-----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, HbmKZTkYbsVR6TTWAKKOiDx63N/Qf0r/aNMrOA219W9/H+9rSV3CRlVqpBd7OORw BjEnD1V8nK3JyFrs9Gl9IQ== 0001047469-98-036040.txt : 19981001 0001047469-98-036040.hdr.sgml : 19981001 ACCESSION NUMBER: 0001047469-98-036040 CONFORMED SUBMISSION TYPE: N-14 PUBLIC DOCUMENT COUNT: 15 FILED AS OF DATE: 19980930 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: PRUDENTIAL GOVERNMENT INCOME FUND INC CENTRAL INDEX KEY: 0000717819 STANDARD INDUSTRIAL CLASSIFICATION: UNKNOWN SIC - 0000 [0000] IRS NUMBER: 133165671 STATE OF INCORPORATION: MD FISCAL YEAR END: 0228 FILING VALUES: FORM TYPE: N-14 SEC ACT: SEC FILE NUMBER: 333-64907 FILM NUMBER: 98718574 BUSINESS ADDRESS: STREET 1: ONE SEAPORT PLZ CITY: NEW YORK STATE: NY ZIP: 10292 BUSINESS PHONE: 2122141250 MAIL ADDRESS: STREET 1: ONE SEAPORT PLAZA CITY: NEW YORK STATE: NY ZIP: 10292 FORMER COMPANY: FORMER CONFORMED NAME: PRUDENTIAL BACHE GOVERNMENT PLUS FUND INC DATE OF NAME CHANGE: 19920703 FORMER COMPANY: FORMER CONFORMED NAME: PRUDENTIAL BACHE TELECOMMUNICATIONS FUND INC DATE OF NAME CHANGE: 19850127 N-14 1 N-14 As filed with the Securities and Exchange Commission on October 30, 1998 Registration No. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------- FORM N-14 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 /X/ PRE-EFFECTIVE AMENDMENT NO. / / POST-EFFECTIVE AMENDMENT NO. / / (Check appropriate box or boxes) -------------- PRUDENTIAL GOVERNMENT INCOME FUND, INC. (Exact name of registrant as specified in charter) GATEWAY CENTER THREE 100 MULBERRY STREET NEWARK, NEW JERSEY 07102-4077 (Address of Principal Executive Offices) (Zip Code) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (973) 367-7530 S. JANE ROSE, ESQ. GATEWAY CENTER THREE 100 MULBERRY STREET NEWARK, NEW JERSEY 07102-4077 (NAME AND ADDRESS OF AGENT FOR SERVICE) APPROXIMATE DATE OF PROPOSED PUBLIC OFFERING: AS SOON AS PRACTICABLE AFTER THE EFFECTIVE DATE OF THE REGISTRATION STATEMENT. 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 THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THIS REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SECTION 8(a), MAY DETERMINE. NO FILING FEE IS REQUIRED BECAUSE OF RELIANCE ON SECTION 24(f) OF THE INVESTMENT COMPANY ACT OF 1940. PURSUANT TO RULE 429 UNDER THE SECURITIES ACT OF 1933, THE PROSPECTUS AND PROXY STATEMENT RELATES TO SHARES PREVIOUSLY REGISTERED ON FORM N-1A (FILE NO. 2-82976). TITLE OF SECURITIES BEING REGISTERED.... SHARES OF COMMON STOCK, PAR VALUE $.01 PER SHARE.
- -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CROSS REFERENCE SHEET (AS REQUIRED BY RULE 481(a)UNDER THE SECURITIES ACT OF 1933)
N-14 ITEM NO. PROSPECTUS/PROXY AND CAPTION STATEMENT CAPTION - ---------------------------------------------------- ---------------------------------------- PART A Item 1. Beginning of Registration Statement and Outside Front Cover Page of Prospectus.............................. Cover Page Item 2. Beginning and Outside Back Cover Page of Prospectus.............................. Table of Contents Item 3. Synopsis and Risk Factors............... Synopsis; Principal Risk Factors Item 4. Information about the Transaction....... Synopsis; The Proposed Transaction Item 5. Information about the Registrant........ Information about Government Income Fund, Inc.; Appendix A Item 6. Information about the Company Being Acquired................................ Information about Prudential Mortgage Income Fund, Inc.; Appendix A Item 7. Voting Information...................... Voting Information Item 8. Interest of Certain Persons and Experts................................. Not Applicable Item 9. Additional Information Required for Reoffering by Persons Deemed to be Underwriters............................ Not Applicable PART B STATEMENT OF ADDITIONAL INFORMATION CAPTION ---------------------------------------- Item 10. Cover Page.............................. Cover Page Item 11. Table of Contents....................... Cover Page Item 12. Additional Information about the Registrant.............................. Statement of Additional Information of Prudential Government Income Fund, Inc. dated April 30, 1998. Item 13. Additional Information about the Company Being Acquired.......................... Not Applicable Item 14. Financial Statements.................... Statement of Additional Information of Prudential Government Income Fund, Inc. dated April 30, 1998. Annual Report to Shareholders of Prudential Government Income Fund, Inc. for the fiscal year ended February 28, 1998; Annual Report to Shareholders of Prudential Mortgage Income Fund, Inc. for the fiscal year ended December 31, 1997; Semi-Annual Report to Shareholders of Prudential Mortgage Income Fund, Inc. for the six-month period ended June 30, 1998. PART C Information required to be included in Part C is set forth under the appropriate item, so numbered, in Part C of this Registration Statement.
[LOGO] PRUDENTIAL MORTGAGE INCOME FUND, INC. October 30, 1998 Dear Shareholder: You may be aware that the Directors of Prudential Mortgage Income Fund have recently approved a proposal to exchange the assets and liabilities of your Series for shares of Prudential Government Income Fund. The enclosed proxy materials describe this proposal in detail. If the proposal is approved by the shareholders and implemented, you will automatically receive shares of Prudential Government Income Fund in exchange for your shares of Prudential Mortgage Income Fund. THE TRUSTEES AND I STRONGLY RECOMMEND THAT YOU VOTE FOR THE PROPOSAL. WE BELIEVE THAT THIS TRANSACTION SERVES YOUR BEST INTERESTS. REASON FOR THE MERGER--GREATER FLEXIBILITY Mortgage-backed securities perform best in a stable interest rate environment. Interest rates would have to increase and remain stable for mortgage-backed securities to regain their attractiveness. Given the current interest rate environment, we believe that investors would be more interested in owning a portfolio that can adjust its mortgage exposure. As stated in the prospectus, Prudential Mortgage Income Fund must hold at least 65% of its assets in mortgage-backed securities. Prudential Government Income Fund is also allowed to hold mortgage-backed securities in its portfolio, however it is not restricted to a definitive amount. PRUDENTIAL GOVERNMENT INCOME FUND'S investment objective is to seek high current income by investing primarily in U.S. government securities--including U.S. Treasuries, U.S. Government agencies and mortgage-backed securities. Portfolio manager Barbara Kenworthy has over 30 years of investment experience investing all types of fixed-income securities. PLEASE READ THE ENCLOSED MATERIALS CAREFULLY FOR MORE COMPLETE INFORMATION. Your vote is important, no matter how many shares you own. Voting your shares early may permit your Series to avoid costly follow-up mail and telephone solicitation. After you have reviewed the enclosed materials, please complete, date and sign your proxy card and mail it in the enclosed postage-paid return envelope today. SAVE TIME AND POSTAGE COSTS. Help us save time and postage costs (savings that we can pass on to you) by voting through the internet or via a touch tone phone. Each method is generally available 24 hours per day. If you are voting via these methods, you do not need to return your proxy card. TO VOTE BY INTERNET, FOLLOW THESE INSTRUCTIONS: Read your proxy statement and have your proxy card available. Go to website www.proxyvote.com. Enter your 12 digit control number found on your proxy card. Follow the simple instructions found at the website. TO VOTE BY TELEPHONE, FOLLOW THESE INSTRUCTIONS: Read your proxy statement and have your proxy card available. Call the toll free number shown on your proxy card. Enter your 12 digit control number found on your proxy card. Follow the simple recorded instructions. SHAREHOLDERS ON SYSTEMATIC ACCUMULATION PLANS SHOULD CONTACT THEIR FINANCIAL ADVISOR OR CALL PRUDENTIAL MUTUAL FUNDS CUSTOMER SERVICE DIVISION (1-800-225-1852) TO CHANGE THEIR OPTIONS. IF NO CHANGE IS MADE BY NOV 20, 1998, FUTURE PURCHASES WILL BE MADE IN SHARES OF PRUDENTIAL GOVERNMENT INCOME FUND. SHAREHOLDERS WITH CERTIFICATES OUTSTANDING SHOULD CONTACT THEIR FINANCIAL ADVISOR OR CALL PRUDENTIAL MUTUAL FUNDS CUSTOMER SERVICE DIVISION (1-800-225-1852) TO DEPOSIT THEIR CERTIFICATES. We value your investment and thank you for the confidence you have placed in Prudential Mutual Funds. Sincerely, [SIGNATURE] Brian M. Storms PRESIDENT, Prudential Mutual Funds and Annuities Prudential Mortgage Income Fund, Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 09102-4077 PRUDENTIAL MORTGAGE INCOME FUND, INC. GATEWAY CENTER THREE 100 MULBERRY STREET NEWARK, NEW JERSEY 07102-4077 -------------- NOTICE OF SPECIAL MEETING OF SHAREHOLDERS -------------- To our Shareholders: Notice is hereby given that a Special Meeting of Shareholders of Prudential Mortgage Income Fund, Inc. (Mortgage Income Fund) will be held at 9:00 A.M., Eastern time, on December 3, 1998, at The Prudential Insurance Company of America, Plaza Building, 751 Broad Street, Newark, New Jersey 07102, for the following purposes: 1. To approve an Agreement and Plan of Reorganization whereby all of the assets of Mortgage Income Fund will be transferred to the Prudential Government Income Fund, Inc. (Government Income Fund) in exchange for Class A, Class B, Class C and Class Z shares of the Government Income Fund and the assumption by Government Income Fund of all of the liabilities, if any, of Mortgage Income Fund. 2. To consider and act upon any other business as may properly come before the Meeting or any adjournment thereof. Only shares of beneficial interest of Mortgage Income Fund of record at the close of business on October 15, 1998, are entitled to notice of and to vote at this Meeting or any adjournment thereof. S. JANE ROSE SECRETARY Dated: October 30, 1998 WHETHER OR NOT YOU EXPECT TO ATTEND THE MEETING, PLEASE SIGN AND PROMPTLY RETURN THE ENCLOSED PROXY IN THE ENCLOSED SELF-ADDRESSED STAMPED ENVELOPE. IN ORDER TO AVOID THE ADDITIONAL EXPENSE OF FURTHER SOLICITATION, WE ASK YOUR COOPERATION IN MAILING IN YOUR PROXY PROMPTLY. PRUDENTIAL GOVERNMENT INCOME FUND, INC. PROSPECTUS AND PRUDENTIAL MORTGAGE INCOME FUND, INC. PROXY STATEMENT GATEWAY CENTER THREE 100 MULBERRY STREET NEWARK, NEW JERSEY 07102-4077 (800) 225-1852 -------------- Prudential Mortgage Income Fund, Inc. (Mortgage Income Fund) is an open-end, diversified, management investment company. Prudential Government Income Fund, Inc. (Government Income Fund) is an open-end, diversified, management investment company. Both Mortgage Income Fund and Government Income Fund (collectively, the Funds) are managed by Prudential Investments Fund Management LLC (PIFM or the Manager), formerly known as Prudential Mutual Fund Management LLC, and have the same office address. The investment objective of Government Income Fund is to seek a high current return. The investment objective of Mortgage Income Fund is to achieve a high level of income over the long term consistent with providing reasonable safety. This Prospectus and Proxy Statement is being furnished to shareholders of Mortgage Income Fund in connection with an Agreement and Plan of Reorganization (the Plan), whereby Government Income Fund will acquire all of the assets of Mortgage Income Fund and assume the liabilities, if any, of Mortgage Income Fund. If the Plan is approved by Mortgage Income Fund's shareholders, all shareholders of Mortgage Income Fund will receive Class A, Class B, Class C or Class Z shares of Government Income Fund equal in value to the Class A, Class B, Class C or Class Z shares of Mortgage Income Fund held by them, and Mortgage Income Fund will be terminated. Shareholders of Government Income Fund are not being asked to vote on the Plan. This Prospectus and Proxy Statement sets forth concisely information about Government Income Fund that prospective investors should know before investing. This Prospectus and Proxy Statement is accompanied by the Prospectus of Government Income Fund, dated April 30, 1998, as supplemented on July 1, 1998 and September 1, 1998. The Annual Report to Shareholders for the fiscal year ended February 28, 1998, which Prospectus, Supplements and Annual Report are incorporated by reference herein. The Prospectus of Mortgage Income Fund, dated March 3, 1998, as supplemented on July 1, 1998, August 27, 1998 and September 1, 1998, which Prospectus and Supplements are incorporated by reference herein, the Annual Report to Shareholders of Mortgage Income Fund for the fiscal year ended December 31, 1997, the Semi-Annual Report to Shareholders of Mortgage Income Fund for the six months ended June 30, 1998, and the Statement of Additional Information of Government Income Fund, dated April 30, 1998, have been filed with the Securities and Exchange Commission (Commission), and are available without charge upon written request to Prudential Mutual Fund Services LLC, Raritan Plaza One, Edison, New Jersey 08837 or by calling the toll-free number shown above. Additional information contained in a Statement of Additional Information dated October , 1998, forming a part of Government Income Fund's Registration Statement on Form N-14, has been filed with the Commission, is incorporated herein by reference and is available without charge upon request to the address or telephone number shown above. This Prospectus and Proxy Statement will first be mailed to shareholders on or about October 30, 1998. Investors are advised to read and retain this Prospectus and Proxy Statement for future reference. -------------- THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION NOR HAS THE COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. The date of this Prospectus and Proxy Statement is October 30, 1998. PRUDENTIAL GOVERNMENT INCOME FUND, INC. PRUDENTIAL MORTGAGE INCOME FUND, INC. GATEWAY CENTER THREE 100 MULBERRY STREET NEWARK, NEW JERSEY 07102-4077 -------------- PROSPECTUS AND PROXY STATEMENT DATED OCTOBER 30, 1998 -------------- SYNOPSIS The following synopsis is a summary of certain information contained elsewhere in this Prospectus and Proxy Statement and the Agreement and Plan of Reorganization (the Plan) and is qualified by reference to the more complete information contained herein as well as in the Prospectus of Prudential Mortgage Income Fund, Inc. (Mortgage Income Fund) and the enclosed Prospectus of the Prudential Government Income Fund, Inc. (Government Income Fund). Shareholders should read the entire Prospectus and Proxy Statement carefully. GENERAL This Prospectus and Proxy Statement is furnished by the Directors of Mortgage Income Fund in connection with the solicitation of Proxies for use at a Special Meeting of Shareholders of Mortgage Income Fund (the Meeting) to be held at 9:00 A.M. on December 3, 1998 at The Prudential Insurance Company of America, Plaza Building, 751 Broad Street, Newark, New Jersey 07102. The purpose of the Meeting is to approve the Plan whereby all of the assets of Mortgage Income Fund will be acquired by, and the liabilities, if any, of Mortgage Income Fund will be assumed by Government Income Fund, in exchange for Class A, Class B, Class C and Class Z shares of common stock of Government Income Fund, and such other business as may properly come before the Meeting or any adjournment thereof. The Plan is attached to this Prospectus and Proxy Statement as Appendix B. Approval of the Plan requires the affirmative vote of a majority of shares of Mortgage Income Fund outstanding and entitled to vote. Shareholders vote in the aggregate and not by separate class within Mortgage Income Fund. Approval of the Plan by the shareholders of Government Income Fund is not required and the Plan is not being submitted for their approval. THE PROPOSED REORGANIZATION The Boards of Directors of Government Income Fund and of Mortgage Income Fund have approved the Plan, which provides for the transfer of all of the assets of Mortgage Income Fund in exchange for Class A, Class B, Class C and Class Z shares of Government Income Fund and the assumption by Government Income Fund of the liabilities, if any, of Mortgage Income Fund. Following approval by Mortgage Income Fund's shareholders, if obtained, Class A, Class B, Class C and Class Z shares of Government Income Fund will be distributed to Class A, Class B, Class C and Class Z shareholders of Mortgage Income Fund, and Mortgage Income Fund will be terminated. The reorganization will become effective as soon as practicable after the Meeting. Mortgage Income Fund's Class A, Class B, Class C and 2 Class Z shareholders will receive the number of full and fractional Class A, Class B, Class C and Class Z shares of Government Income Fund equal in value (rounded to the third decimal place) to such shareholder's Class A, Class B, Class C and Class Z shares of Mortgage Income Fund as of the closing date. REASONS FOR THE REORGANIZATION There are a number of similarities between Mortgage Income Fund and Government Income Fund that led to consideration of the Plan. The following are among the reasons for the reorganization, which was proposed by PIFM, the Manager of each Fund: MORTGAGE INCOME FUND HAS BEEN UNABLE TO ATTRACT AND RETAIN SIGNIFICANT ASSETS. Assets in Mortgage Income Fund have been steadily declining during the past several years. As of June 30, 1998, Mortgage Income Fund's assets were approximately $151,969,000, with 15,856 shareholders. As a result, Mortgage Income Fund has been operating with relatively higher expense ratios. The Distributor of Mortgage Income Fund has agreed to limit distribution fees with respect to the Class A and Class C shares, respectively, to no more than .15 of 1% and .75 of 1% of the average daily net assets of such Class A shares and Class C shares for Mortgage Income Fund's current fiscal year. Because of its size, Mortgage Income Fund does not enjoy the economies of scale of Government Income Fund. The Manager believes Mortgage Income Fund's situation is not likely to improve and although the Distributor's current fee waiver has been in place for some time for Mortgage Income Fund, the waiver is voluntary, is not specified as to duration and could therefore be eliminated at any time. GOVERNMENT INCOME FUND AND MORTGAGE INCOME FUND HAVE SIMILAR INVESTMENT POLICIES. Government Income Fund and Mortgage Income Fund invest primarily in U.S. Government securities, including U.S. Treasury Bills, Notes, Bonds and other debt securities issued by the U.S. Treasury, and obligations issued or guaranteed by the U.S. Government, its agencies and instrumentalities. Furthermore, each Fund may invest in fixed rate and adjustable rate mortgage-backed securities, asset-backed securities and corporate debt securities. Each Fund may also purchase and sell options and futures contracts on U.S. Government securities for hedging and return enhancement purposes. Each Fund may also enter repurchase agreements, hold up to 15% of its net assets in illiquid securities and lend securities. See "Structure of Mortgage Income Fund and Government Income Fund" and "Investment Objectives and Policies" below. AFTER IMPLEMENTATION OF THE PLAN, THE FORMER SHAREHOLDERS OF MORTGAGE INCOME FUND AND GOVERNMENT INCOME FUND MAY BENEFIT FROM REDUCED EXPENSES RESULTING FROM GREATER ECONOMIES OF SCALE. The Boards of Directors of Mortgage Income Fund and Government Income Fund believe that the reorganization may achieve certain economies of scale that Mortgage Income Fund alone cannot realize because of its small size, and that Government Income Fund would realize the benefits of a larger asset base in exchange for its shares. The combination of Mortgage Income Fund and Government Income Fund would eliminate certain duplicate expenses, such as those incurred in connection with separate audits and the preparation of separate financial statements for Mortgage Income Fund and Government Income Fund, and reduce other expenses, because their expenses would be spread across a larger asset base. 3 The ratios of total operating expenses to average net assets for Class A, Class B, Class C and Class Z shares of Government Income Fund and Class A, Class B, Class C and Class Z shares of Mortgage Income Fund for the periods indicated below were as follows:
CLASS A CLASS B CLASS C CLASS Z ----------- ------------ ------------ ------------ GOVERNMENT INCOME FUND: Fiscal Year Ended February 28, 1998.................. 0.86% 1.53% 1.46% 0.71% MORTGAGE INCOME FUND: Six Months Ended June 30, 1998 (1)................... 1.03% 1.63% 1.63% .88% Fiscal Year Ended December 31, 1997 (2).............. .96% 1.56% 1.56% .81% Fiscal Year Ended December 31, 1997 (3).............. 1.10% 1.70% 1.70% .95% - ------------ (1) Figures are annualized and unaudited. (2) Net of management fee waiver and/or expense subsidy. Effective September 1, 1997, the Manager eliminated its management fee waiver (.20 of 1%) with respect to the Mortgage Income Fund. (3) Before consideration of management fee waiver and/or expense subsidy.
GOVERNMENT INCOME FUND HAS A YIELD COMPARABLE TO MORTGAGE INCOME FUND. Government Income Fund has historically provided a comparable yield to Mortgage Income Fund and Government Income Fund has lower expense ratios than Mortgage Income Fund due to its appreciably larger size. The following table presents the 30 day yield for Mortgage Income Fund and Government Income Fund for the thirty-day period ended June 30, 1998. Although the 30 day yield for Government Income Fund is slightly lower than the 30 day yield for Mortgage Income, Government Income Fund has achieved average annual total returns higher than Mortgage Income Fund.
MORTGAGE INCOME GOVERNMENT INCOME FUND FUND 30 DAY 30 DAY CLASS SEC YIELD SEC YIELD - ------ ---------------- ----------------- A 6.28% 5.35% B 5.93% 4.90% C 5.93% 4.98% Z 6.69% 5.73%
- ------------ Past performance is not a guarantee of future results. 4 GOVERNMENT INCOME FUND HAS ACHIEVED AVERAGE ANNUAL TOTAL RETURNS HIGHER THAN MORTGAGE INCOME FUND. The following table reflects each Fund's respective average annual total returns (unaudited) after application of the distribution fee waivers as of June 30, 1998.(+)
CLASS A CLASS B CLASS C CLASS Z -------- -------- -------- -------- GOVERNMENT INCOME FUND:* One Year.............. 5.99% 4.79% 8.87% 10.58% Five Years............ 5.19% 5.18% N/A N/A Ten Years............. N/A 7.42% N/A N/A Since Inception....... 7.46% 7.79% 7.52% 6.88%
AFTER MANAGEMENT FEE WAIVER(++) BEFORE MANAGEMENT FEE WAIVER(++) AND/OR EXPENSE SUBSIDY AND/OR EXPENSE SUBSIDY ----------------------------------------- ----------------------------------------- MORTGAGE INCOME FUND:** One Year.............. 2.87% 1.51% 5.51% 7.31% 2.80% 1.44% 5.44% 7.23% Five Years............ 4.75% 4.81% N/A N/A 4.70% 4.76% N/A N/A Ten Years............. N/A 6.72% N/A N/A N/A 6.70% N/A N/A Since Inception....... 6.64% 8.45% 6.62% 7.98% 6.62% 8.41% 6.57% 7.86%
- ------------ + See "Fees and Expenses--Distribution Fees" below for information on the Distributor's voluntary fee waiver. ++ As of September 1, 1997, PIFM discontinued its management fee waiver for Mortgage Income Fund. * The inception period is January 22, 1990 for Class A shares, April 22, 1985 for Class B shares, August 1, 1994 for Class C shares and March 4, 1996 for Class Z shares. ** The inception period is January 22, 1990 for Class A shares, April 2, 1982 for Class B shares, August 1, 1994 for Class C shares and March 18, 1997 for Class Z shares. Average annual total return takes into account any applicable initial or contingent deferred sales charges but does not take into account any federal or state income taxes that may be payable upon redemption. ANALYSIS OF SIMILARITIES AND DIFFERENCES: There are a number of similarities between Mortgage Income Fund and the Government Income Fund that led to consideration of the proposed acquisition: Under separate management agreements with each of the Funds, PIFM serves as the manager of both Mortgage Income Fund and Government Income Fund.(1) The management fees for both of the Funds is .50 of 1% of the Fund's average daily net assets. Prudential Investment Management Services LLC (PIMS) acts as the Distributor of the shares of both Mortgage Income Fund and Government Income Fund. PIMS is entitled to an annual distribution and service fee at the rate of up to .30 of 1% of the average daily net assets of the Class A shares and up to 1% of the average daily net assets of both the Class B and C shares for both of the Funds. PIMS, with respect to the Government Income Fund, has agreed to limit its distribution fees with respect to Class A shares to no more - ------------ (1)PIC furnishes investment advisory services to Mortgage Income Fund and to Government Income Fund pursuant to a subadvisory agreement with PIFM. PIC is compensated by PIFM, and not the Funds, for its services. PIFM, with respect to each of the Funds, continues to have responsibility for all investment advisory services pursuant to the respective management agreements and supervises PIC's performance of such services. 5 than .15 of 1% of the average daily net assets of the Class A shares, to no more than .825 of 1% of the average daily net assets of the Class B shares and to no more than .75 of 1% of the average daily net assets of the Class C shares for the fiscal year ending February 28, 1999. With respect to the Mortgage Income Fund, PIMS has agreed to limit its distribution fees with respect to Class A shares to no more than .15 of 1% of the average daily net assets of the Class A shares and to no more than .75 of 1% of the average daily net assets of the Class C shares for the fiscal year ending December 31, 1998. Prudential Mutual Fund Services LLC (PMFS) serves as Transfer Agent and Dividend Disbursing Agent for Mortgage Income Fund and Government Income Fund. PMFS has an identical fee structure in place for both, including the same annual fee per shareholder account, the same new account set-up fee for each manually-established account and the same monthly inactive zero balance account fee per shareholder account. Both Mortgage Income Fund and Government Income Fund are able to invest in U.S. Government Securities, including U.S. Treasury Bills, Notes, Bonds and other debt securities issued by the U.S. Treasury, and obligations issued by the U.S. Government, its agencies and instrumentalities. Mortgage Income Fund and Government Income Fund may both also invest in fixed-rate and adjustable rate mortgage-backed securities, asset-backed securities and corporate debt securities. Mortgage Income Fund, however, is required to invest at least 65% of its total assets in mortgage-backed securities while Government Income Fund is required to invest at least 65% of its total assets in U.S. Government Securities. Government Income Fund and Mortgage Income Fund may each purchase and sell options and futures contracts on U.S. Government securities for hedging and return enhancement purposes. Each Fund may also enter repurchase agreements, hold up to 15% of its net assets in illiquid securities and lend securities. Finally, Government Income Fund, but not Mortgage Income Fund, may invest in reverse repurchase agreements, although both may invest in dollar rolls. MARKET CONDITIONS SUPPORTING THE PROPOSED MERGER. Mortgage backed securities (MBS) usually offer yields that exceed that of Treasury securities. Mutual funds choosing to purchase MBS receive this additional yield for the added incremental risk associated with owning them. This risk includes prepayment risk, which is the risk that occurs when individuals refinance their mortgages as interest rates fall, thereby retiring their debt prematurely. In the case of MBS prepayment, a mutual fund will no longer receive the higher interest income that was once provided and must reinvest proceeds at the lower prevailing interest rate. In addition, if the Fund purchased the MBS at a premium, it loses principal as well since the MBS will be prepaid at par. Even without the occurrence of prepayments, a falling interest rate environment will mute MBS price appreciation as opposed to other bonds. On the other hand, in a rising interest rate environment the situation does not improve by much. When rates rise and bond prices fall, MBS fall in line with other bonds. Mortgages perform best in periods of a stable interest rate environment. As a result of today's market, mortgage funds have not been viewed as popular. One way a mutual fund can avoid being hurt by poorly performing mortgage pools (I.E. those experiencing above generic paydowns) is to purchase pools in larger sizes. As the dollar amount of a mortgage position drops in size, the chance of having unexpected performance, as pools either pay down more or less than generics, rises. Partly as a result of the above, better prices are usually generated for larger pool sizes. As positions decline in size (Mortgage Income Fund currently holds only $151 million in assets), the Subadviser does not always see the most attractive swaps among mortgage products, which could negatively impact performance. Presently, there would appear to be more investor interest in owning a portfolio which can adjust the mortgage exposure based on the interest rate outlook. As stated in its prospectus, Mortgage Income Fund 6 must invest at least 65% of its total assets in mortgage-backed securities. Government Income Fund is also allowed to hold mortgages in its portfolio, but is not restricted to a minimum amount. Government Income Fund has the benefit of increasing or decreasing its exposure to mortgages accordingly. In addition, Government Income Fund currently has over $1.2 billion in assets. Therefore, it can purchase mortgage pools of a much greater size than Mortgage Income Fund, simultaneously decreasing the potential risk of prepayments. Table 1 below shows the portfolio holdings and assets of both funds as of June 30, 1998. TABLE 1
MORTGAGES TOTAL --------------------- ASSETS FUND TREASURIES GNMA FNMA FHLMC CMOS OTHER* TOTAL (MILLIONS) - ------------------- ------- ----- ----- ----- ----- ------ ------ --------- Government Income............ 26% 9% 13% 1% 5% 46% 100% $1227.1 Mortgage Income.... 14% 12% 38% 5% 8% 23% 100% $151.9
- --------------- Source: Prudential Consolidated Analytics Reporting as of June 30, 1998 * Other includes securities of other Government Agencies, Corporates, Asset Backs, and Cash. For the reasons set forth below under "The Proposed Transaction--Reasons for the Reorganization Considered by the Directors," the Directors of Mortgage Income Fund and Government Income Fund, including those Directors who are not "interested persons" (Independent Directors), as that term is defined in the Investment Company Act of 1940, as amended (Investment Company Act), have concluded that the reorganization would be in the best interests of the shareholders of Mortgage Income Fund and Government Income Fund and that the interests of shareholders of Mortgage Income Fund and Government Income Fund will not be diluted as a result of the proposed transaction. Accordingly, the Board of Directors of each of Mortgage Income Fund and Government Income Fund recommends approval of the Plan. STRUCTURE OF MORTGAGE INCOME FUND AND GOVERNMENT INCOME FUND Mortgage Income Fund is authorized to issue 500 million shares of common stock, $0.01 par value per share, divided into four classes designated Class A, Class B, Class C and Class Z. Government Income Fund is authorized to issue 2 billion shares of common stock, $0.01 par value per share. Government Income Fund is divided into four classes designated Class A, Class B, Class C and Class Z. Each class of shares of each Fund represents an interest in the same assets of the respective Fund and is identical in all respects except that (i) each class (with the exception of Class Z shares) is subject to different sales charges and distribution and/or service fees, which may affect performance, (ii) each class has exclusive voting rights on any matter submitted to shareholders that relates solely to its arrangement and has separate voting rights on any matter submitted to shareholders in which the interests of one class differ from the interests of any other class, (iii) each class has a different exchange privilege, (iv) only Class B shares have a conversion feature and (v) Class Z shares are offered exclusively for sale to a limited group of investors. The Boards of Government Income Fund and Mortgage Income Fund may increase or decrease the number of authorized shares without shareholder approval. Shares of each Fund, when issued, are fully paid, nonassessable, fully transferable and redeemable at the option of the holder. Shares also are redeemable at the option of each Fund under certain circumstances. Except for the conversion feature applicable to Class B shares (which convert to Class A shares after approximately seven years), there are no conversion, preemptive or other subscription rights. In the event of liquidation of either Fund, each share thereof is entitled to its portion of that Fund's assets after all of its debts and expenses have been paid. Neither Fund's shares have cumulative voting rights for the election of Directors. 7 INVESTMENT OBJECTIVES AND POLICIES Mortgage Income Fund seeks to achieve a high level of income over the long term consistent with providing reasonable safety in the value of each shareholder's investment. It seeks to achieve this objective by investing primarily in mortgage-related instruments, including securities guaranteed as to timely payment of principal and interest by the Government National Mortgage Association (GNMA), other mortgage-backed securities issued or guaranteed by agencies or instrumentalities of the U.S. Government, and non-agency mortgage instruments, along with obligations using mortgages as collateral. Government Income Fund has an investment objective of high current return. The Government Income Fund seeks to achieve its objective primarily by investing in U.S. Government securities, including U.S. Treasury Bills, Notes, Bonds, and other debt securities issued by the U.S. Treasury, and obligations issued or guaranteed by U.S. Government agencies or instrumentalities. The Government Income Fund may also write covered call options and covered put options and purchase put and call options. FEES AND EXPENSES MANAGEMENT FEES. PIFM, the manager of each Fund and an indirect, wholly-owned subsidiary of The Prudential Insurance Company of America (Prudential), is compensated, pursuant to a management agreement with Government Income Fund, at an annual rate of .50 of 1% of the average daily net assets of Government Income Fund, and, pursuant to a management agreement with Mortgage Income Fund, at an annual rate of .50 of 1% of the average daily net assets of Mortgage Income Fund. Under subadvisory agreements between PIFM and PI, PI provides investment advisory services for the management of the respective Funds. Each subadvisory agreement provides that PIFM will reimburse PI for its reasonable costs and expenses in providing investment advisory services. PIFM continues to have responsibility for all investment advisory services pursuant to the management agreements for both Funds and supervises the Subadviser's performance of its services on behalf of each Fund. DISTRIBUTION FEES. Prudential Investment Management Services LLC (the Distributor), a wholly-owned subsidiary of Prudential, serves as the distributor of the Class A, Class B, Class C and Class Z shares of each Fund. Under separate Distribution and Service Plans adopted by each Fund (the Class A Plan, Class B Plan and Class C Plan, collectively, the Plans) pursuant to Rule 12b-1 under the Investment Company Act, and approved by the shareholders of the applicable class of Mortgage Income Fund and Government Income Fund, and under separate distribution agreements, the Distributor incurs the expenses of distributing the Class A, Class B, and Class C shares of each Fund. The Distributor also incurs the expenses of distributing each Fund's Class Z shares under separate distribution agreements, none of which are reimbursed by or paid for by the Funds. The distribution expenses incurred by the Distributor include (i) commissions and account servicing fees, (ii) advertising expenses, (iii) the cost of printing and mailing prospectuses, and (iv) indirect and overhead costs associated with the sale of shares of each of Government Income Fund and Mortgage Income Fund. Under Mortgage Income Fund's Class A Plan, the Fund may pay the Distributor for distribution expenses at an annual rate of up to .30 of 1% of the average daily net assets of the Class A shares. Under Mortgage Income Fund's Class B and Class C Plan, the Fund may pay the Distributor for distribution expenses at an annual rate of up to .75 of 1% and 1%, respectively, of the average daily net assets of Mortgage Income Fund's Class B and Class C shares. For the fiscal year ending December 31, 1998, the 8 Distributor agreed to limit its distribution expenses to .15 of 1% of the average daily net assets for Class A shares, and, to .75 of 1% of the average daily net assets for Class C shares for the fiscal year ending December 31, 1998. Under Government Income Fund's Class A Plan, the Fund may pay the Distributor for distribution expenses at an annual rate of up to .30 of 1% of the average daily net assets of the Class A shares. Under Government Income Fund's Class B Plan, the Fund may pay the Distributor for its distribution expenses at an annual rate of up to 1% of the average daily net assets of the Class B shares up to $3 billion, .80 of 1% of the next $1 billion of such net assets and .50 of 1% of such net assets in excess of $4 billion. Under Government Income Fund's Class C Plan, the Fund may pay the Distributor for its distribution expenses at an annual rate of up to 1% of average daily net assets of Class C shares. The Distributor has agreed to limit its distribution expenses to .15 of 1% of the average daily net assets of the Class A shares and to .825 of 1% of the average daily net assets of the Class C shares for the fiscal year ending February 28, 1999. For the fiscal year ended February 28, 1998, Government Income Fund paid distribution expenses of .15 of 1%, .825 of 1% and .75 of 1%, respectively, of the average daily net assets of the Class A, Class B and Class C shares. For the fiscal year ended December 31, 1997 and six-month period ended June 30, 1998, Mortgage Income Fund paid distribution expenses of .15%, .75% and .75% of the average daily net assets of Class A, Class B and Class C shares, respectively. The Funds record all payments made under the Plans as expenses in the calculation of net investment income. Under each Fund's Class A, Class B and Class C Plans, each such class of shares, as applicable, is obligated to pay distribution and/or service fees to the Distributor as compensation for distribution and service activities, not as reimbursement for specific expenses incurred. If the Distributor's expenses exceed its distribution and service fees, that Fund will not be obligated to pay any additional expenses. If the Distributor's expenses are less than such distribution and service fees, it will retain its full fees and realize a profit. OTHER EXPENSES. The Funds also pay certain other expenses in connection with their operation, including transfer agency, accounting, legal, audit and registration expenses. Although the basis for calculating these fees and expenses is the same for Government Income Fund and Mortgage Income Fund, the per share effect on shareholder returns is affected by their relative size. Combining Mortgage Income Fund with Government Income Fund will reduce certain expenses. For example, only one annual audit of the combined fund will be required rather than separate audits of each Fund as currently required. For a discussion of the level of distribution fee waivers, see the notes to the chart "Expense Ratios--Annual Fund Operating Expenses (as a percentage of average net assets)" below. 9 SHAREHOLDER TRANSACTION EXPENSES. The following tables show the fees that an investor would be subject to in connection with a purchase, redemption or exchange of shares of each of Government Income Fund or Mortgage Income Fund. If the Plan is implemented, Class A, Class B, Class C and Class Z shareholders of Mortgage Income Fund will receive Class A, Class B, Class C and Class Z shares of Government Income Fund.
