As filed with the Securities and Exchange Commission on October 29, 2010
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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
[ ] REGISTRATION STATEMENT UNDER THE INVESTMENT COMPANY ACT OF 1940
[X] Amendment No. 3
First Trust/FIDAC Mortgage Income Fund
Exact Name of Registrant as Specified in Declaration of Trust
120 East Liberty Drive, Suite 400, Wheaton, Illinois 60187
Address of Principal Executive Offices (Number, Street, City, State, Zip Code)
(630) 765-8000
Registrant's Telephone Number, including Area Code
W. Scott Jardine, Esq.
First Trust Portfolios L.P.
120 East Liberty Drive, Suite 400
Wheaton, Illinois 60187
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: From time to time after the
effective date of this Registration Statement
---------------
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. [X]
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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------------------------ ---------------------- --------------------- ---------------------- ---------------------
Proposed Maximum Proposed Maximum
Title of Securities Amount Being Offering Price Aggregate Offering Amount of
Being Registered Registered Per Share(1) Price(1) Registration Fee(2)
------------------------ ---------------------- --------------------- ---------------------- ---------------------
Common Shares, $0.01 1,000 shares $20.24 $20,240 $1.45
par value
------------------------ ---------------------- --------------------- ---------------------- ---------------------
(1) Estimated pursuant to Rule 457(c) of the Securities Act of 1933, as
amended, solely for the purpose of determining the registration fee, based
upon the average of high and low prices reported on October 26, 2010, as
reported on the NYSE.
(2) Transmitted prior to filing.
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.
==================================================================================================================
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 securities and it is not soliciting an offer to buy these securities in
any jurisdiction where the offer or sale is not permitted.
SUBJECT TO COMPLETION, DATED OCTOBER 29, 2010
BASE PROSPECTUS
FIRST TRUST/FIDAC MORTGAGE INCOME FUND
UP TO __________ COMMON SHARES
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The Fund. First Trust/FIDAC Mortgage Income Fund (the "Fund") is a
diversified, closed-end management investment company which commenced operations
in May, 2005.
Investment Objective. The Fund's primary investment objective is to seek a
high level of current income. As a secondary objective, the Fund seeks to
preserve capital. There can be no assurance that the Fund's investment
objectives will be achieved. The Fund pursues its objectives by investing
primarily in mortgage-backed securities representing part ownership in a pool of
either residential or commercial mortgage loans that, in the opinion of the
Sub-Advisor (as defined below), offer an attractive combination of credit
quality, yield and maturity. These securities may be issued by government
agencies or by private originators or issuers, generally in the form of
pass-through certificates, collateralized mortgage obligations, residential
mortgage-backed securities or commercial mortgage-backed securities.
Collectively, agency mortgage pass-through certificates, agency collateralized
mortgage obligations, stripped mortgage-backed securities, non-agency
residential mortgage-backed securities and non-agency commercial mortgage-backed
securities are referred to as "MBS" in this prospectus.
Investment Strategy. Under normal market conditions, the Fund invests 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 invests 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-Advisor. As of
September 30, 2010, 20.94% of the Fund's managed assets were invested in
securities below investment grade quality.
The Fund's currently outstanding common shares are, and the common shares
offered in this prospectus will be, subject to notice of issuance, listed on the
New York Stock Exchange under the trading or "ticker" symbol "FMY." The net
asset value of the Fund's common shares on September 30, 2010 was $19.40 per
common share, and the last sale price of the common shares on the New York Stock
Exchange on such date was $21.75.
The Fund may offer, on an immediate, continuous or delayed basis, up to
____________ of the Fund's common shares in one or more offerings. The Fund may
offer its common shares in amounts, at prices and on terms set forth in a
prospectus supplement to this prospectus. You should read this prospectus and
the related prospectus supplement carefully before you decide to invest in any
of the common shares.
The Fund may offer the common shares directly to one or more purchasers,
through agents that the Fund or the purchasers designate from time to time, or
to or through underwriters or dealers. The prospectus supplement relating to the
particular offering will identify any agents or underwriters involved in the
sale of the common shares, and will set forth any applicable purchase price,
fee, commission or discount arrangement between the Fund and such agents or
underwriters or among the underwriters or the basis upon which such amount may
be calculated. For more information about the manner in which the Fund may offer
the common shares, see "Plan of Distribution." The common shares may not be sold
through agents, underwriters or dealers without delivery of a prospectus
supplement.
INVESTING IN COMMON SHARES INVOLVES CERTAIN RISKS. YOU COULD LOSE SOME OR ALL
OF YOUR INVESTMENT. SEE "RISKS" BEGINNING ON PAGE 27.
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.
(continued on the following page)
(continued from previous page)
Investment Adviser and Sub-Adviser. First Trust Advisors L.P. ("First Trust
Advisors" or the "Advisor") is the Fund's investment adviser and is responsible
for supervising the Fund's sub-adviser, Fixed Income Discount Advisory Company
("FIDAC" or the "Sub-Advisor"), 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 Advisor, in consultation
with the Sub-Advisor, is also responsible for determining the Fund's overall
investment strategy and overseeing its implementation. First Trust Advisors
serves as investment adviser or portfolio supervisor to investment portfolios
with approximately $36 billion in assets which it managed or supervised as of
September 30, 2010. FIDAC is a wholly-owned subsidiary of Annaly Capital
Management, Inc. ("Annaly"), a New York Stock Exchange-listed real estate
investment trust. As of September 30, 2010, Annaly owned approximately $98
billion of gross assets. See "Management of the Fund" in this prospectus and
"Investment Advisor" and "Sub-Advisor" in the Fund's Statement of Additional
Information (the "SAI").
Use of Leverage. The Fund is currently engaged in, and may in the future
engage in the use of leverage through the issuance of preferred shares of
beneficial interest ("Preferred Shares") or through commercial paper, notes,
reverse repurchase agreements and/or other borrowings (collectively
"Borrowings"). The Fund limits 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 Borrowings.
"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 Borrowings). As of September 30, 2010, the
Fund's aggregate leverage through Borrowings was approximately 15.04%. The
determination to use leverage is subject to the approval of the Fund's Board of
Trustees ("Board of Trustees"). Through leveraging, the Fund seeks 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 and any prospectus supplement, which contains
important information about the Fund, before deciding whether to invest in the
common shares, and retain it for future reference. This prospectus, together
with any prospectus supplement, sets forth concisely the information about the
Fund that a prospective investor ought to know before investing. The Statement
of Additional Information (the "SAI"), dated ___________, 2010, 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 53 of this prospectus, annual and semi-annual reports to
shareholders, 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). Please note that the information
contained in the Fund's website, whether currently posted or posted in the
future, is not part of this prospectus or the documents incorporated by
reference in this prospectus. 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).
Shares of common stock of closed-end investment companies, like the Fund,
frequently trade at discounts to their net asset values. If the Fund's common
shares trade at a discount to net asset value, the risk of loss may increase for
purchasers in this offering, especially for those investors who expect to sell
their common shares in a relatively short period after purchasing shares in this
offering. See "Risks - Market Discount From Net Asset Value." 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 Federal
Reserve Board or any other government agency.
Prospectus dated , 2010
-ii-
CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS
This prospectus, any accompanying prospectus supplement and the SAI,
including documents incorporated by reference, contain "forward-looking
statements." Forward-looking statements can be identified by the words "may,"
"will," "intend," "expect," "estimate," "continue," "plan," "anticipate," and
similar terms and the negative of such terms. By their nature, all
forward-looking statements involve risks and uncertainties, and actual results
could differ materially from those contemplated by the forward-looking
statements. Several factors that could materially affect the Fund's actual
results are the performance of the portfolio of securities held by the Fund, the
conditions in the U.S. and international financial and other markets, the price
at which the Fund's common shares trade in the public markets and other factors
discussed in the Fund's periodic filings with the Securities and Exchange
Commission (the "SEC").
Although we believe that the expectations expressed in these forward-looking
statements are reasonable, actual results could differ materially from those
projected or assumed in these forward-looking statements. The Fund's future
financial condition and results of operations, as well as any forward-looking
statements, are subject to change and are subject to inherent risks and
uncertainties, such as those disclosed in the "Risks" section of this
prospectus. All forward-looking statements contained or incorporated by
reference in this prospectus or any accompanying prospectus supplement are made
as of the date of this prospectus or the accompanying prospectus supplement, as
the case may be. We do not intend, and we undertake no obligation, to update any
forward-looking statement. The forward-looking statements contained in this
prospectus and any accompanying prospectus supplement are excluded from the safe
harbor protection provided by Section 27A of the Securities Act of 1933, as
amended (the "Securities Act").
Currently known risk factors that could cause actual results to differ
materially from the Fund's expectations include, but are not limited to, the
factors described in the "Risks" section of this prospectus. We urge you to
review carefully that section for a more detailed discussion of the risks of an
investment in the Fund's securities.
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PROSPECTUS SUMMARY
This summary highlights information contained elsewhere in this prospectus.
This summary does not contain all of the information that you should consider
before investing in the Fund's common shares. You should carefully read the
entire prospectus, any related prospectus supplement and the SAI, including the
documents incorporated by reference, particularly the section entitled "Risks"
beginning on page 27.
THE FUND .............. First Trust/FIDAC Mortgage Income Fund is a
diversified, closed-end management investment company
which commenced operations in May, 2005. The Fund's
primary investment objective is to seek a high level of
current income. As a secondary objective, the Fund seeks
to preserve capital. There can be no assurance that the
Fund's investment objectives will be achieved. The Fund
completed its initial public offering of common shares
in May, 2005, raising approximately $76.2 million in
equity after the payment of offering expenses. As of
September 30, 2010, the Fund had 4,054,454 common shares
outstanding and net assets applicable to common shares
of $78,642,584. The common shares of beneficial interest
offered by this prospectus are called "Common Shares"
and the holders of Common Shares are called "Common
Shareholders" in this prospectus. As used in this
prospectus, unless the context requires otherwise,
"common shares" refers to the Fund's common shares of
beneficial interest currently outstanding as well as
those Common Shares offered by this prospectus and the
holders of common shares are called "common
shareholders."
INVESTMENT ADVISER
AND SUB-ADVISER....... First Trust Advisors L.P. ("First Trust Advisors" or
the "Advisor") is the Fund's investment adviser and is
responsible for supervising the Fund's Sub-Advisor (as
defined below), monitoring the Fund's investment
portfolio, managing the Fund's business affairs and
providing certain clerical and bookkeeping and other
administrative services. The Advisor, in consultation
with the Sub-Advisor, is also responsible for
determining the Fund's overall investment strategy and
overseeing its implementation. Fixed Income Discount
Advisory Company ("FIDAC" or the "Sub-Advisor") is the
Fund's Sub-Advisor and is primarily responsible for the
day to day supervisory and investment strategy for the
Fund.
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 $36 billion in
assets which it managed or supervised as of September
30, 2010.
FIDAC, a registered investment adviser, is a
wholly-owned subsidiary of Annaly Capital Management,
Inc., a New York Stock Exchange-listed real estate
investment trust. As of September 30, 2010, FIDAC and
its parent Annaly collectively had approximately $98
billion of gross assets under management.
THE OFFERING .......... The Fund may offer, on an immediate, continuous or
delayed basis, up to _____ Common Shares on terms to be
determined at the time of the offering. The Common
Shares will be offered at prices and on terms to be set
forth in one or more prospectus supplements to this
prospectus. Offerings of the Common Shares will be
subject to the provisions of the Investment Company Act
of 1940, as amended (the "1940 Act") which generally
require that the public offering price of common shares
of a closed-end investment company (exclusive of
distribution commissions and discounts) must equal or
exceed the net asset value per share of a company's
common stock (calculated within 48 hours of pricing),
absent shareholder approval or under certain other
circumstances. See "Description of Shares."
The Fund may offer the Common Shares directly to one or
more purchasers, through agents that the Fund or the
purchasers designate from time to time, or to or through
underwriters or dealers. The prospectus supplement
relating to the offering will identify any agents or
underwriters involved in the sale of the Common Shares,
and will set forth any applicable purchase price, fee,
commission or discount arrangement between the Fund and
such agents or underwriters or among underwriters or the
basis upon which such amount may be calculated. See
"Plan of Distribution." The Common Shares may not be
sold through agents, underwriters or dealers without
delivery of a prospectus supplement describing the
method and terms of the offering of the Common Shares.
USE OF PROCEEDS ....... Unless otherwise specified in a prospectus
supplement, the Fund will use the net proceeds from the
sale of the Common Shares primarily to invest in
accordance with its investment objective and policies,
or use such proceeds for other general corporate
purposes.
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."
INVESTMENT OBJECTIVE
AND POLICIES.......... The Fund's primary investment objective is to seek a
high level of current income. As a secondary objective,
the Fund seeks to preserve capital. There can be no
assurance that the Fund's investment objectives will be
achieved.
The Fund pursues its objectives by investing primarily
in MBS that, in the opinion of the Fund's Sub-Advisor,
offer an attractive combination of credit quality, yield
and maturity. The Fund's investment securities include:
o mortgage pass-through certificates issued or
guaranteed by the Government National Mortgage
Association ("GNMA"), the Federal National Mortgage
Association ("FNMA") and/or the Federal Home Loan
Mortgage Corporation ("FHLMC") (collectively,
"Agency Mortgage Pass-through Certificates");
o collateralized mortgage obligations ("CMOs") issued
by GNMA, FNMA or FHLMC ("Agency CMOs" and,
collectively with Agency Mortgage Pass-through
Certificates, "Agency MBS");
o interest-only or principal-only stripped
mortgage-backed securities created through Agency
Mortgage Pass-Through Certificates or as tranches of
a CMO ("Stripped Mortgage-Backed Securities");
o debt obligations issued by private originators or
issuers backed by residential mortgage loans
("Non-Agency RMBS");
-2-
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 real estate-related assets collateralized by pools
of assets such as home equity loans and lines of
credit ("Other MBS"); and
o U.S. government securities, or cash or other
short-term instruments.
Under normal market conditions, the Fund invests 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 is fully invested in MBS and Other MBS.
The Fund invests all of its Managed Assets in securities
that at the time of investment are investment grade
quality. The Fund only invests 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/A2 or better by
Moody's Investors Service, Inc. ("Moody's"),
Standard & Poor's Ratings Group, a division of The
McGraw-Hill Companies, Inc. ("S&P") or Fitch
Ratings, Inc. ("Fitch")); or
o unrated but judged to be of comparable quality by
the Sub-Advisor.
While the Fund attempts to minimize credit risk by
investing in securities that are investment grade
quality at the time of purchase, the Fund currently
holds securities which were investment grade quality at
the time of the purchase but are currently rated below
investment grade. As of September 30, 2010 20.94% of the
Fund's Managed Assets were invested in securities below
investment grade quality. In addition, beginning in
2008, the Fund has generally increased its credit risk
profile by pursuing attractive risk-adjusted
opportunities in subordinated classes of MBS, Non-Agency
RMBS and Stripped Mortgage-Backed Securities which, due
to credit and liquidity concerns and volatility in
market conditions for mortgages and mortgage related
assets, have experienced depressed pricing.
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 does not invest in corporate bonds,
other than those primarily secured by interests in real
estate.
The Fund attempts to reduce portfolio prepayment and
credit 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.
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 consist of
fixed-rate investment securities, the Fund may also
invest in adjustable-rate MBS. In selecting MBS and
Other MBS, the Sub-Advisor considers the liquidity of
-3-
the market for the different MBS. Unlike most
fixed-income products, MBS are sold and traded based on
the anticipated 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 interest rate environments), the average life
of the security will be shorter than the original
estimate. If prepayment rates are slower (typical in
rising interest rate environments), the security's
average life will be extended. The Sub-Advisor manages
the Fund's portfolio's prepayment characteristics to
take advantage of observed interest rate trends. In a
rising interest 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 interest 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.
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 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 portfolio
management or hedging techniques 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.
USE OF LEVERAGE ....... The Fund is currently engaged in, and may in the
future engage in, the use of leverage to seek to
enhance the level of its current distributions to common
shareholders. The Fund may leverage its assets through
the use of reverse repurchase agreements and, to a
lesser extent, through the issuance of Preferred Shares
or commercial paper, notes and/or other 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. 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." Investors should understand that Leverage
Instruments have seniority over the Common Shares. The
-4-
Fund currently utilizes leverage primarily through the
use of 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 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 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.
Dividends may be payable 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 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.
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 U.S. federal income tax
purposes and thus will not be eligible for the lower tax
rates on qualified dividends. See "Tax Matters."
LISTING ............... The Fund's currently outstanding common shares are,
and the Common Shares offered in this prospectus and any
applicable prospectus supplement will be, subject to
notice of issuance, listed on the New York Stock
Exchange under the trading or "ticker" symbol "FMY." The
net asset value of the Fund's common shares at the close
of business on September 30, 2010 was $19.40 per common
share, and the last sale price of the common shares on
the New York Stock Exchange on such date was $21.75.
CUSTODIAN,
ADMINISTRATOR
AND TRANSFER AGENT.... BNY Mellon Investment Servicing (US) Inc. serves as the
Fund's Administrator, Fund Accountant, Transfer Agent
and Board Administrator in accordance with certain fee
arrangements. The Bank of New York Mellon serves as the
Fund's Custodian in accordance with certain fee
arrangements.
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
-5-
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 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 net
asset value, 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 the closed-end fund. The foregoing factors may result
in the market price of the common shares of the Fund
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 objective and
policies and has determined that the closed-end
structure is appropriate. As described in this
prospectus, however, the Board of Trustees may review
periodically the trading range and activity of the
Fund's common shares with respect to their net asset
value and 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 investment company. 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 net asset value per
common share. In addition, as noted above, the Board of
Trustees determined in connection with the initial
offering of common shares of the Fund that the
closed-end structure is desirable, given the Fund's
investment objective and policies. Investors should
assume, therefore, that it is highly unlikely that the
Board of Trustees would vote to convert the Fund to an
open-end investment company. See "Structure of the Fund;
Common Share Repurchases and Change in Fund Structure."
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."
Government Agency Risk. The current uncertainties
regarding the status of certain government agencies,
including FNMA and FHLMC, and the impact of changes in
regulatory oversight and accounting policies of these
agencies may adversely impact the credit quality,
availability or investment character of the securities
issued by these agencies. To the extent that legislation
or federal regulators that regulate certain government
agencies impose additional requirements or restrictions
with respect to the ability of such institutions to
issue securities, particularly in connection with highly
leveraged transactions, the availability of government
agency securities for investment may be adversely
affected. Further, such legislation or regulation could
depress the market value of government agency
securities. See "Risks - Risks Associated with Recent
Adverse Developments in Mortgage Finance and Credit
Markets" for a more detailed description of recent
changes affecting government agency securities,
including FNMA and FHLMC securities.
Mortgage Finance and Credit Markets Risk. Volatility in
market conditions for mortgages and mortgage-related
assets as well as the broader financial markets have
-6-
resulted in a significant contraction in liquidity for
mortgages and mortgage-related assets, which may
adversely affect the value of the Fund's investments.
The U.S. government has implemented programs designed to
provide homeowners with assistance in avoiding
residential mortgage loan foreclosures, which includes
mortgage loan modification programs. These programs and
future legislative action and changes in the
requirements necessary to qualify for refinancing a
mortgage with FNMA, FHLMC or GNMA may adversely affect
the value of, and the returns on, the assets in which
the Fund invests. The actions of the U.S. government,
Federal Reserve and Treasury, including the
establishment of various programs to purchase certain
asset backed securities may adversely affect the Fund's
business. Additionally, while these programs are
intended to stabilize the financial markets, it is
unclear whether they will achieve their intended effects
or whether the Fund will benefit from these actions or
that further government or market developments will not
adversely impact the Fund. See "Risks - Risks Associated
with Recent Adverse Developments in Mortgage Finance and
Credit Markets" for a more detailed description of
certain regulatory actions and other events affecting
changes to the market conditions for mortgages and
mortgage-related assets.
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 Advisor
and the Sub-Advisor 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
invests all of its Managed Assets in investment grade
securities at the time of investment, or if unrated,
judged to be of comparable quality by the Sub-Advisor,
no assurance can be given that the value of the
securities will not decline.
Beginning in 2008, the Fund increased the portion of its
Managed Assets invested in subordinated classes of MBS,
Non-Agency RMBS and Stripped Mortgage-Backed Securities
in which the Sub-Advisor deemed to have attractive risk
adjusted returns at the time of such investments. Such
classes may be subject to a greater degree of
non-payment risk. 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.
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
-7-
securities. However, restricted securities determined by
the Sub-Advisor to be illiquid are subject to the
limitations set forth above. The Sub-Advisor, 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. In addition,
regulatory actions and other events affecting changes to
the market conditions for mortgages and mortgage-related
assets could, in the future, adversely affect the
liquidity of the Fund's portfolio securities after the
time of initial investment. 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-Advisor'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.
Prepayment Risk. MBS are backed by pools of mortgage
loans. The Fund receives 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, particularly if the Fund is forced to
invest prepayments it receives in lower yielding
securities.
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. Moreover, the U.S.
government efforts to encourage refinancings of mortgage
loans may substantially effect prepayment rates.
The Fund may also invest in MBS which are interest-only
("IO") securities and principal-only ("PO") securities.
As of September 30, 2010, 12.1% of the Fund's Managed
Assets were invested in IO or 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
-8-
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 seeks 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 primarily invests 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. In addition, 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.
An increase in the interest payments on the Fund's
Borrowings or dividends on Preferred Shares 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 or
dividend payments it must make on its Preferred Shares.
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.
-9-
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 and dividend
rates on its Preferred Shares similarly vary with
changes in an objective index. Nevertheless, the
interest rates on the Fund's Borrowings and dividend
rates on its Preferred Shares 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 and dividend rates on
its Preferred Shares adjust faster than the interest
rates on its adjustable-rate investment securities.
In a period of rising interest rates, the Fund's
interest and dividend 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 may 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 and Preferred Shares, if any, 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 interest rates 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 floating rate CMOs 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.
