
advantage of market opportunities. The risks associated with illiquid and
restricted securities may be particularly acute in situations in which the
Fund's operations require cash and could result in the Fund borrowing to meet
its short-term needs or incurring losses on the sale of illiquid or restricted
securities. In order to dispose of an unregistered security, the Fund, where it
has contractual rights to do so, may have to cause such security to be
registered. A considerable period may elapse between the time the decision is
made to sell the security and the time the security is registered, therefore
enabling the Fund to sell it. Contractual restrictions on the resale of
securities vary in length and scope and are generally the result of a
negotiation between the issuer and acquiror of the securities. In either case,
the Fund would bear market risks during that period.
CERTAIN AFFILIATIONS
Certain broker-dealers may be considered to be affiliated persons of the
Fund or First Trust Advisors. 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 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. In addition, unless and
until the underwriting syndicate is broken in connection with the initial public
offering of the Common Shares, the Fund will be precluded from effecting
principal transactions with brokers who are members of the syndicate.
Page 28
ANTI-TAKEOVER PROVISIONS
The Fund's Declaration of Trust includes provisions that could limit the
ability of other entities or persons to acquire control of the Fund or convert
the Fund to open-end status. These provisions could have the effect of depriving
the Common Shareholders of opportunities to sell their Common Shares at a
premium over the then current market price of the Common Shares. See "Certain
Provisions in the Declaration of Trust."
SECONDARY MARKET FOR THE FUND'S SHARES
The issuance of Common Shares through the Fund's Dividend Reinvestment Plan
may have an adverse effect on the secondary market for the Fund's Common Shares.
The increase in the number of outstanding Common Shares resulting from issuances
pursuant to the Fund's Dividend Reinvestment Plan and the discount to the market
price at which such Common Shares may be issued, may put downward pressure on
the market price for the Common Shares. Common Shares will not be issued
pursuant to the Dividend Reinvestment Plan at any time when Common Shares are
trading at a lower price than the Fund's NAV per Common Share. When the Fund's
Common Shares are trading at a premium, the Fund may also issue Common Shares
that may be sold through private transactions effected on the NYSE or through
broker-dealers. The increase in the number of outstanding Common Shares
resulting from these offerings may put downward pressure on the market price for
Common Shares.
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 Adviser and the
Sub-Adviser. There are five trustees of the Fund, one of whom is an "interested
person" (as defined in the 1940 Act) and four of whom are not "interested
persons." 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 SAI.
INVESTMENT ADVISER
First Trust Advisors, 1001 Warrenville Road, Suite 300, Lisle, Illinois
60532, is the investment adviser to the Fund and is responsible for selecting
and supervising the Sub-Adviser. First Trust Advisors serves as investment
adviser or portfolio supervisor to investment portfolios with approximately
$17.1 billion in assets which it managed or supervised as of February 28, 2005.
First Trust Advisors is also responsible for the ongoing monitoring of the
Fund's investment portfolio, managing the Fund's business affairs and providing
certain clerical, bookkeeping and other administrative services.
First Trust Advisors, a registered investment adviser, is an Illinois
limited partnership formed in 1991 and an investment adviser registered with the
Securities and Exchange Commission under the Investment Advisers Act of 1940
(the "Advisers Act"). First Trust Advisors is a limited partnership with one
limited partner, Grace Partners of DuPage L.P. ("Grace Partners"), and one
general partner, The Charger Corporation. Grace Partners is a limited
partnership with one general partner, The Charger Corporation, and a number of
limited partners. Grace Partners' and The Charger Corporation's primary business
is investment advisory and broker-dealer services through their interests. The
Charger Corporation is an Illinois corporation controlled by the Robert Donald
Van Kampen family. First Trust Advisors is controlled by Grace Partners and The
Charger Corporation.
For additional information concerning First Trust Advisors, including a
description of the services provided, see the SAI.
SUB-ADVISER
FIDAC, which is a registered investment adviser, will act as Sub-Adviser to
the Fund. FIDAC was formed in 1994, and is located in New York, New York. FIDAC
is a leading fixed-income management company specializing in investing in U.S.
agency mortgage-backed and Treasury securities and managing interest
rate-sensitive strategies. From initially managing investment strategies in
separate managed accounts and its first fund, The U.S. Dollar Floating Rate
Fund, Ltd., FIDAC has grown assets under management to approximately US$16
billion as of December 31, 2004 through nine investment vehicles distributed in
Latin America, Europe, China, Japan, Korea, Canada, the United States, Malta and
South Africa. In June of 2004, FIDAC was acquired by Annaly Mortgage Management,
Inc. ("Annaly"), a New York Stock Exchange-listed real estate investment trust
which, at December 31, 2004, owned and managed a portfolio of approximately $20
billion in residential mortgage-backed securities. The following is a brief
description of the background of the key management personnel of FIDAC.
There is no one individual primarily responsible for portfolio management
decisions for the Fund. Investments are made under the direction of a team of
FIDAC professionals led by Michael A.J. Farrell, Wellington Denahan-Norris,
Jennifer Karve, James Fortescue, Kristopher Konrad and Rose-Marie Lyght. Mr.
Farrell is the Chief Executive Officer, President and founder of FIDAC and
Chairman, Chief Executive Officer and President of Annaly. Mrs. Denahan-Norris
is the Executive Vice-President and Chief Investment Officer of FIDAC and
Page 29
Vice Chairman, Chief Investment Officer and founder of Annaly and has been with
both companies since their inception. Ms. Karve is an Executive Vice-President
and Senior Portfolio Manager for FIDAC and Executive Vice-President, Secretary
and Senior Portfolio Manager for Annaly. Ms. Karve joined FIDAC in 1994. Mr.
Fortescue is a Senior Vice-President and Head of Financing for FIDAC and Annaly.
Mr. Fortescue joined FIDAC in 1995. Mr. Konrad is a Senior Vice-President and
Portfolio Manager for FIDAC and Annaly. Mr. Konrad joined both companies in
1997. Ms. Lyght is a Senior Vice-President and Portfolio Manager for FIDAC and
Annaly. Ms. Lyght joined both companies in 1999. The SAI provides additional
information about the portfolio managers' compensation, other accounts managed
by the portfolio managers and their ownership of shares of the Fund.
For additional information concerning FIDAC, including a description of
the services provided, see "Sub-Adviser" in the SAI.
INVESTMENT MANAGEMENT AGREEMENT
Pursuant to an investment management agreement between the Adviser and the
Fund, the Fund has agreed to pay a fee for the services and facilities provided
by the Adviser at the annual rate of % of Managed Assets.
For purposes of calculation of the management fee, the Fund's "Managed
Assets" means the average daily gross asset value of the Fund (which includes
assets attributable to the Fund's Preferred Shares, if any, and the principal
amount of borrowings), minus the sum of the Fund's accrued and unpaid dividends
on any outstanding Preferred Shares and accrued liabilities (other than the
principal amount of any borrowings incurred, commercial paper or notes issued by
the Fund).
In addition to the management fee, the Fund pays all other costs and
expenses of its operations including the compensation of its trustees (other
than those affiliated with the Adviser), custodian, transfer agency,
administrative, accounting and dividend disbursing expenses, legal fees,
leverage expenses, rating agency fees, listing fees and expenses, expenses of
independent auditors, expenses of repurchasing Common Shares, expenses of
preparing, printing and distributing shareholder reports, notices, proxy
statements and reports to governmental agencies and taxes, if any.
The Sub-Adviser receives a portfolio management fee at the annual rate of %
of Managed Assets, which is paid by the Adviser out of the Adviser's management
fee.
The Adviser has agreed to pay (i) all organizational expenses and (ii) all
offering costs of the Fund (other than sales load, but including the partial
reimbursement of certain underwriter expenses) that exceed .2% (or $.04 per
Common Share) of the Fund's offering price. The Sub-Adviser has agreed to
reimburse the Adviser for one-half of such organizational expenses and offering
costs of the Fund that exceed .2% (or $.04 per Common Share) of the Fund's
offering price. The Sub-Adviser has also agreed to reimburse the Adviser for
one-half of the quarterly incentive fee payable by the Adviser to as described
in "Underwriting--Additional Compensation and Other Relationships."
Because the fee paid to the Adviser (and by the Adviser to the Sub-Adviser)
will be calculated on the basis of the Fund's Managed Assets, which include the
proceeds of leverage, the dollar amount of the Adviser's and Sub-Adviser's fees
will be higher (and the Adviser and Sub-Adviser will be benefited to that
extent) when leverage is utilized. In this regard, if the Fund uses leverage in
the amount equal to 33-1/3% of the Fund's Managed Assets (after the issuance of
leverage), the Fund's management fee would be % of net assets attributable to
Common Shares. See "Summary of Fund Expenses."
NET ASSET VALUE
The NAV of the Common Shares of the Fund will be computed based upon the
value of the Fund's portfolio securities and other assets. The NAV will be
determined as of the close of regular trading on the New York Stock Exchange
("NYSE") (normally 4:00 p.m. New York City time) on each day the NYSE is open
for trading. The Fund calculates NAV per Common Share by subtracting the Fund's
liabilities (including accrued expenses, dividends payable and all borrowings of
the Fund) and the liquidation value of any outstanding Preferred Shares from the
Fund's Managed Assets (the value of the securities and other investments the
Fund holds plus cash or other assets, including interest accrued but not yet
received) and dividing the result by the total number of Common Shares
outstanding.
The Fund's portfolio securities and other assets will be valued daily in
accordance with valuation procedures adopted by the Board of Trustees.
Securities for which market quotations are readily available are valued at
market value, which is currently determined using the last reported sale price
or, if no sales are reported (as in the case of some securities traded
over-the-counter) the last reported bid price, except that certain U.S.
government securities are stated at the mean between the last reported bid and
asked prices. The Fund will value MBS and other debt securities not traded in an
organized market on the basis of valuations provided by dealers or by an
independent pricing service, approved by the Board of Trustees, which uses
information with respect to transactions in such securities, quotations from
dealers, market transactions for comparable securities, various relationships
between securities and yield to maturity in determining value. Debt securities
having a remaining maturity of sixty days or less when purchased and debt
securities originally purchased with maturities in excess of sixty days but
which currently have maturities of sixty days or less are valued at cost
Page 30
adjusted for amortization of premiums and accretion of discounts. If the
independent pricing service is unable to provide a price for a security, if the
price provided by the independent pricing service is deemed unreliable, or if
events occurring after the close of a securities market and before the Fund
values its Common Shares would materially affect NAV, such security will be
valued at its fair value as determined in good faith under procedures approved
by the Board of Trustees.
Fair Value. When applicable, fair value of securities of an issuer is
determined by the Board of Trustees or a committee of the Board of Trustees or a
designee of the Board of Trustees. In fair valuing the Fund's investments,
consideration is given to several factors, which may include, among others, the
following:
o the fundamental business data relating to the issuer;
o an evaluation of the forces which influence the market in which the
securities of the issuer are purchased and sold;
o the type, size and cost of the security;
o the financial statements of the issuer;
o the credit quality and cash flow of the issuer, based on the
Sub-Adviser's or external analysis;
o the information as to any transactions in or offers for the
security;
o the price and extent of public trading in similar securities (or
equity securities) of the issuer, or comparable companies;
o the coupon payments;
o the quality, value and saleability of collateral, if any, securing
the security;
o the business prospects of the issuer, including any ability to
obtain money or resources from a parent or affiliate and an
assessment of the issuer's management;
o the prospects for the issuer's industry, and multiples (of earnings
and/or cash flow) being paid for similar businesses in that
industry; and
o other relevant factors.
DISTRIBUTIONS
The Fund's present policy, which may be changed at any time by the Fund's
Board of Trustees, is to distribute to Common Shareholders monthly dividends of
all or a portion of its net income after payment of dividends and interest in
connection with leverage used by the Fund. It is expected that the initial
monthly dividend on the Fund's Common Shares will be declared approximately 45
days, and paid approximately 60 to 90 days, after the completion of this
offering, depending on market conditions. The Fund expects that all or a portion
of any capital gains will be distributed at least annually.
Various factors will affect the level of the Fund's income, including the
asset mix, the average maturity of the Fund's portfolio, the amount of leverage
utilized by the Fund and the Fund's use of hedging. To permit the Fund to
maintain a more stable monthly distribution, the Fund may from time to time
distribute less than the entire amount of income earned in a particular period.
The undistributed income would be available to supplement future distributions.
As a result, the distributions paid by the Fund for any particular monthly
period may be more or less than the amount of income actually earned by the Fund
during that period. Undistributed income will add to the Fund's NAV and,
correspondingly, distributions from undistributed income will decrease the
Fund's NAV. Shareholders will automatically have all dividends and distributions
reinvested in Common Shares issued by the Fund or purchased in the open market
in accordance with the Fund's dividend reinvestment plan unless an election is
made to receive cash. See "Dividend Reinvestment Plan."
DIVIDEND REINVESTMENT PLAN
If your Common Shares are registered directly with the Fund or if you hold
your Common Shares with a brokerage firm that participates in the Fund's
Dividend Reinvestment Plan (the "Plan"), unless you elect to receive cash
distributions, all dividends, including any capital gain dividends, on your
Common Shares will be automatically reinvested by PFPC Inc. (the "Plan Agent"),
in additional Common Shares under the Plan. If you elect to receive cash
distributions, you will receive all distributions in cash paid by check mailed
directly to you by PFPC Inc., as dividend paying agent.
If you decide to participate in the Plan, the number of Common Shares you
will receive will be determined as follows:
(1) If the Common Shares are trading at or above NAV at the time of
valuation, the Fund will issue new shares at a price equal to the greater of (i)
NAV per Common Share on that date or (ii) 95% of the market price on that date.
Page 31
(2) If Common Shares are trading below NAV at the time of valuation, the
Plan Agent will receive the dividend or distribution in cash and will purchase
Common Shares in the open market, on the or elsewhere, for the participants'
accounts. It is possible that the market price for the Common Shares may
increase before the Plan Agent has completed its purchases. Therefore, the
average purchase price per share paid by the Plan Agent may exceed the market
price at that time of valuation, resulting in the purchase of fewer shares than
if the dividend or distribution had been paid in Common Shares issued by the
Fund. The Plan Agent will use all dividends and distributions received in cash
to purchase Common Shares in the open market within 30 days of the valuation
date except where temporary curtailment or suspension of purchases is necessary
to comply with federal securities laws. Interest will not be paid on any
uninvested cash payments.
You may elect to opt-out of or withdraw from the Plan at any time by giving
written notice to the Plan Agent, or by telephone at (800) 331-1710, in
accordance with such reasonable requirements as the Plan Agent and Fund may
agree upon. If you withdraw or the Plan is terminated, you will receive a
certificate for each whole share in your account under the Plan and you will
receive a cash payment for any fraction of a share in your account. If you wish,
the Plan Agent will sell your shares and send you the proceeds, minus brokerage
commissions.
The Plan Agent maintains all Common Shareholders' accounts in the Plan and
gives written confirmation of all transactions in the accounts, including
information you may need for tax records. Common Shares in your account will be
held by the Plan Agent in non-certificated form. The Plan Agent will forward to
each participant any proxy solicitation material and will vote any shares so
held only in accordance with proxies returned to the Fund. Any proxy you receive
will include all Common Shares you have received under the Plan.
There is no brokerage charge for reinvestment of your dividends or
distributions in Common Shares. However, all participants will pay a pro rata
share of brokerage commissions incurred by the Plan Agent when it makes open
market purchases.
Automatically reinvesting dividends and distributions will not affect a
Common Shareholder's tax liability on those dividends and distributions. See
"Tax Matters."
If you hold your Common Shares with a brokerage firm that does not
participate in the Plan, you will not be able to participate in the Plan and any
dividend reinvestment may be effected on different terms than those described
above. Consult your financial advisor for more information.
The Fund reserves the right to amend or terminate the Plan if in the
judgment of the Board of Trustees the change is warranted. There is no direct
service charge to participants in the Plan; however, the Fund reserves the right
to amend the Plan to include a service charge payable by the participants.
Additional information about the Plan may be obtained from PFPC Inc., 301
Bellevue Parkway, Wilmington, Delaware 19809.
DESCRIPTION OF SHARES
COMMON SHARES
The Declaration of Trust authorizes the issuance of an unlimited number of
Common Shares. The Common Shares being offered have a par value of $.01 per
share and subject to the rights of the holders of Preferred Shares, if issued,
have equal rights to the payment of dividends and the distribution of assets
upon liquidation. The Common Shares being offered will, when issued, be fully
paid and, subject to matters discussed in "Certain Provisions in the Declaration
of Trust," non-assessable, and currently have no preemptive or conversion rights
(except as may otherwise be determined by the Board of Trustees in their sole
discretion) or rights to cumulative voting.
The Fund intends to apply to list the common shares on the Exchange. The
trading or "ticker" symbol of the common shares is expected to be " ." 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.
NAV will be reduced immediately following the offering by the amount of the
sales load and offering expenses paid by the Fund. The Adviser has agreed to pay
(i) all organizational expenses and (ii) all offering costs of the Fund (other
than sales load, but including a partial reimbursement of certain underwriter
expenses) that exceed .2% (or $.04 per Common Share) of the Fund's offering
price. The Sub-Adviser has agreed to reimburse the Adviser for one-half of such
organizational expenses and offering costs of the Fund that exceed .2% (or $.04
per Common Share) of the Fund's offering price. See "Use of Proceeds."
Unlike open-end funds, closed-end funds like the Fund do not continuously
offer shares and do not provide daily redemptions. Rather, if a shareholder
determines to buy additional Common Shares or sell shares already held, the
shareholder may conveniently do so by trading on the exchange through a broker
or otherwise. Shares of closed-end investment companies may frequently trade on
an exchange at prices lower than net asset value. Shares of closed-end
investment companies like the Fund have during some periods traded at prices
Page 32
higher than net asset value and during other periods have traded at prices lower
than net asset value. Because the market value of the Common Shares may be
influenced by such factors as dividend levels (which are in turn affected by
expenses), dividend stability, portfolio credit quality, net asset value,
relative demand for and supply of such shares in the market, general market and
economic conditions, and other factors beyond the control of the Fund, the Fund
cannot assure you that Common Shares will trade at a price equal to or higher
than NAV in the future. 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
The Declaration of Trust provides that the Fund's Board of Trustees may
authorize and issue Preferred Shares with rights as determined by the Board of
Trustees, by action of the Board of Trustees without the approval of the Common
Shareholders. Common Shareholders have no preemptive right to purchase any
Preferred Shares that might be issued.
The Fund may elect to issue Preferred Shares as part of its leverage
strategy. The Fund currently intends to issue Leverage Instruments, which may
include Preferred Shares, representing up to 33-1/3% of the Fund's Managed
Assets immediately after the Leverage Instruments are issued. The Board of
Trustees also reserves the right to issue Preferred Shares to the extent
permitted by the 1940 Act, which currently limits the aggregate liquidation
preference of all outstanding Preferred Shares plus the principal amount of any
outstanding leverage consisting of debt to 50% of the value of the Fund's
Managed Assets less liabilities and indebtedness of the Fund (other than
leverage consisting of debt). We cannot assure you, however, that any Preferred
Shares will be issued. Although the terms of any Preferred Shares, including
dividend rate, liquidation preference and redemption provisions, will be
determined by the Board of Trustees, subject to applicable law and the
Declaration of Trust, it is likely that the Preferred Shares will be structured
to carry a relatively short-term dividend rate reflecting interest rates on
short-term bonds, by providing for the periodic redetermination of the dividend
rate at relatively short intervals through an auction, remarketing or other
procedure. The Fund also believes that it is likely that the liquidation
preference, voting rights and redemption provisions of the Preferred Shares will
be similar to those stated below.
Liquidation Preference. In the event of any voluntary or involuntary
liquidation, dissolution or winding up of the Fund, the holders of Preferred
Shares will be entitled to receive a preferential liquidating distribution,
which is expected to equal the original purchase price per Preferred Share plus
accrued and unpaid dividends, whether or not declared, before any distribution
of assets is made to Common Shareholders. After payment of the full amount of
the liquidating distribution to which they are entitled, the holders of
Preferred Shares will not be entitled to any further participation in any
distribution of assets by the Fund.
Voting Rights. The 1940 Act requires that the holders of any Preferred
Shares, voting separately as a single class, have the right to elect at least
two trustees at all times. The remaining trustees will be elected by holders of
Common Shares and Preferred Shares, voting together as a single class. In
addition, subject to the prior rights, if any, of the holders of any other class
of senior securities outstanding, the holders of any Preferred Shares have the
right to elect a majority of the trustees of the Fund at any time two years'
dividends on any Preferred Shares are unpaid. The 1940 Act also requires that,
in addition to any approval by shareholders that might otherwise be required,
the approval of the holders of a majority of any outstanding Preferred Shares,
voting separately as a class, would be required to (1) adopt any plan of
reorganization that would adversely affect the Preferred Shares, and (2) take
any action requiring a vote of security holders under Section 13(a) of the 1940
Act, including, among other things, changes in the Fund's subclassification as a
closed-end investment company or changes in its fundamental investment
restrictions. See "Certain Provisions in the Declaration of Trust." As a result
of these voting rights, the Fund's ability to take any such actions may be
impeded to the extent that there are any Preferred Shares outstanding. The Board
of Trustees presently intends that, except as otherwise indicated in this
prospectus and except as otherwise required by applicable law or the Declaration
of Trust, holders of Preferred Shares will have equal voting rights with Common
Shareholders (one vote per share, unless otherwise required by the 1940 Act) and
will vote together with Common Shareholders as a single class.
The affirmative vote of the holders of a majority of the outstanding
Preferred Shares, voting as a separate class, will be required to amend, alter
or repeal any of the preferences, rights or powers of holders of Preferred
Shares so as to affect materially and adversely such preferences, rights or
powers, or to increase or decrease the authorized number of Preferred Shares.
The class vote of holders of Preferred Shares described above will in each case
be in addition to any other vote required to authorize the action in question.
Redemption, Purchase and Sale of Preferred Shares by the Fund. The terms of
any Preferred Shares issued are expected to provide that (1) they are redeemable
by the Fund in whole or in part at the original purchase price per share plus
accrued dividends per share, (2) the Fund may tender for or purchase Preferred
Shares and (3) the Fund may subsequently resell any shares so tendered for or
purchased. Any redemption or purchase of Preferred Shares by the Fund will
reduce the leverage applicable to the Common Shares, while any resale of shares
by the Fund will increase that leverage.
Page 33
The discussion above describes the possible offering of Preferred Shares by
the Fund. If the Board of Trustees determines to proceed with such an offering,
the terms of the Preferred Shares may be the same as, or different from, the
terms described above, subject to applicable law and the Fund's Declaration of
Trust. The Board of Trustees, without the approval of the Common Shareholders,
may authorize an offering of Preferred Shares or may determine not to authorize
such an offering, and may fix the terms of the Preferred Shares to be offered.
CERTAIN PROVISIONS IN THE DECLARATION OF TRUST
Under Massachusetts law, shareholders, in certain circumstances, could be
held personally liable for the obligations of the Fund. However, the Declaration
of Trust 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 Board of Trustees. The Declaration of Trust further provides for
indemnification out of the assets and property of the Fund for all loss and
expense of any shareholder 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.
The Declaration of Trust 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. Generally, the Declaration of Trust requires a vote by
holders of at least two-thirds of the Common Shares and Preferred Shares, if
any, voting together as a single class, except as described below and in the
Declaration of Trust, to authorize: (1) a conversion of the Fund from a
closed-end to an open-end investment company; (2) a merger or consolidation of
the Fund with any corporation, association, trust or other organization,
including a series or class of such other organization (subject to a limited
exception if the acquiring fund is not an operating entity immediately prior to
the transaction); (3) a sale, lease or exchange of all or substantially all of
the Fund's assets (other than in the regular course of the Fund's investment
activities, in connection with the termination of the Fund, and other limited
circumstances set forth in the Declaration of Trust); (4) in certain
circumstances, a termination of the Fund; (5) a removal of trustees by Common
Shareholders; or (6) certain transactions in which a Principal Shareholder (as
defined in the Declaration of Trust) is a party to the transaction. However,
with respect to (1) above, if there are Preferred Shares outstanding, the
affirmative vote of the holders of two-thirds of the Preferred Shares voting as
a separate class shall also be required. With respect to (2) above, except as
otherwise may be required, if the transaction constitutes a plan of
reorganization which adversely affects Preferred Shares, if any, then an
affirmative vote of two-thirds of the Preferred Shares voting together as a
separate class is required as well. With respect to (1) through (3), if such
transaction has already been authorized by the affirmative vote of two-thirds of
the trustees, then the affirmative vote of the majority of the outstanding
voting securities, as defined in the 1940 Act (a "Majority Shareholder Vote"),
is required, provided that when only a particular class is affected (or, in the
case of removing a trustee, when the trustee has been elected by only one
class), only the required vote of the particular class will be required. Such
affirmative vote or consent shall be in addition to the vote or consent of the
holders of the Fund's shares otherwise required by law or any agreement between
the Fund and any national securities exchange. Approval of Fund shareholders is
not required, however, for any transaction, whether deemed a merger,
consolidation, reorganization, exchange of shares or otherwise whereby the Fund
issues shares in connection with the acquisition of assets (including those
subject to liabilities) from any other investment company or similar entity.
None of the foregoing provisions may be amended except by the vote of at least
two-thirds of the Common Shares and Preferred Shares, if any, outstanding and
entitled to vote. See the SAI under "Certain Provisions in the Declaration of
Trust."
The provisions of the Declaration of Trust described above could have the
effect of depriving the Common Shareholders of opportunities to sell their
Common Shares at a premium over the then current market price of the Common
Shares by discouraging a third party from seeking to obtain control of the Fund
in a tender offer or similar transaction. The overall effect of these provisions
is to render more difficult the accomplishment of a merger or the assumption of
control by a third party. They provide, 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 objectives and policies. 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 and its Common Shareholders.
Reference should be made to the Declaration of Trust on file with the
Securities and Exchange Commission for the full text of these provisions.
Page 34
STRUCTURE OF THE FUND; COMMON SHARE REPURCHASES
AND CONVERSION TO OPEN-END FUND
CLOSED-END STRUCTURE
Closed-end funds differ from open-end management investment companies
(commonly referred to as mutual funds) in that closed-end funds generally list
their shares for trading on a securities exchange and do not redeem their shares
at the option of the shareholder. By comparison, mutual funds issue securities
redeemable at net asset value at the option of the shareholder and typically
engage in a continuous offering of their shares. Mutual funds are subject to
continuous asset in-flows and out-flows that can complicate portfolio
management, whereas closed-end funds generally can stay more fully invested in
securities consistent with the closed-end fund's investment objective and
policies. In addition, in comparison to open-end funds, closed-end funds have
greater flexibility in their ability to make certain types of investments,
including investments in illiquid securities.
However, shares of closed-end investment companies listed for trading on a
securities exchange frequently trade at a discount from net asset value, but in
some cases trade at a premium. The market price may be affected by trading
volume of the shares, general market and economic conditions and other factors
beyond the control of the closed-end fund. The foregoing factors may result in
the market price of the Common Shares being greater than, less than or equal to
net asset value. The Board of Trustees has reviewed the structure of the Fund in
light of its investment objectives and policies and has determined that the
closed-end structure is in the best interests of the shareholders. As described
below, however, the Board of Trustees will review periodically the trading range
and activity of the Fund's shares with respect to its net asset value and the
Board may take certain actions to seek to reduce or eliminate any such discount.
Such actions may include open market repurchases or tender offers for the Common
Shares at net asset value or the possible conversion of the Fund to an open-end
fund. There can be no assurance that the Board will decide to undertake any of
these actions or that, if undertaken, such actions would result in the Common
Shares trading at a price equal to or close to net asset value per Common Share.
In addition, as noted above, the Board of Trustees has determined in connection
with this initial offering of Common Shares of the Fund that the closed-end
structure is desirable, given the Fund's investment objectives and policies.
Investors should assume, therefore, that it is highly unlikely that the Board
would vote to convert the Fund to an open-end investment company.
REPURCHASE OF COMMON SHARES AND TENDER OFFERS
In recognition of the possibility that the Common Shares might trade at a
discount to net asset value and that any such discount may not be in the
interest of shareholders, the Fund's Board of Trustees, in consultation with the
Adviser, Sub-Adviser and any financial adviser that the Adviser may retain, from
time to time will review possible actions to reduce any such discount. The Board
of Trustees of the Fund will consider from time to time open market repurchases
of and/or tender offers for Common Shares to seek to reduce any market discount
from net asset value that may develop. In connection with its consideration from
time to time of open-end repurchases of and/or tender offers for Common Shares,
the Board of Trustees of the Fund will consider whether to commence a tender
offer or share-repurchase program at the first quarterly Board meeting following
a calendar year in which the Fund's Common Shares have traded at an average
weekly discount from net asset value of more than 10% in the last 12 weeks of
that calendar year. After any consideration of potential actions to seek to
reduce any significant market discount, the Board may, subject to its fiduciary
obligations and compliance with applicable state and federal laws, authorize the
commencement of a share-repurchase program or tender offer. The size and timing
of any such share repurchase program or tender offer will be determined by the
Board of Trustees in light of the market discount of the Common Shares, trading
volume of the Common Shares, information presented to the Board of Trustees
regarding the potential impact of any such share repurchase program or tender
offer, and general market and economic conditions. There can be no assurance
that the Fund will in fact effect repurchases of or tender offers for any of its
Common Shares. The Fund may, subject to its investment limitation with respect
to borrowings, incur debt to finance such repurchases or a tender offer or for
other valid purposes. Interest on any such borrowings would increase the Fund's
expenses and reduce the Fund's net income.