CLASS A CLASS Z SHAREHOLDER TRANSACTION EXPENSES+ SHARES CLASS B SHARES CLASS C SHARES SHARES ------- --------------------------------------- --------------------------------- ------- Maximum Sales Load Imposed on Purchases (as a percentage of offering price)...................... 4% None None None Maximum Deferred Sales Load (as a percentage of original purchase price or redemption proceeds, whichever is lower)............................... None 5% during the first year, decreasing by 1% on redemptions made within one None 1% annually to 1% in the fifth and year of purchase sixth years and 0% in the seventh year* Maximum Sales Load Imposed on Reinvested Dividends................. None None None None Redemption Fees....................... None None None None Exchange Fees......................... None None None None
- --------------- + Pursuant to the rules of the National Association of Securities Dealers, Inc., the aggregate initial sales charges, deferred sales charges and asset-based sales charges on shares of each Fund may not exceed 6.25% of the total gross sales, subject to certain exclusions. This 6.25% limitation is imposed on each class of each Fund rather than on a per shareholder basis. Therefore, long-term shareholders of each Fund may pay more in total sales charges than the economic equivalent of 6.25% of such shareholders' investment in such shares. * Class B shares automatically convert to Class A shares approximately seven years after purchase. EXPENSE RATIOS. For the fiscal year ended February 28, 1998 total expenses as a percentage of average net assets of Government Income Fund were .86%, 1.53%, 1.46% and .71%, respectively, for Class A, Class B, Class C and Class Z shares. Without the distribution fee limitation, such ratios would have been 1.01% for the Class A shares and 1.71% for Class B and C shares. For the fiscal year ended December 31, 1997 (net of management fee waiver) and the six month period ended June 30, 1998, total expenses as a percentage of average net assets of Mortgage Income Fund were .96%, 1.56%, 1.56% and .81% and 1.03%, 1.63%, 1.63% and .88% (annualized), respectively, for Class A, Class B, Class C and Class Z shares. Without the distribution fee limitation, such ratios would have been 1.11% for Class A shares and 1.81% for Class C shares for the fiscal year ended December 31, 1997 (before management fee waiver) and 1.18% for Class A shares and 1.88% for Class C shares for the six-month period ended June 30, 1998. Following the reorganization, the actual expense ratios of the combined fund are expected to be lower than those of Mortgage Income Fund for the fiscal year ended December 31, 1997 (taking into account the distribution fee limitation). Set forth below is a comparison of Government Income Fund's and Mortgage Income Fund's operating expenses for, in the case of Government Income Fund, the fiscal year ended February 28, 1998 and, in the case of Mortgage Income Fund, the fiscal year ended December 31, 1997, before management fee waiver. The ratios are also shown on a pro forma (estimated) combined basis, giving effect to the reorganization. 10
ANNUAL FUND OPERATING EXPENSES GOVERNMENT INCOME FUND* MORTGAGE INCOME FUND** (AS A PERCENTAGE OF -------------------------------------------------- --------------------------------------------------- AVERAGE NET ASSETS) CLASS A CLASS B CLASS C CLASS Z CLASS A CLASS B CLASS C CLASS Z Management Fees.......... .50% .50% .50% .50% .50% .50% .50% .50% 12b-1 Fees (After Waiver)+................ .15% .825% .75% None .15% .75% .75% None Other Expenses........... .21% .21% .21% .21% .45% .45% .45% .45% ----- ------------- ------ ----- ------ ------ ------ ----- Total Fund Operating Expenses (After Waiver)................. .86% 1.535% 1.46% .71% 1.10% 1.70% 1.70% .95% ----- ------------- ------ ----- ------ ------ ------ ----- ----- ------------- ------ ----- ------ ------ ------ ----- PRO FORMA COMBINED OPERATING EXPENSES AND GOVERNMENT INCOME FUND) (AS A PERCENTAGE OF -------------------------------------------------- AVERAGE NET ASSETS) CLASS A CLASS B CLASS C CLASS Z Management Fees.......... .50% .50% .50% .50% 12b-1 Fees (After Waiver)+................ .15% .825% .75% None Other Expenses........... .20% .20% .20% .20% ----- ------------- ------ ----- Total Fund Operating Expenses (After Waiver)................. .85% 1.525% 1.45% .70% ----- ------------- ------ ----- ----- ------------- ------ -----
- --------------- * Based on expenses incurred during the fiscal year ended February 28, 1998. ** Based on expenses incurred during the fiscal year ended December 31, 1997. + Although the Class A, Class B and Class C Distribution and Service Plans provide that each Fund may pay higher distribution fees for Class A and C shares and Government Income Fund's Plan may pay higher distribution fees for Class B shares, as described above under "Distribution Fees," the Distributor has agreed to limit its distribution fees, with respect to the Class A and Class C shares of Mortgage Income Fund, to .15 of 1% and .75 of 1% of the average daily net assets of the Class A shares and Class C shares, respectively, for Mortgage Income Fund's fiscal year ending December 31, 1998 and, with respect to the Class A, Class B and Class C shares of Government Income Fund, to .15 of 1%, .825 of 1% and .75 of 1% of the average daily net assets of the Class A, Class B and Class C shares, respectively, for Government Income Fund's fiscal year ending February 28, 1999. Total Fund Operating Expenses without such limitations for Class A and Class C shares, respectively, would be 1.25% and 1.95% for Mortgage Income Fund and 1.00%, 1.70% and 1.70%, respectively for Class A, Class B and Class C shares of Government Income Fund (pro forma combined), as of each Fund's most recent fiscal year end. The example set forth below shows the expenses that an investor in the combined fund (assuming approval by shareholders of Mortgage Income Fund) would pay on a $1,000 investment, based upon the pro forma ratios set forth above.
10 EXAMPLE 1 YEAR 3 YEARS 5 YEARS YEARS - ------------------------------------------- ------ ------- ------- ------ You would pay the following expenses on a $1,000 investment, assuming (1) 5% annual return and (2) redemption at the end of each time period Class A................................ $48 $66 $85 $141 Class B................................ $66 $78 $93 $155 Class C................................ $25 $46 $79 $174 Class Z................................ $ 7 $22 $39 $ 87
THE EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF PAST OR FUTURE EXPENSES. ACTUAL EXPENSES MAY BE GREATER OR LESS THAN THOSE SHOWN. PURCHASES AND REDEMPTIONS Purchases of shares of Mortgage Income Fund and Government Income Fund are made through the Distributor, through dealers, including Prudential Securities Incorporated, Pruco Securities Corporation (Prusec) or directly from the respective Fund, through its Transfer Agent, PMFS, at the net asset value per share next determined after receipt of a purchase order by the Transfer Agent plus a sales charge which may be imposed either at the time of purchase (Class A shares) or on a deferred basis (Class B or Class C shares). The minimum initial investment for Class A and Class B shares of each Fund is $1,000 per class and $5,000 for Class C shares and the minimum subsequent investment is $100 for Class A, Class B and Class C shares. Class Z shares are not subject to any minimum investment requirements. Class A shares of each Fund 11 are sold with an initial sales charge of up to 4.00% of the offering price. Class B shares of each Fund are sold without an initial sales charge but are subject to a contingent deferred sales charge (declining from 5% to zero of the lower of the amount invested or the redemption proceeds) which will be imposed on certain redemptions made within six years of purchase. Although Class B shares are subject to higher ongoing distribution-related expenses than Class A shares, Class B shares will automatically convert to Class A shares (which are subject to lower ongoing distribution-related expenses) approximately seven years after purchase. Class C shares of each Fund are sold without an initial sales charge and, for one year after purchase, are subject to a 1% contingent deferred sales charge on redemptions. Like Class B shares, Class C shares are subject to higher ongoing distribution-related expenses than Class A shares but do not convert to another class. Shares of each Fund may be redeemed at any time at the net asset value next determined after the Distributor or the Transfer Agent receives the sell order. As indicated above, the proceeds of redemptions of Class B and Class C shares may be subject to a contingent deferred sales charge. NO CONTINGENT DEFERRED SALES CHARGE WILL BE IMPOSED IN CONNECTION WITH THE REORGANIZATION. FOLLOWING THE REORGANIZATION, SUCH SHAREHOLDERS' CLASS A SHARES OF GOVERNMENT INCOME FUND WILL NOT BE SUBJECT TO ANY CONTINGENT DEFERRED SALES CHARGES. EXCHANGE PRIVILEGES The exchange privileges available to shareholders of Government Income Fund are substantially similar to the exchange privileges of shareholders of Mortgage Income Fund. Shareholders of both Government Income Fund and Mortgage Income Fund have an exchange privilege with certain other Prudential Mutual Funds, including one or more specified money market funds, subject to the minimum investment requirements of such funds. Class A, Class B, Class C and Class Z shares of each Fund may be exchanged for Class A, Class B, Class C and Class Z shares of another fund on the basis of relative net asset value. No sales charge will be imposed at the time of the exchange. Class B and Class C shares of Mortgage Income Fund may not be exchanged into money market funds other than Prudential Special Money Market Fund, Inc. For purposes of calculating the holding period applicable to the Class B conversion feature, the time period during which Class B shares were held in a Money Market fund will be excluded. An exchange will be treated as a redemption and purchase for tax purposes. DIVIDENDS AND DISTRIBUTIONS Each Fund expects to declare daily and to pay dividends of net investment income, if any, monthly and make distributions at least annually of any net capital gains. Shareholders of Government Income Fund and Mortgage Income Fund receive dividends and other distributions in additional shares of Government Income Fund and Mortgage Income Fund, respectively, unless they elect to receive them in cash. A Mortgage Income Fund shareholder's election with respect to reinvestment of dividends and distributions in Mortgage Income Fund will be automatically applied with respect to the shares of Government Income Fund he or she receives. FEDERAL TAX CONSEQUENCES OF PROPOSED REORGANIZATION The Funds have received an opinion of Swidler Berlin Shereff Friedman, LLP to the effect that the proposed reorganization will constitute a tax-free reorganization within the meaning of Section 368(a)(1)(C) of the Internal Revenue Code of 1986, as amended (the Internal Revenue Code). Accordingly, no gain or loss will be recognized to Government Income Fund or Mortgage Income Fund upon the transfer of assets solely in return for shares of Government Income Fund and Government Income Fund's assumption of liabilities, if any, or to shareholders of Mortgage Income Fund upon their receipt of shares of Government 12 Income Fund in return for their shares of Mortgage Income Fund. The tax basis for the shares of Government Income Fund received by Mortgage Income Fund's shareholders will be the same as their tax basis for the shares of Mortgage Income Fund to be constructively surrendered in exchange therefor. In addition, the holding period of the shares of Government Income Fund to be received pursuant to the reorganization will include the period during which the shares of Mortgage Income Fund to be constructively surrendered in exchange therefor were held, provided the latter shares were held as capital assets by the shareholders on the date of the exchange. See "The Proposed Transaction--Tax Considerations." PRINCIPAL RISK FACTORS As the investment policies of both Funds are similar, the risks associated with investments in either Fund also are similar. Below is a summary of such risks. For a more complete discussion of the risks attendant to an investment in Government Income Fund, please see Government Income Fund's Prospectus, which accompanies this Prospectus and Proxy Statement and is incorporated herein by reference. HEDGING AND RETURN ENHANCEMENT ACTIVITIES Government Income Fund may engage in various portfolio strategies, including using derivatives, to reduce certain risks of its investments and to attempt to enhance return. These strategies include the purchase of and sale of put and call options on securities and indices and the purchase and sale of futures contracts and related options (including futures contracts on U.S. Government securities and indices and options thereon), enter into repurchase agreements, enter into reverse repurchase agreements and dollar rolls, lend its securities, make short sales against the box, purchase and sell securities on a when-issued and delayed delivery basis, engage in interest rate swap transactions and borrow money for temporary, extraordinary or emergency purposes or for the clearance of transactions, subject to certain limitations. Government Income Fund's ability to use these strategies may be limited by market conditions, regulatory limits and tax considerations, and there can be no assurance that any of these strategies will succeed. Participation in the options and futures markets involves investment risks and transaction costs to which Government Income Fund would not be subject absent the use of these strategies. Government Income Fund, and thus its investors, may lose money through the unsuccessful use of these strategies. If the investment adviser's prediction of movements in the direction of the securities and interest rate markets is inaccurate, the adverse consequences to the Government Income Fund may leave the Government Income Fund in a worse position than if such strategies were not used. Risks inherent in the use of options and futures contracts and options on futures contracts include: (1) dependence on the investment adviser's ability to predict correctly movements in the direction of interest rates and securities prices; (2) imperfect correlation between the price of options and futures contracts and options thereon and movements in the prices of the securities being hedged; (3) the fact that skills needed to use these strategies are different from those needed to select portfolio securities; (4) the possible absence of a liquid secondary market for any particular instrument at any time; and (5) and the possible inability of Government Income Fund to purchase or sell a portfolio security at a time that otherwise would be favorable for it to do so, or the possible need for Government Income Fund to sell the security at a disadvantageous time, due to the requirement that Government Income Fund maintain cover or segregate securities in connection with hedging transactions. Mortgage Income Fund may also engage in various portfolio strategies to reduce certain risks and enhance return, including utilizing derivatives, repurchase agreements, dollar rolls, purchasing and selling 13 call and put options, entering into financial futures contracts and related options, interest rate transactions and lending portfolio securities. Mortgage Income Fund's participation in the options and futures markets subjects Mortgage Income Fund to similar types of risks as described above for Government Income Fund. RATINGS The minimum rating for securities in Government Income Fund's portfolio are securities rated A or better by Moody's Investors Service (Moody's) or Standard & Poor's Ratings Group (S&P) or comparably rated by any other NRSRO, or, if unrated, determined to be of comparable quality by the investment adviser. Mortgage Income Fund may invest up to 35% of its net assets in securities rated at least A by Moody's or S&P or similarly rated by another NRSRO or, if not rated, of comparable quality in the view of the investment adviser. The remainder of the portfolio will be rated at least Aa by Moody's or AA by S&P or similarly rated by another NRSRO or, if not so rated, of comparable quality in the view of the investment adviser. Bonds that are rated A by Moody's are judged to possess many favorable investment attributes and are considered as upper medium grade obligations. Factors giving security to principal and interest are considered adequate, but elements may be present that suggest a susceptibility to impairment some time in the future. Debt rated A by S&P has a strong capacity to pay interest and repay principal although it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than bonds in higher rated categories. Securities that are rated Aa by Moody's or AA by S&P are judged to be of very strong quality. They carry a smaller degree of investment risk and their capacity to pay interest and repay principal is extremely strong and differ from the highest-rated issues only in small degree. FOREIGN SECURITIES Government Income Fund may invest up to 10% of its total assets in obligations of foreign banks and foreign branches of U.S. banks. Investments in foreign securities involve certain risks not ordinarily associated with investments in securities of domestic issuers. Such risks include fluctuations in foreign exchange rates, future political and economic developments, and the possible imposition of exchange controls or other foreign governmental laws or restrictions. TAX CONSIDERATIONS Each Fund has elected to qualify and intends to remain qualified as a regulated investment company under the Internal Revenue Code. Accordingly, neither Fund will be subject to federal income taxes on its net investment income and net capital gains, if any, that it distributes to its shareholders. With regard to the Government Income Fund, the performance and tax qualification of one of its series will have no effect on the federal income tax liability of shareholders of the other series. Any dividends out of net investment income, together with distributions of net short-term gains distributed to shareholders of each Fund, will be taxable as ordinary income to those shareholders whether or not reinvested. Any net capital gains (I.E., the excess of net capital gains from the sale of assets held for more than twelve months over net short-term capital losses) distributed to shareholders of each Fund will be taxable as capital gains to those shareholders, whether or not reinvested and regardless of the length of time a shareholder has owned his or her shares. For federal income tax purposes, Mortgage Income Fund had a capital loss carryforward at December 31, 1997 of approximately $19,586,200, of which $2,647,800 expires in 1998, $16,220,800 expires in 2002, and $717,600 expires in 2005. If the reorganization occurs, these losses will carry forward to Government 14 Income Fund, subject to limitations under Section 382 of the Code. Additionally, the reorganization will cause such losses to expire earlier than set forth above if not otherwise used. As of February 28, 1998, Government Income Fund had a capital loss carryforward for federal income tax purposes of approximately $131,130,000, of which $41,964,000 expires in 1999, $1,736,000 expires in 2001, $2,920,000 expires in 2002, $66,560,000 expires in 2003 and $17,950,000 expires in 2005. Accordingly, no capital gains distributions are expected to be paid to shareholders of Government Income Fund until net gains have been realized in excess of the usable portion of such carryforwards. Shareholders are advised to consult their own tax advisors regarding specific questions as to federal, state or local taxes. REALIGNMENT OF INVESTMENT PORTFOLIO The portfolio managers of Government Income Fund anticipate selling certain securities in the investment portfolio of the combined Fund, following the consummation of such transaction. The portfolio managers of Government Income Fund expects that the sale of the assets acquired from Mortgage Income Fund and the purchase of other securities may affect the aggregate amount of taxable gains and losses generated by Government Income Fund. THE PROPOSED TRANSACTION AGREEMENT AND PLAN OF REORGANIZATION The terms and conditions under which the proposed transaction may be consummated are set forth in the Plan. Significant provisions of the Plan are summarized below; however, this summary is qualified in its entirety by reference to the Plan, a copy of which is attached as Appendix B to this Prospectus and Proxy Statement. The Plan contemplates (i) Government Income Fund acquiring all of the assets of Mortgage Income Fund in exchange for shares of Government Income Fund and the assumption by Government Income Fund of Mortgage Income Fund's liabilities, if any, as of the Closing Date (anticipated to be December 4, 1998 or at such later date as the parties may agree) and (ii) the constructive distribution on the date of the exchange, expected to occur on or about the Closing Date, of such shares of Government Income Fund to the shareholders of Mortgage Income Fund, as provided for by the Plan. The assets of Mortgage Income Fund to be acquired by Government Income Fund shall include, without limitation, all cash, cash equivalents, securities, receivables (including interest and dividends receivable) and other property of any kind owned by Mortgage Income Fund and any deferred or prepaid assets shown as assets on the books of Mortgage Income Fund. Government Income Fund will assume from Mortgage Income Fund all debts, liabilities, obligations and duties of Mortgage Income Fund of whatever kind or nature, if any; provided, however, that Mortgage Income Fund will utilize its best efforts, to the extent practicable, to discharge all of its known debts, liabilities, obligations and duties prior to the Closing Date. Government Income Fund will deliver to Mortgage Income Fund shares of Government Income Fund, which Mortgage Income Fund will then distribute to its shareholders. Share certificates in Government Income Fund will only be issued upon written request to the Transfer Agent. See "Shareholder Guide" in Government Income Fund's Prospectus. 15 The value of Mortgage Income Fund's assets to be acquired and liabilities to be assumed by Government Income Fund and the net asset value of shares of Government Income Fund will be determined as of 4:15 P.M., New York time, on the Closing Date in accordance with the valuation procedures of the respective Fund's then current Prospectus and Statement of Additional Information. As soon as practicable after the Closing Date, Mortgage Income Fund will distribute PRO RATA to its shareholders of record the shares of Government Income Fund received by Mortgage Income Fund in exchange for such shareholders' interest in Mortgage Income Fund evidenced by their shares of beneficial interest of Mortgage Income Fund. Such distribution will be accomplished by opening accounts on the books of Government Income Fund in the names of Mortgage Income Fund's shareholders and by transferring thereto the shares of Government Income Fund previously credited to the account of Mortgage Income Fund on those books. Each shareholder account shall represent the respective PRO RATA number of Government Income Fund shares due to such shareholder. Fractional shares of Government Income Fund will be rounded to the third decimal place. Accordingly, every shareholder of Mortgage Income Fund will own shares of Government Income Fund immediately after the reorganization that, except for rounding, will be equal to the value of that shareholder's shares of Mortgage Income Fund immediately prior to the reorganization. Moreover, because shares of Government Income Fund will be issued at net asset value in exchange for net assets of Mortgage Income Fund that, except for rounding, will equal the aggregate value of those shares, the net asset value per share of Government Income Fund will be unchanged. Thus, the reorganization will not result in a dilution of the value of any shareholder account. However, in general, the reorganization will substantially reduce the percentage of ownership of a Mortgage Income Fund's shareholder below such shareholder's current percentage of ownership in Mortgage Income Fund because, while such shareholder will have the same dollar amount invested initially in Government Income Fund that he or she had invested in Mortgage Income Fund, his or her investment will represent a smaller percentage of the combined net assets of Government Income Fund and Mortgage Income Fund. Any transfer taxes payable upon issuance of shares of Government Income Fund in a name other than that of the registered holder of the shares on the books of Mortgage Income Fund as of that time shall be paid by the person to whom such shares are to be issued as a condition of such transfer. Any reporting responsibility of Mortgage Income Fund will continue to be the responsibility of Mortgage Income Fund up to and including the Closing Date and such later date on which Mortgage Income Fund is terminated. On the effective date of the reorganization, the name of Government Income Fund will be unchanged. The consummation of the proposed transaction is subject to a number of conditions set forth in the Plan, some of which may be waived by the Boards of Directors of Mortgage Income Fund and Government Income Fund. The Plan may be terminated and the proposed transaction abandoned at any time, before or after approval by the shareholders of Mortgage Income Fund, prior to the Closing Date. In addition, the Plan may be amended in any mutually agreeable manner, except that no amendment may be made subsequent to the Meeting of shareholders of Mortgage Income Fund that would detrimentally affect the value of Government Income Fund's shares to be distributed to Mortgage Income Fund's shareholders. REASONS FOR THE REORGANIZATION CONSIDERED BY THE DIRECTORS The Board of Directors of Mortgage Income Fund, including a majority of the Independent Directors, have determined that the interests of Mortgage Income Fund's shareholders will not be diluted as a result of the proposed transaction and that the proposed transaction is in the best interests of the shareholders of 16 Mortgage Income Fund. In addition, the Board of Directors of Government Income Fund, including a majority of the Independent Directors, has determined that the interests of Government Income Fund's shareholders will not be diluted as a result of the proposed transaction and that the proposed transaction is in the best interests of the shareholders of Government Income Fund. The reasons that the reorganization was proposed by PIFM are described above under "Synopsis-- Reasons for the Reorganization." The Boards of Directors of Government Income Fund and Mortgage Income Fund based their decisions to approve the Plan on an inquiry into a number of factors, including the following: (1) the relative past decrease in assets, historical investment performance and perceived future prospects of Mortgage Income Fund; (2) the effect of the proposed transaction on the expense ratios of Government Income Fund and Mortgage Income Fund; (3) the costs of the reorganization, which will be paid for by Government Income Fund and Mortgage Income Fund in proportion to their respective asset levels; (4) the tax-free nature of the reorganization to Government Income Fund, Mortgage Income Fund and their shareholders; (5) the compatibility of the investment objectives, policies and restrictions of Government Income Fund and Mortgage Income Fund; (6) the potential benefits to the shareholders of Mortgage Income Fund and Government Income Fund; and (7) other options to the reorganization, including a continuance of Mortgage Income Fund in its present form, a change of investment adviser or investment objective or a termination of Mortgage Income Fund with the distribution of the cash proceeds to Mortgage Income Fund shareholders (which would be a taxable event). If the Plan is not approved by shareholders of Mortgage Income Fund, Mortgage Income Fund's Board of Directors may consider other appropriate action, such as the termination of Mortgage Income Fund or a merger or other business combination with an investment company other than Government Income Fund. DESCRIPTION OF SECURITIES TO BE ISSUED Government Income Fund's shares represent shares of common stock with $.01 par value per share. Shares of Government Income Fund will be issued to Mortgage Income Fund's shareholders on the Closing Date. Each share represents an equal and proportionate interest in Government Income Fund with each other share of the same class. Shares entitle their holders to one vote per full share and fractional votes for fractional shares held. Each share of Government Income Fund has equal voting, dividend and liquidation rights with other shares, except that Class A, Class B and Class C have exclusive voting rights with respect to their respective distribution plan. Dividends paid by Government Income Fund with respect to each class of shares, to the extent any are paid, will be calculated in the same manner, at the same time, on the same day, and will be in the same amount, except that each class other than Class Z will bear its own distribution expenses, generally resulting in lower dividends for Class A, Class B and Class C shares of Government Income Fund compared to its Class Z shares. 17 TAX CONSIDERATIONS The Funds have received an opinion from Swidler Berlin Shereff Friedman, LLP, which opinion is based on representations made by each Fund, to the effect that (1) the proposed transaction described above will constitute a reorganization within the meaning of Section 368(a)(1)(C) of the Internal Revenue Code; (2) no gain or loss will be recognized by shareholders of Mortgage Income Fund upon receipt of shares of Government Income Fund solely in exchange for their shares of Mortgage Income Fund and the termination of Mortgage Income Fund pursuant to the Plan (Internal Revenue Code Section 354(a)(1)) and the termination of Mortgage Income Fund pursuant to the Plan; (3) no gain or loss will be recognized by Mortgage Income Fund upon the transfer of Mortgage Income Fund's assets to Government Income Fund solely in exchange for shares of Government Income Fund and the assumption by Government Income Fund of Mortgage Income Fund's liabilities, if any, and the subsequent distribution of those shares to Mortgage Income Fund's shareholders in liquidation of Mortgage Income Fund (Internal Revenue Code Sections 361(a), 361(c)(1) and 357(a)); (4) no gain or loss will be recognized by Government Income Fund upon the acquisition of such assets solely in exchange for Government Income Fund's shares and its assumption of Mortgage Income Fund's liabilities, if any (Internal Revenue Code Section 1032(a)); (5) Government Income Fund's basis for the assets received pursuant to the reorganization will be the same as the basis thereof in the hands of Mortgage Income Fund immediately before the reorganization, and the holding period of those assets in the hands of Government Income Fund will include the holding period thereof in Mortgage Income Fund's hands (Internal Revenue Code Sections 362(b) and 1223(2)); (6) Mortgage Income Fund's shareholders' basis for the shares of Government Income Fund to be received by them pursuant to the reorganization will be the same as their basis for the shares of Mortgage Income Fund and canceled in the reorganization (Internal Revenue Code Section 358(a)(1)); and (7) the holding period of the shares of Government Income Fund to be received by the shareholders of Mortgage Income Fund pursuant to the reorganization will include the period during which the shares of Mortgage Income Fund canceled in the reorganization were held, provided the latter shares were held as capital assets by the shareholders on the date of the reorganization (Internal Revenue Code Section 1223(1)). It should be noted that no ruling has been sought by the IRS and that an opinion of counsel is not binding on the IRS or any court. If the IRS were to successfully assert that the proposed transaction is taxable, then the proposed transaction would be treated as a taxable sale of Mortgage Income Fund's assets to Government Income Fund followed by the taxable liquidation of Mortgage Income Fund, and shareholders of Mortgage Income Fund would recognize gain or loss as a result of such transaction. CERTAIN COMPARATIVE INFORMATION ABOUT THE FUNDS ORGANIZATION. Government Income Fund and Mortgage Income Fund is each a Maryland corporation, and the rights of their shareholders are governed by their respective Articles of Incorporation, By-Laws and applicable Maryland law. CAPITALIZATION. Government Income Fund is authorized to issue 2 billion shares of common stock, par value $.01 per share. The shares are divided into four classes, designated Class A, Class B, Class C and Class Z, each consisting of 500 million authorized shares. Mortgage Income Fund is authorized to issue 500 million shares of common stock, par value $.01 per share. The shares are divided into four classes of shares, designated Class A, Class B, Class C and Class Z, each consisting of 125 million shares of common stock, $.01 par value per share. Each Fund presently offers the four classes of shares. 18 In addition, the Board of Government Income Fund may authorize an increase in the number of authorized shares and each Board may reclassify unissued shares to authorize additional classes of shares having terms and rights determined by the respective Board without shareholder approval. SHAREHOLDER MEETINGS AND VOTING RIGHTS. Generally, neither Fund is required to hold annual meetings of its shareholders. Each Fund is required to call a meeting of shareholders for the purpose of voting upon the question of removal of a Director when requested in writing to do so by the holders of at least 10% of the Fund's outstanding shares entitled to vote. In addition, each Fund is required to call a meeting of shareholders for the purpose of electing Directors if, at any time, less than a majority of the Directors holding office was elected by shareholders. Shareholders of the Government Income Fund and of Mortgage Income Fund are entitled to to one vote for each share on all matters submitted to a vote of their shareholders, respectively, under Maryland law. Under each Fund's Articles of Incorporation, approval of certain matters, such as an amendment to the Articles of Incorporation, merger, consolidation or transfer of all or substantially all assets, or a dissolution generally requires the affirmative vote of a majority of the votes entitled to be cast at a meeting at which a quorum is present (except as otherwise provided by statute). Government Income Fund's By-Laws and Mortgage Income Fund's By-Laws each provide that the presence in person or by proxy of the holders of record of a majority of the shares of the Fund's common stock issued and outstanding and entitled to vote shall constitute a quorum at a shareholders' meeting, except as otherwise provided in the Articles of Incorporation. SHAREHOLDER LIABILITY. Under Maryland law, shareholders of Mortgage Income Fund and of Government Income Fund have no personal liability as such for Mortgage Income Fund's and Government Income Fund's acts or obligations, respectively. LIABILITY AND INDEMNIFICATION OF DIRECTORS. Under Government Income Fund's Articles of Incorporation and Maryland law, a Director or officer of the Fund is not liable to Government Income Fund or its shareholders for monetary damages for breach of fiduciary duty as a Director or officer except to the extent such exemption from liability or limitation thereof is not permitted by law, including the Investment Company Act. The same is true for Directors of Mortgage Income Fund, under its Articles of Incorporation and Maryland law. Under the Investment Company Act, a Director may not be protected against liability to a Fund and its security holders to which he or she would otherwise be subject as a result of his or her willful misfeasance, bad faith or gross negligence in the performance of his or her duties, or by reason of reckless disregard of his or her obligations and duties. The staff of the Commission interprets the Investment Company Act to require additional limits on indemnification of Directors and officers. The foregoing is only a summary of certain comparative information about Mortgage Income Fund and Government Income Fund and their respective Articles of Incorporation and By-Laws. 19 PRO FORMA CAPITALIZATION The following table shows the capitalization of Government Income Fund and Mortgage Income Fund as of February 28, 1998 and the pro forma combined capitalization as if the reorganization had occurred on that date. These figures are unaudited.
GOVERNMENT INCOME FUND MORTGAGE INCOME FUND ------------------------------------------ ------------------------------------------ CLASS A CLASS B CLASS C CLASS Z CLASS A CLASS B CLASS C CLASS Z Net Assets (000).............. $ 819,536 $ 346,059 $ 2,840 $ 84,733 $ 89,821 $ 71,331 $ 971 $ 96 Net Asset Value per share..... $ 9.05 $ 9.05 $ 9.05 $ 9.04 $ 14.45 $ 14.42 $ 14.42 $ 14.47 Shares Outstanding (000)...... 90,606 38,227 314 9,377 6,216 4,948 67 7 PRO FORMA COMBINED ------------------------------------------ CLASS A CLASS B CLASS C CLASS Z Net Assets (000).............. $ 909,357 $ 417,390 $ 3,811 $ 84,829 Net Asset Value per share..... $ 9.05 $ 9.05 $ 9.05 $ 9.04 Shares Outstanding (000)...... 100,531 46,109 421 9,388
The following table shows the ratios of total expenses and of operating expenses to average net assets and the ratio of net investment income to average net assets of Government Income Fund for the fiscal year ended February 28, 1998 and of Mortgage Income Fund for the fiscal year ended December 31, 1997. The ratios are also shown on a pro forma combined basis. 20 INFORMATION ABOUT GOVERNMENT INCOME FUND FINANCIAL INFORMATION For additional financial information for Government Income Fund, see "Financial Highlights" in Government Income Fund's Prospectus, which accompanies this Prospectus and Proxy Statement. The financial information for the year ended February 28, 1998 has been audited by PricewaterhouseCoopers LLP, independent accountants, whose report thereon was unqualified. The following financial highlights contain selected data for a Class A, Class B, Class C and Class Z share outstanding, total return, ratios to average net assets and other supplemental data for the periods presented.