-10-
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-Advisor than if the Fund were a
stock fund or a corporate bond fund.
Economic Sector Risk. Under normal market conditions,
the Fund is 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. See "Risks--Risks
Associated with Recent Adverse Developments in the
Mortgage Finance and Credit Markets" for a more detailed
description of economic, political and regulatory events
affecting the MBS in which the Fund invests.
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 leverage would likely increase, which
would tend to further reduce returns to Common
Shareholders.
U.S. Government Securities Risk. U.S. government
securities generally do not involve the credit risks
associated with investments in other types of debt
securities, although, as a result, the yields available
from U.S. government securities are generally lower than
the yields available from corporate fixed-income
securities. Like other debt securities, however, the
values of U.S. government securities change as interest
rates fluctuate. Fluctuations in the value of portfolio
securities will not affect interest income on existing
portfolio securities but will be reflected in the Fund's
NAV. Since the magnitude of these fluctuations will
generally be greater at times when the Fund's average
maturity is longer, under certain market conditions the
Fund may, for temporary defensive purposes, accept lower
current income from short-term investments rather than
investing in higher yielding long-term securities.
Asset-Backed Securities Risk. Payment of interest and
repayment of principal on asset-backed securities may be
largely dependent upon the cash flows generated by the
assets backing the securities and, in certain cases,
supported by letters of credit, surety bonds or other
credit enhancements. Asset-backed security values may
also be affected by the creditworthiness of the
servicing agent for the pool, the originator of the
loans or receivables or the entities providing the
credit enhancement. In addition, the underlying assets
are subject to prepayments that shorten the securities'
weighted average maturity and may lower their return.
Market Discount From Net Asset Value. The Fund's common
shares have been publicly traded since May 25, 2005 and
have traded both at a premium and at a discount relative
to net asset value. There is no assurance that any
premium of the public offering price for the Common
Shares over net asset value with respect to any offering
hereunder will continue after such offering or that the
common shares will not again trade at a discount. Shares
of closed-end investment companies frequently trade at a
discount from their NAV. This characteristic is a risk
-11-
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. 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 public offering price with
respect to any offering hereunder.
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). Under normal circumstances, the
Fund anticipates utilizing leverage in an amount up to
33-1/3% of the Fund's Managed Assets. The Fund currently
leverages its assets through the use of reverse
repurchase agreements. 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 other
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
-12-
o when the Fund uses leverage, the investment advisory
fee payable to the Advisor (and by the Advisor to
the Sub-Advisor) will be higher than if the Fund did
not use leverage.
The Sub-Advisor, 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
involve 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-Advisor'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. For the fiscal year
ended October 31, 2009, portfolio turnover was
approximately 39%. 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 for U.S. federal income tax
purposes 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. Ongoing U.S. military action and
related events throughout the world, 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.
-13-
The Fund cannot predict the effects of such events in
the future on the U.S. and world economies, the value of
the Common Shares or the NAV of the Fund.
Certain Affiliations. Certain broker-dealers may be
considered to be affiliated persons of the Fund or First
Trust Advisors. Absent an exemption from the SEC 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.
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 By-Laws" 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 Fund's 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.
-14-
SUMMARY OF FUND EXPENSES
The following table and example contains information about the costs and
expenses that common shareholders will bear directly or indirectly. In
accordance with Securities and Exchange Commission requirements, the table below
shows the Fund's expenses as a percentage of the Fund's net assets as of
September 30, 2010, and not as a percentage of gross assets or Managed Assets.
By showing expenses as a percentage of net assets, expenses are not expressed as
a percentage of all the assets the Fund invests. The table and example are based
on the Fund's capital structure as of September 30, 2010.
SHAREHOLDER TRANSACTION EXPENSES:
Sales Load (as a percentage of offering price) .................................................... -- %*
Offering Expenses Borne by the Fund (as a percentage of offering price)(1)......................... -- %*
Offering Expenses of Reverse Repurchase Agreements Expected to be
Borne by the Fund (as a percentage of offering price)......................................... None(2)
Dividend Reinvestment Plan Fees.................................................................... None(3)
PERCENTAGE OF NET ASSETS
ATTRIBUTABLE TO COMMON SHARES,
(ASSUMES REVERSE REPURCHASE
AGREEMENTS ARE USED)(4)
------------------------------
ANNUAL EXPENSES:
Management Fees(4)................................................................................. 1.18%
Interest and Fees on Leverage...................................................................... 0.10%
Other Expenses..................................................................................... 0.52%
Total Annual Expenses(5)...................................................................... 1.80%
--------------------------------------------------------------------------------
* The applicable prospectus supplement to be used in connection with any
sales of Common Shares will set forth any applicable sales load and the
estimated offering expenses borne by the Fund.
(1) The Fund will pay all offering costs other than sales load.
(2) As of September 30, 2010, the Fund utilized Leverage Instruments in the
form of reverse repurchase agreements and there are no offering expenses
associated with their use. Although the Fund has no current intention to
do so, if the Fund elects to use other forms of Leverage Instruments,
there may be offering expenses associated with such issuance and/or
Borrowings, which expenses would be borne immediately by the Common
Shareholders and result in a reduction of the NAV of the Common Shares.
(3) You will pay brokerage charges if you direct BNY Mellon Investment
Servicing (US) Inc., as agent for the Common Shareholders Dividend
Reinvestment Plan, to sell your Common Shares held in a dividend
reinvestment account.
(4) Represents the aggregate fee payable to the Advisor (and by the Advisor to
the Sub-Advisor).
(5) For the six-month period ended April 30, 2010, actual total annual
expenses were at a higher percentage, 2.14%, primarily as a result of
excise taxes incurred by the Fund.
The purpose of the tables 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 tables under "Other
Expenses" and "Total Annual Expenses" are based on estimated amounts for the
Fund's 12 months of operations after September 30, 2010 unless otherwise
indicated and assumes that the Fund has not issued any additional common shares.
The following examples illustrate the expenses that you would pay on a $1,000
investment in Common Shares, assuming: (i) total annual expenses of 1.80% of net
assets attributable to Common Shares through year 10 and (ii) a 5% annual return
and (iii) all distributions are reinvested at net asset value(1):
1 YEAR 3 YEARS 5 YEARS 10 YEARS
$18 $57 $97 $212
--------------------------------------------------------------------------------
(1) THIS EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF FUTURE EXPENSES.
ACTUAL EXPENSES MAY BE GREATER OR LESS THAN THOSE SHOWN. This example
assumes that the estimated "Other expenses" set forth in the Annual
Expenses table are accurate, all dividends and distributions are
reinvested at net asset value and that the Fund is engaged in leverage of
15.04% of total assets, assuming interest and fees on leverage of 0.10%.
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, $15; three
years, $48; five years, $83; and ten years, $181.
-15-
FINANCIAL HIGHLIGHTS
The information in this table for the years ended October 31, 2009 and 2008
is derived from the Fund's financial statements audited by Deloitte & Touche
LLP, whose report on certain of such financial statements is contained in the
Fund's 2009 Annual Report. The information as of April 30, 2010 appears on the
Fund's unaudited interim financial statements as filed with the SEC in the
Fund's most recent shareholder report for the period ended April 30, 2010. Both
reports are incorporated by reference into the Fund's SAI, both of which are
available from the Fund upon request.
SIX MONTHS
ENDED YEAR YEAR YEAR YEAR PERIOD
4/30/2010 ENDED ENDED ENDED ENDED ENDED
(UNAUDITED) 10/31/2009 10/31/2008 10/31/2007 10/31/2006 10/31/2005(a)
----------- ---------- ---------- ---------- ---------- ----------
Net asset value, beginning of period...... $ 19.63 $ 18.03 $ 18.66 $ 18.41 $ 19.02 $ 19.10(b)
--------- --------- --------- --------- --------- ---------
INCOME FROM INVESTMENT OPERATIONS:
Net investment income (loss).............. 0.92 1.57 1.49 1.04 1.03 0.36
Net realized and unrealized gain (loss)... 0.54 1.40 (1.00) 0.23 (0.58) (0.09)
--------- --------- --------- --------- --------- ---------
Total from investment operations.......... 1.46 2.97 0.49 1.27 0.45 0.27
--------- --------- --------- --------- --------- ---------
DISTRIBUTIONS PAID TO SHAREHOLDERS FROM:
Net investment income..................... (0.81) (1.37) (1.12) (1.02) (1.06) (0.31)
--------- --------- --------- --------- --------- ---------
Total distributions....................... (0.81) (1.37) (1.12) (1.02) (1.06) (0.31)
--------- --------- --------- --------- --------- ---------
Common Shares offering costs charged to
paid-in capital........................ __ __ __ __ __ (0.04)
--------- --------- --------- --------- --------- ---------
Net asset value, end of period............ $ 20.28 $ 19.63 $ 18.03 $ 18.66 $ 18.41 $ 19.02
========= ========= ========= ========= ========= =========
Market value, end of period............... 18.57 $ 17.91 $ 15.71 $ 16.32 $ 16.58 $ 16.40
========= ========= ========= ========= ========= =========
TOTAL RETURN BASED ON NET ASSET VALUE (c). 8.03% 18.21% 3.38% 7.80% 3.30% 1.37%
========= ========= ========= ========= ========= =========
TOTAL RETURN BASED ON MARKET VALUE (c).... 8.37% 23.91% 2.94% 4.69% 7.89% (16.53)%
========= ========= ========= ========= ========= =========
RATIOS TO AVERAGE NET
ASSETS/SUPPLEMENTAL DATA:
Net assets, end of period (in 000's)...... $ 82,096 $ 79,462 $ 72,956 $ 75,487 $ 74,458 $ 76,925
Ratio of total expenses to average net
assets................................. 2.14%(d) 2.07% 2.69% 3.24% 3.10% 2.48%(d)
Ratio of net expenses to average net
assets................................. 2.14%(d) 2.07% 2.69% 3.24% 3.06% 2.28%(d)
Ratio of net expenses to average net
assets excluding interest expense...... 2.09%(d) 1.99% 1.83% 1.71% 1.69% 1.62%(d)
Ratio of net investment income to
average net assets..................... 9.39%(d) 9.01% 7.93% 5.70% 5.55% 4.30%(d)
Portfolio turnover rate................... 4% 39% 10% 22% 76% 14%
_______________________________________________________
(a) Initial seed date of May 17, 2005. The Fund commenced operations on May
25, 2005.
(b) Net of sales load of $0.90 per share on initial shares issued.
(c) Total return is based on the combination of reinvested dividend, capital
gain and return of capital distributions, if any, at prices obtained by
the Dividend Reinvestment Plan, and changes in net asset value per share
for net asset value returns and changes in Common Share price for market
value returns. Total returns do not reflect sales load and are not
annualized for periods less than one year.
(d) Annualized.
-16-
MARKET AND NET ASSET VALUE INFORMATION
The Fund's currently outstanding common shares are, and the Common Shares
offered by this prospectus and the applicable prospectus supplement, subject to
notice of issuance, will be, listed on the New York Stock Exchange. The Fund's
common shares commenced trading on the New York Stock Exchange on May 25, 2005.
The Fund's common shares have traded both at a premium and at a discount
in relation to net asset value. Shares of closed-end investment companies
frequently trade at a discount from net asset value. The Fund's issuance of the
Common Shares may have an adverse effect on prices in the secondary market for
the Fund's common shares by increasing the number of common shares available,
which may put downward pressure on the market price for the Fund's common
shares. See "Risks - Market Discount from Net Asset Value."
The following table sets forth for each of the periods indicated the high and
low closing market prices for common shares of the Fund on the New York Stock
Exchange, the net asset value per share and the premium or discount to net asset
value per share at which the Fund's common shares were trading. Net asset value
is determined daily as of the close of regular trading on the New York Stock
Exchange (normally 4:00 p.m. eastern time). See "Net Asset Value" for
information as to the determination of the Fund's net asset value.
PREMIUM/(DISCOUNT)
MARKET PRICE(1) NET ASSET VALUE (2) TO NET ASSET VALUE (3)
QUARTER ENDED HIGH LOW HIGH LOW HIGH LOW
June 30, 2005(*).............................. $20.05 $20.00 $19.16 $19.06 4.65% 4.93%
September 30, 2005............................ $20.05 $16.45 $19.15 $18.89 4.70% -12.92%
December 30, 2005............................. $16.76 $15.40 $19.00 $18.51 -11.79% -16.80%
March 31, 2006................................ $16.27 $15.83 $18.67 $18.55 -12.85% -14.66%
June 30, 2006................................. $16.28 $15.93 $18.50 $18.49 -12.00% -13.85%
September 30, 2006............................ $16.46 $15.75 $18.44 $18.38 -10.74% -14.31%
December 30, 2006............................. $16.73 $16.33 $18.45 $18.25 -9.32% -10.52%
March 31, 2007................................ $16.83 $16.34 $18.32 $18.16 -8.13% -10.02%
June 29, 2007................................. $16.91 $16.47 $18.52 $18.28 -8.69% -9.90%
September 28, 2007............................ $16.68 $15.59 $18.46 $18.54 -9.64% -15.91%
December 31, 2007............................. $17.15 $16.03 $18.60 $18.80 -7.80% -14.73%
March 31, 2008................................ $17.48 $16.21 $19.17 $18.23 -8.82% -11.08%
June 30, 2008................................. $17.76 $16.78 $19.07 $18.58 -6.87% -9.69%
September 30, 2008............................ $17.18 $14.83 $19.23 $18.19 -10.66% -18.47%
December 31, 2008............................. $17.04 $12.40 $16.59 $18.37 2.71% -32.50%
March 31, 2009................................ $16.57 $14.82 $16.15 $16.51 2.60% -10.24%
June 30, 2009................................. $16.77 $15.65 $17.82 $16.58 -5.89% -5.61%
September 30, 2009............................ $17.86 $16.45 $19.16 $17.65 -6.78% -6.80%
December 31, 2009............................. $18.37 $17.35 $19.90 $19.42 -7.69% -10.66%
March 31, 2010................................ $18.63 $18.14 $20.04 $19.79 -7.04% -8.34%
June 30, 2010................................. $18.60 $17.86 $20.30 $20.17 -8.37% -11.45%
September 30, 2010............................ $21.87 $18.21 $19.31 $19.54 13.26% -6.81%
The last reported sale price, net asset value per share and percentage
premium to net asset value per share of the common shares as of September 30,
2010 were $21.75, $19.40 and 12.11%, respectively. As of September 30, 2010, the
Fund had 4,054,454 common shares outstanding and net assets of the Fund were
$78,642,584.
-------------------------------------------
(1) Based on high and low closing market price for the respective quarter.
(2) Based on the net asset value calculated daily as of the close of regular
trading on the NYSE (normally 4:00 p.m. eastern time).
(3) Calculated based on the information presented.
* The Fund commenced operations on 5/25/05.
-17-
THE FUND
The Fund is a diversified, closed-end management investment company
registered under 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"). On May 25, 2005, the Fund issued an aggregate of
4,005,236 common shares in its initial public offering. The Fund's currently
outstanding common shares are, and the Common Shares offered in this prospectus
and applicable prospectus supplement will be, listed on the New York Stock
Exchange under the symbol "FMY." The Fund's principal office is located at 120
East Liberty Drive, Suite 400, Wheaton, Illinois 60187. Investment in the Fund
involves certain risks and special considerations, including risks associated
with the Fund's use of leverage. See "Risks."
The following table provides information about the Fund's outstanding
securities as of September 30, 2010:
AMOUNT HELD BY
AMOUNT THE FUND OR FOR AMOUNT
TITLE OF CLASS AUTHORIZED ITS ACCOUNT OUTSTANDING
Common shares.......... Unlimited 0 4,054,454
USE OF PROCEEDS
Unless otherwise specified in a prospectus supplement, the Fund will invest
the net proceeds from any sales of Common Shares in accordance with the Fund's
investment objective and policies as stated below, or use such proceeds for
other general corporate purposes. Pending any such use, the proceeds may be
invested in cash, cash equivalents or other securities.
THE FUND'S INVESTMENTS
INVESTMENT OBJECTIVE AND POLICIES
The Fund's primary investment objective is to seek a high level of current
income. As a secondary objective, the Fund seeks to preserve capital. The Fund
pursues its objectives by investing primarily in MBS that, in the opinion of the
Fund's Sub-Advisor, 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 invests substantially all of its
Managed Assets in a diversified portfolio of MBS. The Fund acquires investment
securities that the Sub-Advisor 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 and credit environments. The Sub-Advisor believes
that future interest rates and mortgage prepayment rates and underlying credit
performance are very difficult to predict. Therefore, the Sub-Advisor seeks to
minimize prepayment risk by structuring a diversified portfolio with a variety
of prepayment and credit 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
anticipated average life of the security rather than the stated maturity. The
-18-
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 as well as mitigating credit risk.
In constructing a diversified MBS portfolio, the Sub-Advisor 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-Advisor's research process is internally driven and is predominantly
top down in nature. The Sub-Advisor 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-Advisor 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-Advisor 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-Advisor 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-Advisor's forecasts over a
three to 12 month period. This analysis determines the overall composition of
the Fund's portfolio.
The Sub-Advisor 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-Advisor's strategic
views.
Underlying the investment process is consistent risk management and stress
testing of the portfolio using risk modeling and attribution techniques.
Quantitative techniques are used to identify and test market observations and
are a tool to assist in portfolio construction.
The Sub-Advisor'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
and credit exposure by examining such underlying loan characteristics as
geographic information, servicer information, FICO credit scores (developed by
Fair Isaac & Co.), loan balance and prepayment penalties.
Although analysis focuses on portfolio cash flow, there are other factors
(such as interest rates, credit quality, 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-Advisor'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 is 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.
-19-
Under normal market conditions, the Fund invests 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 is fully invested in MBS and Other MBS.
The Fund invests all of its Managed Assets in securities that at the time of
investment are investment grade quality. The Fund only invests 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/A2 or better by Moody's, S&P or Fitch); or
o unrated but judged to be of comparable quality by the Sub-Advisor.
While the Fund attempts to minimize credit risk by investing in securities
that are investment grade quality at the time of purchase, the Fund currently
holds securities which were investment grade quality at the time of the purchase
but are currently rated below investment grade. As of September 30, 2010, 20.94%
of the Fund's Managed Assets were invested in securities below investment grade
quality. In addition, beginning in 2008, the Fund has generally increased its
credit risk profile by pursuing attractive risk-adjusted opportunities in
subordinated classes of MBS, Non-Agency RMBS and Stripped Mortgage-Backed
Securities which, due to credit and liquidity concerns and volatility in market
conditions for mortgages and mortgage related assets, have experienced depressed
pricing.
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 does not invest in corporate bonds,
other than those primarily secured by interests in real estate.
The Fund attempts to reduce portfolio prepayment and credit 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.
MBS Expected Average Maturity and Stated Final Maturity. The stated final
maturity of 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 MBS or Other MBS, often referred to as "weighted
average life," 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.
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:
o AGENCY MORTGAGE PASS-THROUGH CERTIFICATES. The agency mortgage
pass-through certificates in which the Fund invests 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 were formed as 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 has historically
-20-
been deemed obligations solely of those respective corporations, and
were not historically deemed to be backed by the full faith and credit
of the U.S. government.
Subsequent to June 30, 2008, there were increased market concerns
about FNMA and FHLMC's ability to withstand future credit losses
associated with securities held in their investment portfolios, and on
which they provide guarantees, without the direct support of the U.S.
Government. In September 2008, FNMA and FHLMC were placed into the
conservatorship of the Federal Housing Finance Agency, or FHFA, their
federal regulator, pursuant to its powers under The Federal Housing
Finance Regulatory Reform Act of 2008, a part of the Housing and
Economic Recovery Act of 2008. As the conservator of FNMA and FHLMC,
the FHFA controls and directs the operations of FNMA and FHLMC and may
(1) take over the assets of and operate FNMA and FHLMC with all the
powers of the shareholders, the directors, and the officers of FNMA
and FHLMC and conduct all business of FNMA and FHLMC; (2) collect all
obligations and money due to FNMA and FHLMC; (3) perform all functions
of FNMA and FHLMC which are consistent with the conservator's
appointment; (4) preserve and conserve the assets and property of FNMA
and FHLMC; and (5) contract for assistance in fulfilling any function,
activity, action or duty of the conservator.
In addition to FHFA becoming the conservator of FNMA and FHLMC, the
Treasury and FHFA entered into Preferred Stock Purchase Agreements
(PSPAs) between the Treasury and FNMA and FHLMC pursuant to which the
Treasury will ensure that each of FNMA and FHLMC maintains a positive
net worth. On December 24, 2009, the U.S. Treasury amended the terms
of the U.S. Treasury's PSPAs with FNMA and FHLMC to remove the $200
billion per institution limit established under the PSPAs until the
end of 2012. The U.S. Treasury also amended the PSPAs with respect to
the requirements for FNMA and FHLMC to reduce their portfolios.
o AGENCY COLLATERALIZED MORTGAGE OBLIGATIONS. Agency CMOs are debt
obligations issued by GNMA, FNMA or FHLMC. CMOs 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 interest rate 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 floating rate CMOs 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.
o STRIPPED MORTGAGE-BACKED SECURITIES. The Fund invests in Stripped
Mortgage-Backed Securities. Stripped Mortgage-Backed Securities are
created by segregating the cash flows from underlying mortgage loans
-21-
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 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 issuers 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,
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
include 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 invests are issued in a senior/ subordinated structure. In these
structures, the senior class investors have greater protection against potential
-22-
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 does 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.
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 SEC'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-Advisor to be illiquid are subject
to the limitation 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 Advisor or Sub-Advisor 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 Advisor's or Sub-Advisor'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 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-Advisor seeks to use such practices to further the Fund's investment
objectives, no assurance can be given that the Sub-Advisor 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 portfolio
management or hedging techniques 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
-23-
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-Advisor'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.
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. For the fiscal year ended October 31, 2009, the portfolio
turnover rate was 39%. 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."