There can be no assurance that repurchases of Common Shares or tender
offers, if any, will cause the Common Shares to trade at a price equal to or in
excess of their net asset value. Nevertheless, the possibility that a portion of
the Fund's outstanding Common Shares may be the subject of repurchases or tender
offers may reduce the spread between market price and net asset value that might
otherwise exist. In the opinion of the Fund, sellers may be less inclined to
accept a significant discount in the sale of their Common Shares if they have a
reasonable expectation of being able to receive a price of net asset value for a
portion of their Common Shares in conjunction with an announced repurchase
program or tender offer for the Common Shares.
Although the Board of Trustees believes that repurchases or tender offers
generally would have a favorable effect on the market price of the Common
Shares, the acquisition of Common Shares by the Fund will decrease the Managed
Assets of the Fund and therefore will have the effect of increasing the Fund's
expense ratio and decreasing the asset coverage with respect to any Preferred
Shares outstanding. Because of the nature of the Fund's investment objectives,
policies and portfolio, the Adviser and the Sub-Adviser do not anticipate that
repurchases of Common Shares or tender offers should interfere with the ability
Page 35
of the Fund to manage its investments in order to seek its investment
objectives, and do not anticipate any material difficulty in borrowing money or
disposing of portfolio securities to consummate repurchases of or tender offers
for Common Shares, although no assurance can be given that this will be the
case.
CONVERSION TO OPEN-END FUND
The Fund may be converted to an open-end investment company at any time if
approved by the holders of two-thirds of the Fund's shares outstanding and
entitled to vote; provided, however, that such vote shall be by Majority
Shareholder Vote if the action in question was previously approved by the
affirmative vote of two-thirds of the Board of Trustees. Such affirmative vote
or consent shall be in addition to the vote or consent of the holders of the
shares otherwise required by law or any agreement between the Fund and any
national securities exchange. In the event of conversion, the Common Shares
would cease to be listed on the NYSE or other national securities exchange or
market system. Any Preferred Shares or borrowings would need to be redeemed or
repaid upon conversion to an open-end investment company. The Board of Trustees
believes, however, that the closed-end structure is desirable, given the Fund's
investment objectives and policies. Investors should assume, therefore, that it
is unlikely that the Board of Trustees would vote to convert the Fund to an
open-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 such redemption charge or contingent deferred sales charge, if any, as
might be in effect at the time of a redemption. The Fund expects to pay all such
redemption requests in cash, but intends to reserve the right to pay redemption
requests in a combination of cash or securities. If such partial payment in
securities were made, investors may incur brokerage costs in converting such
securities to cash. If the Fund were converted to an open-end fund, it is likely
that new Common Shares would be sold at net asset value plus a sales load.
TAX MATTERS
The following discussion of federal income tax matters is based on the
advice of Chapman and Cutler LLP, counsel to the Fund.
This section and the discussion in the SAI summarize some of the main U.S.
federal income tax consequences of owning shares of the Fund. This section is
current as of the date of this prospectus. Tax laws and interpretations change
frequently, and this summary does not describe all of the tax consequences to
all taxpayers. For example, this summary generally does not describe your
situation or the tax consequences to you if you are a bank or a financial
institution, an insurance company, a dealer in securities, a non-U.S.
shareholder, a tax-exempt or tax-deferred plan, account or entity, a shareholder
that is subject to the alternative minimum tax or a shareholder that holds its
shares as or in a hedge against currency risk, constructive sale or a conversion
transaction or other investor with special circumstances. In addition, this
section does not describe your state, local or foreign taxes. Investors should
consult their own tax advisors regarding the tax consequences of investing in
the Fund.
Fund Status. The Fund intends to elect and to qualify annually as a
"regulated investment company" under the federal tax laws. To qualify, the Fund
must, among other things, satisfy certain requirements relating to the source
and nature of its income and the diversification of its assets. If the Fund
qualifies as a regulated investment company and distributes all of its income as
required by the tax laws, the Fund generally will not pay federal income or
excise taxes.
Distributions. Fund distributions will constitute dividends to the extent
of the Fund's current and accumulated earnings and profits and are generally
taxable. After the end of each year, you will receive a tax statement that
separates your Fund's distributions into two categories, ordinary income
distributions and capital gains dividends. Ordinary income distributions are
generally taxed at your ordinary tax rate, but, as further discussed below, if
the Fund holds equity securities, under the "Jobs and Growth Tax Relief
Reconciliation Act of 2003" (the "Tax Act"), certain ordinary income
distributions received from the Fund may be taxed at new tax rates equal to
those applicable to net capital gains. Generally, you will treat all capital
gains dividends as long-term capital gains regardless of how long you have
owned your shares. To determine your actual tax liability for your capital gains
dividends, you must calculate your total net capital gain or loss for the tax
year after considering all of your other taxable transactions, as described
below. In addition, to the extent that the Fund makes distributions in excess of
its current and accumulated earnings and profits, such distributions will
represent a return of capital for tax purposes to the extent of your tax basis
in the shares and thus will generally not be taxable to you. To the extent such
distributions exceed your tax basis, they will generally constitute a capital
gain. The tax status of your distributions from the Fund is not affected by
whether you reinvest your distributions in additional shares or receive them in
cash. The tax laws may require you to treat distributions made to you in January
as if you had received them on December 31 of the previous year.
Dividends Received Deduction. A corporation that owns shares generally will
not be entitled to the dividends received deduction with respect to dividends
received from the Fund because the dividends received deduction is generally not
available for distributions from regulated investment companies. However, if the
Fund holds equity securities, certain ordinary income dividends on shares that
are attributable to dividends received by the Fund from certain domestic
corporations may be designated by the Fund as being eligible for the dividends
received deduction, but this amount is not expected to be significant.
Page 36
If You Sell Shares. If you sell your shares, you will generally recognize a
taxable gain or loss. To determine the amount of this gain or loss, you must
subtract your tax basis in your shares from the amount you receive in the
transaction. Your tax basis in your shares is generally equal to the cost of
your shares, generally including sales charges. In some cases, however, you may
have to adjust your tax basis after you purchase your shares. Any loss realized
upon a taxable disposition of the shares may be disallowed if other
substantially identical shares are acquired within a 61-day period beginning 30
days before and ending 30 days after the date the original shares are disposed
of. If disallowed, the loss will be reflected by an upward adjustment to the
basis of the shares acquired. In addition, the ability to deduct capital losses
may otherwise be limited.
Taxation of Capital Gains and Losses and Certain Ordinary Income Dividends.
Under the Tax Act, if you are an individual, the maximum marginal federal tax
rate for net capital gain is generally 15% (generally 5% for certain taxpayers
in the 10% and 15% tax brackets). These capital gains rates are generally
effective for taxable years beginning before January 1, 2009. For periods not
covered by the Tax Act, if you are an individual, the maximum marginal federal
tax rate for net capital gains is generally 20% (10% for certain taxpayers in
the 10% and 15% tax brackets). For tax years not covered by the Tax Act, the 20%
rate is reduced to 18% and the 10% rate is reduced to 8% for net capital gains
from most property acquired after December 31, 2000, with a holding period of
more than five years.
Net capital gain equals net long-term capital gain minus net short-term
capital loss for the taxable year. Capital gain or loss is long-term if the
holding period for the asset is more than one year and is short-term if the
holding period for the asset is one year or less. You must exclude the date you
purchase your shares to determine your holding period. However, if you receive a
capital gain dividend from the Fund and sell your share at a loss after holding
it for six months or less, the loss will be recharacterized as long-term
capital loss to the extent of the capital gain dividend received. The tax rates
for capital gains realized from assets held for one year or less are generally
the same as for ordinary income. In addition, the Code treats certain capital
gains as ordinary income in special situations.
Pursuant to the Tax Act, if the Fund holds certain equity securities, a
portion of the ordinary income dividends received by an individual shareholder
from a regulated investment company such as the Fund generally will be taxed at
the same new rates that apply to net capital gain (as discussed above), but only
if certain holding period requirements are satisfied and the dividends are
attributable to qualified dividends received by the Fund itself. These special
rules relating to the taxation of ordinary income dividends from regulated
investment companies generally apply to taxable years beginning before January
1, 2009. The Fund generally does not expect to generate qualifying dividends
eligible for the new capital gains tax rates.
Backup Withholding. The Fund may be required to withhold, for U.S. federal
income taxes, a portion of all taxable dividends and redemption proceeds payable
to shareholders who fail to provide the Fund with their correct taxpayer
identification numbers or who otherwise fail to make required certifications, or
if the Fund or a shareholder has been notified by the Internal Revenue Service
that such shareholder is subject to backup withholding. Corporate shareholders
and certain other shareholders under federal tax laws are generally exempt from
such backup withholding. Backup withholding is not an additional tax. Any
amounts withheld will be allowed as a refund or credit against the shareholder's
federal income tax liability if the appropriate information is provided to the
Internal Revenue Service.
Foreign Investors. If you are a foreign investor (i.e., investor other than
a U.S. citizen or resident or a U.S. corporation, partnership, estate or fund),
you should be aware that, generally, subject to applicable tax treaties,
distributions from the Fund will be characterized as dividends for federal
income tax purposes (other than dividends which the Fund designates as capital
gain dividends) and will be subject to U.S. income taxes, including withholding
taxes, subject to certain exceptions described below. However, distributions
received by a foreign investor from the Fund that are properly designated by the
Fund as capital gain dividends may not be subject to U.S. federal income taxes,
including withholding taxes, provided that the Fund makes certain elections and
certain other conditions are met. In the case of dividends with respect to
taxable years of the Fund beginning after 2004 and prior to 2008, distributions
from the Fund that are properly designated by the Fund as an interest-related
dividend attributable to certain interest income received by the Fund or as a
short-term capital gain dividend attributable to certain short-term capital gain
income received by the Fund may not be subject to U.S. federal income taxes when
received by certain foreign investors, including withholding taxes, provided
that the Fund makes certain elections and certain other conditions are met.
Foreign investors should consult their tax advisors with respect to U.S. tax
consequences of ownership of Common Shares.
Further Information. The SAI summarizes further federal income tax
considerations that may apply to the Fund and its shareholders and may qualify
the considerations discussed herein.
Page 37
UNDERWRITING
Subject to the terms and conditions stated in a purchase agreement dated ,
2005, each Underwriter named below, for which is acting as representative, has
severally agreed to purchase, and the Fund has agreed to sell to such
Underwriter, the number of Common Shares set forth opposite the name of such
Underwriter.
NUMBER OF
UNDERWRITER COMMON SHARES
..............................................
..............................................
..............................................
..............................................
---------
Total ........................................
=========
The purchase agreement provides that the obligations of the Underwriters to
purchase the Common Shares included in this offering are subject to the approval
of certain legal matters by counsel and certain other conditions. The
Underwriters are obligated to purchase all the Common Shares sold under the
purchase agreement if any of the Common Shares are purchased. In the purchase
agreement, the Fund, the Adviser and the Sub-Adviser have agreed to indemnify
the Underwriters against certain liabilities, including liabilities arising
under the Securities Act of 1933, as amended, or to contribute to payments the
Underwriters may be required to make for any of those liabilities.
COMMISSIONS AND DISCOUNTS
The Underwriters propose to initially offer some of the Common Shares
directly to the public at the public offering price set forth on the cover page
of this prospectus and some of the Common Shares to certain dealers at the
public offering price less a concession not in excess of $ per Common Share. The
sales load the Fund will pay of $.90 per Common Share is equal to 4.5% of the
initial offering price. The Underwriters may allow, and the dealers may reallow,
a discount not in excess of $ per Common Share on sales to other dealers.
Notwithstanding the foregoing, certain Underwriters may pay up to an additional
$ per Common Share from the sales load to certain dealers pursuant to existing
arrangements with such dealers. After the initial public offering, the public
offering price, concession and discount may be changed. Investors must pay for
any Common Shares purchased on or before , 2005.
The following table shows the public offering price, estimated offering
expenses, sales load and proceeds to the Fund. The information assumes either no
exercise or full exercise by the Underwriters of their overallotment option.
PER SHARE WITHOUT OPTION WITH OPTION
Public offering price........................... $20.00 $ $
Sales load...................................... $.90 $ $
Estimated offering expenses..................... $.04 $ $
Proceeds, after expenses, to the Fund .......... $19.06 $ $
The Fund will pay its Common Share offering costs up to and including $.04
per Common Share. The Fund has agreed to pay the Underwriters $ per Common Share
as a partial reimbursement of expenses incurred in connection with the offering.
The amount paid by the Fund as this partial reimbursement to the Underwriters
will not exceed % of the total price to the public of the Common Shares sold in
this offering. The Fund has also agreed to pay certain fees to counsel to the
Underwriters in an amount up to $ , which will not exceed % of the total price
to the public of the Common Shares sold in this offering. The Adviser has agreed
to pay (i) all organizational costs and (ii) all offering costs of the Fund
(other than sales load, but including the partial reimbursement of certain
underwriter expenses described above) that exceed .2% (or $.04 per Common Share)
of the Fund's offering price. The Sub-Adviser has agreed to reimburse the
Adviser for one-half of such organizational expenses and offering costs of the
Fund that exceed .2% (or $.04 per Common Share) of the Fund's offering price. To
the extent that aggregate offering expenses are less than $.04 per Common Share,
up to .10% of the public offering price of the securities sold in this offering,
up to such expense limit, will be paid to First Trust Portfolios, L.P. as
reimbursement for the distribution services it provides to the Fund (the
"Contingent Reimbursement Amount"). First Trust Portfolios, L.P. is an affiliate
of the Adviser.
Page 38
OVERALLOTMENT OPTION
The Fund has granted the Underwriters an option to purchase up to
additional Common Shares at the public offering price, less the sales load,
within 45 days from the date of this prospectus solely to cover any
overallotments. If the Underwriters exercise this option, each will be
obligated, subject to conditions contained in the purchase agreement, to
purchase a number of additional Common Shares proportionate to that
Underwriter's initial amount reflected in the above table.
PRICE STABILIZATION, SHORT POSITIONS AND PENALTY BIDS
Until the distribution of the Common Shares is complete, Securities and
Exchange Commission rules may limit Underwriters and selling group members from
bidding for and purchasing the Common Shares. However, the representatives may
engage in transactions that stabilize the price of the Common Shares, such as
bids or purchases to peg, fix or maintain that price.
If the Underwriters create a short position in the Common Shares in
connection with the offering, i.e., if they sell more Common Shares than are
listed on the cover of this prospectus, the representative may reduce that short
position by purchasing Common Shares in the open market. The representative may
also elect to reduce any short position by exercising all or part of the
overallotment option described above. The Underwriters also may impose a penalty
bid, whereby selling concessions allowed to syndicate members or other
broker-dealers in respect of the Common Shares sold in this offering for their
account may be reclaimed by the syndicate if such Common Shares are repurchased
by the syndicate in stabilizing or covering transactions. Purchases of the
Common Shares to stabilize the price or to reduce a short position may cause the
price of the Common Shares to be higher than it might be in the absence of such
purchases.
Neither the Fund nor any of the Underwriters makes any representations or
prediction as to the direction or magnitude of any effect that the transactions
described above may have on the price of the Common Shares. In addition, neither
the Fund nor any of the Underwriters makes any representation that the
representative will engage in these transactions or that these transactions,
once commenced, will not be discontinued without notice.
The Fund has agreed not to offer or sell any additional Common Shares for a
period of 180 days after the date of the purchase agreement without the prior
written consent of the Underwriters, except for the sale of the Common Shares to
the Underwriters pursuant to the purchase agreement and certain transactions
relating to the Fund's Dividend Reinvestment Plan.
The Fund anticipates that the Underwriters may from time to time act as
brokers or, after they have ceased to be Underwriters, dealers in executing the
Fund's portfolio transactions. The Underwriters are active Underwriters of, and
dealers in, securities and act as market-makers in a number of such securities,
and therefore can be expected to engage in portfolio transactions with the Fund.
Common Shares will be sold so as to ensure that Exchange distribution
standards (i.e., round lots, public shares and aggregate market value) will be
met.
ADDITIONAL COMPENSATION AND OTHER RELATIONSHIPS
The Adviser (and not the Fund) has agreed to pay from its own assets
additional compensation to . This additional compensation will be payable
quarterly at the annual rate of % of the Fund's Managed Assets during the
continuance of the Investment Management Agreement or other investment
management agreement between the Adviser and the Fund. has agreed to provide,
as requested by the Adviser, specified after-market support services designed to
maintain the visibility of the Fund on an ongoing basis; relevant information,
studies or reports regarding the Fund and the closed-end investment company
industry; and consultation regarding market discounts of the Fund. The total
amount of these additional compensation payments to , which are considered
underwriting compensation, will not exceed % of the total price to the public
of the Common Shares sold in this offering.
The Adviser (and not the Fund) has also agreed to pay from its own assets
to (" ") a quarterly incentive fee at an annual rate of up to % of the Fund's
Managed Assets attributable to Common Shares sold by in this offering,
provided it meets a certain sales target established by the Adviser. This fee
will be payable during the continuance of the Investment Management Agreement
or other investment management agreement between the Adviser and the Fund. The
amount of the quarterly incentive fee paid to , which is considered
underwriting compensation, will not exceed % of the total price to the public
of the Common Shares sold in this offering.
First Trust Portfolios, L.P., an affiliate of the Adviser, will provide
distribution assistance in connection with the sale of the Common Shares of the
Fund, and may pay compensation to its respective employees who assist in
marketing securities. In connection with this distribution assistance, to the
extent the offering expenses payable by the Fund are less than .2% (or $.04 per
Common Share) of the Fund's offering price, the Fund will pay the Contingent
Reimbursement Amount of up to .10% of the amount of the total price to the
public of the Common Shares sold in this offering, up to such expense limit, to
First Trust Portfolios, L.P. as reimbursement for its distribution assistance.
Accordingly, the Contingent Reimbursement Amount will not exceed .10% of the
Page 39
total price to the public of the Common Shares sold in this offering. Any
compensation paid by First Trust Portfolios, L.P. to its respective employees
who assist in marketing securities will be paid first from the Contingent
Reimbursement Amount, if any, and then from First Trust Portfolios, L.P.'s
assets (and not the assets of the Fund).
The total amount of the additional compensation payments to and described
above, plus the amounts paid by the Fund as the $ per Common Share partial
reimbursement to the Underwriters, the payment of certain fees to counsel to the
Underwriters and the Contingent Reimbursement Amount payable to First Trust
Portfolios, L.P., will not exceed 4.5% (or $.90 per Common Share) of the total
price to the public of the Common Shares sold in this offering. The sum total of
all compensation to or reimbursement of Underwriters and First Trust Portfolios,
L.P. in connection with this public offering of Common Shares, including sales
load and all forms of additional compensation to Underwriters, will be limited
to 9% (or $1.80 per Common Share) of the total price to the public of the Common
Shares sold in this offering.
The address of is , . The address of
is , .
ADMINISTRATOR, CUSTODIAN AND TRANSFER AGENT
The custodian of the assets of the Fund is PFPC Trust Company, 301 Bellevue
Parkway, Wilmington, Delaware 19809. The Fund's transfer, shareholder services
and dividend paying agent is PFPC Inc., 301 Bellevue Parkway, Wilmington,
Delaware 19809. Pursuant to an Administration and Accounting Services Agreement,
PFPC Inc. also provides certain administrative and accounting services to the
Fund, including maintaining the Fund's books of account, records of the Fund's
securities transactions, and certain other books and records; acting as liaison
with the Fund's independent registered public accounting firm by providing such
accountant with various audit-related information with respect to the Fund; and
providing other continuous accounting and administrative services. As
compensation for these services, the Fund has agreed to pay PFPC Inc. an annual
fee, calculated daily and payable on a monthly basis, of .06% of the Fund's
first $250 million of average Managed Assets, subject to decrease with respect
to additional Fund Managed Assets.
LEGAL OPINIONS
Certain legal matters in connection with the Common Shares will be passed
upon for the Fund by Chapman and Cutler LLP, Chicago, Illinois, and for the
Underwriters by , , . Chapman and Cutler LLP and
may rely as to certain matters of Massachusetts law on the opinion of Bingham
McCutchen LLP.
Page 40
TABLE OF CONTENTS FOR THE
STATEMENT OF ADDITIONAL INFORMATION
Page
Use of Proceeds......................................................... 1
Investment Objectives................................................... 1
Investment Restrictions................................................. 2
Investment Policies and Techniques...................................... 4
Additional Information About the Fund's Investments
and Investment Risks................................................. 12
Other Investment Policies and Techniques................................ 26
Management of the Fund.................................................. 34
Investment Adviser...................................................... 39
Proxy Voting Procedures................................................. 40
Sub-Adviser............................................................. 41
Portfolio Transactions and Brokerage.................................... 44
Description of Shares................................................... 46
Certain Provisions in the Declaration of Trust.......................... 48
Repurchase of Fund Shares; Conversion to Open-End Fund.................. 51
Federal Income Tax Matters.............................................. 53
Performance Related and Comparative Information......................... 58
Independent Registered Public Accounting Firm........................... 60
Custodian, Administrator and Transfer Agent............................. 60
Additional Information.................................................. 61
Report of Independent Registered Public Accounting Firm................. 62
Financial Statements.................................................... 63
Appendix A--Description of Ratings...................................... A-1
Page 41
THIS PAGE IS INTENTIONALLY LEFT BLANK.
Page 42
Blank Inside Back Cover
===============================================================================
Until , 2005 (25 days after the date of this prospectus), all dealers that buy,
sell or trade the Common Shares, whether or not participating in this offering,
may be required to deliver a prospectus. This is in addition to the dealers'
obligation to deliver a prospectus when acting as Underwriters and with respect
to their unsold allotments or subscriptions.
SHARES
FIRST TRUST/FIDAC MORTGAGE INCOME FUND
COMMON SHARES
$20.00 PER SHARE
----------
PROSPECTUS
----------
, 2005
===============================================================================
Back Cover
SUBJECT TO COMPLETION, DATED MARCH 11, 2005
THE INFORMATION IN THIS STATEMENT OF ADDITIONAL INFORMATION IS NOT
COMPLETE AND MAY BE CHANGED. WE MAY NOT SELL THESE SECURITIES UNTIL THE
REGISTRATION STATEMENT FILED WITH THE SECURITIES AND EXCHANGE COMMISSION IS
EFFECTIVE. THIS STATEMENT OF ADDITIONAL INFORMATION IS NOT AN OFFER TO SELL
THESE SECURITIES AND IS NOT SOLICITING AN OFFER TO BUY THESE SECURITIES IN ANY
STATE WHERE THE OFFER OR SALE IS NOT PERMITTED.
FIRST TRUST/FIDAC MORTGAGE INCOME FUND
STATEMENT OF ADDITIONAL INFORMATION
First Trust/FIDAC Mortgage Income Fund (the "Fund") is a newly
organized, closed-end, diversified management investment company.
This Statement of Additional Information relating to the common shares
of beneficial interest of the Fund (the "Common Shares") is not a prospectus,
but should be read in conjunction with the Fund's Prospectus dated
_____________, 2005 (the "Prospectus"). This Statement of Additional Information
does not include all information that a prospective investor should consider
before purchasing Common Shares. Investors should obtain and read the Prospectus
prior to purchasing such Shares. A copy of the Fund's Prospectus may be obtained
without charge by calling (800) 988-5891. You also may obtain a copy of the
Prospectus on the Securities and Exchange Commission's web site
(http://www.sec.gov). Capitalized terms used but not defined in this Statement
of Additional Information have the meanings ascribed to them in the Prospectus.
This Statement of Additional Information is dated __________, 2005.
-Front Cover-
TABLE OF CONTENTS
Page
USE OF PROCEEDS...............................................................1
INVESTMENT OBJECTIVES.........................................................1
INVESTMENT RESTRICTIONS.......................................................2
INVESTMENT POLICIES AND TECHNIQUES............................................4
ADDITIONAL INFORMATION ABOUT THE FUND'S INVESTMENTS AND INVESTMENT RISKS.....12
OTHER INVESTMENT POLICIES AND TECHNIQUES.....................................26
MANAGEMENT OF THE FUND.......................................................34
INVESTMENT ADVISER...........................................................39
PROXY VOTING PROCEDURES......................................................40
SUB-ADVISER..................................................................41
PORTFOLIO TRANSACTIONS AND BROKERAGE.........................................44
DESCRIPTION OF SHARES........................................................46
CERTAIN PROVISIONS IN THE DECLARATION OF TRUST...............................48
REPURCHASE OF FUND SHARES; CONVERSION TO OPEN-END FUND.......................51
FEDERAL INCOME TAX MATTERS...................................................53
PERFORMANCE RELATED AND COMPARATIVE INFORMATION..............................58
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM................................60
CUSTODIAN, ADMINISTRATOR AND TRANSFER AGENT..................................60
ADDITIONAL INFORMATION.......................................................61
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM......................62
FINANCIAL STATEMENTS.........................................................63
APPENDIX A.........DESCRIPTION OF RATINGS...................................A-1
-i-
USE OF PROCEEDS
The net proceeds of the offering of Common Shares of the Fund will be
approximately $__________($___________ if the Underwriters exercise the
overallotment option in full) after payment of the estimated organizational
expenses and offering costs. The Fund expects it will be able to invest
substantially all of the net proceeds in securities and other instruments that
meet the investment objectives and policies within two months after completion
of the offering. Pending such investment, it is anticipated that the proceeds
will be invested in cash or cash equivalents.
For the Fund, First Trust Advisors L.P. ("First Trust Advisors" or
"Adviser") has agreed to pay (i) all organizational expenses and (ii) all
offering costs of the Fund (other than sales load, but including a partial
reimbursement of underwriter expenses) that exceed $0.04 per Common Share. Fixed
Income Discount Advisory Company ("FIDAC" or "Sub-Adviser") has agreed to
reimburse the Adviser for one-half of such organizational expenses and offering
costs of the Fund that exceed $.04 per Common Share.
INVESTMENT OBJECTIVES
Investment Objectives. The Fund's primary investment objective is to
seek a high level of current income. As a secondary objective, the Fund will
seek to preserve capital.
The Fund will pursue its objectives by investing primarily in
investment securities consisting of mortgage-backed securities, which include
agency mortgage pass-through certificates, agency collateralized mortgage
obligations, nonagency mortgage-backed securities and commercial mortgage-backed
securities (collectively, "MBS") that, in the opinion of the Fund's Sub-Adviser,
offer an attractive combination of credit quality, yield and maturity.
Under normal market conditions, the Fund will invest at least 80% of
its Managed Assets in MBS. In addition, the Fund may invest up to 20% of its
Managed Assets in U.S. government securities, or cash or other short-term
instruments, and may invest up to 10% of its Managed Assets in other
mortgage-related assets that are secured by pools of assets that represent
interests in real estate. The Fund will invest all of its managed assets in
securities that at the time of investment are investment grade quality and rated
within the three highest investment grades by at least one rating agency or are
unrated but judged to be of comparable quality by the Sub-Adviser.
"Managed Assets" means the average daily gross asset value of the Fund
(including assets attributable to the Fund's Preferred Shares (defined below),
if any, and the principal amount of borrowings) minus the sum of the Fund's
accrued and unpaid dividends on any outstanding Preferred Shares and accrued
liabilities (other than the principal amount of any reverse repurchase
agreements, other borrowings or of commercial paper or notes issued by the
Fund). For purposes of determining Managed Assets, the liquidation preference of
preferred shares of beneficial interest ("Preferred Shares") is not treated as a
liability. Percentage limitations described in this Statement of Additional
-1-
Information are as of the time of investment by the Fund and may be exceeded on
a going-forward basis as a result of market value fluctuations of the Fund's
portfolio and other events.
The Common Shares may trade at a discount or premium to net asset value
("NAV"). An investment in the Fund may not be appropriate for all investors and
is not intended to be a complete investment program. No assurance can be given
that the Fund will achieve its investment objectives. For further discussion of
the Fund's portfolio composition and associated special risk considerations, see
"The Fund's Investments" and "Risks" in the Prospectus.
INVESTMENT RESTRICTIONS
The Fund's investment objectives and certain investment policies of the
Fund are described in the Prospectus. The Fund, as a fundamental policy, may
not:
1. With respect to 75% of its total assets, purchase any
securities if, as a result, more than 5% of the Fund's total assets
would then be invested in securities of any single issuer or if, as a
result, the Fund would hold more than 10% of the outstanding voting
securities of any single issuer; provided, that Government securities
(as defined in the Investment Company Act of 1940 (the "1940 Act")),
securities issued by other investment companies and cash items
(including receivables) shall not be counted for purposes of this
limitation;
2. Purchase any security if, as a result of the purchase,
25% or more of the Fund's total assets (taken at current value) would
be invested in the securities of borrowers and other issuers having
their principal business activities in the same industry; provided,
that this limitation shall not apply with respect to obligations issued
or guaranteed by the U.S. Government or by its agencies or
instrumentalities;
3. Borrow money, except as permitted by the 1940 Act, the
rules thereunder and interpretations thereof or pursuant to a
Securities and Exchange Commission exemptive order;
4. Issue senior securities, as defined in the 1940 Act,
other than: (i) Preferred Shares which immediately after issuance will
have asset coverage of at least 200%; (ii) indebtedness which
immediately after issuance will have asset coverage of at least 300%;
(iii) the borrowings permitted by investment restriction 3 above, or
(iv) pursuant to a Securities and Exchange Commission exemptive order;
5. Make loans of funds or other assets, other than by
entering into repurchase agreements, lending portfolio securities and
through the purchase of debt securities in accordance with its
investment objectives, policies and limitations;
6. Act as underwriter of another issuer's securities, except
to the extent that the Fund may be deemed to be an underwriter within
the meaning of the Securities Act of 1933 in connection with the
purchase and sale of portfolio securities;
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7. Purchase or sell real estate, but this shall not prevent
the Fund from investing in securities of companies that deal in real
estate or are engaged in the real estate business, including real
estate investment trusts, and securities secured by real estate or
interests therein and the Fund may hold and sell real estate or
mortgages on real estate acquired through default, liquidation, or
other distributions of an interest in real estate as a result of the
Fund's ownership of such securities; and
8. Purchase or sell physical commodities unless acquired as
a result of ownership of securities or other instruments (but this
shall not prevent the Fund from purchasing or selling options, futures
contracts or derivative instruments or from investing in securities or
other instruments backed by physical commodities).