YEAR ENDED FEBRUARY 28, 1998 ------------------------------------------- CLASS A CLASS B CLASS C CLASS Z --------- --------- -------- -------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of year....... $ 8.76 $ 8.77 $ 8.77 $ 8.76 --------- --------- -------- -------- --------- --------- -------- -------- INCOME FROM INVESTMENT OPERATIONS: Net investment income.... 0.58 0.52 0.53 0.59 Net realized and unrealized gain (loss) on investment transactions............ 0.29 0.28 0.28 0.28 --------- --------- -------- -------- Total from investment operations.......... 0.87 0.80 0.81 0.87 --------- --------- -------- -------- LESS DISTRIBUTIONS: Dividends from net investment income....... (0.58) (0.52) (0.53) (0.59) --------- --------- -------- -------- Net asset value, end of period.................. $ 9.05 $ 9.05 $ 9.05 $ 9.04 --------- --------- -------- -------- --------- --------- -------- -------- TOTAL RETURN (a):........ 10.26% 9.40% 9.48% 10.30% RATIOS/SUPPLEMENTAL DATA: Net assets, end of year (000)................... $819,536 $346,059 $ 2,840 $ 84,733 Average net assets (000)................... $842,431 $385,145 $ 2,523 $ 71,425 Ratios to average net assets: Expenses, including distribution fees..... 0.86% 1.53% 1.46% 0.71% Expenses, excluding distribution fees..... 0.71% 0.71% 0.71% 0.71% Net investment income................ 6.52% 5.85% 5.92% 6.67% Portfolio turnover rate.................... 88% 88% 88% 88%
- ------------ (a) Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. 21 GENERAL For a discussion of the organization, classification and sub-classification of Government Income Fund, see "General Information" and "Fund Highlights" in Government Income Fund's Prospectus. INVESTMENT OBJECTIVE AND POLICIES For a discussion of Government Income Fund's investment objective and policies and risk factors associated with an investment in Government Income Fund, see "How the Fund Invests" in Government Income Fund's Prospectus. DIRECTORS For a discussion of the responsibilities of Government Income Fund's Board of Directors, see "How the Fund is Managed" in Government Income Fund's Prospectus. MANAGER AND PORTFOLIO MANAGER For a discussion of Government Income Fund's Manager, investment adviser and portfolio manager, Distributor and Transfer Agent, see "How the Fund is Managed" in Government Income Fund's Prospectus. PERFORMANCE For a discussion of Government Income Fund's performance during the fiscal year ended February 28, 1998, see Appendix A hereto. SHORT INTERMEDIATE SERIES' SHARES For a discussion of Government Income Fund's Class A, Class B, Class C and Class Z shares, including voting rights and the exchange privilege, and how the shares may be purchased and redeemed, see "Shareholder Guide" and "General Information" in Government Income Fund's Prospectus. NET ASSET VALUE For a discussion of how the offering price of Government Income Fund's Class A, Class B, Class C and Class Z shares is determined, see "How the Fund Values its Shares" in Government Income Fund's Prospectus. TAXES, DIVIDENDS AND DISTRIBUTIONS For a discussion of Government Income Fund's policy with respect to dividends and distributions and the tax consequences of an investment in Class A, Class B, Class C and Class Z shares, see "Taxes, Dividends and Distributions" in Government Income Fund's Prospectus. ADDITIONAL INFORMATION Government Income Fund is subject to the informational requirements of the Securities Exchange Act of 1934, as amended, and the Investment Company Act and in accordance therewith files reports and other information with the Commission. Proxy materials, reports and other information filed by Government Income Fund can be inspected and copied at the public reference facilities maintained by the Commission at Room 1024, 450 Fifth Street, N.W., Washington, D.C. 20549 and at the Commission's regional offices in New York (7 World Trade Center, Suite 1300, New York, New York 10048) and Chicago (Citicorp Center, Suite 1400, 500 West Madison Street, Chicago, Illinois 60661-2511). Copies of such material can be obtained at prescribed rates from the Public Reference Branch, Office of Consumer Affairs and Information Services, 22 Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. Shareholder inquiries should be addressed to Government Securities Trust at Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102, or by telephone, at (800) 225-1852 (toll-free) or, from outside the U.S.A., at (908) 417-7555 (collect). INFORMATION ABOUT MORTGAGE INCOME FUND FINANCIAL INFORMATION For financial information for Mortgage Income Fund, see "Financial Highlights" in Mortgage Income Fund's Prospectus dated March 3, 1998, its Annual Report to Shareholders for the fiscal year ended December 31, 1997 and its Semi-Annual Report to Shareholders for the six months ended June 30, 1998 which are available without charge upon request to Mortgage Income Fund. See "Additional Information" below. GENERAL For a discussion of the organization, classification and sub-classification of Mortgage Income Fund, see "General Information" and "Fund Highlights" in Mortgage Income Fund's Prospectus. INVESTMENT OBJECTIVE AND POLICIES For a discussion of Mortgage Income Fund's investment objective and policies and risk factors associated with an investment in Mortgage Income Fund, see "How the Fund Invests" in Mortgage Income Fund's Prospectus. TRUSTEES For a discussion of the responsibilities of Mortgage Income Fund's Board of Directors, see "How the Fund is Managed" in Mortgage Income Fund's Prospectus. MANAGER AND PORTFOLIO MANAGER For a discussion of Mortgage Income Fund's Manager, investment adviser and portfolio manager, Distributor and Transfer Agent, see "How the Fund is Managed" in Mortgage Income Fund's Prospectus. PERFORMANCE For a discussion of Mortgage Income Fund's performance during the fiscal year ended December 31, 1997 and for the six months ended June 30, 1998, see the Annual Report to Shareholders for the fiscal year ended December 31, 1997 and its Semi-Annual Report to Shareholders for the six months ended June 30, 1998, which are available without charge upon request to Mortgage Income Fund. See "Additional Information" below. MORTGAGE INCOME FUND'S SHARES For a discussion of Mortgage Income Fund's Class A, Class B, Class C and Class Z shares, including voting rights and the exchange privilege, and how the shares may be purchased and redeemed, see "Shareholder Guide" and "General Information" in Mortgage Income Fund's Prospectus. NET ASSET VALUE For a discussion of how the offering price of Mortgage Income Fund's Class A, Class B, Class C and Class Z shares is determined, see "How the Fund Values its Shares" in Mortgage Income Fund's Prospectus. 23 TAXES, DIVIDENDS AND DISTRIBUTIONS For a discussion of Mortgage Income Fund's policy with respect to dividends and distributions and the tax consequences of an investment in Class A, Class B, Class C and Class Z shares, see "Taxes, Dividends and Distributions" in Mortgage Income Fund's Prospectus. ADDITIONAL INFORMATION Additional information concerning Mortgage Income Fund is incorporated herein by reference from Mortgage Income Fund's current Prospectus dated March 3, 1998, as supplemented July 1, 1998, August 27, 1998 and September 1, 1998. Copies of Mortgage Income Fund's Prospectus (and supplements thereto) and Mortgage Income Fund's Annual Report to Shareholders for the fiscal year ended December 31, 1997 and Semi-Annual Report to Shareholders for the six-month period ended June 30, 1998 are available without charge upon oral or written request to Mortgage Income Fund. To obtain Mortgage Income Fund's Prospectus, Annual Report or Semi-Annual Report, call (800) 225-1852 or write to Prudential Mutual Fund Services LLC, Raritan Plaza One, Edison, New Jersey 08837. Shareholder inquiries should be addressed to Mortgage Income Fund at Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102, or by telephone, at (800) 225-1852 (toll-free) or, from outside the U.S.A., at (908) 417-7555 (collect). Mortgage Income Fund is subject to the informational requirements of the Securities Exchange Act of 1934, as amended, and the Investment Company Act and in accordance therewith files reports and other information with the Commission. Reports and other information filed by Mortgage Income Fund can be inspected and copied at the public reference facilities maintained by the Commission at Room 1024, 450 Fifth Street, N.W., Washington, D.C. 20549 and at the Commission's regional offices in New York (7 World Trade Center, Suite 1300, New York, New York 10048) and Chicago (Citicorp Center, Suite 1400, 500 West Madison Street, Chicago, Illinois 60661-2511). Copies of such material can also be obtained at prescribed rates from the Public Reference Branch, Office of Consumer Affairs and Information Services, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. VOTING INFORMATION If the accompanying form of Proxy is executed properly and returned, shares represented by it will be voted at the Meeting in accordance with the instructions on the Proxy. However, if no instructions are specified, shares will be voted for the proposal. A Proxy may be revoked at any time prior to the time it is voted by written notice to the Secretary of Mortgage Income Fund or by attendance at the Meeting. If sufficient votes to approve the proposal are not received, the persons named as proxies may propose one or more adjournments of the Meeting to permit further solicitation of Proxies. Any such adjournment will require the affirmative vote of a majority of those shares present at the Meeting or represented by proxy. Any questions as to an adjournment of the Meeting will be voted on by the persons named in the enclosed Proxy in the same manner that the Proxies are instructed to be voted. In the event that the Meeting is adjourned, the same procedures will apply at a later Meeting date. If a Proxy that is properly executed and returned is accompanied by instructions to withhold authority to vote (an abstention) or represents a broker "non-vote" (that is, a Proxy from a broker or nominee indicating that such person has not received instructions from the beneficial owner or other person entitled to vote shares on a particular matter with respect to which the broker or nominee does not have discretionary power), the shares represented thereby will be considered present for purposes 24 of determining the existence of a quorum for the transaction of business. Because approval of the proposed reorganization requires the affirmative vote of a majority of the total shares outstanding, an abstention or broker non-vote will have the effect of a vote against such proposed matters. The close of business on October 15, 1998 has been fixed as the record date for the determination of shareholders entitled to notice of, and to vote at, Mortgage Income Fund's Meeting. On that date, Mortgage Income Fund had Class A shares, Class B shares, Class C shares and Class Z shares outstanding and entitled to vote. Each share of Mortgage Income Fund will be entitled to one vote at Mortgage Income Fund's Meeting. It is expected that the Notice of Special Meeting, Prospectus and Proxy Statement and form of Proxy will be mailed to Mortgage Income Fund's shareholders on or about October , 1998. As of October 15, 1998, the following shareholders owned beneficially or of record 5% or more of the outstanding shares of any class of Mortgage Income Fund:
NAME SHARES CLASS % OWNERSHIP - ---------------------------------------- -------- -------- -----------
As of October 15, 1998, the Directors and officers of Mortgage Income Fund, as a group, owned less than 1% of the outstanding shares of any class of Mortgage Income Fund. As of October 15, 1998, the following shareholders owned beneficially or of record 5% or more of the outstanding shares of any class of Government Income Fund:
NAME SHARES CLASS % OWNERSHIP - ---------------------------------------- -------- ------ -----------
As of October 15, 1998, the Directors and officers of Government Income Fund, as a group, owned less than 1% of the outstanding shares of any class of Government Income Fund. 25 The expenses of reorganization and solicitation will be borne by Mortgage Income Fund and Government Income Fund in proportion to their respective assets and will include reimbursement to brokerage firms and others for expenses in forwarding proxy solicitation material to shareholders. Shareholder Communications Corporation, a proxy solicitation firm, has been retained to assist in the solicitation of Proxies for the Meeting. The fees and expenses of Shareholder Communications Corporation are not expected to exceed $27,000, excluding mailing and printing costs. The solicitation of Proxies will be largely by mail but may include telephonic, telegraphic or oral communication by regular employees of Prudential Securities and its affiliates, including PIFM. This cost, including specified expenses, also will be borne by Mortgage Income Fund and Government Income Fund in proportion to their respective assets. OTHER MATTERS No business other than as set forth herein is expected to come before the Meeting, but should any other matter requiring a vote of shareholders of Mortgage Income Fund arise, including any question as to an adjournment of the Meeting, the persons named in the enclosed Proxy will vote thereon according to their best judgment in the interests of Mortgage Income Fund, taking into account all relevant circumstances. SHAREHOLDERS' PROPOSALS A shareholder proposal intended to be presented at any subsequent meeting of the shareholders of Mortgage Income Fund must be received by Mortgage Income Fund a reasonable time before the Directors' solicitation relating to such meeting is made in order to be included in Mortgage Income Fund's Proxy Statement and form of Proxy relating to that meeting. The mere submission of a proposal by a shareholder does not guarantee that such proposal will be included in the proxy statement because certain rules under the federal securities laws must be complied with before inclusion of the proposal is required. In the event that the Plan is approved at this Meeting with respect to Mortgage Income Fund, it is not expected that there will be any future shareholder meetings of Mortgage Income Fund. It is the present intent of the Board of Directors' of each Fund not to hold annual meetings of shareholders unless the election of Directors' is required under the Investment Company Act nor to hold special meetings of shareholders unless required by the Investment Company Act or state law. S. JANE ROSE SECRETARY Dated: October 30, 1998 26 PRUDENTIAL GOVERNMENT INCOME FUND, INC. PERFORMANCE AT A GLANCE. Exceptionally subdued inflation in the U.S. and concern about economic upheaval in Asia fueled a strong rally in U.S. Treasuries and federal government agency securities over the past year. The Prudential Government Income Fund was well-positioned to take advantage of these gains during the 12-month period ended February 28, 1998. As a result, your Fund's Class A and Z shares provided double-digit returns that beat the average U.S. government bond fund tracked by Lipper Analytical Services, while Class B and C shares finished with competitive returns.
CUMULATIVE TOTAL RETURNS(1) AS OF 2/28/98 - --------------------------------------------------------------------------------------------------------------- One Five Ten Since Year Years Years Inception(2) - --------------------------------------------------------------------------------------------------------------- Class A 10.26% 34.51% N/A 86.14% Class B 9.40 29.95 97.48% 162.38 Class C 9.48 N/A N/A 29.59 Class Z 10.30 N/A N/A 13.77 Lipper General U.S. Government Bond Avg.(3) 9.76 32.48 107.63 ***
AVERAGE ANNUAL TOTAL RETURNS(1) AS OF 3/31/98 - --------------------------------------------------------------------------------------------------------------- One Five Ten Since Year Years Years Inception(2) - --------------------------------------------------------------------------------------------------------------- Class A 7.41% 5.23% N/A 7.38% Class B 6.26 5.20 7.24% 7.76 Class C 10.34 N/A N/A 7.39 Class Z 12.05 N/A N/A 6.47
DISTRIBUTIONS Total Distributions 30-Day & YIELDS Paid for 12 Mos. SEC Yield - ------------------------------------------------------------------------- AS OF 2/28/98 Class A $0.58 5.76% Class B $0.52 5.32 Class C $0.53 5.40 Class Z $0.59 6.15
Past performance is not indicative of future results. Principal and investment return will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. (1) Source: Prudential Investments Fund Management and Lipper Analytical Services. The cumulative total returns do not take into account sales charges. The average annual returns do take into account applicable sales charges. The Fund charges a maximum front-end sales load of 4% for Class A shares and a six-year, declining contingent deferred sales charge (CDSC) of 5%, 4%, 3%, 2%, 1% and 1% for Class B shares. Class C shares have a 1% CDSC for one year. Class B shares automatically convert to Class A shares on a quarterly basis, after approximately seven years. Class Z shares do not carry a sales charge or a distribution fee. (2) Inception dates: Class A, 1/22/90; Class B, 4/22/85; Class C, 8/1/94; Class Z, 3/4/96. (3) These are returns for all funds in each share class for the Lipper General U.S. Government Bond Average for one-, five- and 10-year categories. *** The Lipper Since Inception category return for Class A shares is 84.09%; for Class B shares is 177.61%; for Class C shares is 29.95% and for Class Z shares is 13.94% for all funds in each share class. [GRAPH] HOW INVESTMENTS COMPARED. (AS OF 2/28/98)
U.S. GENERAL GENERAL U.S. GROWTH BOND MUNI DEBT TAXABLE FUNDS FUNDS FUNDS MONEY FUNDS - ------------------------------------------------------------------------------------------ 12 mos 30.38 10.53 9.12 16.48 20 yrs 10.08 7.4 4.93 7.68
Source: Lipper Analytical Services. Financial markets change, so a mutual fund's past performance should never be used to predict future results. The risks to each of the investments listed above are different - we provide 12-month total returns for several Lipper mutual fund categories to show you that reaching for higher yields means tolerating more risk. The greater the risk, the larger the potential reward or loss. In addition, we've included historical 20-year average annual returns. These returns assume the reinvestment of dividends. U.S. Growth Funds will fluctuate a great deal. Investors have received higher historical total returns from stocks than from most other investments. Smaller capitalization stocks offer greater potential for long-term growth but may be more volatile than larger capitalization stocks. General Bond Funds provide more income than stock funds, which can help smooth out their total returns year by year. But their prices still fluctuate (sometimes significantly) and their returns have been historically lower than those of stock funds. General Municipal Debt Funds invest in bonds issued by state governments, state agencies and/or municipalities. This investment provides income that is usually exempt from federal and state income taxes. U.S. Taxable Money Funds attempt to preserve a constant share value; they don't fluctuate much in price but, historically, their returns have been generally among the lowest of the major investment categories. Appendix B AGREEMENT AND PLAN OF REORGANIZATION Agreement and Plan of Reorganization (Agreement) made as of the day of October, 1998, by and between, Prudential Mortgage Income Fund, Inc. (Mortgage Income Fund) and Prudential Government Income Fund (Government Income Fund) (Mortgage Income Fund and Government Income Fund collectively, the Funds and each individually, a Fund). Mortgage Income Fund and Government Income Fund are both corporations organized under the laws of the State of Maryland. Each Fund maintains its principal place of business at Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077. Shares of both Funds are divided into four classes, designated as Class A, Class B, Class C and Class Z. This Agreement is intended to be, and is adopted as, a plan of reorganization pursuant to Section 368(a)(1)(C) of the Internal Revenue Code of 1986, as amended (Internal Revenue Code). Upon receipt of such representations from each of the Funds as Swidler Berlin Shereff Friedman, LLP may require, Swidler Berlin Shereff Friedman, LLP will deliver the opinion referenced in paragraph 8.6 herein. The reorganization will comprise the transfer of the assets of Mortgage Income Fund in exchange for shares of Government Income Fund, and Government Income Fund's assumption of Mortgage Income Fund's liabilities, if any, and the constructive distribution, after the Closing Date hereinafter referred to, as a liquidating distribution of such shares of Government Income Fund to the shareholders of Mortgage Income Fund, and the termination of Mortgage Income Fund as provided herein, all upon the terms and conditions as hereinafter set forth. In consideration of the premises and of the covenants and agreements set forth herein, the parties covenant and agree as follows: 1. TRANSFER OF ASSETS OF MORTGAGE INCOME FUND IN EXCHANGE FOR SHARES OF GOVERNMENT INCOME FUND AND ASSUMPTION OF LIABILITIES, IF ANY, AND TERMINATION OF MORTGAGE INCOME FUND 1.1 Subject to the terms and conditions herein set forth and on the basis of the representations and warranties contained herein, Mortgage Income Fund agrees to sell, assign, transfer and deliver all its assets, as set forth in paragraph 1.2, to Government Income Fund, and Government Income Fund agrees (a) to issue and deliver to Mortgage Income Fund in exchange therefor the number of shares in Government Income Fund determined by dividing the net asset value of the Mortgage Income Fund allocable to Class A, Class B, Class C and Class Z shares and shares of Common Stock (computed in the manner and as of the time and date set forth in paragraph 2.1) by the net asset value allocable to a Class A, Class B, Class C and Class Z shares of Government Income Fund (rounded to the third decimal place) (computed in the manner and as of the time and date set forth in paragraph 2.2) and (b) to assume all of Mortgage Income Fund's liabilities, if any, as set forth in paragraph 1.3. Such transactions shall take place at the closing provided for in paragraph 3 (Closing). 1.2 The assets of Mortgage Income Fund to be acquired by Government Income Fund shall include without limitation all cash, cash equivalents, securities, receivables (including interest and dividends receivable) and other property of any kind owned by Mortgage Income Fund and any deferred or prepaid expenses shown as assets on the books of Mortgage Income Fund on the closing date provided in paragraph 3 (Closing Date). Government Income Fund has no plan or intent to sell or otherwise dispose of significant assets of Mortgage Income Fund, other than in the ordinary course of business. B-1 1.3 Except as otherwise provided herein, Government Income Fund will assume all debts, liabilities, obligations and duties of Mortgage Income Fund of whatever kind or nature, whether absolute, accrued, contingent or otherwise, whether or not determinable as of the Closing Date and whether or not specifically referred to in this Agreement; provided, however, that Mortgage Income Fund agrees to utilize its best efforts, to the extent practicable, to cause such Trust to discharge all of its known debts, liabilities, obligations and duties prior to the Closing Date. 1.4 On or immediately prior to the Closing Date, Mortgage Income Fund will declare and pay to its shareholders of record dividends and/or other distributions so that it will have distributed substantially all (and in any event not less than ninety-eight percent) of such Fund's investment company taxable income (computed without regard to any deduction for dividends paid), net tax-exempt interest income, if any, and realized net capital gains, if any, for all taxable years through its termination. 1.5 On a date (Termination Date), as soon after the Closing Date as is conveniently practicable but in any event within 30 days of the Closing Date, Mortgage Income Fund will distribute PRO RATA to its Class A, Class B, Class C and Class Z shareholders of record, determined as of the close of business on the Closing Date, the Class A, Class B, Class C and Class Z shares of Government Income Fund received by Mortgage Income Fund pursuant to paragraph 1.1 in exchange for their interest in Mortgage Income Fund. Such distribution will be accomplished by opening accounts on the books of Government Income Fund in the names of Mortgage Income Fund's shareholders and transferring thereto the shares credited to the account of Mortgage Income Fund on the books of Government Income Fund. Each account opened shall be credited with the respective PRO RATA number of Government Income Fund Class A, Class B, Class C and Class Z shares due Mortgage Income Fund's Class A, Class B, Class C and Class Z shareholders, respectively. Fractional shares of Government Income Fund shall be rounded to the third decimal place. Upon the receipt of an order from the Securities and Exchange Commission (SEC) indicating acceptance of the Form N-8F that Mortgage Income Fund must file pursuant to the Investment Company Act of 1940, as amended (Investment Company Act) to deregister as an investment company, Mortgage Income Fund will file with the Secretary of State of the State of Maryland a Certificate of Termination terminating Mortgage Income Fund , but in any event such termination will be completed within twelve months following the Closing Date. 1.6 Government Income Fund shall not issue certificates representing its shares in connection with such exchange. With respect to any Mortgage Income Fund shareholder holding Mortgage Income Fund certificates for shares of Common Stock as of the Closing Date, until Government Income Fund is notified by Mortgage Income Fund's transfer agent that such shareholder has surrendered his or her outstanding certificates for shares of Common Stock or, in the event of lost, stolen or destroyed certificates for shares of Common Stock, posted adequate bond or submitted a lost certificate form, as the case may be, Government Income Fund will not permit such shareholder to (1) receive dividends or other distributions on Government Income Fund shares in cash (although such dividends and distributions shall be credited to the account of such shareholder established on Government Income Fund's books pursuant to paragraph 1.5, as provided in the next sentence), (2) exchange Government Income Fund shares credited to such shareholder's account for shares of other Prudential Mutual Funds, or (3) pledge or redeem such shares. In the event that a shareholder is not permitted to receive dividends or other distributions on Government Income Fund shares in cash as provided in the preceding sentence, Government Income Fund shall pay such dividends or other distributions in additional Government Income Fund shares, notwithstanding any election such shareholder shall have made previously with respect to the payment of dividends or other distributions on shares of B-2 Mortgage Income Fund. Mortgage Income Fund will, at its expense, request its shareholders to surrender their outstanding Mortgage Income Fund certificates for shares of beneficial interest, post adequate bond or submit a lost certificate form, as the case may be. 1.7 Ownership of Government Income Fund shares will be shown on the books of the Government Income Fund's transfer agent. Shares of Government Income Fund will be issued in the manner described in Government Income Fund's then current prospectus and statement of additional information. 1.8 Any transfer taxes payable upon issuance of shares of Government Income Fund in exchange for shares of Mortgage Income Fund in a name other than that of the registered holder of the shares being exchanged on the books of Mortgage Income Fund as of that time shall be paid by the person to whom such shares are to be issued as a condition to the registration of such transfer. 1.9 Any reporting responsibility with the SEC or any state securities commission of Mortgage Income Fund is, and shall remain, the responsibility of Mortgage Income Fund up to and including the Termination Date. 1.10 All books and records of Mortgage Income Fund, including all books and records required to be maintained under the Investment Company Act and the rules and regulations thereunder, shall be available to Government Income Fund from and after the Closing Date and shall be turned over to Government Income Fund on or prior to the Termination Date. 2. VALUATION 2.1 The value of Mortgage Income Fund's assets and liabilities to be acquired and assumed, respectively, by Government Income Fund shall be the net asset value computed as of 4:15 p.m., New York time, on the Closing Date (such time and date being hereinafter called the Valuation Time), using the valuation procedures set forth in Mortgage Income Fund's then current prospectus and statement of additional information. 2.2 The net asset value of Class A, Class B, Class C and Class Z shares of Government Income Fund shall be the net asset value for Class A, Class B, Class C and Class Z shares as of the Valuation Time, using the valuation procedures set forth in Government Income Fund's then current prospectus and Government Income Fund's statement of additional information. 2.3 The number of Government Income Fund shares to be issued (including fractional shares, if any) in exchange for Mortgage Income Fund's net assets shall be calculated as set forth in paragraph 1.1. 2.4 All computations of net asset value shall be made by or under the direction of Prudential Investments Fund Management LLC (PIFM) in accordance with its regular practice as manager of the Funds. 3. CLOSING AND CLOSING DATE 3.1 The Closing Date shall be December 4, 1998 or such later date as the parties may agree. All acts taking place at the Closing shall be deemed to take place simultaneously as of the close of business on the Closing Date unless otherwise provided. The Closing shall be at the office of Government Income Fund or at such other place as the parties may agree. 3.2 State Street Bank and Trust Company (State Street), as custodian for Mortgage Income Fund, shall deliver to Government Income Fund at the Closing a certificate of an authorized officer of State Street stating that (a) Mortgage Income Fund's portfolio securities, cash and any other assets have been transferred in proper form to Government Income Fund on the Closing Date and (b) all necessary taxes, if any, have been paid, or provision for payment has been made, in conjunction with the transfer of portfolio securities. B-3 3.3 In the event that immediately prior to the Valuation Time (a) the New York Stock Exchange (NYSE) or other primary exchange is closed to trading or trading thereon is restricted or (b) trading or the reporting of trading on the NYSE or other primary exchange or elsewhere is disrupted so that accurate appraisal of the value of the net assets of Mortgage Income Fund and of the net asset value per share of Government Income Fund is impracticable, the Closing Date shall be postponed until the first business day after the date when such trading shall have been fully resumed and such reporting shall have been restored. 3.4 Mortgage Income Fund shall deliver to Government Income Fund on or prior to the Termination Date the names and addresses of each of the shareholders of Mortgage Income Fund and the number of outstanding shares owned by each such shareholder, all as of the close of business on the Closing Date, certified by the Secretary or Assistant Secretary of Mortgage Income Fund. Government Income Fund shall issue and deliver to Mortgage Income Fund at the Closing a confirmation or other evidence satisfactory to Mortgage Income Fund that shares of Government Income Fund have been or will be credited to Mortgage Income Fund's account on the books of Government Income Fund. At the Closing each party shall deliver to the other such bills of sale, checks, assignments, share certificates, receipts and other documents as such other party or its counsel may reasonably request to effect the transactions contemplated by this Agreement. 4. REPRESENTATIONS AND WARRANTIES 4.1 Mortgage Income Fund represents and warrants as follows: 4.1.1 Mortgage Income Fund is a business trust duly organized and validly existing under the laws of the State of Maryland. 4.1.2 Mortgage Income Fund is an open-end, management investment company duly registered under the Investment Company Act, and such registration is in full force and effect; 4.1.3 Mortgage Income Fund is not, and the execution, delivery and performance of this Agreement will not result, in violation of any provision of the Articles of Incorporation or By-Laws of Mortgage Income Fund or of any material agreement, indenture, instrument, contract, lease or other undertaking to which Mortgage Income Fund is a party or by which Mortgage Income Fund is bound; 4.1.4 All material contracts or other commitments to which Mortgage Income Fund, or the properties or assets of Mortgage Income Fund, is subject, or by which Mortgage Income Fund is bound except this Agreement will be terminated on or prior to the Closing Date without Mortgage Income Fund or Government Income Fund incurring any liability or penalty with respect thereto; 4.1.5 No material litigation or administrative proceeding or investigation of or before any court or governmental body is presently pending or to its knowledge threatened against Mortgage Income Fund or any of its properties or assets. Mortgage Income Fund knows of no facts that might form the basis for the institution of such proceedings, and is not a party to or subject to the provisions of any order, decree or judgment of any court or governmental body that materially and adversely affects its business or its ability to consummate the transactions herein contemplated; 4.1.6 The Portfolio of Investments, Statement of Assets and Liabilities, Statement of Operations, Statement of Cash Flows, Statement of Changes in Net Assets, and Financial Highlights of Mortgage Income Fund at December 31, 1997 and for the year then ended and the Notes thereto (copies of which have been furnished to Government Income Fund) have been audited by PricewaterhouseCoopers LLP, independent accountants, in accordance with generally accepted auditing standards. Such financial statements are prepared in accordance with generally accepted accounting principles and present fairly, B-4 in all material respects, the financial condition, results of operations, changes in net assets and financial highlights of Mortgage Income Fund as of and for the period ended on such date, and there are no material known liabilities of Mortgage Income Fund (contingent or otherwise) not disclosed therein; 4.1.7 Since , 1998, there has not been any material adverse change in Mortgage Income Fund's financial condition, assets, liabilities or business other than changes occurring in the ordinary course of business, or any incurrence by Mortgage Income Fund of indebtedness maturing more than one year from the date such indebtedness was incurred, except as otherwise disclosed to and accepted by Government Income Fund. For the purposes of this paragraph 4.1.7, a decline in net assets or change in the number of shares outstanding shall not constitute a material adverse change; 4.1.8 At the date hereof and at the Closing Date, all federal and other tax returns and reports of Mortgage Income Fund required by law to have been filed on or before such dates shall have been timely filed, and all federal and other taxes shown as due on said returns and reports shall have been paid insofar as due, or provision shall have been made for the payment thereof, and, to the best of Mortgage Income Fund's knowledge, all federal or other taxes required to be shown on any such return or report have been shown on such return or report, no such return is currently under audit and no assessment has been asserted with respect to such returns; 4.1.9 For each past taxable year since it commenced operations, Mortgage Income Fund has met the requirements of Subchapter M of the Internal Revenue Code for qualification and treatment as a regulated investment company and has elected to be treated as such and Mortgage Income Fund intends to meet those requirements for the current taxable year; and, for each past calendar year since it commenced operations, Mortgage Income Fund has made such distributions as are necessary to avoid the imposition of federal excise tax or has paid or provided for the payment of any excise tax imposed; 4.1.10 All issued and outstanding shares of Mortgage Income Fund are, and at the Closing Date will be, duly and validly authorized, issued and outstanding, fully paid and non-assessable. All issued and outstanding shares of Mortgage Income Fund will, at the Closing Date, be held in the name of the persons and in the amounts set forth in the list of shareholders submitted to Government Income Fund in accordance with the provisions of paragraph 3.4. Mortgage Income Fund does not have outstanding any options, warrants or other rights to subscribe for or purchase any shares, nor is there outstanding any security convertible into any of its shares, except for Class B shares of Mortgage Income Fund which have the conversion feature described in Mortgage Income Fund's Prospectus dated March 3, 1998; 4.1.11 At the Closing Date, the Mortgage Income Fund will have good and marketable title to the assets to be transferred to Government Income Fund pursuant to paragraph 1.1, and full right, power and authority to sell, assign, transfer and deliver such assets hereunder free of any liens, claims, charges or other encumbrances, and, upon delivery and payment for such assets, Government Income Fund will acquire good and marketable title thereto; 4.1.12 The execution, delivery and performance of this Agreement has been duly authorized by the Board of Trustees of Mortgage Income Fund and by all necessary action, other than shareholder approval, on the part of Mortgage Income Fund, and this Agreement constitutes a valid and binding obligation, subject to shareholder approval, of Mortgage Income Fund; 4.1.13 The information furnished and to be furnished by Mortgage Income Fund for use in applications for orders, registration statements, proxy materials and other documents that may be necessary in B-5 connection with the transactions contemplated hereby is and shall be accurate and complete in all material respects and is in compliance and shall comply in all material respects with applicable federal securities and other laws and regulations; and 4.1.14 On the effective date of the registration statement filed with the SEC by Government Income Fund on Form N-14 relating to the shares of Government Income Fund issuable hereunder, and any supplement or amendment thereto (Registration Statement), at the time of the meeting of the shareholders of Mortgage Income Fund and on the Closing Date, the Proxy Statement of Mortgage Income Fund, the Prospectus of Government Income Fund, and the Statement of Additional Information of Government Income Fund to be included in the Registration Statement (collectively, Proxy Statement) (i) will comply in all material respects with the provisions and regulations of the Securities Act of 1933, as amended (1933 Act), the Securities Exchange Act of 1934, as amended (1934 Act) and the Investment Company Act, and the rules and regulations under such Acts and (ii) will not contain any untrue statement of a material fact or omit to state a material fact required to be stated therein in light of the circumstances under which they were made or necessary to make the statements therein not misleading; provided, however, that the representations and warranties in this paragraph 4.1.14 shall not apply to statements in or omissions from the Proxy Statement and Registration Statement made in reliance upon and in conformity with information furnished by Government Income Fund for use therein. 4.2 Government Income Fund represents and warrants as follows: 4.2.1 Government Income Fund is a corporation duly organized and validly existing under the laws of the State of Maryland; 4.2.2 Government Income Fund is an open-end, management investment company duly registered under the Investment Company Act, and such registration is in full force and effect; 4.2.3 Government Income Fund is not, and the execution, delivery and performance of this Agreement will not result, in violation of any provision of the Articles of Incorporation or By-Laws of Government Income Fund or of any material agreement, indenture, instrument, contract, lease or other undertaking to which Government Income Fund is a party or by which Government Income Fund is bound; 4.2.4 No material litigation or administrative proceeding or investigation of or before any court or governmental body is presently pending or threatened against Government Income Fund or any of its properties or assets, except as previously disclosed in writing to Mortgage Income Fund. Except as previously disclosed in writing to Mortgage Income Fund, Government Income Fund knows of no facts that might form the basis for the institution of such proceedings, and Government Income Fund is not a party to or subject to the provisions of any order, decree or judgment of any court or governmental body that materially and adversely affects its business or its ability to consummate the transactions herein contemplated; 4.2.5 The Portfolio of Investments, Statement of Assets and Liabilities, Statement of Operations, Statement of Changes in Net Assets, and Financial Highlights of Government Income Fund at February 28, 1998, and for the fiscal year then ended and the Notes thereto (copies of which have been furnished to Mortgage Income Fund) have been audited by PricewaterhouseCoopers LLP, independent accountants, in accordance with generally accepted auditing standards. Such financial statements are prepared in accordance with generally accepted accounting principles and present fairly, in all material B-6 respects, the financial condition, results of operations, changes in net assets and financial highlights of Government Income Fund as of and for the period ended on such date, and there are no material known liabilities of Government Income Fund (contingent or otherwise) not disclosed therein; 4.2.6 Since February 28, 1998, there has not been any material adverse change in Government Income Fund's financial condition, assets, liabilities or business other than changes occurring in the ordinary course of business, or any incurrence by Government Income Fund of indebtedness maturing more than one year from the date such indebtedness was incurred, except as otherwise disclosed to and accepted by Mortgage Income Fund. For the purposes of this paragraph, a decline in net asset value per share or a decrease in the number of shares outstanding shall not constitute a material adverse change; 4.2.7 At the date hereof and at the Closing Date, all federal and other tax returns and reports of Government Income Fund required by law to have been filed on or before such dates shall have been filed, and all federal and other taxes shown as due on said returns and reports shall have been paid insofar as due, or provision shall have been made for the payment thereof, and, to the best of Government Income Fund's knowledge, all federal or other taxes required to be shown on any such return or report are shown on such return or report, no such return is currently under audit and no assessment has been asserted with respect to such returns; 4.2.8 For each past taxable year since it commenced operations, Government Income Fund has met the requirements of Subchapter M of the Internal Revenue Code for qualification and treatment as a regulated investment company and has elected to be treated as such and Government Income Fund intends to meet those requirements for the current taxable year; and, for each past calendar year since it commenced operations, Government Income Fund has made such distributions as are necessary to avoid the imposition of federal excise tax or has paid or provided for the payment of any excise tax imposed; 4.2.9 All issued and outstanding shares of Government Income Fund are, and at the Closing Date will be, duly and validly authorized, issued and outstanding, fully paid and non-assessable. Except as contemplated by this Agreement, Government Income Fund does not have outstanding any options, warrants or other rights to subscribe for or purchase any of its shares nor is there outstanding any security convertible into any of its shares, except for the Class B shares which have a conversion feature described in Government Income Fund's Prospectus dated April 30, 1998; 4.2.10 The execution, delivery and performance of this Agreement has been duly authorized by the Board of Directors of Government Income Fund and by all necessary corporate action on the part of Government Income Fund, and this Agreement constitutes a valid and binding obligation of Government Income Fund; 4.2.11 The shares of Government Income Fund to be issued and delivered to Mortgage Income Fund pursuant to this Agreement will, at the Closing Date, have been duly authorized and, when issued and delivered as provided in this Agreement, will be duly and validly issued and outstanding shares of Government Income Fund, fully paid and non-assessable; 4.2.12 The information furnished and to be furnished by Government Income Fund for use in applications for orders, registration statements, proxy materials and other documents which may be necessary in connection with the transactions contemplated hereby is and shall be accurate and complete in all material respects and is and shall comply in all material respects with applicable federal securities and other laws and regulations; and B-7 4.2.13 On the effective date of the Registration Statement, at the time of the meeting of the shareholders of Mortgage Income Fund and on the Closing Date, the Proxy Statement and the Registration Statement (i) will comply in all material respects with the provisions of the 1933 Act, the 1934 Act and the Investment Company Act and the rules and regulations under such Acts, (ii) will not contain any untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein not misleading and (iii) with respect to the Registration Statement, at the time it becomes effective, it will not contain an untrue statement of a material fact or omit to state a material fact necessary to make the statements therein in the light of the circumstances under which they were made, not misleading; provided, however, that the representations and warranties in this paragraph 4.2.13 shall not apply to statements in or omissions from the Proxy Statement and the Registration Statement made in reliance upon and in conformity with information furnished by Mortgage Income Fund for use therein. 