-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, QUPB3FCTHe+3NY9VxDGtQVxAaCuyfyftEbDZFmOgVhc90y8k6AGX1NH/wO2qpW7G hkGe1wYkWkjfvepPTD6Anw== 0000950146-96-002392.txt : 19970102 0000950146-96-002392.hdr.sgml : 19970102 ACCESSION NUMBER: 0000950146-96-002392 CONFORMED SUBMISSION TYPE: N-30D PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 19961031 FILED AS OF DATE: 19961231 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: KEYSTONE QUALITY BOND FUND B-1 CENTRAL INDEX KEY: 0000055611 STANDARD INDUSTRIAL CLASSIFICATION: [] IRS NUMBER: 042394419 FISCAL YEAR END: 1031 FILING VALUES: FORM TYPE: N-30D SEC ACT: 1940 Act SEC FILE NUMBER: 811-00092 FILM NUMBER: 96688697 BUSINESS ADDRESS: STREET 1: 200 BERKELEY STREET CITY: BOSTON STATE: MA ZIP: 02116 BUSINESS PHONE: 6173383200 MAIL ADDRESS: STREET 1: 200 BERKELEY STREET CITY: BOSTON STATE: MA ZIP: 02116 N-30D 1 - ------------------------------------------------------------------------------ KEYSTONE FAMILY OF FUNDS [DIAMOND] Balanced Fund (K-1) Diversified Bond Fund (B-2) Growth and Income Fund (S-1) High Income Bond Fund (B-4) International Fund Inc. Liquid Trust Mid-Cap Growth Fund (S-3) Precious Metals Holdings, Inc. Quality Bond Fund (B-1) Small Company Growth Fund (S-4) Strategic Growth Fund (K-2) Tax Free Fund - ------------------------------------------------------------------------------ This report was prepared primarily for the information of the Fund's shareholders. It is authorized for distribution if preceded or accompanied by the Fund's current prospectus. The prospectus contains important information about the Fund including fees and expenses. Read it carefully before you invest or send money. For a free prospectus on other Keystone funds, contact your financial adviser or call Keystone. [KEYSTONE INVESTMENTS LOGO] P.O. Box 2121 Boston, Massachusetts 02106-2121 B1-R-12/96 15.7M - ------------------------------------------------------------------------------ KEYSTONE [PHOTO OF COUPLE ON BEACH] QUALITY BOND FUND (B-1) - ------------------------------------------------------------------------------ [KEYSTONE LOGO] ANNUAL REPORT OCTOBER 31, 1996 PAGE 1 - -------------------------------- Keystone Quality Bond Fund (B-1) Seeks generous income and capital preservation from high quality bonds. Dear Shareholder: We are pleased to report on the activities of Keystone Quality Bond Fund (B-1) for the twelve-month period which ended October 31, 1996. Following our letter we have included a discussion with your Fund's manager and complete financial information. Performance Your Fund returned 5.08% for the six-month period and 3.99% for the twelve-month period which ended October 31, 1996. For the same periods, the Lehman Aggregate Bond Index--a widely recognized index of corporate, government and mortgage securities--returned 5.29% for the six-month period and 5.83% for the twelve-month period. Keystone Quality Bond Fund (B-1) provided satisfactory performance during a period of sharp price fluctuations as interest rates rose and then fell in reaction to changing economic conditions. Fund performance improved particularly during the last six months of the period. While interest rates were relatively unchanged from their levels of one year ago, the credit markets endured considerable short-term price volatility during the twelve-month period. In November and December 1995, interest rates trended down as economic growth slowed from moderate levels, inflation remained under control and the government appeared to be making progress toward reducing the federal budget deficit. Most investors expected these trends to continue into 1996. On October 31, 1996 the benchmark 30-year U.S. Treasury bond yielded 6.35%. By January 1996 Treasuries had reached a low of 5.97% on this favorable news. During the first quarter of 1996 economic reports showed stronger-than-expected economic growth and employment gains, which increased fears of higher inflation rates. Because inflation reduces returns to bond holders, interest rates generally rose with each economic report that indicated strong growth. By early July rates had peaked at 7.19%. As rates rose, prices generally declined for nearly all fixed income investments. Expectations of stronger growth moderated during the third quarter of 1996 as it appeared that the strong growth of the first half of the year was slowing. Still watchful for signs of future inflation, investors gained confidence that this favorable environment could be sustained and interest rates began to move within a narrow range. On October 31, 1996 the 30-year Treasury stood at 6.82%, not far from where it was at the beginning of the fiscal period. Portfolio strategy Over the past six months, we restructured Keystone Quality Bond Fund (B-1) to improve stability and enhance long-term potential total returns. We invested a portion of the Fund in government bonds of Canada, Germany and Spain. With their attractive yields, high quality and solid economic fundamentals, we believed these investments offered good relative values. All transactions were currency-hedged into U.S. dollars to protect the portfolio from foreign currency fluctuations. We also increased your Fund's investments in collateralized mortgage obligations (CMOs), asset-backed securities, and bonds in the bank and finance sectors. We believe these securities contributed favorably to your Fund's income and total return. In its entirety, we believe the portfolio's new structure increased diversification while maintaining a high degree of quality and liquidity. (continued on next page) PAGE 2 - -------------------------------- Keystone Quality Bond Fund (B-1) Keystone Quality Bond Fund (B-1) is designed for conservative, income-oriented investors. We invest in a selection of high quality fixed income securities, which include among others, U.S. government obligations, mortgage-backed and asset-backed securities, and high-quality corporate bonds. We apply careful credit analysis in selecting high quality securities for the portfolio. We attempt to identify securities that we believe will perform well given our expectations for the market environment. We believe that your Fund's ability to diversify and be flexible are key elements in navigating the changing conditions of the fixed income markets. Looking ahead, we anticipate a stable-to-positive environment for high quality bonds. We expect moderate economic growth and low inflation to provide a positive background for interest rates to move within a narrow range through early 1997. New portfolio manager After 20 years of distinguished service with Keystone, your Fund's manager Barbara McCue has retired effective September 30, 1996. The leader of Keystone's high grade bond team, Christopher P. Conkey, has assumed responsibilities as your Fund's portfolio manager. Mr. Conkey is a Chartered Financial Analyst and has over 13 years of investment experience. He currently manages several other Keystone funds that invest in high grade bonds. We look forward to his contribution to your Fund's management. Keystone acquired by First Union Corporation On another note, we are pleased to inform you that Keystone has been acquired by First Union Corporation. First Union is a financial services firm based in Charlotte, North Carolina. It is the nation's sixth largest bank holding company with assets of approximately $130 billion. First Union, through its wholly-owned subsidiary Evergreen Asset Management Corp., together with Keystone mutual funds, manages more than $30 billion in 70 mutual funds. While Keystone will remain a separate entity and will continue to provide investment advisory and management services to the Fund, services will be provided under the "Evergreen Keystone Funds" name. We believe First Union's acquisition of Keystone strengthens the investment management services we provide you. We appreciate your continued support of Keystone Quality Bond Fund (B-1). If you have any questions or comments about your investment, we encourage you to write to us. Sincerely, /s/ Albert H. Elfner, III - ------------------------- Albert H. Elfner, III Chairman and President Keystone Investments, Inc. /s/ George S. Bissell - ------------------------- George S. Bissell Chairman of the Board Keystone Funds December 1996 PAGE 3 - -------------------------------- A Discussion With Your Fund Manager [PHOTO OF