For the purpose of applying the limitation set forth in subparagraph
(2) above, an issuer shall be deemed the sole issuer of a security when its
assets and revenues are separate from other governmental entities and its
securities are backed only by its assets and revenues. Similarly, in the case of
a non-governmental issuer, such as an industrial corporation or a privately
owned or operated hospital, if the security is backed only by the assets and
revenues of the non-governmental issuer, then such non-governmental issuer would
be deemed to be the sole issuer. Where a security is also backed by the
enforceable obligation of a superior or unrelated governmental or other entity
(other than a bond insurer), it shall also be included in the computation of
securities owned that are issued by such governmental or other entity. Where a
security is guaranteed by a governmental entity or some other facility, such as
a bank guarantee or letter of credit, such a guarantee or letter of credit would
be considered a separate security and would be treated as an issue of such
government, other entity or bank. When a municipal bond is insured by bond
insurance, it shall not be considered a security that is issued or guaranteed by
the insurer; instead, the issuer of such municipal bond will be determined in
accordance with the principles set forth above.
Except as noted above, the foregoing fundamental investment policies,
together with the investment objectives of the Fund, cannot be changed without
approval by holders of a majority of the outstanding voting securities of the
Fund, as defined in the 1940 Act, which includes Common Shares and Preferred
Shares, if any, voting together as a single class, and of the holders of the
outstanding Preferred Shares voting as a single class. Under the 1940 Act a
"majority of the outstanding voting securities" means the vote of: (A) 67% or
more of the Fund's shares present at a meeting, if the holders of more than 50%
of the Fund's shares are present or represented by proxy; or (B) more than 50%
of the Fund's shares, whichever is less.
In addition to the foregoing investment policies, the Fund is also
subject to the following non-fundamental restrictions and policies, which may be
changed by the Board of Trustees. The Fund may not:
1. Sell securities short, unless the Fund owns or has the
right to obtain securities equivalent in kind and amount to the
securities sold at no added cost, and provided that transactions in
options, futures contracts, options on futures contracts, or other
derivative instruments are not deemed to constitute selling securities
short; or
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2. Purchase securities of listed companies for the purpose
of exercising control.
The foregoing restrictions and limitations will apply only at the time
of purchase of securities, and the percentage limitations will not be considered
violated unless an excess or deficiency occurs or exists immediately after and
as a result of an acquisition of securities, unless otherwise indicated.
INVESTMENT POLICIES AND TECHNIQUES
The following information supplements the discussion of the Fund's
investment objectives, policies, and techniques that are described in the Fund's
Prospectus.
INVESTMENT PHILOSOPHY AND PROCESS
Under normal market conditions, the Fund will invest substantially all
of its Managed Assets in a diversified portfolio of MBS. The Fund will acquire
investment securities that the Sub-Adviser has the necessary expertise to
evaluate and manage. For example, each individual MBS has a unique cash flow
that can change in different interest rate environments. The Sub-Adviser
believes that future interest rates and mortgage prepayment rates are very
difficult to predict. Therefore, the Sub-Adviser will seek to minimize
prepayment risk by structuring a diversified portfolio with a variety of
prepayment characteristics and through other means which it believes will
provide acceptable returns over a broad range of interest rate and prepayment
scenarios.
Unlike most fixed income products, MBS are sold and traded based on the
average life of the security rather than the stated maturity. The average life
is the average number of years that each dollar of unpaid principal due on the
security remains outstanding. If prepayment rates are faster than expected
(typical in declining rate environments), the average life of the security will
be shorter than the original estimate. If prepayments rates are slower (typical
in rising rate environments) the security's average life will be extended. The
total return of MBS is highly dependent on the underlying cash flows which
determine the average life and therefore on prepayments. Constructing a
diversified MBS portfolio means exposure to securities that can benefit from
both increasing and declining prepayment environments.
In constructing a diversified MBS portfolio, the Sub-Adviser utilizes a
disciplined investment process that identifies assets that it expects will
provide income in a wide range of interest rate environments. The investment
process is designed to consistently evaluate five sources of portfolio
performance: yield curve, duration, prepayment performance, credit and leverage.
The Sub-Adviser's research process is internally driven and is
predominantly top down in nature. The Sub-Adviser analyzes the fixed income
market from the perspectives of (1) long term structural trends, (2) medium term
bond market valuations and (3) short-term tactical views.
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Generally, the Sub-Adviser views long-term structural trends as being
driven by an understanding of demographics, political systems/cycles, fiscal
sustainability, international trade, capital market structures, global growth
rates and regulatory regimes. The Sub-Adviser believes these factors influence
the demand/supply for capital, and therefore have a structural impact on long
term yield patterns. Opportunities are identified by comparative sector
analysis, determining which sectors are likely to benefit or suffer as economic
and political cycles change.
The Sub-Adviser examines medium term bond market valuations in order to
judge whether they are consistent with economic and political environments, and
how they are likely to change in the context of the Sub-Adviser's forecasts over
a 3 to 12 month period. This analysis determines the overall composition of the
Fund's portfolio.
The Sub-Adviser determines tactical views through continuous monitoring
of market developments. Relative value, cash flow analysis, market positioning
intelligence and portfolio flow data are used to determine the timing,
implementation and scale of positions suggested by the Sub-Adviser's strategic
views.
Underlying the investment process is consistent risk management and
stress testing of the portfolio using risk modeling and attribution techniques.
The quantitative techniques are used to identify and test market observations
and are a tool to assist in portfolio construction.
The Sub-Adviser's investment team follows a disciplined investment
process that applies daily information flow into portfolio construction,
liability management and risk management. The process is designed to highlight
investment opportunities that provide current income and capital protection
across the MBS market, and the underlying philosophy is to invest in a "balanced
portfolio" that provides income in a wide range of market environments.
Mortgage cash flow characteristics can vary greatly between different
securities. The building block for an investment decision is to gauge prepayment
exposure by examining such underlying loan characteristics as geographic
information, servicer information, FICO scores, loan balance and prepayment
penalties.
Although analysis focuses on portfolio cash flow, there are other
factors (such as interest rates, swap spreads, currency moves and risk appetite
indicators) that will also contribute to performance irrespective of underlying
yield performance. The portfolio is constructed to reflect the Sub-Adviser's
investment team's views, on a diversified basis, and in a manner to optimize
returns according to market conditions. Each investment idea is monitored on a
daily basis using risk modeling and attribution techniques to determine that the
risk/reward ratio is acceptable.
PORTFOLIO COMPOSITION
The Fund's portfolio will be composed principally of the following
investments:
Under normal market conditions, the Fund will invest at least 80% of
its Managed Assets in Agency MBS, Non-Agency RMBS, and CMBS (collectively,
"MBS"). In addition, the Fund may invest up to 20% of its Managed Assets in U.S.
government securities, or cash or other short-term instruments, and may invest
-5-
up to 10% of its Managed Assets in Other MBS. Under normal market conditions,
the Fund will be fully invested in Agency MBS, Non-Agency RMBS, CMBS, and Other
MBS.
The Fund will invest all of its Managed Assets in securities that at
the time of investment are investment grade quality. The Fund will only invest
in securities which are: o issued or guaranteed by the U.S. government or any
agency or instrumentality thereof, o rated within the three highest investment
grades by at least one rating agency (A or better by Moody's Investors Service,
Inc. ("Moody's"), Standard & Poor's Rating Group ("S&P") and/or
Fitch IBCA, Inc. ("Fitch"), or o unrated but judged to be of comparable quality
by the Sub-Adviser.
The MBS in which the Fund may invest include those with fixed, floating
or variable interest rates, those with interest rates that change based on
multiples of changes in a specified index of interest rates and those with
interest rates that change inversely to changes in interest rates, as well as
those that do not bear interest. The Fund will not invest in corporate bonds,
other than those primarily secured by interests in real estate.
The Fund will attempt to reduce portfolio prepayment risk by investing
in MBS, such as certain Non-Agency RMBS, whose returns may be enhanced by faster
prepayments, and also by investing in MBS, such as certain Agency MBS, whose
returns may be enhanced by slower prepayments. The Fund may invest a portion of
its Managed Assets in subordinated classes of MBS, including Non-Agency RMBS and
CMBS.
The discussion below describes the principal categories of securities
in which the Fund intends to invest.
Agency MBS. Agency MBS are securities that represent participations in,
are secured by or are payable from, mortgage loans secured by real residential
property. Agency MBS include the following:
Agency Mortgage Pass-through Certificates. The agency mortgage
pass-through certificates in which the Fund will invest include those issued or
guaranteed by the Government National Mortgage Association ("GNMA," or "Ginnie
Mae"), the Federal National Mortgage Association ("FNMA," or "Fannie Mae") and
the Federal Home Loan Mortgage Corporation ("FHLMC," or "Freddie Mac").
These mortgage pass-through certificates provide for the pass-through
to investors of their pro rata share of monthly payments (including any
prepayments) made by the individual borrowers on the pooled mortgage loans, net
of any fees paid to the guarantor of such securities and the servicer of the
underlying loans. GNMA, FNMA and FHLMC guarantee timely distributions of
interest and principal to shareholders.
-6-
GNMA is a wholly-owned corporate instrumentality of the U.S. Department
of Housing and Urban Development. The full faith and credit of the U.S.
government is pledged to payment of all amounts that may be required to be paid
under GNMA's guaranty. FNMA and FHLMC are federally chartered and privately
owned corporations created pursuant to the Federal National Mortgage Association
Charter Act of 1938 and the Emergency Home Finance Act of 1970, respectively.
The obligations of FNMA and FHLMC are obligations solely of those respective
corporations, and are not backed by the full faith and credit of the U.S.
government.
Agency Collateralized Mortgage Obligations ("Agency CMOs"). Agency CMOs
are debt obligations issued by GNMA, FNMA or FHLMC. CMOs, which may be Agency or
Non-Agency, are backed by mortgage pass-through certificates (discussed above)
and are evidenced by a series of bonds or certificates issued in multiple
"classes." The principal and interest on the underlying mortgage assets may be
allocated among the several classes of a series of CMOs in many ways.
In a CMO, a series of bonds or certificates are issued in multiple
classes. Each class of CMOs, often referred to as a "tranche," is issued at a
specific coupon rate and has a stated maturity or final distribution date.
Principal prepayments on collateral underlying a CMO may cause it to be retired
substantially earlier than the stated maturities or final distribution dates.
The principal and interest on the underlying mortgages may be allocated among
the several tranches of a series of a CMO in many ways. As a result of this
allocation process, certain tranches of a CMO may have more predictable cash
flows, while the cash flows of other tranches may be less predictable. CMO
tranches with less predictable cash flows will generally exhibit more volatile
market prices and yields. One or more tranches of a CMO may have coupon rates
which reset periodically at a specified increment over an index, such as LIBOR
(or sometimes more than one index). These floating rate CMOs typically are
issued with lifetime caps on the coupon rate thereon. The Fund also may invest
in inverse floating rate CMOs. Inverse floating rate CMOs constitute a tranche
of a CMO with a coupon rate that moves in the reverse direction to an applicable
index such as LIBOR. Accordingly, the coupon rate thereon will increase as
interest rates decrease. Inverse floating rate CMOs are typically more volatile
than fixed or floating rate tranches of CMOs. Many inverse floating rate CMOs
have coupons that move inversely to a multiple of the applicable indexes. The
effect of the coupon varying inversely to a multiple of an applicable index
creates a leverage factor. Inverse floaters based on multiples of a stated index
are designed to be highly sensitive to changes in interest rates and can subject
the holders thereof to extreme reductions of yield and loss of principal. The
markets for inverse floating rate CMOs with highly leveraged characteristics at
times may be very thin.
Agency CMOs issued after 1991 have generally elected to be treated, for
federal income tax purposes, as a Real Estate Mortgage Investment Conduit (a
"REMIC"). A Non-Agency issuer of CMOs issued after 1991 must elect to be treated
as a REMIC or it will be taxable as a corporation under rules regarding taxable
mortgage pools.
Stripped Mortgage-Backed Securities. The Fund also may invest in
stripped mortgage-backed securities ("Stripped Mortgage-Backed Securities").
Stripped Mortgage-Backed Securities are created by segregating the cash flows
from underlying mortgage loans or mortgage securities to create two or more new
securities, each with a specified percentage of the underlying security's
-7-
principal or interest payments. Mortgage securities may be partially stripped so
that each investor class receives some interest and some principal. When
securities are completely stripped, however, all of the interest is distributed
to holders of one type of securities, known as an interest-only or IO security,
and all of the principal is distributed to holders of another type of security
known as a principal-only or PO security. Strips can be created in a
pass-through structure or as tranches of a CMO. The yields to maturity on IOs
and POs are very sensitive to the rate of principal payments (including
prepayments) on the related underlying mortgage assets. If the underlying
mortgage assets experience greater than anticipated prepayments of principal,
the Fund may not fully recoup its initial investment in IOs. Conversely, if the
underlying mortgage assets experience less than anticipated prepayments of
principal, the yield on POs could be materially and adversely affected.
Non-Agency RMBS. Non-Agency RMBS are debt obligations issued by private
originators or investors in residential mortgage loans. Non-Agency RMBS
generally are issued as CMOs, and are backed by pools of whole mortgage loans or
by mortgage pass-through certificates.
Non-Agency RMBS generally are securitized in senior/subordinated
structures, or structured with one or more of the types of credit enhancement
described below under "Credit Support." In senior/subordinated structures, the
senior class investors have greater protection against potential losses on the
underlying mortgage loans or assets than the subordinated class investors, who
assume the first losses if there are defaults on the underlying loans. See
"Additional Information about the Fund's Investments and Investment Risks" for
more information.
CMBS. CMBS are multi-class debt or pass-through or pay-through
securities backed by a mortgage loan or pool of mortgage loans on commercial
real estate, such as industrial and warehouse properties, office buildings,
retail space and shopping malls, multifamily properties, hotels and motels,
nursing homes and medical facilities. Assets underlying CMBS may relate to many
properties, only a few properties, or to a single property. Each commercial
mortgage loan that underlies a CMBS has certain distinct characteristics.
Commercial mortgage loans are sometimes non-amortizing and often not
fully amortizing. At their maturity date, repayment of the remaining principal
balance or "balloon" is due and is repaid through the attainment of an
additional loan, the sale of the property or the contribution of additional
capital.
Unlike most single family residential mortgages, commercial real estate
loans often contain provisions that substantially reduce the likelihood that
they will be prepaid. The provisions generally impose significant prepayment
penalties on loans and, in some cases, there may be prohibitions on principal
prepayments for several years following origination.
Changing real estate markets may adversely affect both the value of the
underlying collateral and the borrower's ability to meet contractual
obligations, either of which may lead to delinquencies, defaults, modifications
or foreclosure that in turn may lead to the realization of losses in CMBS.
-8-
CMBS have been issued in public and private transactions by a variety
of public and private issuers. The Fund may from time to time purchase CMBS
directly from issuers in negotiated or non-negotiated transactions or from a
holder of such CMBS in the secondary market.
Commercial mortgage securitizations generally are senior/subordinated
structures. The senior class investors have greater protection against potential
losses on the underlying mortgage loans or assets than the subordinated class
investors who take the first loss if there are defaults on the underlying
commercial mortgage loans. Other protections, which may benefit all of the
classes including the subordinated classes, may include issuer guarantees,
additional subordinated securities, cross-collateralization,
overcollateralization and the equity in the underlying properties.
Other MBS. Other MBS, which will be mortgage-related assets, are
collateralized by pools of assets such as home equity loans and lines of credit.
Other MBS include pools of loans generally secured by property and other forms
of residential dwellings such as manufactured housing and by loans used to
finance the building and establishment of franchise businesses. Other MBS
includes securities secured by second liens on residential property, commonly
referred to as "home equity loans" and "home equity lines-of-credit."
Credit Support. Many of the Non-Agency RMBS, CMBS and Other MBS in
which the Fund will invest are issued in a senior/ subordinated structure. In
these structures, the senior class investors have greater protection against
potential losses on the underlying loans or assets than do the subordinated
class investors. In senior/subordinated structures, Non-Agency RMBS, CMBS and
Other MBS are often backed by a pool of assets representing the obligations of a
number of different parties. To lessen the effect of a failure by obligors on
underlying assets to make payments, such securities may contain elements of
credit support. Such credit support falls into two categories: (1) liquidity
protection and (2) protection against losses resulting from ultimate default by
an obligor on the underlying assets. Liquidity protection generally refers to
the provision of advances, typically by the entity administering the pool of
assets, to ensure that the pass-through of payments due on the underlying pool
occurs in a timely fashion. Protection against losses resulting from ultimate
default enhances the likelihood of ultimate payment of the obligations on at
least a portion of the assets in the pool. Such protection may be provided
through guarantees, insurance policies or letters of credit obtained by the
issuer or sponsor from third parties (referred to herein as "third party credit
support"), through various means of structuring the transaction or through a
combination of such approaches. The Fund will not pay any additional fees for
such credit support, although the existence of credit support may increase the
price the Fund pays for a security.
MBS Expected Average Maturity and Stated Final Maturity. The stated
final maturity of an MBS or Other MBS often corresponds to the last scheduled
payment of the longest maturity individual loan in the underlying pool of
assets. The expected average maturity of an MBS or Other MBS, often referred to
as "weighted average life," as described below, depends upon the expected timing
of all the return of principal from the security, which in turn depends upon
assumptions regarding the expected cash flow from the underlying pool, including
scheduled principal, prepayments and other factors that may affect cash flow.
-9-
Weighted average life is a measure of expected average maturity for an
MBS or Other MBS that pays principal to investors over a period of time, rather
than on a single maturity date. It is equal to the projected weighted average
time to return of principal from the MBS or Other MBS, based upon assumptions
regarding prepayments and other factors that may affect cash flow.
U.S. Government Securities. U.S. government securities include issues
of the U.S. Treasury, such as bills, certificates of indebtedness, notes and
bonds, as well as obligations of agencies and instrumentalities of the U.S.
government. U.S. Treasury securities are backed by the full faith and credit of
the U.S. government. Obligations of agencies and instrumentalities of the U.S.
government often are not backed by the full faith and credit of the U.S.
government.
Illiquid/Restricted Securities. The Fund may invest up to 10% of its
Managed Assets in securities that, at the time of investment, are illiquid
(determined using the Securities and Exchange Commission's standard applicable
to investment companies, i.e., 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). The Fund may also invest, without
limit, in securities that are unregistered (but are eligible for purchase and
sale by certain qualified institutional buyers) or are held by control persons
of the issuer and securities that are subject to contractual restrictions on
their resale ("restricted securities"). However, restricted securities
determined by the Sub-Adviser to be illiquid are subject to the limitations set
forth above.
Short-Term Debt Securities; Temporary Defensive Position; Invest-Up
Period. During the period which the net proceeds of the offering of Common
Shares are being invested, the issuance of Preferred Shares, if any, commercial
paper or notes and/or borrowings are being invested or during periods in which
the Adviser or the Sub-Adviser determines that it is temporarily unable to
follow the Fund's investment strategy or that it is impractical to do so, the
Fund may deviate from its investment strategy and invest all or any portion of
its Managed Assets in cash and cash equivalents. The Adviser's or the
Sub-Adviser's determination that it is temporarily unable to follow the Fund's
investment strategy or that it is impracticable to do so will generally occur
only in situations in which a market disruption event has occurred and where
trading in the securities selected through application of the Fund's investment
strategy is extremely limited or absent. In such a case, the Fund may not pursue
or achieve its investment objectives.
The cash and cash equivalents 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 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
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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. Under current FDIC regulations, the
maximum insurance payable as to any one certificate of deposit is
$100,000, therefore, certificates of deposit purchased by the Fund may
not be fully insured.
(3) Repurchase agreements, which involve purchases of debt
securities. At the time the Fund purchases securities pursuant to a
repurchase agreement, it simultaneously agrees to resell and redeliver
such securities to the seller, who also simultaneously agrees to buy
back the securities at a fixed price and time. This assures a
predetermined yield for the Fund during its holding period, since the
resale price is always greater than the purchase price and reflects an
agreed-upon market rate. Such actions afford an opportunity for the
Fund to invest temporarily available cash. Pursuant to the Fund's
policies and procedures, the Fund may enter into repurchase agreements
only with respect to obligations of the U.S. government, its agencies
or instrumentalities; certificates of deposit; or bankers' acceptances
in which the Fund may invest. Repurchase agreements may be considered
loans to the seller, collateralized by the underlying securities. The
risk to the Fund is limited to the ability of the seller to pay the
agreed-upon sum on the repurchase date; in the event of default, the
repurchase agreement provides that the Fund is entitled to sell the
underlying collateral. If the seller defaults under a repurchase
agreement when the value of the underlying collateral is less than the
repurchase price, the Fund could incur a loss of both principal and
interest. The Sub-Adviser monitors the value of the collateral at the
time the action is entered into and at all times during the term of the
repurchase agreement. The Sub-Adviser does so in an effort to determine
that the value of the collateral always equals or exceeds the
agreed-upon repurchase price to be paid to the Fund. If the seller were
to be subject to a federal bankruptcy proceeding, the ability of the
Fund to liquidate the collateral could be delayed or impaired because
of certain provisions of the bankruptcy laws.
(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. The Sub-Adviser will consider the
financial condition of the corporation (e.g., earning power, cash flow,
-11-
and other liquidity measures) and will continuously monitor the
corporation's ability to meet all 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 in the highest
categories by a nationally recognized statistical rating organization
and which mature within one year of the date of purchase or carry a
variable or floating rate of interest.
(5) The Fund may invest in bankers' acceptances, which are
short-term credit instruments used to finance commercial transactions.
Generally, an acceptance is a time draft drawn on a bank by an exporter
or an importer to obtain a stated amount of funds to pay for specific
merchandise. The draft is then "accepted" by a bank that, in effect,
unconditionally guarantees to pay the face value of the instrument on
its maturity date. The acceptance may then be held by the accepting
bank as an asset or it may be sold in the secondary market at the going
rate of interest for a specific maturity.
(6) The Fund may invest in bank time deposits, which are
monies kept on deposit with banks or savings and loan associations for
a stated period of time at a fixed rate of interest. There may be
penalties for the early withdrawal of such time deposits, in which case
the yields of these investments will be reduced.
(7) The Fund may invest in shares of money market funds in
accordance with the provisions of the 1940 Act.
ADDITIONAL INFORMATION ABOUT THE FUND'S INVESTMENTS AND INVESTMENT RISKS
NO OPERATING HISTORY
The Fund is a newly organized, diversified, closed-end management
investment company with no operating history.
INVESTMENT AND MARKET RISK
An investment in Common Shares is subject to investment risk, including
the possible loss of the entire principal amount that you invest. Your
investment in Common Shares represents an indirect investment in the securities
owned by the Fund. The value of these securities, like other market investments,
may move up or down, sometimes rapidly and unpredictably. The value of the
securities in which the Fund invests will affect the value of the Common Shares.
Your Common Shares at any point in time may be worth less than your original
investment, even after taking into account the reinvestment of Fund dividends
and distributions.
MANAGEMENT RISK
The Fund is subject to management risk because it is an actively
managed portfolio. The Adviser and the Sub-Adviser will apply investment
-12-
techniques and risk analyses in making investment decisions for the Fund, but
there can be no guarantee that these will produce the desired results.
CREDIT RISK
Credit risk is the risk that one or more securities in the Fund's
portfolio will (1) decline in price due to deterioration of the issuer's or
underlying pool's financial condition or other events or (2) fail to pay
interest or principal when due. Although the Fund will invest all of its Managed
Assets in investment grade securities, or if unrated, judged to be of comparable
quality by the Sub-Adviser, no assurance can be given that the value of the
securities will not decline.
The Fund may invest a portion of its assets in subordinated classes of
MBS, including Non-Agency RMBS and CMBS. Such subordinated classes are subject
to a greater degree of non-payment than are senior classes of the same issuer or
Agency MBS. In addition, under certain market conditions, the market for
subordinated classes of MBS may not be as liquid as the market for other
fixed-income securities.
PREPAYMENT RISK
MBS are backed by pools of mortgage loans. The Fund will receive
payments, generally, from the payments that are made on these underlying
mortgage loans. If borrowers prepay their mortgage loans at rates that are
faster than expected, this results in prepayments that are faster than expected
on the MBS. These faster than expected prepayments may adversely affect the
Fund's profitability. The Fund may purchase MBS that have a higher interest rate
than the market interest rate at the time. In exchange for this higher interest
rate, the Fund will be required to pay a premium over the redemption value to
acquire the security. If the MBS is prepaid in whole or in part prior to its
maturity date, the Fund's profitability will be adversely affected.
Prepayment rates generally increase when interest rates fall and
decrease when interest rates rise, but changes in prepayment rates are difficult
to predict. Prepayment rates also may be affected by conditions in the housing
and financial markets, general economic conditions and the relative interest
rates on fixed-rate and adjustable-rate mortgage loans.
The Fund may also invest in MBS which are interest only ("IO")
securities and principal-only ("PO") securities. An IO security receives some or
all of the interest portion of the underlying collateral and little or no
principal. A reference principal value called a notional value is used to
calculate the amount of interest due. IOs are sold at a deep discount to their
notional principal amount. A PO security does not receive any interest, is
priced a deep discount to its redemption value and ultimately receives the
redemption value. Generally speaking, when interest rates are falling and
prepayment rates are increasing, the value of a PO security will rise and the
value of an IO security will fall. Conversely, when interest rates are rising
and prepayment rates are decreasing, generally the value of a PO security will
fall and the value of an IO security will rise.
-13-
The Fund may also acquire MBS that are less affected by prepayments.
For example, CMOs divide a pool of mortgage loans into multiple tranches that
allow for shifting of prepayment risks from slower-paying tranches to faster
paying tranches. This is in contrast to pass-through or pay-through MBS, where
all investors share equally in all payments, including all prepayments. While
the Fund will seek to minimize prepayment risk to the extent practical, the Fund
must balance prepayment risk against other risks and the potential returns of
each investment in selecting investments. No strategy can completely insulate
the Fund from prepayment risk.
REINVESTMENT RISK
Reinvestment risk is the risk that income from the Fund's portfolio
will decline if the Fund invests the proceeds from matured, traded or called
bonds at market interest rates that are below the Fund portfolio's current
earnings rate. A decline in income could affect the Common Shares' market price
or their overall returns.
INTEREST RATE RISK
Interest rate risk is the risk that fixed-income securities will
decline in value because of changes in market interest rates. When market
interest rates rise, the market value of such securities generally will fall.
Under current market conditions, the Fund will primarily invest in securities
that pay a fixed rate of return, therefore the NAV and market price of the
Common Shares will tend to decline if the market interest rates applicable to
such investments were to rise. During periods of rising interest rates, the
average life of certain types of securities may be extended because of slower
than expected prepayments. This may lock in a below market yield, increase the
security's duration and reduce the value of the security. Investments in debt
securities with long-term maturities may experience significant price declines
if long-term interest rates increase. Market interest rates in the United States
currently are near historically low levels.
An increase in the interest payments on the Fund's borrowings relative
to the interest it earns on its investment securities may adversely affect the
Fund's profitability. The Fund earns money based upon the spread between the
interest payments it earns on its investment securities and the interest
payments it must make on its borrowings.
The Fund relies primarily on short-term borrowings to acquire
investment securities with long-term maturities. Accordingly, if short-term
interest rates increase, this may adversely affect its profitability. Some of
the investment securities the Fund may acquire are adjustable-rate securities.
This means that their interest rates may vary over time based upon changes in an
objective index, such as:
o LIBOR. The interest rate that banks in London offer for deposits
in London of U.S. dollars.
o Treasury Rate. A monthly or weekly average yield of benchmark U.S.
Treasury securities, as published by the Federal Reserve Board.
-14-
o CD Rate. The weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the
Federal Reserve Board.
These indices generally reflect short-term interest rates.
The interest rates on the Fund's borrowings similarly vary with changes
in an objective index. Nevertheless, the interest rates on the Fund's borrowings
generally adjust more frequently than the interest rates on its adjustable-rate
investment securities. In a period of rising interest rates, the Fund could
experience a decrease in net income or a net loss because the interest rates on
its borrowings adjust faster than the interest rates on its adjustable-rate
investment securities.
In a period of rising interest rates, the Fund's interest payments
could increase while the interest it earns on its fixed-rate MBS would not
change. This would adversely affect the Fund's profitability.