USE OF LEVERAGE
The Fund is currently engaged in, and may in the future engage in, the use of
leverage to seek to enhance the level of its current distributions to common
shareholders. The Fund may borrow (by use of commercial paper, notes, reverse
repurchase agreements and/or other Borrowings) an amount up to 331/3% (or such
other percentage to the extent permitted by the 1940 Act) 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 of the Preferred Shares and any
Borrowings). As of September 30, 2010, the Fund utilized leverage in an amount
equal to approximately 15.04% of the Fund's Managed Assets. Reverse repurchase
agreements, commercial paper, notes or other Borrowings and Preferred Shares are
each considered a "Leverage Instrument" and collectively, the "Leverage
Instruments." Leverage Instruments have seniority in liquidation and
distribution rights over the Fund's common shares. Any use of Leverage
Instruments by the Fund will, however, be consistent with the provisions of the
1940 Act.
The Fund utilizes leverage primarily through the use of 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.
Any Leverage Instruments would have complete priority upon distribution of
the Fund's 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 re-determined periodically by an auction process. The
adjustment period for Preferred Share 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
-24-
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 reverse repurchase agreements, Borrowings
and other 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-Advisor 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 Advisor (and by the
Advisor to the Sub-Advisor) will be calculated on the basis of the Managed
Assets including proceeds from reverse repurchase agreements and other
Borrowings for leverage and the issuance of Preferred Shares. During periods in
which the Fund is utilizing leverage, the investment advisory fee payable to the
Advisor (and by the Advisor to the Sub-Advisor) 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.
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-Advisor
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 re-determined 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
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(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 15.04% of
the Fund's capital and pay dividends or interest at an annual combined average
rate of 0.55%, the income generated by the Fund's portfolio (net of estimated
expenses) must exceed 0.08% 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 SEC. 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 reverse repurchase agreements
representing 15.04% of the Fund's capital, net of expenses, and the Fund's
currently projected annual interest rate on its reverse repurchase agreements
of 0.55%.
Assumed Portfolio Total Return (Net of Expenses) ...... (10%) (5%) 0% 5% 10%
Common Share Total Return ............................. (11.87)% (5.98)% (0.10)% 5.79% 11.67%
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 SEC rules, the table above assumes 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 investments.
While the Fund is using leverage, the amount of the fees paid to both the
Advisor and the Sub-Advisor for investment advisory and management services are
higher than if the Fund did not use leverage because the fees paid are
calculated based on the Fund's Managed Assets, which include assets purchased
with leverage. Therefore, the Advisor and the Sub-Advisor have a financial
incentive to leverage the Fund, which may create a conflict of interest between
the Advisor and Sub-Advisor on the one hand and the common shareholders on the
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other. Because payments on any leverage would be paid by the Fund at a specified
rate, only the Fund's common shareholders would bear the Fund's management fees
and other expenses.
RISKS
GENERAL
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 and
Investment Risks" in the SAI.
RISKS ASSOCIATED WITH RECENT ADVERSE DEVELOPMENTS IN THE MORTGAGE FINANCE AND
CREDIT MARKETS
Volatile market conditions for mortgages and mortgage-related assets. The Fund's
results of operations are materially affected by conditions in the markets for
mortgages and mortgage-related assets, including MBS, as well as the broader
financial markets and the economy generally. Beginning in the summer of 2007,
significant adverse changes in financial market conditions resulted in a
deleveraging of the entire global financial system and the forced sale of large
quantities of mortgage-related and other financial assets. Concerns over
economic recession, geopolitical issues, unemployment, the availability and cost
of financing, the mortgage market and a declining real estate market contributed
to increased volatility and diminished expectations for the economy and markets.
As a result of these conditions, many traditional mortgage investors suffered
severe losses in their residential mortgage portfolios and several major market
participants failed or have been impaired, resulting in a significant
contraction in market liquidity for mortgage-related assets. This illiquidity
negatively affected both the terms and availability of financing for all
mortgage-related assets. Further increased volatility and deterioration in the
markets for mortgages and mortgage-related assets as well as the broader
financial markets may adversely affect the performance and market value of the
Fund's MBS. If these conditions persist, institutions from which the Fund seeks
financing for the Fund's investments may tighten their lending standards or
become insolvent, which could make it more difficult for the Fund to obtain
financing on favorable terms or at all. Continued adverse developments in the
broader residential mortgage market may adversely affect the value of the assets
in which the Fund invests.
Since the summer of 2007, the residential mortgage market in the United
States experienced a variety of difficulties and changed economic conditions,
including defaults, credit losses and liquidity concerns. Certain commercial
banks, investment banks and insurance companies have announced extensive losses
from exposure to the residential mortgage market. These losses have reduced
financial industry capital, leading to reduced liquidity for some institutions.
These factors have impacted investor perception of the risk associated with MBS
in which the Fund invests. As a result, values for MBS in which the Fund invests
have experienced a certain amount of volatility. Further increased volatility
and deterioration in the broader residential mortgage and MBS markets may
adversely affect the performance and market value of the Fund's investments.
Laws and regulations affecting the relationship between FNMA and FHLMC and the
U.S. government. Due to increased market concerns about FNMA and FHLMC's ability
to withstand future credit losses associated with securities held in their
investment portfolios, and on which they provide guarantees, without the direct
support of the U.S. government, on July 30, 2008, Congress passed the Housing
and Economic Recovery Act of 2008, or the "HERA." Among other things, the HERA
established the Federal Housing Finance Agency, or the "FHFA", which has broad
regulatory powers over FNMA and FHLMC. On September 6, 2008, the FHFA placed
FNMA and FHLMC into conservatorship and, together with the Treasury, established
a program designed to boost investor confidence in FNMA's and FHLMC's debt and
MBS. As the conservator of FNMA and FHLMC, the FHFA controls and directs the
operations of FNMA and FHLMC and may (1) take over the assets of and operate
FNMA and FHLMC with all the powers of the shareholders, the directors and the
officers of FNMA and FHLMC and conduct all business of FNMA and FHLMC; (2)
collect all obligations and money due to FNMA and FHLMC; (3) perform all
functions of FNMA and FHLMC which are consistent with the conservator's
appointment; (4) preserve and conserve the assets and property of FNMA and
FHLMC; and (5) contract for assistance in fulfilling any function, activity,
action or duty of the conservator.
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In addition to FHFA becoming the conservator of FNMA and FHLMC, the Treasury
and FHFA have entered into Preferred Stock Purchase Agreements (PSPAs) between
the Treasury and FNMA and FHLMC pursuant to which the Treasury will ensure that
each of FNMA and FHLMC maintains a positive net worth. On December 24, 2009, the
U.S. Treasury amended the terms of the U.S. Treasury's PSPAs with FNMA and FHLMC
to remove the $200 billion per institution limit established under the PSPAs
until the end of 2012. The U.S. Treasury also amended the PSPAs with respect to
the requirements for FNMA and FHLMC to reduce their portfolios.
Although the Treasury has committed capital to FNMA and FHLMC, there can be
no assurance that these actions will be adequate for their needs. If these
actions are inadequate, FNMA and FHLMC could continue to suffer losses and could
fail to honor their guarantees and other obligations. The future roles of FNMA
and FHLMC could be significantly reduced and the nature of their guarantees
could be considerably diminished. Any changes to the nature of the guarantees
provided by FNMA and FHLMC could redefine what constitutes MBS and could have
broad adverse market implications.
The problems faced by FNMA and FHLMC resulting in their being placed into
federal conservatorship have stirred debate among some federal policy makers
regarding the continued role of the U.S. government in providing liquidity for
mortgage loans. Following expiration of the current authorization, each of FNMA
and FHLMC could be dissolved and the U.S. government could determine to stop
providing liquidity support of any kind to the mortgage market. The future roles
of FNMA and FHLMC could be significantly reduced and the nature of their
guarantee obligations could be considerably limited relative to historical
measurements. Any changes to the nature of their guarantee obligations could
redefine what constitutes a MBS and could have broad adverse implications for
the market and the Fund's investment objectives and strategy. If FNMA or FHLMC
were eliminated, or their structures were to change radically (i.e., limitation
or removal of the guarantee obligation), the Fund may be unable to acquire
additional MBS and the Fund's existing MBS could be materially and adversely
impacted.
The Fund could be negatively affected in a number of ways depending on the
manner in which related events unfold for FNMA and FHLMC. The Fund relies on the
Fund's MBS as collateral for the Fund's financings under the Fund's repurchase
agreements. Any decline in their value, or perceived market uncertainty about
their value, would make it more difficult for the Fund to obtain financing on
acceptable terms or at all, or to maintain the Fund's compliance with the terms
of any financing transactions. Further, the current credit support provided by
the Treasury to FNMA and FHLMC, and any additional credit support it may provide
in the future, could have the effect of lowering the interest rates the Fund
expects to receive from MBS, thereby tightening the spread between the interest
the Fund earns on the Fund's MBS and the cost of financing those assets. A
reduction in the supply of MBS could also negatively affect the pricing of MBS
by reducing the spread between the interest the Fund earns on the Fund's
portfolio of MBS and the Fund's cost of financing that portfolio.
As indicated above, recent legislation has changed the relationship between
FNMA and FHLMC and the U.S. government and requires FNMA and FHLMC to reduce the
amount of mortgage loans they own or for which they provide guarantees on MBS.
Future legislation could further change the relationship between FNMA and FHLMC
and the U.S. government, and could also nationalize or eliminate such entities
entirely. Any law affecting these government-sponsored enterprises may create
market uncertainty and have the effect of reducing the actual or perceived
credit quality of securities issued or guaranteed by FNMA or FHLMC. As a result,
such laws could increase the risk of loss on investments in MBS guaranteed by
FNMA and/or FHLMC. It also is possible that such laws could adversely impact the
market for such securities and spreads at which they trade. All of the foregoing
could materially and adversely affect the Fund's business, operations and
financial condition.
Mortgage loan modification programs, future legislative action and changes in
the requirements necessary to qualify for refinancing a mortgage with FNMA,
FHLMC or GNMA. During the second half of 2008, in 2009, and so far in 2010, the
U.S. government, through the Federal Housing Administration ("FHA"), and the
Federal Deposit Insurance Corporation (the "FDIC"), implemented programs
designed to provide homeowners with assistance in avoiding residential mortgage
loan foreclosures including the Hope for Homeowners Act of 2008, which allows
certain distressed borrowers to refinance their mortgages into FHA-insured
loans. The programs may also involve, among other things, the modification of
mortgage loans to reduce the principal amount of the loans or the rate of
interest payable on the loans, or to extend the payment terms of the loans.
Members of the U.S. Congress have indicated support for additional legislative
relief for homeowners, including an amendment of the bankruptcy laws to permit
the modification of mortgage loans in bankruptcy proceedings. These loan
modification programs, future legislative or regulatory actions, including
-28-
amendments to the bankruptcy laws, that result in the modification of
outstanding mortgage loans, as well as changes in the requirements necessary to
qualify for refinancing a mortgage with FNMA, FHLMC or GNMA may adversely affect
the value of, and the returns on, the Fund's MBS. Depending on whether or not
the Fund purchased an instrument at a premium or discount, the yield the Fund
receives may be positively or negatively impacted by any modification.
Scrutiny of the practices of entities involved in the origination or servicing
of mortgage loans underlying MBS. Recently, allegations have been made that
entities involved in the origination or servicing of mortgage loans underlying
MBS submitted fraudulent documents in foreclosure proceedings or committed other
errors related to the origination and servicing of such mortgage loans. The
allegations are the subject of various lawsuits and investigations by various
state governmental authorities. If the entities involved in the origination or
servicing of mortgage loans underlying MBS did not or do not follow all
applicable law and regulation, and undertake prudent servicing practices as
required by the applicable MBS documents, investors in the MBS may incur losses
related to such mortgage loans or suffer a delay in receiving the payments
related to the mortgage loans.
U.S. government's pressing for refinancing of certain mortgage loans may affect
prepayment rates for mortgage loans in MBS. In addition to the increased
pressure upon residential mortgage loan investors and servicers to engage in
loss mitigation activities, the U.S. government is pressing for refinancing of
certain loans, and this encouragement may affect prepayment rates for mortgage
loans in MBS. In connection with government-related securities, in February 2009
President Obama unveiled the Homeowner Affordability and Stability Plan, which,
in part, calls upon FNMA and FHLMC to loosen their eligibility criteria for the
purchase of loans in order to provide access to low-cost refinancing for
borrowers who are current on their mortgage payments but who cannot otherwise
qualify to refinance at a lower market rate. The major change was to permit an
increase in the loan-to-value, or LTV, ratio of a refinancing loan eligible for
sale up to 105%. In July 2009, the FHFA authorized FNMA and FHLMC to raise the
present LTV ratio ceiling of 105% to 125%. The charters governing the operations
of FNMA and FHLMC prohibit purchases of loans with loan to value ratios in
excess of 80% unless the loans have mortgage insurance (or unless other types of
credit enhancement are provided in accordance with the statutory requirements).
The FHFA, which regulates FNMA and FHLMC, determined that new mortgage insurance
will not be required on the refinancing if the applicable entity already owns
the loan or guarantees the related MBS. Additionally, the Treasury reports that
in some cases a new appraisal will not be necessary upon refinancing. The
Treasury estimated that up to 5,000,000 homeowners with loans owned or
guaranteed by FNMA or FHLMC were eligible for this refinancing program, which
has been extended until June 30, 2011.
The HERA authorized a voluntary FHA mortgage insurance program called HOPE
for Homeowners, or "H4H Program", designed to refinance certain delinquent
borrowers into new FHA-insured loans. The H4H Program targets delinquent
borrowers under conventional mortgage loans, as well as under government-insured
or -guaranteed mortgage loans, that were originated on or before January 1,
2008. Holders of existing mortgage loans being refinanced under the H4H Program
must accept a write-down of principal and waive all prepayment fees. While the
use of the program has been extremely limited to date, Congress continues to
amend the program to encourage its use. The H4H Program is effective through
September 30, 2011.
To the extent these and other economic stabilization or stimulus efforts are
successful in increasing prepayment speeds for residential mortgage loans, such
as those in MBS, that could potentially harm the Fund's income and operating
results, particularly in connection with loans or MBS purchased at a premium or
the Fund's IO securities.
Actions of the U.S. government, Federal Reserve and Treasury, including the
establishment of the TALF, the PPIP and TARP. The Term Asset-Backed Securities
Loan Facility (the "TALF") was first announced by the Treasury on November 25,
2008, and stopped accepting applications on June 30, 2010. Under the TALF, the
Federal Reserve Bank of New York made non-recourse loans to borrowers to fund
their purchase of eligible assets. On March 23, 2009, the Treasury in
conjunction with the FDIC, and the Federal Reserve, announced the Public-Private
Investment Program (the "PPIP"). The PPIP aims to recreate a market for specific
illiquid residential and commercial loans and securities through a number of
joint public and private investment funds. The PPIP is designed to draw new
private capital into the market for these securities and loans by providing
government equity co-investment and attractive public financing.
In addition, in response to the financial issues affecting the banking system
and the financial markets and going concern threats to investment banks and
other financial institutions, the U.S. government, the Federal Reserve, the
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Treasury and other governmental and regulatory bodies have taken action to
attempt to stabilize the financial markets. Significant measures include the
enactment of the Economic Stabilization Act of 2008 ("EESA"), to, among other
things, establish the Troubled Asset Relief Program ("TARP"); the enactment of
the HERA, which established a new regulator for FNMA and FHLMC; the
establishment of the TALF; and the establishment of the PPIP.
It is not possible to predict how the TALF, the PPIP, or other recent U.S.
government actions will impact the financial markets, including current
significant levels of volatility, or the Fund's current or future investments.
To the extent the market does not respond favorably to these initiatives or they
do not function as intended, the Fund's business may not receive any benefits
from this legislation. In addition, the U.S. government, Federal Reserve,
Treasury and other governmental and regulatory bodies have taken or are
considering taking other actions to address the financial crisis. The Fund
cannot predict whether or when such actions may occur, and such actions could
have a dramatic impact on the Fund's business, results of operations and
financial condition.
There can be no assurance that the EESA, HERA, TALF, PPIP or other recent
U.S. government actions will have a beneficial impact on the financial markets,
including on current levels of volatility. To the extent the market does not
respond favorably to these initiatives or these initiatives do not function as
intended, the Fund's business may not receive the anticipated positive impact
from the legislation. There can also be no assurance that the Fund will be
eligible to participate in any programs established by the U.S. government such
as the TALF or the PPIP or, if the Fund is eligible, that the Fund will be able
to utilize them successfully or at all. In addition, because the programs are
designed, in part, to provide liquidity to restart the market for certain of the
Fund's targeted assets, the establishment of these programs may result in
increased competition for attractive opportunities in the Fund's targeted
assets. It is also possible that the Fund's competitors may utilize the programs
which would provide them with attractive debt and equity capital funding from
the U.S. government. In addition, the U.S. government, the Federal Reserve, the
Treasury and other governmental and regulatory bodies have taken or are
considering taking other actions to address the financial crisis. The Fund
cannot predict whether or when such actions may occur, and such actions could
have a dramatic impact on the Fund's business, results of operations and
financial condition.
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 Advisor and the Sub-Advisor 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 invests all of its Managed Assets in
investment grade securities at the time of investment, or if unrated, judged to
be of comparable quality by the Sub-Advisor, no assurance can be given that the
value of the securities will not decline.
Beginning in 2008, the Fund increased the portion of its Managed Assets
invested in subordinated classes of MBS, Non-Agency RMBS and Stripped
Mortgage-Back Securities, which the Sub-Advisor deemed to have attractive risk
adjusted returns at the time of such investments. Such classes may be subject to
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a greater degree of non-payment risk. In addition, under certain market
conditions, the market for subordinated classes of MBS in which the Fund invests
may not be as liquid as the market for other fixed-income securities.
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 SEC'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-Advisor to be illiquid are subject to the limitations set forth above.
The Sub-Advisor, 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. In addition, regulatory actions and other events affecting changes
to the market conditions for mortgages and mortgage-related assets could, in the
future, adversely affect the liquidity of the Fund's portfolio securities after
the time of initial investment. 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-Advisor'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.
PREPAYMENT RISK
MBS are backed by pools of mortgage loans. The Fund receives 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, particularly
if the Fund is forced to invest prepayments it receives in lower yielding
securities.
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. Moreover, the U.S. government
efforts to encourage refinancings of mortgage loans may substantially effect
prepayment rates.
The Fund may also invest in MBS which are IO securities and PO securities. As
of September 30, 2010, 12.1% of the Fund's Managed Assets were invested in IO or
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.
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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 seeks 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 primarily invests 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. In addition, 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.
An increase in the interest payments on the Fund's Borrowings or dividends on
Preferred Shares 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 or dividend payments it
must make on its Preferred Shares.
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 and dividend rates on its
Preferred Shares similarly vary with changes in an objective index.
Nevertheless, the interest rates on the Fund's Borrowings and dividend rates on
its Preferred Shares 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 and dividend rates on its Preferred Shares
adjust faster than the interest rates on its adjustable-rate investment
securities.
In a period of rising interest rates, the Fund's interest and dividend
payments could increase while the interest it earns on its fixed-rate MBS would
not change. This would adversely affect the Fund's profitability.
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While the majority of the Fund's investments may 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 and Preferred Shares,
if any, 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 and
Preferred Shares 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 interest rates 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
floating rate CMOs 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.
TAX RISK RELATING TO INVESTMENTS IN CERTAIN REMICS
The Fund may acquire residual interests in REMICs. The Fund may be taxable at
the highest corporate income tax rate on a portion of the income arising from a
residual interest in a REMIC that is allocable to the percentage of the Fund's
Common Shares held by "disqualified organizations," which are generally certain
cooperatives, governmental entities and tax-exempt organizations that are exempt
from unrelated business taxable income. Because this tax would be imposed on the
Fund, all of the Fund's investors, including investors that are not disqualified
organizations, would bear a portion of the tax cost associated with the Fund's
investment in a residual interest in a REMIC. See "Tax Matters."
In addition, if the Fund realizes excess inclusion income and allocates it to
Common Shareholders, this income cannot be offset by net operating losses of the
Common Shareholders. If the Common Shareholder is a tax-exempt entity and not a
disqualified organization, then this income would be fully taxable as unrelated
business taxable income under Section 512 of the Code. If the Common Shareholder
is a foreign person, it would be subject to U.S. federal income tax withholding
on this income without reduction or exemption pursuant to any otherwise
applicable income tax treaty.
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-Advisor
than if the Fund were a stock fund or a corporate bond fund.
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ECONOMIC SECTOR RISK
Under normal market conditions, the Fund fully invests 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. See "Risks--Risks Associated with Recent Adverse
Developments in the Mortgage Finance and Credit Markets" for a more detailed
description of economic, political and regulatory events affecting the MBS in
which the Fund invests.
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 leverage
would likely increase, which would tend to further reduce returns to Common
Shareholders.
U.S. GOVERNMENT SECURITIES RISK
U.S. government securities generally do not involve the credit risks
associated with investments in other types of debt securities, although, as a
result, the yields available from U.S. government securities are generally lower
than the yields available from corporate fixed-income securities. Like other
debt securities, however, the values of U.S. government securities change as
interest rates fluctuate. Fluctuations in the value of portfolio securities will
not affect interest income on existing portfolio securities but will be
reflected in the Fund's net asset value. Since the magnitude of these
fluctuations will generally be greater at times when the Fund's average maturity
is longer, under certain market conditions the Fund may, for temporary defensive
purposes, accept lower current income from short-term investments rather than
investing in higher yielding long-term securities.
ASSET-BACKED SECURITIES RISK
Payment of interest and repayment of principal on asset-backed securities may
be largely dependent upon the cash flows generated by the assets backing the
securities and, in certain cases, supported by letters of credit, surety bonds
or other credit enhancements. Asset-backed security values may also be affected
by the creditworthiness of the servicing agent for the pool, the originator of
the loans or receivables or the entities providing the credit enhancement. In
addition, the underlying assets are subject to prepayments that shorten the
securities' weighted average maturity and may lower their return.
MARKET DISCOUNT FROM NET ASSET VALUE
The Fund's common shares have been publicly traded since May 25, 2005 and
have traded both at a premium and at a discount relative to net asset value.