5. COVENANTS OF GOVERNMENT INCOME FUND AND MORTGAGE INCOME FUND 5.1 Mortgage Income Fund and Government Income Fund each covenants to operate its respective business in the ordinary course between the date hereof and the Closing Date, it being understood that the ordinary course of business will include declaring and paying customary dividends and other distributions and such changes in operations as are contemplated by the normal operations of the Funds, except as may otherwise be allowed by paragraph 1.2 hereof or required by paragraph 1.4 hereof. 5.2 Mortgage Income Fund covenants to call a meeting of its shareholders to consider and act upon this Agreement and to take all other action necessary to obtain approval of the transactions contemplated hereby (including the determinations of its Directors as set forth in Rule 17a-8(a) under the Investment Company Act). 5.3 Mortgage Income Fund covenants that Government Income Fund shares to be received for and on behalf of Mortgage Income Fund in accordance herewith are not being acquired for the purpose of making any distribution thereof other than in accordance with the terms of this Agreement. 5.4 Mortgage Income Fund covenants that it will assist Government Income Fund in obtaining such information as Government Income Fund reasonably requests concerning the beneficial ownership of Mortgage Income Fund's shares. 5.5 Subject to the provisions of this Agreement, each Fund will take, or cause to be taken, all action, and will do, or cause to be done, all things, reasonably necessary, proper or advisable to consummate and make effective the transactions contemplated by this Agreement. 5.6 Mortgage Income Fund covenants to prepare the Proxy Statement in compliance with the 1934 Act, the Investment Company Act and the rules and regulations under each Act. 5.7 Mortgage Income Fund covenants that it will, from time to time, as and when requested by Government Income Fund, execute and deliver or cause to be executed and delivered all such assignments and other instruments, and will take or cause to be taken such further action, as Government Income Fund may deem necessary or desirable in order to vest in and confirm to Government Income Fund title to and possession of all the assets of Mortgage Income Fund to be sold, assigned, transferred and delivered hereunder and otherwise to carry out the intent and purpose of this Agreement. B-8 5.8 Government Income Fund covenants to use all reasonable efforts to obtain the approvals and authorizations required by the 1933 Act, the Investment Company Act (including the determinations of its Board of Directors as set forth in Rule 17a-8(a) thereunder) and such of the state Blue Sky or securities laws as it may deem appropriate in order to continue its operations after the Closing Date. 5.9 Government Income Fund covenants that it will, from time to time, as and when requested by Mortgage Income Fund, execute and deliver or cause to be executed and delivered all such assignments and other instruments, and will take and cause to be taken such further action, as Government Income Fund may deem necessary or desirable in order to (i) vest in and confirm to the Mortgage Income Fund title to and possession of all the shares of Government Income Fund to be transferred to the shareholders of Mortgage Income Fund pursuant to this Agreement and (ii) assume all of the liabilities of Mortgage Income Fund in accordance with this Agreement. 6. CONDITIONS PRECEDENT TO OBLIGATIONS OF MORTGAGE INCOME FUND The obligations of Mortgage Income Fund to consummate the transactions provided for herein shall be subject to the performance by Government Income Fund of all the obligations to be performed by them hereunder on or before the Closing Date and the following further conditions: 6.1 All representations and warranties of Government Income Fund contained in this Agreement shall be true and correct in all material respects as of the date hereof and, except as they may be affected by the transaction contemplated by this Agreement, as of the Closing Date with the same force and effect as if made on and as of the Closing Date. 6.2 Government Income Fund shall have delivered to Mortgage Income Fund on the Closing Date a certificate executed in its name by the President or a Vice President of Government Income Fund, in form and substance satisfactory to Mortgage Income Fund and dated as of the Closing Date, to the effect that the representations and warranties of Government Income Fund in this Agreement are true and correct at and as of the Closing Date, except as they may be affected by the transaction contemplated by this Agreement, and as to such other matters as Mortgage Income Fund shall reasonably request. 6.3 Mortgage Income Fund shall have received on the Closing Date a favorable opinion from Swidler Berlin Shereff Friedman, LLP, counsel to Government Income Fund, dated as of the Closing Date, to the effect that: 6.3.1 Government Income Fund is a corporation duly organized and validly existing under the laws of the State of Maryland with power under its Articles of Incorporation to own all of its properties and assets and, to the knowledge of such counsel, to carry on its business as presently conducted; 6.3.2 This Agreement has been duly authorized, executed and delivered by Government Income Fund and, assuming due authorization, execution and delivery of the Agreement by Mortgage Income Fund, is a valid and binding obligation of Government Income Fund enforceable in accordance with its terms, subject to bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and similar laws of general applicability relating to or affecting creditors' rights and to general equity principles; 6.3.3 The shares of the Government Income Fund to be distributed to the shareholders of Mortgage Income Fund under this Agreement, assuming their due authorization, execution and delivery as contemplated by this Agreement, will be validly issued and outstanding and fully paid and non-assessable, and no shareholder of Government Income Fund has any pre-emptive right to subscribe therefor or purchase such shares; B-9 6.3.4 The execution and delivery of this Agreement did not, and the consummation of the transactions contemplated hereby will not, (i) conflict with Government Income Fund's Declaration of Trust or By-Laws or (ii) result in a default or a breach of (a) the Management Agreement dated July 1, 1988 between Government Income Fund and Prudential Investments Fund Management LLC, as successor to Prudential Mutual Fund Management, Inc., (b) the Custodian Contract dated July 31, 1990 between Government Income Fund and State Street Bank and Trust Company, (c) the Distribution Agreement dated April 10, 1996 between Government Income Fund and Prudential Securities Incorporated and (d) the Transfer Agency and Service Agreement dated January 1, 1990 between Government Income Fund and Prudential Mutual Fund Services LLC, as successor to Prudential Mutual Fund Services, Inc.; provided, however, that such counsel may state that they express no opinion as to bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and similar laws of general applicability relating to or affecting creditors' rights and to general equity principles; 6.3.5 To the knowledge of such counsel, no consent, approval, authorization, filing or order of any court or governmental authority is required for the consummation by Government Income Fund of the transactions contemplated herein, except such as have been obtained under the 1933 Act, the 1934 Act and the Investment Company Act and such as may be required under state Blue Sky or securities laws; 6.3.6 Government Income Fund is registered with the SEC as an investment company, and, to the knowledge of such counsel, no order has been issued or proceeding instituted to suspend such registration; and 6.3.7 Such counsel knows of no litigation or government proceeding instituted or threatened against Government Income Fund that could be required to be disclosed in its registration statement on Form N-1A and is not so disclosed. Such opinion may rely on an opinion of Maryland Counsel to the extent it addresses Maryland law. 7. CONDITIONS PRECEDENT TO OBLIGATIONS OF GOVERNMENT INCOME FUND The obligations of Government Income Fund to complete the transactions provided for herein shall be subject to the performance by Mortgage Income Fund of all the obligations to be performed by it hereunder on or before the Closing Date and the following further conditions: 7.1 All representations and warranties of Mortgage Income Fund contained in this Agreement shall be true and correct in all material respects as of the date hereof and, except as they may be affected by the transaction contemplated by this Agreement, as of the Closing Date with the same force and effect as if made on and as of the Closing Date. 7.2 Mortgage Income Fund shall have delivered to Government Income Fund on the Closing Date a statement of the assets and liabilities, which shall be prepared in accordance with generally accepted accounting principles consistently applied, together with a list of the portfolio securities of Mortgage Income Fund showing the adjusted tax base of such securities by lot, as of the Closing Date, certified by the Treasurer of Mortgage Income Fund. 7.3 Mortgage Income Fund shall have delivered to Government Income Fund on the Closing Date a certificate executed in its name by its President or one of its Vice Presidents, in form and substance B-10 satisfactory to Government Income Fund and dated as of the Closing Date, to the effect that the representations and warranties of Mortgage Income Fund made in this Agreement are true and correct at and as of the Closing Date except as they may be affected by the transaction contemplated by this Agreement, and as to such other matters as Government Income Fund shall reasonably request. 7.4 On or immediately prior to the Closing Date, Mortgage Income Fund shall have declared and paid to its shareholders of record one or more dividends and/or other distributions so that it will have distributed substantially all (and in any event not less than ninety-eight percent) each of such Fund's investment company taxable income (computed without regard to any deduction for dividends paid), net tax-exempt interest income, if any, and realized net capital gain, if any, of Mortgage Income Fund for all completed taxable years from the inception of such Fund through December 31, 1997, and for the period from and after December 31, 1997 through the Closing Date. 7.5 Government Income Fund shall have received on the Closing Date a favorable opinion from Swidler Berlin Shereff Friedman, LLP, counsel to Mortgage Income Fund, dated as of the Closing Date, to the effect that: 7.5.1 Mortgage Income Fund is duly organized and validly existing under the laws of the State of Maryland with power under its Articles of Incorporation to own all of its properties and assets and, to the knowledge of such counsel, to carry on its business as presently conducted; 7.5.2 This Agreement has been duly authorized, executed and delivered by Mortgage Income Fund and constitutes a valid and legally binding obligation of Mortgage Income Fund enforceable against the assets of such Fund in accordance with its terms, subject to bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and similar laws of general applicability relating to or affecting creditors' rights and to general equity principles; 7.5.3 The execution and delivery of the Agreement did not, and the performance by Mortgage Income Fund of its obligations hereunder will not, (i) violate Mortgage Income Fund's Articles of Incorporation or By-Laws or (ii) result in a default or a breach of (a) the Management Agreement, dated May 2, 1988 between Mortgage Income Fund and Prudential Investments Fund Management LLC, as successor to Prudential Mutual Fund Management, Inc., (b) the Custodian Contract dated August 1, 1990 between Mortgage Income Fund and State Street Bank and Trust Company, (c) the Distribution Agreement dated May 9, 1996 between Mortgage Income Fund and Prudential Securities Incorporated and (d) the Transfer Agency and Service Agreement dated January 1, 1990 between Mortgage Income Fund and Prudential Mutual Fund Services LLC, as successor to Prudential Mutual Fund Services, Inc.; provided, however, that such counsel may state that insofar as performance by Mortgage Income Fund of its obligations under this Agreement is concerned they express no opinion as to bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and similar laws of general applicability relating to or affecting creditors' rights and to general equity principles; 7.5.4 All regulatory consents, authorizations and approvals required to be obtained by Mortgage Income Fund under the federal laws of the United States and the laws of the State of Maryland for the consummation of the transactions contemplated by this Agreement have been obtained; 7.5.5 Such counsel knows of no litigation or any governmental proceeding instituted or threatened against Mortgage Income Fund that would be required to be disclosed in its Registration Statement on Form N-1A and is not so disclosed; and B-11 7.5.6 Mortgage Income Fund is registered with the SEC as an investment company, and, to the knowledge of such counsel, no order has been issued or proceeding instituted to suspend such registration. Such opinion may rely on an opinion of Maryland counsel to the extent it addresses Maryland law, and may assume for purposes of the opinion given pursuant to paragraph 7.5.2 that New York law is the same as Illinois law. 8. FURTHER CONDITIONS PRECEDENT TO OBLIGATIONS OF GOVERNMENT INCOME FUND The obligations of Government Income Fund and Mortgage Income Fund hereunder are subject to the further conditions that on or before the Closing Date: 8.1 This Agreement and the transactions contemplated herein shall have been approved by the requisite vote of (a) the Boards of Directors of Government Income Fund and Mortgage Income Fund, as to the determinations set forth in Rule 17a-8(a) under the Investment Company Act, (b) the Board of Directors of Government Income Fund as to the assumption by Government Income Fund of the liabilities of Mortgage Income Fund and (c) the holders of the outstanding shares of Mortgage Income Fund in accordance with the provisions of Mortgage Income Fund's Articles of Incorporation and By-Laws, and certified copies of the resolutions evidencing such approvals shall have been delivered to Government Income Fund and Mortgage Income Fund, as applicable. 8.2 Any proposed change to Government Income Fund's operations that may be approved by the Board of Directors of Government Income Fund subsequent to the date of this Agreement but in connection with and as a condition to implementing the transactions contemplated by this Agreement, for which the approval of Government Income Fund shareholders is required pursuant to the Investment Company Act or otherwise, shall have been approved by the requisite vote of the holders of the outstanding shares of Government Income Fund in accordance with the Investment Company Act and the provisions of Maryland law, and certified copies of the resolution evidencing such approval shall have been delivered to Mortgage Income Fund. 8.3 On the Closing Date no action, suit or other proceeding shall be pending before any court or governmental agency in which it is sought to restrain or prohibit, or obtain damages or other relief in connection with, this Agreement or the transactions contemplated herein. 8.4 All consents of other parties and all consents, orders and permits of federal, state and local regulatory authorities (including those of the SEC and of state Blue Sky or securities authorities, including "no-action" positions of such authorities) deemed necessary by Government Income Fund or Mortgage Income Fund to permit consummation, in all material respects, of the transactions contemplated hereby shall have been obtained, except where failure to obtain any such consent, order or permit would not involve a risk of a material adverse effect on the assets or properties of Government Income Fund or Mortgage Income Fund, provided, that either party hereto may for itself waive any part of this condition. 8.5 The Registration Statement shall have become effective under the 1933 Act, and no stop order suspending the effectiveness thereof shall have been issued, and to the best knowledge of the parties hereto, no investigation or proceeding under the 1933 Act for that purpose shall have been instituted or be pending, threatened or contemplated. B-12 8.6 The Funds shall have received on or before the Closing Date an opinion of Swidler Berlin Shereff Friedman, LLP with respect to Mortgage Income Fund satisfactory to each of them, substantially to the effect that for federal income tax purposes: 8.6.1 The acquisition by Government Income Fund of the assets of Mortgage Income Fund solely in exchange for voting shares of Government Income Fund and the assumption by Government Income Fund of Mortgage Income Fund's liabilities, if any, followed by the distribution of Government Income Fund's voting shares as a liquidating distribution pro rata to Mortgage Income Fund's shareholders and the termination of Mortgage Income Fund pursuant to the Plan and constructively in exchange for Mortgage Income Fund's shares, will constitute a reorganization within the meaning of Section 368(a)(1)(C) of the Internal Revenue Code, and each Fund will be "a party to a reorganization" within the meaning of Section 368(b) of the Internal Revenue Code; 8.6.2 No gain or loss will be recognized by the shareholders of the Mortgage Income Fund upon receipt of the Government Income Fund Class A, Class B, Class C and Class Z shares solely in exchange for and in cancellation of the Mortgage Income Fund shares of Common Stock, as described above and in the Agreement; 8.6.3 No gain or loss will be recognized to the Mortgage Income Fund upon the transfer of all of its assets to the Government Income Fund solely in exchange for Class A, Class B, Class C and Class Z shares of the Government Income Fund and the assumption by the Government Income Fund of the liabilities, if any, of the Mortgage Income Fund. In addition, no gain or loss will be recognized to the Mortgage Income Fund on the distribution of such shares to the Mortgage Income Fund's shareholders in liquidation by terminating the Mortgage Income Fund; 8.6.4 No gain or loss will be recognized to Government Income Fund upon the acquisition of the assets of the Mortgage Income Fund solely in exchange for Class A shares of the Government Income Fund and the assumption of the Mortgage Income Fund's liabilities, if any; 8.6.5 The basis of the Mortgage Income Fund assets in the hands of the Government Income Fund will be the same as the basis of such assets in the hands of the Mortgage Income Fund immediately prior to the Reorganization; 8.6.6 The holding period of the Mortgage Income Fund assets in the hands of the Government Income Fund will include the period during which such assets were held by the Mortgage Income Fund immediately prior to the Reorganization; 8.6.7 The basis of the Government Income Fund Class A, Class B, Class C and Class Z shares to be received by shareholders of the Mortgage Income Fund will, in each instance, be the same as the basis of the Class A, Class B, Class C and Class Z shares of beneficial interest of the Mortgage Income Fund held by such shareholders and canceled in the Reorganization; and 8.6.8 The holding period of the Government Income Fund shares to be received by the shareholders of the Mortgage Income Fund will include the holding period of the shares of Common Stock of the Mortgage Income Fund canceled pursuant to the Reorganization, provided that the Government Income Fund shares were held as capital assets on the date of the Reorganization. 9. FINDER'S FEES AND EXPENSES 9.1 Each Fund represents and warrants to the other that there are no finder's fees payable in connection with the transactions provided for herein. B-13 9.2 The expenses incurred in connection with the entering into and carrying out of the provisions of this Agreement shall be allocated to Government Income Fund and Mortgage Income Fund pro rata in a fair and equitable manner in proportion to its assets. 10. ENTIRE AGREEMENT; SURVIVAL OF WARRANTIES 10.1 This Agreement constitutes the entire agreement between the Funds. 10.2 The representations, warranties and covenants contained in this Agreement or in any document delivered pursuant hereto or in connection herewith shall survive the consummation of the transactions contemplated hereunder. 11. TERMINATION Government Income Fund or Mortgage Income Fund may at its option terminate this Agreement at or prior to the Closing Date because of: 11.1 A material breach by the other of any representation, warranty or covenant contained herein to be performed at or prior to the Closing Date; or 11.2 A condition herein expressed to be precedent to the obligations of either party not having been met and it reasonably appearing that it will not or cannot be met; or 11.3 A mutual written agreement of Mortgage Income Fund and Government Income Fund. In the event of any such termination, there shall be no liability for damages on the part of either Fund (other than the liability of the Funds to pay their allocated expenses pursuant to paragraph 9.2) or any Director or officer of either Government Income Fund or Mortgage Income Fund. 12. AMENDMENT This Agreement may be amended, modified or supplemented only in writing by the parties; provided, however, that following the shareholders' meeting called by Mortgage Income Fund pursuant to paragraph 5.2, no such amendment may have the effect of changing the provisions for determining the number of shares of Government Income Fund to be distributed to Mortgage Income Fund's shareholders under this Agreement to the detriment of such shareholders without their further approval. 13. NOTICES Any notice, report, demand or other communication required or permitted by any provision of this Agreement shall be in writing and shall be given by hand delivery, or prepaid certified mail or overnight service addressed to Prudential Investments Fund Management LLC, Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102, Attention: S. Jane Rose. 14. HEADINGS; COUNTERPARTS; GOVERNING LAW; ASSIGNMENT 14.1 The paragraph headings contained in this Agreement are for reference purposes only and shall not affect in any way the meaning or interpretation of this Agreement. 14.2 This Agreement may be executed in any number of counterparts, each of which will be deemed an original. 14.3 This Agreement shall be governed by and construed in accordance with the laws of the State of New York. B-14 14.4 This Agreement shall bind and inure to the benefit of the parties and their respective successors and assigns, and no assignment or transfer hereof or of any rights or obligations hereunder shall be made by either party without the written consent of the other party. Nothing herein expressed or implied is intended or shall be construed to confer upon or give any person, firm or corporation other than the parties and their respective successors and assigns any rights or remedies under or by reason of this Agreement. 15. NO PERSONAL LIABILITY Each Fund's Articles of Incorporation provides that no shareholder of the Fund shall be subject to any personal liability whatsoever to any person in connection with the Fund's property, or the acts, obligations or affairs of the Fund. No Director, officer, employee or agent of the Fund shall be subject to any personal liability whatsoever to any person, other than the Fund or its shareholders, in connection with the Fund's property or the affairs of the Fund, save only that arising from bad faith, willful misfeasance, gross negligence or reckless disregard of his or its duty to such person; and all persons shall look solely to the Fund's property for satisfaction of claims of any nature arising in connection with the affairs of the Fund. If any shareholder, Director, officer, employee or agent, as such, of the Fund is made a party to any suit or proceeding to enforce any such liability, he or it shall not, on account thereof, be held to any personal liability. IN WITNESS WHEREOF, each of the parties has caused this Agreement to be executed by the President of each Fund. Prudential Mortgage Income Fund, Inc. By /s/ Richard A. Redeker --------------------------------- PRESIDENT Prudential Government Income Fund, Inc. By /s/ Richard A. Redeker --------------------------------- PRESIDENT B-15 TABLE OF CONTENTS
PAGE SYNOPSIS.............................................................. 2 General........................................................... 2 The Proposed Reorganization....................................... 2 Reasons for the Reorganization.................................... 3 Structure of Mortgage Income Fund and Government Income Fund...... 7 Investment Objectives and Policies................................ 8 Fees and Expenses................................................. 8 Management Fees............................................... 8 Distribution Fees............................................. 8 Other Expenses................................................ 9 Shareholder Transaction Expenses.............................. 10 Expense Ratios................................................ 10 Purchases and Redemptions......................................... 11 Exchange Privileges............................................... 12 Dividends and Distributions....................................... 12 Federal Tax Consequences of Proposed Reorganization............... 12 PRINCIPAL RISK FACTORS................................................ 13 Hedging and Return Enhancement Activities......................... 13 Ratings........................................................... 14 Foreign Securities................................................ 14 Tax Considerations................................................ 14 Realignment of Investment Portfolio............................... 15 THE PROPOSED TRANSACTION.............................................. 15 Agreement and Plan of Reorganization.............................. 15 Reasons for the Reorganization Considered by the Directors........ 16 Description of Securities to be Issued............................ 17 Tax Considerations................................................ 18 Certain Comparative Information About the Funds................... 18 Organization.................................................. 18 Capitalization................................................ 18 Shareholder Meetings and Voting Rights........................ 19 Shareholder Liability......................................... 19 Liability and Indemnification of Directors.................... 19 Pro Forma Capitalization.......................................... 20 INFORMATION ABOUT GOVERNMENT INCOME FUND.............................. 21 INFORMATION ABOUT MORTGAGE INCOME FUND................................ 23 VOTING INFORMATION.................................................... 24 OTHER MATTERS......................................................... 26 SHAREHOLDERS' PROPOSALS............................................... 26 APPENDIX A--Performance Overview...................................... A-1 APPENDIX B--Agreement and Plan of Reorganization...................... B-1 TABLE OF CONTENTS ENCLOSURES Prospectus of Government Income Fund dated April 30, 1998, as supplemented on July 1, 1998, August 27, 1998 and September 1, 1998.
PRUDENTIAL GOVERNMENT INCOME FUND, INC. STATEMENT OF ADDITIONAL INFORMATION DATED OCTOBER 30, 1998 ACQUISITION OF ASSETS OF MORTGAGE INCOME FUND, INC. GATEWAY CENTER THREE 100 MULBERRY STREET NEWARK, NEW JERSEY 07102-4077 (800) 225-1852 ------------------------ BY AND IN EXCHANGE FOR THE SHARES OF PRUDENTIAL GOVERNMENT INCOME FUND, INC. GATEWAY CENTER THREE 100 MULBERRY STREET NEWARK, NEW JERSEY 07102-4077 (800) 225-1852 This Statement of Additional Information, relating specifically to the proposed transfer of all the assets and the assumption of all of the liabilities, if any, of Prudential Mortgage Income Fund, Inc. (the Acquired Fund) by Prudential Government Income Fund, Inc. (the Acquiring Fund) consists of this cover page and the following described documents, each of which is attached hereto and incorporated by reference. 1. Pro Forma Financial Statements as of and at February 28, 1998. 2. The Statement of Additional Information of the Acquiring Fund dated April 30, 1998. 3. The Annual Report to Shareholders of the Acquiring Fund for the fiscal year ended February 28, 1998. 4. The Annual Report to Shareholders of the Acquired Fund for the fiscal year ended December 31, 1997. 5. The Semi-Annual Report to Shareholders of the Acquired Fund for the six months ended June 30, 1998. The Statement of Additional Information is not a prospectus. A Prospectus and Proxy Statement dated October 30, 1998 relating to the above referenced matter may be obtained from the Acquiring Fund without charge by writing or calling Prudential Government Income Fund, Inc. at the address or telephone number listed above. This Statement of Additional Information relates to, and should be read in conjunction with, the Prospectus and Proxy Statement. FINANCIAL STATEMENTS PRO-FORMA FINANCIAL STATEMENTS PRO-FORMA PORTFOLIO OF INVESTMENTS FEBRUARY 28, 1998 (UNAUDITED)
PRINCIPAL (000) DESCRIPTION VALUE - ----------------------------------- ----------------------------------------- ----------------------------------------------- GOVERNMENT MORTGAGE PRO GOVERNMENT MORTGAGE PRO INCOME INCOME FORMA INCOME INCOME FORMA PORTFOLIO PORTFOLIO COMBINED PORTFOLIO PORTFOLIO COMBINED - ----------- --------- ----------- --------------- ------------- --------------- LONG-TERM INVESTMENTS--94.8% ASSET-BACKED SECURITIES--1.8% Aesop Funding II LLC, Series 1997-1, Class A2, $ 10,000 $ 10,000 6.40%, 10/20/03........................ $ 10,109,677 $ 10,109,677 Chase Manhattan Credit Card Trust, $ 1,400 1,400 Ser. 96-2 A, 5.955%, 12/15/02.......... $ 1,407,000 1,407,000 ContiMortgage Home Equity Loan Trust, 2,875 2,875 Ser. 97-1 M2, 7.67%, 3/15/28........... 2,958,555 2,958,555 Federal Home Loan Mortgage Corp. Loan Receivables Trust, 4,000 4,000 Ser. 97-B, C, 7.40%, 9/15/19........... 4,136,250 4,136,250 Money Store Home Impt. Ln. Trust, 6,125 6,125 Ser. 97-1 M2, 8.07%, 5/15/23........... 6,450,391 6,450,391 --------------- ------------- --------------- Total asset-backed securities (cost $24,458,088)..................... 10,109,677 14,952,196 25,061,873 --------------- ------------- --------------- COLLATERIZED MORTGAGE OBLIGATIONS--5.7% Federal National Mortgage Association, 37,000 37,000 6.425%, 2/17/30........................ 37,138,750 37,138,750 GMAC Commercial Mortgage Securities, Inc., Series 1997-C1, Class A3, 6.869%, 20,000 20,000 8/15/07................................ 20,706,250 20,706,250 ICI Funding Corp. Secured Asset Corp., 4,913 4,913 Ser. 97-2 1A4, 7.60%, 7/25/28.......... 5,002,048 5,002,048 Resolution Trust Corp., Series 1994-1, Class B2, 5,125 5,125 7.75%, 9/25/29......................... 5,291,838 5,291,838 Ryland Mortgage Participation Securities, Series 1993-3, Class A-3, 7.54%, 2,643 2,643 9/25/24................................ 2,668,906 2,668,906 Merrill Lynch Mortgage Investors, Inc., 52,605 52,605 Ser. 96-C2, 1.535%, 11/21/28, I/O...... 4,545,372 4,545,372 Structured Asset Securities Corp., Series 1995-C1, Class C, 5,000 5,000 7.375%, 9/25/24........................ 5,039,453 5,039,453 --------------- ------------- --------------- Total collateralized mortgage obligations (cost $79,219,784)..................... 70,845,197 9,547,420 80,392,617 --------------- ------------- ---------------
2 PRO-FORMA FINANCIAL STATEMENTS PRO-FORMA PORTFOLIO OF INVESTMENTS FEBRUARY 28, 1998 (UNAUDITED)
PRINCIPAL (000) DESCRIPTION VALUE - ----------------------------------- ----------------------------------------- ----------------------------------------------- GOVERNMENT MORTGAGE PRO GOVERNMENT MORTGAGE PRO INCOME INCOME FORMA INCOME INCOME FORMA PORTFOLIO PORTFOLIO COMBINED PORTFOLIO PORTFOLIO COMBINED - ----------- --------- ----------- --------------- ------------- --------------- CORPORATE BONDS--12.5% Associates Corp. of North America, $ 15,000 $ 15,000 5.96%, 5/15/37......................... $ 15,225,000 $ 15,225,000 Ford Motor Credit Corp., 25,000 25,000 7.32%, 5/23/02......................... 25,250,000 25,250,000 Merck and Co., 17,000 $ 5,000 22,000 5.76%, 5/03/37......................... 17,340,000 $ 5,100,000 22,440,000 New Jersey Economic Development 105,000 105,000 Authority, Series A, 7.425%, 2/15/29... 115,024,245 115,024,245 --------------- ------------- --------------- Total Corporate Bonds (cost $172,478,100).................... 172,839,245 5,100,000 177,939,245 --------------- ------------- --------------- U.S. GOVERNMENT AGENCY MORTGAGE PASS-THROUGH OBLIGATIONS--29.8% Federal Home Loan Mortgage Corp., 1,005 1,005 7.50%, 2/01/22 - 4/01/25............... 1,033,630 1,033,630 6,828 6,828 8.00%, 1/01/22 - 5/01/23............... 7,114,140 7,114,140 4,390 4,390 8.50%, 6/01/07 - 4/01/20............... 4,641,347 4,641,347 2,001 2,001 11.50%, 10/01/19....................... 2,287,437 2,287,437 Federal National Mortgage Association, 6,500 6,500 6.425%, 2/17/30........................ 6,524,375 6,524,375 22,510 22,510 6.50%, 5/01/11 - 6/01/24............... 22,403,627 22,403,627 47,731 7 47,738 7.00%, 7/01/03 - 9/01/26............... 48,418,547 6,993 48,425,540 31,638 31,638 7.125%, 2/01/07........................ 33,111,104 33,111,104 43,100 24,571 67,671 7.50%, 4/01/07 - 1/01/2099............. 44,500,297 25,303,129 69,803,426 19 19 8.00%, 10/01/24........................ 19,594 19,594 33,873 33,873 8.50%, 6/01/17 - 3/01/25............... 35,618,750 35,618,750 8,284 8,284 9.00%, 8/01/24 - 4/01/25............... 8,811,168 8,811,168 1,681 1,681 9.50%, 10/01/19 - 3/01/25.............. 1,800,031 1,800,031 Government National Mortgage Association, 56,499 56,499 7.00%, 2/15/09 - 1/15/28............... 57,272,946 57,272,946 19,479 17,773 37,252 7.50%, 5/15/02 - 11/15/24.............. 20,038,802 18,344,867 38,383,669 1,100 30,009 31,109 8.00%, 2/15/04 - 5/15/24............... 1,147,652 31,251,813 32,399,465 17,262 12,024 29,286 9.00%, 4/15/01 - 4/15/25............... 18,165,122 12,920,072 31,085,194 16,211 16,211 9.50%, 10/15/09 - 12/15/17............. 17,674,119 17,674,119 Government National Mortgage Association II, 2,740 2,740 9.50%, 5/20/18 - 8/20/21............... 2,954,496 2,954,496 --------------- ------------- --------------- Total U.S. government agency mortgage pass-through obligations (cost $403,286,720).................... 326,993,215 94,370,843 421,364,058 --------------- ------------- ---------------
3 PRO-FORMA FINANCIAL STATEMENTS PRO-FORMA PORTFOLIO OF INVESTMENTS FEBRUARY 28, 1998 (UNAUDITED)
PRINCIPAL (000) DESCRIPTION VALUE - ----------------------------------- ----------------------------------------- ----------------------------------------------- GOVERNMENT MORTGAGE PRO GOVERNMENT MORTGAGE PRO INCOME INCOME FORMA INCOME INCOME FORMA PORTFOLIO PORTFOLIO COMBINED PORTFOLIO PORTFOLIO COMBINED - ----------- --------- ----------- --------------- ------------- --------------- U.S. GOVERNMENT OBLIGATIONS--20.6% United States Treasury Bonds, $ 21,000 $ 21,000 6.125%, 11/15/27....................... $ 21,587,370 $ 21,587,370 10,000 10,000 6.625%, 2/15/27........................ 10,882,800 10,882,800 $ 2,000 2,000 7.125%, 2/15/23........................ $ 2,287,820 2,287,820 3,000 3,000 7.625%, 2/15/25........................ 3,651,090 3,651,090 25,000 25,000 8.125%, 8/15/19........................ 31,363,250 31,363,250 1,860 1,860 12.00%, 8/15/13........................ 2,744,374 2,744,374 45,000 45,000 12.50%, 8/15/14........................ 69,581,250 69,581,250 3,000 3,000 12.375%, 5/15/04....................... 4,040,610 4,040,610 20,000 20,000 12.75%, 11/15/10....................... 28,550,000 28,550,000 United States Treasury Notes, 32,000 32,000 5.50%, 2/29/00......................... 31,975,040 31,975,040 11,000 6,000 17,000 5.50%, 1/31/03......................... 10,953,580 5,974,680 16,928,260 18,000 11,000 29,000 6.125%, 8/15/07........................ 18,565,380 11,345,510 29,910,890 10,000 10,000 6.25%, 10/31/01........................ 10,207,800 10,207,800 20,000 20,000 12.375%, 5/15/04....................... 26,937,400 26,937,400 United States Treasury Strips, 800 800 Zero Coupon, 8/15/08................... 437,272 437,272 700 700 Zero Coupon, 8/15/11................... 315,490 315,490 500 500 Zero Coupon, 11/15/11.................. 221,945 221,945 --------------- ------------- --------------- Total U.S. government obligations (cost $289,765,431).................... 267,974,041 23,648,620 291,622,661 --------------- ------------- --------------- U.S. GOVERNMENT AGENCY SECURITIES--18.0% Federal Home Loan Bank, 1,000 1,000 6.78%, 7/24/02......................... 1,000,940 1,000,940 Federal National Mortgage Association, 42,350 42,350 5.70%, 1/22/03......................... 41,820,625 41,820,625 20,000 20,000 6.30%, 9/25/02......................... 20,115,600 20,115,600 51,125 51,125 6.56%, 8/27/04......................... 51,851,934 51,851,934 Small Business Administration, 19,346 19,346 Series 1995-20B, 8.15%, 2/01/15........ 20,973,087 20,973,087 22,952 22,952 Series 1995-20L, 6.45%, 12/01/15....... 23,108,382 23,108,382 32,940 32,940 Series 1996-20H, 7.25%, 8/01/16........ 34,484,746 34,484,746 19,171 19,171 Series 1996-20K, 6.95%, 11/01/16....... 19,798,009 19,798,009 10,125 10,125 Series 1997-20A, 7.15%, 1/01/17........ 10,611,786 10,611,786 Tennessee Valley Authority, 600 600 Series 1993-D, 7.25%, 7/15/43.......... 625,440 625,440 30,000 30,000 Series 1995-B, 6.235%, 7/15/45......... 30,513,000 30,513,000 --------------- ------------- --------------- Total U.S. government agency securities (cost $251,045,078).................... 254,903,549 254,903,549 --------------- ------------- ---------------
4 PRO-FORMA FINANCIAL STATEMENTS PRO-FORMA PORTFOLIO OF INVESTMENTS FEBRUARY 28, 1998 (UNAUDITED)
PRINCIPAL (000) DESCRIPTION VALUE - ----------------------------------- ----------------------------------------- ----------------------------------------------- GOVERNMENT MORTGAGE PRO GOVERNMENT MORTGAGE PRO INCOME INCOME FORMA INCOME INCOME FORMA PORTFOLIO PORTFOLIO COMBINED PORTFOLIO PORTFOLIO COMBINED - ----------- --------- ----------- --------------- ------------- --------------- U.S. GOVERNMENT AGENCY--STRIPPED SECURITY--5.5% Federal National Mortgage Association, $ 9,045 $ 9,045 Zero Coupon, 10/08/06.................. $ 5,438,306 $ 5,438,306 6,045 6,045 Zero Coupon, 10/08/07.................. 3,396,504 3,396,504 4,745 4,745 Zero Coupon, 4/08/08................... 2,586,025 2,586,025 9,045 9,045 Zero Coupon, 4/08/10................... 4,317,541 4,317,541 Financing Corp., 5,000 5,000 Zero Coupon, 3/07/04................... 3,516,450 3,516,450 Israel AID, 46,100 46,100 Zero Coupon, 2/15/09................... 23,997,816 23,997,816 25,584 25,584 Zero Coupon, 8/15/09................... 12,898,429 12,898,429 37,600 37,600 Zero Coupon, 5/15/15................... 13,854,848 13,854,848 46,100 46,100 Zero Coupon, 2/15/26................... 8,229,772 8,229,772 --------------- ------------- --------------- Total U.S. government agency--stripped security (cost $67,162,168)............ 78,235,691 78,235,691 --------------- ------------- --------------- SUPRANATIONAL BOND--0.9% International Bank For Reconstruction & Development, 8.625%, 10/15/16 10,000 10,000 (cost $12,400,900)..................... 12,458,100 12,458,100 --------------- ------------- --------------- TOTAL LONG-TERM INVESTMENTS (cost $1,299,816,269).................. 1,194,358,715 $ 147,619,079 1,341,977,794 --------------- ------------- --------------- SHORT-TERM INVESTMENTS--5.8% REPURCHASE AGREEMENT--5.8% Joint Repurchase Agreement Account, 60,446 $ 5,187 65,633 5.634%, 3/02/98........................ 60,446,000 5,187,000 65,633,000 16,000 16,000 UBS Securities, 5.67%, 3/02/98........... 16,000,000 16,000,000 --------------- ------------- --------------- Total repurchase agreements (cost $81,633,000)..................... 60,446,000 21,187,000 81,633,000 --------------- ------------- --------------- TOTAL INVESTMENTS--100.6% (COST $1,381,449,269).................... 1,254,804,715 168,806,079 1,423,610,794 LIABILITIES IN EXCESS OF OTHER ASSETS--(0.6%)........................ (1,636,959) (6,587,020) (8,223,979) --------------- ------------- --------------- NET ASSETS--100%......................... $ 1,253,167,756 $ 162,219,059 $ 1,415,386,815 --------------- ------------- --------------- --------------- ------------- ---------------
5 PRO-FORMA FINANCIAL STATEMENTS PRO-FORMA STATEMENT OF ASSETS AND LIABILITIES FEBRUARY 28, 1998 (UNAUDITED)
PRUDENTIAL PRUDENTIAL GOVERNMENT MORTGAGE INCOME INCOME PRO FORMA FUND FUND COMBINED --------------- ------------- --------------- ASSETS Investments, at value (cost $1,214,834,143, $166,615,126 and $1,381,449,269 respectively)........... $1,254,804,715 $168,806,079 $ 1,423,610,794 Cash.................................... -- 6,064 6,064 Interest receivable..................... 9,232,873 1,012,075 10,244,948 Receivable for investments sold......... 69,727,147 12,009,858 81,737,005 Receivable for Fund shares sold......... 1,306,597 5,378 1,311,975 Stock loan receivable................... -- 16,956 16,956 Due from broker--variation margin....... -- 4,844 4,844 Deferred expenses and other assets...... 29,109 3,875 32,984 --------------- ------------- --------------- Total assets........................ 1,335,100,441 181,865,129 1,516,965,570 --------------- ------------- --------------- LIABILITIES Bank overdraft.......................... 38,809,104 -- 38,809,104 Payable for investments purchased....... 32,025,711 18,600,771 50,626,482 Payable for dollar roll purchased....... 5,679,896 -- 5,679,896 Payable for Fund shares reacquired...... 2,024,294 349,738 2,374,032 Accrued expenses and other liabilities............................ 1,886,660 352,973 2,239,633 Dividends payable....................... 656,503 168,531 825,034 Management fee payable.................. 483,797 76,463 560,260 Distribution fee payable................ 317,201 59,464 376,665 Due to broker variation margin.......... 49,519 -- 49,519 Deferred directors' fees................ -- 38,130 38,130 --------------- ------------- --------------- Total liabilities................... 81,932,685 19,646,070 101,578,755 --------------- ------------- --------------- NET ASSETS.............................. $1,253,167,756 $162,219,059 $ 1,415,386,815 --------------- ------------- --------------- --------------- ------------- --------------- Net assets were comprised of: Common stock/shares of beneficial interest at par.................... $ 1,385,232 $ 112,383 $ 1,564,480 Paid in capital in excess of par.... 1,342,841,205 178,428,264 1,521,202,604 --------------- ------------- --------------- 1,344,226,437 178,540,647 1,522,767,084 Undistributed net investment income..... -- 893,762 893,762 Accumulated net realized gain (loss) on investment............................. (131,040,581) (19,406,303) (150,446,884) Net unrealized appreciation of investments............................ 39,981,900 2,190,953 42,172,853 --------------- ------------- --------------- Net assets, February 28, 1998........... $1,253,167,756 $162,219,059 $ 1,415,386,815 --------------- ------------- --------------- --------------- ------------- --------------- Class A: Net asset value and redemption price per share.......................... $ 9.05 $ 14.45 $ 9.05 Maximum sales charge (4.00% of offering price).................... 0.38 0.60 .38 --------------- ------------- --------------- Maximum offering price.............. $ 9.43 $ 15.05 $ 9.43 --------------- ------------- --------------- --------------- ------------- --------------- Shares outstanding 90,606,290, 6,237,712 and 100,531,288 respectively. Class B: Net asset value, offering price and redemption price per share.......... $ 9.05 $ 14.42 $ 9.05 --------------- ------------- --------------- --------------- ------------- --------------- Shares outstanding 38,226,563, 5,081,464 and 46,108,434 respectively. Class C: Net asset value, offering price and redemption price per share.......... $ 9.05 $ 14.42 $ 9.05 --------------- ------------- --------------- --------------- ------------- --------------- Shares outstanding 313,687, 62,370 and 420,951 respectively. Class Z: Net asset value, offering price and redemption price per share.......... $ 9.04 $ 14.47 $ 9.04 --------------- ------------- --------------- --------------- ------------- --------------- Shares outstanding 9,376,690, 2,670 and 9,387,326 respectively.