While the majority of the Fund's investments are expected initially to
consist of fixed-rate investment securities, the Fund may also invest in
adjustable-rate MBS. The Fund may acquire adjustable-rate investment securities,
which typically are subject to periodic and lifetime interest rate caps.
Periodic interest rate caps limit the amount an interest rate can increase
during any given period. Lifetime interest rate caps limit the amount an
interest rate can increase through maturity of an investment security. The
Fund's borrowings are not subject to similar restrictions. Accordingly, in a
period of rapidly increasing interest rates, the Fund could experience a
decrease in net income or experience a net loss because the interest rates on
its borrowings could increase without limitation while the interest rates on its
adjustable-rate investment securities would be limited by caps. The Fund may
also invest in MBS whose interests move in a direction opposite to the changes
in the designated index.
FLOATING RATE CMOS/INVERSE FLOATING RATE CMOS RISK
The Fund may invest in tranches of CMOs which have coupon rates which
reset periodically at a specified increment over an index, such as LIBOR (or
sometimes more than one index). These floating rate CMOs typically are issued
with lifetime caps on the coupon rate thereon. In a falling interest rate
environment, coupon rates on floating rate CMOs will generally fall, adversely
affecting the amount of income received by the Fund as well as the value of the
security. The Fund also may invest in inverse floating rate CMOs. Inverse
floating rate CMOs constitute a tranche of a CMO with a coupon rate that moves
in the reverse direction to an applicable index such as LIBOR. Accordingly, the
coupon rate thereon will increase as interest rates decrease. Inverse floating
rate CMOs are typically more volatile than fixed or floating rate tranches of
CMOs. Many inverse floating rate CMOs have coupons that move inversely to a
multiple of the applicable indexes. The effect of the coupon varying inversely
to a multiple of an applicable index creates a leverage situation. Inverse
floaters based on multiples of a stated index are designed to be highly
sensitive to changes in interest rates and can subject the holders thereof to
extreme reductions of yield and loss of principal. The markets for inverse
floating rate CMOs with highly leveraged characteristics at times may be very
thin.
-15-
BOND MARKET RISK
The yield spreads of the Fund's portfolio securities, or yield
differentials between the Fund's portfolio securities and Treasury securities
with comparable maturities, may widen, causing the value of the Fund's portfolio
securities to underperform Treasury securities. The amount of public information
available about the MBS and ABS 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 capabilities of the
Sub-Adviser than if the Fund were a stock fund or a corporate bond fund. The
secondary market for certain types of MBS, including Other MBS, may be less
well-developed or liquid than many other securities markets, which may affect
the Fund's ability to sell its portfolio securities at attractive prices.
ECONOMIC SECTOR RISK
Under normal market conditions, the Fund will be fully invested in
Agency MBS, Non-Agency RMBS, CMBS or ABS. This may make the Fund more
susceptible to adverse economic, political or regulatory events that affect the
value of real estate, and increase the potential for fluctuation in the net
asset value of the Fund's Common Shares.
INFLATION RISK
Inflation risk is the risk that the value of assets or income from
investments will be worth less in the future as inflation decreases the value of
money. As inflation increases, the real value of the Common Shares and
distributions can decline. In addition, during any periods of rising inflation,
the dividend rates or borrowing costs associated with the Fund's use of
financial leverage would likely increase, which would tend to further reduce
returns to Common Shareholders.
MARKET DISCOUNT FROM NET ASSET VALUE
Shares of closed-end investment companies frequently trade at a
discount from their NAV. This characteristic is a risk separate and distinct
from the risk that the Fund's NAV could decrease as a result of its investment
activities and may be greater for investors expecting to sell their Common
Shares in a relatively short period following completion of this offering. The
NAV of the Common Shares will be reduced immediately following the offering as a
result of the payment of certain offering costs. Although the value of the
Fund's net assets is generally considered by market participants in determining
whether to purchase or sell Common Shares, whether investors will realize gains
or losses upon the sale of the Common Shares will depend entirely upon whether
the market price of the Common Shares at the time of sale is above or below the
investor's purchase price for the Common Shares. Because the market price of the
Common Shares will be determined by factors such as NAV, dividend and
distribution levels (which are dependent, in part, on expenses), supply of and
demand for the Common Shares, stability of dividends or distributions, trading
volume of the Common Shares, general market and economic conditions and other
factors beyond the control of the Fund, the Fund cannot predict whether the
-16-
Common Shares will trade at, below or above NAV or at, below or above the
initial public offering price.
LEVERAGE RISK
The Fund may borrow an amount up to 33 1/3% (or such other percentage
as permitted by law) of its Managed Assets (including the amounts borrowed
pursuant to reverse repurchase agreements) less all liabilities other than
borrowings. The Fund may also issue Preferred Shares in an amount up to 50% of
the Fund's Managed Assets (including the proceeds from Preferred Shares,
commercial paper or notes and/or borrowing (each a "Leverage Instrument" and
collectively, the "Leverage Instruments")). However, the Fund intends, under
normal circumstances, to utilize leverage in an amount up to 33 1/3% of the
Fund's Managed Assets. The Fund intends to use leverage through the use of
reverse repurchase agreements. Reverse repurchase agreements and the issuance of
Preferred Shares, commercial paper or notes or incurring other indebtedness is
referred to in this Statement of Additional Information collectively as
"leverage." The Fund may use leverage for investment purposes, to finance the
repurchase of its Common Shares and to meet cash requirements. Although the use
of leverage by the Fund may create an opportunity for increased return for the
Common Shares, it also results in additional risks and can magnify the effect of
any losses. If the income and gains earned on the securities and investments
purchased with leverage proceeds are greater than the cost of the leverage, the
Common Shares' return will be greater than if leverage had not been used.
Conversely, if the income or gains from the securities and investments purchased
with such proceeds does not cover the cost of leverage, the return to the Common
Shares will be less than if leverage had not been used. Reverse repurchase
agreements are also subject to the risks that the market value of the securities
sold by the Fund may decline below the price of the securities the Fund is
obligated to repurchase, and that the securities may not be returned to the
Fund. There is no assurance that a leveraging strategy will be successful.
Leverage involves risks and special considerations for Common Shareholders
including:
o the likelihood of greater volatility of NAV and market price of
the Common Shares than a comparable portfolio without leverage;
o the risk that fluctuations in interest rates on reverse repurchase
agreements, borrowings and short-term debt or in the dividend
rates on any Preferred Shares that the Fund may pay will reduce
the return to the Common Shareholders or will result in
fluctuations in the dividends paid on the Common Shares;
o the effect of leverage in a declining market, which is likely to
cause a greater decline in the NAV of the Common Shares than if
the Fund were not leveraged, which may result in a greater decline
in the market price of the Common Shares; and
o when the Fund uses financial leverage, the investment advisory fee
payable to the Adviser (and by the Adviser to the Sub-Adviser)
will be higher than if the Fund did not use leverage.
-17-
The Sub-Adviser, in its judgment, nevertheless may determine to
continue to use leverage if it expects that the benefits to the Fund's
shareholders of maintaining the leveraged position will outweigh the current
reduced return.
The funds borrowed pursuant to a leverage borrowing program (such as a
reverse repurchase agreement, credit line or commercial paper program), or
obtained through the issuance of Preferred Shares, constitute a substantial lien
and burden by reason of their prior claim against the income of the Fund and
against the net assets of the Fund in liquidation. The rights of lenders to
receive payments of interest on and repayments of principal on any borrowings
made by the Fund under a leverage borrowing program are senior to the rights of
holders of Common Shares and the holders of Preferred Shares, with respect to
the payment of dividends or upon liquidation. The Fund may not be permitted to
declare dividends or other distributions, including dividends and distributions
with respect to Common Shares or Preferred Shares or purchase Common Shares or
Preferred Shares, unless at the time thereof the Fund meets certain asset
coverage requirements and no event of default exists under any leverage program.
In addition, the Fund may not be permitted to pay dividends on Common Shares
unless all dividends on the Preferred Shares and/or accrued interest on
borrowings have been paid, or set aside for payment. In an event of default
under a leverage borrowing program, the lenders have the right to cause a
liquidation of collateral (i.e., sell and other assets of the Fund) and, if any
such default is not cured, the lenders may be able to control the liquidation as
well. Certain types of leverage may result in the Fund being subject to
covenants relating to asset coverage and Fund composition requirements. The Fund
may be subject to certain restrictions on investments imposed by guidelines of
one or more rating agencies, which may issue ratings for the Preferred Shares or
other leverage securities issued by the Fund. These guidelines may impose asset
coverage or Fund composition requirements that are more stringent than those
imposed by the 1940 Act. The Sub-Adviser does not believe that these covenants
or guidelines will impede it from managing the Fund's portfolio in accordance
with the Fund's investment objectives and policies.
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 NAV 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 benefit the Common
Shareholders. 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 income and/or total returns to Common Shareholders relative to the
circumstance if 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 Common Share price if the prediction were to turn out to be
correct, and determine not to reduce leverage as described above.
INTEREST RATE TRANSACTIONS RISK
In order to reduce the variability of leverage borrowing costs from
short-term reverse repurchase agreements, the Fund may to enter into interest
rate swaps with the effect of fixing net borrowing costs for longer periods of
-18-
time. The value of the Fund's interest rate swaps could increase or decrease,
with a corresponding impact on the net asset value of the Fund. To the extent
there is a decline in interest rates, the value of the interest rate swap could
decrease, and could result in a decrease in the Fund's NAV. In addition, if the
counterparty to an interest rate swap defaults, the Fund would be obligated to
make the payments that it had intended to avoid. Depending on whether the Fund
would be entitled to receive net payments from the counterparty on the swap,
which in turn would depend on the general state of short-term interest rates and
the returns on the Fund's portfolio securities at that point in time, a default
could adversely affect the NAV of the Common Shares.
DERIVATIVES RISK
The Fund may use various other investment management techniques that
also involve certain risks and special considerations, including engaging in
hedging and risk management transactions, including interest rate options,
futures, swaps, caps, floors, and collars, and other derivative transactions.
These strategic transactions will be entered into to seek to manage the risks of
the Fund's portfolio securities, but may have the effect of limiting the gains
from favorable market movements.
A derivative is a financial instrument whose performance is derived at
least in part from the performance of an underlying index, security or asset.
The values of certain derivatives can be affected dramatically by even small
market movements, sometimes in ways that are difficult to predict. There are
many different types of derivatives, with many different uses. The Fund expects
to enter into these transactions primarily to seek to preserve a return on a
particular investment or portion of its portfolio, and also may enter into such
transactions to seek to protect against decreases in the anticipated rate of
return on floating or variable rate financial instruments the Fund owns or
anticipates purchasing at a later date, or for other risk management strategies
such as managing the effective dollar-weighted average duration of the Fund's
portfolio. The Fund also may engage in hedging transactions to seek to protect
the value of its portfolio against declines in NAV resulting from changes in
interest rates or other market changes. Market conditions will determine whether
and in what circumstances the Fund would employ any of the hedging and risk
management techniques described below. The successful utilization of hedging and
risk management transactions requires skills different from those needed in the
selection of the Fund's portfolio securities. The Fund believes that the
Sub-Adviser possesses the skills necessary for the successful utilization of
hedging and risk management transactions. The Fund will incur brokerage and
other costs in connection with its hedging transactions.
The Fund may enter into interest rate swaps or total rate of return
swaps or purchase or sell interest rate caps or floors. Interest rate swaps
involve the exchange by the Fund with another party of their respective
obligations to pay or receive interest, e.g., an obligation to make floating
rate payments for an obligation to make fixed rate payments.
The purchase of an interest rate cap entitles the purchaser, to the
extent that a specified index exceeds a predetermined interest rate, to receive
payments of interest at the difference of the index and the predetermined rate
on a notional principal amount (the reference amount with respect to which
-19-
interest obligations are determined although no actual exchange of principal
occurs) from the party selling the interest rate cap. The purchase of an
interest rate floor entitles the purchaser, to the extent that a specified index
falls below a predetermined interest rate, to receive payments of interest at
the difference of the index and the predetermined rate on a notional principal
amount from the party selling the interest rate floor.
In circumstances in which the Sub-Adviser anticipates that interest
rates will decline, the Fund might, for example, enter into an interest rate
swap as the floating rate payor or, alternatively, purchase an interest rate
floor. In the case of purchasing an interest rate floor, if interest rates
declined below the floor rate, the Fund would receive payments from its
counterparty which would wholly or partially offset the decrease in the payments
it would receive in respect of the portfolio assets being hedged. In the case
where the Fund purchases an interest rate swap, if the floating rate payments
fell below the level of the fixed rate payment set in the swap agreement, the
Fund's counterparty would pay the Fund amounts equal to interest computed at the
difference between the fixed and floating rates over the notional principal
amount. Such payments would offset or partially offset the decrease in the
payments the Fund would receive in respect of floating rate portfolio assets
being hedged.
The successful use of swaps, caps and floors to preserve the rate of
return on a portfolio of financial instruments depends on the Sub-Adviser's
ability to predict correctly the direction and extent of movements in interest
rates.
Although the Fund believes that use of the hedging and risk management
techniques described above will benefit the Fund, if the Sub-Adviser's judgment
about the direction or extent of the movement in interest rates is incorrect,
the Fund's overall performance would be worse than if it had not entered into
any such transactions.
Because these hedging transactions are entered into for good-faith risk
management purposes, the Sub-Adviser and the Fund believe these obligations do
not constitute senior securities. The Fund usually will enter into interest rate
swaps on a net basis, i.e., where the two parties make net payments with the
Fund receiving or paying, as the case may be, only the net amount of the two
payments. The net amount of the excess, if any, of the Fund's obligations over
its entitlements with respect to each interest rate swap will be accrued and an
amount of cash or liquid securities having an aggregate NAV at least equal to
the accrued excess will be maintained in a segregated account by the Fund's
custodian. If the Fund enters into a swap on other than a net basis, the Fund
will maintain in the segregated account the full amount of the Fund's
obligations under each swap. Accordingly, the Fund does not treat swaps as
senior securities. The Fund may enter into swaps, caps and floors with member
banks of the Federal Reserve System, members of the New York Stock Exchange or
other entities determined by the Sub-Adviser, pursuant to procedures adopted and
reviewed on an ongoing basis by the Board of Trustees, to be creditworthy. If a
default occurs by the other party to the transaction, the Fund will have
contractual remedies pursuant to the agreements related to the transaction but
remedies may be subject to bankruptcy and insolvency laws which could affect the
Fund's rights as a creditor. The swap market has grown substantially in recent
years with a large number of banks and financial services firms acting both as
principals and as agents utilizing standardized swap documentation. As a result,
the swap market has become relatively liquid. Caps and floors are more recent
-20-
innovations and they are less liquid than swaps. There can be no assurance,
however, that the Fund will be able to enter into interest rate swaps or to
purchase interest rate caps or floors at prices or on terms the Sub-Adviser
believes are advantageous to the Fund. In addition, although the terms of
interest rate swaps, caps and floors may provide for termination, there can be
no assurance that the Fund will be able to terminate an interest rate swap or to
sell or offset interest rate caps or floors that it has purchased.
The Fund also may engage in credit derivative transactions. Default
risk derivatives are linked to the price of reference securities or loans after
a default by the issuer or borrower, respectively. Market spread derivatives are
based on the risk that changes in market factors, such as credit spreads, can
cause a decline in the value of a security, loan or index. There are three basic
transactional forms for credit derivatives: swaps, options and structured
instruments. The use of credit derivatives is a highly specialized activity
which involves strategies and risks different from those associated with
ordinary portfolio security transactions. If the Sub-Adviser is incorrect in its
forecasts of default risks, market spreads or other applicable factors, the
investment performance of the Fund would diminish compared with what it would
have been if these techniques were not used. Moreover, even if the Sub-Adviser
is correct in its forecasts, there is a risk that a credit derivative position
may correlate imperfectly with the price of the asset or liability being hedged.
Risks and Special Considerations Concerning Derivatives. In addition to
the foregoing, the use of derivative instruments involves certain general risks
and considerations as described below.
(1) Market Risk. Market risk is the risk that the value of
the underlying assets may go up or down. Adverse movements in the value
of an underlying asset can expose the Fund to losses. Market risk is
the primary risk associated with derivative transactions. Derivative
instruments may include elements of leverage and, accordingly,
fluctuations in the value of the derivative instrument in relation to
the underlying asset may be magnified. The successful use of derivative
instruments depends upon a variety of factors, particularly the
Sub-Adviser's ability to predict correctly changes in the relationships
of such hedge instruments to the Fund's portfolio holdings, and there
can be no assurance the Sub-Adviser's judgment in this respect will be
accurate. Consequently, the use of derivatives for hedging purposes
might result in a poorer overall performance for the Fund, whether or
not adjusted for risk, than if the Fund had not hedged its portfolio
holdings.
(2) Credit Risk. Credit risk is the risk that a loss is
sustained as a result of the failure of a counterparty to comply with
the terms of a derivative instrument. The counterparty risk for
exchange-traded derivatives is generally less than for
privately-negotiated or over-the-counter derivatives, since generally a
clearing agency, which is the issuer or counterparty to each
exchange-traded instrument, provides a guarantee of performance. For
privately-negotiated instruments, there is no similar clearing agency
guarantee. In all transactions, the Fund will bear the risk that the
counterparty will default, and this could result in a loss of the
expected benefit of the derivative transactions and possibly other
-21-
losses to the Fund. The Fund will enter into transactions in derivative
instruments only with counterparties that the Sub-Adviser reasonably
believes are capable of performing under the contract.
(3) Correlation Risk. Correlation risk is the risk that there
might be an imperfect correlation, or even no correlation, between
price movements of a derivative instrument and price movements of
investments being hedged. When a derivative transaction is used to
completely hedge another position, changes in the market value of the
combined position (the derivative instrument plus the position being
hedged) result from an imperfect correlation between the price
movements of the two instruments. With a perfect hedge, the value of
the combined position remains unchanged with any change in the price of
the underlying asset. With an imperfect hedge, the value of the
derivative instrument and its hedge are not perfectly correlated. For
example, if the value of a derivative instrument used in a short hedge
(such as buying a put option or selling a futures contract) increased
by less than the decline in value of the hedged investments, the hedge
would not be perfectly correlated. This might occur due to factors
unrelated to the value of the investments being hedged, such as
speculative or other pressures on the markets in which these
instruments are traded. In addition, the Fund's success in using
hedging instruments is subject to the Sub-Adviser's ability to
correctly predict changes in relationships of such hedge instruments to
the Fund's portfolio holdings, and there can be no assurance that the
Sub-Adviser's judgment in this respect will be accurate. An imperfect
correlation may prevent the Fund from achieving the intended hedge or
expose the Fund to a risk of loss.
(4) Liquidity Risk. Liquidity risk is the risk that a
derivative instrument cannot be sold, closed out, or replaced quickly
at or very close to its fundamental value. Generally, exchange
contracts are liquid because the exchange clearinghouse is the
counterparty of every contract. OTC transactions are less liquid than
exchange-traded derivatives since they often can only be closed out
with the other party to the transaction. The Fund might be required by
applicable regulatory requirements to maintain assets as "cover,"
maintain segregated accounts and/or make margin payments when it takes
positions in derivative instruments involving obligations to third
parties (i.e., instruments other than purchase options). If the Fund is
unable to close out its positions in such instruments, it might be
required to continue to maintain such accounts or make such payments
until the position expires, matures, or is closed out. These
requirements might impair the Fund's ability to sell a security or make
an investment at a time when it would otherwise be favorable to do so,
or require that the Fund sell a portfolio security at a disadvantageous
time. The Fund's ability to sell or close out a position in an
instrument prior to expiration or maturity depends upon the existence
of a liquid secondary market or, in the absence of such a market, the
ability and willingness of the counterparty to enter into a transaction
closing out the position. Due to liquidity risk, there is no assurance
that any derivatives position can be sold or closed out at a time and
price that is favorable to the Fund.
(5) Legal Risk. Legal risk is the risk of loss caused by the
unenforceability of a party's obligations under the derivative. While a
party seeking price certainty agrees to surrender the potential upside
in exchange for downside protection, the party taking the risk is
-22-
looking for a positive payoff. Despite this voluntary assumption of
risk, a counterparty that has lost money in a derivative transaction
may try to avoid payment by exploiting various legal uncertainties
about certain derivative products.
(6) Systemic or "Interconnection" Risk. Systemic or
interconnection risk is the risk that a disruption in the financial
markets will cause difficulties for all market participants. In other
words, a disruption in one market will spill over into other markets,
perhaps creating a chain reaction. Much of the OTC derivatives market
takes place among the OTC dealers themselves, thus creating a large
interconnected web of financial obligations. This interconnectedness
raises the possibility that a default by one large dealer could create
losses for other dealers and destabilize the entire market for OTC
derivative instruments.
PORTFOLIO TURNOVER RISK
The Fund's annual portfolio turnover rate may vary greatly from year to
year. Although the Fund cannot accurately predict its annual portfolio turnover
rate, it is not expected to exceed 100% under normal circumstances. However,
portfolio turnover rate is not considered a limiting factor in the execution of
investment decisions for the Fund. High portfolio turnover may result in the
Fund's recognition of gains that will be taxable as ordinary income to the Fund.
A high portfolio turnover may increase the Fund's current and accumulated
earnings and profits, resulting in a greater portion of the Fund's distributions
being treated as a dividend to the Fund's Common Shareholders. In addition, a
higher portfolio turnover rate results in correspondingly greater brokerage
commissions and other transactional expenses that are borne by the Fund. See
"Other Investment Policies and Techniques--Portfolio Turnover" and "Federal
Income Tax Matters."
MARKET DISRUPTION RISK
The terrorist attacks in the United States on September 11, 2001 had a
disruptive effect on the securities markets. The ongoing United States military
and related action in Iraq and events in the Middle East, as well as the
continuing threat of terrorist attacks, could have significant adverse effects
on the U.S. economy, the stock market and world economies and markets generally.
The Fund cannot predict the effects of similar events in the future on the U.S.
and world economies, the value of the Common Shares or the NAV of the Fund.
ILLIQUID/RESTRICTED SECURITIES
The Fund may invest up to 10% of its Managed Assets in securities that,
at the time of investment, are illiquid (determined using the Securities and
Exchange Commission's standard applicable to investment companies, i.e.,
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). The Fund may also invest, without limit, in restricted securities.
However, restricted securities determined by the Sub-Adviser, under the
supervision of the Board of Trustees, to be illiquid, are subject to the
limitations set forth above. As a result, restricted securities may be more
-23-
difficult to value and the Fund may have difficulty disposing of such assets
either in a timely manner or for a reasonable price. In order to dispose of an
unregistered security, the Fund, where it has contractual rights to do so, may
have to cause such security to be registered. A considerable period may elapse
between the time the decision is made to sell the security and the time the
security is registered in order for the Fund could sell it. Contractual
restrictions on the resale of securities vary in length and scope and are
generally the result of a negotiation between the issuer and acquiror of the
securities. The Fund would, in either case, bear market risks during that
period.
Historically, illiquid securities have included securities subject to
contractual or legal restrictions on resale because they have not been
registered under the Securities Act of 1933, as amended (the "Securities Act"),
securities which are otherwise not readily marketable and reverse repurchase
agreements having a maturity of longer than seven days. Securities that have not
been registered under the Securities Act are referred to as restricted
securities and are purchased directly from the issuer or in the secondary
market. Limitations on resale may have an adverse effect on the marketability of
portfolio securities and the Fund might be unable to dispose of restricted or
other illiquid securities promptly or at reasonable prices. The Fund might also
have to register the restricted securities to dispose of them resulting in
additional expense and delay. Adverse market conditions could impede the public
offering of securities.
Over time, a large institutional market has developed for certain
securities that are not registered under the Securities Act including repurchase
agreements, commercial paper, foreign securities, municipal securities,
convertible securities and corporate bonds and notes. Institutional investors
depend on an efficient institutional market in which the unregistered security
can be readily resold or on an issuer's ability to honor a demand for repayment.
The fact that there are contractual or legal restrictions on resale to the
general public or to certain institutions may not be indicative of the liquidity
of such investments.
CERTAIN AFFILIATIONS
Certain broker-dealers may be considered to be affiliated persons of
the Fund or First Trust Advisors. 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 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. In addition, unless and
until the underwriting syndicate is broken in connection with the initial public
offering of the Common Shares, the Fund will be precluded from effecting
principal transactions with brokers who are members of the syndicate.
ANTI-TAKEOVER PROVISIONS
The Fund's Declaration of Trust (the "Declaration") includes provisions
that could limit the ability of other entities or persons to acquire control of
the Fund or convert the Fund to open-end status. These provisions could have the
effect of depriving the Common Shareholders of opportunities to sell their
Common Shares at a premium over the then current market price of the Common
Shares. See "Certain Provisions in the Declaration of Trust."
-24-
RESTRICTIVE COVENANTS AND 1940 ACT RESTRICTIONS
With respect to a leverage borrowing program instituted by the Fund,
the credit agreements governing such a program (the "Credit Agreements") will
likely include usual and customary covenants for this type of transaction,
including, but not limited to, limits on the Fund's ability to: (i) issue
Preferred Shares; (ii) incur liens or pledge portfolio securities or
investments; (iii) change its investment objectives or fundamental investment
restrictions without the approval of lenders; (iv) make changes in any of its
business objectives, purposes or operations that could result in a material
adverse effect; (v) make any changes in its capital structure; (vi) amend the
Fund documents in a manner which could adversely affect the rights, interests or
obligations of any of the lenders; (vii) engage in any business other than the
business currently engaged in; (viii) create, incur, assume or permit to exist
certain debt except for certain specific types of debt; and (ix) permit any of
its Employee Retirement Income Security Act ("ERISA") affiliates to cause or
permit to occur an event that could result in the imposition of a lien under the
Code or ERISA. In addition, the Credit Agreements would not permit the Fund's
asset coverage ratio (as defined in the Credit Agreements) to fall below 300% at
any time.
Under the requirements of the 1940 Act, the Fund must have asset
coverage of at least 300% immediately after any borrowing, including borrowing
under any leverage borrowing program the Fund implements. For this purpose,
asset coverage means the ratio which the value of the total assets of the Fund,
less liabilities and indebtedness not represented by senior securities, bears to
the aggregate amount of borrowings represented by senior securities issued by
the Fund. The Credit Agreements would limit the Fund's ability to pay dividends
or make other distributions on the Fund's Common Shares unless the Fund complies
with the Credit Agreements' 300% asset coverage test. In addition, the Credit
Agreements will not permit the Fund to declare dividends or other distributions
or purchase or redeem Common Shares or Preferred Shares: (i) at any time that
any event of default under the Credit Agreements has occurred and is continuing;
or (ii) if, after giving effect to such declaration, the Fund would not meet the
Credit Agreements' 300% asset coverage test set forth in the Credit Agreements.
SECONDARY MARKET FOR THE FUND'S SHARES
The issuance of Common Shares through the Fund's Dividend Reinvestment
Plan may have an adverse effect on the secondary market for the Common Shares.
The increase in the number of outstanding Common Shares resulting from issuances
pursuant to the Fund's Dividend Reinvestment Plan and the discount to the market
price at which such Common Shares may be issued, may put downward pressure on
the market price for the Common Shares of the Fund. Common Shares will not be
issued pursuant to the Dividend Reinvestment Plan at any time when Common Shares
are trading at a lower price than the Fund's NAV per Common Share. When the
Fund's Common Shares are trading at a premium, the Fund may also issue Common
Shares that may be sold through private transactions effected on the New York
Stock Exchange ("NYSE") or through broker-dealers. The increase in the number of
outstanding Common Shares resulting from these offerings may put downward
pressure on the market price for Common Shares.
-25-
OTHER INVESTMENT POLICIES AND TECHNIQUES
HEDGING STRATEGIES
General Description of Hedging Strategies. The Fund may use derivatives
or other transactions for the purpose of hedging the Fund's exposure to an
increase in the price of a security prior to its anticipated purchase or a
decrease in the price of a security prior to its anticipated sale, to seek to
reduce interest rate risks arising from the use of any Financial Leverage by the
Fund and to mitigate risks, including interest rate, currency and credit risks.
The specific derivative instruments to be used, or other transactions to be
entered into, for such hedging purposes may include exchange-listed and
over-the-counter put and call options on currencies, securities, fixed-income,
currency and interest rate indices, and other financial instruments, financial
futures contracts and options thereon (hereinafter referred to as "Futures" or
"futures contracts"), interest rate and currency transactions such as swaps,
caps, floors or collars or credit derivative instruments.
Hedging or derivative instruments on securities generally are used to
hedge against price movements in one or more particular securities positions
that the Fund owns or intends to acquire. Such instruments may also be used to
"lock-in" recognized but unrealized gains in the value of portfolio securities.
Hedging strategies, if successful, can reduce the risk of loss by wholly or
partially offsetting the negative effect of unfavorable price movements in the
investments being hedged. However, hedging strategies can also reduce the
opportunity for gain by offsetting the positive effect of favorable price
movements in the hedged investments. The use of hedging instruments is subject
to applicable regulations of the Securities and Exchange Commission, the several
options and futures exchanges upon which they are traded, the CFTC and various
state regulatory authorities. In addition, the Fund's ability to use hedging
instruments may be limited by tax considerations.
General Limitations on Futures and Options Transactions. The Fund has
filed a notice of eligibility for exclusion from the definition of the term
"commodity pool operator" with the CFTC and the National Futures Association,
which regulate trading in the futures markets. Pursuant to Section 4.5 of the
regulations under the Commodity Exchange Act (the "CEA"), the Fund is not
subject to regulation as a commodity pool under the CEA.