There is no assurance that any premium of the public offering price for the
Common Shares over net asset value with respect to any offering hereunder will
continue after such offering or that the common shares will not again trade at a
discount. 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
-34-
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, under normal circumstances, utilizes leverage in an amount up to 33-1/3%
of the Fund's Managed Assets. The Fund currently leverages its assets through
the use of reverse repurchase agreements. Reverse repurchase agreements,
Borrowings and the issuance of Preferred Shares are referred to in this
prospectus collectively as "leverage." The Fund may leverage its assets 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 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 leverage, the investment advisory fee payable to
the Advisor (and by the Advisor to the Sub-Advisor) will be higher
than if the Fund did not use leverage.
The Sub-Advisor, 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
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more stringent than those imposed by the 1940 Act. The Sub-Advisor 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.
DERIVATIVES RISK
Strategic Transactions involve 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-Advisor'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
-36-
on futures contracts to reduce risk involves costs and will be subject to the
Sub-Advisor'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 leverage, the Fund may be required to redeem or prepay some or all of
the 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 maintains, 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 - confirm 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.
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. For the fiscal
year ended October 31, 2009, portfolio turnover was approximately 39%. 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 for U.S. federal tax income purposes to the Fund's
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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
Ongoing U.S. military action and related events throughout the world, 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 such events in the future on
the U.S. and world economies, the value of the Common Shares or the NAV of the
Fund.
CERTAIN AFFILIATIONS
Certain broker-dealers may be considered to be affiliated persons of the Fund
or First Trust Advisors. Absent an exemption from the SEC 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.
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 By-Laws."
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 Fund's 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 general supervision of the
duties performed by the Advisor and the Sub-Advisor. 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, 120 East Liberty Drive, Suite 400, Wheaton, Illinois
60187, is the investment adviser to the Fund and is responsible for supervising
the Sub-Advisor. First Trust Advisors serves as investment adviser or portfolio
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supervisor to investment portfolios with approximately $36 billion in assets
which it managed or supervised as of September 30, 2010.
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 ownership
interests in various entities.
The Charger Corporation is an Illinois corporation that was previously
controlled by the Robert Donald Van Kampen family. On August 24, 2010, members
of the Robert Donald Van Kampen family entered into a stock purchase agreement
with James A. Bowen, the President of the Advisor, to sell 100% of the common
stock of The Charger Corporation to Mr. Bowen (who holds the interest through a
limited liability company of which he is the sole member) ("General Partner
Transaction"). The General Partner Transaction was completed in accordance with
its terms on October 12, 2010.
For additional information concerning First Trust Advisors, including a
description of the services provided, see "Investment Adviser" in the SAI.
SUB-ADVISER
FIDAC, which is a registered investment adviser, is the 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 $12.6 billion as of June 30, 2010
through nine investment vehicles distributed in Latin America, Europe, China,
Japan, South Korea, Canada, the United States, Malta and South Africa. FIDAC is
the wholly-owned registered investment advisor of Annaly Capital Management Inc.
("Annaly"), a publicly-traded real estate investment trust that trades under the
New York Stock Exchange symbol of NLY and at September 30, 2010, owned and
managed a portfolio of approximately $98 billion in 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 Wellington Denahan-Norris, James Fortescue,
Rose-Marie Lyght, Eric Szabo, Mohit Marria and Nancy Murtha.
Ms. Denahan-Norris is the Vice-Chairman of Annaly, Chief Investment Officer
and Chief Operating Officer of Annaly and FIDAC. Ms. Denahan-Norris has been
with FIDAC since its inception and was one of the original founders of Annaly.
Mr. Fortescue is a Managing Director and Head of Liabilities for FIDAC and
Annaly. Mr. Fortescue joined FIDAC in 1995.
Ms. Lyght is the Chief Investment Officer of FIDAC. Ms. Lyght joined FIDAC in
1999.
Mr. Szabo is a Managing Director and the Chief Risk Officer for FIDAC and
Annaly. Mr. Szabo joined both companies in 2004.
Mr. Marria is a Senior Vice President and Portfolio Manager for FIDAC and
Annaly. Mr. Marria joined both companies in 2005.
Ms. Murtha is a Senior Vice President and Portfolio Manager for FIDAC and
Annaly. Ms. Murtha joined both companies in 2002.
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-Advisor" in the SAI.
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INVESTMENT MANAGEMENT AGREEMENT
Pursuant to an investment management agreement between the Advisor and the
Fund (the "Investment Management Agreement"), the Fund has agreed to pay a fee
for the services and facilities provided by the Advisor at the annual rate of
1.00% 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 Advisor), custodian, transfer agency, administrative,
accounting and dividend disbursing expenses, legal fees, leverage expenses,
rating agency fees, listing fees and expenses, expenses of the independent
registered public accounting firm, 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-Advisor receives a portfolio management fee at the annual rate of
..50% of Managed Assets, which is paid by the Advisor out of the Advisor's
management fee.
Because the fee paid to the Advisor (and by the Advisor to the Sub-Advisor)
will be calculated on the basis of the Fund's Managed Assets, which include the
proceeds of leverage, the dollar amount of the Advisor's and Sub-Advisor's fees
will be higher (and the Advisor and Sub-Advisor will be benefited to that
extent) when leverage is utilized. In this regard, if the Fund uses leverage in
the amount equal to 15.04% of the Fund's Managed Assets (after the issuance of
leverage), the Fund's management fee would be 1.18% of net assets attributable
to Common Shares. See "Summary of Fund Expenses."
NET ASSET VALUE
The NAV of the Common Shares of the Fund is 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 is 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 values 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
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
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events occurring after the close of the market for a security but before the
time as of which 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-Advisor'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. 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, unless you elect to receive cash distributions, all
dividends and distributions on your common shares will be automatically
reinvested by the Plan Agent, BNY Mellon Investment Servicing (U.S.) Inc., in
additional common shares under the Dividend Reinvestment Plan (the "Plan"). If
you elect to receive cash distributions, you will receive all distributions in
cash paid by check mailed directly to you by BNY Mellon Investment Servicing
(U.S.) Inc., as dividend paying agent.
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You are automatically enrolled in the Plan when you become a shareholder of
the Fund. As a participant 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 net asset value at the time
of valuation, the Fund will issue new shares at a price equal to the greater of
(i) net asset value per common share on that date or (ii) 95% of the market
price on that date.
(2) If common shares are trading below net asset value 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 New York Stock Exchange
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 the 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 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 does not mean that you
do not have to pay income taxes due upon receiving 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 BNY Mellon Investment
Servicing (U.S.) Inc., 301 Bellevue Parkway, Wilmington, Delaware 19809.
PLAN OF DISTRIBUTION
The Fund may sell the Common Shares being offered under this prospectus in
any one or more of the following ways:
o directly to purchasers;
o through agents;
o to or through underwriters; or
o through dealers.
The Fund may distribute the Common Shares from time to time in one or more
transactions at:
o a fixed price or prices, which may be changed;
o market prices prevailing at the time of sale;
o prices related to prevailing market prices; or
o negotiated prices.
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The Fund may directly solicit offers to purchase Common Shares, or the Fund
may designate agents to solicit such offers. The Fund will, in a prospectus
supplement relating to such offering, name any agent that could be viewed as an
underwriter under the Securities Act and describe any commissions the Fund must
pay. Any such agent will be acting on a best efforts basis for the period of its
appointment or, if indicated in the applicable prospectus supplement or other
offering materials, on a firm commitment basis. Agents, dealers and underwriters
may be customers of, engage in transactions with, or perform services for the
Fund in the ordinary course of business.
If any underwriters or agents are utilized in the sale of Common Shares in
respect of which this prospectus is delivered, the Fund will enter into an
underwriting agreement or other agreement with them at the time of sale to them,
and the Fund will set forth in the prospectus supplement relating to such
offering their names and the terms of the Fund's agreement with them.
If a dealer is utilized in the sale of Common Shares in respect of which this
prospectus is delivered, the Fund will sell such Common Shares to the dealer, as
principal. The dealer may then resell such Common Shares to the public at
varying prices to be determined by such dealer at the time of resale.
The Fund may engage in at-the-market offerings to or through a market maker
or into an existing trading market, on an exchange or otherwise, in accordance
with Rule 415(a)(4). An at-the-market offering may be through an underwriter or
underwriters acting as principal or agent for the Fund.
Agents, underwriters and dealers may be entitled under agreements which they
may enter into with the Fund to indemnification by the Fund against certain
civil liabilities, including liabilities under the Securities Act, and may be
customers of, engage in transactions with or perform services for the Fund in
the ordinary course of business.
In order to facilitate the offering of the Common Shares, any underwriters
may engage in transactions that stabilize, maintain or otherwise affect the
price of the Common Shares or any other Common Shares the prices of which may be
used to determine payments on the Common Shares. Specifically, any underwriters
may over-allot in connection with the offering, creating a short position for
their own accounts. In addition, to cover over-allotments or to stabilize the
price of the Common Shares or of any such other Common Shares, the underwriters
may bid for, and purchase, the Common Shares or any such other Common Shares in
the open market. Finally, in any offering of the Common Shares through a
syndicate of underwriters, the underwriting syndicate may reclaim selling
concessions allowed to an underwriter or a dealer for distributing the Common
Shares in the offering if the syndicate repurchases previously distributed
Common Shares in transactions to cover syndicate short positions, in
stabilization transactions or otherwise. Any of these activities may stabilize
or maintain the market price of the Common Shares above independent market
levels. Any such underwriters are not required to engage in these activities and
may end any of these activities at any time.
The Fund may enter into derivative transactions with third parties, or sell
Common Shares not covered by this prospectus to third parties in privately
negotiated transactions. If the applicable prospectus supplement indicates, in
connection with those derivatives, the third parties may sell Common Shares
covered by this prospectus and the applicable prospectus supplement or other
offering materials, including in short sale transactions. If so, the third
parties may use Common Shares pledged by the Fund or borrowed from the Fund or
others to settle those sales or to close out any related open borrowings of
stock, and may use Common Shares received from the Fund in settlement of those
derivatives to close out any related open borrowings of stock. The third parties
in such sale transactions will be underwriters and, if not identified in this
prospectus, will be identified in the applicable prospectus supplement or other
offering materials (or a post-effective amendment).
The Fund or one of the Fund's affiliates may loan or pledge Common Shares to
a financial institution or other third party that in turn may sell the Common
Shares using this prospectus. Such financial institution or third party may
transfer its short position to investors in our Common Shares or in connection
with a simultaneous offering of other Common Shares offered by this prospectus
or otherwise.
The maximum commission or discount to be received by any member of the
Financial Industry Regulatory Authority will not be greater than eight percent
of the initial gross proceeds from the sale of any security being sold.
Any underwriter, agent or dealer utilized in the initial offering of Common
Shares will not confirm sales to accounts over which it exercises discretionary
authority without the prior specific written approval of its customer.
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DESCRIPTION OF SHARES
COMMON SHARES
The Declaration of Trust authorizes the issuance of an unlimited number of
common shares. The Common Shares being offered in this offering have a par value
of $0.01 per share and, subject to the rights of holders of Preferred Shares, if
any, have equal rights to the payment of dividends and the distribution of
assets upon liquidation. As of September 30, 2010, the Fund had 4,054,454 common
shares outstanding. The Common Shares being offered by this prospectus will,
when issued, be fully paid and, subject to matters discussed in "Certain
Provisions in the Declaration of Trust and By-Laws," non-assessable, and
currently have no preemptive or conversion rights (except as may otherwise be
determined by the Trustees in their sole discretion) or rights to cumulative
voting.
The Fund's currently outstanding common shares are, and the Common Shares
offered in this prospectus will be, subject to notice of issuance, listed on the
New York Stock Exchange under the trading or "ticker" symbol "FMY."
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
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 the common shares will trade at a price equal to or
higher than net asset value 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. See "Structure of the Fund;
Common Share Repurchases and Change in Fund Structure."
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 issues 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.
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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 and By-Laws."
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.
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.
DESCRIPTION OF BORROWINGS
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
use reverse repurchase agreements or 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% (331/3% of Managed Assets after Borrowings). With
respect to such Borrowing, asset coverage means the ratio which the value of the
Managed 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 the Fund elects to be treated as a regulated investment company,
and that such provisions would impair the Fund's status as a regulated
investment company under the Internal Revenue Code, the Fund, subject to its
ability to liquidate its relatively illiquid portfolio, intends to repay the
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Borrowings. Any borrowing will likely be ranked 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-Advisor
from managing the Fund's portfolio in accordance with the Fund's investment
objective and policies.
CERTAIN PROVISIONS IN THE DECLARATION OF TRUST AND BY-LAWS
Under Massachusetts law, shareholders could, in certain circumstances, 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 and By-Laws include provisions that could limit the
ability of other entities or persons to acquire control of the Fund or to
convert the Fund to open-end status. The number of trustees is currently five,
but by action of two-thirds of the trustees, the Board of Trustees may from time
to time be increased or decreased. The Board of Trustees is divided into three
classes of trustees serving staggered three-year terms, with the terms of one
class expiring at each annual meeting of shareholders. If the Fund issues
Preferred Shares, the Fund may establish a separate class for the trustees
elected by the holders of the Preferred Shares. Subject to applicable provisions
of the 1940 Act, vacancies on the Board of Trustees may be filled by a majority
action of the remaining trustees. Such provisions may work to delay a change in
the majority of the Board of Trustees. The provisions of the Declaration of
Trust relating to the election and removal of trustees may be amended only by a
vote of two-thirds of the trustees then in office. 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 and By-Laws."
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The provisions of the Declaration of Trust and By-Laws 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 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 of Trust on file with the SEC for
the full text of these provisions.
STRUCTURE OF THE FUND; COMMON SHARE REPURCHASES AND CHANGE IN FUND
STRUCTURE
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 objective 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 determined in connection with
the initial offering of common shares of the Fund that the closed-end structure
is desirable, given the Fund's investment objective and policies. Investors
should assume, therefore, that it is highly unlikely that the Board of Trustees
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
Advisor, Sub-Advisor and the corporate finance services and consulting agent
that the Advisor has retained, 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
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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 and limitations on seniority within the Fund's capital structure if
the Fund has other Borrowings outstanding at such time, 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 objective,
policies and portfolio, the Advisor and the Sub-Advisor do not anticipate that
repurchases of common shares or tender offers should interfere with the ability
of the Fund to manage its investments in order to seek its investment objective,
and does 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 common 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 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 New York Stock Exchange or other national securities
exchange or market system. Any Preferred Shares would need to be redeemed and
any Borrowings may need to be repaid upon conversion to an open-end investment
company. Additionally, the 1940 Act imposes limitations on open-end funds'
investments in illiquid securities, which could restrict the Fund's ability to
invest in certain securities discussed in this prospectus to the extent
discussed herein. Such limitations could adversely affect distributions to Fund
common shareholders in the event of conversion to an open-end fund. The Board of
Trustees believes, however, that the closed-end structure is desirable, given
the Fund's investment objective 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, if any, as might be in
effect at the time of a redemption. The Fund would expect 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
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
-48-
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 Subchapter M of the Code. 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 net
income as required under the Code, the Fund generally will not be subject to
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 ordinary tax rates, 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 by non-corporate shareholders from the Fund may be taxed
at reduced tax rates equal to those applicable to net capital gains but this
amount is not expected to be significant. 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.
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 0% for certain taxpayers
in the 10% and 15% tax brackets). These capital gains rates are generally
effective for taxable years beginning before January 1, 2011. For later periods,
if you are an individual, the maximum marginal federal tax rate for capital
gains is generally 20% (10% for certain taxpayers in the 10% and 15% brackets).
The 20% rate is reduced to 18% and the 10% rate is reduced to 8% for most
property with a holding period 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
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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 rates that apply to net capital gain (as discussed above), but only if
certain holding period and other requirements are satisfied by both the Fund and
the shareholder 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, 2011. The Fund generally does not
expect to generate qualifying dividends eligible for taxation at capital gains
tax rates.
Medicare Tax. Under the "Health Care and Education Reconciliation Act of
2010," income from the Fund may also be subject to a new 3.8 percent "medicare
tax" imposed for taxable years beginning after 2012. This tax will generally
apply to the net investment income of a Member who is an individual if such
Member's adjusted gross income exceeds certain threshold amounts, which are
$250,000 in the case of married couples filing joint returns and $200,000 in the
case of single individuals.
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. federal 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. There can be no
assurance as to what portion, if any, of the Fund's distributions will
constitute interest related dividends or short-term capital gain dividends.
Foreign investors should consult their tax advisors with respect to U.S. tax
consequences of ownership of Common Shares.
In addition, distributions after December 31, 2012 may be subject to a U.S.
withholding tax of 30% in the case of distributions to (i) certain non-U.S.
financial institutions that have not entered into an agreement with the U.S.
Treasury to collect and disclose certain information and (ii) certain other
non-U.S. entities that do not provide certain certifications and information
about the entity's U.S. owners.
Certain Investments in REMICs. If the Fund acquires a residual interest in a
REMIC, the Fund may realize excess inclusion income. Excess inclusion income is
an amount, with respect to any calendar quarter, equal to the excess, if any, of
(i) the taxable income of the REMIC allocable to the holder of a residual
interest in a REMIC during such calendar quarter over (ii) the sum of amounts
allocated to each day in the calendar quarter equal to its ratable portion of
the product of (a) the adjusted issue price of the interest at the beginning of
the quarter multiplied by (b) 120% of the long term federal rate (determined on
the basis of compounding at the close of each calendar quarter and properly
adjusted for the length of such quarter). Excess inclusion income generated by a
residual interest in a REMIC would be allocated among the holders of the Fund,
generally in a manner set forth under the applicable Treasury regulations. A
shareholder's share of any excess inclusion income: (i) could not be offset by
net operating losses of a shareholder; (ii) would be subject to tax as unrelated
business taxable income to a tax-exempt holder; (iii) would be subject to the
application of the U.S. federal income tax withholding (without reduction
pursuant to any otherwise applicable income tax treaty) with respect to amounts
allocable to non-U.S. shareholders; and (iv) would be taxable (at the highest
corporate tax rates) to the Fund, rather than the Fund's shareholders, to the
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extent allocable to shares held by disqualified organizations (generally,
tax-exempt entities not subject to unrelated business income tax, including
governmental organizations).
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.
CUSTODIAN, ADMINISTRATOR AND TRANSFER AGENT
The custodian of the assets of the Fund is The Bank of New York Mellon
("Custodian"), One Wall Street, New York, New York 10286. The Fund's transfer,
shareholder services and dividend paying agent is BNY Mellon Investment
Servicing (U.S.) Inc., 301 Bellevue Parkway, Wilmington, Delaware 19809.
Pursuant to an Administration and Accounting Services Agreement, BNY Mellon
Investment Servicing (U.S.) 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 providing such independent registered public accounting firm
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 BNY Mellon Investment Servicing
(U.S.) Inc. an annual fee, calculated daily and payable on a monthly basis, of
[0.06%] 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. Chapman and
Cutler LLP may rely as to certain matters of Massachusetts law on the opinion of
Bingham McCutchen LLP. If certain legal matters in connection with an offering
of Common Shares are passed upon by counsel for the underwriters or sales agent
of such offering, such counsel will be named in a prospectus supplement.
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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.... 11
Other Investment Policies and Techniques ................................... 18
Management of the Fund ..................................................... 26
Investment Adviser ......................................................... 37
Proxy Voting Policies and Procedures........................................ 40
Sub-Advisor ................................................................ 40
Portfolio Transactions and Brokerage ....................................... 43
Description of Shares ...................................................... 45
Certain Provisions in the Declaration of Trust and By-Laws.................. 47
Repurchase of Fund Shares; Conversion to Open-End Fund ..................... 50
Federal Income Tax Matters ................................................. 52
Performance Related and Comparative Information ............................ 58
Independent Registered Public Accounting Firm .............................. 60
Custodian, Administrator and Transfer Agent ................................ 61
Additional Information ..................................................... 61
Financial Statements and Report of Independent Registered
Public Accounting Firm .................................................. F-1
Appendix A -- Description of Ratings ....................................... A-1
Appendix B -- First Trust Advisors L.P. Proxy Voting Guidelines ............ B-1
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THIS PAGE IS INTENTIONALLY LEFT BLANK.
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YOU SHOULD RELY ONLY ON THE INFORMATION CONTAINED OR INCORPORATED BY
REFERENCE IN THIS PROSPECTUS. THE FUND HAS NOT AUTHORIZED ANYONE TO PROVIDE YOU
WITH DIFFERENT INFORMATION. THE FUND IS NOT MAKING AN OFFER OF THESE SECURITIES
IN ANY STATE WHERE THE OFFER IS NOT PERMITTED.
--------------------------------------------------------------------------------
TABLE OF CONTENTS
PAGE
Prospectus Summary...........................................................1
Summary of Fund Expenses....................................................15
Financial Highlights........................................................16
Market and Net Asset Value Information......................................17
The Fund....................................................................18
Use of Proceeds.............................................................18
The Fund's Investments......................................................18
Use of Leverage.............................................................24
Risks.......................................................................27
Management of the Fund......................................................38
Net Asset Value.............................................................40
Distributions...............................................................41
Dividend Reinvestment Plan..................................................41
Plan of Distribution........................................................42
Description of Shares.......................................................44
Certain Provisions in the Declaration of Trust and By-Laws..................46
Structure of the Fund; Common Share Repurchases and Change in
Fund Structure.........................................................47
Tax Matters.................................................................48
Custodian, Administrator and Transfer Agent.................................51
Legal Opinions..............................................................51
--------------------------------------------------------------------------------
-55-
FIRST TRUST/FIDAC MORTGAGE INCOME FUND
UP TO ________________ COMMON SHARES
--------------------------------------------------------------------------------
PROSPECTUS
--------------------------------------------------------------------------------
, 2010
Preliminary Statement of Additional Information
Dated October 29, 2010
Subject to Completion
FIRST TRUST/FIDAC MORTGAGE INCOME FUND
STATEMENT OF ADDITIONAL INFORMATION
First Trust/FIDAC Mortgage Income Fund (the "Fund") is a closed-end,
diversified management investment company.