6 PRO-FORMA FINANCIAL STATEMENTS PRO FORMA STATEMENT OF OPERATIONS YEAR ENDED FEBRUARY 28, 1998 (UNAUDITED)
PRUDENTIAL PRUDENTIAL GOVERNMENT INCOME MORTGAGE INCOME PRO FORMA PRO FORMA FUND FUND ADJUSTMENTS COMBINED ----------------- --------------- ------------ ------------ NET INVESTMENT INCOME Income Interest and discount earned......................... $96,024,178 $12,989,251 -- $109,013,429 ----------------- --------------- ------------ ------------ Expenses Distribution Fee--Class A............................ 1,263,646 136,128 1,399,774 Distribution Fee--Class B............................ 3,177,448 602,298 $ 123,000(a) 3,902,746 Distribution Fee--Class C............................ 18,923 6,533 25,456 Management fee....................................... 6,507,621 859,747 (39,728)(b) 7,327,640 Transfer agent's fees & expenses..................... 2,008,000 331,000 (189,000)(c) 2,150,000 Reports to shareholders.............................. 305,000 89,000 (69,000)(c) 325,000 Custodian's fees & expenses.......................... 175,000 147,000 (142,000)(c) 180,000 Registration fees.................................... 40,000 72,000 (57,000)(c) 55,000 Directors'/Trustees' fees............................ 44,000 24,000 (20,000)(c) 48,000 Legal fees........................................... 88,000 30,000 (23,000)(c) 95,000 Audit fee............................................ 44,000 25,000 (21,000)(c) 48,000 Insurance expense.................................... 23,000 0 -- 23,000 Miscellaneous........................................ 11,610 14,191 (13,801)(c) 12,000 ----------------- --------------- ------------ ------------ Total Expenses..................................... 13,706,248 2,336,897 (451,529) 15,591,616 Less: Management fee waiver............................ -- (178,075) 178,075(d) -- ----------------- --------------- ------------ ------------ Net Expenses....................................... 13,706,248 2,158,822 (273,454) 15,591,611 ----------------- --------------- ------------ ------------ Net investment income.................................. 82,317,930 10,830,429 273,454 93,421,813 ----------------- --------------- ------------ ------------ REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS Net realized gain (loss) on: Investment transactions.............................. 12,654,531 1,488,347 -- 14,142,878 Financial futures contracts.......................... (5,079,275) (199,073) -- (5,278,348) ----------------- --------------- ------------ ------------ 7,575,256 1,289,274 -- 8,864,530 ----------------- --------------- ------------ ------------ Net change in unrealized appreciation/depreciation of: Investment transactions.............................. 32,404,595 712,580 -- 33,117,175 Financial futures contracts.......................... 11,328 0 -- 11,328 ----------------- --------------- ------------ ------------ 32,415,923 712,580 -- 33,128,503 ----------------- --------------- ------------ ------------ Net gain (loss) on investments....................... 39,991,179 2,001,854 -- 41,993,033 ----------------- --------------- ------------ ------------ NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS.............................. $122,309,109 $12,832,283 $ 273,454 $135,414,846 ----------------- --------------- ------------ ------------ ----------------- --------------- ------------ ------------
- ------------------------ (a) Adjustment to reflect 0.075% increase in Class B 12b-1 fee. (b) Adjustment to reflect management fee based on combined average net assets. (c) Adjustment to reflect elimination of duplicative expenses. (d) Adjustment to reflect elimination of management fee waiver. 7 NOTES TO FINANCIAL STATEMENTS PRUDENTIAL GOVERNMENT INCOME FUND, INC. Prudential Government Income Fund, (the "Fund") is registered under the Investment Company Act of 1940 as a diversified, open-end management investment company. Investment operations commenced on April 22, 1985. The Fund's investment objective is to seek a high current return. The Fund will seek to achieve this objective by investing primarily in U.S. Government Securities, including U.S. Treasury Bills, Notes, Bonds and other debt securities issued by the U.S. Treasury, and obligations issued or guaranteed by U.S. Government agencies or instrumentalities, and by engaging in various derivative transactions such as the purchase and sale of put and call options. The preceding are pro forma financial statements which give effect to the following proposed transaction whereby all of the assets of the Prudential Mortgage Income Fund will be exchanged for the shares of the Prudential Government Fund and the Fund will assume the liabilities of the Prudential Mortgage Income Fund. Immediately after the exchange, shares of the Prudential Government Income Fund will be distributed to shareholders of the Prudential Mortgage Income Fund and the Prudential Mortgage Income Fund will be terminated. The preceding pro forma financial statements include a pro forma Portfolio of Investments at February 28, 1998, a pro forma Statement of Assets and Liabilities at February 28, 1998, and a pro forma Statement of Operations for the 12 months ended February 28, 1998. NOTE 1. ACCOUNTING POLICIES The following is a summary of significant accounting policies followed by the Fund in the preparation of its financial statements. Security Valuation: The Fund values portfolio securities (including commitments to purchase such securities on a "when-issued" basis) on the basis of current market quotations provided by dealers or by a pricing service approved by the Board of Directors, which uses information such as quotations from dealers, market transactions in comparable securities, various relationships between securities and calculations on yield to maturity in determining values. Options and financial futures contracts listed on exchanges are valued at their closing price on the applicable exchange. When market quotations are not readily available, a security is valued at fair value as determined in good faith by or under the direction of the Board of Directors. Short-term securities which mature in more than 60 days are valued at current market quotations. Short-term securities which mature in 60 days or less are valued at amortized cost which approximates market value. In connection with repurchase agreements with U.S. financial institutions, it is the Fund's policy that its custodian, or designated subcustodians as the case may be under triparty repurchase agreements, takes possession of the underlying collateral securities, the value of which exceeds the principal amount of the repurchase agreement transaction, including accrued interest. To the extent that any repurchase agreement transaction exceeds one business day, the value of the collateral is marked-to-market on a daily basis to ensure the adequacy of the collateral. If the seller defaults and the value of the collateral declines or if bankruptcy proceedings are commenced with respect to the seller of the security, realization of the collateral by the Fund may be delayed or limited. Financial Futures Contracts: A financial futures contract is an agreement to purchase (long) or sell (short) an agreed amount of securities at a set price for delivery on a future date. Upon entering into a financial futures contract, the Fund is required to pledge to the broker an amount of cash and/or other assets equal to a certain percentage of the contract amount. This amount is known as the "initial margin." Subsequent payments, known as "variation margin," are made or received by the Fund each day, depending on the daily fluctuation in the value of the underlying security. Such variation margin is recorded for financial statement purposes on a daily basis as unrealized gain or loss. When the contract expires or is closed, the gain or loss is realized and is presented in the statement of operations as net realized gain (loss) on financial futures contracts. The Fund invests in financial futures contracts in order to hedge its existing portfolio securities, or securities the Fund intends to purchase, against fluctuations in value caused by changes in prevailing interest rates. Should interest rates move unexpectedly, the Fund may not achieve the anticipated benefits of the financial futures contracts and may realize a loss. The use of futures transactions involves the risk of imperfect correlation in movements in the price of futures contracts, interest rates and the underlying hedged assets. DOLLAR ROLLS: The Fund enters into mortgage dollar rolls in which the Fund sells mortgage securities for delivery in the current month, realizing a gain or loss and simultaneously contracts to repurchase somewhat similar (same type, coupon and maturity) securities on a specified future date. During the roll period, the Fund forgoes principal and interest paid on the securities. The Fund is compensated by the interest earned on the cash proceeds of the initial sale and by the lower repurchase price at the future date. The difference between the sales proceeds and the lower repurchase price is 8 recorded as interest income. The Fund maintains a segregated account, the dollar value of which is at least equal to its obligations, in respect of dollar rolls. SECURITIES LENDING: The Fund may lend its U.S. Government securities to broker-dealers or government securities dealers. The loans are secured by collateral at least equal at all times to the market value of the securities loaned. The Fund may bear the risk of delay in recovery of, or even loss of rights in, the securities loaned should the borrower of the securities fail financially. The Fund receives compensation for lending its securities in the form of fees or it retains a portion of interest on the investment of any cash received as collateral. The Fund also continues to receive interest on the securities loaned and any gain or loss in the market price of the securities loaned that may occur during the term of the loan will be for the account of the Fund. SECURITIES TRANSACTIONS AND NET INVESTMENT INCOME: Securities transactions are recorded on the trade date. Since certain mortgage-backed securities, such as GNMA's only settle on one day each month, there can be occasions when, pending settlement, there may be substantial short-term securities in the portfolio available to fund the purchases of these mortgage-backed securities. Realized gains or losses on sales of securities are calculated on the identified cost basis. Interest income is recorded on the accrual basis. The Fund accretes original issue discount on portfolio securities as adjustments to interest income. Net investment income (other than distribution fees) and unrealized and realized gains or losses are allocated daily to each class of shares based upon the relative proportion of net assets of each class at the beginning of the day. Expenses are recorded on the accrual basis which may require the use of certain estimates by management. DIVIDENDS AND DISTRIBUTIONS: The Fund declares daily and pays monthly dividends from net investment income. The Fund will distribute at least annually any net capital gains in excess of loss carryforwards, if any. Dividends and distributions are recorded on the ex-dividend date. Income distributions and capital gain distributions are determined in accordance with income tax regulations which may differ from generally accepted accounting principles. FEDERAL INCOME TAXES: It is the Fund's policy to continue to meet the requirements of the Internal Revenue Code applicable to regulated investment companies and to distribute all of its taxable net income to its shareholders. Therefore, no federal income tax provision is required. NOTE 2. AGREEMENTS The Fund has a management agreement with Prudential Investments Fund Management, LLC ("PIFM"). Pursuant to this agreement, PIFM has responsibility for all investment advisory services and supervises the subadviser's performance of such services. PIFM has entered into a subadvisory agreement with The Prudential Investment Corporation ("PIC"); PIC furnishes investment advisory services in connection with the management of the Fund. PIFM pays for the cost of the subadviser's services, the compensation of officers of the Fund, occupancy and certain clerical and bookkeeping costs of the Fund. The Fund bears all other costs and expenses. The management fee paid PIFM is computed daily and payable monthly, at an annual rate of .50 of 1% of the Fund's average daily net assets up to $3 billion and .35 of 1% of the average daily net assets of the Fund in excess of $3 billion. The Fund has a distribution agreement with Prudential Securities Incorporated ("PSI"), which acts as the distributor of the Class A, Class B, Class C and Class Z shares of the Fund. The Fund compensates PSI for distributing and servicing the Fund's Class A, Class B and Class C shares, pursuant to plans of distribution (the "Class A, B and C Plans"), regardless of expenses actually incurred by them. The distribution fees for Class A, B and C shares are accrued daily and payable monthly. No distribution or service fees are paid to PSI as distributor of the Class Z shares of the Fund. Effective July 1, 1998, Prudential Investment Management Services LLC ("PIMS") became the distributor of the Fund and serves the Fund under the same terms and conditions as under the arrangement with PSI. Pursuant to the Class A Plan, the Fund compensates PSI for its distribution-related expenses with respect to Class A shares, at an annual rate of up to .30 of 1% of the average daily net assets of the Class A shares. Such expenses under the Class A Plan were .15 of 1% of the average daily net assets of the Class A shares. Pursuant to the Class B Plan, the Fund compensates PSI for its distribution-related expenses with respect to Class B shares at an annual rate of up to 1% of the average daily net assets up to $3 billion, .80 of 1% of the next $1 billion of such net assets and .50 of 1% over $4 billion of the average daily net assets of the Class B shares. Such expenses under the Class B Plan were charged at an effective rate of .825 of 1% of the average daily net assets of the Class B shares. Pursuant to the Class C Plan, the Fund compensates PSI for its distribution-related expenses with respect to 9 Class C shares at an annual rate of up to .825 of 1% of the average daily net assets up to $3 billion, .80 of 1% of the next $1 billion of such net assets and .50 of 1% over $4 billion of the average daily net assets of the Class C shares. Such expenses under the Class C Plan were charged at an effective rate of .75 of 1% of the average daily net assets of the Class C shares. PSI, PIFM, PIC and PIMS are indirect, wholly owned subsidiaries of The Prudential Insurance Company of America. The Fund, along with other affiliated registered investment companies (the "Funds"), has a credit agreement (the "Agreement") with an unaffiliated lender. The maximum commitment under the Agreement is $200,000,000. Interest on any such borrowings outstanding will be at market rates. The purpose of the Agreement is to serve as an alternative source of funding for capital share redemptions. The Fund did not borrow any amounts pursuant to the Agreement during the year ended February 28, 1998. The Funds pay a commitment fee at an annual rate of .055 of 1% on the unused portion of the credit facility. The commitment fee is accrued and paid quarterly on a pro rata basis by the Funds. The Agreement expired on December 30, 1997 and has been extended through December 29, 1998 under the same terms. 10 PRUDENTIAL GOVERNMENT INCOME FUND, INC. STATEMENT OF ADDITIONAL INFORMATION DATED APRIL 30, 1998 Prudential Government Income Fund, Inc. (the Fund), is an open-end, diversified management investment company, or mutual fund, which has as its investment objective the seeking of a high current return. The Fund will seek to achieve this objective primarily by investing in U.S. Government securities, including U.S. Treasury Bills, Notes and Bonds and other debt securities issued by the U.S. Treasury, and obligations issued or guaranteed by U.S. Government agencies or instrumentalities; writing covered put and call options and purchasing put and call options. In an effort to hedge against changes in interest rates and thus preserve its capital, the Fund may also engage in transactions involving futures contracts on U.S. Government securities and options on such contracts. There can be no assurance that the Fund's investment objective will be achieved. See "Investment Objective and Policies." The Fund's address is Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077, and its telephone number is (800) 225-1852. This Statement of Additional Information is not a prospectus and should be read in conjunction with the Fund's Prospectus, dated April 30, 1998, a copy of which may be obtained from the Fund upon request. TABLE OF CONTENTS
CROSS-REFERENCE TO PAGE IN PAGE PROSPECTUS ---- --------------- General Information................................... B-2 23 Investment Objective and Policies..................... B-2 9 Investment Restrictions............................... B-10 17 Directors and Officers................................ B-11 17 Manager............................................... B-15 17 Distributor........................................... B-16 18 Portfolio Transactions and Brokerage.................. B-18 20 Purchase and Redemption of Fund Shares................ B-19 24 Shareholder Investment Account........................ B-23 24 Net Asset Value....................................... B-26 20 Taxes, Dividends and Distributions.................... B-27 21 Performance Information............................... B-30 21 Custodian, Transfer and Dividend Disbursing Agent and Independent Accountants.............................. B-32 20 Financial Statements.................................. B-33 -- Independent Accountants' Report....................... B-45 -- Appendix I -- Historical Performance Data............. I-1 -- Appendix II -- General Investment Information......... II-1 -- Appendix III -- Information Relating to The Prudential........................................... III-1 --
- -------------------------------------------------------------------------------- MF128B GENERAL INFORMATION At a special meeting held on July 19, 1994, shareholders approved an amendment to the Fund's Articles of Incorporation to change the Fund's name from Prudential-Bache Government Plus Fund, Inc. to Prudential Government Income Fund, Inc. INVESTMENT OBJECTIVE AND POLICIES The Fund's investment objective is to seek a high current return. The Fund will seek a high current return primarily from interest income from U.S. Government securities, premiums from put and call options on U.S. Government securities and net gains from closing purchase and sale transactions with respect to options on U.S. Government securities. The Fund may also realize net gains from sales of portfolio securities. There can be no assurance that the Fund's investment objective will be achieved. See "How the Fund Invests--Investment Objective and Policies" in the Prospectus. U.S. GOVERNMENT SECURITIES MORTGAGE-RELATED SECURITIES ISSUED BY U.S. GOVERNMENT INSTRUMENTALITIES. Mortgages backing the securities purchased by the Fund include conventional thirty-year fixed rate mortgages, graduated payment mortgages, fifteen-year mortgages and adjustable rate mortgages. All of these mortgages can be used to create pass-through securities. A pass-through security is formed when mortgages are pooled together and undivided interests in the pool or pools are sold. The cash flow from the mortgages is passed through to the holders of the securities in the form of periodic payments of interest, principal and prepayments (net of a service fee). Prepayments occur when the holder of an individual mortgage prepays the remaining principal before the mortgage's scheduled maturity date. As a result of the pass-through of prepayments of principal on the underlying securities, mortgage-backed securities are often subject to more rapid prepayment of principal than their stated maturity would indicate. Because the prepayment characteristics of the underlying mortgages vary, it is not possible to predict accurately the realized yield or average life of a particular issue of pass-through certificates. Prepayment rates are important because of their effect on the yield and price of the securities. Accelerated prepayments adversely impact yields for pass-throughs purchased at a premium. The opposite is true for pass-throughs purchased at a discount. GNMA CERTIFICATES. Certificates of the Government National Mortgage Association (GNMA Certificates) are mortgage-backed securities, which evidence an undivided interest in a pool of mortgage loans. GNMA Certificates differ from bonds in that principal is paid back monthly by the borrower over the term of the loan rather than returned in a lump sum at maturity. GNMA Certificates that the Fund purchases are the modified pass-through type. Modified pass-through GNMA Certificates entitle the holder to receive a share of all interest and principal payments paid and owed on the mortgage pool, net of fees paid to the issuer and GNMA, regardless of whether or not the mortgagor actually makes the payment. The GNMA Certificates will represent a PRO RATA interest in one or more pools of the following types of mortgage loans: (i) fixed-rate level payment mortgage loans; (ii) fixed-rate graduated payment mortgage loans; (iii) fixed-rate growing equity mortgage loans; (iv) fixed-rate mortgage loans secured by manufactured (mobile) homes; (v) mortgage loans on multifamily residential properties under construction; (vi) mortgage loans on completed multifamily projects; (vii) fixed-rate mortgage loans as to which escrowed funds are used to reduce the borrower's monthly payments during the early years of the mortgage loans (buydown mortgage loans); (viii) mortgage loans that provide for adjustments in payments based on periodic changes in interest rates or in other payment terms of the mortgage loans; and (ix) mortgage-backed serial notes. All of these mortgage loans will be FHA Loans or VA Loans and, except as otherwise specified above, will be fully-amortizing loans secured by first liens on one-to-four-family housing units. Legislative changes may be proposed from time to time in relation to the Department of Housing and Urban Development which, if adopted, could alter the viability of investing in GNMAs. The Fund's adviser may re-evaluate the Fund's investment objectives and policies if any such legislative proposals are adopted. GNMA GUARANTEE. The National Housing Act authorizes GNMA to guarantee the timely payment of principal and interest on securities backed by a pool of mortgages insured by the Federal Housing Administration (FHA) or the Farmers' Home Administration (FMHA), or guaranteed by the Veterans Administration (VA). The GNMA guarantee is backed by the full faith and credit of the United States. The GNMA is also empowered to borrow without limitation from the U.S. Treasury if necessary to make any payments required under its guarantee. B-2 LIFE OF GNMA CERTIFICATES. The average life of a GNMA Certificate is likely to be substantially shorter than the original maturity of the mortgages underlying the securities. Prepayments of principal by mortgagors and mortgage foreclosures will usually result in the return of the greater part of principal investment long before the maturity of the mortgages in the pool. Foreclosures impose no risk to principal investment because of the GNMA guarantee, except to the extent that the Fund has purchased the certificates above par in the secondary market. FHLMC SECURITIES. The Federal Home Loan Mortgage Corporation was created in 1970 through enactment of Title III of the Emergency Home Finance Act of 1970. Its purpose is to promote development of a nationwide secondary market in conventional residential mortgages. The FHLMC issues two types of mortgage pass-through securities, mortgage participation certificates (PCs) and guaranteed mortgage certificates (GMCs). PCs resemble GNMA Certificates in that each PC represents a PRO RATA share of all interest and principal payments made and owed on the underlying pool. The FHLMC guarantees timely monthly payment of interest on PCs and the ultimate payment of principal. GMCs also represent a PRO RATA interest in a pool of mortgages. However, these instruments pay interest semi-annually and return principal once a year in guaranteed minimum payments. The expected average life of these securities is approximately ten years. FNMA SECURITIES. The Federal National Mortgage Association was established in 1938 to create a secondary market in mortgages insured by the FHA. FNMA issues guaranteed mortgage pass-through certificates (FNMA Certificates). FNMA Certificates resemble GNMA Certificates in that each FNMA Certificate represents a PRO RATA share of all interest and principal payments made and owed on the underlying pool. FNMA guarantees timely payment of interest on FNMA Certificates and the full return of principal. Like GNMA Certificates, FNMA Certificates are assumed to be prepaid fully in their twelfth year. CHARACTERISTICS OF MORTGAGE-BACKED SECURITIES. The market value of mortgage securities, like other U.S. Government securities, will generally vary inversely with changes in market interest rates, declining when interest rates rise and rising when interest rates decline. However, mortgage securities, while having comparable risk of decline during periods of rising rates, usually have less potential for capital appreciation than other investments of comparable maturities due to the likelihood of increased prepayments of mortgages as interest rates decline. In addition, to the extent such mortgage securities are purchased at a premium, mortgage foreclosures and unscheduled principal prepayments generally will result in some loss of the holders' principal to the extent of the premium paid. On the other hand, if such mortgage securities are purchased at a discount, an unscheduled prepayment of principal will increase current and total returns and accelerate the recognition of income which when distributed to shareholders will be taxable as ordinary income. COLLATERALIZED MORTGAGE OBLIGATIONS Certain issuers of mortgage-backed obligations (CMOs), including certain CMOs that have elected to be treated as Real Estate Mortgage Investment Conduits (REMICs), are not considered investment companies pursuant to a rule adopted by the Securities and Exchange Commission (Commission), and the Fund may invest in the securities of such issuers without the limitations imposed by the Investment Company Act of 1940, as amended (the Investment Company Act) on investments by the Fund in other investment companies. In addition, in reliance on an earlier Commission interpretation, the Fund's investments in certain other qualifying CMOs, which cannot or do not rely on the rule, are also not subject to the limitation of the Investment Company Act on acquiring interests in other investment companies. In order to be able to rely on the Commission's interpretation, these CMOs must be unmanaged, fixed asset issuers, that (a) invest primarily in mortgage-backed securities, (b) do not issue redeemable securities, (c) operate under general exemptive orders exempting them from all provisions of the Investment Company Act and (d) are not registered or regulated under the Investment Company Act as investment companies. To the extent that the Fund selects CMOs or REMICs that cannot rely on the rule or do not meet the above requirements, the Fund may not invest more than 10% of its assets in all such entities and may not acquire more than 3% of the voting securities of any single such entity. B-3 OTHER SECURITIES The Fund will invest in foreign banks and foreign branches of U.S. banks only if after giving effect to such investments all such investments would constitute less than 10% of the Fund's total assets (determined at the time of investment). Investing in securities of foreign companies in foreign countries involves certain considerations and risks which are not typically associated with investing in U.S. Government securities and those of domestic companies. Foreign companies are not generally subject to uniform accounting, auditing and financial standards and requirements comparable to those applicable to U.S. companies. There may be less publicly available information about foreign companies and governments compared to reports and ratings published about U.S. companies. Securities of some foreign companies are less liquid and more volatile than securities of comparable U.S. companies, and brokerage commissions and other transaction costs on foreign securities exchanges are generally higher than in the United States. OPTION WRITING AND RELATED RISKS The Fund will write (I.E., sell) covered call or put options which are traded on registered securities exchanges (the Exchanges) and may also write such options with primary U.S. Government securities dealers recognized by the Federal Reserve Bank of New York (OTC options). A call option gives the purchaser of the option the right to buy, and the writer the obligation to sell, the underlying security at the exercise price during the option period. Conversely, a put option gives the purchaser the right to sell, and the writer the obligation to buy, the underlying security at the exercise price during the option period. OPTIONS TRANSACTIONS Exchange-traded options are issued by the Options Clearing Corporation (OCC) which, in effect, gives its guarantee to every exchange-traded option transaction. In contrast, OTC options represent a contract between a U.S. Government securities dealer and the Fund with no guarantee of the OCC. Thus, when the Fund purchases an OTC option, it relies on the dealer from which it has purchased the OTC option to make or take delivery of the U.S. Government securities underlying the OTC option. Failure by the dealer to do so would result in the loss of premium paid by the Fund as well as loss of the expected benefit of the transaction. Exchange-traded options generally have a continuous liquid market while OTC options do not. Consequently, the Fund will generally be able to realize the value of an OTC option it has purchased only by exercising it or reselling it to the issuing dealer. Similarly, when the Fund writes an OTC option, it generally will be able to close out the OTC option prior to its expiration only by entering into a closing purchase transaction with the dealer to which the Fund originally wrote the OTC option. While the Fund will enter into OTC option transactions only with dealers who will agree to and which are expected to be capable of entering into closing transactions with the Fund, there can be no assurance that the Fund will be able to liquidate an OTC option at a favorable price at any time prior to expiration. Until the Fund, as a covered OTC call option writer, is able to effect a closing purchase transaction, it will not be able to liquidate securities used as cover until the option expires, is exercised or the Fund provides substitute cover. See "How the Fund Invests--Other Investment Information--Illiquid Securities" in the Prospectus. In the event of insolvency of the counterparty, the Fund may be unable to liquidate an OTC option. With respect to options written by the Fund, the inability to enter into a closing transaction may result in material losses to the Fund. This requirement may impair the Fund's ability to sell a portfolio security at a time when such a sale might be advantageous. The principal reason for writing options on a securities portfolio is to attempt to realize, through the receipt of premiums, a greater return than would be realized on the underlying securities alone. In return for the premium, the covered call option writer has given up the opportunity for profit from a price increase in the underlying security above the exercise price so long as the option remains open, but retains the risk of loss should the price of the security decline. Conversely, the put option writer gains a profit, in the form of the premium, so long as the price of the underlying security remains above the exercise price, but assumes an obligation to purchase the underlying security from the buyer of the put option at the exercise price, even though the security may fall below the exercise price, at any time during the option period. If an option expires, the writer realizes a gain in the amount of the premium. Such a gain may, in the case of a covered call option, be offset by a decline in the market value of the underlying security during the option period. If a call B-4 option is exercised, the writer realizes a gain or loss from the sale of the underlying security. If a put option is exercised, the writer must fulfill its obligation to purchase the underlying security at the exercise price, which will usually exceed the market value of the underlying security at that time. So long as the obligation of the writer continues, the writer may be assigned an exercise notice by the broker-dealer through whom the option was sold. The exercise notice would require the writer to deliver, in the case of a call, or take delivery of, in the case of a put, the underlying security against payment of the exercise price. This obligation terminates upon expiration of the option, or at such earlier time that the writer effects a closing purchase transaction by purchasing an option covering the same underlying security and having the same exercise price and expiration date (of the same series) as the one previously sold. Once an option has been exercised, the writer may not execute a closing purchase transaction. To secure the obligation to deliver the underlying security in the case of a call option, the writer of the option is required to pledge for the benefit of the broker the underlying security or other assets in accordance with the rules of the OCC, an institution created to interpose itself between buyers and sellers of options. Technically, the OCC assumes the other side of every purchase and sale transaction on an Exchange and, by doing so, guarantees the transaction. The Fund writes only "covered" options. This means that, so long as the Fund is obligated as the writer of a call option, it will (a) own the underlying securities subject to the option, except that, in the case of call options on U.S. Treasury Bills, the Fund might own U.S. Treasury Bills of a different series from those underlying the call option, but with a principal amount and value corresponding to the option contract amount and a maturity date no later than that of the securities deliverable under the call option or (b) deposit and maintain in a segregated account cash or other liquid assets having a value at least equal to the fluctuating market value of the securities underlying the call. The Fund will be considered "covered" with respect to a put option it writes if, so long as it is obligated as the writer of a put option, it will (a) deposit and maintain in a segregated account cash or other liquid assets having a value equal to or greater than the exercise price of the option, or (b) own a put option on the same security with an exercise price the same or higher than the exercise price of the put option sold or, if lower, deposit and maintain the differential in cash or other liquid assets in a segregated account. To the extent that a secondary market is available on the Exchanges, the covered option writer may close out options it has written prior to the assignment of an exercise notice by purchasing, in a closing purchase transaction, an option of the same series as the option previously written. If the cost of such a closing purchase, plus transaction costs, is greater than the premium received upon writing the original option, the writer will incur a loss in the transaction. Because the Fund can write only covered options, it may at times be unable to write additional options unless it sells a portion of its portfolio holdings to obtain new debt securities or other cover against which it can write options. If the Fund writes a substantial number of options, its portfolio turnover will be higher than if it did not do so. Portfolio turnover will increase to the extent that options written by the Fund are exercised. Because the exercise of such options depends on changes in the price of the underlying securities, the Fund's portfolio turnover rate cannot be accurately predicted. See "Portfolio Turnover" below. SPECIAL CONSIDERATIONS APPLICABLE TO OPTIONS ON TREASURY BONDS AND NOTES. Because trading interest in Treasury Bonds and Notes tends to center on the most recently auctioned issues, the Exchanges will not indefinitely continue to introduce new series of options with expirations to replace expiring options on particular issues. Instead, the expirations introduced at the commencement of options trading on a particular issue will be allowed to run their course, with the possible addition of a limited number of new expirations as the original ones expire. Options trading on each series of Bonds or Notes will thus be phased out as new options are listed on the more recent issues, and a full range of expiration dates will not ordinarily be available for every series on which options are traded. ON TREASURY BILLS. Because the availability of deliverable Treasury Bills changes from week to week, writers of Treasury Bill call options cannot provide in advance for their potential exercise settlement obligations by acquiring and holding the underlying security. However, if the Fund holds a long position in Treasury Bills with a principal amount corresponding to the option contract size, the Fund may be hedged from a risk standpoint. In addition, the Fund will maintain in a segregated account Treasury Bills maturing no later than those which would be deliverable in the event of an assignment of an exercise notice to ensure that it can meet its open option obligations. B-5 ON GNMA CERTIFICATES. Options on GNMA Certificates are not currently traded on any Exchange. However, the Fund intends to purchase and write such options should they commence trading on any Exchange. Since the remaining principal balance of GNMA Certificates declines each month as a result of mortgage payments, the Fund, as a writer of a covered GNMA call holding GNMA Certificates as "cover" to satisfy its delivery obligation in the event of assignment of an exercise notice, may find that its GNMA Certificates no longer have a sufficient remaining principal balance for this purpose. Should this occur, the Fund will enter into a closing purchase transaction or will purchase additional GNMA Certificates from the same pool (if obtainable) or replacement GNMA Certificates in the cash market in order to remain covered. A GNMA Certificate held by the Fund to cover an option position in any but the nearest expiration month may cease to represent cover for the option in the event of a decline in the GNMA coupon rate at which new pools are originated under the FHA/VA loan ceiling in effect at any given time. Should this occur, the Fund will no longer be covered, and the Fund will either enter into a closing purchase transaction or replace the GNMA Certificate with a GNMA Certificate which represents cover. When the Fund closes its position or replaces the GNMA Certificate, it may realize an unanticipated loss and incur transaction costs. RISKS PERTAINING TO THE SECONDARY MARKET. An option position may be closed out only on an Exchange which provides a secondary market for an option of the same series. Although the Fund will generally purchase or write only those options for which there appears to be an active secondary market, there is no assurance that a liquid secondary market on an Exchange will exist for any particular option at any particular time, and for some options no secondary market on an Exchange may exist. In such event, it might not be possible to effect closing transactions in particular options, with the result that the Fund would have to exercise its options in order to realize any profit and may incur transaction costs in connection therewith. If the Fund as a covered call option writer is unable to effect a closing purchase transaction in a secondary market, it will not be able to sell the underlying security until the option expires or it delivers the underlying security upon exercise. Reasons for the absence of a liquid secondary market on an exchange include the following: (a) insufficient trading interest in certain options; (b) restrictions on transactions imposed by an Exchange; (c) trading halts, suspensions or other restrictions imposed with respect to particular classes or series of options or underlying securities; (d) interruption of the normal operations on an Exchange; (e) inadequacy of the facilities of an Exchange or the OCC to handle current trading volume; or (f) a decision by one or more Exchanges to discontinue the trading of options (or a particular class or series of options), in which event the secondary market on that Exchange (or in that class or series of options) would cease to exist, although outstanding options on that Exchange that had been issued by the OCC as a result of trades on that Exchange would generally continue to be exercisable in accordance with their terms. The hours of trading for options on U.S. Government securities may not conform to the hours during which the underlying securities are traded. To the extent that the option 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 option markets. FUTURES CONTRACTS ON U.S. GOVERNMENT SECURITIES CHARACTERISTICS AND PURPOSE OF INTEREST RATE FUTURES. The Fund may purchase and sell U.S. Exchange-traded interest-rate futures. Currently, there are futures contracts based on U.S. Treasury Bonds, U.S. Treasury Notes, three-month U.S. Treasury Bills and GNMA certificates. A clearing corporation associated with the commodities exchange on which a futures contract trades assumes responsibility for the completion of transactions and guarantees that futures contracts will be performed. Although futures contracts call for actual delivery or acceptance of debt securities, in most cases the contracts are closed out before the settlement date without the making or taking of delivery. CHARACTERISTICS. The Fund neither pays nor receives money upon the purchase or sale of a futures contract. Instead, when the Fund enters into a futures contract, it will initially be required to deposit in a segregated account for the benefit of the broker (the futures commission merchant) an amount of "initial margin" of cash or U.S. Treasury Bills, currently equal to approximately 1 1/2 to 2% of the contract amount for futures on Treasury Bonds and Notes and approximately 1/10 of 1% of the contract amount for futures on Treasury Bills. Initial margin in futures transactions is different from margin in securities transactions in that futures contract initial margin does not involve the borrowing of