CHRISTOPHER P. CONKEY] Christopher P. Conkey is portfolio manager of your Fund and heads Keystone's high grade bond team. A Chartered Financial Analyst, Mr. Conkey has 13 years of experience managing fixed-income investments. He holds a BA in economics from Clark University and an MBA in finance from Boston University. Together with analysts David J. Bowers and Gary E. Pzegeo, he evaluates interest rate and credit risk in selecting high quality bonds for Keystone fixed income funds. Q What was the investment climate like for high quality bonds over the past year? A The climate for high quality bonds changed several times over the past year. There was a high degree of price volatility throughout much of the period, as investors revised their interest rate and economic forecasts. Despite these fluctuations, however, interest rates were relatively unchanged at the end of this reporting period from one year ago. Q What changed the outlooks for interest rates and the economy? A Stronger-than-expected growth in employment and consumer spending in the first quarter of 1996 caused investors to revise their economic and interest rate forecasts. Interest rates had fallen to near historic lows during much of 1995 on the outlook for a slow economy and low inflation. The reports of strength in employment and consumer activity stimulated concerns that the economy might be more robust than expected. Interest rates rose and bond prices fell during that time. By mid-year, signs of moderating economic growth appeared, relieving inflation fears. While watchful of preliminary signs of future inflation, investors became more confident that this trend of moderate growth and low inflation could be sustained. Q What strategies did you employ during these changing market climates? A We restructured the portfolio's assets and adjusted its average maturity. We believe the combination reduced the Fund's risk to U.S. interest rate fluctuations, increased yield and improved diversification. First, we reduced the Fund's holdings in U.S. government securities from 48% to 5% of net assets. Since U.S. government securities carry no credit risk, their prices are primarily influenced by the movement in interest rates. We believe reducing the portfolio's exposure to interest rate risk increased stability, particularly in light of the price volatility over the past year. We reinvested the proceeds from these sales in non-dollar foreign government bonds, collateralized mortgage obligations (CMOs), asset-backed securities, and bonds in the bank and finance sectors. These bonds improved diversification, increased income, and provided price appreciation to the Fund's portfolio. Fund Profile Objective: Seeks the highest possible income consistent with preservation of principal. Commencement of investment operations: September 11, 1935 Average quality: AA+ Average maturity: 11 years Net assets: $229 million Newspaper symbol: "QultyB1" PAGE 4 - -------------------------------- Keystone Quality Bond Fund (B-1) Asset Allocation as of October 31, 1996 [TABULAR REPRESENTATION OF PIE CHART] Corporates (31.7%) Collateralized mortgage obligations (CMOs) (22.3%) Foreign (15.6%) Mortgage-backed (13.6%) Asset-backed (10.6%) U.S. government & agency (5.1%) Other(1) (1.1%) (as a percent of net assets) We adjusted average maturity, ultimately shortening it when interest rates rose last spring. As of October 31, 1996, the Fund's average maturity stood at 11 years. The average quality of Keystone Quality Bond Fund (B-1) was AA+, the second highest rating available from Standard and Poor's Corporation. Q Why did you invest in the foreign sector? A The foreign sector offered higher yields and greater potential for capital appreciation than many domestic alternatives. We did not increase credit risk in the foreign sector, preferring to emphasize securities with high quality ratings. Further, all of the investments were currency-hedged, to protect our holdings from foreign currency exchange rate changes. We invested in the government bonds of Canada, Germany and Spain; countries that we believed offered attractive values based on solid economic fundamentals, stable political environments and large, liquid securities markets. In fact, interest rates in these countries have fallen over the past year resulting in price appreciation. In addition, our foreign investments avoided the price declines experienced in the U.S. credit markets. Q How about other sectors? A Collateralized mortgage obligations and asset-backed securities also offered investors higher yields than U.S. government bonds, while enabling the Fund to maintain credit quality. We invested in well structured, AAA-rated securities. We concentrated on commercial loans and securities that were collateralized by home equity loans and credit card receivables. We chose these sectors because of their link to the consumer. Consumer confidence ran high throughout the period, due to strength in employment, income growth, and improving net wealth which was caused by a rising stock market and generally higher housing prices. We believed that the strength of the consumer sector would have a favorable effect on these securities versus alternative investments. We also increased the Fund's investments in the bank and finance sector as interest rates rose. We believed that higher U.S. rates would eventually slow economic growth. Slower growth historically has resulted in falling interest rates. Typically, banks and finance companies have benefitted from this type of environment. Towards the end of the reporting period this scenario of lower rates appeared to be unfolding. Q What is your outlook for the next six months? A We believe the next six months should be a neutral environment for high quality bonds with interest rates fluctuating in a narrow range. We anticipate moderate economic growth accompanied by low inflation. On an annual basis, we think the economy will grow at a pace of 2-2-1/2% and that inflation, as measured by the consumer price index (CPI), will stay in the area of 3%. Q With interest rates at relatively low levels, do you believe that bonds offer good long term value? A We believe they do. While nominal interest rates have been relatively low, "real" interest rates, or the rate received by investors after subtracting inflation, continues to be attractive. For example, the 30-year U.S. Treasury bond had a yield of 6.82% as of October 31, 1996. - --------------- (1) Includes repurchase agreement, and other assets and liabilities. PAGE 5 - -------------------------------- Portfolio Quality Summary as of October 31, 1996 [TABULAR REPRESENTATION OF PIE CHART] AAA (36.3%) U.S. government and agency(3) (26.6%) A (15.2%) AA (11.0%) BBB (10.9%) (as a percentage of portfolio assets) Inflation was recently about 3%. Thus, the real return after subtracting inflation was approximately 3.82% at the end of the period, a historically attractive level. Like most investments, high quality bonds can experience periods of short-term price volatility. Over the long-run, however, high-quality bonds have demonstrated relative stability and attractive income. We believe high quality bonds will continue to produce solid total returns in the future. In our opinion, the Fund serves an important role in a well-rounded investment portfolio. - ------------ (2) Where Standard & Poor's ratings were not available, we have used ratings from Moody's Investor Service, Inc., Fitch Investors' Service, Inc., or ratings assigned by another nationally recognized statistical rating organization. (3) Includes all U.S. government and agency securities including CMOs, asset- backed and mortgage pass-through securities issued by the U.S. government or its agencies. Ratings are very important to evaluating bonds. What do they mean? Bond ratings provide an indication of the relative investment quality of an issuer. Each rating agency uses its own criteria for assigning ratings. In general, each agency examines the ability of an issuer to maintain debt protection levels in periods of recession as well as recovery. Bonds with identical ratings are not necessarily equal. Different industries have different business risks. However, most bonds within a certain rating category tend to have similar characteristics. The following table briefly defines investment grade bond ratings. Investment Grade Bond Ratings