This Statement of Additional Information relates to the offering, on an
immediate, continuous or delayed basis, of up to ____________ common shares of
beneficial interest in the Fund in one or more offerings (the "Common Shares").
This Statement of Additional Information does not constitute a prospectus, but
should be read in conjunction with the Fund's prospectus dated ____________,
2010 and any related prospectus supplement. The Fund's currently outstanding
common shares are, and the Common Shares offered by the Prospectus and any
prospectus supplement will be, subject to notice of issuance, listed on the New
York Stock Exchange under the symbol "FMY."
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 and any prospectus supplement
prior to purchasing such Common Shares. A copy of the Fund's Prospectus and any
prospectus supplement 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). As used in this Statement of
Additional Information, unless the context requires otherwise, "common shares"
refers to the Fund's common shares of beneficial interest currently outstanding
as well as those Common Shares offered by the Prospectus and any prospectus
supplement and the holders of the common shares are called "common
shareholders." Capitalized terms used but not defined in this Statement of
Additional Information have the meanings ascribed to them in the Prospectus and
any prospectus supplement.
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 IT IS NOT SOLICITING AN OFFER TO BUY THESE SECURITIES IN
ANY STATE WHERE THE OFFER OR SALE IS NOT PERMITTED.
This Statement of Additional Information is dated __________, 2010.
TABLE OF CONTENTS
PAGE
----
USE OF PROCEEDS................................................................1
INVESTMENT OBJECTIVES..........................................................1
INVESTMENT RESTRICTIONS........................................................
INVESTMENT POLICIES AND TECHNIQUES.............................................4
ADDITIONAL INFORMATION ABOUT THE FUND'S INVESTMENTS AND INVESTMENT RISKS......11
OTHER INVESTMENT POLICIES AND TECHNIQUES......................................18
MANAGEMENT OF THE FUND........................................................26
INVESTMENT ADVISER............................................................37
PROXY VOTING POLICIES AND PROCEDURES..........................................40
SUB-ADVISOR...................................................................41
PORTFOLIO TRANSACTIONS AND BROKERAGE..........................................44
DESCRIPTION OF SHARES.........................................................46
CERTAIN PROVISIONS IN THE DECLARATION OF TRUST AND BY-LAWS....................48
REPURCHASE OF FUND SHARES; CONVERSION TO OPEN-END FUND........................51
FEDERAL INCOME TAX MATTERS....................................................53
PERFORMANCE RELATED AND COMPARATIVE INFORMATION...............................59
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.................................61
-i-
CUSTODIAN, ADMINISTRATOR AND TRANSFER AGENT...................................62
ADDITIONAL INFORMATION........................................................62
FINANCIAL STATEMENTS AND REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM..............................................................F-1
APPENDIX A - DESCRIPTION OF RATINGS..........................................A-1
APPENDIX B - FIRST TRUST ADVISORS L.P. PROXY VOTING GUIDELINES...............B-1
-ii-
USE OF PROCEEDS
The Fund will invest substantially all of the net proceeds from any sales
of Common Shares pursuant to the Prospectus and any prospectus supplement in
accordance with the Fund's investment objectives and policies as stated below or
for other general corporate purposes.
Pending investment in securities that meet the Fund's investment
objectives and policies, the net proceeds of this offering will be invested in
cash or cash equivalents.
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 seeks to
preserve capital.
The Fund pursues its objectives by investing primarily in mortgage-backed
securities representing part ownership in a pool of either residential or
commercial mortgage loans that, in the opinion of the Fixed Income Discount
Advisory Company ("FIDAC" or "Sub-Advisor"), offer an attractive combination of
credit quality, yield and maturity. These securities may be issued by government
agencies or by private originators or issuers, generally in the form of
pass-through certificates, collateralized mortgage obligations, residential
mortgage-backed securities or commercial mortgage-backed securities.
Collectively, agency mortgage pass-through certificates, agency collateralized
mortgage obligations, stripped mortgage-backed securities, non-agency
residential mortgage-backed securities and non-agency commercial mortgage-backed
securities are referred to as "MBS."
Under normal market conditions, the Fund invests 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 invests 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-Advisor.
"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
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.
- 1 -
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 issuers of mortgage-backed securities or
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;
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
- 2 -
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
2. Purchase securities of listed companies for the purpose of
exercising control.
- 3 -
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.
PORTFOLIO COMPOSITION
The Fund's portfolio is composed principally of the following investments:
Under normal market conditions, the Fund invests 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 is fully invested in Agency MBS, Non-Agency RMBS, CMBS and
Other MBS.
The Fund invests all of its Managed Assets in securities that at the time
of investment are investment grade quality. The Fund only invests 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/A2 or better by Moody's Investors Service, Inc.
("Moody's"), Standard & Poor's Rating Group, a division of The
McGraw-Hill Companies, Inc. ("S&P") and/or Fitch Ratings, Inc.
("Fitch") or
o unrated but judged to be of comparable quality by the Sub-Advisor.
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 does not invest in corporate bonds,
other than those primarily secured by interests in real estate.
The Fund attempts to reduce portfolio prepayment and credit 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.
- 4 -
The discussion below describes the principal categories of securities in
which the Fund invests.
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 invests include those issued or
guaranteed by the Government National Mortgage Association ("GNMA"), the Federal
National Mortgage Association ("FNMA") and the Federal Home Loan Mortgage
Corporation ("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 were formed as 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 were obligations solely of those respective
corporations, and were not historically deemed to be backed by the full faith
and credit of the U.S. government.
Subsequent to June 30, 2008, there were increased market concerns about
FNMA and FHLMC's ability to withstand future credit losses associated with
securities held in their investment portfolios, and on which they provide
guarantees, without the direct support of the U.S. government. In September
2008, FNMA and FHLMC were placed into the conservatorship of the Federal Housing
Finance Agency, or FHFA, their federal regulator, pursuant to its powers under
The Federal Housing Finance Regulatory Reform Act of 2008, a part of the Housing
and Economic Recovery Act of 2008. As the conservator of FNMA and FHLMC, the
FHFA controls and directs the operations of FNMA and FHLMC and may (i) take over
the assets of and operate FNMA and FHLMC with all the powers of the
shareholders, the directors and the officers of FNMA and FHLMC and conduct all
business of FNMA and FHLMC; (ii) collect all obligations and money due to FNMA
and FHLMC; (iii) perform all functions of FNMA and FHLMC which are consistent
with the conservator's appointment; (iv) preserve and conserve the assets and
property of FNMA and FHLMC; and (v) contract for assistance in fulfilling any
function, activity, action or duty of the conservator.
In addition to FHFA becoming the conservator of FNMA and FHLMC, the
Treasury and FHFA entered into Preferred Stock Purchase Agreements (PSPAs)
between the Treasury and FNMA and FHLMC pursuant to which the Treasury will
ensure that each of FNMA and FHLMC maintains a positive net worth. On December
24, 2009, the U.S. Treasury amended the terms of the U.S. Treasury's PSPAs with
- 5 -
FNMA and FHLMC to remove the $200 billion per institution limit established
under the PSPAs until the end of 2012. The U.S. Treasury also amended the PSPAs
with respect to the requirements for FNMA and FHLMC to reduce their portfolios.
Agency Collateralized Mortgage Obligations ("Agency CMOs"). Agency CMOs
are debt obligations issued by GNMA, FNMA or FHLMC. CMOs 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
interest rate 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 floating rate CMOs 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,
- 6 -
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 issuers 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.
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
- 7 -
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
include 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 invests 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.
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
- 8 -
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-Advisor 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 Advisor or the Sub-Advisor 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 Advisor's or the
Sub-Advisor'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. Non-U.S. government securities which have received the highest
investment-grade credit rating and 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: (i) 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 U.S.
government; (ii) the Federal Home Loan Banks, Federal Intermediate Credit
Banks, and the Tennessee Valley Authority, whose securities are supported
by the right of the agency to borrow from the U.S. Treasury; (iii) the
Federal National Mortgage Association and the Federal Home Loan Mortgage
Corporation; and (iv) 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 Federal Deposit Insurance
Corporation ("FDIC") regulations, the maximum insurance payable as to any
- 9 -
one certificate of deposit is $250,000; 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 typically reflects current
market interest rates. 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-Advisor
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-Advisor 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-Advisor will consider the financial condition of
the corporation (e.g., earning power, cash flow, 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 an NRSRO 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.
- 10 -
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, the rules thereunder and
interpretations thereof.
ADDITIONAL INFORMATION ABOUT THE FUND'S INVESTMENTS AND INVESTMENT RISKS
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.
- 11 -
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.
DERIVATIVES RISK
The Fund may use various other investment management techniques that also
involve certain risks and special considerations, including utilizing derivative
instruments to generate income or for hedging and risk management purposes.
Derivative instruments the Fund may use include interest rate options, futures,
swaps, caps, floors, collars, structured notes, special purpose vehicles and
other derivative transactions. These strategic transactions will be entered into
to generate income or 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 generate income or 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, currencies 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 derivative transactions requires skills
different from those needed in the selection of the Fund's portfolio securities.
The Fund believes that the Sub-Advisor possesses the skills necessary for the
successful utilization of derivative transactions. The Fund will incur brokerage
and other costs in connection with its derivative 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
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
- 12 -
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-Advisor 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 ability of the
Sub-Advisor to predict correctly the direction and extent of movements in
interest rates.
At the maturity of a forward contract to deliver a particular currency,
the Fund may either sell the portfolio security related to such contract and
make delivery of the currency, or it may retain the security and either acquire
the currency on the spot market or terminate its contractual obligation to
deliver the currency by purchasing an offsetting contract with the same currency
trader obligating it to purchase on the same maturity date the same amount of
the currency.
It is impossible to forecast with absolute precision the market value of
portfolio securities at the expiration of a forward contract. Accordingly, it
may be necessary for the Fund to purchase additional currency on the spot market
(and bear the expense of such purchase) if the market value of the security is
less than the amount of currency that the Fund is obligated to deliver and if a
decision is made to sell the security and make delivery of the currency.
Conversely, it may be necessary to sell on the spot market some of the currency
received upon the sale of the portfolio security if its market value exceeds the
amount of currency the Fund is obligated to deliver.
If the Fund retains the portfolio security and engages in an offsetting
transaction, the Fund will incur a gain or a loss to the extent that there has
been movement in forward contract prices. If the Fund engages in an offsetting
transaction, it may subsequently enter into a new forward contract to sell the
currency. Should forward prices decline during the period between the Fund's
entering into a forward contract for the sale of a currency and the date it
enters into an offsetting contract for the purchase of the currency, the Fund
will realize a gain to the extent the price of the currency it has agreed to
sell exceeds the price of the currency it has agreed to purchase. Should forward
prices increase, the Fund will suffer a loss to the extent the price of the
currency it has agreed to purchase exceeds the price of the currency it has
agreed to sell. A default on the contract would deprive the Fund of unrealized
profits or force the Fund to cover its commitments for purchase or sale of
currency, if any, at the current market price.
- 13 -
Although the Fund believes that the use of the derivative transactions
described above will benefit the Fund, if the Sub-Advisor'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 the Fund intends to segregate assets on the Fund's records in the
form of cash, cash equivalents or liquid securities in an amount equal to the
net exposure under a derivative instrument or the notional value of a derivative
instrument (depending on the applicable segregation requirements pursuant to
interpretations of the SEC and SEC staff) or enter into offsetting positions in
respect of derivative instruments, the Sub-Advisor and the Fund believe these
hedging transactions do not constitute senior securities. Certain of the
derivative instruments in which the Fund may invest may, in certain
circumstances, give rise to a form of financial leverage, which may magnify the
risk of owning such instruments. 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, cash equivalents or liquid securities having an aggregate market
value at least equal to the accrued excess will be segregated on the Fund's
records. If the Fund enters into a swap on other than a net basis, the Fund
intends to segregate assets on the Fund's records in 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
entities determined by the Sub-Advisor, 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
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-Advisor
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-Advisor 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
- 14 -
have been if these techniques were not used. Moreover, even if the Sub-Advisor
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.
Congress has recently passed the Restoring American Financial Stability
Act of 2010 (the "Financial Stability Act"). The Financial Stability Act will
likely impact the use of derivatives by entities, which may include the Fund,
and is intended to improve the existing regulatory framework by closing the
regulatory gaps and eliminating the speculative trading practices that
contributed to the 2008 financial market crisis. The legislation is designed to
impose stringent regulation on the over-the-counter derivatives market in an
attempt to increase transparency and accountability. Such legislation may impact
or restrict the Fund's ability to use certain Strategic Transactions.
Credit Default Swap Transactions. The Fund may invest in credit default
swap transactions, including credit linked notes (described below). The "buyer"
in a credit default contract is obligated to pay the "seller" a periodic stream
of payments over the term of the contract, provided that no event of default on
an underlying reference obligation has occurred. If an event of default occurs,
the seller must pay the buyer the full notional value, or "par value," of the
reference obligation. Credit default swap transactions are either "physical
delivery" settled or "cash" settled. Physical delivery entails the actual
delivery of the reference asset to the seller in exchange for the payment of the
full par value of the reference asset. Cash settled entails a net cash payment
from the seller to the buyer based on the difference of the par value of the
reference asset and the current value of the reference asset that may have,
through default, lost some, most or all of its value. The Fund may be either the
buyer or seller in a credit default swap transaction. If the Fund is a buyer and
no event of default occurs, the Fund will have made a series of periodic
payments and recover nothing of monetary value. However, if an event of default
occurs, the Fund (if the buyer) will receive the full notional value of the
reference obligation either through a cash payment in exchange for the asset or
a cash payment in addition to owning the reference asset. As a seller, the Fund
receives a fixed rate of income throughout the term of the contract, which
typically is between six months and five years, provided that there is no event
of default. The Fund currently intends to segregate assets on the Fund's records
in the form of cash, cash equivalents or liquid securities in an amount equal to
the full notional value of the credit default swaps of which it is the seller.
If such assets are not fully segregated on the Fund's records, the use of credit
default swap transactions could then be considered a senior security. If an
event of default occurs, the seller must pay the buyer the full notional value
of the reference obligation through either physical delivery settlement or cash
settlement. Credit default swap transactions involve greater risks than if the
Fund had invested in the reference obligation directly.
The Fund also may purchase credit default swap contracts in an attempt to
hedge against the risk of default of debt securities it holds, in which case the
Fund would function as the counterparty referenced in the preceding paragraph.
This would involve the risk that the swap may expire worthless and would only
generate income in the event of an actual default by the issuer of the
underlying obligation (as opposed to a credit downgrade or other indication of
financial instability). It would also involve credit risk that the seller may
fail to satisfy its payment obligations to the Fund in the event of a default.
- 15 -
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. 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 ability of the Sub-Advisor to predict
correctly market movements or changes in the relationships of such
instruments to the Fund's portfolio holdings, and there can be no
assurance the Sub-Advisor's judgment in this respect will be accurate.
Consequently, the use of derivatives for investment or hedging purposes
might result in a poorer overall performance for the Fund, whether or not
adjusted for risk, than if the Fund had not used derivatives.
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 ("OTC") 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 losses to the Fund. The Fund will enter into
transactions in derivative instruments only with counterparties that the
Sub-Advisor 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-Advisor'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-Advisor's judgment in
- 16 -
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 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.
ILLIQUID/RESTRICTED SECURITIES
The Fund may invest 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 by
the Fund of within seven days in the ordinary course of business at
approximately the amount at which the Fund values the securities). The Fund may
also invest in restricted securities. The Sub-Advisor, under the supervision of
- 17 -
the Advisor and the Board of Trustees, will determine whether restricted
securities are illiquid. As a result, restricted securities may be more
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 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. 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.
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.
- 18 -
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
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
- 19 -
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
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
- 20 -
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 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
- 21 -
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.
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
- 22 -
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
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
- 23 -
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 may use leverage in an aggregate amount of up to 33 1/3% of its
Managed Assets, after such issuance and/or borrowings. Any use of leverage by
the Fund will, however, be consistent with the provisions of the 1940 Act. The
Fund's current use of leverage is primarily through the use of 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.
Leverage instruments have complete priority upon distribution of assets
over Common Shares. The issuance of leverage instruments leverages the Common
Shares. The Fund has invested the proceeds of the repurchase agreements
consistent with the Fund's investment objective and policies. Although the
timing and other terms of the offering of additional leverage instruments and
the terms of additional leverage instruments would be determined by the Fund's
Board of Trustees, the Fund expects to invest the proceeds derived from any
future 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.
- 24 -
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-Advisor 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 Advisor and Sub-Advisor are 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 Advisor and
Sub-Advisor is 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 "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.
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.
- 25 -
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-Advisor 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
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 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, the number of portfolios each Trustee oversees and the other
directorships they hold, if applicable. The Board of Trustees is divided into
three classes: Class I, Class II and Class III. In connection with the
organization of the Fund, each Trustee has been elected for one initial term,
- 26 -
the length of which depends on the class, as more fully described below.
Subsequently, the Trustees in each class will be elected to serve for a term
expiring at the third succeeding annual shareholder meeting subsequent to their
election at an annual meeting, in each case until their respective successors
are duly elected and qualified, as described below. The officers of the Fund
serve indefinite terms. Each Trustee, except for James A. Bowen, is an
Independent Trustee. Mr. Bowen is deemed an "interested person" (as that term is
defined in the 1940 Act) ("Interested Trustee") of the Funds due to his position
as President of First Trust Advisors L.P., investment adviser to the Funds.
NUMBER OF
PORTFOLIOS
IN FUND
TERM OF OFFICE COMPLEX OTHER
AND YEAR FIRST OVERSEEN BY TRUSTEESHIPS
POSITION AND ELECTED OR PRINCIPAL OCCUPATIONS TRUSTEE OR HELD BY
NAME, ADDRESS AND AGE OFFICES WITH FUND APPOINTED DURING PAST 5 YEARS OFFICER TRUSTEE
Trustee who is an
Interested Person of the Fund
------------------------------
James A. Bowen(1) President, o Class III President, First 64 Trustee of
120 East Liberty Drive, Chairman of the (3)(4) Trust Portfolios L.P. Portfolios Wheaton College
Suite 400 Board, Chief and First Trust
Wheaton, IL 60187 Executive Officer Advisors L.P.;
D.O.B.: 09/55 and Trustee o 2005 Chairman of the Board
of Directors, Bond
Wave LLC (Software
Development
Company/Investment
Advisor) and
Stonebridge Advisors
LLC (Investment Advisor)
Trustees who are not
Interested Persons of the Fund
------------------------------
Richard E. Erickson Trustee o Class II Physician; President, 64 None
c/o First Trust Advisors (3)(4) Wheaton Orthopedics; Portfolios
L.P. Co-owner and
120 East Liberty Drive, Co-Director (January
Suite 400 o 2005 1996 to May 2007),
Wheaton, IL 60187 Sports Med Center for
D.O.B.: 04/51 Fitness; Limited
Partner, Gundersen
Real Estate Limited
Partnership; Member,
Sportsmed LLC
Thomas R. Kadlec Trustee o Class II President (March 2010 64 Director of
c/o First Trust Advisors (3)(4) to present), Senior Portfolios ADM Investor
L.P. Vice President and Services,
120 East Liberty Drive, o 2005 Chief Financial Inc. and ADM
Suite 400 Officer (May 2007 to Investor
Wheaton, IL 60187 March 2010), Vice Services
D.O.B.: 11/57 President and Chief International
Financial Officer
(1990 to May 2007),
ADM Investor Services,
Inc. (Futures Commission
Merchant)
Robert F. Keith Trustee o Class I President (2003 to 64 None
c/o First Trust Advisors (3)(4) Present), Hibs Portfolios
L.P. Enterprises
120 East Liberty Drive, o June 12, (Financial and
Suite 400 2006 Management
Wheaton, IL 60187 Consulting)
D.O.B.: 11/56
Niel B. Nielson Trustee o Class III President (2002 to 64 Director of
c/o First Trust Advisors (3)(4) Present), Covenant Portfolios Covenant Transport Inc.
L.P. College
120 East Liberty Drive, o 2005
Suite 400
Wheaton, IL 60187
D.O.B.: 03/54
- 27 -
NUMBER OF
PORTFOLIOS
IN FUND
TERM OF OFFICE COMPLEX OTHER
AND YEAR FIRST OVERSEEN BY TRUSTEESHIPS
POSITION AND ELECTED OR PRINCIPAL OCCUPATIONS TRUSTEE OR HELD BY
NAME, ADDRESS AND AGE OFFICES WITH FUND APPOINTED DURING PAST 5 YEARS OFFICER TRUSTEE
Officers of the Fund
--------------------
Mark R. Bradley Treasurer, Chief o Indefinite Chief Financial N/A N/A
120 East Liberty Drive, Financial Officer term Officer, First Trust
Suite 400 and Chief Portfolios L.P. and
Wheaton, IL 60187 Accounting First Trust Advisors
D.O.B.: 11/57 Officer o Since Fund L.P.; Chief Financial
Inception Officer, BondWave LLC
(Software Development
Company/Investment
Advisor) and
Stonebridge Advisors
LLC (Investment Advisor)
Erin E. Chapman Assistant o Indefinite Assistant General N/A N/A
120 East Liberty Drive, Secretary term Counsel
Suite 400 (October 2007 to
Wheaton, IL 60187 o 2009 Present),
D.O.B.: 08/76 Associate Counsel
(March 2006 to
October 2007), First
Trust Portfolios L.P.
and First Trust
Advisors L.P.;
Associate Attorney
(November 2003 to
March 2006) Doyle &
Bolotin, Ltd.
James M. Dykas
120 East Liberty Drive, Assistant o Indefinite Senior Vice President N/A N/A
Suite 400 Treasurer term (April 2007 to
Wheaton, IL 60187 Present), Vice
D.O.B.: 01/66 o Since Fund President (January
Inception 2005 to April 2007),
First Trust Advisors
L.P. and First Trust
Portfolios L.P.