funds by the B-6 customer to finance the transactions. Rather, initial margin is in the nature of a good faith deposit on the contract which is returned to the Fund upon termination of the futures contract, assuming all contractual obligations have been satisfied. Subsequent payments, called variation margin, to and from the futures commission merchant are made on a daily basis as the market price of the futures contract fluctuates. This process is known as "marking to market." At any time prior to expiration of the futures contract, the Fund may elect to close the position by taking an offsetting position which will operate to terminate the Fund's position in the futures contract. While interest rate futures contracts provide for the delivery and acceptance of securities, most futures contracts are terminated by entering into offsetting transactions. Successful use of futures contracts by the Fund is also subject to the ability of the Fund's investment adviser to predict correctly movements in the direction of interest rates and other factors affecting markets for securities. For example, if the Fund has hedged against the possibility of an increase in interest rates which would adversely affect the price of securities in its portfolio and the price of such securities increases instead, the Fund will lose part or all of the benefit of the increased value of its securities because it will have offsetting losses in its futures positions. In addition, in such situations, if the Fund has insufficient cash to meet daily variation margin requirements, it may have to sell securities to meet such requirements. Such sales of securities may be, but will not necessarily be, at increased prices which reflect the rising market. The Fund may have to sell securities at a time when it is disadvantageous to do so. The hours of trading futures contracts on U.S. Government securities may not conform to the hours during which the Fund may trade such securities. To the extent that the futures markets close before or after the U.S. Government securities markets, significant variations can occur in one market that cannot be reflected in the other market. OPTIONS ON FUTURES CONTRACTS CHARACTERISTICS. An option on a futures contract gives the purchaser the right, but not the obligation, to assume a position in a futures contract (a long position if the option is a call and a short position if the option is a put) at a specified exercise price at any time during the option exercise period. The writer of the option is required upon exercise to assume an offsetting futures position (a short position if the option is a call and a long position if the option is a put). Upon exercise of the option, the assumption of offsetting futures positions by the writer and holder of the option will be accompanied by delivery of the accumulated cash balance in the writer's futures margin account which represents the amount by which the market price of the futures contract, at exercise, exceeds, in the case of a call, or is less than, in the case of a put, the exercise price of the option on the futures contract. Currently, options can be purchased or written with respect to futures contracts on GNMAs, U.S. Treasury Bonds and U.S. Treasury Notes on The Chicago Board of Trade and U.S. Treasury Bills on the International Monetary Market at the Chicago Mercantile Exchange. The holder or writer of an option may terminate its position by selling or purchasing an option of the same series. There is no guarantee that such closing transactions can be effected. The Fund will be considered "covered" with respect to a call option it writes on a futures contract if it (a) owns a long position in the underlying futures contract or the security underlying the futures contract, (b) owns a security which is deliverable under the futures contract or (c) owns a separate call option to purchase the same futures contract at a price no higher than the exercise price of the call option written by the Fund or, if higher, the Fund deposits and maintains the differential in cash or other liquid assets in a segregated account. The Fund is considered "covered" with respect to a put option it writes on a futures contract if it (a) segregates and maintains in a segregated account cash or other liquid assets at all times equal in value to the exercise price of the put (less any related margin deposited), or (b) owns a put option on the same futures contract with an exercise price as high or higher than the price of the contract held by the Fund or, if lower, the Fund deposits and maintains the differential in cash or other liquid assets in a segregated account. There is no limitation on the amount of the Fund's assets which can be placed in the segregated account. The Fund will be required to deposit initial and maintenance margin with respect to put and call options on futures contracts written by it pursuant to the Fund's futures commissions merchants' requirements similar to those applicable to futures contracts, described above. The skills needed to trade futures contracts and options thereon are different than those needed to select U.S. Government securities. The Fund's investment adviser has experience in managing other securities portfolios which uses similar options and futures strategies as the Fund. B-7 REPURCHASE AGREEMENTS The Fund's repurchase agreements will be collateralized by U.S. Government obligations. The Fund will enter into repurchase transactions only with parties meeting creditworthiness standards approved by the Fund's Board of Directors. The Fund's investment adviser will monitor the creditworthiness of such parties, under the general supervision of the Board of Directors. In the event of a default or bankruptcy by a seller, the Fund will promptly seek to liquidate the collateral. To the extent that the proceeds from any sale of such collateral upon a default in the obligation to repurchase are less than the repurchase price, the Fund will suffer a loss. The Fund participates in a joint repurchase account with other investment companies managed by Prudential Investments Fund Management LLC (PIFM) pursuant to an order of the Commission. On a daily basis, any uninvested cash balances of the Fund may be aggregated with such of other investment companies and invested in one or more repurchase agreements. Each fund participates in the income earned or accrued in the joint account based on the percentage of its investment. INTEREST RATE TRANSACTIONS The Fund may enter into interest rate swaps, on either an asset-based or liability-based basis, depending on whether it is hedging its assets or its liabilities. Under normal circumstances, the Fund will enter into interest rate swaps on a net basis, I.E., the two payment streams netted out, 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 on a daily basis and an amount of cash or other liquid assets having an aggregate net asset value per share (NAV) at least equal to the accrued excess will be maintained in a segregated account that satisfies the requirements of the Investment Company Act. To the extent that the Fund enters into interest rate swaps on other than a net basis, the amount maintained in a segregated account will be the full amount of the Fund's obligations, if any, with respect to such interest rate swaps, accrued on a daily basis. Inasmuch as segregated accounts are established for these hedging transactions the investment adviser and the Fund believe such obligations do not constitute senior securities. If there is a default by the other party to such a transaction, the Fund will have contractual remedies pursuant to the agreement related to the transaction. The swap market has grown substantially in recent years with a large number of banks and investment banking firms acting both as principals and as agents utilizing standardized swap documentation. As a result, the swap market has become relatively liquid. The Fund will enter into interest rate swaps only with parties meeting creditworthiness standards approved by the Fund's Board of Directors. The investment adviser will monitor the creditworthiness of such parties under the supervision of the Board of Directors. The use of interest rate swaps is a highly speculative activity which involves investment techniques and risks different from those associated with ordinary portfolio securities transactions. If the investment adviser is incorrect in its forecast of market values, interest rates and other applicable factors, the investment performance of the Fund would diminish compared to what it would have been if this investment technique was never used. The Fund may only enter into interest rate swaps to hedge its portfolio. Interest rate swaps 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 other party to an interest rate swap defaults, the Fund's risk of loss consists of the net amount of interest payments that the Fund is contractually entitled to receive. Since interest rate swaps are individually negotiated, the Fund expects to achieve an acceptable degree of correlation between its rights to receive interest on its portfolio securities and its rights and obligations to receive and pay interest pursuant to interest rate swaps. ILLIQUID SECURITIES The Fund may hold up to 15% of its net assets in repurchase agreements which have a maturity of longer than seven days or in other illiquid securities, including securities that are illiquid by virtue of the absence of a readily available market (either within or outside of the United States) or legal or contractual restrictions on resale. 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 (Securities Act), securities which are otherwise not readily marketable and repurchase agreements having a maturity of longer than seven days. Securities which have not been registered under the Securities Act are referred to as private placements or restricted securities and are purchased directly from the issuer or in B-8 the secondary market. Mutual funds do not typically hold a significant amount of these restricted or other illiquid securities because of the potential for delays on resale and uncertainty in valuation. Limitations on resale may have an adverse effect on the marketability of portfolio securities and a mutual fund might be unable to dispose of restricted or other illiquid securities promptly or at reasonable prices and might thereby experience difficulty satisfying redemptions within seven days. A mutual fund might also have to register such restricted securities in order to dispose of them resulting in additional expense and delay. Adverse market conditions could impede such a public offering of securities. In recent years, however, 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 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. Rule 144A of the Securities Act allows for a broader institutional trading market for securities otherwise subject to restriction on resale to the general public. Rule 144A establishes a "safe harbor" from the registration requirements of the Securities Act for resales of certain securities to qualified institutional buyers. The investment adviser anticipates that the market for certain restricted securities such as institutional commercial paper, convertible securities and foreign securities will expand further as a result of this regulation and the development of automated systems for the trading, clearance and settlement of unregistered securities of domestic and foreign issuers, such as the PORTAL System sponsored by the National Association of Securities Dealers, Inc. (NASD). Restricted securities eligible for resale pursuant to Rule 144A under the Securities Act and commercial paper for which there is a readily available market will not be deemed to be illiquid. The investment adviser will monitor the liquidity of such restricted securities subject to the supervision of the Board of Directors. In reaching liquidity decisions, the investment adviser will consider, INTER ALIA, the following factors: (1) the frequency of trades and quotes for the security; (2) the number of dealers wishing to purchase or sell the security and the number of other potential purchasers; (3) dealer undertakings to make a market in the security and (4) the nature of the security and the nature of the marketplace trades (E.G., the time needed to dispose of the security, the method of soliciting offers and the mechanics of the transfer). In addition, in order for commercial paper that is issued in reliance on Section 4(2) of the Securities Act to be considered liquid, (i) it must be rated in one of the two highest rating categories by at least two nationally recognized statistical rating organizations (NRSRO), or if only one NRSRO rates the securities, by that NRSRO, or, if unrated, be of comparable quality in the view of the investment adviser; and (ii) it must not be "traded flat" (I.E., without accrued interest) or in default as to principal or interest. Repurchase agreements subject to demand are deemed to have a maturity equal to the notice period. The staff of the Commission has also taken the position that purchased OTC options and the assets used as "cover" for written OTC options are illiquid securities unless the Fund and the counterparty have provided for the Fund, at the Fund's election, to unwind the OTC option. The exercise of such an option would ordinarily involve the payment by the Fund of an amount designed to reflect the counterparty's economic loss from an early termination, but does allow the Fund to treat the assets used as "cover" as "liquid." PORTFOLIO TURNOVER The Fund's portfolio turnover rate for the fiscal years ended February 28, 1997 and February 28, 1998 was 107% and 88%, respectively. The investment adviser expects that, under normal circumstances, if the Fund writes a substantial number of options, and those options are exercised, the Fund's portfolio turnover rate may be as high as 250% or higher, see "Options Transactions" above and "How the Fund Invests--Other Investment Information--Portfolio Turnover and Brokerage" in the Prospectus. SEGREGATED ACCOUNTS When the Fund is required to segregate assets in connection with certain hedging transactions, it will maintain cash or liquid assets in a segregated account. "Liquid assets" means cash, U.S. Government securities, foreign securities, equity securities, debt obligations or other liquid, unencumbered assets marked-to-market daily. B-9 INVESTMENT RESTRICTIONS The following restrictions are fundamental policies. Fundamental policies are those which cannot be changed without the approval of the holders of a majority of the Fund's outstanding voting securities. A "majority of the Fund's outstanding voting securities," when used in this Statement of Additional Information, means the lesser of (i) 67% of the voting shares represented at a meeting at which more than 50% of the outstanding voting shares are present in person or represented by proxy or (ii) more than 50% of the outstanding voting shares. The Fund may not: 1. Purchase securities on margin (but the Fund may obtain such short-term credits as may be necessary for the clearance of transactions); the deposit or payment by the Fund of initial or variation margin in connection with interest rate futures contracts or related options transactions is not considered the purchase of a security on margin. 2. Make short sales of securities or maintain a short position, except short sales "against the box." 3. Issue senior securities, borrow money or pledge its assets except that the Fund may borrow up to 20% of the value of its total assets (calculated when the loan is made) for temporary, extraordinary or emergency purposes or for the clearance of transactions. The Fund may pledge up to 20% of the value of its total assets to secure such borrowings. For purposes of this restriction, the purchase or sale of securities on a when-issued or delayed delivery basis, collateral arrangements with respect to interest rate swap transactions, reverse repurchase agreements or dollar roll transactions or the writing of options on debt securities or on interest rate futures contracts or other financial futures contracts are not deemed to be a pledge of assets and neither such arrangements, nor the purchase or sale of interest rate futures contracts or other financial futures contracts or the purchase or sale of related options, nor obligations of the Fund to Directors pursuant to deferred compensation arrangements are deemed to be the issuance of a senior security. 4. Purchase any security (other than obligations of the U.S. Government, its agencies, or instrumentalities) if as a result: (i) with respect to 75% of the Fund's total assets, more than 5% of the Fund's total assets (determined at the time of investment) would then be invested in securities of a single issuer, or (ii) 25% or more of the Fund's total assets (determined at the time of investment) would be invested in a single industry. 5. Purchase any security if as a result the Fund would then hold more than 10% of the outstanding voting securities of an issuer. 6. Buy or sell commodities or commodity contracts or real estate or interests in real estate, except it may purchase and sell securities which are secured by real estate, securities of companies which invest or deal in real estate, interest rate futures contracts and other financial futures contracts and options thereon. 7. Act as underwriter except to the extent that, in connection with the disposition of portfolio securities, it may be deemed to be an underwriter under certain federal securities laws. 8. Make investments for the purpose of exercising control or management. 9. Invest in securities of other registered investment companies, except by purchases in the open market involving only customary brokerage commissions and as a result of which not more than 10% of its total assets (determined at the time of investment) would be invested in such securities, or except as part of a merger, consolidation or other acquisition. 10. Invest in interests in oil, gas or other mineral exploration or development programs. 11. Make loans, except through (i) repurchase agreements and (ii) loans of portfolio securities (limited to 30% of the Fund's total assets). 12. Purchase warrants if as a result the Fund would then have more than 5% of its total assets (determined at the time of investment) invested in warrants. 13. Write, purchase or sell puts, calls or combinations thereof, or purchase or sell futures contracts or related options, except that the Fund may write put and call options on U.S. Government securities, purchase put and call options on U.S. Government securities and purchase or sell interest rate futures contracts and other financial futures contracts and related options. Whenever any fundamental investment policy or investment restriction states a maximum percentage of the Fund's assets, it is intended that if the percentage limitation is met at the time the investment is made, a later change in percentage B-10 resulting from changing total or net asset values will not be considered a violation of such policy. However, in the event that the Fund's asset coverage for borrowings falls below 300%, the Fund will take prompt action to reduce its borrowings, as required by applicable law. DIRECTORS AND OFFICERS
PRINCIPAL OCCUPATIONS NAME, ADDRESS(1) AND AGE POSITION WITH FUND DURING PAST FIVE YEARS - ----------------------------- ----------------------- ---------------------------------------------------------- Edward D. Beach (73) Director President and Director of BMC Fund, Inc., a closed-end investment company; prior thereto, Vice Chairman of Broyhill Furniture Industries, Inc.; Certified Public Accountant; Secretary and Treasurer of Broyhill Family Foundation, Inc.; Member of the Board of Trustees of Mars Hill College; Director of The High Yield Income Fund, Inc. Eugene C. Dorsey (71) Director Retired President, Chief Executive Officer and Trustee of the Gannett Foundation (now Freedom Forum); former Publisher of four Gannett newspapers and Vice President of Gannett Company; past Chairman of Independent Sector (national coalition of philanthropic organizations); former Chairman of the American Council for the Arts; Director of the Advisory Board of Chase Manhattan Bank of Rochester, The High Yield Income Fund, Inc. and First Financial Fund, Inc. Delayne Dedrick Gold (59) Director Marketing and Management Consultant; Director of The High Yield Income Fund, Inc. *Robert F. Gunia (51) Director and Vice Vice President (since September 1997), Prudential President Investments; Executive Vice President and Treasurer (since December 1996), Prudential Investments Fund Management LLC (PIFM); Senior Vice President (since March 1987) of Prudential Securities Incorporated (Prudential Securities); formerly Chief Administrative Officer (July 1990-September 1996), Director (January 1989-September 1996) and Executive Vice President, Treasurer and Chief Financial Officer (June 1987-September 1996) of Prudential Mutual Fund Management, Inc. (PMF); Vice President and Director of The Asia Pacific Fund, Inc. (since May 1989); Director of The High Yield Income Fund, Inc. *Harry A. Jacobs, Jr. (76) Director Senior Director (since January 1986) of Prudential One Seaport Plaza Securities; formerly Interim Chairman and Chief Executive New York, NY 10292 Officer of PMF (June-September 1993); formerly Chairman of the Board of Prudential Securities (1982-1985) and Chairman of the Board and Chief Executive Officer of Bache Group Inc. (1977-1982); Trustee of The Trudeau Institute; Director of The First Australia Fund, Inc., The First Australia Prime Income Fund, Inc and The High Yield Income Fund, Inc.
- ------------ * "Interested" director, as defined in the Investment Company Act, by reason of his affiliation with Prudential Securities, Prudential or PIFM. B-11
PRINCIPAL OCCUPATIONS NAME, ADDRESS(1) AND AGE POSITION WITH FUND DURING PAST FIVE YEARS - ----------------------------- ----------------------- ---------------------------------------------------------- *Mendel A. Melzer CFA (37) Director Chief Investment Officer (since October 1996) of 751 Broad Street Prudential Mutual Funds; formerly Chief Financial Officer Newark, NJ 07102 of Prudential Investments (November 1995-September 1996), Senior Vice President and Chief Financial Officer of Prudential Preferred Financial Services (April 1993-November 1995), Managing Director of Prudential Investment Advisors (April 1991-April 1993) and Senior Vice President of Prudential Capital Corporation (July 1989-April 1991); Director of the High Yield Income Fund, Inc. Thomas T. Mooney (56) Director President of the Greater Rochester Metro Chamber of Commerce; former Rochester City Manager; Trustee of Center for Governmental Research, Inc.; Director of Blue Cross of Rochester, The Business Council of New York State, Monroe County Water Authority, Rochester Jobs, Inc., Northeast-Midwest Institute, Executive Service Corps of Rochester, Monroe County Industrial Development Corporation and The High Yield Income Fund, Inc.; President, Director and Treasurer of First Financial Fund, Inc. and The High Yield Plus Fund, Inc. Thomas H. O'Brien (73) Director President, O'Brien Associates (financial and management consultants) (since April 1984); formerly President of Jamaica Water Securities Corp. (holding company) (February 1989-August 1990); Chairman and Chief Executive Officer (September 1987-February 1989) and Director (September 1987-August 1990) of Jamaica Water Supply Company; Director and President of Winthrop Regional Health Systems, Inc. and United Presbyterian Homes; Director of Ridgewood Savings Bank; Trustee of Hofstra University. Director of The High Yield Income Fund, Inc. *Richard A. Redeker (54) Director and President Employee of Prudential Investments; formerly President, 751 Broad Street Chief Executive Officer and Director (October Newark, N.J. 07102 1993-September 1996), PMF; Executive Vice President, Director and Member of the Operating Committee (October 1993-September 1996), Prudential Securities; Director (October 1993-September 1996) of Prudential Securities Group, Inc. (PSG); Executive Vice President, The Prudential Investment Corporation (July 1994-September 1996); Director (January 1994-September 1996) of Prudential Mutual Fund Distributors, Inc. (PMFD) and Prudential Mutual Fund Services, Inc. (PMFS); formerly Senior Executive Vice President and Director of Kemper Financial Services, Inc. (September 1978-September 1993); Director and President of The High Yield Income Fund, Inc.
- ------------ * "Interested" director, as defined in the Investment Company Act, by reason of his affiliation with Prudential Securities, Prudential or PIFM. B-12
PRINCIPAL OCCUPATIONS NAME, ADDRESS(1) AND AGE POSITION WITH FUND DURING PAST FIVE YEARS - ----------------------------- ----------------------- ---------------------------------------------------------- Nancy H. Teeters (67) Director Economist; formerly Vice President and Chief Economist of International Business Machines Corporation (March 1986-June 1990); Member of the Board of Governors of the Horace Rackham School of Graduate Studies of the University of Michigan; Director of Inland Steel Industries (since July 1991) and the High Yield Income Fund, Inc. Louis A. Weil, III (56) Director Publisher and Chief Executive Officer (since January 1996) and Director (since September 1991) of Central Newspapers, Inc.; Chairman (since January 1996), Publisher and Chief Executive Officer of Phoenix Newspapers, Inc. (August 1991-December 1995), prior thereto, Publisher of Time Magazine (May 1989-March 1991); formerly President, Publisher and Chief Executive Officer of the Detroit News (February 1986-August 1989); formerly member of the Advisory Board, Chase Manhattan Bank-Westchester, Director of the High Yield Income Fund, Inc. Stephen M. Ungerman (45) Assistant Treasurer Tax Director (since March 1996) of Prudential Investments and the Private Asset Group of The Prudential Insurance Company of America; formerly First Vice President of Prudential Mutual Fund Management, Inc. (February 1993-September 1996); prior thereto, Senior Tax Manager at PricewaterhouseCoopers LLP (1981-January 1993). S. Jane Rose (52) Secretary Senior Vice President (since December 1996) of PIFM; Senior Vice President and Senior Counsel of Prudential Securities (since July 1992); formerly Senior Vice President (January 1991-September 1996) and Senior Counsel (June 1987-September 1996) of Prudential Mutual Fund Management, Inc. Grace C. Torres (38) Treasurer and Principal First Vice President (since December 1996) of PIFM; First Financial and Vice President of Prudential Securities (since March Accounting Officer 1994); formerly First Vice President (March 1994-September 1996), of Prudential Mutual Fund Management, Inc., and Vice President (July 1989-March 1994) of Bankers Trust Corporation. Deborah A. Docs (40) Assistant Secretary Vice President (since December 1996) of PIFM; formerly Vice President and Associate General Counsel (January 1993-September 1996) of Prudential Mutual Fund Management, Inc.; Vice President and Associate General Counsel of Prudential Securities.
- ------------ * "Interested" director, as defined in the Investment Company Act, by reason of his affiliation with Prudential Securities, Prudential or PIFM. (1) Unless otherwise noted the address for each of the above persons is c/o: Prudential Investments Fund Management LLC, Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077. Directors and officers of the Fund are also trustees, directors and officers of some or all of the other investment companies distributed by Prudential Securities. The officers conduct and supervise the daily business operations of the Fund, while the Directors, in addition to their functions set forth under "Manager" and "Distributor," review such actions and decide on general policy. B-13 The Fund pays each of its Directors who is not an affiliated person of the Manager annual compensation of $5,500, in addition to certain out-of-pocket expenses. The amount of annual compensation paid to each Director may change as a result of the introduction of additional funds upon which the Director may be asked to serve. Directors may receive their Directors' fees pursuant to a deferred fee arrangement with the Fund. Under the terms of the agreement, the Fund accrues daily the amount of Directors' fees which accrue interest at a rate equivalent to the prevailing rate applicable to 90-day U.S. Treasury Bills at the beginning of each calendar quarter or at the daily rate of the Fund. Payment of the interest so accrued is also deferred and accruals become payable at the option of the Director. The Fund's obligation to make payments of deferred Directors' fees, together with interest thereon, is a general obligation of the Fund. The Directors have adopted a retirement policy which calls for the retirement of Directors on December 31 of the year in which they reach the age of 72, except that retirement is being phased in for Directors who were age 68 or older as of December 31, 1993. Under this phase-in provision, Messrs. Beach, Jacobs, and O'Brien are scheduled to retire on December 31, 1999, 1998, and 1999, respectively. Pursuant to the terms of the Management Agreement with the Fund, the Manager pays all compensation of officers and employees of the Fund as well as the fees and expenses of all Directors of the Fund who are affiliated persons of the Manager. The following table sets forth the aggregate compensation paid by the Fund for the fiscal year ended February 28, 1998 to the Directors who are not affiliated with the Manager and the aggregate compensation paid to such Directors for service on the Fund's Board and the Board of any other investment companies managed by Prudential Mutual Fund Management, Inc. (Fund Complex) for the calender year ended December 31, 1997. COMPENSATION TABLE
PENSION OR RETIREMENT TOTAL COMPENSATION AGGREGATE BENEFITS ACCRUED ESTIMATED ANNUAL FROM FUND AND FUND COMPENSATION AS PART OF FUND BENEFITS UPON COMPLEX PAID TO NAME AND POSITION FROM FUND EXPENSES RETIREMENT DIRECTORS - ---------------------------------------------- ------------- ----------------- ------------------- ------------------ Edward D. Beach, Director $ 5,500 None N/A $ 135,000(38/63)* Eugene C. Dorsey, Director** $ 5,500 None N/A $ 70,000(16/43)* Delayne Dedrick Gold, Director $ 5,500 None N/A $ 135,000(38/63)* Robert F. Gunia, Director and Vice President+ $ -- -- -- -- Harry A. Jacobs, Jr., Director+ $ -- -- -- -- Donald D. Lennox, Retired Director $ 5,500 None N/A $ 90,000(26/50)* Mendel A. Melzer, CFA, Director+ $ -- -- -- -- Thomas T. Mooney, Director** $ 5,500 None N/A $ 115,000(31/64)* Thomas H. O'Brien, Director $ 5,500 None N/A $ 45,000(11/29)* Richard A. Redeker, Director and President+ $ -- -- -- -- Nancy H. Teeters, Director $ 5,500 None N/A $ 90,000(23/42)* Louis A. Weil, III, Director $ 5,500 None N/A $ 90,000(26/50)*
* Indicates number of funds/portfolios in Fund Complex (including the Fund) to which aggregate compensation relates. ** Total aggregate compensation from all of the funds in the Fund Complex for the calendar year ended December 31, 1997, includes amounts deferred at the election of Directors. Including accrued interest, total compensation amounted to $87,401, and $143,909 for Eugene C. Dorsey and Thomas T. Mooney, respectively. + Robert F. Gunia, Harry A. Jacobs, Jr., Mendel A. Melzer and Richard A. Redeker, who are each interested Directors do not receive compensation from the Fund or any other fund in the Fund Complex. As of April 10, 1998, the Directors and officers of the Fund, as a group, owned less than 1% of the outstanding shares of the Fund. As of April 10, 1998, the only beneficial owners, directly or indirectly of more than 5% of any class of shares of the Fund were: F.H. Peterson Machine Corp., P/S Plan UAD 11-31-78, FBO Wilbur J. Boss, P.O. Box 617, Stoughton, MA 02072-0617, who held 19,264 Class C shares (5.7% of the outstanding Class C shares); Prudential Trust Company, FBO PRU-DC Trust Accounts, Attn. John Sturdy, 30 Scranton Office Park, Moosic, PA 18507-1796, who held 24,602 Class C B-14 shares (approximately 7.3% of the outstanding Class C shares); Prudential Defined Contribution Services, FBO PRU-NON Trust Accounts, Attn. John Sturdy, 30 Scranton Office Park, Moosic, PA 18507-1755, who held 5,058,807 Class Z shares (approximately 54.6% of the outstanding Class Z shares); and Prudential Trust Company, FBO PRU-DC Trust Accounts, Attn. John Sturdy, 30 Scranton Office Park, Moosic, PA 18507-1796, who held 1,599,665 Class Z shares (approximately 17.3% of the outstanding Class Z shares). As of April 10, 1998, Prudential Securities was the record holder for other beneficial owners of 54,345,743 Class A shares (or 60% of the outstanding Class A shares), 17,164,696 Class B shares (or 47% of the outstanding Class B shares), 215,784 Class C shares (or 64% of the outstanding Class C shares) and 207,487 Class Z shares (or 2% of the outstanding Class Z shares) of the Fund. In the event of any meetings of shareholders, Prudential Securities will forward, or cause the forwarding of, proxy materials to the beneficial owners for which it is the record holder. MANAGER The manager of the Fund is Prudential Investments Fund Management LLC (PIFM or the Manager), Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077. The Manager serves as manager to all of the other investment companies that, together with the Fund, comprise the "Prudential Mutual Funds." See "How the Fund is Managed--Manager" in the Prospectus. As of March 31, 1998, PIFM managed and/or administered open-end and closed-end management investment companies with assets of approximately $64.8 billion. According to the Investment Company Institute, as of December 31, 1997, the Prudential Mutual Funds were the 17th largest family of mutual funds in the United States. The Manager is a subsidiary of Prudential Securities and Prudential. Prudential Mutual Fund Services LLC (the Transfer Agent), a wholly owned subsidiary of the Manager, serves as the Transfer Agent for the Prudential Mutual Funds and, in addition, provides customer service, record keeping and management and administration services to qualified plans. Pursuant to the Management Agreement with the Fund (the Management Agreement), the Manager, subject to the supervision of the Fund's Board of Directors and in conformity with the stated policies of the Fund, manages both the investment operations of the Fund and the composition of the Fund's portfolio, including the purchase, retention, disposition and loan of securities. In connection therewith, the Manager is obligated to keep certain books and records of the Fund. The Manager also administers the Fund's corporate affairs and, in connection therewith, furnishes the Fund with office facilities, together with those ordinary clerical and bookkeeping services which are not being furnished by State Street Bank and Trust Company (the Custodian) and the Fund's transfer and dividend disbursing agent. The services of the Manager for the Fund are not exclusive under the terms of the Management Agreement and the Manager is free to, and does, render management services to others. For its services, the Manager receives, pursuant to the Management Agreement, a fee at an annual rate of 0.50 of 1% of the average daily net assets of the Fund up to $3 billion and .35 of 1% of the average daily net assets of the Fund in excess of $3 billion. The fee is computed daily and payable monthly. The Management Agreement also provides that, in the event the expenses of the Fund (including the fees of the Manager, but excluding interest, taxes, brokerage commissions, distribution fees and litigation and indemnification expenses and other extraordinary expenses not incurred in the ordinary course of the Fund's business) for any fiscal year exceed the lowest applicable annual expense limitation established and enforced pursuant to the statutes or regulations of any jurisdiction in which the Fund's shares are qualified for offer and sale, the compensation due to the Manager will be reduced by the amount of such excess. Currently, the Fund believes there are no such restrictions. In connection with its management of the corporate affairs of the Fund, the Manager bears the following expenses: (a) the salaries and expenses of all of its and the Fund's personnel except the fees and expenses of Directors who are not affiliated persons of the Manager or the Subadviser; (b) all expenses incurred by the Manager or by the Fund in connection with managing the ordinary course of the Fund's business, other than those assumed by the Fund as described below; and (c) the costs and expenses payable to the Subadviser pursuant to the subadvisory agreement between the Manager and the Subadviser (the Subadvisory Agreement). B-15 Under the terms of the Management Agreement, the Fund is responsible for the payment of the following expenses: (a) the fees payable to the Manager, (b) the fees and expenses of Directors who are not affiliated persons of the Manager or the Subadviser, (c) the fees and certain expenses of the Custodian and Transfer Agent, including the cost of providing records to the Manager in connection with its obligation of maintaining required records of the Fund and of pricing the Fund's shares, (d) the charges and expenses of legal counsel and independent accountants for the Fund, (e) brokerage commissions and any issue or transfer taxes chargeable to the Fund in connection with its securities transactions, (f) all taxes and corporate fees payable by the Fund to governmental agencies, (g) the fees of any trade associations of which the Fund may be a member, (h) the cost of stock certificates representing shares of the Fund, (i) the cost of fidelity and liability insurance, (j) the fees and expenses involved in registering and maintaining registration of the Fund and of its shares with the Commission, including the preparation and printing of the Fund's registration statements and prospectuses for such purposes and paying the fees and expenses of notice filings made in accordance with state securities laws, (k) allocable communications expenses with respect to investor services and all expenses of shareholders' and Directors' meetings and of preparing, printing and mailing reports, proxy statements and prospectuses to shareholders in the amount necessary for distribution to the shareholders, (l) litigation and indemnification expenses and other extraordinary expenses not incurred in the ordinary course of the Fund's business and (m) distribution fees. The Management Agreement provides that the Manager will not be liable for any error of judgment or for any loss suffered by the Fund in connection with the matters to which the Management Agreement relates, except a loss resulting from willful misfeasance, bad faith, gross negligence or reckless disregard of duty. The Management Agreement provides that it will terminate automatically if assigned, and that it may be terminated without penalty by either party upon not more than 60 days' nor less than 30 days' written notice. The Management Agreement will continue in effect for a period of more than two years from the date of execution only so long as such continuance is specifically approved at least annually in conformity with the Investment Company Act. The Management Agreement was last approved by the Board of Directors, including a majority of the Directors who are not parties to the contract or interested persons of any such party as defined in the Investment Company Act, on May 22, 1997 and by the shareholders of the Fund on March 30, 1988. For the fiscal years ended February 28, 1998, February 28, 1997 and February 29, 1996, the Fund paid management fees to the Manager or its predecessors of $6,507,621, $7,351,081 and $7,787,246, respectively. The Manager has entered into the Subadvisory Agreement with the Subadviser, a wholly-owned subsidiary of Prudential. The Subadvisory Agreement provides that the Subadviser will furnish investment advisory services in connection with the management of the Fund. In connection therewith, the Subadviser is obligated to keep certain books and records of the Fund. The Manager continues to have responsibility for all investment advisory services pursuant to the Management Agreement and supervises the Subadviser's performance of such services. The Subadviser is reimbursed by the Manager for the reasonable costs and expenses incurred by the Subadviser in furnishing those services. Investment advisory services are provided to the Fund by a unit of the Subadviser, known as Prudential Mutual Fund Investment Management. The Subadvisory Agreement was last approved by the Board of Directors, including a majority of the Directors who are not parties to the contract or interested persons of any such party as defined in the Investment Company Act, on May 22, 1997, and by shareholders of the Fund on March 30, 1988. The Subadvisory Agreement provides that it will terminate in the event of its assignment (as defined in the Investment Company Act) or upon the termination of the Management Agreement. The Subadvisory Agreement may be terminated by the Fund, the Manager or the Subadviser upon not more than 60 days', nor less than 30 days', written notice. The Subadvisory Agreement provides that it will continue in effect for a period of more than two years from its execution only so long as such continuance is specifically approved at least annually in accordance with the requirements of the Investment Company Act. DISTRIBUTOR Prudential Securities Incorporated (Prudential Securities or the Distributor), One Seaport Plaza, New York, New York 10292, acts as the distributor of the shares of the Fund. Prior to January 2, 1996, Prudential Mutual Fund Distributors, Inc. (PMFD), One Seaport Plaza, New York, New York 10292, acted as distributor of the Class A shares of the Fund. Pursuant to separate Plans of Distribution (the Class A Plan, the Class B Plan and the Class C Plan, collectively, the Plans) adopted by the Fund under Rule 12b-1 under the Investment Company Act and a distribution agreement (the Distribution Agreement), the Distributor incurs the expenses of distributing the Fund's Class A, Class B and Class C B-16 shares. The Distributor also incurs the expenses of distributing the Fund's Class Z shares under the Distribution Agreement, none of which are reimbursed by or paid for by the Fund. See "How the Fund is Managed--Distributor" in the Prospectus. On May 22, 1997, the Board of Directors, including a majority of the Directors who are not interested persons of the Fund and who have no direct or indirect financial interest in the operation of the Class A Plan, Class B Plan or Class C Plan or in any agreement related to any Plan (the Rule 12b-1 Directors), at a meeting called for the purpose of voting on each Plan, approved the continuance of the Plans and Distribution Agreement. The Class A Plan provides that (i) up to .25 of 1% of the average daily net assets of the