Various exchanges and regulatory authorities have undertaken reviews of
options and Futures trading in light of market volatility. Among the possible
actions that have been presented are proposals to adopt new or more stringent
daily price fluctuation limits for Futures and options transactions and
proposals to increase the margin requirements for various types of futures
transactions.
Asset Coverage for Futures and Options Positions. The Fund will comply
with the regulatory requirements of the Securities and Exchange Commission and
the CFTC with respect to coverage of options and Futures positions by registered
investment companies and, if the guidelines so require, will set aside cash,
U.S. government securities, high grade liquid debt securities and/or other
liquid assets permitted by the Securities and Exchange Commission and CFTC in a
segregated custodial account in the amount prescribed. Securities held in a
-26-
segregated account cannot be sold while the Futures or options position is
outstanding, unless replaced with other permissible assets, and will be
marked-to-market daily.
Options. As an anticipatory hedge, the Fund may purchase put and call
options on stock or other securities. A put option embodies the right of its
purchaser to compel the writer of the option to purchase from the option holder
an underlying security or its equivalent at a specified price at any time during
the option period. In contrast, a call option gives the purchaser the right to
buy the underlying security covered by the option or its equivalent from the
writer of the option at the stated exercise price.
As a holder of a put option, the Fund will have the right to sell the
securities underlying the option and as the holder of a call option, the Fund
will have the right to purchase the securities underlying the option, in each
case at their exercise price at any time prior to the option's expiration date.
The Fund may seek to terminate its option positions prior to their expiration by
entering into closing transactions. The ability of the Fund to enter into a
closing sale transaction depends on the existence of a liquid secondary market.
There can be no assurance that a closing purchase or sale transaction can be
effected when the Fund so desires.
Certain Considerations Regarding Options. The hours of trading for
options may not conform to the hours during which the underlying securities are
traded. To the extent that the options markets close before the markets for the
underlying securities, significant price and rate movements can take place in
the underlying markets that cannot be reflected in the options markets. The
purchase of options is a highly specialized activity which involves investment
techniques and risks different from those associated with ordinary portfolio
securities transactions. The purchase of options involves the risk that the
premium and transaction costs paid by the Fund in purchasing an option will be
lost as a result of unanticipated movements in prices of the securities on which
the option is based. Imperfect correlation between the options and securities
markets may detract from the effectiveness of attempted hedging. Options
transactions may result in significantly higher transaction costs and portfolio
turnover for the Fund.
Some, but not all, of the derivative instruments may be traded and
listed on an exchange. There is no assurance that a liquid secondary market on
an options exchange will exist for any particular option, or at any particular
time, and for some options no secondary market on an exchange or elsewhere may
exist. If the Fund is unable to effect a closing sale transaction with respect
to options on securities that it has purchased, it would have to exercise the
option in order to realize any profit and would incur transaction costs upon the
purchase and sale of the underlying securities.
Futures Contracts. The Fund may enter into securities-related futures
contracts, including security futures contracts as an anticipatory hedge. The
Fund's hedging may include sales of Futures as an offset against the effect of
expected declines in securities prices and purchases of Futures as an offset
against the effect of expected increases in securities prices. The Fund will not
enter into futures contracts which are prohibited under the CEA and will, to the
extent required by regulatory authorities, enter only into futures contracts
that are traded on exchanges and are standardized as to maturity date and
underlying financial instrument. A security futures contract is a legally
-27-
binding agreement between two parties to purchase or sell in the future a
specific quantity of shares of a security or of the component securities of a
narrow-based security index, at a certain price. A person who buys a security
futures contract enters into a contract to purchase an underlying security and
is said to be "long" the contract. A person who sells a security futures contact
enters into a contract to sell the underlying security and is said to be "short"
the contract. The price at which the contract trades (the "contract price") is
determined by relative buying and selling interest on a regulated exchange.
Transaction costs are incurred when a futures contract is bought or
sold and margin deposits must be maintained. In order to enter into a security
futures contract, the Fund must deposit funds with its custodian in the name of
the futures commodities merchant equal to a specified percentage of the current
market value of the contract as a performance bond. Moreover, all security
futures contracts are marked-to-market at least daily, usually after the close
of trading. At that time, the account of each buyer and seller reflects the
amount of any gain or loss on the security futures contract based on the
contract price established at the end of the day for settlement purposes.
An open position, either a long or short position, is closed or
liquidated by entering into an offsetting transaction (i.e., an equal and
opposite transaction to the one that opened the position) prior to the contract
expiration. Traditionally, most futures contracts are liquidated prior to
expiration through an offsetting transaction and, thus, holders do not incur a
settlement obligation. If the offsetting purchase price is less than the
original sale price, a gain will be realized. Conversely, if the offsetting sale
price is more than the original purchase price, a gain will be realized; if it
is less, a loss will be realized. The transaction costs must also be included in
these calculations. There can be no assurance, however, that the Fund will be
able to enter into an offsetting transaction with respect to a particular
futures contract at a particular time. If the Fund is not able to enter into an
offsetting transaction, the Fund will continue to be required to maintain the
margin deposits on the futures contract and the Fund may not be able to realize
a gain in the value of its future position or prevent losses from mounting. This
inability to liquidate could occur, for example, if trading is halted due to
unusual trading activity in either the security futures contract or the
underlying security; if trading is halted due to recent news events involving
the issuer of the underlying security; if systems failures occur on an exchange
or at the firm carrying the position; or, if the position is on an illiquid
market. Even if the Fund can liquidate its position, it may be forced to do so
at a price that involves a large loss.
Under certain market conditions, it may also be difficult or impossible
to manage the risk from open security futures positions by entering into an
equivalent but opposite position in another contract month, on another market,
or in the underlying security. This inability to take positions to limit the
risk could occur, for example, if trading is halted across markets due to
unusual trading activity in the security futures contract or the underlying
security or due to recent news events involving the issuer of the underlying
security.
There can be no assurance that a liquid market will exist at a time
when the Fund seeks to close out a futures contract position. The Fund would
continue to be required to meet margin requirements until the position is
closed, possibly resulting in a decline in the Fund's NAV. In addition, many of
the contracts discussed above are relatively new instruments without a
-28-
significant trading history. As a result, there can be no assurance that an
active secondary market will develop or continue to exist.
Security futures contracts that are not liquidated prior to expiration
must be settled in accordance with the terms of the contract. Some security
futures contracts are settled by physical delivery of the underlying security.
At the expiration of a security futures contract that is settled through
physical delivery, a person who is long the contract must pay the final
settlement price set by the regulated exchange or the clearing organization and
take delivery of the underlying shares. Conversely, a person who is short the
contract must make delivery of the underlying shares in exchange for the final
settlement price. Settlement with physical delivery may involve additional
costs.
Other security futures contracts are settled through cash settlement.
In this case, the underlying security is not delivered. Instead, any positions
in such security futures contracts that are open at the end of the last trading
day are settled through a final cash payment based on a final settlement price
determined by the exchange or clearing organization. Once this payment is made,
neither party has any further obligations on the contract.
As noted above, margin is the amount of funds that must be deposited by
the Fund in order to initiate futures trading and to maintain the Fund's open
positions in futures contracts. A margin deposit is intended to ensure the
Fund's performance of the futures contract. The margin required for a particular
futures contract is set by the exchange on which the futures contract is traded
and may be significantly modified from time to time by the exchange during the
term of the futures contract.
If the price of an open futures contract changes (by increase in the
case of a sale or by decrease in the case of a purchase) so that the loss on the
futures contract reaches a point at which the margin on deposit does not satisfy
margin requirements, the broker will require an increase in the margin. However,
if the value of a position increases because of favorable price changes in the
futures contract so that the margin deposit exceeds the required margin, the
broker will pay the excess to the Fund. In computing daily NAV, the Fund will
mark to market the current value of its open futures contracts. The Fund expects
to earn interest income on its margin deposits.
Because of the low margin deposits required, futures contracts trading
involves an extremely high degree of leverage. As a result, a relatively small
price movement in a futures contract may result in immediate and substantial
loss, as well as gain, to the investor. For example, if at the time of purchase,
10% of the value of the futures contract is deposited as margin, a subsequent
10% decrease in the value of the futures contract would result in a total loss
of the margin deposit, before any deduction for the transaction costs, if the
account were then closed out. A 15% decrease would result in a loss equal to
150% of the original margin deposit, if the futures contracts were closed out.
Thus, a purchase or sale of a futures contract may result in losses in excess of
the amount initially invested in the futures contract. However, the Fund would
presumably have sustained comparable losses if, instead of the futures contract,
it had invested in the underlying financial instrument and sold it after the
decline.
-29-
In addition to the foregoing, imperfect correlation between the futures
contracts and the underlying securities may prevent the Fund from achieving the
intended hedge or expose the Fund to risk of loss. Under certain market
conditions, the prices of security futures contracts may not maintain their
customary or anticipated relationships to the prices of the underlying security
or index. These pricing disparities could occur, for example, when the market
for the security futures contract is illiquid, when the primary market for the
underlying security is closed, or when the reporting of transactions in the
underlying security has been delayed.
In addition, the value of a position in security futures contracts
could be affected if trading is halted in either the security futures contract
or the underlying security. In certain circumstances, regulated exchanges are
required by law to halt trading in security futures contracts. For example,
trading on a particular security futures contract must be halted if trading is
halted on the listed market for the underlying security as a result of pending
news, regulatory concerns, or market volatility. Similarly, trading of a
security futures contract on a narrow-based security index must be halted under
circumstances such as where trading is halted on securities accounting for at
least 50% of the market capitalization of the index. In addition, regulated
exchanges are required to halt trading in all security futures contracts for a
specified period of time when the Dow Jones Industrial Average ("DJIA")
experiences one-day declines of 10-, 20- and 30%. The regulated exchanges may
also have discretion under their rules to halt trading in other circumstances -
such as when the exchange determines that the halt would be advisable in
maintaining a fair and orderly market.
A trading halt, either by a regulated exchange that trades security
futures or an exchange trading the underlying security or instrument, could
prevent the Fund from liquidating a position in security futures contracts in a
timely manner, which could expose the Fund to a loss.
Each regulated exchange trading a security futures contract may also
open and close for trading at different times than other regulated exchanges
trading security futures contracts or markets trading the underlying security or
securities. Trading in security futures contracts prior to the opening or after
the close of the primary market for the underlying security may be less liquid
than trading during regular market hours.
Swap Agreements. For hedging purposes, the Fund may enter into swap
agreements. A swap is a financial instrument that typically involves the
exchange of cash flows between two parties on specified dates (settlement
dates), where the cash flows are based on agreed-upon prices, rates, indices,
etc. The nominal amount on which the cash flows are calculated is called the
notional amount. Swaps are individually negotiated and structured to include
exposure to a variety of different types of investments or market factors, such
as interest rates, commodity prices, non-U.S. currency rates, mortgage
securities, corporate borrowing rates, security prices, indexes or inflation
rates.
Swap agreements may increase or decrease the overall volatility of the
investments of the Fund and its share price. The performance of swap agreements
may be affected by a change in the specific interest rate, currency, or other
factors that determine the amounts of payments due to and from the Fund. If a
swap agreement calls for payments by the Fund, the Fund must be prepared to make
-30-
such payments when due. In addition, if the counterparty's creditworthiness
declines, the value of a swap agreement would be likely to decline, potentially
resulting in losses.
Generally, swap agreements have fixed maturity dates that are agreed
upon by the parties to the swap. The agreement can be terminated before the
maturity date only under limited circumstances, such as default by one of the
parties or insolvency, among others, and can be transferred by a party only with
the prior written consent of the other party. The Fund may be able to eliminate
its exposure under a swap agreement either by assignment or by other
disposition, or by entering into an offsetting swap agreement with the same
party or a similarly creditworthy party. If the counterparty is unable to meet
its obligations under the contract, declares bankruptcy, defaults or becomes
insolvent, the Fund may not be able to recover the money it expected to receive
under the contract.
A swap agreement can be a form of leverage, which can magnify the
Fund's gains or losses. In order to reduce the risk associated with leveraging,
the Fund may cover its current obligations under swap agreements according to
guidelines established by the Securities and Exchange Commission. If the Fund
enters into a swap agreement on a net basis, it will be required to segregate
assets with a daily value at least equal to the excess, if any, of the Fund's
accrued obligations under the swap agreement over the accrued amount the Fund is
entitled to receive under the agreement. If the Fund enters into a swap
agreement on other than a net basis, it will be required to segregate assets
with a value equal to the full amount of the Fund's accrued obligations under
the agreement.
Equity Swaps. In a typical equity swap, one party agrees to pay another
party the return on a security, security index or basket of securities in return
for a specified interest rate. By entering into an equity index swap, for
example, the index receiver can gain exposure to securities making up the index
of securities without actually purchasing those securities. Equity index swaps
involve not only the risk associated with investment in the securities
represented in the index, but also the risk that the performance of such
securities, including dividends, will not exceed the interest that the Fund will
be committed to pay under the swap.
BORROWINGS AND PREFERRED SHARES
The Fund anticipates that under current market conditions it will issue
Leverage Instruments representing no more than 33 1/3% of its Managed Assets
approximately two months after the completion of this offering. If as a result
of market conditions, or any other reason, the Fund does not issue Preferred
Shares, the Fund will limit its borrowings to 33 1/3% (or such other percentage
permitted by law) of its Managed Assets. Any use of Leverage Instruments by the
Fund will, however, be consistent with the provisions of the 1940 Act. The Fund
intends to borrow primarily using reverse repurchase agreements. A reverse
repurchase agreement, although structured as a sale and repurchase obligation,
acts as a financing under which the Fund will effectively pledge its securities
as collateral to secure a short-term loan. Generally, the other party to the
agreement makes the loan in an amount equal to a percentage of the market value
of the pledged collateral. At the maturity of the reverse repurchase agreement,
the Fund will be required to repay the loan and correspondingly receive back its
-31-
collateral. While used as collateral, the securities continue to pay principal
and interest which are for the benefit of the Fund. The Fund may borrow from
banks and other financial institutions.
The Leverage Instruments would have complete priority upon distribution
of assets over Common Shares. The issuance of Leverage Instruments would
leverage the Common Shares. Although the timing and other terms of the offering
of Leverage Instruments and the terms of the Leverage Instruments would be
determined by the Fund's Board of Trustees, the Fund expects to invest the
proceeds derived from any Leverage Instrument offering in securities consistent
with the Fund's investment objective and policies. If Preferred Shares are
issued they would pay adjustable rate dividends based on shorter-term interest
rates, which would be redetermined periodically by an auction process. The
adjustment period for Preferred Shares dividends could be as short as one day or
as long as a year or more. So long as the Fund's portfolio is invested in
securities that provide a higher rate of return than the dividend rate or
interest rate of the Leverage Instruments, after taking expenses into
consideration, the leverage will cause Common Shareholders to receive a higher
rate of income than if the Fund were not leveraged.
Leverage creates risk for holders of the Common Shares, including the
likelihood of greater volatility of NAV and market price of the Common Shares,
and the risk that fluctuations in interest rates on borrowings and debt or in
the dividend rates on any Preferred Shares may affect the return to the holders
of the Common Shares or will result in fluctuations in the dividends paid on the
Common Shares. To the extent total return exceeds the cost of leverage, the
Fund's return will be greater than if leverage had not been used. Conversely, if
the total return derived from securities purchased with funds received from the
use of leverage is less than the cost of leverage, the Fund's return will be
less than if leverage had not been used, and therefore the amount available for
distribution to Common Shareholders as dividends and other distributions will be
reduced. In the latter case, the Sub-Adviser in its best judgment nevertheless
may determine to maintain the Fund's leveraged position if it expects that the
benefits to the Fund's Common Shareholders of maintaining the leveraged position
will outweigh the current reduced return. Under normal market conditions, the
Fund anticipates that it will be able to invest the proceeds from leverage at a
higher rate than the costs of leverage, which would enhance returns to Common
Shareholders. The fees paid to the Adviser and Sub-Adviser will be calculated on
the basis of the Managed Assets including proceeds from borrowings for leverage
and the issuance of Preferred Shares. During periods in which the Fund is
utilizing financial leverage, the investment advisory fee payable to the Adviser
and Sub-Adviser will be higher than if the Fund did not utilize a leveraged
capital structure. The use of leverage creates risks and involves special
considerations.
The Fund's Declaration authorizes the Fund, without prior approval of
the Common Shareholders, to borrow money. In this connection, the Fund may enter
into reverse repurchase agreements, issue notes or other evidence of
indebtedness (including bank borrowings or commercial paper) and may secure any
such borrowings by mortgaging, pledging or otherwise subjecting as security the
Fund's assets. In connection with such borrowing, the Fund may be required to
maintain minimum average balances with the lender or to pay a commitment or
other fee to maintain a line of credit. Any such requirements will increase the
cost of borrowing over the stated interest rate. Under the requirements of the
1940 Act, the Fund, immediately after any such borrowings, must have an "asset
coverage" of at least 300% (33-1/3% of Managed Assets after borrowings). With
-32-
respect to such borrowing, asset coverage means the ratio which the value of the
total assets of the Fund, less all liabilities and indebtedness not represented
by senior securities (as defined in the 1940 Act), bears to the aggregate amount
of such borrowing represented by senior securities issued by the Fund.
The rights of lenders to the Fund to receive interest on and repayment
of principal of any such borrowings will be senior to those of the Common
Shareholders, and the terms of any such borrowings may contain provisions which
limit certain activities of the Fund, including the payment of dividends to
Common Shareholders in certain circumstances. Further, the 1940 Act does (in
certain circumstances) grant to the lenders to the Fund certain voting rights in
the event of default in the payment of interest on or repayment of principal. In
the event that such provisions would impair the Fund's status as a regulated
investment company under the Internal Revenue Code of 1986, as amended (the
"Code"), the Fund, subject to its ability to liquidate its portfolio, intends to
repay the borrowings. Any borrowing will likely be ranked senior or equal to all
other existing and future borrowings of the Fund.
Certain types of borrowings may result in the Fund being subject to
covenants in credit agreements relating to asset coverage and portfolio
composition requirements. The Fund may be subject to certain restrictions on
investments imposed by guidelines of one or more rating agencies, which may
issue ratings for the short-term corporate debt securities or Preferred Shares
issued by the Fund. These guidelines may impose asset coverage or portfolio
composition requirements that are more stringent than those imposed by the 1940
Act. It is not anticipated that these covenants or guidelines will impede the
Sub-Adviser from managing the Fund's portfolio in accordance with the Fund's
investment objective and policies.
Under the 1940 Act, the Fund is not permitted to issue Preferred Shares
unless immediately after such issuance the value of the Fund's Managed Assets is
at least 200% of the liquidation value of the outstanding Preferred Shares
(i.e., the liquidation value may not exceed 50% of the Fund's Managed Assets).
In addition, the Fund is not permitted to declare any cash dividend or other
distribution on its Common Shares unless, at the time of such declaration, the
value of the Fund's Managed Assets is at least 200% of such liquidation value.
If Preferred Shares are issued, the Fund intends, to the extent possible, to
purchase or redeem Preferred Shares from time to time to the extent necessary in
order to maintain coverage of any Preferred Shares of at least 200%. In
addition, as a condition to obtaining ratings on the Preferred Shares, the terms
of any Preferred Shares issued are expected to include asset coverage
maintenance provisions which will require the redemption of the Preferred Shares
in the event of non-compliance by the Fund and may also prohibit dividends and
other distributions on the Common Shares in such circumstances. In order to meet
redemption requirements, the Fund may have to liquidate portfolio securities.
Such liquidations and redemptions would cause the Fund to incur related
transaction costs and could result in capital losses to the Fund. Prohibitions
on dividends and other distributions on the Common Shares could impair the
Fund's ability to qualify as a regulated investment company under the Code. If
the Fund has Preferred Shares outstanding, two of the Fund's trustees will be
elected by the holders of Preferred Shares as a class. The remaining trustees of
the Fund will be elected by holders of Common Shares and Preferred Shares voting
together as a single class. In the event the Fund failed to pay dividends on
-33-
Preferred Shares for two years, holders of Preferred Shares would be entitled to
elect a majority of the trustees of the Fund.
The Fund may also borrow money as a temporary measure for extraordinary
or emergency purposes, including the payment of dividends and the settlement of
securities transactions which otherwise might require untimely dispositions of
Fund securities.
MANAGEMENT OF THE FUND
TRUSTEES AND OFFICERS
The general supervision of the duties performed for the Fund under the
Investment Management Agreement is the responsibility of the Board of Trustees.
The trustees set broad policies for the Fund and choose the Fund's officers. The
following is a list of the trustees and officers of the Fund and a statement of
their present positions and principal occupations during the past five years,
with the trustee who is an "interested person" (as such term is defined in the
1940 Act) of the Fund indicated by an asterisk.
NUMBER OF
PORTFOLIOS
TERM OF IN FUND
OFFICE AND COMPLEX OTHER
POSITION AND YEAR FIRST PRINCIPAL OVERSEEN TRUSTEESHIPS
OFFICES WITH ELECTED OR OCCUPATIONS DURING BY TRUSTEE HELD BY
NAME, ADDRESS AND AGE FUND APPOINTED PAST 5 YEARS OR OFFICER TRUSTEE
--------------------- ------------ ---------- ------------- ---------- ------------
Trustee who is an
Interested Person of
the Fund
--------------------
James A. Bowen(1)* President, o One Year(2) President, First Trust 21 Portfolios None
1001 Warrenville Road, Chairman of Portfolios and First
Suite 300 the Board, Chief o 2005 Trust Advisors; Chairman
Lisle, IL 60532 Executive Officer of the Board of Directors
D.O.B.: 09/55 and Trustee Bond Wave, LL and
Stonebridge Advisors LLC
Trustees who are not
Interested Persons of
the Fund
--------------------
Richard E. Erickson Trustee o One Year(2) Physician, 21 Portfolios None
c/o First Trust Sportsmed/Wheaton
Advisors L.P. o 2005 Orthopedics
1001 Warrenville Road,
Suite 300
Lisle, IL 60532
D.O.B.: 04/51
Niel B. Nielson Trustee o One Year(2) President (2002 to 21 Portfolios Director of Good
c/o First Trust to Present), Covenant News Publishers -
Advisors L.P. o 2005 College; Pastor (1997 to Crossway Books;
1001 Warrenville Road, 2002), College Church Covenant Transport
Suite 300 in Wheaton Inc.
Lisle, IL 60532
D.O.B.: 03/54
-34-
NUMBER OF
PORTFOLIOS
TERM OF IN FUND
OFFICE AND COMPLEX OTHER
POSITION AND YEAR FIRST PRINCIPAL OVERSEEN TRUSTEESHIPS
OFFICES WITH ELECTED OR OCCUPATIONS DURING BY TRUSTEE HELD BY
NAME, ADDRESS AND AGE FUND APPOINTED PAST 5 YEARS OR OFFICER TRUSTEE
--------------------- ------------ ---------- ------------- ---------- ------------
Thomas R. Kadlec Trustee o One Year(2) Vice President, Chief 21 Portfolios None
c/o First Trust Financial Officer (1990
Advisors L.P. o 2005 to Present), ADM Investor
1001 Warrenville Road, Services, Inc. (Futures
Suite 300 Commission Merchant);
Lisle, IL 60532 Registered Representative
D.O.B.: 11/57 (2000 to Present), Segerdahl
& Company, Inc., an NASD
member (Broker-Dealer)
David M. Oster Trustee o One Year(2) Trader (Self-Employed) 10 Portfolios None
c/o First Trust (1987 to Present)
Advisors L.P. o 2005 (Options Trading and
1001 Warrenville Road, Market Making)
Suite 300
Lisle, IL 60532
D.O.B.: 03/64
Officers of the Fund
--------------------
Mark R. Bradley Treasurer, o Indefinite term Chief Financial 21 Portfolios N/A
1001 Warrenville Road, Controller, Officer, Managing
Suite 300 Chief Financial o 2005 Director, First Trust
Lisle, IL 60532 Officer and Portfolios and First
D.O.B.: 11/57 Chief Accounting Trust Advisors; Chief
Officer Financial Officer, Bond
Wave LLC and Stonebridge
Advisors LLC
Susan M. Brix Assistant o Indefinite term Representative, 21 Portfolios N/A
1001 Warrenville Road, Vice President First Trust Portfolios;
Suite 300 o 2005 Assistant Portfolio
Lisle, IL 60532 Manager, First
D.O.B.: 01/60 Trust Advisors
Robert F. Carey Vice President o Indefinite term Senior Vice President, 21 Portfolios N/A
1001 Warrenville Road, First Trust Portfolios
Suite 300 o 2005 and First Trust
Lisle, IL 60532 Advisors
D.O.B.: 07/63
W. Scott Jardine Secretary and o Indefinite term General Counsel, First 21 Portfolios N/A
1001 Warrenville Road, Chief Compliance Trust Portfolios and
Suite 300 Officer o 2005 First Trust Advisors;
Lisle, IL 60532 Secretary, Bond Wave, LLC
D.O.B.: 05/60 and Stonebridge Advisors
LLC
Kristi A. Maher Assistant o Indefinite term Assistant General 21 Portfolios N/A
1001 Warrenville Road, Secretary Counsel (March 2004 to
Suite 300 o 2005 Present), First Trust
Lisle, IL 60532 Portfolios and First Trust
D.O.B.: 12/66 Advisors; Associate
(1995 to March 2004),
Chapman and Cutler LLP
Roger Testin Vice President o Indefinite term Vice President 21 Portfolios N/A
1001 Warrenville Road, (August 2001 to Present),
Suite 300 o 2005 First Trust Advisors;
Lisle, IL 60532 Analyst (1998 to 2001),
D.O.B.: 06/66 Dolan Capital Management
--------------------
(1) Mr. Bowen is deemed an "interested person" of the Fund due to his position
of President of First Trust Advisors, investment adviser of the Fund.
(2) Trustees are elected each year by shareholders and serve a one year term
until their successors are elected. Mr. Bowen's officer positions with the
Fund have an indefinite term.
-35-
The Board of Trustees of the Fund has four standing committees, the
Executive Committee (and Pricing and Dividend Committee), the Nominating and
Governance Committee, the Valuation Committee and the Audit Committee. The
Executive Committee, which meets between Board meetings, is authorized to
exercise all powers of and to act in the place of the Board of Trustees to the
extent permitted by the Fund's Declaration and By-laws. The members of the
Executive Committee shall also serve as a special committee of the Board known
as the Pricing and Dividend Committee which is authorized to exercise all of the
powers and authority of the Board in respect of the issuance and sale, through
an underwritten public offering, of the Common Shares of the Fund and all other
such matters relating to such financing, including determining the price at
which such shares are to be sold and approval of the final terms of the
underwriting agreement, including approval of the members of the underwriting
syndicate. Such committee is also responsible for the declaration and setting of
dividends. Messrs. Kadlec and Bowen are members of the Executive Committee. The
Nominating and Governance Committee is responsible for appointing and nominating
non-interested persons to the Fund's Board of Trustees. Messrs. Erickson,
Nielson, Kadlec and Oster are members of the Nominating and Governance
Committee. If there is no vacancy on the Board of Trustees, the Board will not
actively seek recommendations from other parties, including Shareholders. When a
vacancy on the Board occurs and nominations are sought to fill such vacancy, the
Nominating and Governance Committee may seek nominations from those sources it
deems appropriate in its discretion, including Shareholders of the Fund. To
submit a recommendation for nomination as a candidate for a position on the
Board, Shareholders of the Fund shall mail such recommendation to W. Scott
Jardine at the Fund's address, 1001 Warrenville Road, Suite 300, Lisle, Illinois
60532. Such recommendation shall include the following information: (a) evidence
of Fund ownership of the person or entity recommending the candidate (if a Fund
Shareholder); (b) a full description of the proposed candidate's background,
including their education, experience, current employment and date of birth; (c)
names and addresses of at least three professional references for the candidate;
(d) information as to whether the candidate is an "interested person" in
relation to such Fund, as such term is defined in the 1940 Act, and such other
information that may be considered to impair the candidate's independence; and
(e) any other information that may be helpful to the Committee in evaluating the
candidate. If a recommendation is received with satisfactorily completed
information regarding a candidate during a time when a vacancy exists on the
Board or during such other time as the Nominating and Governance Committee is
accepting recommendations, the recommendation will be forwarded to the Chair of
the Nominating and Governance Committee and the outside counsel to the
independent trustees. Recommendations received at any other time will be kept on
file until such time as the Nominating and Governance Committee is accepting
recommendations, at which point they may be considered for nomination. The
Valuation Committee is responsible for the oversight of the pricing procedures
of the Fund. Messrs. Erickson, Kadlec and Oster are members of the Valuation
Committee. The Audit Committee is responsible for overseeing the Fund's
accounting and financial reporting process, the system of internal controls,
audit process and evaluating and appointing independent auditors (subject also
to Board approval). Messrs. Erickson, Nielson, Kadlec and Oster serve on the
Audit Committee. The Audit Committee met on March 7, 2005.