Moody's Investors Service S&P Aaa AAA Highest Quality, lowest likelihood of default Aa AA High Quality A A Upper Medium Grade Baa BBB Medium Grade We use bond ratings as one component of our credit research. For Keystone Quality Bond Fund (B-1), we consider only investment-grade securities. That is, bonds rated AAA, AA, A, and BBB. Lower rated bonds are considered speculative grade. [DIAMOND] This column is intended to answer questions about your Fund. If you have a question you would like answered, please write to: Evergreen Keystone Investment Services, Inc. Attn: Shareholder Communications, 22nd Floor 200 Berkeley Street, Boston, Massachusetts 02116-5034. PAGE 6 - -------------------------------- Keystone Quality Bond Fund (B-1) Your Fund's Performance Growth of an investment in Keystone Quality Bond Fund (B-1) [MOUNTAIN CHART] In Thousands Initial Reinvested Investment Distributions 10/86 10000 10000 8937 9756 10/88 9045 10740 9125 11794 10/90 8708 12259 9160 13986 10/92 9160 15065 9377 16647 10/94 8256 15603 8816 17739 10/96 8685 18447 A $10,000 investment in Keystone Quality Bond Fund (B-1) made on October 31, 1986 with all distributions reinvested as worth $18,447 on October 31, 1996. Past performance is no guarantee of future results. Twelve-Month Performance as of October 31, 1996 - ------------------------------------------------------ Total return* 3.99% Net asset value 10/31/95 $15.42 10/31/96 $15.19 Distributions $ 0.82 Capital gains None * Before deduction of contingent deferred sales charge (CDSC). Historical Record as of October 31, 1996 - ------------------------------------------------------- If you If you did Cumulative total return redeemed not redeem 1-year 1.03% 3.99% 5-year 31.89% 31.89% 10-year 84.47% 84.47% Average annual total return 1-year 1.03% 3.99% 5-year 5.69% 5.69% 10-year 6.31% 6.31% The "if you redeemed" returns reflect the deduction of the 3% CDSC for those investors who sold Fund shares after one calendar year. Investors who retained their fund investment earned the returns reported in the second column of the table. The investment return and principal value will fluctuate so that your shares, when redeemed, may be worth more or less than the original cost. Past performance is no guarantee of future results. Shareholders may exchange shares for another Keystone fund by calling or writing to Keystone directly, or through Keystone's Automated Response Line (KARL). The Fund reserves the right to change or terminate the exchange offer. PAGE 7 - -------------------------------- Growth of an Investment Comparison of change in value of a $10,000 investment in Keystone Quality Bond Fund (B-1), the Lehman Aggregate Bond Index and the Consumer Price Index. In Thousands October 1986 through October 1996 Fund Average Annual Total Return - ------------------------------------- 1 Year 5 Year 10 Year 1.03% 5.69% 6.31% [LINE CHART] Fund LABI CPI 10/86 10000 10000 10000 9756 10205 10453 10/88 10740 11374 10898 11794 12726 11387 10/90 12259 13528 12103 13986 15663 12457 10/92 15065 17204 12856 16647 19247 13209 10/94 15603 18539 13554 17739 21441 13935 10/96 18447 22692 14306 Past performance is no guarantee of future results. The one-year return reflects the deduction of the Fund's 3% contingent sales charge for shares held for at least one year. The Consumer Price Index is through September 30, 1996. This chart graphically compares your Fund's performance to certain investment indexes. It is the result of fund performance guidelines issued by the Securities and Exchange Commission. The intent is to provide investors with more information about their investment. Components of the chart The chart is composed of several lines that represent the accumulated value of an initial $10,000 investment for the period indicated. The lines illustrate a hypothetical investment in: 1. Keystone Quality Bond Fund (B-1) Your Fund seeks the highest possible income consistent with preservation of principal. The return is quoted after deducting sales charges (if applicable), fund expenses, and transaction costs and assumes reinvestment of all distributions. 2. Lehman Aggregate Bond Index (LABI) The LABI is a broad-based, unmanaged fixed income index of U.S. government, corporate and mortgage-backed securities. It represents the price change and coupon income of several thousand securities of various credit qualities and maturities. Securities are selected and compiled by Lehman Brothers, Inc. according to criteria that may be unrelated to your Fund's investment objective. It would be difficult for most individual investors to duplicate this index. 3. Consumer Price Index (CPI) This index is a widely recognized measure of the cost of goods and services produced in the U.S. The index contains factors such as prices of services, housing, food, transportation and electricity which are compiled by the U.S. Bureau of Labor Statistics. The CPI is generally considered a valuable benchmark for investors who seek to outperform increases in the cost of living. These indexes do not include transaction costs associated with buying and selling securities, and do not hold cash to meet redemptions. It would be difficult for most individual investors to duplicate these indexes. Understanding what the chart means The chart demonstrates your Fund's performance in relation to a well known investment index and to increases in the cost of living. It is important to understand what the chart shows and does not show. This illustration is useful because it charts Fund and index performance over the same time frame and over a long period. Long-term performance is a more reliable and useful measure of performance than measurements of short-term returns or temporary swings in the market. Your financial adviser can help you PAGE 8 - -------------------------------- Keystone Quality Bond Fund (B-1) evaluate fund performance in conjunction with the other important financial considerations such as safety, stability and consistency. Limitations of the chart The chart, however, limits the evaluation of Fund performance in several ways. Because the measurement is based on total returns over an extended period of time, the comparison often favors those funds which emphasize capital appreciation when the market is rising. Likewise, when the market is declining, the comparison usually favors those funds which take less risk. Performance can be distorted Funds which are more conservative in their orientation and which place an emphasis on capital preservation will tend to compare less favorably when the market is rising. In addition, funds which have income as one of their objectives also will tend to compare less favorably to relevant indexes. Indexes may also reflect the performance of some securities which a fund may be prohibited from buying. A bond fund, for example, may be limited to investments in only high quality bonds, or a stock fund may only be able to buy stocks that have been traded on a stock exchange for a minimum number of years or stocks that have a certain market capitalization. Indexes usually do not have the same investment restrictions as your Fund. Indexes do not include costs of investing The comparison is further limited in its utility because the indexes do not take into account any deductions for sales charges, transaction costs or other fund expenses. Your Fund's performance figures do reflect such deductions. Sales charges--whether up-front or deferred--pay for the cost of the investment advice of your financial adviser. Transaction costs pay for the costs of buying and selling securities for your Fund's portfolio. Fund expenses pay for the costs of investment management and various shareholder services. None of these costs are reflected in index total returns. The comparison is not completely realistic because an index cannot be duplicated by an investor--even an unmanaged index--without incurring some charges and expenses. One of several measures The chart is one of several tools you can use to understand your investment. It should be read in conjunction with the Fund's prospectus, and annual and semiannual reports. Also, your financial adviser, who understands your personal financial situation, can best explain the features of your Keystone fund and how it applies to your financial needs. Future returns may be different Shareholders also should be mindful that the long-run