Class A shares may be used to pay for personal service and the maintenance of shareholder accounts (service fee) and (ii) total distribution fees (including the service fee of up to .25 of 1%) may not exceed .30 of 1%. The Class B Plan provides that (i) up to .25 of 1% of the average daily net assets of the Class B shares may be paid as a service fee and (ii) up to .75 of 1% of the average daily net assets up to $3 billion, .55 of 1% of the next $1 billion of such assets and .25 of 1% of such assets in excess of $4 billion (not including the service fee) may be used for distribution-related expenses with respect to the Class B shares. The Class C Plan provides that (i) up to .25 of 1% of the average daily net assets of the Class C shares may be paid as a service fee and (ii) up to .75 of 1% (not including the service fee) may be used for distribution-related expenses with respect to the Class C shares. The Class A Plan was approved by Class A and Class B shareholders, and the Class B Plan was approved by Class B shareholders on July 19, 1994. The Class C Plan was approved by the sole shareholder of Class C shares on August 1, 1994. CLASS A PLAN. For the fiscal year ended February 28, 1998, the Distributor received payments of $1,263,646 under the Class A Plan. This amount was primarily expended for payment of account servicing fees to financial advisers and other persons who sell Class A shares. For the fiscal year ended February 28, 1998, the Distributor also received approximately $294,300 in initial sales charges. CLASS B PLAN. For the fiscal year ended February 28, 1998, the Distributor received $3,177,448 from the Fund under the Class B Plan and spent approximately $1,274,800 in distributing the Class B shares of the Fund. It is estimated that of the latter amount, approximately $6,700 (.5%) was spent on printing and mailing of prospectuses to other than current shareholders, $208,300 (16.3%) on compensation to Pruco Securities Corporation, an affiliated broker-dealer, for commissions to its representatives and other expenses, including an allocation on account of overhead and other branch office distribution-related expenses incurred by it for distribution of Fund shares; and $1,859,800 (88.2%) on the aggregate of (i) payment of commissions and account servicing fees to financial advisers ($746,600 or 58.6%), and (ii) an allocation on account of overhead and other branch office distribution-related expenses ($313,200 or 24.6%). The term "overhead and other branch office distribution-related expenses" represents (a) the expenses of operating branch offices of Prusec and the Distributor in connection with the sale of Fund shares, including lease costs, the salaries and employee benefits of operations and sales support personnel, utility costs, communications costs and the costs of stationery and supplies, (b) the costs of client sales seminars, (c) expenses of mutual fund sales coordinators to promote the sale of Fund shares and (d) other incidental expenses relating to branch promotion of Fund sales. The Distributor also receives the proceeds of contingent deferred sales charges paid by investors upon certain redemptions of Class B shares. See "Shareholder Guide--How to Sell Your Shares--Contingent Deferred Sales Charges" in the Prospectus. For the fiscal year ended February 28, 1998, the Distributor received approximately $781,400 in contingent deferred sales charges attributable to the Class B shares. CLASS C PLAN. For the fiscal year ended February 28, 1998, the Distributor received $18,923 from the Fund under the Class C Plan and spent approximately $18,400 in distributing the Fund's Class C shares. It is estimated that of the latter amount approximately $400 (2.2%) was spent on printing and mailing of prospectuses to other than current shareholders; $800 (4.3%) on compensation to Pruco Securities Corporation, an affiliated broker-dealer, for commissions to its representatives and other expenses, including an allocation of overhead and other branch office distribution-related expenses, incurred by it for distribution of Fund shares; and $17,200 (93.5%) on the aggregate of (i) payments of commission and account servicing fees to financial advisors ($14,600 or 79.3%) and (ii) an allocation of overhead and other branch office distribution-related expenses ($2,600 or 14.2%). The term "overhead and other branch office distribution-related expenses" represents (a) the expenses of operating Prudential Securities' branch offices in connection with the sale of Fund shares, including lease costs, the salaries and employee benefits of operations and sales support personnel, utility costs, communications costs and the costs of stationery and supplies, (b) the costs of client sales seminars, (c) expenses of mutual fund sales coordinators to promote the sale of Fund shares and (d) other incidental expenses relating to branch promotion of Fund sales. B-17 The Distributor also receives the proceeds of contingent deferred sales charges paid by holders of Class C shares upon certain redemptions of Class C shares. See "Shareholder Guide--How to Sell Your Shares--Contingent Deferred Sales Charges" in the Prospectus. For the fiscal year ended February 28, 1998, the Distributor received approximately $400 in contingent deferred sales charges attributable to Class C shares. The Plans continue in effect from year to year, provided that each such continuance is approved at least annually by a vote of the Board of Directors, including a majority vote of the Rule 12b-1 Directors, cast in person at a meeting called for the purpose of voting on such continuance. The Plans may each be terminated at any time, without penalty, by the vote of a majority of the Rule 12b-1 Directors or by the vote of the holders of a majority of the outstanding shares of the applicable class on not more than 30 days' written notice to any other party to the Plans. The Plans may not be amended to increase materially the amounts to be spent for the services described therein without approval by the shareholders of the applicable class (by both Class A and Class B shareholders, voting separately, in the case of material amendments to the Class A Plan), and all material amendments are required to be approved by the Board of Directors in the manner described above. Each Plan will automatically terminate in the event of its assignment. The Fund will not be contractually obligated to pay expenses incurred under any Plan if it is terminated or not continued. Pursuant to each Plan, the Board of Directors will review at least quarterly a written report of the distribution expenses incurred on behalf of each class of shares of Fund by the Distributor. The report will include an itemization of the distribution expenses and the purposes of such expenditures. In addition, as long as the Plans remain in effect, the selection and nomination of the Rule 12b-1 Directors shall be committed to the Rule 12b-1 Directors. Pursuant to the Distribution Agreement, the Fund has agreed to indemnify the Distributor to the extent permitted by applicable law against certain liabilities under the Securities Act. On November 3, 1995, the Board of Directors approved the transfer of the Distribution Agreement for Class A shares with PMFD to the Distributor, and on May 22, 1997, the Board of Directors, including a majority of the Rule 12b-1 Directors, approved a restated distribution agreement between the Fund and the Distributor relating to all four classes of shares. NASD MAXIMUM SALES CHARGE RULE. Pursuant to rules of the NASD, the Distributor is required to limit aggregate initial sales charges, deferred sales charges and asset-based sales charges to 6.25% of total gross sales of each class of shares. Interest charges on unreimbursed distribution expenses equal to the prime rate plus one percent per annum may be added to the 6.25% limitation. Sales from the reinvestment of dividends and distributions are not included in the calculation of the 6.25% limitation. The annual asset-based sales charge on shares of the Fund may not exceed .75 of 1% per class. The 6.25% limitation applies to the Fund rather than on a per shareholder basis. If aggregate sales charges were to exceed 6.25% of total gross sales of shares of any class, all sales charges on shares of that class would be suspended. PORTFOLIO TRANSACTIONS AND BROKERAGE The Manager is responsible for decisions to buy and sell securities, futures contracts and options on such securities and futures for the Fund, the selection of brokers, dealers and futures commission merchants to effect the transactions and the negotiation of brokerage commissions, if any. For purposes of this section, the term "Manager" includes the Subadviser. Broker-dealers may receive brokerage commissions on Fund portfolio transactions, including options, futures and options on futures transactions and the purchase and sale of underlying securities upon the exercise of options. Orders may be directed to any broker or futures commission merchant including, to the extent and in the manner permitted by applicable law, Prudential Securities and its affiliates. In the U.S. Government securities market, securities are generally traded on a "net" basis with dealers acting as principal for their own accounts without a stated commission, although the price of the security usually includes a profit to the dealer. In underwritten offerings, securities are purchased at a fixed price which includes an amount of compensation to the underwriter, generally referred to as the underwriter's concession or discount. On occasion, certain money market instruments and agency securities may be purchased directly from the issuer, in which case no commissions or discounts are paid. The Fund will not deal with Prudential Securities or its affiliates in any transaction in which Prudential Securities or its affiliates act as principal. Thus, it will not deal in U.S. Government securities with Prudential Securities or its affiliates acting as market maker, and it will not execute a negotiated trade with Prudential or its affiliates if execution involves Prudential Securities or its affiliates acting as principal with respect to any part of the Fund's order. Portfolio securities may not be purchased from any underwriting or selling syndicate of which Prudential Securities or its affiliates, during the existence of the syndicate, is a principal underwriter (as defined in the Investment Company Act), except in accordance with rules of the Commission. This limitation, in the opinion of the Fund, will not significantly B-18 affect the Fund's ability to pursue its present investment objective. However, in the future in other circumstances, the Fund may be at a disadvantage because of this limitation in comparison to other funds with similar objectives but not subject to such limitations. In placing orders for portfolio securities of the Fund, the Manager is required to give primary consideration to obtaining the most favorable price and efficient execution. Within the framework of this policy, the Manager will consider the research and investment services provided by brokers, dealers or futures commission merchants who effect or are parties to portfolio transactions of the Fund, the Manager or the Manager's other clients. Such research and investment services are those which brokerage houses customarily provide to institutional investors and include statistical and economic data and research reports on particular companies and industries. Such services are used by the Manager in connection with all of its investment activities, and some of such services obtained in connection with the execution of transactions for the Fund may be used in managing other investment accounts. Conversely, brokers, dealers or futures commission merchants furnishing such services may be selected for the execution of transactions of such other accounts, whose aggregate assets are far larger than the Fund's, and the services furnished by such brokers, dealers or futures commission merchants may be used by the Manager in providing investment management for the Fund. Commission rates are established pursuant to negotiations with the broker, dealer or futures commission merchant based on the quality and quantity of execution services provided by the broker or futures commission merchant in the light of generally prevailing rates. The Manager's policy is to pay higher commissions to brokers and futures commission merchants, other than Prudential Securities, for particular transactions than might be charged if a different broker had been selected, on occasions when, in the Manager's opinion, this policy furthers the objective of obtaining best price and execution. In addition, the Manager is authorized to pay higher commissions on brokerage transactions for the Fund to brokers and futures commission merchants other than Prudential Securities in order to secure research and investment services described above, subject to review by the Fund's Board of Directors from time to time as to the extent and continuation of this practice. The allocation of orders among brokers and futures commission merchants and the commission rates paid are reviewed periodically by the Fund's Board of Directors. Subject to the above considerations, Prudential Securities may act as a broker or futures commission merchant for the Fund. In order for Prudential Securities (or any affiliate) to effect any portfolio transactions for the Fund, the commissions, fees or other remuneration received by Prudential Securities (or any affiliate) must be reasonable and fair compared to the commissions, fees or other remuneration paid to other such brokers or futures commission merchants in connection with comparable transactions involving similar securities or futures contracts being purchased or sold on an exchange or board of trade during a comparable period of time. This standard would allow Prudential Securities (or any affiliate) to receive no more than the remuneration which would be expected to be received by an unaffiliated broker or futures commission merchant in a commensurate arms-length transaction. Furthermore, the Board of Directors of the Fund, including a majority of the non-interested Directors, has adopted procedures which are reasonably designed to provide that any commissions, fees or other remuneration paid to Prudential Securities (or any affiliate) are consistent with the foregoing standard. In accordance with Section 11(a) of the Securities Exchange Act of 1934, Prudential Securities may not retain compensation for effecting transactions on a national securities exchange for the Fund unless the Fund has expressly authorized the retention of such compensation. Prudential Securities must furnish to the Fund at least annually a statement setting forth the total amount of all compensation retained by Prudential Securities from transactions effected for the Fund during the applicable period. Brokerage and futures transactions with Prudential Securities (or any affiliate) are also subject to such fiduciary standards as may be imposed upon Prudential Securities (or such affiliate) by applicable law. During the fiscal years ended February 28, 1998, February 28, 1997 and February 29, 1996, the Fund paid no brokerage commissions to Prudential Securities. PURCHASE AND REDEMPTION OF FUND SHARES Shares of the Fund may be purchased at a price equal to the next determined net asset value per share (NAV) plus a sales charge which, at the election of the investor, may be imposed either (i) at the time of purchase (Class A shares), or (ii) on a deferred basis (Class B or Class C shares). Class Z shares of the Fund are offered to a limited group of investors at net asset value without any sales charges. See "Shareholder Guide--How to Buy Shares of the Fund" in the Prospectus. Each class represents an interest in the same assets of the Fund and is identical in all respects except that (i) each class is subject to different sales charges and distribution and/or service expenses which may affect performance, B-19 (ii) each class has exclusive voting rights with respect to any matter submitted to shareholders that relates solely to its arrangement and has separate voting rights on any matter submitted to shareholders in which the interests of one class differ from the interests of any other class, (iii) each class has a different exchange privilege, (iv) only Class B shares have a conversion feature and (v) Class Z shares are offered exclusively for sale to a limited group of investors. See "Distributor" and "Shareholder Investment Account--Exchange Privilege." ISSUANCE OF FUND SHARES FOR SECURITIES Transactions involving the issuance of Fund shares for securities (rather than cash) will be limited to (i) reorganizations, (ii) statutory mergers, or (iii) other acquisitions of portfolio securities that: (a) meet the investment objectives and policies of the Fund, (b) are liquid and not subject to restrictions on resale, (c) have a value that is readily ascertainable via listing on or trading in a recognized United States or international exchange or market, and (d) are approved by the Fund's investment adviser. SPECIMEN PRICE MAKE-UP Under the current distribution arrangements between the Fund and the Distributor, Class A shares are sold at a maximum sales charge of 4%, and Class B*, Class C* and Class Z shares are sold at NAV. Using the Fund's NAV at February 28, 1998, the maximum offering price of the Fund's shares is as follows: CLASS A Net asset value and redemption price per Class A share............. $ 9.05 Maximum sales charge (4% of offering price)........................ .38 --------- Offering price to public........................................... $ 9.43 --------- --------- CLASS B Net asset value, offering price and redemption price per Class B share*........................................................... $ 9.05 --------- --------- CLASS C Net asset value, offering price and redemption price per Class C share*........................................................... $ 9.05 --------- --------- CLASS Z Net asset value, offering price and redemption price per Class Z share............................................................ $ 9.04 --------- ---------
- ------------------------ * Class B and Class C shares are subject to a contingent deferred sales charge on certain redemptions. See "Shareholder Guide--How to Sell Your Shares--Contingent Deferred Sales Charges" in the Prospectus. REDUCTION AND WAIVER OF INITIAL SALES CHARGES--CLASS A SHARES COMBINED PURCHASE AND CUMULATIVE PURCHASE PRIVILEGE. If an investor or eligible group of related investors purchases Class A shares of the Fund concurrently with Class A shares of other Prudential Mutual Funds, the purchases may be combined to take advantage of the reduced sales charges applicable to larger purchases. See the table of breakpoints under "Shareholder Guide--Alternative Purchase Plan" in the Prospectus. An eligible group of related Fund investors includes any combination of the following: (a) an individual; (b) the individual's spouse, their children and their parents; (c) the individual's and spouse's Individual Retirement Account (IRA); (d) any company controlled by the individual (a person, entity or group that holds 25% or more of the outstanding voting securities of a corporation will be deemed to control the corporation, and a partnership will be deemed to be controlled by each of its general partners); (e) a trust created by the individual, the beneficiaries of which are the individual, his or her spouse, parents or children; B-20 (f) a Uniform Gifts to Minors Act/Uniform Transfers to Minors Act account created by the individual or the individual's spouse; and (g) one or more employee benefit plans of a company controlled by an individual. In addition, an eligible group of related Fund investors may include an employer (or group of related employers) and one or more qualified retirement plans of such employer or employers (an employer controlling, controlled by or under common control with another employer is deemed related to that employer). The Distributor must be notified at the time of purchase that the investor is entitled to a reduced sales charge. The reduced sales charge will be granted subject to confirmation of the investors holdings. The Combined Purchase and Cumulative Purchase Privilege does not apply to individual participants in any retirement or group plans. RIGHTS OF ACCUMULATION. Reduced sales charges are also available through Rights of Accumulation, under which an investor or an eligible group of related investors, as described above under "Combined Purchase and Cumulative Purchase Privilege," may aggregate the value of their existing holdings of the shares of the Fund and shares of other Prudential Mutual Funds (excluding money market funds other than those acquired pursuant to the exchange privilege) to determine the reduced sales charge. However, the value of shares held directly with the Transfer Agent and through Prudential Securities will not be aggregated to determine the reduced sales charge. All shares must be held either directly with the Transfer Agent or through Prudential Securities. The value of existing holdings for purposes of determining the reduced sales charge is calculated using the maximum offering or price (net asset value plus maximum sales charge) as of the previous business day. See "How the Fund Values Its Shares" in the Prospectus. The Distributor must be notified at the time of purchase that the investor is entitled to a reduced sales charge. The reduced sales charges will be granted subject to confirmation of the investor's holdings. Rights of accumulation are not available to individual participants in any retirement or group plans. LETTERS OF INTENT. Reduced sales charges are available to investors (or an eligible group of related investors), including retirement and group plans, who enter into a written Letter of Intent providing for the purchase, within a thirteen-month period, of shares of the Fund and shares of other Prudential Mutual Funds (Investment Letter of Intent). Retirement and group plans may also qualify to purchase Class A shares at NAV by entering into a Letter of Intent whereby they agree to enroll, within a thirteen month period, a specified number of eligible employees or participants (Participant Letter of Intent). For purposes of the Investment Letter of Intent, all shares of the Fund and shares of other Prudential Mutual Funds (excluding money market funds other than those acquired pursuant to the exchange privilege) which were previously purchased and are still owned are also included in determining the applicable reduction. However, the value of shares held directly with the Transfer Agent and through Prudential Securities will not be aggregated to determine the reduced sales charge. All shares must be held either directly with the Transfer Agent or through Prudential Securities. A Letter of Intent permits a purchaser, in the case of an Investment Letter of Intent, to establish a total investment goal to be achieved by any number of investments over a thirteen-month period and, in the case of a Participant Letter of Intent, to establish a minimum eligible employee or participant enrollment goal over a thirteen month period. Each investment made during the period, in the case of an Investment Letter of Intent, will receive the reduced sales charge applicable to the amount represented by the goal, as if it were a single investment. In the case of a Participant Letter of Intent, each investment made during the period will be made at net asset value. Escrowed Class A shares totaling 5% of the dollar amount of the Letter of Intent will be held by the Transfer Agent in the name of the purchaser, except in the case of retirement and group plans where the employer or plan sponsor will be responsible for paying any applicable sales charge. The effective date of an Investment Letter of Intent (except in the case of retirement and group plans) may be back-dated up to 90 days, in order that any investments made during this 90-day period, valued at the purchaser's cost, can be applied to the fulfillment of the Letter of Intent goal, except in the case of retirement and group plans. The Investment Letter of Intent does not obligate the investor to purchase, nor the Fund to sell, the indicated amount. Similarly, the Participant Letter of Intent does not obligate the retirement or group plan to enroll the indicated number of eligible employees or participants. In the event the Letter of Intent goal is not achieved within the thirteen-month period, the purchaser (or the employer or plan sponsor in the case of any retirement or group plan) is required to pay the difference between the sales charge otherwise applicable to the purchases made during this period and sales charges B-21 actually paid. Such payment may be made directly to the Distributor or, if not paid, the Distributor will liquidate sufficient escrowed shares to obtain such difference. Investors electing to purchase Class A shares of the Fund pursuant to a Letter of Intent should carefully read such Letter of Intent. The Distributor must be notified at the time of purchase that the investor is entitled to a reduced sales charge. The reduced sales charge will, in the case of an Investment Letter of Intent, be granted subject to confirmation of the investor's holdings or in the case of a Participant Letter of Intent, subject to confirmation of the number of eligible employees or participants in the retirement or group plan. Letters of Intent are not available to individual participants in any retirement or group plans. WAIVER OF THE CONTINGENT DEFERRED SALES CHARGE--CLASS B SHARES The contingent deferred sales charge (CDSC) is waived under circumstances described in the Prospectus. See "Shareholder Guide--How to Sell Your Shares--Waiver of Contingent Deferred Sales Charges--Class B Shares" in the Prospectus. In connection with these waivers, the Transfer Agent will require you to submit the supporting documentation set forth below. CATEGORY OF WAIVER REQUIRED DOCUMENTATION Death A copy of the shareholder's death certificate or, in the case of a trust, a copy of the grantor's death certificate, plus a copy of the trust agreement identifying the grantor. Disability--An individual will be considered A copy of the Social Security Administration disabled if he or she is unable to engage in award letter or a letter from a physician on any substantial gainful activity by reason of the physician's letterhead stating that the any medically determinable physical or mental shareholder (or, in the case of a trust, the impairment which can be expected to result in grantor) is permanently disabled. The letter death or to be of long-continued and must also indicate the date of disability. indefinite duration. Distribution from an IRA or 403(b) Custodial A copy of the distribution form from the Account custodial firm indicating (i) the date of birth of the shareholder and (ii) that the shareholder is over age 59 1/2 and is taking a normal distribution--signed by the shareholder. Distribution from Retirement Plan A letter signed by the plan administrator/trustee indicating the reason for the distribution. Excess Contributions A letter from the shareholder (for an IRA) or the plan administrator/trustee on company letterhead indicating the amount of the excess and whether or not taxes have been paid.
The Transfer Agent reserves the right to request such additional documents as it may deem appropriate. QUANTITY DISCOUNT--CLASS B SHARES PURCHASED PRIOR TO AUGUST 1, 1994 The CDSC is reduced on redemptions of Class B shares of the Fund purchased prior to August 1, 1994 if immediately after a purchase of such shares, the aggregate cost of all Class B shares of the Fund owned by you in a single account exceeded $500,000. For example, if you purchased $100,000 of Class B shares of the Fund and the following year purchased an additional $450,000 of Class B shares with the result that the aggregate cost of your Class B shares of the B-22 Fund following the second purchase was $550,000, the quantity discount would be available for the second purchase of $450,000 but not for the first purchase of $100,000. The quantity discount will be imposed at the following rates depending on whether the aggregate value exceeded $500,000 or $1 million:
CONTINGENT DEFERRED SALES CHARGE AS A PERCENTAGE OF DOLLARS INVESTED OR REDEMPTION PROCEEDS YEAR SINCE PURCHASE ----------------------------------------------- PAYMENT MADE $500,001 TO $1 MILLION OVER $1 MILLION - ----------------------------------- ------------------------ ---------------- First.............................. 3.0% 2.0% Second............................. 2.0% 1.0% Third.............................. 1.0% 0% Fourth and thereafter.............. 0% 0%
You must notify the Fund's Transfer Agent either directly or through Prudential Securities or Prusec, at the time of redemption, that you are entitled to the reduced CDSC. The reduced CDSC will be granted subject to confirmation of your holdings. SHAREHOLDER INVESTMENT ACCOUNT Upon the initial purchase of Fund shares, a Shareholder Investment Account is established for each investor under which the shares are held for the investor by the Transfer Agent. If a stock certificate is desired, it must be requested in writing for each transaction. Certificates are issued only for full shares and may be redeposited in the Account at any time. There is no charge to the investor for issuance of a certificate. The Fund makes available to the shareholders the following privileges and plans. AUTOMATIC REINVESTMENT OF DIVIDENDS AND/OR DISTRIBUTIONS For the convenience of investors, all dividends and distributions are automatically reinvested in full and fractional shares of the Fund. An investor may direct the Transfer Agent in writing not less than 5 full business days prior to the payment date to have subsequent dividends and/or distributions sent in cash rather than reinvested. In the case of recently purchased shares for which registration instructions have not been received on the payment date, cash payment will be made directly to the dealer. Any shareholder who receives a cash payment representing a dividend or distribution may reinvest such distribution at NAV by returning the check or the proceeds to the Transfer Agent within 30 days after the payment date. Such investment will be made at the NAV next determined after receipt of the check or proceeds by the Transfer Agent. Such shareholder will receive credit for any CDSC paid in connection with the amount of proceeds being reinvested. EXCHANGE PRIVILEGE The Fund makes available to its shareholders the privilege of exchanging their shares of the Fund for shares of certain other Prudential Mutual Funds, including one or more specified money market funds, subject in each case to the minimum investment requirements of such funds. Shares of such other Prudential Mutual Funds may also be exchanged for shares of the Fund. All exchanges are made on the basis of the relative NAV next determined after receipt of an order in proper form. An exchange will be treated as a redemption and purchase for tax purposes. Shares may be exchanged for shares of another fund only if shares of such fund may legally be sold under applicable state laws. For retirement and group plans having a limited menu of Prudential Mutual Funds, the exchange privilege is available for those funds eligible for investment in the particular program. It is contemplated that the exchange privilege may be applicable to new mutual funds whose shares may be distributed by the Distributor. CLASS A. Shareholders of the Fund may exchange their Class A shares for Class A shares of certain other Prudential Mutual Funds, shares of Prudential Government Securities Trust (Short-Intermediate Term Series) and shares of the money market funds specified below. No fee or sales load will be imposed upon the exchange. Shareholders of money market funds who acquired such shares upon exchange of Class A shares may use the exchange privilege only to acquire Class A shares of the Prudential Mutual Funds participating in the exchange privilege. B-23 The following money market funds participate in the Class A exchange privilege: Prudential California Municipal Fund (California Money Market Series) Prudential Government Securities Trust (Money Market Series) (Class A shares) (U.S. Treasury Money Market Series) (Class A shares) Prudential Municipal Series Fund (Connecticut Money Market Series) (Massachusetts Money Market Series) (New Jersey Money Market Series) (New York Money Market Series) Prudential MoneyMart Assets, Inc. (Class A Shares) Prudential Tax-Free Money Fund, Inc. CLASS B AND CLASS C. Shareholders of the Fund may exchange their Class B and Class C shares for Class B and Class C shares, respectively, of certain other Prudential Mutual Funds and shares of Prudential Special Money Market Fund, Inc., a money market fund. No CDSC will be payable upon such exchange, but a CDSC may be payable upon the redemption of Class B and Class C shares acquired as a result of the exchange. The applicable sales charge will be that imposed by the fund in which shares were initially purchased and the purchase date will be deemed to be the first day of the month after initial purchase, rather than the date of the exchange. Class B and Class C shares of the Fund may also be exchanged for shares of Prudential Special Money Market Fund without imposition of any CDSC at the time of exchange. Upon subsequent redemption from such money market fund or after re-exchange into the Fund, such shares will be subject to the CDSC calculated excluding the time such shares were held in the money market fund. In order to minimize the period of time in which shares are subject to a CDSC, shares exchanged out of the money market fund will be exchanged on the basis of their remaining holding periods, with the longest remaining holding periods being transferred first. In measuring the time period shares are held in a money market fund and "tolled" for purposes of calculating the CDSC holding period, exchanges are deemed to have been made on the last day of the month. Thus, if shares are exchanged into the Fund from a money market fund during the month (and are held in the Fund at the end of the month), the entire month will be included in the CDSC holding period. Conversely, if shares are exchanged into a money market fund prior to the last day of the month (and are held in the money market fund on the last day of the month), the entire month will be excluded from the CDSC holding period. For purposes of calculating the seven year holding period applicable to the Class B conversion feature, the time period during which Class B shares were held in a money market fund will be excluded. At any time after acquiring shares of other funds participating in the Class B or Class C exchange privilege, a shareholder may again exchange those shares (and any reinvested dividends and distributions) for Class B or Class C shares of the Fund, respectively, without subjecting such shares to any CDSC. Shares of any fund participating in the Class B or Class C exchange privilege that were acquired through reinvestment of dividends or distributions may be exchanged for Class B or Class C, respectively, shares of other funds without being subject to any CDSC. CLASS Z. Class Z shares may be exchanged for Class Z shares of other Prudential Mutual Funds. Additional details about the exchange privilege for each of the Prudential Mutual Funds are available from the Fund's Transfer Agent, Prudential Securities or Prusec. The exchange privilege may be modified, terminated or suspended on sixty (60) days' notice, and any fund, including the Fund, or Prudential Securities, has the right to reject any exchange application relating to such Fund's shares. DOLLAR COST AVERAGING Dollar cost averaging is a method of accumulating shares by investing a fixed amount of dollars in shares at set intervals. An investor buys more shares when the price is low and fewer shares when the price is high. The average cost per share is lower than it would be if a constant number of shares were bought at set intervals. Dollar cost averaging may be used, for example, to plan for retirement to save for a major expenditure, such as the purchase of a home, or to finance a college education. The cost of a year's education at a four-year college today B-24 averages around $14,000 at a private college and around $6,000 at a public university. Assuming these costs increase at a rate of 7% a year, as has been projected, for the freshman class of 2011, the cost of four years at a private college could reach $210,000 and over $90,000 at a public university.(1) The following chart shows how much you would need in monthly investments to achieve specified lump sums to finance your investment goals.(2)
PERIOD OF MONTHLY INVESTMENTS: $100,000 $150,000 $200,000 $250,000 - ------------------------------------------------------------ ----------- ----------- ----------- ----------- 25 Years.................................................... $ 110 $ 165 $ 220 $ 275 20 Years.................................................... 176 264 352 440 15 Years.................................................... 296 444 592 740 10 Years.................................................... 555 833 1,110 1,388 5 Years.................................................... 1,371 2,057 2,742 3,428 See "Automatic Savings Accumulation Plan (ASAP)" below. - ------------------------ (1) Source information concerning the costs of education at public and private universities is available from The College Board Annual Survey of Colleges, 1993. Average costs for private institutions include tuition, fees, room and board for its 1993-1994 academic year. (2) The chart assumes an effective rate of return of 8% (assuming monthly compounding). This example is for illustrative purposes only and is not intended to reflect the performance of an investment in shares of the Fund. The investment return and principal value of an investment will fluctuate so that an investor's shares when redeemed may be worth more or less than their original cost.
AUTOMATIC SAVINGS ACCUMULATION PLAN (ASAP) Under ASAP, an investor may arrange to have a fixed amount automatically invested in shares of the Fund monthly by authorizing his or her bank account or Prudential Securities account (including a Command Account) to be debited to invest specified dollar amounts in shares of the Fund. The investor's bank must be a member of the Automatic Clearing House System. Stock certificates are not issued to ASAP participants. Further information about this program and an application form can be obtained from the Transfer Agent, Prudential Securities or Prusec. SYSTEMATIC WITHDRAWAL PLAN A systematic withdrawal plan is available to shareholders through Prudential Securities or the Transfer Agent. Such withdrawal plan provides for monthly or quarterly checks in any amount, except as provided below, up to the value of the shares in the shareholder's account. Withdrawals of Class B or Class C shares may be subject to a CDSC. See "Shareholder Guide--How to Sell Your Shares--Contingent Deferred Sales Charges" in the Prospectus. In the case of shares held through the Transfer Agent (i) a $10,000 minimum account values applies, (ii) withdrawals may not be for less than $100 and (iii) the shareholder must elect to have all dividends and/or distributions automatically reinvested in additional full and fractional shares at NAV on shares held under this plan. See "Automatic Reinvestment of Dividends and/or Distributions" above. Prudential Securities and the Transfer Agent act as agents for the shareholder in redeeming sufficient full and fractional shares to provide the amount of the periodic withdrawal payment. The systematic withdrawal plan may be terminated at any time, and the Distributor reserves the right to initiate a fee of up to $5 per withdrawal, upon 30 days' written notice to the shareholder. Withdrawal payments should not be considered as dividends, yield or income. If periodic withdrawals continuously exceed reinvested dividends and distributions, the shareholder's original investment will be correspondingly reduced and ultimately exhausted. Furthermore, each withdrawal constitutes a redemption of shares, and any gain or loss realized must be recognized for federal income tax purposes. In addition, withdrawals made concurrently with purchases of additional shares are inadvisable because of the sales charges applicable to (i) the purchase of Class A shares and (ii) the withdrawal of Class B and Class C shares. Each shareholder should consult his or her own tax adviser with regard to the tax consequences of the systematic withdrawal plan, particularly if used in connection with a retirement plan. B-25 TAX-DEFERRED RETIREMENT PLANS Various tax-deferred retirement plans, including 401(k) plans, self-directed individual retirement accounts and "tax-sheltered accounts" under Section 403(b)(7) of the Internal Revenue Code are available through Prudential Securities. These plans are for use by both self-employed individuals and corporate employers. These plans permit either self-direction of accounts by participants, or a pooled account arrangement. Information regarding the establishment of these plans, the administration, custodial fees and other details are available from Prudential Securities or the Transfer Agent. Investors who are considering the adoption of such a plan should consult with their own legal counsel or tax adviser with respect to the establishment and maintenance of any such plan. TAX-DEFERRED RETIREMENT ACCOUNTS INDIVIDUAL RETIREMENT ACCOUNTS. An individual retirement account (IRA) permits the deferral of federal income tax on income earned in the account until the earnings are withdrawn (or, in the case of a Roth IRA, the avoidance of federal income tax on such income). The following chart represents a comparison of the earnings in a personal savings account with those in an IRA, assuming a $2,000 annual contribution, an 8% rate of return and a 39.6% federal income tax bracket and shows how much more retirement income can accumulate within an IRA as opposed to a taxable individual savings account.
TAX-DEFERRED COMPOUNDING(1) CONTRIBUTIONS PERSONAL MADE OVER: SAVINGS IRA -------------------- -------- -------- 10 years............ $ 26,165 $ 31,291 15 years............ 44,675 58,649 20 years............ 68,109 98,846 25 years............ 97,780 157,909 30 years............ 135,346 244,692 - ------------------------ (1) The chart is for illustrative purposes only and does not represent the performance of the Fund or any specific investment. It shows taxable versus tax-deferred compounding for the periods and on the terms indicated. Earnings in a traditional IRA account will be subject to tax when withdrawn from the account. Distributions from a Roth IRA which meet the conditions under the Internal Revenue Code will not be subject to tax withdrawal from the account.