Messrs. Erickson, Nielson, Kadlec and Bowen are also trustees of First
Defined Portfolio Fund, LLC, an open-end fund advised by First Trust Advisors
with 11 portfolios. Messrs. Bowen, Erickson, Nielson, Kadlec and Oster are also
-36-
trustees of the First Trust Value Line(R) 100 Fund, First Trust Value Line(R)
Dividend Fund, First Trust/Four Corners Senior Floating Rate Income Fund, First
Trust/Four Corners Senior Floating Rate Income Fund II, Macquarie/First Trust
Global Infrastructure/Utilities Dividend & Income Fund, First Trust/Value
Line(R) & Ibbotson Equity Allocation Fund, Energy Income and Growth Fund, First
Trust/Fiduciary Asset Management Covered Call Fund and First Trust/Aberdeen
Global Opportunity Income Fund, closed-end funds advised by First Trust
Advisors. None of the trustees who are not "interested persons" of the Fund, nor
any of their immediate family members, has ever been a director, officer or
employee of, or consultant to, First Trust Advisors, First Trust Portfolios or
their affiliates. In addition, Mr. Bowen and the other officers of the Fund hold
the same positions with the First Defined Portfolio Fund, LLC, First Trust Value
Line(R) 100 Fund, First Trust Value Line(R) Dividend Fund, First Trust/Four
Corners Senior Floating Rate Income Fund, First Trust/Four Corners Senior
Floating Rate Income Fund II, Macquarie/First Trust Global
Infrastructure/Utilities Dividend & Income Fund, First Trust/Value Line(R) &
Ibbotson Equity Allocation Fund, Energy Income and Growth Fund, First Trust/
Fiduciary Asset Management Covered Call Fund and First Trust/Aberdeen Global
Opportunity Income Fund (collectively, the "First Trust Fund Complex") as they
hold with the Fund.
Each fund in the First Trust Fund Complex pays each trustee who is not
an officer or employee of First Trust Advisors, any sub-adviser or any of their
affiliates ("Independent Trustees") an annual retainer of $10,000 which includes
compensation for all regular quarterly board meetings and regular committee
meetings. No additional meeting fees are paid in connection with regular
quarterly board meetings or regular committee meetings. Additional fees of
$1,000 and $500 are paid to Independent Trustees for special board meetings and
non-regular committee meetings, respectively. These additional fees are shared
by the funds in the First Trust Fund Complex that participate in the particular
meeting and are not per fund fees. Trustees are also reimbursed for travel and
out-of-pocket expenses in connection with all meetings.
The following table sets forth estimated compensation to be paid by the
Fund projected during the Fund's first full fiscal year to each of the trustees
and estimated total compensation to be paid to each of the trustees by the First
Trust Fund Complex for a full calendar year. The Fund has no retirement or
pension plans.
ESTIMATED ESTIMATED TOTAL
AGGREGATE COMPENSATION
COMPENSATION FROM FUND AND
NAME OF TRUSTEE FROM FUND(1) FUND COMPLEX(2)
--------------- ------------ ---------------
James A. Bowen $0 $0
Richard E. Erickson $10,000 $110,000
Thomas R. Kadlec $10,000 $110,000
Niel B. Nielson $10,000 $110,000
David M. Oster $10,000 $100,000
--------------------
(1) The compensation estimated to be paid by the Fund to the trustees for the
first full fiscal year for services to the Fund.
-37-
(2) The total estimated compensation to be paid to Messrs. Erickson, Kadlec and
Nielson, Independent Trustees, from the Fund and Fund Complex for a full
calendar year is based on estimated compensation to be paid to these
trustees for a full calendar year for services as trustees to the First
Defined Portfolio Fund, LLC, an open-end fund (with 12 portfolios) advised
by First Trust Advisors plus estimated compensation to be paid to these
trustees by the First Value Line(R) 100 Fund, the First Trust Value Line(R)
Dividend Fund, the First Trust/Four Corners Senior Floating Rate Income
Fund, the First Trust/Four Corners Senior Floating Rate Income Fund II, the
Macquarie/First Trust Global Infrastructure/Utilities Dividend & Income
Fund, the First Trust/Value Line(R) & Ibbotson Equity Allocation Fund, the
Energy Income and Growth Fund, the First Trust/Fiduciary Asset Management
Covered Call Fund, the First Trust/Aberdeen Global Opportunity Income Fund
and the Fund for a full calendar year. Mr. Oster is currently not a trustee
of the First Defined Portfolio Fund, LLC. Accordingly, his estimated total
compensation is based on the estimated compensation to be paid by the First
Trust Value Line(R) 100 Fund, the First Trust/Four Corners Senior Floating
Rate Income Fund II, the First Trust Value Line(R) Dividend Fund, the First
Trust/Four Corners Senior Floating Rate Income Fund, the Macquarie/First
Trust Global Infrastructure/Utilities Dividend & Income Fund, the First
Trust/Value Line(R) & Ibbotson Equity Allocation Fund, the Energy Income and
Growth Fund, the First Trust/Fiduciary Asset Management Covered Call Fund,
the First Trust/Aberdeen Global Opportunity Income Fund and the Fund for a
full calendar year.
The Fund has no employees. Its officers are compensated by First Trust
Advisors. The Shareholders of the Fund will elect trustees at the next annual
meeting of shareholders.
The following table sets forth the dollar range of equity securities
beneficially owned by the trustees in the Fund and in other funds overseen by
the trustees in the First Trust Fund Complex as of ________, 2005:
AGGREGATE DOLLAR RANGE OF EQUITY
SECURITIES IN ALL REGISTERED
DOLLAR RANGE OF INVESTMENT COMPANIES
EQUITY SECURITIES OVERSEEN BY TRUSTEE IN
TRUSTEE IN THE FUND FIRST TRUST FUND COMPLEX
------- ----------------- --------------------------------
Mr. Bowen None Over $100,000
Mr. Erickson None $ 10,001-$50,000
Mr. Kadlec None $ 50,001-$100,000
Mr. Nielson None $10,001-$50,000
Mr. Oster None Over $100,000
As of ________, 2005, the trustees of the Fund who are not "interested
persons" of the Fund and immediate family members do not own beneficially or of
record any class of securities of an investment adviser or principal underwriter
of the Fund or any person directly or indirectly controlling, controlled by, or
under common control with an investment adviser or principal underwriter of the
Fund.
As of ____________, 2005, First Trust Portfolios L.P. owned both
beneficially and of record all of the Common Shares of the Fund.
-38-
INVESTMENT ADVISER
First Trust Advisors L.P., 1001 Warrenville Road, Suite 300, Lisle,
Illinois 60532, is the investment adviser to the Fund. As investment adviser,
First Trust Advisors provides the Fund with professional investment supervision
and selects the Fund's Sub-Adviser (with the approval of the Board of Trustees)
and permits any of its officers or employees to serve without compensation as
trustees or officers of the Fund if elected to such positions. First Trust
Advisors supervises the activities of the Fund's Sub-Adviser and provides the
Fund with certain other services necessary with the management of the portfolio.
First Trust Advisors is an Illinois limited partnership formed in 1991
and an investment adviser registered with the Securities and Exchange Commission
under the Investment Advisers Act of 1940 (the "Advisers Act"). First Trust
Advisors is a limited partnership with one limited partner, Grace Partners of
DuPage L.P. ("Grace Partners"), and one general partner, The Charger
Corporation. Grace Partners is a limited partnership with one general partner,
The Charger Corporation, and a number of limited partners. Grace Partners' and
The Charger Corporation's primary business is investment advisory and
broker/dealer services through their interests. The Charger Corporation is an
Illinois corporation controlled by the Robert Donald Van Kampen family. First
Trust Advisors is controlled by Grace Partners and The Charger Corporation.
First Trust Advisors is also adviser or sub-adviser to eight mutual
funds and ten closed-end funds (including the Fund) and is the portfolio
supervisor of certain unit investment trusts sponsored by First Trust
Portfolios. First Trust Portfolios specializes in the underwriting, trading and
distribution of unit investment trusts and other securities. First Trust
Portfolios, an Illinois limited partnership formed in 1991, acts as sponsor for
successive series of The First Trust Combined Series, FT Series (formerly known
as The First Trust Special Situations Trust), the First Trust Insured Corporate
Trust, The First Trust of Insured Municipal Bonds and The First Trust GNMA.
First Trust Portfolios introduced the first insured unit investment trust in
1974 and to date, more than $56 billion in gross assets have been deposited in
First Trust Portfolios unit investment trusts.
First Trust Advisors acts as investment adviser to the Fund pursuant to
an Investment Management Agreement. The Investment Management Agreement
continues in effect for the Fund from year to year after its initial two-year
term so long as its continuation is approved at least annually by the trustees
including a majority of the Independent Trustees, or the vote of a majority of
the outstanding voting securities of the Fund. It may be terminated at any time
without the payment of any penalty upon 60 days' written notice by either party,
or by a majority vote of the outstanding voting securities of the Fund
(accompanied by appropriate notice), and will terminate automatically upon
assignment. The Investment Management Agreement also may be terminated, at any
time, without payment of any penalty, by the Board or by vote of a majority of
the outstanding voting securities of the Fund, in the event that it shall have
been established by a court of competent jurisdiction that the Adviser, or any
officer or director of the Adviser, has taken any action which results in a
breach of the covenants of the Adviser set forth in the Investment Management
Agreement. The Investment Management Agreement provides that First Trust
Advisors shall not be liable for any loss sustained by reason of the purchase,
-39-
sale or retention of any security, whether or not the purchase, sale or
retention shall have been based upon the investigation and research made by any
other individual, firm or corporation, if the recommendation shall have been
selected with due care and in good faith, except loss resulting from willful
misfeasance, bad faith or gross negligence on the part of the Adviser in
performance of its obligations and duties, or by reason of its reckless
disregard of its obligations and duties under the Investment Management
Agreement. As compensation for its services, the Fund pays First Trust Advisors
a fee as described in the Prospectus. See "Management of the Fund--Investment
Management Agreement" in the Fund's Prospectus.
In addition to the fee of First Trust Advisors, the Fund pays all other
costs and expenses of its operations, including: compensation of its trustees
(other than those affiliated with First Trust Advisors); custodian, transfer
agency, administrative, accounting and dividend disbursing expenses; legal fees;
sub-licensing fee; expenses of independent auditors; expenses of preparing,
printing and distributing shareholder reports, notices, proxy statements and
reports to governmental agencies; and taxes, if any. All fees and expenses are
accrued daily and deducted before payment of dividends to investors.
On March 7, 2005, the Trustees of the Fund met with representatives of
First Trust Advisors and the Sub-Adviser (the "Fund Advisers") to consider,
among other things, the possible approval of the Investment Management Agreement
between the Fund and First Trust Advisors and the Sub-Advisory Agreement among
the Adviser, the Sub-Adviser and the Fund.
[TO COME]
CODE OF ETHICS
The Fund, Adviser and Sub-Adviser have adopted codes of ethics under
Rule 17j-1 under the 1940 Act. These codes permit personnel subject to the code
to invest in securities, including securities that may be purchased or held by
the Fund. These codes can be reviewed and copied at the Securities and Exchange
Commission's Public Reference Room in Washington, D.C. Information on the
operation of the Public Reference Room may be obtained by calling the Securities
and Exchange Commission at (202) 942-8090. The codes of ethics are available on
the EDGAR Database on the Securities and Exchange Commission's web site
(http://www.sec.gov), and copies of these codes may be obtained, after paying a
duplicating fee, by electronic request at the following e-mail address:
publicinfo@sec.gov, or by writing the Commission Public Reference Section,
Washington, D.C. 20549-0102.
PROXY VOTING POLICIES AND PROCEDURES
The Fund has adopted a proxy voting policy that seeks to ensure that
proxies for securities held by the Fund are voted consistently and solely in the
best economic interests of the Fund.
A senior member of First Trust Advisors is responsible for oversight of
the Fund's proxy voting process. First Trust Advisors has engaged the services
-40-
of Institutional Shareholder Services, Inc. ("ISS"), to make recommendations to
First Trust Advisors on the voting of proxies relating to securities held by the
Fund. ISS provides voting recommendations based upon established guidelines and
practices. First Trust Advisors reviews ISS recommendations and frequently
follows the ISS recommendations. However, on selected issues, First Trust
Advisors may not vote in accordance with the ISS recommendations when First
Trust Advisors believes that specific ISS recommendations are not in the best
interests of the Fund. If First Trust Advisors manages the assets of a company
or its pension plan and any of First Trust clients hold any securities of that
company, First Trust Advisors will vote proxies relating to such company's
securities in accordance with the ISS recommendations to avoid any conflict of
interest. If a client requests First Trust Advisors to follow specific voting
guidelines or additional guidelines, First Trust Advisors will review the
request and inform the client only if First Trust Advisors is not able to follow
the client's request.
First Trust Advisors has adopted the ISS Proxy Voting Guidelines. While
these guidelines are not intended to be all-inclusive, they do provide guidance
on First Trust Advisors' general voting policies.
Information regarding how the Fund voted proxies relating to portfolio
securities is available without charge, upon request, by calling (800) 621-1675
or by accessing the Securities and Exchange Commission's website at
http://www.sec.gov.
SUB-ADVISER
FIDAC, which is a registered investment adviser, will act as
Sub-Adviser to the Fund. FIDAC was formed in 1994, and is located in New York,
New York. FIDAC is a leading fixed-income management company specializing in
investing in US agency mortgage-backed and Treasury securities and managing
interest rate-sensitive strategies. From initially managing investment
strategies in separate managed accounts and its first fund, The U.S. Dollar
Floating Rate Fund, Ltd., FIDAC has grown assets under management to
approximately US$16 billion as of December 31, 2004 through nine investment
vehicles distributed in Latin America, Europe, China, Japan, Korea, Canada, the
United States, Malta and South Africa. In June of 2004, FIDAC was acquired by
Annaly Mortgage Management, Inc. ("Annaly"), a New York Stock Exchange-listed
real estate investment trust which, at December 31, 2004, owned and managed a
portfolio of approximately $20 billion in residential mortgage-backed
securities. The following is a brief description of the background of the key
management personnel of FIDAC.
There is no one individual primarily responsible for portfolio
management decisions for the Fund. Investments are made under the direction of a
team of FIDAC professionals led by Michael A.J. Farrell, Wellington
Denahan-Norris, Jennifer Karve, James Fortescue, Kristopher Konrad and
Rose-Marie Lyght. Mr. Farrell is the Chief Executive Officer, President and
founder of FIDAC and Chairman, Chief Executive Officer and President of Annaly.
Mrs. Denahan-Norris is the Executive Vice-President and Chief Investment Officer
of FIDAC and Vice Chairman, Chief Investment Officer and founder of Annaly
and has been with both companies since their inception. Ms. Karve is an
Executive Vice-President and Senior Portfolio Manager for FIDAC and Executive
Vice-President and Senior Portfolio Manager for Annaly. Ms. Karve joined FIDAC
in 1994. Mr. Fortescue is a Senior Vice-President and Head of Financing for
-41-
FIDAC and Annaly. Mr. Fortescue joined FIDAC in 1995. Mr. Konrad is a Senior
Vice-President and Portfolio Manager for FIDAC and Annaly. Mr. Konrad joined
both companies in 1997. Ms. Lyght is a Senior Vice-President and Portfolio
Manager for FIDAC and Annaly. Ms. Lyght joined both companies in 1999. The SAI
provides additional information about the portfolio managers' compensation,
other accounts managed by the portfolio managers and their ownership of shares
of the Fund.
The portfolio managers also have responsibility for the day-to-day
management of accounts other than the Fund, including separate accounts and
unregistered funds. The advisory fees received by FIDAC in connection with the
management of the Fund and other accounts are not based on the performance of
the Fund or the other accounts. Information regarding those other accounts is
set forth below.
----------------------------------------------------------------------------------------------------------------------
Number of Other Accounts Managed and Assets by Account Type
As of December 31, 2004
----------------------------------------------------------------------------------------------------------------------
Portfolio Manager* Registered Investment Other Pooled Investment Other Accounts
Companies Vehicles
(other than the Funds)
------------------------------- ---------------------------- ---------------------------- ----------------------------
Michael A.J. Farrell Number: Number: Number:
Assets: $ Assets: $ Assets: $
------------------------------- ---------------------------- ---------------------------- ----------------------------
Wellington Denahan-Norris Number: Number: Number:
Assets: $ Assets: $ Assets: $
------------------------------- ---------------------------- ---------------------------- ----------------------------
Jennifer Karve Number: Number: Number:
Assets: $ Assets: $ Assets: $
------------------------------- ---------------------------- ---------------------------- ----------------------------
James Fortescue Number: Number: Number:
Assets: $ Assets: $ Assets: $
------------------------------- ---------------------------- ---------------------------- ----------------------------
Kristopher Konrad Number: Number: Number:
Assets: $ Assets: $ Assets: $
------------------------------- ---------------------------- ---------------------------- ----------------------------
Rose-Marie Lyght Number: Number: Number:
Assets: $ Assets: $ Assets: $
------------------------------- ---------------------------- ---------------------------- ----------------------------
* Each of the Portfolio Managers set forth in the above table also have
responsibility for the day-to-day management of Annaly Mortgage Management,
Inc., a New York Stock Exchange-listed real estate investment trust which, at
December 31, 2004, owned and managed a portfolio of approximately $20 billion in
residential mortgage-backed securities.
As shown in the table above, certain portfolio managers may manage
other accounts with investment strategies similar to the Fund. Fees earned by
FIDAC may vary among these accounts. These factors could create conflicts of
interest if a portfolio manager identified a limited investment opportunity that
may be appropriate for more than one account, but the Fund is not able to take
full advantage of that opportunity due to the need to allocate that opportunity
among multiple accounts. In addition, the portfolio manager may execute
transactions for another account that may adversely impact the value of
securities held by the Fund. However, FIDAC believes that these risks are
mitigated by the fact that: (i) accounts with like investment strategies managed
by a particular portfolio manager are generally managed in a similar fashion,
subject to exceptions to account for particular investment restrictions or
policies applicable only to certain accounts, differences in cash flows and
account sizes, and similar factors; (ii) the securities in which the Fund will
invest are typically highly rated liquid securities; and (iii) the portfolio
-42-
managers do not invest personally in any of these accounts. In addition, FIDAC
has adopted trade allocation procedures that require equitable allocation of
trade orders for a particular security among participating accounts.
As of February 28, 2005, the portfolio managers receive all of their
compensation from FIDAC and its parent company, Annaly. Michael A.J. Farrell,
Wellington Denahan-Norris, Jennifer Karve, James Fortescue, Kristopher Konrad
and Rose-Marie Lyght. Each received compensation in the form of salary as well
as an annual discretionary bonus. Discretionary bonuses are determined by
Annaly's compensation committee after consideration of several factors including
but not necessarily limited to:
(a) Individual performance;
(b) Annaly's overall performance; and
(c) Other factors the compensation committee determines to be
appropriate.
At December 31, 2004, none of the portfolio managers beneficially owned
(as determined pursuant to Rule 16a-1(a)(2) under the Securities Exchange Act of
1934 Act (the "1934 Act") any shares of the Fund.
The Sub-Adviser, subject to the Board of Trustees' and Adviser's
supervision, provides the Fund with discretionary investment services.
Specifically, the Sub-Adviser is responsible for managing the investments of the
Fund in accordance with the Fund's investment objectives, policies, and
restrictions as provided in the Prospectus and this Statement of Additional
Information, as may be subsequently changed by the Board of Trustees. The
Sub-Adviser further agrees to conform to all applicable laws and regulations of
the Securities and Exchange Commission in all material respects and to conduct
its activities under the Sub-Advisory Agreement in accordance with applicable
regulations of any governmental authority pertaining to its investment advisory
services. In the performance of its duties, the Sub-Adviser will satisfy its
fiduciary duties to the Fund, will monitor the Fund's investments, and will
comply with the provisions of the Fund's Declaration and By-laws, and the stated
investment objectives, policies and restrictions of the Fund. The Sub-Adviser is
responsible for effecting all security transactions for the Fund's assets. The
Sub-Advisory Agreement provides that the Sub-Adviser shall not be liable for any
loss suffered by the Fund or the Adviser (including, without limitation, by
reason of the purchase, sale or retention of any security) in connection with
the performance of the Sub-Adviser's duties under the Sub-Advisory Agreement,
except for a loss resulting from willful misfeasance, bad faith or gross
negligence on the part of the Sub-Adviser in performance of its duties under
such Sub-Advisory Agreement, or by reason of its reckless disregard of its
obligations and duties under such Sub-Advisory Agreement.
Pursuant to the Sub-Advisory Agreement between the Adviser, the
Sub-Adviser and the Fund, the Adviser has agreed to pay for the services and
facilities provided by the Sub-Adviser through sub-advisory fees, as set forth
in the Fund's Prospectus.
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The Sub-Advisory Agreement may be terminated without the payment of any
penalty by the Adviser, First Trust Advisors, the Fund's Board of Trustees, or a
majority of the outstanding voting securities of the Fund (as defined in the
1940 Act), upon 60 days' written notice to the Sub-Adviser.
All fees and expenses are accrued daily and deducted before payment of
dividends to investors. The Sub-Advisory Agreement has been approved by a
majority of the Independent Trustees of the Fund and the sole shareholder of the
Fund.
PORTFOLIO TRANSACTIONS AND BROKERAGE
Subject to the supervision of the Board of Trustees, the Sub-Adviser
shall have authority and discretion to select brokers and dealers to execute
transactions initiated by the Sub-Adviser and to select the market in which the
transactions will be executed. In placing orders for the sale and purchase of
securities for the Fund, the Sub-Adviser's primary responsibility shall be to
seek the best execution of orders at the most favorable prices. However, this
responsibility shall not obligate the Sub-Adviser to solicit competitive bids
for each transaction or to seek the lowest available commission cost to the
Fund, so long as the Sub-Adviser reasonably believes that the broker or dealer
selected by it can be expected to obtain a "best execution" market price on the
particular transaction and determines in good faith that the commission cost is
reasonable in relation to the value of the brokerage and research services (as
defined in Section 28(e)(3) of the Securities Exchange Act of 1934) provided by
such broker or dealer to the Sub-Adviser, viewed in terms of either that
particular transaction or of the Sub-Adviser's overall responsibilities with
respect to its clients, including the Fund, as to which the Sub-Adviser
exercises investment discretion, notwithstanding that the Fund may not be the
direct or exclusive beneficiary of any such services or that another broker may
be willing to charge the Fund a lower commission on the particular transaction.
Subject to compliance with the policies and procedures adopted by the
Board of Trustees for the Fund and communicated to the Sub-Adviser and to the
extent permitted by and in conformance with applicable law (including Rule 17e-1
of the 1940 Act), the Sub-Adviser may select brokers or dealers affiliated with
Sub-Adviser.
The Sub-Adviser's objective in selecting brokers and dealers and in
effecting portfolio transactions is to seek to obtain the best combination of
price and execution with respect to its clients' portfolio transactions. Steps
associated with seeking best execution are: (1) determine each client's trading
requirements; (2) select appropriate trading methods, venues, and agents to
execute the trades under the circumstances; (3) evaluate market liquidity of
each security and take appropriate steps to avoid excessive market impact; (4)
maintain client confidentiality and proprietary information inherent in the
decision to trade; and (5) review the results on a periodic basis.
In arranging for the purchase and sale of clients' portfolio
securities, the Sub-Adviser takes numerous factors into consideration. The best
net price, giving effect to brokerage commissions, spreads and other costs, is
normally an important factor in this decision, but a number of other judgmental
factors are considered as they are deemed relevant. The factors include, but are
-44-
not limited to: the execution capabilities required by the transactions; the
ability and willingness of the broker or dealer to facilitate the accounts'
portfolio transactions by participating therein for its own account; the
importance to the account of speed, efficiency and confidentiality; the broker
or dealer's apparent familiarity with sources from or to whom particular
securities might be purchased or sold; the reputation and perceived soundness of
the broker or dealer; the Sub-Adviser's knowledge of negotiated commission rates
and spreads currently available; the nature of the security being traded; the
size and type of the transaction; the nature and character of the markets for
the security to be purchased or sold; the desired timing of the trade; the
activity existing and expected in the market for the particular security;
confidentiality; the execution, clearance and settlement capabilities as well as
the reputation and perceived soundness of the broker-dealer selected and others
which are considered; the Sub-Adviser's knowledge of actual or apparent
operational problems of any broker-dealer; the broker-dealer's execution
services rendered on a continuing basis and in other transactions; the
reasonableness of spreads or commissions; as well as other matters relevant to
the selection of a broker or dealer for portfolio transactions for any account.
The Sub-Adviser does not adhere to any rigid formula in making the selection of
the applicable broker or dealer for portfolio transactions, but weighs a
combination of the preceding factors.
When buying or selling securities in dealer markets, the Sub-Adviser
generally prefers to deal directly with market makers in the securities. The
Sub-Adviser will typically effect these trades on a "net" basis, and will not
pay the market maker any commission, commission equivalent or markup/markdown
other than the "spread." Usually, the market maker profits from the "spread,"
that is, the difference between the price paid (or received) by the Sub-Adviser
and the price received (or paid) by the market maker in trades with other
broker-dealers or other customers.
The Sub-Adviser may use Electronic Communications Networks ("ECN") or
Alternative Trading Systems ("ATS") to effect such over-the-counter trades when,
in the Sub-Adviser's judgment, the use of an ECN or ATS may result in equal or
more favorable overall executions for the transactions.
When appropriate under its discretionary authority and consistent its
duty to obtain best execution and its adopted policies and procedures, the
Sub-Adviser may direct brokerage transactions for client accounts to
broker-dealers who provide the Sub-Adviser with research and brokerage products
and services. The brokerage commissions used to acquire research in these
arrangements are known as "soft dollars." While the Sub-Adviser currently does
not utilize soft dollars for its clients, including the Fund, and does not
anticipate doing so, the policy of the Sub-Adviser for such transactions is set
forth below. To the extent that the Sub-Adviser does utilize soft dollars to
acquire research, this research may be shared across all of such advisers and
any of their respective clients whose accounts may benefit from such research.
Consistent with obtaining best execution, brokerage commissions on
accounts' portfolio transactions may be directed to broker-dealers in
recognition of research services furnished by them, as well as for services
rendered in the execution of orders by such broker-dealers. As a general matter,
such research services are used to service all of the accounts of the
Sub-Adviser. However, research obtained with soft dollars may not necessarily be
utilized for the specific account that generated the soft dollars and every
-45-
research service may not necessarily be used to service every account managed by
the respective adviser. The Sub-Adviser does not usually attempt to allocate the
relative costs or benefits of research among client accounts because they
believe that, in the aggregate, the research received benefits clients and
assists such advisers in fulfilling their overall duty to their respective
clients. The Sub-Adviser will not enter into any agreement or understanding with
any broker-dealer who would obligate it to direct a specific amount of brokerage
transactions or commissions in return for research services.
Portfolio transactions for each client account will generally be
completed independently, except when the Sub-Adviser is in the position of
buying or selling the same security for a number of clients at approximately the
same time. Because of market fluctuations, the prices obtained on such
transactions within a single day may vary substantially. In order to avoid
having clients receive different prices for the same security on the same day,
the Sub-Adviser endeavors, when possible, to use an "averaging" procedure.
Under this procedure, purchases or sales of a particular security for
clients' accounts will at times be combined or "batched" with purchases or sales
for other advisory clients by the Sub-Adviser unless the client has expressly
directed otherwise. Such batched trades may be used to facilitate best
execution, including negotiating more favorable prices, obtaining more timely or
equitable execution or reducing overall commission charges. In such cases, the
price shown on confirmations of clients' purchases or sales will be the average
execution price on all of the purchases and sales that are aggregated for this
purpose.
The Sub-Adviser may also consider the following when deciding on
allocations: 1) cash flow changes (including available cash, redemptions,
exchanges, capital additions and capital withdrawals) may provide a basis to
deviate from a pre-established allocation as long as it does not result in an
unfair advantage to specific accounts or types of accounts over time; 2)
accounts with specialized investment objectives or restrictions emphasizing
investment in a specific category of securities may be given priority over other
accounts in allocating such securities; and 3) for bond trades, street
convention and good delivery often dictate the minimum size and par amounts and
may result in small deviations from pro rata distribution.
DESCRIPTION OF SHARES
COMMON SHARES
The beneficial interest of the Fund may be divided from time to time
into shares of beneficial interest of such classes and of such designations and
par value (if any) and with such rights, preferences, privileges and
restrictions as shall be determined by the trustees in their sole discretion,
without shareholder vote. The Fund's Declaration initially authorizes the
issuance of an unlimited number of Common Shares. The Common Shares being
offered have a par value of $0.01 per share and, subject to the rights of
holders of Preferred Shares, if issued, have equal rights as to the payment of
dividends and the distribution of assets upon liquidation of the Fund. The
Common Shares being offered will, when issued, be fully paid and, subject to
matters discussed in "Certain Provisions in the Declaration of Trust,"
-46-
non-assessable, and currently have no pre-emptive or conversion rights (except
as may otherwise be determined by the trustees in their sole discretion) or
rights to cumulative voting in the election of trustees.
The Fund intends to apply to list the Common Shares on the
__________Exchange, subject to notice of issuance, under the symbol " ." 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 NAV. NAV will be reduced immediately following the offering
after payment of the sales load and organization and offering expenses. Although
the value of the Fund's net assets is generally considered by market
participants in determining whether to purchase or sell shares, whether
investors will realize gains or losses upon the sale of Common Shares will
depend 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 Fund's Common Shares will be determined by factors beyond
the control of the Fund, the Fund cannot predict whether the Common Shares will
trade at, below, or above NAV 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. See "Repurchase of Fund Shares; Conversion to
Open-End Fund" below and "The Fund's Investments" in the Fund's Prospectus.