performance of either the Fund or the indexes is not representative of what shareholders should expect to receive from their Fund investment in the future; it is presented to illustrate only past performance and is not a guarantee of future returns. PAGE 9 - -------------------------------- Glossary of Mutual Fund Terms MUTUAL FUND--A company which combines the investment money of many people whose financial goals are similar, and invests that money in a variety of securities. A mutual fund allows the smaller investor the benefits of diversification, professional management and constant supervision usually available only to large investors. PORTFOLIO MANAGER--An investment professional who is responsible for managing a portfolio's assets prudently and making appropriate investment decisions, such as which securities to buy, hold and sell, based on the investment objectives of the portfolio. STOCK--Equity or ownership interest in a corporation, which represents a claim on the corporation's assets and earnings. BOND--Security issued by a government or corporation to those from whom it has borrowed money. A bond usually promises to pay interest income to the bondholder at regular intervals and to repay the entire amount borrowed at maturity date. CONVERTIBLE SECURITY--A corporate security (usually preferred stock or bonds) that is exchangeable for a set number of another security type (usually common stocks) at a pre-stated price. MONEY MARKET FUND--A mutual fund whose assets are invested in a diversified portfolio of short- term securities, including commercial paper, bankers' acceptances, certificates of deposit and other short-term instruments. The fund pays income which can fluctuate daily. Liquidity and safety of principal are primary objectives. NET ASSET VALUE (NAV) PER SHARE--The value of one share of a mutual fund. The NAV per share is determined by subtracting a fund's total liabilities from its total assets, and dividing that amount by the number of fund shares outstanding. DIVIDEND--A per share distribution of the income earned from the fund's portfolio holdings. When a dividend distribution is made, the fund's net asset value drops by the amount of the distribution because the distribution is no longer considered part of the fund's assets. CAPITAL GAIN--The profit from the sale of securities, less any losses. Capital gains are paid to fund shareholders on a per share basis. When a capital gain distribution is made, the fund's net asset value drops by the amount of the distribution because the distribution is no longer considered part of the fund's assets. YIELD--The annualized rate of income as measured against the current net asset value of fund shares. TOTAL RETURN--The change in value of a fund investment over a specified period of time, taking into account the change in a fund's market price and the reinvestment of all fund distributions. SHORT-TERM--An investment with a maturity of one year or less. LONG-TERM--An investment with a maturity of greater than one year. AVERAGE MATURITY--The average number of days until the notes, drafts, acceptances, bonds or other debt instruments in a portfolio become due and payable. OFFERING PRICE--The offering price of a share of a mutual fund is the price at which the share is sold to the public. PAGE 10 - -------------------------------- Keystone Quality Bond Fund (B-1) SCHEDULE OF INVESTMENTS--October 31, 1996
Interest Maturity Par Market Rate Date Value Value ================================================================================================================ FIXED INCOME (98.9%) CORPORATE BONDS & NOTES (31.7%) AIRCRAFT (0.9%) Boeing Co. 7.875% 2043 $2,000,000 $ 2,146,420 - ---------------------------------------------------------------------------------------------------------------- BANK & FINANCE (13.0%) AmSouth Bancorp. Subord. Deb. 6.750 2025 3,500,000 3,461,920 Associates Corp. North America Sr. Notes 7.625 2000 1,500,000 1,560,375 International Bank for Reconstruction & Development (World Bank) Deb. 8.250 2016 5,000,000 5,629,550 International Lease Finance Corp. Notes 6.250 2000 2,235,000 2,219,377 Mellon Bank Corp. Subord. Notes 7.625 2007 3,500,000 3,665,340 NationsBank Corp. Subord. Notes 7.500 2006 4,500,000 4,656,555 Paine Webber Group, Inc. Sr. Notes 7.490 2004 3,500,000 3,545,500 Smith Barney Holdings, Inc. Notes 7.125 2006 3,000,000 3,016,770 Wachovia Corp. Subord. Notes 6.605 2025 2,000,000 1,974,840 - ---------------------------------------------------------------------------------------------------------------- 29,730,227 - ---------------------------------------------------------------------------------------------------------------- CAPITAL GOODS (1.9%) John Deere Capital Corp. Deb. 8.625 2019 4,000,000 4,280,000 - ---------------------------------------------------------------------------------------------------------------- CONSUMER GOODS (2.9%) ConAgra, Inc. Sr. Notes 7.125 2026 3,000,000 3,070,440 Mattel, Inc. Notes 6.750 2000 3,500,000 3,455,760 - ---------------------------------------------------------------------------------------------------------------- 6,526,200 - ---------------------------------------------------------------------------------------------------------------- DIVERSIFIED COMPANIES (0.5%) Grand Metro Investment Corp. (Eff. Yield 8.13%) (e) Co. Gtd. 0.000 2004 2,000,000 1,225,100 - ---------------------------------------------------------------------------------------------------------------- DRUGS (0.8%) Lilly (Eli) & Co. Notes 6.570 2016 2,000,000 1,871,560 - ---------------------------------------------------------------------------------------------------------------- INSURANCE (4.6%) AMBAC, Inc. Deb. 9.375 2011 2,000,000 2,414,500 Lumbermans Mutual Co. (d) Subord. Notes 9.150 2026 2,000,000 2,175,400 MBIA, Inc. Deb. 7.000 2025 4,000,000 3,816,280 Vesta Insurance Group, Inc. Deb. 8.750 2025 2,000,000 2,182,980 - ---------------------------------------------------------------------------------------------------------------- 10,589,160 - ---------------------------------------------------------------------------------------------------------------- OIL (4.4%) Atlantic Richfield Co. Deb. 9.875 2016 3,000,000 3,770,790 Occidental Petroleum Corp. Deb. 10.125 2009 3,000,000 3,716,970 Oslo Seismic Services, Inc. (d) 1st Pfd. Mtg. Notes 8.280 2011 2,500,000 2,577,375 - ---------------------------------------------------------------------------------------------------------------- 10,065,135 - ---------------------------------------------------------------------------------------------------------------- PAGE 11 - -------------------------------- SCHEDULE OF INVESTMENTS--October 31, 1996 Interest Maturity Par Market Rate Date Value Value ================================================================================================================ RETAIL (1.1%) Kohl's Corp. Notes 7.375% 2011 $ 2,500,000 $ 2,524,800 - ---------------------------------------------------------------------------------------------------------------- TELECOMMUNICATIONS (1.6%) Sprint Corp. Deb. 9.250 2022 3,000,000 3,619,688 - ---------------------------------------------------------------------------------------------------------------- TOTAL CORPORATE BONDS & NOTES (COST--$70,823,953) 72,578,290 ================================================================================================================ COLLATERALIZED MORTGAGE OBLIGATIONS (22.3%) American Southwest Financial Securities (Est. Mat. 1998) (b) Series 1994-C2 Class A3 8.000 2010 4,400,000 4,500,375 Asset Securitization Corp. (Est. Mat. 2010) (b) Series 1996-D3 Class A3 7.526 2026 1,416,414 1,457,357 Criimi Mae Financial Corp. (Est. Mat. 2004) (b) Series 1 Class A 7.000 2033 956,632 925,542 DeBartolo Limited Capital Partnership (Est. Mat. 2001) (b) (d) Series 1 Class B1 7.610 2004 1,550,000 1,598,437 FNMA REMIC Trust (Est. Mat. 2001) (b) Series 1996-17 Class A 6.000 2004 3,500,000 3,409,219 FNMA REMIC Trust (Est. Mat. 2004) (b) Series 1993-156 Class B 6.500 2018 2,800,000 2,697,604 FNMA REMIC Trust (Est. Mat. 2002) (b) Series 1996-28 Class PE 6.500 2020 5,000,000 4,957,031 FNMA REMIC Trust (Est. Mat. 2005) (b) Series 1992-181 Class PK 6.500 2021 4,000,000 3,862,480 FNMA REMIC Trust (Est. Mat. 2007) (b) Series 1993-38 Class L 5.000 2022 2,500,000 2,116,400 GS Mortgage Security Corp. (Est. Mat. 2005) (b) Series 