Christopher R. Fallow Assistant Vice o Indefinite Assistant Vice N/A N/A
120 East Liberty Drive, President term President (August
Suite 400 2006 to Present),
Wheaton, IL 60187 o Since Fund Associate (January
D.O.B.: 04/79 Inception 2005 to August 2006),
First Trust
Portfolios L.P. and
First Trust Advisors
L.P.
W. Scott Jardine Secretary and o Indefinite General Counsel, N/A N/A
120 East Liberty Drive, Chief Compliance term First Trust
Suite 400 Officer Portfolios L.P.,
Wheaton, IL 60187 o Since Fund First Trust Advisors
D.O.B.: 05/60 Inception L.P. and BondWave LLC
(Software Development
Company/ Investment
Advisor); Secretary,
Stonebridge Advisors
LLC (Investment Advisor)
Daniel J. Lindquist Vice President o Indefinite Senior Vice President N/A N/A
120 East Liberty Drive, term (September 2005 to
Suite 400 Present), Vice
Wheaton, IL 60187 o Since Fund President (April 2004
D.O.B.: 02/70 Inception to September 2005),
First Trust
Portfolios L.P. and
First Trust Advisors L.P.
- 28 -
NUMBER OF
PORTFOLIOS
IN FUND
TERM OF OFFICE COMPLEX OTHER
AND YEAR FIRST OVERSEEN BY TRUSTEESHIPS
POSITION AND ELECTED OR PRINCIPAL OCCUPATIONS TRUSTEE OR HELD BY
NAME, ADDRESS AND AGE OFFICES WITH FUND APPOINTED DURING PAST 5 YEARS OFFICER TRUSTEE
Coleen D. Lynch Assistant o Indefinite Assistant Vice N/A N/A
120 East Liberty Drive, Vice President term President
Suite 400 (January 2008 to
Wheaton, IL 60187 o 2008 Present),
D.O.B.: 07/58 First Trust
Portfolios L.P. and
First Trust Advisors
L.P.; Vice President
(May 1998 to January
2008), Van Kampen
Asset Management and
Morgan Stanley
Investment Management
Kristi A. Maher Assistant o Indefinite Deputy General N/A N/A
120 East Liberty Drive, Secretary and term Counsel (May 2007 to
Suite 400 Deputy Chief Present), Assistant
Wheaton, IL 60187 Compliance o Assistant General Counsel
D.O.B.: 12/66 Officer Secretary (March 2004 to May
since Fund 2007), First Trust
Inception Portfolios L.P. and
and Deputy First Trust Advisors
CCO since L.P.
November
2009
--------------------
(1) Mr. Bowen is deemed an "interested person" of the Fund due to his position
as President of First Trust Advisors, investment adviser of the Fund.
(2) Officer positions with the Fund have an indefinite term.
(3) Currently, Robert F. Keith, as a Class I Trustee, is serving a term until
the Fund's 2011 annual meeting. Richard E. Erickson and Thomas R. Kadlec,
as Class II Trustees, are each serving a term until the Fund's 2012 annual
meeting. James A. Bowen and Niel B. Nielson, as Class III Trustees, are
each serving a term until the Fund's 2013 annual meeting.
(4) Each Trustee has served in such capacity since the Fund's inception except
for Robert F. Keith, who was elected in June 2006.
- 29 -
UNITARY BOARD LEADERSHIP STRUCTURE
Each Trustee serves as a trustee of all open-end and closed-end funds in
the First Trust Fund Complex (as defined below), which is known as a "unitary"
board leadership structure. Each Trustee currently serves as a trustee of First
Defined Portfolio Fund, LLC, an open-end fund with eight portfolios advised by
First Trust Advisors L.P.; First Trust High Income Long/Short Fund, First Trust
Senior Floating Rate Income Fund II, Macquarie/First Trust Global
Infrastructure/Utilities Dividend & Income Fund, Energy Income and Growth Fund,
First Trust Enhanced Equity Income Fund, First Trust/Aberdeen Global Opportunity
Income Fund, First Trust/FIDAC Mortgage Income Fund, First Trust Strategic High
Income Fund, First Trust Strategic High Income Fund II, First Trust Strategic
High Income Fund III, First Trust/Aberdeen Emerging Opportunity Fund, First
Trust Specialty Finance and Financial Opportunities Fund and First Trust Active
Dividend Income Fund, closed-end funds advised by First Trust; and First Trust
Exchange-Traded Fund, First Trust Exchange-Traded Fund II, First Trust
Exchange-Traded AlphaDEX(R) Fund and First Trust Exchange-Traded Fund III,
exchange-traded funds with 43 portfolios advised by First Trust Advisors L.P.
(each a "First Trust Fund" and collectively, the "First Trust Fund Complex").
None of the Trustees who are not "interested persons" of the Trust, nor any of
their immediate family members, has ever been a director, officer or employee
of, or consultant to, First Trust, First Trust Portfolios or their affiliates.
In addition, Mr. Bowen and the other officers of the Fund hold the same
positions with the other funds in the First Trust Fund Complex as they hold with
the Fund.
The management of the Fund, including general supervision of the duties
performed for the Fund under the investment management agreement between the
Fund and the Advisor, is the responsibility of the Board of Trustees. The
Trustees of the Fund set broad policies for the Fund, choose the Fund's
officers, and hire the Fund's investment advisor and other service providers.
The officers of the Fund manage the day-to-day operations and are responsible to
the Fund's Board. The Fund's Board is composed of four Independent Trustees and
one Interested Trustee. The Interested Trustee, James A. Bowen, serves as both
the Chief Executive Officer for each First Trust Fund and the Chairman of each
Board in the First Trust Fund Complex.
The same five persons serve as Trustees on the Trust's Board and on the
boards of all other First Trust Funds. The unitary board structure was adopted
for the First Trust Funds because of the efficiencies it achieves with respect
to the governance and oversight of the First Trust Funds. Each First Trust Fund
is subject to the rules and regulations of the 1940 Act (and other applicable
securities laws), which means that many of the First Trust Funds face similar
issues with respect to certain of their fundamental activities, including risk
management, portfolio liquidity, portfolio valuation and financial reporting. In
addition, all of the First Trust exchange-traded funds are managed by the
Advisor and employ common service providers for custody, fund accounting,
administration and transfer agency that provide substantially similar services
to each such fund pursuant to substantially similar contractual arrangements.
Because of the similar and often overlapping issues facing the First Trust
Funds, including among the First Trust exchange-traded funds, the Board of the
First Trust Funds believes that maintaining a unitary board structure promotes
efficiency and consistency in the governance and oversight of all First Trust
Funds and reduces the costs, administrative burdens and possible conflicts that
may result from having multiple boards. In adopting a unitary board structure,
- 30 -
the Trustees seek to provide effective governance through establishing a board
the overall composition of which will, as a body, possesses the appropriate
skills, diversity, independence and experience to oversee the Funds' business.
Annually, the Board reviews its governance structure and the committee
structures, their performance and functions and reviews any processes that would
enhance Board governance over the Funds' business. Each Board has determined
that its leadership structure, including the unitary board and committee
structure, is appropriate based on the characteristics of the funds it serves
and the characteristics of the First Trust Fund Complex as a whole.
In order to streamline communication between the Advisor and the
Independent Trustees and create certain efficiencies, each Board has a Lead
Independent Trustee who is responsible for: (i) coordinating activities of the
Independent Trustees; (ii) working with the Advisor, Fund counsel and the
independent legal counsel to the Independent Trustees to determine the agenda
for Board meetings; (iii) serving as the principal contact for and facilitating
communication between the Independent Trustees and the Funds' service providers,
particularly the Advisor; and (iv) any other duties that the Independent
Trustees may delegate to the Lead Independent Trustee. The Lead Independent
Trustee is selected by the Independent Trustees and serves a two-year term or
until his successor is selected. Effective January 1, 2010, Niel B. Nielson
serves as the Lead Independent Trustee.
The Board has established four standing committees (as described below)
and has delegated certain of its responsibilities to those committees. The Board
and its committees meet frequently throughout the year to oversee the Funds'
activities, review contractual arrangements with and performance of service
providers, oversee compliance with regulatory requirements, and review Fund
performance. The Independent Trustees are represented by independent legal
counsel at all Board and committee meetings. Generally, each Board acts by
majority vote of all the Trustees, including a majority vote of the Independent
Trustees if required by applicable law.
The three committee chairs and the Lead Independent Trustee rotate every
two years in serving as chair of the Audit Committee, the Nominating and
Governance Committee or the Valuation Committee, or as Lead Independent Trustee.
The Lead Independent Trustee also serves on the Executive Committee with the
Interested Trustee.
The four standing committees of the First Trust Fund Complex are: 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 of Trust and By-Laws. Such Committee
is also responsible for the declaration and setting of dividends. Mr. Nielson
and Mr. Bowen are members of the Executive Committee. During the last fiscal
year, the Executive Committee held twelve meetings.
The Nominating and Governance Committee is responsible for appointing and
nominating non-interested persons to the Trust's Board of Trustees. Messrs.
Erickson, Kadlec, Keith and Nielson are members of the Nominating and Governance
Committee. If there is no vacancy on the Board of Trustees, the Board will not
- 31 -
actively seek recommendations from other parties, including shareholders. The
Committee will not consider new trustee candidates who are 72 years of age or
older or will turn 72 years old during the initial term. When a vacancy on the
Board of Trustees of a Fund 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
applicable Fund. To submit a recommendation for nomination as a candidate for a
position on the Board of Trustees, shareholders of the applicable Fund shall
mail such recommendation to W. Scott Jardine, Secretary, at the Fund's address,
120 East Liberty Drive, Suite 400, Wheaton, Illinois 60187. Such recommendation
shall include the following information: (i) evidence of Fund ownership of the
person or entity recommending the candidate (if a Fund shareholder); (ii) a full
description of the proposed candidate's background, including their education,
experience, current employment and date of birth; (iii) names and addresses of
at least three professional references for the candidate; (iv) information as to
whether the candidate is an "interested person" in relation to the 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 (v) 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 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. During the last fiscal year,
the Nominating and Governance Committee held four meetings.
The Valuation Committee is responsible for the oversight of the pricing
procedures of each Fund. Messrs. Erickson, Kadlec, Keith and Nielson are members
of the Valuation Committee. During the last fiscal year, the Valuation Committee
held four meetings.
The Audit Committee is responsible for overseeing each 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, Kadlec, Keith and Nielson serve on the Audit
Committee. During the last fiscal year, the Audit Committee held six meetings.
RISK OVERSIGHT
As part of the general oversight of the Fund, the Board is involved in the
risk oversight of the Fund. The Board has adopted and periodically reviews
policies and procedures designed to address the Fund's risks. Oversight of
investment and compliance risk, including oversight of any sub-advisors, is
performed primarily at the Board level in conjunction with the Advisor's
investment oversight group and the Fund's Chief Compliance Officer ("CCO") and
Deputy Chief Compliance Officer. Oversight of other risks also occurs at the
committee level. The Advisor's investment oversight group reports to the Board
at quarterly meetings regarding, among other things, Fund performance and the
various drivers of such performance as well as information related to
- 32 -
sub-advisors and their operations and processes. The Board reviews reports on
the Fund's and the service providers' compliance policies and procedures at each
quarterly Board meeting and receives an annual report from the CCO regarding the
operations of the Fund's and the service providers' compliance program. In
addition, the Independent Trustees meet privately each quarter with the CCO. The
Audit Committee reviews with the Advisor the Fund's major financial risk
exposures and the steps the Advisor has taken to monitor and control these
exposures, including the Fund's risk assessment and risk management policies and
guidelines. The Audit Committee also, as appropriate, reviews in a general
manner the processes other Board committees have in place with respect to risk
assessment and risk management. The Nominating and Governance Committee monitors
all matters related to the corporate governance of the Fund. The Valuation
Committee monitors valuation risk and compliance with the Fund's Valuation
Procedures and oversees the pricing agents and actions by the Advisor's Pricing
Committee with respect to the valuation of portfolio securities.
BOARD DIVERSIFICATION AND TRUSTEE QUALIFICATIONS
As described above, the Nominating and Governance Committee of each Board
oversees matters related to the nomination of Trustees. The Nominating and
Governance Committee seeks to establish an effective Board with an appropriate
range of skills and diversity, including, as appropriate, differences in
background, professional experience, education, vocations, and other individual
characteristics and traits in the aggregate. Each Trustee must meet certain
basic requirements, including relevant skills and experience, time availability,
and if qualifying as an Independent Trustee, independence from the Advisor,
sub-advisors, underwriters or other service providers, including any affiliates
of these entities.
Listed below for each current Trustee are the experiences, qualifications
and attributes that led to the conclusion, as of the date of this SAI, that each
current Trustee should serve as a trustee.
Richard E. Erickson, M.D., is an orthopedic surgeon and President of
Wheaton Orthopedics. He also has been a co-owner and director of a fitness
center and a limited partner of two real estate companies. Dr. Erickson has
served as a Trustee of each First Trust Fund since its inception and of the
First Trust Funds since 1999. Dr. Erickson has also served as the Lead
Independent Trustee (2008 - 2009), Chairman of the Nominating and Governance
Committee (2003 - 2007) and Chairman of the Valuation Committee (June 2006 -
2007) of the First Trust Funds.
Thomas R. Kadlec is President of ADM Investor Services Inc. ("ADMIS"), a
futures commission merchant and wholly-owned subsidiary of the Archer Daniels
Midland Company ("ADM"). Mr. Kadlec has been employed by ADMIS and its
affiliates since 1990 in various accounting, financial, operations and risk
management capacities. Mr. Kadlec serves on the boards of several international
affiliates of ADMIS and is a member of ADM's Integrated Risk Committee, which is
tasked with the duty of implementing and communicating enterprise-wide risk
management. Mr. Kadlec has served as a Trustee of each First Trust Fund since
its inception. Mr. Kadlec has also served on the Executive Committee since the
organization of the first First Trust closed-end Fund in 2003 until he was
elected as the first Lead Independent Trustee in December 2005, serving as such
- 33 -
through 2007. He also served as Chairman of the Valuation Committee (2008 -
2009) and currently serves as Chairman of the Audit Committee (since 2010) of
the First Trust Funds.
Robert F. Keith is President of Hibs Enterprises, a financial and
management consulting firm. Mr. Keith has been with Hibs Enterprises since 2004.
Prior thereto, Mr. Keith spent 18 years with ServiceMaster and Aramark,
including three years as President and COO of ServiceMaster Consumer Services,
where he led the initial expansion of certain products overseas, five years as
President and COO of ServiceMaster Management Services and two years as
President of Aramark ServiceMaster Management Services. Mr. Keith is a certified
public accountant and also has held the positions of Treasurer and Chief
Financial Officer of ServiceMaster, at which time he oversaw the financial
aspects of ServiceMaster's expansion of its Management Services division in to
Europe, the Middle East and Asia. Mr. Keith has served as a Trustee of the First
Trust Funds since June 2006. Mr. Keith has also served as the Chairman of the
Audit Committee (2008 - 2009) of the First Trust Funds.
Niel B. Nielson, Ph.D., has served as the President of Covenant College
since 2002. Mr. Nielson formerly served as a partner and trader (of options and
futures contracts for hedging options) for Ritchie Capital Markets Group (1996 -
1997), where he held an administrative management position at this proprietary
derivatives trading company. He also held prior positions in new business
development for ServiceMaster Management Services Company, and in personnel and
human resources for NationsBank of North Carolina, N.A. and Chicago Research and
Trading Group, Ltd. ("CRT"). His international experience includes serving as a
director of CRT Europe, Inc. for two years, directing out of London all aspects
of business conducted by the U.K. and European subsidiary of CRT. Prior to that,
Mr. Nielson was a trader and manager at CRT in Chicago. Mr. Nielson has served
as a Trustee of each First Trust Fund since its inception and of the First Trust
Funds since 1999. Mr. Nielson has also served as the Chairman of the Audit
Committee (2003 - 2006), Chairman of the Nominating and Governance Committee
(2008 - 2009) and currently serves as Lead Independent Trustee (since 2010) of
the First Trust Funds.
James A. Bowen is President and Chief Executive Officer of the First Trust
Funds and President of First Trust Advisors L.P. and First Trust Portfolios L.P.
Mr. Bowen is involved in the day-to-day management of the First Trust Funds and
serves on the Executive Committee. He has over 26 years of experience in the
investment company business in sales, sales management and executive management.
Mr. Bowen has served on the Board of Trustees for Wheaton College since October
2005. Mr. Bowen has served as a Trustee of each First Trust Fund since its
inception and of the First Trust Funds since 1999.
Each trust in the First Trust Fund Complex pays each Trustee who is not an
officer or employee of First Trust Advisors, any sub-advisor or any of their
affiliates ("Independent Trustees") an annual retainer of $10,000 per trust for
the first 14 trusts in the First Trust Fund Complex and an annual retainer of
$7,500 per trust for each subsequent trust added to the First Trust Fund
Complex. The annual retainer is allocated equally among each of the trusts. In
addition, for all the trusts in the First Trust Fund Complex, Dr. Nielson is
paid annual compensation of $10,000 to serve as the Lead Trustee, Mr. Kadlec is
- 34 -
paid annual compensation of $5,000 to serve as the chairman of the Audit
Committee, Dr. Erickson is paid annual compensation of $2,500 to serve as
chairman of the Valuation Committee and Mr. Keith is paid annual compensation of
$2,500 to serve as the chairman of the Nominating and Governance Committee. Each
chairman and the Lead Trustee will serve a two year term expiring December 31,
2011 before rotating to serve as a chairman of another committee or as Lead
Trustee. The annual compensation is allocated equally among each of the trusts
in the First Trust Fund Complex. Trustees are also reimbursed by the investment
companies in the First Trust Fund Complex for travel and out-of-pocket expenses
incurred in connection with all meetings.
The following table sets forth the estimated compensation (including
reimbursement for travel and out-of-pocket expenses) to be paid by the Fund and
the First Trust Fund Complex to each of the Independent Trustees for a full
fiscal year and full calendar year, respectively. The Fund has no retirement or
pension plans. The officer and Trustee who is an "interested person" as
designated above serve without any compensation from the Fund. The Fund has no
employees. Its officers are compensated by First Trust Advisors L.P.
ESTIMATED TOTAL COMPENSATION
COMPENSATION FROM THE FROM THE FIRST
NAME OF TRUSTEE FUND(1) TRUST FUND COMPLEX(2)
Richard E. Erickson $9,706 $176,733
Thomas R. Kadlec $9,853 $168,750
Robert F. Keith $9,706 $171,250
Niel B. Nielson $10,147 $171,591
--------------------
(1) The estimated compensation to be paid by the Fund to the Independent
Trustees for a full fiscal year for services to the Fund.
(2) The total compensation paid to the Independent Trustees for the
calendar year ended December 31, 2009 for services to the eight
portfolios of First Defined Portfolio Fund, LLC, an open-end fund, 13
closed-end funds and the First Trust Exchange-Traded Fund, First Trust
Exchange-Traded Fund II and First Trust Exchange-Traded AlphaDEX(R)
Fund, all advised by First Trust Advisors L.P.
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 December 31, 2009:
AGGREGATE DOLLAR RANGE OF
EQUITY SECURITIES IN
DOLLAR RANGE OF ALL REGISTERED INVESTMENT
EQUITY SECURITIES COMPANIES OVERSEEN BY TRUSTEE
IN THE FUND IN THE FIRST TRUST
TRUSTEE (NUMBER OF SHARES HELD) FUND COMPLEX
Interested Trustee
James Bowen None $50,001 - $100,000
Independent Trustees
Richard Erickson None Over $100,000
Thomas Kadlec None Over $100,000
Robert Keith None Over $100,000
Niel Nielson None $50,001 - $100,000
- 35 -
As of September 30, 2010, the Independent Trustees of the Fund and
immediate family members do not own beneficially or of record any class of
securities of the investment advisor or principal underwriter of the Fund or any
person directly or indirectly controlling, controlled by, or under common
control with an investment advisor or principal underwriter of the Fund.
As of September 30, 2010, the officers and Trustees, in the aggregate,
owned less than 1% of the Shares of the Fund.
CONTROL PERSONS
To the knowledge of the Fund, as of September 30, 2010, no single
shareholder or "group" (as that term is used in Section 13(d) of the 1934 Act)
beneficially owned more than 5% of the Fund's outstanding Shares, except as
described in the following table. Information as to beneficial ownership of
Shares, including percentage of Shares beneficially owned, is based on reports
filed with the SEC by such holders and a securities position listing report from
The Depository Trust & Clearing Corporation as of September 30, 2010. The Fund
does not have any knowledge of the identity of the ultimate beneficiaries of the
Common Shares of beneficial interest listed below. A control person is one who
owns, either directly or indirectly, more than 25% of the voting securities of
the Fund or acknowledges the existence of control.
PERCENT NUMBER OF
SHAREHOLDER AND ADDRESS* OWNERSHIP SHARES HELD
------------------------ --------- -----------
Charles Schwab & Co., Inc. 5.17% 209,692
2423 E. Lincoln Drive
Phoenix, AZ 85016
First Clearing, LLC 12.76% 517,406
One North Jefferson Street
St. Louis, MO 63103
Merrill Lynch, Pierce Fenner & Smith Safekeeping 7.56% 306,586
101 Hudson Street
8th Floor
Jersey City, NJ 07302
National Financial Services LLC 16.83% 682,179
200 Liberty Street
New York, NY 10281
The Northern Trust Company 7.86% 318,816
801 S. Canal Street
Attn: Capital Structures-C1N
Chicago, IL 60607
- 36 -
Raymond James & Associates, Inc. 5.26% 213,242
880 Carilion Parkway
P.O. Box 12749
St. Petersburg, FL 33716
* Sit Investment Associates, Inc., 3300 IDS Center, 80 South Eighth Street,
Minneapolis, MN 55402, beneficially owned 525,300 Shares of the Fund as of
December 31, 2009, according to Schedule 13G filed with the SEC.