PREFERRED SHARE AUTHORIZATION
Under the terms of the Declaration, the Board of Trustees has the
authority in its sole discretion, without shareholder vote, to authorize the
issuance of Preferred Shares in one or more classes or series with such rights
and terms, including voting rights, dividend rates, redemption provisions,
liquidation preferences and conversion provisions as determined by the Board of
Trustees.
BORROWINGS
The Declaration authorizes the Fund, without prior approval of the
shareholders of Common Shares, to borrow money. In this connection, the Fund may
enter into reverse repurchase agreements, issue notes or other evidence of
indebtedness (including bank borrowings or commercial paper) ("Borrowings") and
may secure any such Borrowings by mortgaging, pledging or otherwise subjecting
as security the Fund's assets. In connection with such Borrowings, the Fund may
be required to maintain average balances with the lender or to pay a commitment
or other fee to maintain a line of credit. Any such requirements will increase
the cost of borrowing over the stated interest rate. The Fund intends to borrow
primarily using reverse repurchase agreements. A reverse repurchase agreement,
although structured as a sale and repurchase obligation, acts as a financing
under which the Fund will effectively pledge its securities as collateral to
secure a short-term loan. Generally, the other party to the agreement makes the
loan in an amount equal to a percentage of the market value of the pledged
collateral. At the maturity of the reverse repurchase agreement, the Fund will
be required to repay the loan and correspondingly receive back its collateral.
While used as collateral, the securities continue to pay principal and interest
-47-
which are for the benefit of the Fund. The Fund may borrow from banks and other
financial institutions.
Limitations on Borrowings. Under the requirements of the 1940 Act, the
Fund, immediately after any Borrowings, must have an "asset coverage" of at
least 300% (33 1/3 of Managed Assets after Borrowings). With respect to such
Borrowings, "asset coverage" means the ratio which the value of the total assets
of the Fund, less all liabilities and indebtedness not represented by senior
securities (as defined in the 1940 Act), bears to the aggregate amount of such
Borrowings represented by senior securities issued by the Fund. Certain types of
Borrowings may result in the Fund being subject to covenants in credit
agreements relating to asset coverages or portfolio composition or otherwise. In
addition, the Fund may be subject to certain restrictions imposed by guidelines
of one or more nationally recognized statistical rating organizations which may
issue ratings for short-term corporate debt securities or Preferred Shares
issued by the Fund. Such restrictions may be more stringent than those imposed
by the 1940 Act.
Distribution Preference. The rights of lenders to the Fund to receive
interest on and repayment of principal of any such Borrowings will be senior to
those of the Common Shareholders, and the terms of any such Borrowings may
contain provisions which limit certain activities of the Fund, including the
payment of dividends to Common Shareholders in certain circumstances.
Voting Rights. The 1940 Act grants (in certain circumstances) to the
lenders to the Fund certain voting rights in the event the asset coverage falls
below specified levels. In the event that the Fund elects to be treated as a
regulated investment company under the Code and such provisions would impair the
Fund's status as a regulated investment company, the Fund, subject to its
ability to liquidate its portfolio, intends to repay the Borrowings. Any
Borrowings will likely be ranked senior or equal to all other existing and
future borrowings of the Fund.
The discussion above describes the Fund's Board of Trustees' present
intention with respect to an offering of Borrowings. If authorized by the Board
of Trustees, the terms of any Borrowings may be the same as, or different from,
the terms described above, subject to applicable law and the Fund's Declaration.
CERTAIN PROVISIONS IN THE DECLARATION OF TRUST
Under Massachusetts law, shareholders in certain circumstances, could
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 solely by
reason of his or her being a shareholder. 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.
-48-
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. Specifically, the Declaration requires the affirmative vote
or consent by holders of at least two-thirds of the shares outstanding and
entitled to vote, except as described below, to authorize (1) a conversion of
the Fund from a closed-end to an open-end investment company, (2) a merger or
consolidation of the Fund with any corporation, association, trust or other
organization, including a series or class of such other organization (other than
a merger, consolidation, reorganization or sale of assets with an acquiring fund
that is not an operating entity immediately prior to the transaction), (3) a
sale, lease or exchange of all or substantially all of the Fund's assets (other
than in the regular course of business of the Fund, sales of assets in
connection with the termination of the Fund as provided in the Declaration, or
sale of assets with an acquiring fund that is not an operating entity
immediately prior to the transaction), (4) in certain circumstances, a
termination of the Fund, (5) removal of trustees by shareholders, or (6) certain
transactions in which a Principal Shareholder (as defined below) is a party to
the transactions. However, with respect to items (1), (2) and (3) above, if the
applicable transaction has been already approved by the affirmative vote of
two-thirds of the trustees, then the majority of the outstanding voting
securities as defined in the 1940 Act (a "Majority Shareholder Vote") is
required. In addition, if there are then Preferred Shares outstanding, with
respect to (1) above, two-thirds of the preferred shares voting as a separate
class shall also be required unless the action has already been approved by
two-thirds of the trustees, in which case then a Majority Shareholder Vote is
required. Such affirmative vote or consent shall be in addition to the vote or
consent of the holders of the shares otherwise required by law or by the terms
of any class or series of preferred shares, whether now or hereafter authorized,
or any agreement between the Fund and any national securities exchange. Further,
in the case of items (2) or (3) that constitute a plan of reorganization (as
such term is used in the 1940 Act) which adversely affects the Preferred Shares
within the meaning of section 18(a)(2)(D) of the 1940 Act, except as may
otherwise be required by law, the approval of the action in question will also
require the affirmative vote of two-thirds of the Preferred Shares voting as a
separate class provided, however, that such separate class vote shall be by a
Majority Shareholder Vote if the action in question has previously been approved
by the affirmative vote of two-thirds of the trustees.
Approval of shareholders is not required, however, for any transaction,
whether deemed a merger, consolidation, reorganization or otherwise whereby the
Fund issues shares in connection with the acquisition of assets (including those
subject to liabilities) from any other investment company or similar entity.
None of the foregoing provisions may be amended except by the vote of at least
two-thirds of the Shares outstanding and entitled to vote.
As noted above, pursuant to the Declaration, the affirmative approval
of two-thirds of the Shares outstanding and entitled to vote, subject to certain
exceptions, shall be required for the following transactions in which a
Principal Shareholder (as defined below) is a party: (i) the merger or
consolidation of the Fund or any subsidiary of the Fund with or into any
Principal Shareholder; (ii) the issuance of any securities of the Fund to any
Principal Shareholder for cash other than pursuant to a dividend reinvestment or
similar plan available to all shareholders; (iii) the sale, lease or exchange of
all or any substantial part of the assets of the Fund to any Principal
Shareholder (except assets having an aggregate fair market value of less than
$1,000,000, aggregating for the purpose of such computation all assets sold,
-49-
leased or exchanged in any series of similar transactions within a twelve-month
period); (iv) the sale, lease or exchange to the Fund or any subsidiary thereof,
in exchange for securities of the Fund, of any assets of any Principal
Shareholder (except assets having an aggregate fair market value of less than
$1,000,000, aggregating for the purposes of such computation all assets sold,
leased or exchanged in any series of similar transactions within a twelve-month
period). However, shareholder approval for the foregoing transactions shall not
be applicable to (i) any transaction, including, without limitation, any rights
offering, made available on a pro rata basis to all shareholders of the Fund or
class thereof unless the trustees specifically make such transaction subject to
this voting provision, (ii) any transaction if the trustees shall by resolution
have approved a memorandum of understanding with such Principal Shareholder with
respect to and substantially consistent with such transaction or (iii) any such
transaction with any corporation of which a majority of the outstanding shares
of all classes of stock normally entitled to vote in elections of directors is
owned of record or beneficially by the Fund and its subsidiaries. As described
in the Declaration, a Principal Shareholder shall mean any corporation, person
or other entity which is the beneficial owner, directly or indirectly, of more
than 5% of the outstanding shares and shall include any affiliate or associate
(as such terms are defined in the Declaration) of a Principal Shareholder. The
above affirmative vote shall be in addition to the vote of the shareholders
otherwise required by law or by the terms of any class or series of preferred
shares, whether now or hereafter authorized, or any agreement between the Fund
and any national securities exchange.
The provisions of the Declaration described above could have the effect
of depriving the Common Shareholders of opportunities to sell their Common
Shares at a premium over market value by discouraging a third party from seeking
to obtain control of the Fund in a tender offer or similar transaction. The
overall effect of these provisions is to render more difficult the
accomplishment of a merger or the assumption of control by a third party. They
provide, however, the advantage of potentially requiring persons seeking control
of a 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
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 and its
Common Shareholders.
Reference should be made to the Declaration on file with the Securities
and Exchange Commission for the full text of these provisions.
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 to any person in
connection with the Fund property or the affairs of the Fund or for any neglect
or wrongdoing of any officer, employee or agent of the Fund or for the act or
omission of any other trustee. Nothing in the Declaration, however, protects a
trustee against any liability to which he or she 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 with or on behalf of the
Fund.
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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 Fund's 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), NAV, call protection, price, dividend stability,
relative demand for and supply of such shares in the market, general market and
economic conditions and other factors. Because shares of a closed-end investment
company may frequently trade at prices lower than NAV, the trustees, in
consultation with the Fund's Adviser, Sub-Adviser and any corporate finance
services and consulting agent that the Adviser may retain, from time to time may
review possible actions to reduce any such discount. Actions may include the
repurchase of such shares in 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. There can be no assurance, however, that the
trustees will decide to take any of these actions, or that share repurchases or
tender offers, if undertaken, will reduce a market discount. After any
consideration of potential actions to seek to reduce any significant market
discount, the trustees may, subject to their fiduciary obligations and
compliance with applicable state and federal laws, authorize the commencement of
a share-repurchase program or tender offer. The size and timing of any such
share repurchase program or tender offer will be determined by the trustees in
light of the market discount of the Common Shares, trading volume of the Common
Shares, information presented to the trustees regarding the potential impact of
any such share repurchase program or tender offer, and general market and
economic conditions. There can be no assurance that the Fund will in fact effect
repurchases of or tender offers for any of its Common Shares. In addition, any
service fees incurred in connection with any tender offer made by the Fund will
be borne by the Fund and will not reduce the stated consideration to be paid to
tendering Shareholders. Before deciding whether to take any action if the Fund's
Common Shares trade below NAV, the 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 trustees may determine that,
in the interest of the Fund and its Shareholders, no action should be taken.
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 increase the Fund's
expenses and reduce the Fund's net income. Any share repurchase, tender offer or
borrowing that might be approved by the trustees would have to comply with the
Securities Exchange Act of 1934, as amended, and the 1940 Act and the rules and
regulations thereunder.
Although the decision to take action in response to a discount from NAV
will be made by the trustees at the time they consider such issue, it is the
trustees' present policy, which may be changed by the trustees, not to authorize
repurchases of Common Shares or a tender offer for such shares if (1) such
transactions, if consummated, would (a) result in the delisting of the Common
Shares from the _______________ Exchange, or (b) impair status as a registered
closed-end investment company under the 1940 Act; (2) the Fund would not be able
-51-
to liquidate portfolio securities in an orderly manner and consistent with the
Fund's investment objectives and policies in order to repurchase shares; or (3)
there is, in the Board's judgment, any (a) material legal action or proceeding
instituted or threatened challenging such transactions or otherwise materially
adversely affecting the Fund, (b) general suspension of or limitation on prices
for trading securities on the _______________ Exchange, (c) declaration of a
banking moratorium by Federal or state authorities or any suspension of payment
by United States or state banks in which the Fund invests, (d) material
limitation affecting the Fund or the issuers of its portfolio securities by
Federal or state authorities on the extension of credit by lending institutions
or on the exchange of non-U.S. currency, (e) commencement of war, armed
hostilities or other international or national calamity directly or indirectly
involving the United States or (f) other event or condition which would have a
material adverse effect (including any adverse tax effect) on the Fund or its
shareholders if shares were repurchased. The trustees may in the future modify
these conditions in light of experience with respect to the Fund.
Conversion to an open-end company would require the approval of the
holders of at least two-thirds of the Fund's shares outstanding and entitled to
vote; provided, however, that unless otherwise provided by law, if there are
Preferred Shares outstanding, the affirmative vote of two-thirds of the
Preferred Shares voting as a separate class shall be required; provided,
however, that such votes shall be by the affirmative vote of the majority of the
outstanding voting securities, as defined in the 1940 Act, if the action in
question was previously approved by the affirmative vote of two-thirds of the
trustees. Such affirmative vote or consent shall be in addition to the vote or
consent of the holders of the shares otherwise required by law or by the terms
of any class or series of preferred shares, whether now or hereafter authorized,
or any agreement between the Fund and any national securities exchange. See the
Prospectus under "Closed-End Fund Structure" for a discussion of voting
requirements applicable to conversion of the Fund to an open-end company. If the
Fund converted to an open-end company, the Fund's Common Shares would no longer
be listed on the _______________ Exchange. Any Preferred Shares or other
Borrowings would need to be redeemed or repaid upon conversion to an open-end
investment company. 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 NAV, less such
redemption charge or contingent deferred sales change, 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 trustees may at any time propose conversion
of the Fund to an open-end company depending upon their judgment as to the
advisability of such action in light of circumstances then prevailing.
The repurchase by the Fund of its shares at prices below NAV will
result in an increase in the NAV of those shares that remain outstanding.
However, there can be no assurance that share repurchases or tenders at or below
NAV will result in the Fund's shares trading at a price equal to their NAV.
Nevertheless, the fact that the Fund's shares may be the subject of repurchase
or tender offers from time to time may reduce any spread between market price
and NAV that might otherwise exist.
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In addition, a purchase by the Fund of its Common Shares will decrease
the Fund's Managed Assets which would likely have the effect of increasing the
Fund's expense ratio.
FEDERAL INCOME TAX MATTERS
The following discussion of federal income tax matters is based upon
the advice of Chapman and Cutler LLP, counsel to the Fund.
GENERAL
Set forth below is a discussion of certain U.S. federal income tax
issues concerning the Fund and the purchase, ownership and disposition of Fund
shares. This discussion does not purport to be complete or to deal with all
aspects of federal income taxation that may be relevant to shareholders in light
of their particular circumstances. This discussion also does not address the tax
consequences to shareholders that are subject to special rules, including
without limitation, banks or financial institutions, insurance companies,
dealers in securities, non-U.S. shareholders, tax-exempt or tax-deferred plans,
accounts or entities, shareholders that are subject to the alternative minimum
tax or shareholders that holds their shares as or in a hedge against currency
risk, constructive sale or a conversion transaction. Unless otherwise noted,
this discussion assumes you are a U.S. shareholder and that you hold your shares
as a capital asset. This discussion is based upon present provisions of the
Code, the regulations promulgated thereunder, and judicial and administrative
ruling authorities, all of which are subject to change, which change may be
retroactive. In addition, this discussion does not address state, local or
foreign tax consequences. Prospective investors should consult their own tax
advisors with regard to the federal tax consequences of the purchase, ownership,
or disposition of Fund shares, as well as the tax consequences arising under the
laws of any state, locality, non-U.S. country, or other taxing jurisdiction.
The Fund intends to qualify annually and to elect to be treated as a
regulated investment company under the Code and to comply with applicable
distribution requirements so that it will not pay federal income tax on income
and capital gains distributed to its shareholders.
To qualify for the favorable U.S. federal income tax treatment
generally accorded to regulated investment companies, the Fund must, among other
things, (a) derive in each taxable year at least 90% of its gross income from
dividends, interest, payments with respect to securities loans and gains from
the sale or other disposition of stock, securities or foreign currencies or
other income derived with respect to its business of investing in such stock,
securities or currencies; (b) diversify its holdings so that, at the end of each
quarter of the taxable year, (i) at least 50% of the market value of the Fund's
assets is represented by cash and cash items (including receivables), U.S.
government securities, the securities of other regulated investment companies
and other securities, with such other securities of any one issuer generally
limited for the purposes of this calculation to an amount not greater than 5% of
the value of the Fund's total assets and not greater than 10% of the outstanding
voting securities of such issuer, and (ii) not more than 25% of the value of its
total assets is invested in the securities (other than U.S. government
securities or the securities of other regulated investment companies) of any one
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issuer, or two or more issuers which the Fund controls and are engaged in the
same, similar or related trades or businesses; and (c) distribute at least 90%
of its investment company taxable income (which includes, among other items,
dividends, interest and net short-term capital gains in excess of net long-term
capital losses) and at least 90% of its net tax-exempt interest income each
taxable year.
As a regulated investment company, the Fund generally will not be
subject to U.S. federal income tax on its investment company taxable income (as
that term is defined in the Code, but without regard to the deduction for
dividends paid) and net capital gain (the excess of net long-term capital gain
over net short-term capital loss), if any, that it distributes to shareholders.
The Fund intends to distribute to its shareholders, at least annually,
substantially all of its investment company taxable income and net capital gain.
If the Fund retains any net capital gain or investment company taxable income,
it will generally be subject to federal income tax at regular corporate rates on
the amount retained. In addition, amounts not distributed on a timely basis in
accordance with a calendar year distribution requirement are subject to a
nondeductible 4% excise tax unless, generally, the Fund distributes during each
calendar year an amount equal to the sum of (1) at least 98% of its ordinary
income (not taking into account any capital gains or losses) for the calendar
year, (2) at least 98% of its capital gains in excess of its capital losses
(adjusted for certain ordinary losses) for the one-year period ending October 31
of the calendar year, and (3) any ordinary income and capital gains for previous
years that were not distributed during those years. To prevent application of
the excise tax, the Fund intends to make its distributions in accordance with
the calendar year distribution requirement. A distribution will be treated as
paid on December 31 of the current calendar year if it is declared by the Fund
in October, November or December with a record date in such a month and paid by
the Fund during January of the following calendar year. These distributions will
be taxable to shareholders in the calendar year in which the distributions are
declared, rather than the calendar year in which the distributions are received.
If the Fund failed to qualify as a regulated investment company or
failed to satisfy the 90% distribution requirement in any taxable year, the Fund
would be taxed as an ordinary corporation on its taxable income (even if such
income were distributed to its shareholders) and all distributions out of
earnings and profits would be taxed to shareholders as ordinary income.
DISTRIBUTIONS
Dividends paid out of the Fund's investment company taxable income
generally are taxable to a shareholder as ordinary income to the extent of the
Fund's earnings and profits, whether paid in cash or reinvested in additional
shares. However, pursuant to the "Jobs and Growth Tax Relief Reconciliation Act
of 2003" (the "Tax Act"), if the Fund holds certain equity securities, certain
ordinary income distributions that are designated by the Fund and received from
the Fund may be taxed at new lower tax rates. In particular, under the Tax Act,
a portion of the ordinary income dividends received by an individual shareholder
from a regulated investment company such as the Fund are generally taxed at the
same new rates that apply to net capital gain, provided certain holding period
requirements are satisfied and provided the dividends are attributable to
"qualified dividends" received by the Fund itself. Dividends received by the
Fund from REITs and foreign corporations are qualified dividends eligible for
-54-
this lower tax rate only in certain circumstances. These special rules relating
to the taxation of ordinary income dividends from regulated investment companies
generally apply to taxable years beginning before January 1, 2009. The Fund
generally does not expect to generate qualified dividends eligible for the new
lower tax rates.
Distributions of net capital gain (the excess of net long-term capital
gain over net short-term capital loss), if any, properly designated as capital
gain dividends are taxable to a shareholder as long-term capital gains,
regardless of how long the shareholder has held Fund shares. Shareholders
receiving distributions in the form of additional shares, rather than cash,
generally will have a cost basis in each such share equal to the value of a
share of the Fund on the reinvestment date. A distribution of an amount in
excess of the Fund's current and accumulated earnings and profits will be
treated by a shareholder as a return of capital which is applied against and
reduces the shareholder's tax basis in his or her shares. To the extent that the
amount of any distribution exceeds the shareholder's basis in his or her shares,
the excess will be treated by the shareholder as gain from a sale or exchange of
the shares.
Shareholders will be notified annually as to the U.S. federal income
tax status of distributions, and shareholders receiving distributions in the
form of additional shares will receive a report as to the value of those shares.
DIVIDENDS RECEIVED DEDUCTION
A corporation that owns shares generally will not be entitled to the
dividends received deduction with respect to dividends received from the Fund
because the dividends received deduction is generally not available for
distributions from regulated investment companies. However, if the Fund holds
equity securities, certain ordinary income dividends on shares that are
attributable to dividends received by the Fund from certain domestic
corporations may be designated by the Fund as being eligible for the dividends
received deduction, but this amount is not expected to be significant.
SALE OR EXCHANGE OF FUND SHARES
Upon the sale or other disposition of shares of the Fund, which a
shareholder holds as a capital asset, a shareholder may realize a capital gain
or loss which will be long-term or short-term, depending upon the shareholder's
holding period for the shares. Generally, a shareholder's gain or loss will be a
long-term gain or loss if the shares have been held for more than one year.
Any loss realized on a sale or exchange will be disallowed to the
extent that shares disposed of are replaced (including through reinvestment of
dividends) within a period of 61 days beginning 30 days before and ending 30
days after disposition of shares or to the extent that the shareholder, during
such period, acquires or enters into an option or contract to acquire,
substantially identical stock or securities. In this case, the basis of the
shares acquired will be adjusted to reflect the disallowed loss. Any loss
realized by a shareholder on a disposition of Fund shares held by the
shareholder for six months or less will be treated as a long-term capital loss
-55-
to the extent of any distributions of net capital gain received by the
shareholder with respect to the shares.
NATURE OF THE FUND'S INVESTMENTS
Certain of the Fund's investment practices may be subject to special
and complex federal income tax provisions that may, among other things, (1)
disallow, suspend or otherwise limit the allowance of certain losses or
deductions, (2) convert lower taxed long-term capital gain into higher taxed
short-term capital or ordinary income, (3) convert an ordinary loss or a
deduction into a capital loss (the deductibility of which is more limited), (4)
cause the Fund to recognize income or gain without a corresponding receipt of
cash, (5) adversely affect the time as to when a purchase or sale of stock or
securities is deemed to occur and (6) adversely alter the characterization of
certain complex financial transactions. The Fund will monitor its transactions,
will make the appropriate tax elections and take appropriate actions in order to
mitigate the effect of these rules and prevent disqualification of the Fund from
being taxed as a regulated investment company (including disposing of certain
investments to generate cash or borrowing cash to satisfy its distribution
requirements). The ability to deduct capital losses may otherwise be limited.
INVESTMENT IN SECURITIES OF UNCERTAIN TAX CHARACTER
The Fund may invest in preferred securities or other securities the
U.S. federal income tax treatment of which may not be clear or may be subject to
recharacterization by the Internal Revenue Service. To the extent the tax
treatment of such securities or the income from such securities differs from the
tax treatment expected by the Fund, it could affect the timing or character of
income recognized by the Fund, requiring the Fund to purchase or sell
securities, or otherwise change its portfolio, in order to comply with the tax
rules applicable to regulated investment companies under the Code.
BACKUP WITHHOLDING
The Fund may be required to withhold U.S. federal income tax from all
taxable distributions and sale proceeds payable to shareholders who fail to
provide the Fund with their correct taxpayer identification number or to make
required certifications, or who have been notified by the Internal Revenue
Service that they are subject to backup withholding. The withholding percentage
is 28% until 2011, when the percentage will revert to 31% unless amended by
Congress. Corporate shareholders and certain other shareholders specified in the
Code generally are exempt from backup withholding. This withholding is not an
additional tax. Any amounts withheld may be credited against the shareholder's
U.S. federal income tax liability.
NON-U.S. SHAREHOLDERS
U.S. taxation of a shareholder who, as to the United States, is a
nonresident alien individual, a foreign trust or estate, a foreign corporation
-56-
or foreign partnership ("non-U.S. Shareholder") depends on whether the income of
the Fund is "effectively connected" with a U.S. trade or business carried on by
the shareholder.
Income Not Effectively Connected. If the income from the Fund is not
"effectively connected" with a U.S. trade or business carried on by the non-U.S.
shareholder, distributions of investment company taxable income will generally
be subject to U.S. tax of 30% (or lower treaty rate), which tax is generally
withheld from such distributions, subject to certain exceptions described below.
Distributions of capital gain dividends and any amounts retained by the
Fund which are designated as undistributed capital gains will not be subject to
U.S. tax at the rate of 30% (or lower treaty rate) unless the non-U.S.
shareholder is a nonresident alien individual and is physically present in the
United States for more than 182 days during the taxable year and meets certain
other requirements. However, this 30% tax on capital gains of nonresident alien
individuals who are physically present in the United States for more than the
182 day period only applies in exceptional cases because any individual present
in the United States for more than 182 days during the taxable year is generally
treated as a resident for U.S. income tax purposes; in that case, he or she
would be subject to U.S. income tax on his or her worldwide income at the
graduated rates applicable to U.S. citizens, rather than the 30% U.S. tax. In
the case of a non-U.S. shareholder who is a nonresident alien individual, the
Fund may be required to withhold U.S. income tax from distributions of net
capital gain unless the non-U.S. shareholder certifies his or her non-U.S.
status under penalties of perjury or otherwise establishes an exemption. If a
non-U.S. shareholder is a nonresident alien individual, any gain such
shareholder realizes upon the sale or exchange of such shareholder's shares of
the Fund in the United States will ordinarily be exempt from U.S. tax unless the
gain is U.S. source income and such shareholder is physically present in the
United States for more than 182 days during the taxable year and meets certain
other requirements. In the case of dividends with respect to taxable years of
the Fund beginning after 2004 and prior to 2008, distributions from the Fund
that are properly designated by the Fund as short-term capital gain dividends
attributable to certain short-term capital gains recognized by the Fund are
subject to similar rules.
In the case of dividends with respect to taxable years of the Fund
beginning after 2004 and prior to 2008, distributions from the Fund that are
properly designated by the Fund as interest-related dividends attributable to
certain interest received by the Fund may not be subject to U.S. federal income
tax when received by certain non-U.S. shareholders, provided the Fund makes
certain elections and certain conditions are met.
Income Effectively Connected. If the income from the Fund is
"effectively connected" with a U.S. trade or business carried on by a non-U.S.
shareholder, then distributions of investment company taxable income and capital
gain dividends, any amounts retained by the Fund which are designated as
undistributed capital gains and any gains realized upon the sale or exchange of
shares of the Fund will be subject to U.S. income tax at the graduated rates
applicable to U.S. citizens, residents and domestic corporations. Non-U.S.
corporate shareholders may also be subject to the branch profits tax imposed by
the Code. The tax consequences to a non-U.S. shareholder entitled to claim the
benefits of an applicable tax treaty may differ from those described herein.
-57-
Non-U.S. shareholders are advised to consult their own tax advisors with respect
to the particular tax consequences to them of an investment in the Fund.
PERFORMANCE RELATED AND COMPARATIVE INFORMATION
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. In reports or other communications to shareholders of
the Fund or in advertising materials, the Fund may compare its performance with
that of (i) other investment companies listed in the rankings prepared by
Lipper, Inc., Morningstar Inc. or other independent services; publications such
as Barrons, Business Week, Forbes, Fortune, Institutional Investor, Kiplinger's
Personal Finance, Money, Morningstar Mutual Fund Values, The New York Times, The
Wall Street Journal and USA Today; or other industry or financial publications
or (ii) the Lehman Brothers MBS Fixed Rate Index and other relevant indices and
industry publications. The Fund may also compare the historical volatility of
its portfolio to the volatility of such indices during the same time periods.
(Volatility is a generally accepted barometer of the market risk associated with
a portfolio of securities and is generally measured in comparison to the stock
market as a whole -- the beta -- or in absolute terms -- the standard
deviation.) 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
and Lipper Inc., that the Fund believes to be generally accurate.
The Fund may, from time to time, show the standard deviation of either
the Fund or the Fund's investment strategy and the standard deviation of the
Fund's benchmark index. Standard deviation is a statistical measure of the
historical volatility of a portfolio. Standard deviation is the measure of
dispersion of historical returns around the mean rate of return.
From time to time, the Fund may quote the Fund's total return,
aggregate total return or yield in advertisements or in reports and other
communications to shareholders. The Fund's performance will vary depending upon
market conditions, the composition of its portfolio and its operating expenses.
Consequently any given performance quotation should not be considered
representative of the Fund's performance in the future. In addition, because
performance will fluctuate, it may not provide a basis for comparing an
investment in the Fund with certain bank deposits or other investments that pay
a fixed yield for a stated period of time. Investments comparing the Fund's
performance with that of other investment companies should give consideration to
the quality and type of the respective investment companies' portfolio
securities.
The Fund's "average annual total return" is computed according to a
formula prescribed by the Securities and Exchange Commission. The formula can be
expressed as follows:
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Average Annual Total Return will be computed as follows:
ERV = P(1+T)/n/
Where P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1,000
payment made at the beginning of the 1-, 5-, or 10-year
periods at the end of the 1-, 5-, or 10-year periods (or
fractional portion).
The Fund may also quote after-tax total returns to show the impact of
assumed federal income taxes on an investment in the Fund. The Fund's total
return "after taxes on distributions" shows the effect of taxable distributions,
but not any taxable gain or loss, on an investment in shares of the Fund for a
specified period of time. The Fund's total return "after taxes on distributions
and sale of Fund shares" shows the effect of both taxable distributions and any
taxable gain or loss realized by the shareholder upon the sale of fund shares at
the end of a specified period. To determine these figures, all income,
short-term capital gain distributions, and long-term capital gains distributions
are assumed to have been taxed at the highest marginal individualized federal
tax rate then in effect. Those maximum tax rates are applied to distributions
prior to reinvestment and the after-tax portion is assumed to have been
reinvested in the Fund. State and local taxes are ignored.