1996-PL Class A2 7.410 2027 1,850,000 1,851,156 KS Mortgage Capital LP (Est. Mat. 1999) (b) (d) Series 1995-1 Class A1 7.041 2002 2,890,543 2,911,319 Merrill Lynch Trust (Est. Mat. 2005) (b) Series 35 Class G 8.450 2018 2,700,000 2,874,636 Morgan Stanley Capital I (Est. Mat. 2004) (b) (d) Series 1996-WF Class 1B 6.586 2028 1,000,000 965,938 Paine Webber Mortgage Acceptance Corp. IV (Est. Mat. 1997) (b) Series 1993-5 Class A3 6.875 2008 1,457,376 1,459,198 RASTA (Est. Mat. 1999) (b) Series 1996-AS Class A3 7.750 2026 3,000,000 3,034,453 Residential Accredit Loans, Inc. Series 1996-QS4 Class (Est. Mat. 2005) (b) Series 1996-QS4 Class AI10 7.900 2026 3,500,000 3,582,031 Residential Funding Corp. (Est. Mat. 1997) (b) Series 1994-S15 Class A1 7.750 2024 2,958,697 2,990,119 Ryland Acceptance Corp. (Est. Mat. 2004) (b) Series 1988-E, 2 PAC 7.950 2019 2,794,173 2,828,206 Structured Asset Securities Corp. (Est. Mat. 2000) (b) Series 1996-CFL Class B 6.303 2028 2,963,625 2,886,756 - ---------------------------------------------------------------------------------------------------------------- TOTAL COLLATERALIZED MORTGAGE OBLIGATIONS (COST--$50,578,120) 50,908,257 ================================================================================================================ FOREIGN BONDS (NON U.S. DOLLARS) (14.3%) Canadian Government Deb. 7.500 2003 11,000,000 8,879,114 Canadian Dollars Canadian Government Deb. 8.750 2005 14,300,000 12,423,138 Canadian Dollars Germany (Republic of) Deb. 6.500 2003 6,652,000 4,609,488 German Marks Germany (Republic of) Deb. 6.875 2005 9,750,000 6,826,416 German Marks - ---------------------------------------------------------------------------------------------------------------- TOTAL FOREIGN BONDS (NON U.S. DOLLARS) (COST--$30,889,476) 32,738,156 ================================================================================================================ PAGE 12 - -------------------------------- Keystone Quality Bond Fund (B-1) SCHEDULE OF INVESTMENTS--October 31, 1996 Interest Maturity Par Market Rate Date Value Value ================================================================================================================ MORTGAGE-BACKED SECURITIES (13.6%) FHLMC Pool #303865 8.500% 1997 $ 23,337 $ 24,100 FHLMC Pool #607352 7.680 2022 820,651 856,046 FHLMC Pool #846298 7.191 2022 2,201,840 2,266,519 FNMA Pool #303664 6.500 2008 6,248,506 6,188,895 FNMA Pool #338867 6.500 2011 4,978,113 4,895,626 FNMA Pool #124945 7.617 2031 1,226,907 1,279,824 GNMA Pool #410254 7.000 2025 4,337,207 4,253,152 GNMA Pool #411526 7.000 2025 3,161,961 3,100,683 GNMA Pool #423413 7.000 2025 3,427,252 3,360,832 GNMA Pool #405576 6.500 2026 5,015,631 4,794,592 - ---------------------------------------------------------------------------------------------------------------- TOTAL MORTGAGE-BACKED SECURITIES (COST--$30,936,080) 31,020,269 ================================================================================================================ ASSET-BACKED SECURITIES (10.6%) CoreStates Home Equity Trust Series 1996-1 Class A4 7.000 2012 3,000,000 2,949,375 Ford Credit Auto Owner Trust Series 1996-B Class A4 6.300 2001 3,614,000 3,629,811 Merrill Lynch Mortgage Investors, Inc. Series 1991-D Class A 9.000 2011 491 501 Merrill Lynch Mortgage Investors, Inc. Series 1991-G Class B 9.150 2011 3,550,242 3,720,654 Merrill Lynch Mortgage Investors, Inc. Series 1992-B Class B 8.500 2012 2,012,027 2,076,774 Merrill Lynch Mortgage Investors, Inc. Series 1992-D Class B 8.500 2017 2,364,881 2,487,146 Olympic Auto Receivables Series 1996-C 6.800 2002 3,000,000 3,042,188 Southern Pacific Secured Assets Corp. Series 1996-3 Class A4 7.600 2027 3,300,000 3,338,156 University Support Services, Inc. Series 1992-D 9.074 2007 915,000 916,716 World Omni Automobile Lease Trust Series 1996-B Class A3 6.250 2002 2,000,000 2,003,750 - ---------------------------------------------------------------------------------------------------------------- TOTAL ASSET-BACKED SECURITIES (COST--$23,560,144) 24,165,071 ================================================================================================================ UNITED STATES GOVERNMENT (AND AGENCY) ISSUES (5.1%) FHLB Deb. 8.700 2005 1,000,000 1,030,620 FHLMC Deb. 7.800 2016 2,000,000 2,065,000 U.S. Treasury Bonds 7.875 2021 4,200,000 4,756,500 U.S. Treasury Bonds 6.875 2025 1,250,000 1,277,925 U.S. Treasury Bonds 6.000 2026 2,900,000 2,645,351 - ---------------------------------------------------------------------------------------------------------------- TOTAL UNITED STATES GOVERNMENT (AND AGENCY) ISSUES (COST--$11,454,386) 11,775,396 ================================================================================================================ FOREIGN BONDS (U.S. DOLLARS) (1.3%) (COST--$3,098,550) Bayer Corp. (d) Notes 7.125 2015 3,000,000 2,940,870 - ---------------------------------------------------------------------------------------------------------------- TOTAL FIXED INCOME (COST--$221,340,709) 226,126,309 ================================================================================================================ PAGE 13 - -------------------------------- SCHEDULE OF INVESTMENTS--October 31, 1996 Interest Maturity Par Market Rate Date Value Value ================================================================================================================ Keystone Joint Repurchase Agreement (Investments in repurchase agreements, in a joint trading account, purchased 10/31/96) (c) 5.565% 11/1/96 $307,047 $ 307,000 - ---------------------------------------------------------------------------------------------------------------- TOTAL INVESTMENTS (COST--$221,647,709) (A) 226,433,309 OTHER ASSETS AND LIABILITIES--NET (1.0%) 2,215,850 - ---------------------------------------------------------------------------------------------------------------- NET ASSETS (100%) $228,649,159 ================================================================================================================
(a) The cost of investments for federal income tax purposes is $222,327,705. Gross unrealized appreciation and depreciation on investments, based on identified tax cost at October 31, 1996, are as follows: Gross unrealized appreciation $4,681,003 Gross unrealized depreciation (575,399) ---------- Net unrealized appreciation $4,105,604 ========== (b) The estimated maturity of a Collateralized Mortgage Obligation ("CMO") is based on current and projected prepayment rates. Changes in interest rates can cause the estimated maturity to differ from the listed dates. (c) The repurchase agreements are fully collateralized by U.S. government and/or agency obligations based on market prices at October 31, 1996. (d) Securities that may be resold to "qualified institutional buyers" under Rule 144A or securities offered pursuant to Section 4(2) of the Federal Securities Act of 1933, as amended. These securities have been determined to be liquid under guidelines established by the Board of Trustees. (e) Effective yield (calculated at date of purchase) is the yield at which the bond accretes on an annualized basis until maturity date. Legend of Portfolio Abbreviations FHLB--Federal Home Loan Bank FHLMC--Federal Home Loan Mortgage Corporation FNMA--Federal National Mortgage Association GNMA--Government National Mortgage Association RASTA--Residential Asset Securitization Trust Association REMIC--Real Estate Mortgage Investment Conduit PAC--Planned Amortization Class FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS
Unrealized Exchange U.S. $ value at In Exchange Appreciation/ Date October 31, 1996 for U.S. $ (Depreciation) ================================================================================================== Forward Foreign Currency Exchange Contracts to Buy: Contracts to Receive 11/7/96 4,900,000 German Marks $ 3,237,007 $ 3,227,400 $ 9,607 11/29/96 8,569,000 Canadian Dollars 6,404,794 6,284,884 119,910 Forward Foreign Currency Exchange Contracts to Sell: Contracts to Deliver 11/7/96 22,251,500 German Marks 14,699,645 15,104,211 404,566 11/29/96 36,579,000 Canadian Dollars 27,340,527 26,841,063 (499,464)
See Notes to Financial Statements PAGE 14 - -------------------------------- Keystone Quality Bond Fund (B-1) FINANCIAL HIGHLIGHTS (For a share outstanding throughout each year)See Notes to Financial Statements.