INVESTMENT ADVISER
First Trust Advisors L.P., 120 East Liberty Drive, Suite 400, Wheaton,
Illinois 60187, 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-Advisor (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-Advisor and provides the
Fund with certain other services necessary with the management of the portfolio.
First Trust Advisors is also adviser or sub-advisor to 20 mutual funds, 43
exchange-traded funds and 13 closed-end funds (including the Fund) and is the
portfolio supervisor of certain unit investment trusts sponsored by First Trust
Portfolios L.P. First Trust Portfolios L.P. specializes in the underwriting,
trading and distribution of unit investment trusts and other securities. First
Trust Portfolios L.P., an Illinois limited partnership formed in 1991, took over
the First Trust product line and 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. The First Trust
product line commenced with the first insured unit investment trust in 1974 and
to date, more than $115 billion in gross assets have been deposited in First
Trust Portfolios L.P. unit investment trusts.
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 ownership interests. The Charger
Corporation is an Illinois corporation that was previously controlled by the
Robert Donald Van Kampen family. On August 24, 2010, members of the Robert
Donald Van Kampen family entered into a stock purchase agreement with James A.
Bowen, the President of First Trust Advisors, to sell 100% of the common stock
of The Charger Corporation to Mr. Bowen (who holds the interest through a
limited liability company of which he is the sole member) (the "General Partner
Transaction"). This General Partner Transaction was completed in accordance with
its terms on October 12, 2010.
- 37 -
The Transaction is not anticipated to result in any changes in the
personnel or operations of the Advisor. However, the consummation of the
Transaction constituted an "assignment" (as defined in the 1940 Act) of the
investment management agreement between the Fund and the Advisor and the
sub-advisory agreement among the Fund, the Advisor and the Sub-Advisor, which
resulted in the automatic termination of the agreements.
As a result of the Transaction, the Board of Trustees of the Fund approved
an interim investment management agreement between the Fund and the Advisor (the
"Interim Investment Management Agreement") and an interim sub-advisory agreement
among the Fund, the Advisor and the Sub-Advisor (the "Interim Sub-Advisory
Agreement"), each of which has substantially identical terms to the terminated
investment management agreement and the terminated sub-advisory agreement and
each of which was entered into effective upon the Transaction. First Trust
Advisors continues to serve as the Fund's adviser and Fixed Income Discount
Advisory Company continues to serve as the Fund's sub-advisor for a maximum
period of 150 days from the date of the Transaction (March 11, 2011). The Board
of Trustees of the Fund has also considered and approved a new investment
management agreement with the Advisor (the "New Investment Management
Agreement", and together with the Interim Investment Management Agreement, the
"Investment Management Agreement") and a new sub-advisory agreement with the
Advisor and the Sub-Advisor (the "New Sub-Advisory Agreement", and together with
the Interim Sub-Advisory Agreement, the "Sub-Advisory Agreement"), also with
substantially identical terms to the former investment management agreement and
the former sub-advisory agreement, respectively. The New Investment Management
Agreement and the New Sub-Advisory Agreement will be presented for shareholder
approval at a special shareholder meeting of the Fund expected to be held in
December 2010 (the "Shareholder Meeting"). The New Investment Management
Agreement and the New Sub-Advisory Agreement will take effect upon the approval
of the Fund's shareholders at the Shareholder Meeting.
In the event that the Fund is unable to obtain the necessary shareholder
vote to approve the New Investment Management Agreement and the New Sub-Advisory
Agreement, the Board of Trustees will consider alternatives available to the
Fund in a manner and to the extent permitted by the 1940 Act.
The New Investment Management Agreement, upon approval, 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 Advisor, or any
officer or director of the Advisor, has taken any action which results in a
breach of the covenants of the Advisor 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,
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
- 38 -
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 Advisor in
performance of its obligations and duties, or by reason of its reckless
disregard of its obligations and duties under the Investment Management
Agreement.
Pursuant to the Investment Management Agreement, the Fund has agreed to
pay for the services and facilities provided by the Advisor an annual management
fee, payable on a monthly basis, equal to 1.00% of the Fund's Managed Assets.
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.
The Sub-Advisor receives a portfolio management fee at the annual rate of
0.50% of Managed Assets, which is paid by the Advisor out of the Advisor's
management fee. Because the fee paid to the Advisor and by the Advisor to the
Sub-Advisor will be calculated on the basis of the Fund's Managed Assets, which
include the proceeds of leverage, the dollar amount of the Advisor's and
Sub-Advisor's fees will be higher (and the Advisor and Sub-Advisor will be
benefited to that extent) when leverage is utilized. In this regard, if the Fund
uses leverage in the amount equal to 28% of the Fund's Managed Assets (after
their issuance), the Fund's management fee would be 1.39% of net assets
attributable to common shares. See "Summary of Fund Expenses" in the Fund's
Prospectus.
CODE OF ETHICS
The Fund, Advisor and Sub-Advisor 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, except that Sub-Advisor personnel are not permitted to trade for their own
account in mortgage-backed securities, derivatives of mortgage-backed securities
or other real estate-related securities. 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.
- 39 -
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
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 clients' 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. The First
Trust Advisors Proxy Voting Guidelines are attached as Appendix B to this
Statement of Additional Information.
Information regarding how the Fund voted proxies relating to portfolio
securities is available: (i) without charge, upon request, by calling (800)
621-1675; (ii) on the Fund's website at http://www.ftportfolios.com; and
(iii) by accessing the Securities and Exchange Commission's website at
http://www.sec.gov.
SUB-ADVISOR
Fixed Income Discount Advisory Company, a registered investment adviser,
is Sub-Advisor to the Fund. Formed in 1994, FIDAC specializes in managing
residential and commercial loans and securities, collateralized debt obligation
liquidations and other financial services.
FIDAC, located at 1211 Avenue of the Americas, 29th Floor, New York, New
York 10036, is a direct wholly owned subsidiary of Annaly Capital Management,
Inc. ("Annaly") (NYSE:NLY), a publicly traded real estate investment trust. The
address of Annaly Capital Management, Inc. is 1211 Avenue of the Americas, 29th
Floor, New York, NY 10036. As of June 30, 2010, FIDAC had approximately $12.6
billion in assets under management.
FIDAC is responsible for the day-to-day management of the Fund's
portfolio. 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 Wellington Denahan-Norris, James Fortescue,
Rose-Marie Lyght, Eric Szabo, Mohit Marria and Nancy Murtha. Mrs. Denahan-Norris
- 40 -
is the Vice Chairman of Annaly, Chief Investment Officer and Chief Operating
Officer of Annaly and FIDAC and has been with both companies since their
inception. Mr. Fortescue is a Managing Director and Head of Liabilities for
FIDAC and Annaly. Mr. Fortescue joined FIDAC in 1995. Ms. Lyght is the Chief
Investment Officer of FIDAC. Ms. Lyght joined FIDAC in 1999. Mr. Szabo is a
Managing Director and the Chief Risk Officer for FIDAC and Annaly. Mr. Szabo
joined both companies in 2004. Mr. Marria is a Senior Vice President and
Portfolio Manager for FIDAC and Annaly. Mr. Marria joined both companies in
2005. Ms. Murtha is a Senior Vice President and Portfolio Manager for FIDAC and
Annaly. Ms. Murtha joined both companies in 2002.
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 SEPTEMBER 30, 2010
------------------------------ -----------------------------------------------------------------------------------
REGISTERED INVESTMENT OTHER POOLED
COMPANIES INVESTMENT VEHICLES
PORTFOLIO MANAGER (OTHER THAN THE FUND) (IN BILLIONS) OTHER ACCOUNTS
------------------------------ --------------------------- --------------------------- ---------------------------
Wellington Denahan - Norris Number: 0 Number: 4 Number: 0
Assets: $0 Assets: $3.42 Assets: $0
------------------------------ --------------------------- --------------------------- ---------------------------
Rose-Marie Lyght Number: 0 Number: 4 Number: 0
Assets: $0 Assets: $3.42 Assets: $0
------------------------------ --------------------------- --------------------------- ---------------------------
Eric Szabo Number: 0 Number: 3 Number: 0
Assets: $0 Assets: $2.04 Assets: $0
------------------------------ --------------------------- --------------------------- ---------------------------
James Fortescue Number: 0 Number: 4 Number: 0
Assets: $0 Assets: $3.42 Assets: $0
------------------------------ --------------------------- --------------------------- ---------------------------
Mohit Marria Number: 0 Number: 0 Number: 0
Assets: $0 Assets: $0 Assets: $0
------------------------------ --------------------------- --------------------------- ---------------------------
Nancy Murtha Number: 0 Number: 0 Number: 0
Assets: $0 Assets: $0 Assets: $0
------------------------------ --------------------------- --------------------------- ---------------------------
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. Such management of other accounts 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
- 41 -
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
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.
The portfolio managers receive all of their compensation from FIDAC and
its parent company, Annaly. Wellington Denahan-Norris, James Fortescue,
Rose-Marie Lyght, Eric Szabo, Mohit Marria and Nancy Murtha each receive
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) An individual's performance with respect to their designated work
responsibilities;
(b) Annaly's overall performance; and
(c) Other factors the compensation committee determines to be appropriate.
At September 30, 2010, none of the portfolio managers beneficially owned
(as determined pursuant to Rule 16a-1(a)(2) under the Securities Exchange Act of
1934 (the "1934 Act")) any shares of the Fund, and the Sub-Advisor prohibits its
personnel from purchasing shares of the Fund.
The Sub-Advisor, subject to the Board of Trustees' and Advisor's
supervision, provides the Fund with discretionary investment services.
Specifically, the Sub-Advisor 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-Advisor 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-Advisor 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-Advisor is
responsible for effecting all security transactions for the Fund's assets. The
Sub-Advisory Agreement provides that the Sub-Advisor shall not be liable for any
loss suffered by the Fund or the Advisor (including, without limitation, by
reason of the purchase, sale or retention of any security) in connection with
the performance of the Sub-Advisor'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-Advisor 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.
- 42 -
From the commencement of the Fund's operations through September 30, 2010,
the Fund paid the Advisor $5,075,999 of which $2,547,887 was paid by the Advisor
to the Sub-Advisor. See "Summary of Fund Expenses" and "Management of the Fund
-- Investment Management Agreement" in the Fund's Prospectus. All fees and
expenses are accrued daily and deducted before payment of dividends to
investors.
The Sub-Advisory Agreement may be terminated without the payment of any
penalty by the Advisor, 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-Advisor.
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-Advisor shall
have authority and discretion to select brokers and dealers to execute
transactions initiated by the Sub-Advisor 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-Advisor'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-Advisor to solicit competitive bids
for each transaction or to seek the lowest available commission cost to the
Fund, so long as the Sub-Advisor 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
(within the meaning of Section 28(e)(3) of the 1934 Act) provided by such broker
or dealer to the Sub-Advisor, viewed in terms of either that particular
transaction or of the Sub-Advisor's overall responsibilities with respect to its
clients, including the Fund, as to which the Sub-Advisor 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.
The Sub-Advisor'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-Advisor 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
- 43 -
considered as they are deemed relevant. The factors include, but are 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-Advisor'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-Advisor'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-Advisor 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-Advisor
generally prefers to deal directly with market makers in the securities. The
Sub-Advisor 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-Advisor
and the price received (or paid) by the market maker in trades with other
broker-dealers or other customers.
The Sub-Advisor may use Electronic Communications Networks ("ECN") or
Alternative Trading Systems ("ATS") to effect such over-the-counter trades for
equity securities when, in the Sub-Advisor's judgment, the use of an ECN or ATS
may result in equal or more favorable overall executions for the transactions.
Portfolio transactions for each client account will generally be completed
independently, except when the Sub-Advisor 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-Advisor
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-Advisor 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.
- 44 -
The Sub-Advisor 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 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 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," 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.
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,
- 45 -
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 borrows 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 effectively pledges 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.
Limitations on Borrowings. Under the requirements of the 1940 Act, the
Fund, immediately after any Borrowings, must have "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 coverage 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
- 46 -
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 AND BY-LAWS
Under Massachusetts law, shareholders could, in certain circumstances, be
held personally liable for the obligations of the Fund. However, the Declaration
of Trust (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. In addition, the Fund
will assume the defense of any claim against a shareholder for personal
liability at the request of the 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.
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. The Declaration further provides that a Trustee acting in
his or her capacity as Trustee is not personally liable to any person other than
the Fund or its shareholders, for any act, omission, or obligation of the Fund.
A present or former Trustee, officer or employee of the Fund is not liable to
the Fund or its shareholders for any action or failure to act (including without
limitation the failure to compel in any way any former or acting trustee to
redress any breach of trust) except for his or her own bad faith, willful
misfeasance, gross negligence or reckless disregard of his or her duties
involved in the conduct of the individual's office, and for nothing else and is
not liable for errors of judgment or mistakes of fact or law.
The Declaration requires the Fund to indemnify any persons who are or who
have been Trustees, officers or employees of the Fund for any liability for
actions or failure to act except to extent prohibited by applicable federal law.
In making any determination as to whether any person is entitled to the
advancement of expenses or indemnification, such person is entitled to a
rebuttable presumption that he or she did not engage in conduct for which
indemnification is not available.
The Declaration also clarifies that any Trustee who serves as chair of the
board or of a committee of the board, lead independent Trustee, or audit
committee financial expert, or in any other similar capacity will not be subject
to any greater standard of care or liability because of such position.
- 47 -
The Declaration requires a shareholder vote only on those matters where
the 1940 Act or the Fund's listing with an exchange require a shareholder vote,
but otherwise permits the Trustees to take actions without seeking the consent
of shareholders. For example, the Declaration gives the Trustees broad authority
to approve reorganizations between the Fund and another entity, such as another
closed end fund, and the sale of all or substantially all of its assets without
shareholder approval if the 1940 Act would not require such approval. The
Declaration further provides that the Trustees may amend the Declaration in any
respect without shareholder approval. The Declaration, however, prohibits
amendments that impair the exemption from personal liability granted in the
Declaration to persons who are or have been shareholders, Trustees, officers or,
employees of the Fund or that limit the rights to indemnification or insurance
provided in the Declaration with respect to actions or omissions of persons
entitled to indemnification under the Declaration prior to the amendment.
The Declaration and By-Laws include provisions that could limit the
ability of other entities or persons to acquire control of the Fund or to
convert the Fund to open-end status. The number of trustees is currently five,
but by action of two-thirds of the Trustees, the Board of Trustees may from time
to time be increased or decreased. The Board of Trustees is divided into three
classes, with the terms of one class expiring at each annual meeting of
shareholders. If the Fund issues Preferred Shares, the Fund may establish a
separate class for the Trustees elected by the holders of the Preferred Shares.
Vacancies on the Board of Trustees may be filled by a majority action of the
remaining trustees. Such provisions may work to delay a change in the majority
of the Board of Trustees. The provisions of the Declaration relating to the
election and removal of Trustees may be amended only by vote of two-thirds of
the Trustees then in office.
Generally, 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 (in the limited
circumstances where a vote by shareholders is otherwise required under the
Declaration); (3) a sale, lease or exchange of all or substantially all of the
Fund's assets (in the limited circumstances where a vote by shareholders is
otherwise required under the Declaration); (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
- 48 -
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.
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,
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 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 Shareholders.
- 49 -
The Declaration of Trust also provides that prior to bringing a derivative
action, a demand must first be made on the Trustees by three unrelated
shareholders that hold shares representing at least 5% of the voting power of
the Fund or affected class. The Declaration details various information,
certifications, undertakings and acknowledgements that must be included in the
demand. Following receipt of the demand, the Trustees have a period of 90 days,
which may be extended by an additional 60 days, to consider the demand. If a
majority of the trustees who are considered independent for the purposes of
considering the demand determine that maintaining the suit would not be in the
best interests of the Fund, the Trustees are required to reject the demand and
the complaining shareholders may not proceed with the derivative action unless
the shareholders are able to sustain the burden of proof to a court that the
decision of the Trustees not to pursue the requested action was not a good faith
exercise of their business judgment on behalf of the Fund. If a demand is
rejected, the complaining shareholders will be responsible for the costs and
expenses (including attorneys' fees) incurred by the Fund in connection with the
consideration of the demand under a number of circumstances. If a derivative
action is brought in violation of the Declaration, the shareholders bringing the
action may be responsible for the Fund's costs, including attorney's fees. The
Declaration also includes a forum selection clause requiring that any
shareholder litigation be brought in certain courts in Illinois and further
provides that any shareholder bringing an action against the Fund waive the
right to trial by jury to the fullest extent permitted by law.
Reference should be made to the Declaration on file with the Securities
and Exchange Commission for the full text of these provisions.
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 trade in the open market at a price that will be a function
of several factors, including dividend levels (which are in turn affected by
expenses), net asset value, call protection, price, dividend stability, relative
demand for and supply of such shares in the market, general market and economic
conditions and other factors. Because shares of a closed-end investment company
may frequently trade at prices lower than net asset value, the Trustees, in
consultation with the Fund's Adviser, Sub-Advisor and any corporate finance
services and consulting agent that the Advisor 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
- 50 -
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 net asset value, 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.
Further, the staff of the Commission currently requires that any tender
offer made by a closed-end investment company for its shares must be at a price
equal to the net asset value of such shares on the close of business on the last
day of the tender offer. 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.
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
1934 Act and the 1940 Act and the rules and regulations thereunder.
Although the decision to take action in response to a discount from net
asset value 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 New York Stock Exchange, or (b) impair the Fund's status
as a registered closed-end investment company under the 1940 Act; (2) the Fund
would not be able 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 of Trustee'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 New York
Stock 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
- 51 -
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 New York Stock Exchange. Any preferred shares or other
Borrowings would need to be redeemed or repaid upon conversion to an open-end
investment company. Additionally, the 1940 Act imposes limitations on open-end
funds' investments in illiquid securities, which could restrict the Fund's
ability to invest in certain securities discussed in the Prospectus to the
extent discussed therein. Such limitations could adversely affect distributions
to common shareholders in the event of conversion to an open-end fund.
Shareholders of an open-end investment company may require the company to redeem
their shares on any business day (except in certain circumstances as authorized
by or under the 1940 Act) at their net asset value, less such redemption charge
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 net asset value
will result in an increase in the net asset value of those shares that remain
outstanding. However, there can be no assurance that share repurchases or
tenders at or below net asset value will result in the Fund's shares trading at
a price equal to their net asset value. Nevertheless, the fact that the Fund's
shares may be the subject of repurchase or tender offers from time to time may
reduce any spread between market price and net asset value that might otherwise
exist.
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
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U.S. 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 U.S. federal net 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 (i)
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 and (ii) net income from interests in "qualified
publicly traded partnerships" (as defined in the Code); (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 (I) any one issuer, (II) two or more
issuers which the Fund controls and are engaged in the same, similar or related
trades or businesses or (III) any one or more "qualified publicly traded
partnerships" (as defined in the Code); 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, all or
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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 current and accumulated earnings and profits, whether paid in cash or
reinvested in additional shares. If the Fund holds certain equity securities,
certain ordinary income distributions that are designated by the Fund and
received from the Fund by non-corporate shareholders may be taxed at lower tax
rates applicable to net capital gains, provided certain holding period and other
requirements are satisfied by both the fund and the shareholder and provided the
dividends are attributable to "qualified dividend income" received by the Fund
itself. Dividends received by the Fund from REITs and foreign corporations are
qualified dividends eligible for 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, 2011. The Fund generally does not expect to generate
qualified dividend income 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
- 54 -
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 by substantially identical shares
(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 to the extent of any distributions of net capital gain
received by the shareholder with respect to the shares. The ability to otherwise
deduct capital losses may be subject to other limitations under the Code.
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
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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).
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.
INVESTMENT IN CERTAIN REMIC INTERESTS
If the Fund acquires a residual interest in a REMIC, the Fund may realize
excess inclusion income. Excess inclusion income is an amount, with respect to
any calendar quarter, equal to the excess, if any, of (i) the taxable income of
the REMIC allocable to the holder of a residual interest in a REMIC during such
calendar quarter over (ii) the sum of amounts allocated to each day in the
calendar quarter equal to its ratable portion of the product of (a) the adjusted
issue price of the interest at the beginning of the quarter multiplied by (b)
120% of the long term federal rate (determined on the basis of compounding at
the close of each calendar quarter and properly adjusted for the length of such
quarter). Excess inclusion income generated by a residual interest in a REMIC
would be allocated among the holders of the Fund, generally in a manner set
forth under the applicable Treasury regulations. A stockholder's share of any
excess inclusion income: (i) could not be offset by net operating losses of a
stockholder; (ii) would be subject to tax as unrelated business taxable income
to a tax-exempt holder; (iii) would be subject to the application of the U.S.
federal income tax withholding (without reduction pursuant to any otherwise
applicable income tax treaty) with respect to amounts allocable to non-U.S.
stockholders; and (iv) would be taxable (at the highest corporate tax rates) to
the Fund, rather than the Fund's stockholders, to the extent allocable to shares
held by disqualified organizations (generally, tax-exempt entities not subject
to unrelated business income tax, including governmental organizations).
MEDICARE TAX
Under the "Health Care and Education Reconciliation Act of 2010," income
from the Fund may also be subject to a new 3.8 percent "medicare tax" imposed
for taxable years beginning after 2012. This tax will generally apply to the net
investment income of a Member who is an individual if such Member's adjusted
gross income exceeds certain threshold amounts, which are $250,000 in the case
of married couples filing joint returns and $200,000 in the case of single
individuals.
- 56 -
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
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.
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
- 57 -
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.
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.
FATCA Withholding. In addition to the rules described above concerning the
potential imposition of withholding on distributions to non-U.S. persons,
distributions after December 31, 2012, to non-U.S. persons that are "financial
institutions" may be subject to a withholding tax of 30% unless an agreement is
in place between the financial institution and the U.S. Treasury to collect and
disclose information about accounts, equity investments, or debt interests in
the financial institution held by one or more U.S. persons. Similarly,
dispositions of shares in the Fund by non-U.S. person that are "financial
institutions" may be subject to withholding on the gross proceeds of the sale
unless such an agreement is in place between the financial institution and the
U.S. Treasury. For these purpose, a "financial institution" means any entity
that (i) accepts deposits in the ordinary course of a banking or similar
business, (ii) holds financial assets for the account of others as a substantial
portion of its business, or (iii) is engage (or holds itself out as being
engaged) primarily in the business of investing, reinvesting or trading in
securities, partnership interests, commodities or any interest (including a
futures contract or option) in such securities, partnership interests or
commodities.