Actual after-tax returns depend on a shareholder's tax situation and
may differ from those shown. After-tax returns reflect past tax effects and are
not predictive of future tax effects.
Average Annual Total Return (After Taxes on Distributions) will be
computed as follows:
ATV/D/ = P(1+T)/n/
Where: P = a hypothetical initial investment of $1,000
T = average annual total return (after taxes on distributions)
n = number of years
ATV/D/ = ending value of a hypothetical $1,000 investment made
at the beginning of the period, at the end of the period
(or fractional portion thereof), after taxes on fund
distributions but not after taxes on redemptions.
Average Annual Total Return (After Taxes on Distributions and Sale of
Fund Shares) will be computed as follows:
ATV/DR/ = P(1+T)/n/
Where: P = a hypothetical initial investment of $1,000
T = average annual total return (after taxes on distributions
and redemption)
n = number of years
ATV/DR/ = ending value of a hypothetical $1,000 investment made
at the beginning periods, at the end of the periods (or
fractional portion thereof), after taxes on fund
distributions and redemptions.
-59-
Quotations of yield for the Fund will be based on all investment income
per share earned during a particular 30-day period (including dividends and
interest), less expenses accrued during the period ("net investment income") and
are computed by dividing net investment income by the maximum offering price per
share on the last day of the period, according to the following formula:
Yield = 2 [( a-b/cd +1)/6/ - 1]
Where: a = dividends and interest earned during the period
b = expenses accrued for the period (net of reimbursements)
c = the average daily number of shares outstanding during the
period that were entitled to receive dividends
d = the maximum offering price per share on the last day
of the period
Past performance is not indicative of future results. At the time
Common Shareholders sell their shares, they may be worth more or less than their
original investment.
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Financial Statements of the Fund as of _______________, 2005,
appearing in this Statement of Additional Information have been audited by
Deloitte & Touche LLP, an independent registered public accounting firm, as set
forth in their report thereon appearing elsewhere herein, and is included in
reliance upon such report given upon the authority of such firm as experts in
accounting and auditing. Deloitte & Touche LLP audits and reports on the Fund's
annual financial statements, and performs other professional accounting,
auditing and advisory services when engaged to do so by the Fund. The principal
business address of Deloitte & Touche LLP is 180 North Stetson Avenue, Chicago,
Illinois 60601.
CUSTODIAN, ADMINISTRATOR AND TRANSFER AGENT
PFPC Trust Company, 301 Bellevue Parkway, Wilmington, Delaware 19809,
serves as custodian for the Fund. As such, PFPC Trust Company has custody of all
securities and cash of the Fund and attends to the collection of principal and
income and payment for and collection of proceeds of securities bought and sold
by the Fund. PFPC Inc., 301 Bellevue Parkway, Wilmington, Delaware 19809 is the
transfer, registrar, dividend disbursing agent and shareholder servicing agent
for the Fund and provides certain clerical, bookkeeping, shareholder servicing
and administrative services necessary for the operation of the Fund and
maintenance of shareholder accounts. PFPC Inc. also provides certain accounting
and administrative services to the Fund pursuant to an Administration and
Accounting Services Agreement, including maintaining the Fund's books of
account, records of the Fund's securities transactions, and certain other books
and records; acting as liaison with the Fund's independent registered public
accounting firm by providing such accountant certain Fund accounting
information; and providing other continuous accounting and administrative
services.
-60
ADDITIONAL INFORMATION
A Registration Statement on Form N-2, including amendments thereto,
relating to the shares of the Fund offered hereby, has been filed by the Fund
with the Securities and Exchange Commission. The Fund's 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
hereby, reference is made to the Fund's Registration Statement. Statements
contained in the Fund's 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 the
contract or other document filed as an exhibit to the Registration Statement,
each statement being qualified in all respects by such reference. Copies of the
Registration Statement may be inspected without charge at the Securities and
Exchange Commission's principal office in Washington, D.C., and copies of all or
any part thereof may be obtained from the Securities and Exchange Commission
upon the payment of certain fees prescribed by the Securities and Exchange
Commission.
-61-
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Trustees and Shareholder of
First Trust/FIDAC Mortgage Income Fund:
We have audited the accompanying statement of assets and liabilities of First
Trust/FIDAC Mortgage Income Fund (the "Fund"), as of _____________, 2005. This
statement of assets and liabilities is the responsibility of the Fund's
management. Our responsibility is to express an opinion on this statement of
assets and liabilities based on our audit.
We conducted our audits in accordance with standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the statement
of net asset is free of material misstatement. An audit includes consideration
of internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the Funds' internal control over
financial reporting. Accordingly, we express no such opinion. An audit also
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the statements of net assets, assessing the accounting principles
used and significant estimates made by the Funds' Sponsor, as well as evaluating
the overall presentation of the statements of net assets. Our procedures
included confirmation of cash owned of ___________, 2005, by correspondence with
the Fund's custodian. We believe that our audit provides a reasonable basis for
our opinion.
In our opinion, the statement of assets and liabilities referred to above
presents fairly, in all material respects, the financial position of First
Trust/FIDAC Mortgage Income Fund as of __________, 2005, in conformity with
accounting principles generally accepted in the United States of America.
DELOITTE & TOUCHE LLP
Chicago, Illinois
________, 2005
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FIRST TRUST/FIDAC MORTGAGE INCOME FUND
STATEMENT OF ASSETS AND LIABILITIES
-63-
FIRST TRUST/FIDAC MORTGAGE INCOME FUND
______________ COMMON SHARES
STATEMENT OF ADDITIONAL INFORMATION
_______________, 2005
-Back Cover-
APPENDIX A
DESCRIPTION OF RATINGS
Standard & Poor's Corporation -- A brief description of the applicable
Standard & Poor's Corporation, a division of The McGraw-Hill Companies
("Standard & Poor's" or "S&P") rating symbols and their meanings (as published
by S&P) follows:
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. It
takes into consideration the creditworthiness of guarantors, insurers, or other
forms of credit enhancement on the obligation. 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.
LONG-TERM ISSUE CREDIT 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; and
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 ratings 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.
A-1
"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.
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.
"c"
The "c" subscript is used to provide additional information to
investors that the bank may terminate its obligation to purchase tendered bonds
if the long-term credit rating of the issuer is below an investment-grade level
and/or the issuer's bonds are deemed taxable.
"p"
The letter "p" indicates that the rating is provisional. A provisional
rating assumes the successful completion of the project financed by the debt
being rated and indicates that payment of debt service requirements is largely
or entirely dependent upon the successful, 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.
"*"
Continuance of the ratings is contingent upon Standard & Poor's receipt
of an executed copy of the escrow agreement or closing documentation confirming
investments and cash flows.
A-2
"r"
The "r" highlights derivative, hybrid, and certain other obligations
that Standard & Poor's believes may experience high volatility or high
variability in expected returns as a result of noncredit risks. Examples of such
obligations are securities with principal or interest return indexed to
equities, commodities, or currencies; certain swaps and options; and
interest-only and principal-only mortgage securities. 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."
Not rated.
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.
BOND INVESTMENT QUALITY STANDARDS
Under present commercial bank regulations issued by the Comptroller of
the Currency, bonds rated in the top four categories ("AAA", "A", "A", "BBB",
commonly known as investment-grade ratings) generally are regarded as eligible
for bank investment. Also, the laws of various states governing legal
investments impose certain rating or other standards for obligations eligible
for investment by savings banks, trust companies, insurance companies, and
fiduciaries in general.
SHORT-TERM ISSUE CREDIT RATINGS
Notes. A Standard & Poor's note ratings reflects the liquidity factors
and market access risks unique to notes. Notes due in three years or less will
likely receive a note rating. Notes maturing beyond three years will most likely
receive a long-term debt rating. The following criteria will be used in making
that assessment:
o Amortization schedule -- the larger the final maturity relative to
other maturities, the more likely it will be treated as a note;
and
o Source of payment -- the more dependent the issue is on the market
for its refinancing, the more likely it will be treated as a note.
Note rating symbols are as follows:
A-3
"SP-1"
Strong capacity to pay principal and interest. An issue determined to
possess a very strong capacity to pay debt service is given a plus ("+")
designation.
"SP-2"
Satisfactory capacity to pay principal and interest, with some
vulnerability to adverse financial and economic changes over the term of the
notes.
"SP-3"
Speculative capacity to pay principal and interest.
COMMERCIAL PAPER
An S&P 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-1" 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.
A-4
"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.
Moody's Investors Service, Inc. -- A brief description of the
applicable Moody's Investors Service, Inc. ("Moody's") rating symbols and their
meanings (as published by Moody's) follows:
Municipal Ratings are opinions of the investment quality of issuers and
issues in the US municipal and tax-exempt markets. As such, these ratings
incorporate Moody's assessment of the default probability and loss severity of
these issuers and issues. The default and loss content for Moody's municipal
long-term rating scale differs from Moody's general long-term rating scale.
Municipal Ratings are based upon the analysis of four primary factors
relating to municipal finance: economy, debt, finances, and
administration/management strategies. Each of the factors is evaluated
individually and for its effect on the other factors in the context of the
municipality's ability to repay its debt.
MUNICIPAL LONG-TERM RATING DEFINITIONS
"Aaa"
Issuers or issues rated "Aaa" demonstrate the strongest
creditworthiness relative to other US municipal or tax-exempt issuers or issues.
A-5
"Aa"
Issuers or issues rated "Aa" demonstrate very strong creditworthiness
relative to other US municipal or tax-exempt issuers or issues.
"A"
Issuers or issues rated "A" present above-average creditworthiness
relative to other US municipal or tax-exempt issuers or issues.
Note: Moody's appends numerical modifiers "1", "2", and "3" to each
generic rating category from "Aa" through "Caa." The modifier "1" indicates that
the issuer or obligation ranks in the higher end of its generic rating category;
the modifier "2" indicates a mid-range ranking; and the modifier "3" indicates a
ranking in the lower end of that generic rating category.
SHORT-TERM DEBT RATINGS
There are three rating categories for short-term municipal obligations
that are considered investment grade. These ratings are designated as Municipal
Investment Grade ("MIG") and are divided into three levels -- "MIG 1" through
"MIG 3." In addition, those short-term obligations that are of speculative
quality are designated "SG", or speculative grade. "MIG" ratings expire at the
maturity of the obligation.
"MIG 1"
This designation denotes superior credit quality. Excellent protection
is afforded by established cash flows, highly reliable liquidity support, or
demonstrated broad-based access to the market for refinancing.
"MIG 2"
This designation denotes strong credit quality. Margins of protection
are ample, although not as large as in the preceding group.
"MIG 3"
This designation denotes acceptable credit quality. Liquidity and cash-flow
protection may be narrow, and market access for refinancing is likely to be less
well-established.
"SG"
This designation denotes speculative-grade credit quality. Debt
instruments in this category may lack sufficient margins of protection.
A-6
DEMAND OBLIGATION RATINGS
In the case of variable rate demand obligations ("VRDOs"), a
two-component rating is assigned; a long or short-term debt rating and a demand
obligation rating. The first element represents Moody's evaluation of the degree
of risk associated with scheduled principal and interest payments. The second
element represents Moody's evaluation of the degree of risk associated with the
ability to receive purchase price upon demand ("demand feature"), using a
variation of the "MIG" rating scale, the Variable Municipal Investment Grade or
"VMIG" rating. When either the long- or short-term aspect of a "VRDO" is not
rated, that piece is designated NR, e.g., "Aaa/NR" or "NR/VMIG 1." "VMIG" rating
expirations are a function of each issue's specific structural or credit
features.
"VMIG 1"
This designation denotes superior credit quality. Excellent protection
is afforded by the superior short-term credit strength of the liquidity provider
and structural and legal protections that ensure the timely payment of purchase
price upon demand.
"VMIG 2"
This designation denotes strong credit quality. Good protection is
afforded by the strong short-term credit strength of the liquidity provider and
structural and legal protections that ensure the timely payment of purchase
price upon demand.
"VMIG 3"
This designation denotes acceptable credit quality. Adequate protection
is afforded by the satisfactory short-term credit strength of the liquidity
provider and structural and legal protections that ensure the timely payment of
purchase price upon demand.
"SG"
This designation denotes speculative-grade credit quality. Demand
features rated in this category may supported by a liquidity provider that does
not have an investment grade short-term rating or may lack the structural and/or
legal protections necessary to ensure the timely payment of purchase price upon
demand.
COMMERCIAL PAPER
Moody's short-term ratings are opinions of the ability of issuers to
honor short-term financial obligations. Ratings may be assigned to issuers,
short-term programs or to individual short-term debt instruments. Such
obligations generally have an original maturity not exceeding thirteen months,
unless explicitly noted.
A-7
Moody's employs the following designations to indicate the relative
repayment ability of rated issuers:
"P-1"
Issuers (or supporting institutions) rated "Prime-1" have a superior
ability to repay short-term debt obligations.
"P-2"
Issuers (or supporting institutions) rated "Prime-2" have a strong
ability to repay short-term debt obligations.
"P-3"
Issuers (or supporting institutions) rated "Prime-3" have an acceptable
ability to repay short-term obligations.
"NP"
Issuers (or supporting institutions) rated "Not Prime" do not fall
within any of the Prime rating categories.
Note: Canadian issuers rated "P-1" or "P-2" have their short-term
ratings enhanced by the senior-most long-term rating of the issuer, its
guarantor or support-provider.
Fitch Ratings -- A brief description of the applicable Fitch Ratings
("Fitch") ratings symbols and meanings (as published by Fitch) follows:
LONG-TERM CREDIT RATINGS
International Long-Term Credit Ratings are more commonly referred to as
simply "Long-Term Ratings." The following scale applies to foreign currency and
local currency ratings.
International credit ratings assess the capacity to meet foreign or
local currency commitments. Both foreign and local currency ratings are
internationally comparable assessments. The local currency rating measures the
probability of payment only within the sovereign state's currency and
jurisdiction.
"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.
A-8
"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.
SHORT-TERM CREDIT RATINGS
International Short-Term Credit Ratings are more commonly referred to
as simply "Short-Term Ratings." The following scale applies to foreign currency
and local currency 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.
International credit ratings assess the capacity to meet foreign or
local currency commitments. Both foreign and local currency ratings are
internationally comparable assessments. The local currency rating measures the
probability of payment only within the sovereign state's currency and
jurisdiction.
"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.
A-9
"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.
Notes to Long-term and Short-term ratings:
"+" 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.
Rating Watch: Ratings are placed on Rating Watch 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, ratings for which outlooks are "stable" could be
downgraded before an outlook moves to positive or negative if circumstances
warrant such an action. Occasionally, Moody's may be unable to identify the
fundamental trend. In these cases, the Rating Outlook may be described as
evolving.
A-10
PART C - OTHER INFORMATION
Item 24: Financial Statements and Exhibits
1. Financial Statements:
Registrant has not conducted any business as of the date of this
filing, other than in connection with its organization. Financial Statements
indicating that the Registrant has met the net worth requirements of Section
14(a) of the 1940 Act will be filed by Pre-effective Amendment to the
Registration Statement.
2. Exhibits:
a. Declaration of Trust dated February 22, 2005.
b. By-Laws of Fund.
c. None.
d. Form of Share Certificate.*
e. Terms and Conditions of the Dividend Reinvestment Plan. *
f. None.
g.1 Form of Investment Management Agreement between Registrant and First Trust
Advisors L.P. *
g.2 Form of Sub-Advisory Agreement between Registrant, First Trust Advisors
L.P. and Fixed Income Discount Advisory Company.*
h.1 Form of Purchase Agreement.*
i. None.
j. Form of Custodian Services Agreement between Registrant and PFPC Trust
Company.*
k.1 Form of Transfer Agency Services Agreement between Registrant and PFPC
Inc.*
k.2 Form of Administration and Accounting Services Agreement.*
l.1 Opinion and consent of Chapman and Cutler LLP.*
l.2 Opinion and consent of Bingham McCutchen LLP. *
m. None.
Page 1
n. Consent of Independent Registered Public Accounting Firm.*
o. None.
p. Subscription Agreement between Registrant and First Trust Advisors L.P. *
q. None.
r.1 Code of Ethics of Registrant. *
r.2 Code of Ethics of First Trust Portfolios L.P. *
r.3 Code of Ethics of First Trust Advisors L.P.*
r.4 Code of Ethics of Fixed Income Discount Advisory Company.*
s. Powers of Attorney.
-------------------
* To be filed by amendment.
Item 25: Marketing Arrangements
[TO COME]
Page 2
Item 26: Other Expenses of Issuance and Distribution
------------------------------------------------------------ -----------------
Securities and Exchange Commission Fees $2.35
------------------------------------------------------------ -----------------
National Association of Securities Dealers, Inc. Fees $ *
------------------------------------------------------------ -----------------
Printing and Engraving Expenses $ *
------------------------------------------------------------ -----------------
Legal Fees $ *
------------------------------------------------------------ -----------------
Listing Fees $ *
------------------------------------------------------------ -----------------
Accounting Expenses $ *
------------------------------------------------------------ -----------------
Blue Sky Filing Fees and Expenses $ *
------------------------------------------------------------ -----------------
Miscellaneous Expenses $ *
------------------------------------------------------------ -----------------
Total $ *
------------------------------------------------------------ -----------------
---------
Item 27: Persons Controlled by or under Common Control with Registrant
Not applicable.
Item 28: Number of Holders of Securities
At ________________:
--------------------------------------------- ---------------------------------
Title of Class Number of Record Holders
--------------------------------------------- ---------------------------------
Common Shares, $0.01 par value
--------------------------------------------- ---------------------------------
Page 3
Item 29: Indemnification
Section 5.3 of the Registrant's Declaration of Trust provides as follows:
(a) Subject to the exceptions and limitations contained in paragraph
(b) below:
(i) every person who is or has been a Trustee or officer of
the Trust (hereinafter referred to as a "Covered Person") shall be
indemnified by the Trust against all liability and against all expenses
reasonably incurred or paid by him or her in connection with any claim,
action, suit or proceeding in which that individual becomes involved as
a party or otherwise by virtue of being or having been a Trustee or
officer and against amounts paid or incurred by that individual in the
settlement thereof; and
(ii) the words "claim," "action," "suit" or "proceeding" shall
apply to all claims, actions, suits or proceedings (civil, criminal,
administrative or other, including appeals), actual or threatened; and
the words "liability" and "expenses" shall include, without limitation,
attorneys' fees, costs, judgments, amounts paid in settlement or
compromise, fines, penalties and other liabilities.
(b) No indemnification shall be provided hereunder to a Covered Person:
(i) against any liability to the Trust or the Shareholders by
reason of a final adjudication by the court or other body before which
the proceeding was brought that the Covered Person engaged in willful
misfeasance, bad faith, gross negligence or reckless disregard of the
duties involved in the conduct of that individual's office;
(ii) with respect to any matter as to which the Covered Person
shall have been finally adjudicated not to have acted in good faith in
the reasonable belief that that individual's action was in the best
interest of the Trust; or
(iii) in the event of a settlement involving a payment by a
Trustee, Trustee Emeritus or officer or other disposition not involving
a final adjudication as provided in paragraph (b)(i) or (b)(ii) above
resulting in a payment by a Covered Person, unless there has been
either a determination that such Covered Person did not engage in
willful misfeasance, bad faith, gross negligence or reckless disregard
of the duties involved in the conduct of that individual's office by
the court or other body approving the settlement or other disposition
or by a reasonable determination, based upon a review of readily
available facts (as opposed to a full trial-type inquiry) that that
individual did not engage in such conduct:
(A) by vote of a majority of the Disinterested
Trustees (as defined below) acting on the matter (provided that a
majority of the Disinterested Trustees then in office act on the
matter); or
(B) by written opinion of (i) the then-current legal
counsel to the Trustees who are not Interested Persons of the Trust or
Page 4
(ii) other legal counsel chosen by a majority of the Disinterested
Trustees (or if there are no Disinterested Trustees with respect to the
matter in question, by a majority of the Trustees who are not
Interested Persons of the Trust) and determined by them in their
reasonable judgment to be independent.
(c) The rights of indemnification herein provided may be insured
against by policies maintained by the Trust, shall be severable, shall not
affect any other rights to which any Covered Person may now or hereafter be
entitled, shall continue as to a person who has ceased to be a Covered Person
and shall inure to the benefit of the heirs, executors and administrators of
such person. Nothing contained herein shall limit the Trust from entering into
other insurance arrangements or affect any rights to indemnification to which
Trust personnel, including Covered Persons, may be entitled by contract or
otherwise under law.
(d) Expenses of preparation and presentation of a defense to any claim,
action, suit, or proceeding of the character described in paragraph (a) of this
Section 5.3 shall be advanced by the Trust prior to final disposition thereof
upon receipt of an undertaking by or on behalf of the Covered Person to repay
such amount if it is ultimately determined that the Covered Person is not
entitled to indemnification under this Section 5.3, provided that either:
(i) such undertaking is secured by a surety bond or some
other appropriate security or the Trust shall be insured against losses
arising out of any such advances; or
(ii) a majority of the Disinterested Trustees acting on the
matter (provided that a majority of the Disinterested Trustees then in
office act on the matter) or legal counsel meeting the requirement in
Section 5.3(b)(iii)(B) above in a written opinion, shall determine,
based upon a review of readily available facts (as opposed to a full
trial-type inquiry), that there is reason to believe that the Covered
Person ultimately will be found entitled to indemnification.
As used in this Section 5.3, a "Disinterested Trustee" is one (i) who
is not an "Interested Person" of the Trust (including anyone who has
been exempted from being an "Interested Person" by any rule, regulation
or order of the Commission), and (ii) against whom none of such
actions, suits or other proceedings or another action, suit or other
proceeding on the same or similar grounds is then or had been pending.
(e) With respect to any such determination or opinion referred to in
clause (b)(iii) above or clause (d)(ii) above, a rebuttable presumption shall be
afforded that the Covered Person has not engaged in willful misfeasance, bad
faith, gross negligence or reckless disregard of the duties involved in the
conduct of such Covered Person's office in accordance with pronouncements of the
Commission.
Item 30: Business and Other Connections of Investment Advisers
a) First Trust Advisors L.P. ("First Trust Advisors") serves as investment
adviser to the fund and the First Defined Portfolio Fund, LLC and also serves as
Page 5
subadviser to 29 mutual funds and is the portfolio supervisor of certain unit
investment trusts. Its principal address is 1001 Warrenville Road, Suite 300,
Lisle, Illinois 60532.
The principal business of certain of First Trust Advisors' principal executive
officers involves various activities in connection with the family of unit
investment trusts sponsored by First Trust Portfolios L. P. ("First Trust
Portfolios"). The principal address of First Trust Portfolios is 1001
Warrenville Road, Suite 300, Lisle, Illinois 60532.
Page 6
Other Business, Profession, Vocation or Employment During Past Two Years
Name and Position with First Trust Advisors L.P. Employment During Past Two Years
------------------------------------------------------------ ---------------------------------------------------------
James A. Bowen, Managing Director/President Managing Director/President, First Trust Portfolios and
Chairman of the Board of Directors, Bond Wave LLC and
Stonebridge Advisors LLC
------------------------------------------------------------ ---------------------------------------------------------
Ronald Dean McAlister, Managing Director Managing Director, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Mark R. Bradley, Chief Financial Officer and Managing Chief Financial Officer and Managing Director, First
Director Trust Portfolios and Chief Financial Officer, Bond Wave
LLC and Stonebridge Advisors LLC
------------------------------------------------------------ ---------------------------------------------------------
Robert W. Bredemeier, Chief Operating Officer and Managing Chief Operations Officer and Managing Director, First
Director Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Robert Franklin Carey, Chief Investment Officer and Senior Senior Vice President, First Trust Portfolios
Vice President
------------------------------------------------------------ ---------------------------------------------------------
William Scott Jardine, General Counsel General Counsel, First Trust Portfolios and Secretary
of Bond Wave LLC and Stonebridge Advisors LLC
------------------------------------------------------------ ---------------------------------------------------------
Kristi A. Maher, Assistant General Counsel Assistant General Counsel, First Trust Portfolios and
Associate (1995 to March 2004), Chapman and Cutler LLP
------------------------------------------------------------ ---------------------------------------------------------
Scott Hall, Managing Director Managing Director, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Andy Roggensack, Managing Director Managing Director, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Jon Carl Erickson, Senior Vice President Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Jason Henry, Senior Vice President Senior Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
David McGarel, Senior Vice President Senior Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Bob Porcellino, Senior Vice President Senior Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Mark Sullivan, Senior Vice President Senior Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Al Davis, Vice President Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
James P. Koeneman, Vice President Vice President, First Trust Portfolios since December
2003; President, Burr Oak Advisors, Inc., June 2000 to
December 2003
------------------------------------------------------------ ---------------------------------------------------------
Daniel J. Lindquist, Vice President Vice President, First Trust Portfolios since April 2004;
Chief Operating Officer, Mina Capital Management, LLC,
January 2004 to April 2004; Chief Operating Officer,
Samaritan Asset Management Services, Inc.
------------------------------------------------------------ ---------------------------------------------------------
Mitch Mohr, Vice President Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
David Pinsen, Vice President Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Jonathan Steiner, Vice President Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Walter E. Stubbings, Jr., Vice President Vice President, First Trust Portfolios since July 2004;
Assistant Vice President, Kansas City Life Insurance
Company, May 1999 to July 2004
------------------------------------------------------------ ---------------------------------------------------------
Rick Swiatek, Vice President Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Douglas Tichenor, Vice President Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Roger Testin, Vice President Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Kitty Collins, Assistant Vice President Assistant Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Charles Bradley, Assistant Vice President Assistant Vice President, First Trust Portfolios
------------------------------------------------------------ ---------------------------------------------------------
Page 7
b) Sub-Advisers. Fixed Income Discount Advisory Company serves as an investment
sub-adviser of the Fund. Reference is made to: (i) the information set forth
under "Management of the Fund" in the Prospectus and "Sub-Adviser" in the
Statement of Additional Information; and (ii) the Form ADV of Fixed Income
Discount Advisory Company (File No. 801-46034) filed with the Commission, all
of which are incorporated herein by reference.
Item 31: Location of Accounts and Records.
First Trust Advisors L.P. maintains the Declaration of Trust, By-Laws, minutes
of trustees and shareholders meetings and contracts of the Registrant, all
advisory material of the investment adviser, all general and subsidiary ledgers,
journals, trial balances, records of all portfolio purchases and sales, and all
other required records.
Item 32: Management Services
Not applicable.
Item 33: Undertakings
1. Registrant undertakes to suspend the offering of its shares until it amends
its prospectus if (1) subsequent to the effective date of its Registration
Statement, the net asset value declines more than 10 percent from its net asset
value as of the effective date of the Registration Statement, or (2) the net
asset value increases to an amount greater than its net proceeds as stated in
the prospectus.
2. Not applicable.
3. Not applicable.
4. Not applicable.
5. The Registrant undertakes that:
a. For purposes of determining any liability under the Securities Act of 1933,
the information omitted from the form of prospectus filed as part of a
registration statement in reliance upon Rule 430A and contained in the form of
prospectus filed by the Registrant under Rule 497(h) under the Securities Act of
1933 shall be deemed to be part of the Registration Statement as of the time it
was declared effective.
b. For the purpose of determining any liability under the Securities Act of
1933, each post-effective amendment that contains a form of prospectus shall be
deemed to be a new registration statement relating to the securities offered
therein, and the offering of the securities at that time shall be deemed to be
the initial bona fide offering thereof.
6. The Registrant undertakes to send by first class mail or other means designed
to ensure equally prompt delivery, within two business days of receipt of a
written or oral request, any Statement of Additional Information.
Page 8
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933 and the
Investment Company Act of 1940, the Registrant has duly caused this Registration
Statement to be signed on its behalf by the undersigned, thereunto duly
authorized, in this City of Lisle, and State of Illinois, on the 11th day of
March, 2005.
FIRST TRUST/FIDAC MORTGAGE INCOME FUND
By: /s/ James A. Bowen
--------------------------------
James A. Bowen, President
Pursuant to the requirements of the Securities Act of 1933, this
Registration Statement has been signed below by the following persons in the
capacities and on the date indicated.
------------------------ -------------------------------------- ----------------
Signature Title Date
------------------------ -------------------------------------- ----------------
/s/ James A. Bowen President, Chairman of the Board March 11, 2005
--------------------- and Trustee (Principal Executive
James A. Bowen Officer)
------------------------ -------------------------------------- ----------------
/s/ Mark R. Bradley Chief Financial Officer and March 11, 2005
--------------------- Treasurer (Principal Financial and
Mark R. Bradley Accounting Officer)
------------------------ -------------------------------------- ----------------
Richard E. Erickson* Trustee )
---------------------- ------------------------------- By: /s/ W. Scott Jardine
Thomas R. Kadlec* Trustee ) --------------------
---------------------- ------------------------------- W. Scott Jardine
Niel B. Nielson* Trustee ) Attorney-In-Fact
---------------------- ------------------------------- March 11, 2005
David M. Oster* Trustee )
---------------------- ------------------------------- -------------------------
* Original powers of attorney authorizing James A. Bowen, W. Scott Jardine and
Eric F. Fess to execute this Registration Statement, and Amendments thereto, for
each of the trustees of the Registrant on whose behalf this Registration
Statement is filed, were previously executed and are filed as an exhibit hereto.
Page 9
INDEX TO EXHIBITS
a. Declaration of Trust dated February 22, 2005.
b. By-Laws of the Fund
s. Powers of Attorney
Page 10