Year Ended October 31, 1996 1995 1994 1993 1992 ================================================================================================== Net asset value beginning of year $ 15.42 $ 14.44 $ 16.40 $ 15.92 $ 15.92 - -------------------------------------------------------------------------------------------------- Income from investment operations: Net investment income 0.75 0.87 0.76 0.96 1.04 Net realized and unrealized gain (loss) on investments, closed futures contracts and foreign currency related transactions (0.16) 1.05 (1.76) 0.66 0.15 - -------------------------------------------------------------------------------------------------- Total from investment operations 0.59 1.92 (1.00) 1.62 1.19 - -------------------------------------------------------------------------------------------------- Less distributions from: Net investment income (0.76) (0.87) (0.76) (0.96) (1.04) In excess of net investment income 0 (0.05) (0.09) (0.18) (0.15) Tax basis return of capital (0.06) (0.02) (0.11) 0 0 - -------------------------------------------------------------------------------------------------- Total distributions (0.82) (0.94) (0.96) (1.14) (1.19) - -------------------------------------------------------------------------------------------------- Net asset value end of year $ 15.19 $ 15.42 $ 14.44 $ 16.40 $ 15.92 ================================================================================================== Total return (a) 3.99% 13.69% (6.27%) 10.50% 7.71% Ratios/supplemental data Ratios to average net assets: Total expenses 1.95%(b) 1.96%(b) 1.86% 1.94% 2.01% Net investment income 5.06% 5.86% 5.05% 5.85% 6.40% Portfolio turnover rate 231% 244% 169% 190% 102% - -------------------------------------------------------------------------------------------------- Net assets end of year (thousands) $228,649 $310,791 $327,276 $458,925 $456,912 ==================================================================================================
1991 1990 1989 1988 1987 ================================================================================================== Net asset value beginning of year $ 15.11 $ 15.85 $ 15.71 $ 15.52 $ 17.30 - -------------------------------------------------------------------------------------------------- Income from investment operations: Net investment income 1.08 1.11 1.21 1.19 1.20 Net realized and unrealized gain loss) on investments, closed futures contracts and foreign currency related transactions 0.99 (0.53) 0.25 0.32 (1.59) - -------------------------------------------------------------------------------------------------- Total from investment operations 2.07 0.58 1.46 1.51 (0.39) - -------------------------------------------------------------------------------------------------- Less distributions from: Net investment income (1.08) (1.18) (1.32) (1.32) (1.39) In excess of net investment income (0.18) (0.14) 0 0 0 Tax basis return of capital 0 0 0 0 0 - -------------------------------------------------------------------------------------------------- Total distributions (1.26) (1.32) (1.32) (1.32) (1.39) - -------------------------------------------------------------------------------------------------- Net asset value end of year $ 15.92 $ 15.11 $ 15.85 $ 15.71 $ 15.52 ================================================================================================== Total return (a) 14.09% 3.93% 9.82% 10.09% (2.44%) Ratios/supplemental data Ratios to average net assets: Total expenses 2.04% 1.95% 1.82% 1.64% 1.56% Net investment income 6.95% 7.45% 7.61% 7.49% 7.32% Portfolio turnover rate 158% 117% 116% 153% 127% - -------------------------------------------------------------------------------------------------- Net assets end of year (thousands) $453,528 $408,330 $462,425 $447,454 $440,836 ==================================================================================================
(a) Excluding applicable sales charges. (b) The ratio of total expenses to average net assets includes indirectly paid expenses. Excluding indirectly paid expenses, the expense ratios would have been 1.93% and 1.94% for the years ended October 31, 1996 and 1995, respectively. See Notes to Financial Statements. PAGE 15 - -------------------------------- STATEMENT OF ASSETS AND LIABILITIES October 31, 1996 ======================================================================= Assets (Note 2) Investments at market value (identified cost-- $221,647,709) $226,433,309 Cash 492 Receivable for: Investments sold 36,889 Interest 2,873,463 Fund shares sold 10,499 Unrealized appreciation on forward foreign currency exchange contracts 534,083 Prepaid expenses and other assets 52,276 - ----------------------------------------------------------------------- Total assets 229,941,011 - ----------------------------------------------------------------------- Liabilities (Notes 2 and 5) Payable for: Fund shares redeemed 366,406 Distributions to shareholders 365,366 Unrealized depreciation on forward foreign currency exchange contracts 499,464 Due to related parties 6,219 Other accrued expenses 54,397 - ----------------------------------------------------------------------- Total liabilities 1,291,852 - ----------------------------------------------------------------------- Net assets $228,649,159 ======================================================================= Net assets represented by Paid-in capital $255,530,019 Accumulated distributions in excess of net investment income (399,985) Accumulated net realized loss on investments and foreign currency related transactions (31,308,109) Net unrealized appreciation on investments and foreign currency related transactions 4,827,234 - ----------------------------------------------------------------------- Total net assets $228,649,159 - ----------------------------------------------------------------------- Net asset value per share (Note 2) Net assets of $228,649,159 / 15,055,747 shares outstanding $ 15.19 ======================================================================= STATEMENT OF OPERATIONS Year Ended October 31, 1996 ======================================================================= Investment income Interest $18,504,392 - ----------------------------------------------------------------------- Expenses (Notes 4, 5 and 6) Management fee $ 1,578,211 Transfer agent fees 627,068 Accounting, auditing and legal fees 53,738 Custodian fees 142,613 Trustees' fees and expenses 31,867 Distribution Plan expenses 2,645,899 Other 65,509 - ----------------------------------------------------------------------- Total expenses 5,144,905 Less: Expenses paid indirectly (30,574) - ----------------------------------------------------------------------- Net expenses 5,114,331 - ----------------------------------------------------------------------- Net investment income 13,390,061 - ----------------------------------------------------------------------- Net realized and unrealized loss on investments and foreign currency related transactions (Notes 1 and 3) Net realized loss on: Investments (1,910,620) Foreign currency related transactions (273,044) - ----------------------------------------------------------------------- Net realized loss on investments and foreign currency related transactions (2,183,664) - ----------------------------------------------------------------------- Net change in unrealized appreciation (depreciation) on: Investments (1,978,287) Foreign currency related transactions 41,634 - ----------------------------------------------------------------------- Net change in unrealized appreciation (depreciation) on investments and foreign currency related transactions (1,936,653) - ----------------------------------------------------------------------- Net realized and unrealized loss on investments and foreign currency related transactions (4,120,317) - ----------------------------------------------------------------------- Net increase in net assets resulting from operations $ 9,269,744 ======================================================================= See Notes to Financial Statements. PAGE 16 - -------------------------------- Keystone Quality Bond Fund (B-1) STATEMENTS OF CHANGES IN NET ASSETS
Year Ended October 31, 1996 1995 =================================================================================================== Operations Net investment income $ 13,390,061 $ 18,237,187 Net realized loss on investments, closed futures contracts and foreign currency related transactions (2,183,664) (6,749,977) Net change in unrealized appreciation (depreciation) on investments and foreign currency related transactions (1,936,653) 28,285,126 - --------------------------------------------------------------------------------------------------- Net increase in net assets resulting from operations 9,269,744 39,772,336 - --------------------------------------------------------------------------------------------------- Distributions to shareholders from (Note 1) Net investment income (13,289,851) (18,237,187) In excess of net investment income 0 (763,245) Tax basis return of capital (950,184) (472,154) - --------------------------------------------------------------------------------------------------- Total distributions to shareholders (14,240,035) (19,472,586) - --------------------------------------------------------------------------------------------------- Capital share transactions (Note 2) Proceeds from shares sold 44,210,094 78,243,761 Payments for shares redeemed (130,171,813) (126,927,895) Net asset value of shares issued in reinvestment of dividends and distributions 8,789,681 11,900,336 - --------------------------------------------------------------------------------------------------- Net decrease in net assets resulting from capital share transactions (77,172,038) (36,783,798) - --------------------------------------------------------------------------------------------------- Total decrease in net assets (82,142,329) (16,484,048) Net assets Beginning of year 310,791,488 327,275,536 - --------------------------------------------------------------------------------------------------- End of year [including accumulated distributions in excess of net investment income as follows: 1996--($399,985) and 1995--($575,212)] (Note 1) $ 228,649,159 $ 310,791,488 ===================================================================================================