Distributions to non-financial non-U.S. entities (other than publicly
traded foreign entities, entities owned by residents of U.S. possessions,
foreign governments, international organizations, or foreign central banks)
after December 31, 2012, may also be subject to a withholding tax of 30% if the
non-U.S. entity does not certify that the entity does not have any substantial
U.S. owners or provide the name, address and TIN of each substantial U.S. owner.
Similarly, dispositions of shares in the Fund by non-U.S. person that are
non-financial entities may be subject to withholding on the gross proceeds of
the sale unless such a certification is provided.
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 or indices. 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 Standard & Poor's Index of 500 stocks, the Dow Jones Industrial
Average, NASDAQ Composite 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.
- 58 -
(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. Investors 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:
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.
- 59 -
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.
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
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 October 31, 2009, incorporated
by referenced in this Statement of Additional Information, have been audited by
Deloitte & Touche LLP, an independent registered public accounting firm, as
stated in their report which is incorporated herein by reference. Such financial
- 60 -
statements have been so incorporated in reliance upon the report of such firm
given upon their authority as experts in accounting and auditing. Deloitte &
Touche LLP provides auditing services to the Fund. The principal business
address of Deloitte & Touche LLP is 111 South Wacker Drive, Chicago, Illinois
60606.
CUSTODIAN, ADMINISTRATOR AND TRANSFER AGENT
The Bank of New York Mellon, One Wall Street, New York, New York 10286,
serves as custodian for the Fund. As such, The Bank of New York Mellon 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. BNY Mellon Investment Servicing (US) Inc. serves as
administrator and accountant for the Fund. As such, BNY Mellon Investment
Servicing (US) Inc. 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. BNY Mellon Investment Servicing (US)
Inc., 301 Bellevue Parkway, Wilmington, Delaware 19809, is the transfer agent,
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.
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 -
FINANCIAL STATEMENTS AND
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Fund's financial statements and financial highlights and the reports
of Deloitte & Touche LLP thereon, contained in the following documents filed by
the Fund with the Commission, are hereby incorporated by reference into, and are
made part of, this Statement of Additional Information: The Fund's Annual Report
for the year ended October 31, 2009 contained in the Fund's Form N-CSR filed
with the Commission on January 14, 2010 and the Fund's Semi-Annual Report for
the six months ended April 30, 2010 contained in the Fund's Form N-CSRS filed
with the Commission on July 8, 2010. A copy of such Annual Report and
Semi-Annual Report must accompany the delivery of this Statement of Additional
Information and may be obtained without charge by calling (800) 988-5891 or
writing to First Trust Advisors L.P., 120 E. Liberty Drive, Suite 400, Wheaton,
IL 60187.
APPENDIX A
RATINGS OF INVESTMENTS
Standard & Poor's Ratings Group -- A brief description of the applicable
Standard & Poor's Ratings Group, 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:
o 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;
o Nature of and provisions of the obligation; and
o 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.
A-1
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.
AAA
An obligation rated 'AAA' has the highest rating assigned by Standard &
Poor's. The obligor's capacity to meet its financial commitment on the
obligation is extremely strong.
AA
An obligation rated 'AA' differs from the highest-rated obligations only
in small degree. The obligor's capacity to meet its financial commitment on the
obligation is very strong.
A
An obligation rated 'A' is somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than obligations in
higher-rated categories. However, the obligor's capacity to meet its financial
commitment on the obligation is still strong.
BBB
An obligation rated 'BBB' exhibits adequate protection parameters.
However, adverse economic conditions or changing circumstances are more likely
to lead to a weakened capacity of the obligor to meet its financial commitment
on the obligation.
BB, B, CCC, CC, AND C
Obligations rated 'BB,' 'B,' 'CCC,' 'CC,' and 'C' are regarded as having
significant speculative characteristics. 'BB' indicates the least degree of
speculation and 'C' the highest. While such obligations will likely have some
quality and protective characteristics, these may be outweighed by large
uncertainties or major exposures to adverse conditions.
BB
An obligation rated 'BB' is less vulnerable to nonpayment than other
speculative issues. However, it faces major ongoing uncertainties or exposure to
adverse business, financial, or economic conditions, which could lead to the
obligor's inadequate capacity to meet its financial commitment on the
obligation.
B
An obligation rated 'B' is more vulnerable to nonpayment than obligations
rated 'BB,' but the obligor currently has the capacity to meet its financial
A-2
commitment on the obligation. Adverse business, financial, or economic
conditions will likely impair the obligor's capacity or willingness to meet its
financial commitment on the obligation.
CCC
An obligation rated 'CCC' is currently vulnerable to nonpayment and is
dependent upon favorable business, financial, and economic conditions for the
obligor to meet its financial commitment on the obligation. In the event of
adverse business, financial, or economic conditions, the obligor is not likely
to have the capacity to meet its financial commitment on the obligation.
CC
An obligation rated 'CC' is currently highly vulnerable to nonpayment.
C
The 'C' rating may be used to cover a situation where a bankruptcy
petition has been filed or similar action has been taken, but payments on this
obligation are being continued.
D
An obligation rated 'D' is in payment default. The 'D' rating category is
used when payments on an obligation are not made on the date due even if the
applicable grace period has not expired, unless Standard & Poor's believes that
such payments will be made during such grace period. The 'D' rating also will be
used upon the filing of a bankruptcy petition or the taking of a similar action
if payments on an obligation are jeopardized.
Plus (+) or minus (-)
The ratings from 'AA' to 'CCC' may be modified by the addition of a plus
or minus sign to show relative standing within the major rating categories.
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
A-3
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.
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.
NR
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,' 'AA,' '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 rating 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:
- Chapter 1 Amortization schedule -- the larger the final maturity
relative to other maturities, the more likely it will be treated as a
note; and
A-4
- Chapter 2 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:
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-5
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:
LONG-TERM DEBT RATINGS
Aaa
Bonds rated Aaa are judged to be of the best quality. They carry the
smallest degree of investment risk and are generally referred to as "gilt
edged." Interest payments are protected by a large or by an exceptionally stable
margin and principal is secure. While the various protective elements are likely
to change, such changes as can be visualized are most unlikely to impair the
fundamentally strong position of such issues.
Aa
Bonds rated Aa are judged to be of high quality by all standards. Together
with the Aaa group they comprise what are generally known as high-grade bonds.
They are rated lower than the best bonds because margins of protection may not
be as large as in Aaa securities or fluctuation of protective elements may be of
greater amplitude or there may be other elements present which make the
long-term risk appear somewhat larger than the Aaa securities.
A-6
A
Bonds rated A possess many favorable investment attributes and are to be
considered as upper-medium-grade obligations. Factors giving security to
principal and interest are considered adequate, but elements may be present
which suggest a susceptibility to impairment some time in the future.
Baa
Bonds rated Baa are considered as medium-grade obligations (i.e., they are
neither highly protected nor poorly secured). Interest payments and principal
security appear adequate for the present, but certain protective elements may be
lacking or may be characteristically unreliable over any great length of time.
Such bonds lack outstanding investment characteristics and in fact have
speculative characteristics as well.
Ba
Bonds rated Ba are judged to have speculative elements; their future
cannot be considered as well-assured. Often the protection of interest and
principal payments may be very moderate, and thereby not well safeguarded during
both good and bad times over the future. Uncertainty of position characterizes
bonds in this class.
B
Bonds rated B generally lack characteristics of the desirable investment.
Assurance of interest and principal payments or of maintenance of other terms of
the contract over any long period of time may be small.
Caa
Bonds rated Caa are of poor standing. Such issues may be in default or
there may be present elements of danger with respect to principal or interest.
Ca
Bonds rated Ca represent obligations which are speculative in a high
degree. Such issues are often in default or have other marked shortcomings.
C
Bonds rated C are the lowest rated class of bonds, and issues so rated can
be regarded as having extremely poor prospects of ever attaining any real
investment standing.
Note: Moody's applies numerical modifiers 1, 2, and 3 in each generic rating
classification from Aa through Caa. The modifier 1 indicates that the obligation
A-7
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.
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.
A-8
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.
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.
A-9
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 Ltd.-- A brief description of the applicable Fitch Ratings
Ltd. ("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.
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.
A-10
BBB
Good credit quality. 'BBB' ratings indicate that there is currently a low
expectation of credit risk. The capacity for timely payment of financial
commitments is considered adequate, but adverse changes in circumstances and in
economic conditions are more likely to impair this capacity. This is the lowest
investment-grade category.
BB
Speculative. 'BB' ratings indicate that there is a possibility of credit
risk developing, particularly as the result of adverse economic change over
time; however, business or financial alternatives may be available to allow
financial commitments to be met. Securities rated in this category are not
investment grade.
B
Highly speculative. 'B' ratings indicate that significant credit risk is
present, but a limited margin of safety remains. Financial commitments are
currently being met; however, capacity for continued payment is contingent upon
a sustained, favorable business and economic environment.
CCC, CC, C
High default risk. Default is a real possibility. Capacity for meeting
financial commitments is solely reliant upon sustained, favorable business or
economic developments. A 'CC' rating indicates that default of some kind appears
probable. 'C' ratings signal imminent default.
DDD, DD, D
Default. The ratings of obligations in this category are based on their
prospects for achieving partial or full recovery in a reorganization or
liquidation of the obligor. While expected recovery values are highly
speculative and cannot be estimated with any precision, the following serve as
general guidelines. 'DDD' obligations have the highest potential for recovery,
around 90%-100% of outstanding amounts and accrued interest. 'DD' indicates
potential recoveries in the range of 50%-90% and 'D' the lowest recovery
potential, i.e., below 50%.
Entities rated in this category have defaulted on some or all of their
obligations. Entities rated 'DDD' have the highest prospect for resumption of
performance or continued operation with or without a formal reorganization
process. Entities rated 'DD' and 'D' are generally undergoing a formal
reorganization or liquidation process; those rated 'DD' are likely to satisfy a
higher portion of their outstanding obligations, while entities rated 'D' have a
poor prospect of repaying all obligations.
A-11
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.
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.
A-12
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, Fitch may be unable to identify the
fundamental trend. In these cases, the Rating Outlook may be described as
evolving.
A-13
APPENDIX B
FIRST TRUST ADVISORS L.P.
PROXY VOTING GUIDELINES
First Trust Advisors L.P. (the "Adviser") serves as investment adviser
providing discretionary investment advisory services for separate managed
accounts, ERISA accounts and open- and closed-end investment companies (the
"Clients"). As part of these services, the Adviser may have responsibility for
proxy voting and related duties. In fulfilling these duties, the Adviser has
adopted the following policies and procedures:
1. It is the Adviser's policy to seek and to ensure that proxies are
voted on securities in a Client's account consistently and solely in the best
economic interests of the Client.
2. The Adviser shall be responsible for the oversight of Client proxy
voting processes and shall assign a senior member of its staff to be responsible
for this oversight.
3. The Adviser has engaged the services of Institutional Shareholder
Services, Inc. ("ISS") to make recommendations to the Adviser on the voting of
proxies related to securities held by Clients. ISS provides voting
recommendations based on established guidelines and practices. The Adviser has
adopted these ISS Proxy Voting Guidelines.
4. The Adviser shall review the ISS recommendations and generally will
vote proxies in accordance with such recommendations. Notwithstanding the
foregoing, the Adviser may not vote in accordance with the ISS recommendations
if the Adviser believes that the specific ISS recommendation is not in the best
interests of the Client. In addition, whenever a conflict of interest arises
between ISS and a company subject to a proxy vote, the Adviser will vote the
proxy without using the analyses of ISS and will consider the recommendation of
the company and what the Adviser believes to be in the best interests of the
Client. In addition, if the Adviser has actual knowledge of any other type of
material conflict of interest between itself and the respective Client with
respect to the voting of a proxy, the Adviser shall vote the applicable proxy in
accordance with the ISS recommendations to avoid such conflict of interest. With
respect to open- and closed-end funds and variable annuity sub-accounts, if
there is a conflict of interest between fund shareholders and FTA, the fund's
principal underwriter, or sub-adviser, if applicable, FTA will vote the proxy
based on the recommendations of ISS to avoid such conflict of interest.
5. If the Adviser manages the assets or pension fund of a company and any
of the Adviser's Clients hold any securities in that company, the Adviser will
vote proxies relating to such company's securities in accordance with the ISS
recommendations to avoid any conflict of interest.
6. If a Client requests the Adviser to follow specific voting guidelines
or additional guidelines, the Adviser shall review the request and follow such
guidelines, unless the Adviser determines that it is unable to follow such
guidelines. In such case, the Adviser shall inform the Client that it is not
able to follow the Client's request.
B-1
7. FTA will monitor changes to the ISS guidelines to determine that such
guidelines continue to result in a voting policy that is in the best interests
of Clients.
8. In certain circumstances, where FTA has determined that it is
consistent with the Client's best interest, FTA will not take steps to ensure
that proxies are voted on securities in the Client's accounts. The following are
circumstances where this may occur:
(a) Limited Value. Proxies will not be required to be voted on
securities in a Client's account if the value of the Client's economic
interest in the securities is indeterminable or insignificant (less than
$1,000). Proxies will also not be required to be voted for any securities
that are no longer held by the Client's account.
(b) Securities Lending Program. When securities are out on loan,
they are transferred into the borrower's name and are voted by the
borrower, in its discretion. In most cases, FTA will not take steps to see
that loaned securities are voted. However, where FTA determines that a
proxy vote, or other shareholder action, is materially important to the
Client's account, FTA will make a good faith effort to recall the security
for purposes of voting, understanding that in certain cases, the attempt
to recall the security may not be effective in time for voting deadlines
to be met.
(c) Unjustifiable Costs. In certain circumstances, after doing a
cost-benefit analysis, FTA may choose not to vote where the cost of voting
a Client's proxy would exceed any anticipated benefits to the Client of
the proxy proposal (e.g. foreign securities).
9. For certain open- or closed-end funds relying on Section 12(d)(1)(F)
of the 1940 Act, FTA will vote on proxies of securities of investment companies
held by such funds in the same proportion as all other holders of such
securities (i.e. mirror or echo voting) to the extent possible.
Adopted: September 15, 2003
Amended: December 10, 2007
Amended: September 21, 2009
B-2
PART C - OTHER INFORMATION
Item 25: Financial Statements and Exhibits
1. Financial Statements:
The Registrant's audited financial statements, notes to the financial
statements and the report of independent public accounting firm thereon have
been incorporated into Part B of the Registration Statement by reference to
Registrant's Annual Report for the fiscal year ended October 31, 2009 contained
in its Form N-CSR, as described in the statement of additional information.
2. Exhibits:
a. Declaration of Trust dated February 22, 2005.(1)
b. By-Laws of Fund.
c. None.
d. Form of Share Certificate.(2)
e. Terms and Conditions of the Dividend Reinvestment Plan.(2)
f. None.
g.1 Interim Investment Management Agreement between Registrant and First Trust
Advisors L.P.
g.2 Interim Sub-Advisory Agreement between Registrant, First Trust Advisors
L.P. and Fixed Income Discount Advisory Company.
h.1 Form of Underwriting Agreement.*
h.2 Form of Sales Agreement.*
i. None.
j. Custodian Services Agreement.(2)
k.1 Transfer Agency Services Agreement.(2)
k.2 Administration and Accounting Services Agreement.(2)
l.1 Opinion and consent of Chapman and Cutler LLP.*
l.2 Opinion and consent of Bingham McCutchen LLP.*
m. None.
n. Consent of Independent Registered Public Accounting Firm.
o. None.
p. Subscription Agreement between Registrant and First Trust Advisors L.P.(2)
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.
(1) Filed on March 11, 2005 in Registrant's Registration Statement on Form N-2
(File No. 333-123262) and incorporated herein by reference.
(2) Filed on May 25, 2005 in Registrant's Amended Registration Statement on
Form N-2/A (File No. 333-123262) and incorporated herein by reference.
Item 26: Marketing Arrangements
Reference is made to the form of underwriting agreement and/or sales
agreement for the Registrant's common shares to be filed in a post-effective
amendment to the Registrant's Registration Statement and the section entitled
"Plan of Distribution" contained in Registrant's Prospectus, filed herewith as
Part A of Registrant's Registration Statement.
Item 27: Other Expenses of Issuance and Distribution
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Securities and Exchange Commission Fees $ *
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Financial Industry Regulatory Authority, Inc. Fees $ *
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Printing and Engraving Expenses $ *
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Legal Fees $ *
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Listing Fees $ *
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Accounting Expenses $ *
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Blue Sky Filing Fees and Expenses $ *
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Miscellaneous Expenses $ *
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Total $ *
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* To be completed by amendment.
Item 28: Persons Controlled by or under Common Control with Registrant
Not applicable.
Item 29: Number of Holders of Securities
At __________, 2010
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Title of Class Number of Record Holders
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Common Shares, $0.01 par value *
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* To be completed by amendment.
Item 30: Indemnification
Section 5.3 of the Registrant's Declaration of Trust provides as follows:
Section 5.3. Mandatory Indemnification. (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;
(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 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 (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 31: Business and Other Connections of Investment Advisers
The information in the Statement of Additional Information under the captions
"Management of the Company--Directors and Officers" and "Sub-Advisor" is hereby
incorporated by reference.
Item 32: 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 33: Management Services
Not applicable.
Item 34: 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. The Registrant undertakes (a) to file, during any period in which offers
or sales are being made, a post-effective amendment to this Registration
Statement:
(1) to include any prospectus required by Section 10(a)(3) of the Securities
Act of 1933;
(2) to reflect in the prospectus any facts or events arising after the
effective date of the registration statement (or the most recent
post-effective amendment thereof) which, individually or in the aggregate,
represent a fundamental change in the information set forth in the
registration statement; and
(3) to include any material information with respect to the plan of
distribution not previously disclosed in the registration statement or any
material change to such information in the registration statement;
(b) that, for the purpose of determining liability under the Securities Act of
1933, each such post-effective amendment shall be deemed to be a new
registration statement relating to the securities offered therein, and the
offering of those securities at that time shall be deemed to be the
initial bona fide offering thereof; and
(c) to remove from registration by means of a post-effective amendment any of
the securities being registered which remain unsold at the termination of
the offering;
(d) that, for the purpose of determining liability under the Securities Act of
1933 to any purchaser, if the Registrant is subject to Rule 430C; each
prospectus filed pursuant to Rule 497(b), (c), (d) or (e) under the
Securities Act of 1933, shall be deemed to be part of and included in this
Registration Statement as of the date it is first used after
effectiveness. Provided, however, that no statement made in this
Registration Statement or prospectus that is part of this registration
statement or made in a document incorporated or deemed incorporated by
reference into this registration statement or prospectus that is art of
this registration statement will, as to a purchaser with a time of
contract of sale prior to such first use, supercede or modify any
statement that was made in this registration statement or prospectus that
was part of this registration statement or made in any such document
immediately prior to such date of first use;
(e) that for the purpose of determining liability of the Registrant under the
Securities Act of 1933 to any purchaser in the initial distribution of
securities:
The undersigned Registrant undertakes that in a primary offering of
securities of the undersigned Registrant pursuant to this registration
statement, regardless of the underwriting method used to sell the
securities to the purchaser, if the securities are offered or sold to such
purchaser by means of any of the following communications, the undersigned
Registrant will be a seller to the purchaser and will be considered to
offer or sell such securities to the purchaser:
(1) any preliminary prospectus or prospectus of the undersigned Registrant
relating to the offering required to be filed pursuant to Rule 497 under
the Securities Act of 1933;
(2) the portion of any advertisement pursuant to Rule 482 under the Securities
Act of 1933 relating to the offering containing material information about
the undersigned Registrant or its securities provided by or on behalf of
the undersigned Registrant; and
(3) any other communication that is an offer in the offering made by the
undersigned Registrant to the purchaser.
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; and
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.
7. Upon each issuance of securities pursuant to this Registration Statement,
the Registrant undertakes to file a form of prospectus and/or prospectus
supplement pursuant to Rule 497 and a post-effective amendment to the
extent required by the Securities Act of 1933 and the rules and
regulations thereunder, including, but not limited to a post-effective
amendment pursuant to Rule 462(c) or Rule 462(d) under the Securities Act
of 1933.
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 Wheaton, and State of Illinois, on the 29th day of
October, 2010.
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
--------------------------------------- ------------------------------------- ------------------------------------
By: /s/ James A. Bowen President, Chairman of the Board and October 29, 2010
------------------------------ Trustee (Principal Executive
James A. Bowen Officer)
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By: /s/ Mark R. Bradley Chief Financial Officer and October 29, 2010
------------------------------ Treasurer (Principal Financial and
Mark R. Bradley Accounting Officer)
--------------------------------------- ------------------------------------- ------------------------------------
Richard E. Erickson(1) Trustee )
--------------------------------------- ------------------------------------- By: /s/ W. Scott Jardine
Thomas R. Kadlec(1) Trustee ) --------------------------
--------------------------------------- ------------------------------------- W. Scott Jardine
Robert F. Keith(1) Trustee ) Attorney-In-Fact
--------------------------------------- ------------------------------------- October 29, 2010
Niel B. Nielson(1) Trustee )
--------------------------------------- ------------------------------------- ------------------------------------
---------------
(1) Original powers of attorney authorizing James A. Bowen, W. Scott Jardine,
Kristi A. Maher and Eric F. Fess to execute Registrant's 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.
INDEX TO EXHIBITS
b. By-Laws of the Fund.
g.1 Interim Investment Management Agreement between Registrant and First Trust
Advisors L.P.
g.2 Interim Sub-Advisory Agreement between Registrant, First Trust Advisors
L.P. and Fixed Income Discount Advisory Company.
n. Consent of Independent Registered Public Accounting Firm.
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.