See Notes to Financial Statements. PAGE 17 - -------------------------------- NOTES TO FINANCIAL STATEMENTS 1. Significant Accounting Policies Keystone Quality Bond Fund (B-1) (the "Fund") is a Pennsylvania common law trust for which Keystone Management, Inc. ("KMI") is the Investment Manager and Keystone Investment Management Company ("Keystone") is the Investment Adviser. Keystone is a wholly-owned subsidiary of Keystone Investments, Inc. ("KII") and KMI is, in turn, a wholly-owned subsidiary of Keystone. The Fund is registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as a diversified, open-end investment company. The Fund seeks the highest possible income consistent with preservation of principal. The Fund invests primarily in high and investment grade corporate bonds, which possess a high degree of dependability of interest and principal payments. The following is a summary of significant accounting policies consistently followed by the Fund in the preparation of its financial statements. The policies are in conformity with generally accepted accounting principles, which require management to make estimates and assumptions that affect amounts reported herein. Although actual results could differ from these estimates, any such differences are expected to be immaterial to the net assets of the Fund. A. Valuation of Securities U.S. Government obligations held by the Fund are valued at the mean between the over-the-counter bid and asked prices, as furnished by an independent pricing service. Listed corporate bonds, other fixed income securities, mortgage and other asset-backed securities, and other related securities are valued at prices provided by an independent pricing service. In determining value for normal institutional-size transactions, the pricing service uses methods based on market transactions for comparable securities and various relationships between securities that are generally recognized by institutional traders. Securities for which valuations are not available from an independent pricing service (including restricted securities) are valued at fair value as determined in good faith according to procedures established by the Board of Trustees. Short-term investments with remaining maturities of 60 days or less are carried at amortized cost, which approximates market value. Short-term securities with greater than 60 days to maturity are valued at market value. B. Repurchase Agreements Pursuant to an exemptive order issued by the Securities and Exchange Commission, the Fund, along with certain other Keystone funds, may transfer uninvested cash balances into a joint trading account. These balances are invested in one or more repurchase agreements that are fully collateralized by U.S. Treasury and/or Federal Agency obligations. Securities pledged as collateral for repurchase agreements are held by the custodian on the Fund's behalf. The Fund monitors the adequacy of the collateral daily and will require the seller to provide additional collateral in the event the market value of the securities pledged falls below the carrying value of the repurchase agreement. C. Reverse Repurchase Agreements The Fund enters into reverse repurchase agreements with qualified third-party broker-dealers. Interest on the value of reverse repurchase agreements is based upon competitive market rates at the time of issuance. At the time the Fund enters into a reverse repurchase agreement, it will establish and maintain a segregated account with its custodian containing liquid assets having a value not less than the repurchase price (including accrued interest). If the counterparty to the transaction is rendered insolvent, the ultimate realiza- PAGE 18 - -------------------------------- Keystone Quality Bond Fund (B-1) tion of the securities to be repurchased by the Fund may be delayed or limited. D. Foreign Currency The books and records of the Fund are maintained in United States (U.S.) dollars. Foreign currency amounts are translated into United States dollars as follows: market value of investments, assets and liabilities at the daily rate of exchange; purchases and sales of investments, income and expenses at the rate of exchange prevailing on the respective dates of such transactions. Net unrealized foreign exchange gain (loss) resulting from changes in foreign currency exchange rates is a component of net unrealized appreciation (depreciation) on investments and foreign currency transactions. Net realized foreign currency gains and losses resulting from changes in exchange rates include foreign currency gains and losses between trade date and settlement date on investment securities transactions, foreign currency transactions and the difference between the amounts of interest and dividends recorded on the books of the Fund and the amount actually received. The portion of foreign currency gains and losses related to fluctuations in exchange rates between the initial purchase trade date and subsequent sale trade date is included in realized gain (loss) on foreign currency transactions. E. Futures Contracts In order to gain exposure to or protect against changes in security values, the Fund may buy and sell futures contracts. The initial margin deposited with a broker when entering into a futures transaction is subsequently adjusted by daily payments or receipts as the value of the contract changes. Such changes are recorded as unrealized gains or losses. Realized gains or losses are recognized upon closing the contract. Risks of entering into futures contracts include (i) the possibility of an illiquid market for the contract, (ii) the possibility that a change in value of the contract may not correlate with changes in the value of the underlying instrument or index, and (iii) the credit risk that the other party will not fulfill their obligations under the contract. Futures contracts also involve elements of market risk in excess of the amount reflected in the statement of assets and liabilities. F. Forward Foreign Currency Exchange Contracts The Fund may enter into forward foreign currency exchange contracts ("forward contracts") to settle portfolio purchases and sales of securities denominated in a foreign currency and to hedge certain foreign currency assets or liabilities. Forward contracts are recorded at the forward rate and are marked-to-market daily. Realized gains and losses arising from such transactions are included in net realized gain (loss) on foreign currency related transactions. The Fund bears the risk of an unfavorable change in the foreign currency exchange rate underlying the forward contract and is subject to the credit risk that the other party will not fulfill their obligations under the contract. Forward contracts involve elements of market risk in excess of the amount reflected in the statement of assets and liabilities. G. Security Transactions and Investment Income Securities transactions are accounted for no later than one business day after the trade date. Realized gains and losses are computed on the identified cost basis. Interest income is recorded on the accrual basis and includes amortization of discounts. H. Federal Income Taxes The Fund has qualified and intends to qualify in the future as a regulated investment company under the Internal Revenue Code of 1986, as amended (the "Code"). Thus, the Fund is relieved of any federal income tax liability by distributing all of its net tax- PAGE 19 - -------------------------------- able investment income and net taxable capital gains, if any, to its shareholders. The Fund also intends to avoid excise tax liability by making the required distributions under the Code. Accordingly, no provision for federal income tax is required. I. Distributions The Fund distributes net investment income monthly and net capital gains, if any, at least annually. Distributions to shareholders are recorded at the close of business on the ex-dividend date. Income and capital gains distributions to shareholders are determined in accordance with income tax regulations which may differ from generally accepted accounting principles. These differences are primarily due to differing treatment for paydown gains (losses) and foreign currency transactions. 2. Capital Share Transactions The Fund's Trust Agreement, as amended and restored, authorizes the issuance of an unlimited number of shares of beneficial interest with a par value of $1.00. Transactions in shares of the Fund were as follows: Year ended October 31, 1996 1995 - ------------------------------------------------------------- Shares sold 2,902,677 5,215,666 Shares redeemed (8,577,419) (8,523,861) Shares issued in reinvestment of dividends and distributions 581,588 799,017 - ------------------------------------------------------------- Net decrease (5,093,154) (2,509,178) ============================================================= 3. Securities Transactions Cost of purchases and proceeds from sales of investment securities (excluding short-term securities) for the year ended October 31, 1996 were as follows: Cost of Proceeds Purchases from Sales - ---------------------------------------------------- Non-U.S. Government $309,095,323 $255,751,880 U.S. Government 282,174,491 402,430,535 ==================================================== The average daily balance of reverse repurchase agreements outstanding during the year ended October 31, 1996 was approximately $7,133,000 at a weighted average interest rate of 3.65%. The maximum amount of borrowing during the year was $17,694,856 (including accrued interest). As of October 31, 1996, the Fund has a capital loss carryover for federal income tax purposes of approximately $30,627,000 which expires as follows: $2,251,000--1998; $20,145,000--2002; $6,153,000--2003; and $2,078,000--2004. 4. Distribution Plan The Fund bears some of the costs of selling its shares under a Distribution Plan (the "Plan") adopted pursuant to Rule 12b-1 under the 1940 Act. Under the Plan, the Fund pays its principal underwriter, Keystone Investment Distributors Company ("KIDC"), a wholly-owned subsidiary of Keystone, amounts which are calculated and paid daily. Under the Plan, the Fund pays a distribution fee amount which may not exceed 1.00% of the Fund's average daily net assets. Of that amount, 0.75% is used to pay distribution expenses and 0.25% may be used to pay service fees. Contingent deferred sales charges paid by redeeming shareholders may be paid to KIDC. The Plan may be terminated at any time by vote of the Independent Trustees or by vote of a majority of the outstanding voting shares of the Fund. However, PAGE 20 - -------------------------------- Keystone Quality Bond Fund (B-1) after the termination of the Plan, at the discretion of the Board of Trustees, payments to KIDC may continue as compensation for its services which had been earned while the Plan was in effect. KIDC intends, but is not obligated, to continue to pay distribution costs that exceed the current annual payments from the Fund. KIDC intends to seek full payment of such distribution costs from the Fund at such time in the future as, and to the extent that, payment thereof by the Fund would be within permitted limits. Total unpaid distribution costs at October 31, 1996 amounted to $9,151,321. 5. Investment Management Agreement and Other Affiliated Transactions Under the terms of the Investment Management Agreement between KMI and the Fund, KMI provides investment management and administrative services to the Fund. In return, KMI is paid a management fee, computed and paid daily, at an annual rate of 2.00% of the Fund's gross investment income plus an amount determined by applying percentage rates starting at 0.50% and declining as net assets increase to 0.25% per annum, to the average daily net asset value of the Fund. KMI has entered into an Investment Advisory Agreement with Keystone under which Keystone provides investment advisory and management services to the Fund. In return for its services, Keystone receives an annual fee equal to 85% of the management fee received by KMI. During the year ended October 31, 1996, the Fund paid or accrued $23,191 to Keystone for certain accounting services. The Fund paid or accrued $627,068 to Keystone Investor Resource Center, Inc., a wholly-owned subsidiary of Keystone, for services rendered as the Fund's transfer and dividend disbursing agent. Certain officers and/or Directors of Keystone are also officers and/or Trustees of the Fund. Officers of Keystone and affiliated Trustees receive no compensation directly from the Fund. 6. Expense Offset Arrangement The Fund has entered into an expense offset arrangement with its custodian. For the year ended October 31, 1996, the Fund incurred total custody fees of $142,613 and received a credit of $30,574 pursuant to this expense offset arrangement, resulting in a net custody expense of $112,039. The assets deposited with the custodian under this expense offset arrangement could have been invested in income-producing assets. 7. Subsequent Distribution to Shareholders A distribution from net investment income of $0.065 per share was declared payable on December 5, 1996 to shareholders of record November 25, 1996. This distribution is not reflected in the accompanying financial statements. 8. Agreement and Plan of Acquisition On September 6, 1996, KII entered into an Agreement and Plan of Acquisition and Merger with First Union Corporation ("First Union") and First Union National Bank of North Carolina ("FUNB-NC") and certain other parties pursuant to which KII will be merged with and into a wholly-owned subsidiary of FUNB-NC. Subject to the receipt of required regulatory and shareholder approvals, the proposed merger is expected to take place in December 1996. PAGE 21 - -------------------------------- INDEPENDENT AUDITORS' REPORT The Trustees and Shareholders Keystone Quality Bond Fund (B-1) We have audited the accompanying statement of assets and liabilities of Keystone Quality Bond Fund (B-1), including the schedule of investments, as of October 31, 1996, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the years in the two-year period then ended, and the financial highlights for each of the years in the ten-year period then ended. These financial statements and financial highlights are the responsibility of the Fund's management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. Our procedures included confirmation of securities owned as of October 31, 1996 by correspondence with the custodian and brokers. An audit includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Keystone Quality Bond Fund (B-1) as of October 31, 1996, the results of its operations for the year then ended, the changes in its net assets for each of the years in the two-year period then ended, and the financial highlights for each of the years in the ten-year period then ended in conformity with generally accepted accounting principles. KPMG Peat Marwick LLP Boston, Massachusetts November 29, 1996 PAGE 22 - -------------------------------- Keystone Quality Bond Fund (B-1) Federal Tax Status--Fiscal 1996 Distributions (Unaudited) During the fiscal year ended October 31, 1996, distributions of $0.82 per share were paid in shares or cash. This total includes a nontaxable return of capital equal to $0.06 per share. The remaining dividends are taxable to shareholders as ordinary income in the year in which received by them or credited to their accounts and are not eligible for the corporate dividend received deduction. In January 1997, we will send you complete information on the distributions paid during the calendar year 1996 to help you in completing your federal tax return. Keystone's Services for Shareholders KEYSTONE AUTOMATED RESPONSE LINE (KARL)--Receive up-to-date account information on your balance, last transaction and recent Fund distribution. You may also process transactions such as investments, redemptions and exchanges using a touch-tone telephone as well as receive quotes on price, yield, and total return of your Keystone Fund. Call toll-free, 1-800-346-3858. EASY ACCESS TO INFORMATION ON YOUR ACCOUNT--Information about your Keystone account is available 24 hours a day through KARL. To speak with a Shareholder Services representative about your account, call toll-free 1-800-343-2898 between 8:00 A.M. and 6:00 P.M. Eastern time. Retirement Plan investors should call 1-800-247-4075. ADDITIONS TO YOUR ACCOUNT--You can buy additional shares for your account at any time, with no minimum additional investment. REINVESTMENT OF DISTRIBUTIONS--You can compound the return on your investment by automatically reinvesting your Fund's distributions at net asset value with no sales charge. EXCHANGE PRIVILEGE--You may move your money among funds in the same Keystone family quickly and easily for a nominal service fee. KARL gives you the added ability to move your money any time of day, any day of the week. Keystone offers a variety of funds with different investment objectives for your changing investment needs. ELECTRONIC FUNDS TRANSFER (EFT)-- Referred to as the "paper-less transaction," EFT allows you to take advantage of a variety of preauthorized account transactions, including automatic monthly investments and systematic monthly or quarterly withdrawals. EFT is a quick, safe and accurate way to move money between your bank account and your Keystone account. CHECK WRITING--Shareholders of Keystone Liquid Trust may exercise the check writing privilege to draw from their accounts. EASY REDEMPTION--KARL makes redemption services available to you 24 hours a day, every day of the year. The amount you receive may be more or less than your original account value depending on the value of fund shares at time of redemption. RETIREMENT PLANS--Keystone offers a full range of retirement plans, including IRA, SEP-IRA, profit sharing, money purchase, and defined contribution plans. For more information, please call Retirement Plan Services, toll-free at 1-800-247-4075. Keystone is committed to providing you with quality, responsive account service. We will do our best to assist you and your financial adviser in carrying out your investment plans. -----END PRIVACY-ENHANCED MESSAGE-----