MUTUAL FUND PROGRAMS From time to time, the Fund may be included in a mutual fund program with other Prudential Mutual Funds. Under such a program, a group of portfolios will be selected and thereafter marketed collectively. Typically, these programs are created with an investment theme, E.G., to seek greater diversification, protection from interest rate movements or access to different management styles. In the event such a program is instituted, there may be a minimum investment requirement for the program as a whole. The Fund may waive or reduce the minimum initial investment requirements in connection with such a program. The mutual funds in the program may be purchased individually or as a part of a program. Since the allocation of portfolios included in a program may not be appropriate for all investors, investors should consult their Prudential Securities Financial Adviser or Prudential/Pruco Securities Representative concerning the appropriate blends of portfolios for them. If investors elect to purchase the individual mutual funds that constitute a program in an investment ratio different from that offered by the program, the standard minimum investment requirements for the individual mutual funds will apply. NET ASSET VALUE Under the Investment Company Act, the Board of Directors is responsible for determining in good faith the fair value of securities of the Fund. In accordance with procedures adopted by the Board of Directors, the value of each U.S. Government security for which quotations are available will be based on the valuations provided by a pricing service which uses information with respect to transactions in bonds, quotations from bond dealers, agency ratings, market transactions in comparable securities and various relationships between securities in determining value. Options on U.S. Government B-26 securities traded on an exchange are valued at the mean between the most recently quoted bid and asked prices on the respective exchange. Futures contracts and options thereon are valued at their last sales prices as of the close of the commodities exchange or board of trade or, if there was no sale on such day, the mean between the most recently quoted bid and asked prices on such exchange or board of trade. Should an extraordinary event, which is likely to affect the value of the security, occur after the close of an exchange on which a portfolio security is traded, such security will be valued at fair value considering factors determined in good faith by the investment adviser under procedures established by and under the general supervision of the Fund's Board of Directors. The Fund will compute its NAV at 4:15 P.M., New York time, on each day the New York Stock Exchange is open for trading except on days on which no orders to purchase, sell or redeem Fund shares have been received or days on which changes in the value of the Fund's portfolio securities do not affect NAV. In the event the New York Stock Exchange closes early on any business day, the net asset value of the Fund's shares shall be determined at a time between such closing and 4:15 P.M., New York time. NAV is calculated separately for each class. The NAV of Class B and Class C shares will generally be lower than the NAV of Class A shares as a result of the larger distribution-related fee to which Class B and Class C shares are subject. The NAV of Class Z shares will generally be higher than the NAV of Class A, Class B or Class C shares as a result of the fact that the Class Z shares are not subject to any distribution of service fee. It is expected, however, that the NAV per share of each class will tend to converge immediately after the recording the dividends, which will differ by approximately the amount of the distribution-related expense accrual differential among the classes. TAXES, DIVIDENDS AND DISTRIBUTIONS GENERAL. The Fund has elected to qualify and intends to remain qualified as a regulated investment company under Subchapter M of the Internal Revenue Code for each taxable year. Accordingly, the Fund generally must, among other things, (a) derive at least 90% of its gross income (without offset for losses from the sale or other disposition of securities or foreign currencies) from dividends, interest, proceeds from loans of securities and gains from the sale or other disposition of securities or foreign currencies or other income related to its business of investing in securities and currencies, including, but not limited to, gains derived from options and futures on such securities or foreign currencies; and (b) diversify its holdings so that, at the end of each fiscal quarter, (i) 50% of the market value of the Fund's assets is represented by cash, U.S. Government securities and other securities limited, in respect of any one issuer, to an amount not greater than 5% of the Fund's assets and no more than 10% of the outstanding voting securities of any such issuer, and (ii) not more than 25% of the value of its assets is invested in the securities of any one issuer (other than U.S. Government securities). These requirements may limit the Fund's ability to engage in or close out transactions involving options on securities, interest rate futures and options thereon. The Fund has received a private letter ruling from the Internal Revenue Service (IRS) to the effect that the Fund's investments in options on U.S. Government securities, in interest rate futures contracts and in options thereon will be treated as "securities" for purposes of the foregoing requirements for qualification under Subchapter M of the Internal Revenue Code. As a regulated investment company, the Fund will not be subject to federal income tax on its net investment income and capital gains, if any, that it distributes to its shareholders, provided that it distributes at least 90% of its net investment income and short-term capital gains earned in each year. A 4% nondeductible excise tax will be imposed on the Fund to the extent the Fund does not meet certain distribution requirements by the end of each calendar year. The Fund intends to make sufficient distributions to avoid imposition of excise tax. Distributions of net investment income and net short-term capital gains will be taxable to the shareholder at ordinary income rates regardless of whether the shareholder receives such distributions in additional shares or in cash. Distributions of net capital gains, if any, are taxable as capital gains regardless of how long the investor has held his or her Fund shares. Recent legislation created various categories of capital gains applicable to individuals. However, if a shareholder holds shares in the Fund for not more than six months, then any loss recognized on the sale of such shares will be treated as long-term capital loss to the extent of any distribution on the shares which was treated as long-term capital gain. Shareholders will be notified annually by the Fund as to the federal tax status of distributions made by the Fund. Dividends B-27 paid by the Fund will not be subject to the dividends received deduction available to corporations. Distributions and gains from the sale, redemption or exchange of shares of the Fund may be subject to additional state, local and foreign taxes. Shareholders are urged to consult their tax advisers regarding specific questions as to federal, state, local or foreign taxes. Dividends and distributions generally are taxable to shareholders in the year in which they are received; however, dividends declared in October, November and December and paid on the following January will be treated as having been paid on December 31 of such prior year. Under this rule, a shareholder may be taxed in one year on dividends received in the following January. Any distributions paid shortly after a purchase by an investor may have the effect of reducing the per share net asset value of the investor's shares by the per share amount of the distributions. Furthermore, such distributions, although in effect a return of capital, are subject to federal income taxes. Therefore, prior to purchasing shares of the Fund, the investor should carefully consider the impact of capital gains distributions, which are expected to be or have been announced. Dividends of net investment income and distributions of net short-term capital gains paid to a shareholder (including a shareholder acting as a nominee or fiduciary) who is a nonresident alien individual, a foreign corporation or a foreign partnership (foreign shareholder) are subject to a 30% (or lower treaty rate) withholding tax upon the gross amount of the dividends unless the dividends are effectively connected with a U.S. trade or business conducted by the foreign shareholder. Capital gain distributions paid to a foreign shareholder are generally not subject to withholding tax. A foreign shareholder will, however, be required to pay U.S. income tax on any dividends and capital gain distributions which are effectively connected with a U.S. trade or business of the foreign shareholder. Any loss realized on a sale, redemption or exchange of shares of the Fund by a shareholder will be disallowed to the extent the shares are replaced within a 61-day period (beginning 30 days before the disposition of shares). Shares purchased pursuant to the reinvestment of a dividend or distribution will constitute a replacement of shares. A shareholder who acquires shares of the Fund and sells or otherwise disposes of such shares within 90 days of acquisition may not be allowed to include certain sales charges incurred in acquiring such shares for purposes of calculating gain or loss realized upon a sale or exchange of shares of the Fund. Although the Fund does not receive interest payments on zero-coupon bonds in cash, it is required to accrue interest on such bonds for tax purposes. Accordingly, in order to meet the distribution requirements discussed above, the Fund may have to liquidate securities or borrow money. To date, the Fund has not engaged in borrowing or liquidated securities solely or primarily for the purpose of meeting income distribution requirements attributable to investments in zero coupon bonds. Income received by the Fund from sources within foreign countries may be subject to withholding and other taxes imposed by such countries. Income tax treaties between certain countries and the United States may reduce or eliminate such taxes. It is impossible to determine in advance the effective rate of foreign tax to which the Fund will be subject since the amount of the Fund's assets to be invested in various countries will vary. The Fund has a capital loss carryforward for federal income tax purposes as of February 28, 1998 of approximately $131,130,000, of which $41,964,000 expires in 1999, $1,736,000 expires in 2001, $2,920,000 expires in 2002, $66,560,000 expires in 2003 and $17,950,000 expires in 2005. The per share dividends on Class B and Class C shares will be lower than the per share dividends on Class A shares as a result of the higher distribution-related fee applicable to the Class B and Class C shares. The per share dividends on Class A shares will be lower than the per share dividends on Class Z shares. The per share distributions of net capital gains, if any, will be paid in the same amount for Class A, Class B, Class C and Class Z shares. See "Net Asset Value." LISTED OPTIONS AND FUTURES. Exchange-traded futures contracts, listed options on futures contracts and listed options on U.S. Government securities constitute "Section 1256 contracts" under the Internal Revenue Code. Section 1256 contracts are required to be "marked-to-market" at the end of the Fund's tax year; that is, treated as having been sold at market value. Sixty percent of any gain or loss recognized as a result of such "deemed sales" will be treated as long-term capital gain or loss and the remainder will be treated as short-term capital gain or loss. B-28 If the Fund holds a U.S. Government security which is offset by a Section 1256 contract, the Fund is considered to hold a "mixed straddle". The Fund may elect whether to make a straddle-by-straddle identification of mixed straddles. By electing to identify its mixed straddles, the Fund can avoid the application of certain rules which could, in some circumstances, cause deferral or disallowance of losses, the change of long-term capital gains into short-term capital gains, or the change of short-term capital losses into long-term capital losses. Nevertheless, the Fund would be subject to the following rules. If the Fund owns a U.S. Government security and acquires an offsetting Section 1256 contract in a transaction which the Fund elects to identify as a mixed straddle, the acquisition of the offsetting position will result in recognition of the unrealized gain or loss on the U.S. Government security. This gain or loss will be long-term or short-term depending on the holding period of the security at the time the mixed straddle is entered into. This recognition of unrealized gain or loss will be taken into account in determining the amount of income available for the Fund's quarterly distributions, and can result in an amount which is greater or less than the Fund's net realized gains being available for such distributions. If an amount which is less than the Fund's net realized gains is available for distribution, the Fund may elect to distribute more than such available amount, up to the full amount of such net realized gains. The rules for determining whether gain or loss upon exercise, expiration or termination of an identified mixed straddle will be treated as long-term, short-term, or sixty percent long-term and forty percent short-term are complex. In general, which treatment applies will depend upon the order of disposition of the Section 1256 and the non-Section 1256 positions of a straddle and whether all or fewer than all of such positions are disposed of on any day. If the Fund does not elect to identify a mixed straddle, no recognition of gain or loss on the U.S. Government securities in the Fund's portfolio will result when the mixed straddle is entered into. However, any gains or losses realized on the straddle will be governed by a number of tax rules which might, under certain circumstances, defer or disallow the losses in whole or in part, change long-term gains into short-term gains, change short-term losses into long-term losses, or change capital gains into ordinary income. A deferral or disallowance of recognition of a realized loss may result in the Fund being required to distribute an amount greater than the Fund's net realized gains. The Fund may also elect under Section 1256(d) of the Internal Revenue Code that the provisions of Section 1256 will not apply to Section 1256 contracts which are part of a mixed straddle. In the case of such an election, the taxation of options on U.S. Government securities and the taxation of futures will be governed by provisions of the Internal Revenue Code dealing with taxation of capital assets generally. OTC OPTIONS. Non-listed options on U.S. Government securities (OTC options) are not Section 1256 contracts. If an OTC option written by the Fund on U.S. Government securities expires, the amount of the premium will be treated as short-term capital gain. If the option is terminated through a closing purchase transaction, the Fund will generally recognize a short-term capital gain or loss, depending on whether the premium income is greater or less than the amount paid by the Fund in the closing transaction. If U.S. Government securities are delivered by the Fund upon exercise of a written call option, or sold to the Fund upon exercise of a written put option, the premium received when the option was written will be treated as an addition to the proceeds received in the case of the call option, or a decrease in the cost basis of the security received in the case of a put option. The gain or loss realized on the exercise of a written call option will be long-term or short-term depending upon the holding period of the U.S. Government security delivered. The premium paid for a purchased put or call option is a capital expenditure, and loss will be realized on the expiration, and gain or loss will be realized upon the sale of, a put or call option. The characterization of the gain or loss as short-term or long-term will depend upon the holding period of the option. If U.S. Government securities are purchased by the Fund upon exercise of a purchased call option, or delivered by the Fund upon exercise of a purchased put option, the premium paid when the option was purchased will be treated as an addition to the basis of the securities purchased in the case of a call option, or as a decrease in the proceeds received for the securities delivered in the case of a put option. Losses realized on straddles which include a purchased put option, can, under certain circumstances, be subject to a number of tax rules which might defer or disallow the losses in whole or in part, change long-term gains into short-term gains, change short-term losses into long-term losses, or change capital gains into ordinary income. As noted above, a deferral or disallowance of recognition of realized loss can result in the Fund being required to distribute an amount greater than the Fund's net realized gains. B-29 PENNSYLVANIA PERSONAL PROPERTY TAX. The Fund has obtained a written letter of determination from the Pennsylvania Department of Revenue that the Fund is subject to the Pennsylvania foreign franchise and corporate net income tax. Accordingly, it is expected that Fund shares will be exempt from Pennsylvania personal property taxes. The Fund anticipates that it will continue such business activities but reserves the right to suspend them at any time, resulting in the termination of the exemption. PERFORMANCE INFORMATION YIELD. The Fund may from time to time advertise its yield as calculated over a 30-day period. Yield is calculated separately for Class A, Class B, Class C and Class Z shares. The yield will be computed by dividing the Fund's net investment income per share earned during this 30-day period by the net asset value per share on the last day of this period. Yield is calculated according to the following formula: a - b YIELD = 2[( ------- +1)to the power of 6 - 1] cd 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. The yield for the 30-day period ended February 28, 1998 for the Fund's Class A, Class B, Class C and Class Z shares was 5.76%, 5.32%, 5.40% and 6.15%, respectively. Yield fluctuates and an annualized yield quotation is not a representation by the Fund as to what an investment in the Fund will actually yield for any given period. Actual yields will depend upon not only changes in interest rates generally during the period in which the investment in the Fund is held, but also on any realized or unrealized gains and losses and changes in the Fund's expenses. AVERAGE ANNUAL TOTAL RETURN. The Fund may from time to time also advertise its average annual total return. Average annual total return is determined separately for Class A, Class B and Class C shares. See "How the Fund Calculates Performance" in the Prospectus. Average annual total return is computed according to the following formula: P(1+T)to the power of n = ERV Where: P = a hypothetical initial payment of $1000. T = average annual total return. n = number of years. ERV = ending redeemable value of a hypothetical $1000 investment 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 thereof). Average annual return takes into account any applicable initial or contingent deferred sales charges but does not take into account any federal or state income taxes that may be payable upon redemption. The average annual total return for Class A shares for the one year, five year and since commencement of offering of Class A shares (January 22, 1990) periods ended on February 28, 1998 was 5.74%, 5.25% and 7.43%, respectively. The average annual total return with respect to the Class B shares of the Fund for the one, five and ten year periods ended February 28, 1998 was 4.40%, 5.25% and 7.04%, respectively. The average annual total return for Class C shares for the one year and since commencement of offering Class C shares (August 1, 1994) periods ended February 28, 1998, was 8.48% and 7.51%, respectively. The average annual total return for Class Z shares for the one year and since commencement of offering of Class Z shares (March 1, 1996) was 10.30% and 6.68%, respectively. B-30 AGGREGATE TOTAL RETURN. The Fund may also advertise its aggregate total return. Aggregate total return is determined separately for Class A, Class B, Class C and Class Z shares. See "How the Fund Calculates Performance" in the Prospectus. Aggregate total return represents the cumulative change in the value of an investment in the Fund and is computed by the following formula: ERV - P ------- P Where: P = a hypothetical initial payment of $1000. ERV = ending redeemable value of a hypothetical $1000 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 thereof). Aggregate total return does not take into account any federal or state income taxes that may be payable upon redemption or any applicable initial or contingent deferred sales charges. The aggregate total return for Class A shares for the one year, five year and since commencement of offering Class A shares (January 22, 1990) periods ended February 28, 1998 was 10.26%, 34.51% and 86.14%, respectively. The aggregate total return for Class B shares for the one, five and ten year periods ended February 28, 1998 was 9.40%, 29.95% and 97.48%, respectively. The aggregate total return for Class C shares for the one year and since commencement of offering Class C shares (August 1, 1994) periods ended February 28, 1998 was 9.48% and 29.59%, respectively. The aggregate total return for Class Z shares for the one year and since commencement of offering of Class Z shares (March 1, 1996) was 10.30% and 13.77%, respectively. From time to time, the performance of the Fund may be measured against various indices. Set forth below is a chart which compares the performance of different types of investments over the long-term and the rate of inflation.(1) A LOOK AT PERFORMANCE OVER THE LONG TERM (1926-1992)
A LOOK AT PERFORMANCE Over the Long-Term Average Annual Returns 1/1/2612/31/97 Long-Term Govt. Common Stocks Bonds Inflation 11.0% 5.2% 3.1%
(1)Source: Ibbotson Associates, "Stocks, Bonds, Bills and Inflation--1997 Yearbook" (annually updates the work of Roger G. Ibbotson and Rex A. Sinquefield). Used with permission. All rights reserved. Common stock returns are based on the Standard & Poor's 500 Stock Index, a market-weighted, unmanaged index of 500 common stocks in a variety of industry sectors. It is a commonly used indicator of broad stock price movements. This chart is for illustrative purposes only, and is not intended to represent the performance of any particular investment or fund. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. B-31 CUSTODIAN, TRANSFER AND DIVIDEND DISBURSING AGENT, AND INDEPENDENT ACCOUNTANTS State Street Bank and Trust Company, One Heritage Drive, North Quincy, Massachusetts 02171, serves as Custodian for the Fund's portfolio securities and cash and, in that capacity, maintains certain financial and accounting books and records pursuant to an agreement with the Fund. See "How the Fund is Managed--Custodian and Transfer and Dividend Disbursing Agent." Prudential Mutual Fund Services LLC (PMFS), Raritan Plaza One, Edison, New Jersey 08837, serves as the Transfer and Dividend Disbursing Agent of the Fund. It is a wholly-owned subsidiary of PIFM. PMFS provides customary transfer agency services to the Fund, including the handling of shareholder communications, the processing of shareholder transactions, the maintenance of shareholder account records, payment of dividends and distributions, and related functions. For these services, PMFS receives an annual fee of $13.00 per shareholder account, a new account set-up fee of $2.00 for each manually-established account and a monthly inactive zero balance account fee of $.20 per shareholder account. PMFS is also reimbursed for its out-of-pocket expenses, including but not limited to postage, stationery, printing, allocable communications expenses and other costs. For the fiscal year ended February 28, 1998, the Fund incurred fees of approximately $1,832,500 for the services of PMFS. PricewaterhouseCoopers LLP, 1177 Avenue of the Americas, New York, New York 10036, serves as the Fund's independent public accountants and, in that capacity, audits the Fund's annual financial statements. B-32 PORTFOLIO OF INVESTMENTS AS OF PRUDENTIAL GOVERNMENT INCOME FEBRUARY 28, 1998 FUND, INC. - ---------------------------------------------------------------------------- - ----------------------------------------------------------------------------
PRINCIPAL AMOUNT (000) DESCRIPTION VALUE (NOTE 1) - ------------------------------------------------------------ LONG-TERM INVESTMENTS--95.3% - ------------------------------------------------------------ U.S. GOVERNMENT AGENCY MORTGAGE PASS-THROUGHS--26.1% Federal Home Loan Mortgage Corp., $1,005 7.50%, 2/01/22 - 4/01/25 $ 1,033,630 6,828 8.00%, 1/01/22 - 5/01/23 7,114,140 4,390 8.50%, 6/01/07 - 4/01/20 4,641,347 2,001 11.50%, 10/01/19 2,287,437 Federal National Mortgage Assoc., 22,510 6.50%, 5/01/11 - 6/01/24 22,403,627 47,731 7.00%, 7/01/03 - 9/01/26 48,418,547 31,638 7.125%, 2/01/07 33,111,104 43,100(a) 7.50%, 4/01/07 - 1/01/2099 44,500,297 33,873 8.50%, 6/01/17 - 3/01/25 35,618,750 8,284 9.00%, 8/01/24 - 4/01/25 8,811,168 1,681 9.50%, 10/01/19 - 3/01/25 1,800,031 Government National Mortgage Assoc., 56,499 7.00%, 2/15/09 - 1/15/28 57,272,946 19,479 7.50%, 5/15/02 - 11/15/24 20,038,802 1,100 8.00%, 7/15/16 - 3/15/24 1,147,652 17,262 9.00%, 4/15/01 - 7/15/21 18,165,122 16,211 9.50%, 10/15/09 - 12/15/17 17,674,119 Government National Mortgage Assoc. II, 2,740 9.50%, 5/20/18 - 8/20/21 2,954,496 -------------- Total U.S. Government Agency Mortgage Pass-Throughs (cost $310,558,520) 326,993,215 - ------------------------------------------------------------ U.S. GOVERNMENT OBLIGATIONS--21.4% United States Treasury Bonds, 21,000(d) 6.125%, 11/15/27 21,587,370 10,000 6.625%, 2/15/27 10,882,800 3,000(c) 7.625%, 2/15/25 3,651,090 25,000 8.125%, 8/15/19 31,363,250 1,860 12.00%, 8/15/13 2,744,374 45,000(c) 12.50%, 8/15/14 69,581,250 20,000(c) 12.75%, 11/15/10 28,550,000 United States Treasury Notes, $32,000(b) 5.50%, 2/29/00 $ 31,975,040 11,000(d) 5.50%, 1/31/03 10,953,580 18,000(d) 6.125%, 8/15/07 18,565,380 10,000 6.25%, 10/31/01 10,207,800 20,000(c) 12.375%, 5/15/04 26,937,400 United States Treasury Strips, 800 Zero Coupon, 8/15/08 437,272 700 Zero Coupon, 8/15/11 315,490 500 Zero Coupon, 11/15/11 221,945 -------------- Total U.S. Government Obligations (cost $265,905,749) 267,974,041 - ------------------------------------------------------------ U.S. GOVERNMENT AGENCY SECURITIES--20.3% Federal Home Loan Bank, 1,000 6.78%, 7/24/02 1,000,940 Federal National Mortgage Assoc., 42,350 5.70%, 1/22/03 41,820,625 20,000 6.30%, 9/25/02 20,115,600 51,125 6.56%, 8/27/04 51,851,934 Small Business Administration, 19,346 Series 1995-20B, 8.15%, 2/01/15 20,973,087 22,952 Series 1995-20L, 6.45%, 12/01/15 23,108,382 32,940 Series 1996-20H, 7.25%, 8/01/16 34,484,746 19,171 Series 1996-20K, 6.95%, 11/01/16 19,798,009 10,125 Series 1997-20A, 7.15%, 1/01/17 10,611,786 Tennessee Valley Authority, 600 Series 1993-D, 7.25%, 7/15/43 625,440 30,000(c) Series 1995-B, 6.235%, 7/15/45 30,513,000 -------------- Total U.S. Government Agency Securities (cost $251,045,078) 254,903,549 - ------------------------------------------------------------ COLLATERALIZED MORTGAGE OBLIGATIONS--5.7% Federal National Mortgage Assoc., 37,000 6.425%, 2/17/30 37,138,750 GMAC Commercial Mortgage Securities, Inc., Series 1997-C1, 20,000 Class A3, 6.869%, 8/15/07 20,706,250 Resolution Trust Corp., Series 1994-1, Class B2, 5,125 7.75%, 9/25/29 5,291,838
- -------------------------------------------------------------------------------- See Notes to Financial Statements. B-33 PORTFOLIO OF INVESTMENTS AS OF PRUDENTIAL GOVERNMENT INCOME FEBRUARY 28, 1998 FUND, INC. - ---------------------------------------------------------------------------- - ----------------------------------------------------------------------------
PRINCIPAL AMOUNT (000) DESCRIPTION VALUE (NOTE 1) - ------------------------------------------------------------ Ryland Mortgage Participation Securities, Series 1993-3, Class A-3, $2,643 7.54%, 9/25/24, (ARM) $ 2,668,906 Structured Asset Securities Corp., Series 1995-C1, Class C, 5,000 7.375%, 9/25/24 5,039,453 -------------- Total Collateralized Mortgage Obligations (cost $69,839,190) 70,845,197 - ------------------------------------------------------------ U.S. GOVERNMENT AGENCY - STRIPPED SECURITIES--6.2% Federal National Mortgage Assoc., 9,045 Zero Coupon, 10/08/06 5,438,306 6,045 Zero Coupon, 10/08/07 3,396,504 4,745 Zero Coupon, 4/08/08 2,586,025 9,045 Zero Coupon, 4/08/10 4,317,541 Financing Corp., 5,000 Zero Coupon, 3/07/04 3,516,450 Israel AID, 46,100 Zero Coupon, 2/15/09 23,997,816 25,584 Zero Coupon, 8/15/09 12,898,429 37,600 Zero Coupon, 5/15/15 13,854,848 46,100 Zero Coupon, 2/15/26 8,229,772 -------------- Total U.S. Government Agency - Stripped Securities (cost $67,162,168) 78,235,691 - ------------------------------------------------------------ SUPRANATIONAL BOND--1.0% International Bank For Reconstruction & Development, 8.625%, 10/15/16 10,000(c) (cost $12,400,900) 12,458,100 - ------------------------------------------------------------ ASSET BACKED SECURITIES--0.8% Aesop Funding II LLC, Series 1997-1, Class A2, 6.40%, 10/20/03 10,000 (cost $9,998,438) 10,109,677 - ------------------------------------------------------------ CORPORATE BONDS--13.8% Associates Corp. of North America, $15,000 5.96%, 5/15/37 $ 15,225,000 Ford Motor Credit Corp., 25,000(c) 7.32%, 5/23/02 25,250,000 Merck and Co., 17,000 5.76%, 5/03/37 17,340,000 New Jersey Economic Development Authority, 105,000(c) Series A, 7.425%, 2/15/29 115,024,245 -------------- Total corporate bonds (cost $167,478,100) 172,839,245 Total long-term investments (cost $1,154,388,143) 1,194,358,715 SHORT-TERM INVESTMENT--4.8% - ------------------------------------------------------------ REPURCHASE AGREEMENT Joint Repurchase Agreement Account, 5.63%, 3/02/98 60,446 (cost $60,446,000; Note 5) 60,446,000 - ------------------------------------------------------------ TOTAL INVESTMENTS--100.1% (cost $1,214,834,143; Note 4) 1,254,804,715 Liabilities in excess of other assets--(0.1%) (1,636,959) -------------- Net Assets--100% $1,253,167,756 -------------- --------------
- --------------- AID--Agency for International Development ARM--Adjusted Rate Mortgage (a) Partial principal amount of $5,500,000 represents a to-be-announced ('TBA') mortgage dollar roll, see Note 1 and Note 4. (b) Represents a when-issued security. (c) Partial principal amount pledged as collateral for mortgage dollar roll, financial futures contracts and when-issued security. (d) Portion of securities on loan, see Note 4. - -------------------------------------------------------------------------------- See Notes to Financial Statements. B-34 STATEMENT OF ASSETS AND LIABILITIES PRUDENTIAL GOVERNMENT INCOME FUND, INC. - --------------------------------------------------------------------------------
ASSETS FEBRUARY 28, 1998 Investments, at value (cost $1,214,834,143).............................................................. $ 1,254,804,715 Receivable for investments sold.......................................................................... 69,727,147 Interest receivable...................................................................................... 9,232,873 Receivable for Fund shares sold.......................................................................... 1,306,597 Prepaid expenses and other assets........................................................................ 29,109 ----------------- Total assets.......................................................................................... 1,335,100,441 ----------------- LIABILITIES Bank overdraft........................................................................................... 38,809,104 Payable for investments purchased........................................................................ 32,025,711 Payable for dollar roll.................................................................................. 5,679,896 Payable for Fund shares reacquired....................................................................... 2,024,294 Accrued expenses......................................................................................... 1,886,660 Dividends payable........................................................................................ 656,503 Management fee payable................................................................................... 483,797 Distribution fee payable................................................................................. 317,201 Due to broker - variation margin......................................................................... 49,519 ----------------- Total liabilities..................................................................................... 81,932,685 ----------------- NET ASSETS............................................................................................... $ 1,253,167,756 ----------------- ----------------- Net assets were comprised of: Common stock, at par.................................................................................. $ 1,385,232 Paid-in capital in excess of par...................................................................... 1,342,841,205 ----------------- 1,344,226,437 Accumulated net realized losses on investments........................................................ (131,040,581) Net unrealized appreciation on investments............................................................ 39,981,900 ----------------- Net assets at February 28, 1998.......................................................................... $ 1,253,167,756 ----------------- ----------------- Class A: Net asset value and redemption price per share ($819,536,440 / 90,606,290 shares of common stock issued and outstanding).......................... $9.05 Maximum sales charge (4.0% of offering price)......................................................... .38 ----------------- Maximum offering price to public...................................................................... $9.43 ----------------- ----------------- Class B: Net asset value, offering price and redemption price per share ($346,059,079 / 38,226,563 shares of common stock issued and outstanding).......................... $9.05 ----------------- ----------------- Class C: Net asset value, offering price and redemption price per share ($2,839,723 / 313,687 shares of common stock issued and outstanding)............................... $9.05 ----------------- ----------------- Class Z: Net asset value, offering price and redemption price per share ($84,732,514 / 9,376,690 shares of common stock issued and outstanding)............................ $9.04 ----------------- -----------------
- -------------------------------------------------------------------------------- See Notes to Financial Statements. B-35 PRUDENTIAL GOVERNMENT INCOME FUND, INC. STATEMENT OF OPERATIONS - ------------------------------------------------------------
Year Ended NET INVESTMENT INCOME February 28, 1998 Income Interest................................. $ 96,024,178 ----------------- Expenses Management fee........................... 6,507,621 Distribution fee--Class A................ 1,263,646 Distribution fee--Class B................ 3,177,448 Distribution fee--Class C................ 18,923 Transfer agent's fees and expenses....... 2,008,000 Reports to shareholders.................. 305,000 Custodian's fees and expenses............ 175,000 Legal fees and expenses.................. 88,000 Audit fee and expenses................... 44,000 Directors' fees.......................... 44,000 Registration fees........................ 40,000 Insurance expense........................ 23,000 Miscellaneous............................ 11,610 ----------------- Total expenses........................ 13,706,248 ----------------- Net investment income...................... 82,317,930 ----------------- REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS Net realized gain (loss) on: Investment transactions.................. 12,654,531 Financial futures contracts.............. (5,079,275) ----------------- 7,575,256 ----------------- Net change in unrealized appreciation on: Investments.............................. 32,404,595 Financial futures contracts.............. 11,328 ----------------- 32,415,923 ----------------- Net gain on investments.................... 39,991,179 ----------------- NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS.................. $ 122,309,109 ----------------- -----------------
PRUDENTIAL GOVERNMENT INCOME FUND, INC. STATEMENT OF CHANGES IN NET ASSETS - ------------------------------------------------------------
INCREASE (DECREASE) Year Ended February 28 IN NET ASSETS 1998 1997 Operations Net investment income...... $ 82,317,930 $ 96,065,519 Net realized gain (loss) on investment transactions............ 7,575,256 (20,189,194) Net change in unrealized appreciation/depreciation on investments.......... 32,415,923 (26,314,444) ----------------- ----------------- Net increase in net assets resulting from operations.............. 122,309,109 49,561,881 ----------------- ----------------- Dividends from net investment income (Note 1) Class A................. (54,904,893) (60,005,745) Class B................. (22,493,247) (33,204,797) Class C................. (149,286) (151,010) Class Z................. (4,770,504) (2,703,967) ----------------- ----------------- (82,317,930) (96,065,519) ----------------- ----------------- Fund share transactions (net of share conversions) (Note 6) Net proceeds from shares subscribed.............. 236,235,904 326,332,216 Net asset value of shares issued in reinvestment of dividends............ 51,329,375 57,955,409 Cost of shares reacquired.............. (472,675,912) (528,279,294) ----------------- ----------------- Net decrease in net assets from Fund share transactions............ (185,110,633) (143,991,669) ----------------- ----------------- Total decrease............... (145,119,454) (190,495,307) NET ASSETS Beginning of year............ 1,398,287,210 1,588,782,517 ----------------- ----------------- End of year.................. $ 1,253,167,756 $ 1,398,287,210 ----------------- ----------------- ----------------- -----------------
- -------------------------------------------------------------------------------- See Notes to Financial Statements. B-36 NOTES TO FINANCIAL STATEMENTS PRUDENTIAL GOVERNMENT INCOME FUND, INC. - -------------------------------------------------------------------------------- Prudential Government Income Fund, (the "Fund") is registered under the Investment Company Act of 1940 as a diversified, open-end management investment company. Investment operations commenced on April 22, 1985. The Fund's investment objective is to seek a high current return. The Fund will seek to achieve this objective by investing primarily in U.S. Government Securities, including U.S. Treasury Bills, Notes, Bonds and other debt securities issued by the U.S. Treasury, and obligations issued or guaranteed by U.S. Government agencies or instrumentalities, and by engaging in various derivative transactions such as the purchase and sale of put and call options. - ------------------------------------------------------------ NOTE 1. ACCOUNTING POLICIES The following is a summary of significant accounting policies followed by the Fund in the preparation of its financial statements. SECURITY VALUATION: The Fund values portfolio securities (including commitments to purchase such securities on a "when-issued" basis) on the basis of current market quotations provided by dealers or by a pricing service approved by the Board of Directors, which uses information such as quotations from dealers, market transactions in comparable securities, various relationships between securities and calculations on yield to maturity in determining values. Options and financial futures contracts listed on exchanges are valued at their closing price on the applicable exchange. When market quotations are not readily available, a security is valued at fair value as determined in good faith by or under the direction of the Board of Directors. Short-term securities which mature in more than 60 days are valued at current market quotations. Short-term securities which mature in 60 days or less are valued at amortized cost. In connection with repurchase agreements with U.S. financial institutions, it is the Fund's policy that its custodian, or designated subcustodians as the case may be under triparty repurchase agreements, takes possession of the underlying collateral securities, the value of which exceeds the principal amount of the repurchase agreement transaction, including accrued interest. To the extent that any repurchase agreement transaction exceeds one business day, the value of the collateral is marked-to-market on a daily basis to ensure the adequacy of the collateral. If the seller defaults and the value of the collateral declines or if bankruptcy proceedings are commenced with respect to the seller of the security, realization of the collateral by the Fund may be delayed or limited. FINANCIAL FUTURES CONTRACTS: A financial futures contract is an agreement to purchase (long) or sell (short) an agreed amount of securities at a set price for delivery on a future date. Upon entering into a financial futures contract, the Fund is required to pledge to the broker an amount of cash and/or other assets equal to a certain percentage of the contract amount. This amount is known as the "initial margin." Subsequent payments, known as "variation margin," are made or received by the Fund each day, depending on the daily fluctuation in the value of the underlying security. Such variation margin is recorded for financial statement purposes on a daily basis as unrealized gain or loss. When the contract expires or is closed, the gain or loss is realized and is presented in the statement of operations as net realized gain (loss) on financial futures contracts. The Fund invests in financial futures contracts in order to hedge its existing portfolio securities, or securities the Fund intends to purchase, against fluctuations in value caused by changes in prevailing interest rates. Should interest rates move unexpectedly, the Fund may not achieve the anticipated benefits of the financial futures contracts and may realize a loss. The use of futures transactions involves the risk of imperfect correlation in movements in the price of futures contracts, interest rates and the underlying hedged assets. DOLLAR ROLLS: The Fund enters into mortgage dollar rolls in which the Fund sells mortgage securities for delivery in the current month, realizing a gain or loss and simultaneously contracts to repurchase somewhat similar (same type, coupon and maturity) securities on a specified future date. During the roll period, the Fund forgoes principal and interest paid on the securities. The Fund is compensated by the interest earned on the cash proceeds of the initial sale and by the lower repurchase price at the future date. The difference between the sales proceeds and the lower repurchase price is recorded as interest income. The Fund maintains a segregated account, the dollar value of which is at least equal to its obligations, in respect of dollar rolls. SECURITIES LENDING: The Fund may lend its U.S. Government securities to broker-dealers or government securities dealers. The loans are secured by collateral at least equal at all times to the market value of the securities loaned. The Fund may bear the risk of delay in recovery of, or even loss of rights in, the securities loaned should the borrower of the securities fail financially. The Fund receives compensation for lending its securities in the form of fees or it retains a portion of interest on the investment of any cash received as collateral. The Fund also continues to receive interest on the securities loaned and any gain or loss in the market price of the securities loaned that may occur during the term of the loan will be for the account of the Fund. SECURITIES TRANSACTIONS AND NET INVESTMENT INCOME: Securities transactions are recorded on the trade date. Realized gains or losses on sales of securities are calculated on the identified cost basis. Interest income is recorded - -------------------------------------------------------------------------------- B-37 NOTES TO FINANCIAL STATEMENTS PRUDENTIAL GOVERNMENT INCOME FUND, INC. - -------------------------------------------------------------------------------- on the accrual basis. The Fund accretes original issue discount on portfolio securities as adjustments to interest income. Net investment income (other than distribution fees) and unrealized and realized gains or losses are allocated daily to each class of shares based upon the relative proportion of net assets of each class at the beginning of the day. Expenses are recorded on the accrual basis which may require the use of certain estimates by management. RECLASSIFICATION OF CAPITAL ACCOUNTS: The Fund accounts and reports for distributions to shareholders in accordance with Statement of Position 93-2: Determination, Disclosure and Financial Statement Presentation of Income, Capital Gain and Return of Capital Distributions by Investment Companies. The effect of applying this statement was to decrease paid-in capital in excess of par by $1,419,491 and decrease accumulated net realized losses on investments by $1,419,491. The current year effect of applying the Statement of Position was due to capital loss carryforward expired unused. Net investment income, net realized gains and net assets were not affected by this change. DIVIDENDS AND DISTRIBUTIONS: The Fund declares daily and pays monthly dividends from net investment income. The Fund will distribute at least annually any net capital gains in excess of loss carryforwards, if any. Dividends and distributions are recorded on the ex-dividend date. Income distributions and capital gain distributions are determined in accordance with income tax regulations which may differ from generally accepted accounting principles. FEDERAL INCOME TAXES: It is the Fund's policy to continue to meet the requirements of the Internal Revenue Code applicable to regulated investment companies and to distribute all of its taxable net income to its shareholders. Therefore, no federal income tax provision is required. - ------------------------------------------------------------ NOTE 2. AGREEMENTS The Fund has a management agreement with Prudential Investments Fund Management, LLC ("PIFM"). Pursuant to this agreement, PIFM has responsibility for all investment advisory services and supervises the subadviser's performance of such services. PIFM has entered into a subadvisory agreement with The Prudential Investment Corporation ("PIC"); PIC furnishes investment advisory services in connection with the management of the Fund. PIFM pays for the cost of the subadviser's services, the compensation of officers of the Fund, occupancy and certain clerical and bookkeeping costs of the Fund. The Fund bears all other costs and expenses. The management fee paid PIFM is computed daily and payable monthly, at an annual rate of .50 of 1% of the Fund's average daily net assets up to $3 billion and .35 of 1% of the average daily net assets of the Fund in excess of $3 billion. The Fund has a distribution agreement with Prudential Securities Incorporated ("PSI"), which acts as the distributor of the Class A, Class B, Class C and Class Z shares of the Fund. The Fund compensates PSI for distributing and servicing the Fund's Class A, Class B and Class C shares, pursuant to plans of distribution (the "Class A, B and C Plans"), regardless of expenses actually incurred by them. The distribution fees for Class A, B and C shares are accrued daily and payable monthly. No distribution or service fees are paid to PSI as distributor of the Class Z shares of the Fund. Pursuant to the Class A Plan, the Fund compensates PSI for its distribution-related expenses with respect to Class A shares, at an annual rate of up to .30 of 1% of the average daily net assets of the Class A shares. Such expenses under the Class A Plan were .15 of 1% of the average daily net assets of the Class A shares for the year ended February 28, 1998. Pursuant to the Class B Plan, the Fund compensates PSI for its distribution-related expenses with respect to Class B shares at an annual rate of up to 1% of the average daily net assets up to $3 billion, .80 of 1% of the next $1 billion of such net assets and .50 of 1% over $4 billion of the average daily net assets of the Class B shares. Such expenses under the Class B Plan were charged at an effective rate of .825 of 1% of the average daily net assets of the Class B shares for the year ended February 28, 1998. Pursuant to the Class C Plan, the Fund compensates PSI for its distribution-related expenses with respect to Class C shares at an annual rate of up to .825 of 1% of the average daily net assets up to $3 billion, .80 of 1% of the next $1 billion of such net assets and .50 of 1% over $4 billion of the average daily net assets of the Class C shares. Such expenses under the Class C Plan were charged at an effective rate of .75 of 1% of the average daily net assets of the Class C shares for the year ended February 28, 1998. PSI advised the Fund that it received approximately $294,300 in front-end sales charges resulting from sales of Class A shares during the year ended February 28, 1998. From these fees, PSI paid such sales charges to Pruco Securities Corporation, an affiliated broker-dealer, which in turn paid commissions to salespersons and incurred other distribution costs. PSI has advised the Fund that for the year ended February 28, 1998 it received approximately $781,400 and $400 in contingent deferred sales - -------------------------------------------------------------------------------- B-38 NOTES TO FINANCIAL STATEMENTS PRUDENTIAL GOVERNMENT INCOME FUND, INC. - -------------------------------------------------------------------------------- charges imposed upon redemptions by certain Class B and Class C shareholders, respectively. PSI, PIFM and PIC are indirect, wholly owned subsidiaries of The Prudential Insurance Company of America. The Fund, along with other affiliated registered investment companies (the "Funds"), has a credit agreement (the "Agreement") with an unaffiliated lender. The maximum commitment under the Agreement is $200,000,000. Interest on any such borrowings outstanding will be at market rates. The purpose of the Agreement is to serve as an alternative source of funding for capital share redemptions. The Fund did not borrow any amounts pursuant to the Agreement during the year ended February 28, 1998. The Funds pay a commitment fee at an annual rate of .055 of 1% on the unused portion of the credit facility. The commitment fee is accrued and paid quarterly on a pro rata basis by the Funds. The Agreement expired on December 30, 1997 and has been extended through December 29, 1998 under the same terms. - ------------------------------------------------------------ NOTE 3. OTHER TRANSACTIONS WITH AFFILIATES Prudential Mutual Fund Services LLC ("PMFS"), a wholly owned subsidiary of PIFM, serves as the Fund's transfer agent. During year ended February 28, 1998, the Fund incurred fees of approximately $1,832,500 for the services of PMFS. As of February 28, 1998, approximately $151,900 of such fees were due to PMFS. Transfer agent fees and expenses in the Statement of Operations also include certain out of pocket expenses paid to nonaffiliates. - ------------------------------------------------------------ NOTE 4. PORTFOLIO SECURITIES Purchases and sales of investment securities, other than short-term investments, for the year ended February 28, 1998, were $1,109,606,649 and $1,263,542,179, respectively. During the year ended February 28, 1998, the Fund entered into financial future contracts. Details of open contracts at February 28, 1998 are as follows:
VALUE AT VALUE AT UNREALIZED NUMBER OF EXPIRATION TRADE FEBRUARY 28, APPRECIATION CONTRACTS TYPE DATE DATE 1998 (DEPRECIATION) - --------- ----------- ----------- ------------ ------------ -------------- Short positions: 30 yr. June 131 T-Note 1998 $15,893,984 $15,781,406 $ 112,578 10 yr. June 10 T-Note 1998 1,123,125 1,123,125 -- 10 yr. March 90 T-Bond 1998 10,040,625 10,141,875 (101,250) -------------- $ 11,328 -------------- --------------
The federal income tax basis of the Fund's investments at February 28, 1998 was $1,214,912,655 and, accordingly, net unrealized appreciation for federal income tax purposes was $39,892,060 (gross unrealized appreciation-$41,154,658; gross unrealized depreciation-$1,262,598). The Fund had a capital loss carryforward as of February 28, 1998 of approximately $131,130,000 of which $41,964,000 expires in 1999, $1,736,000 expires in 2001, $2,920,000 expires in 2002, $66,560,000 expires in 2003 and $17,950,000 expires in 2005. Such carryforward is after utilization of approximately $4,981,000 to offset net taxable gains realized and recognized during the fiscal year ended February 28, 1998. Accordingly, no capital gains distribution is expected to be paid to shareholders until net gains have been realized in excess of such amounts. During the fiscal year ended February 28, 1998, approximately $7,409,000 of the capital loss carryforward expired unused. The average balance of dollar rolls outstanding during the year ended February 28, 1998 was approximately $6,459,000. The amount of dollar rolls outstanding at February 28, 1998 was $5,645,313, which was 0.4% of total assets. As of February 28, 1998, the Fund had securities on loan with an aggregate market value of $39,798,660. As of this date, the collateral held for securities on loan was comprised of U.S. government securities with an aggregate market value of $41,001,991. - ------------------------------------------------------------ NOTE 5. JOINT REPURCHASE AGREEMENT ACCOUNT The Fund, along with other affiliated registered investment companies, transfers uninvested cash balances into a single joint account, the daily aggregate balance of which is invested in one or more repurchase agreements collateralized by U.S. Treasury or federal agency obligations. As of February 28, 1998, the Fund had a 4.60% undivided interest in the repurchase agreements in the joint account. This undivided interest represented $60,446,000 in principal amount. As of such date, the repurchase agreements in the joint account and the value of the collateral therefore were as follows: Bear, Stearns & Co., 5.65%, in the principal amount of $360,000,000, repurchase price $360,169,500, due 3/2/98. The value of the collateral including accrued interest was $369,861,965. Credit Suisse First Boston Corp., 5.58%, in the principal amount of $78,125,000, repurchase price $78,161,328, due 3/2/98. The value of the collateral including accrued interest was $80,423,029. - -------------------------------------------------------------------------------- B-39 NOTES TO FINANCIAL STATEMENTS PRUDENTIAL GOVERNMENT INCOME FUND, INC. - -------------------------------------------------------------------------------- Credit Suisse First Boston Corp., 5.65%, in the principal amount of $300,000,000, repurchase price $300,141,250, due 3/2/98. The value of the collateral including accrued interest was $310,827,022. Merrill Lynch, Pierce, Fenner & Smith, Inc., 5.55% in the principal amount of $156,252,000, repurchase price $156,324,266, due 3/2/98. The value of the collateral including accrued interest was $159,381,768. Morgan Stanley, Dean Witter, Discover & Co., 5.65%, in the principal amount of $60,000,000, repurchase price $60,028,250, due 3/2/98. The value of the collateral including accrued interest was $61,200,403. Salomon Smith Barney Inc., 5.65%, in the principal amount of $360,000,000, repurchase price $360,169,500, due 3/2/98. The value of the collateral including accrued interest was $367,376,399. - ------------------------------------------------------------ NOTE 6. CAPITAL The Fund offers Class A, Class B, Class C and Class Z shares. Class A shares are sold with a front-end sales charge of up to 4%. Class B shares are sold with a contingent deferred sales charge which declines from 5% to zero depending on the period of time the shares are held. Class C shares are sold with a contingent deferred sales charge of 1% during the first year. Class B shares automatically convert to Class A shares on a quarterly basis approximately seven years after purchase. Class Z shares are not subject to any sales charge and are offered exclusively for sale to a limited group of investors. There are 2 billion shares of common stock, $.01 par value per share, divided into four classes, designated Class A, B, C and Class Z common stock, each of which consists of 500,000,000 authorized shares. Transactions in shares of common stock were as follows:
Class A SHARES AMOUNT - ----------------------------------- ----------- ------------- Year ended February 28, 1998: Shares sold........................ 15,454,541 $ 136,602,902 Shares issued in reinvestment of dividends........................ 3,691,357 32,742,038 Shares reacquired.................. (33,350,895) (294,958,733) ----------- ------------- Net decrease in shares outstanding before conversion................ (14,204,997) (125,613,793) Shares issued upon conversion from Class B.......................... 6,652,848 58,526,575 ----------- ------------- Net decrease in shares outstanding...................... (7,552,149) $ (67,087,218) ----------- ------------- ----------- ------------- Class A SHARES AMOUNT - ----------------------------------- ----------- ------------- Year ended February 28, 1997: Shares sold........................ 23,880,421 $ 211,010,343 Shares issued in reinvestment of dividends........................ 3,985,757 35,069,511 Shares reacquired.................. (41,836,738) (368,907,729) ----------- ------------- Net decrease in shares outstanding before conversion................ (13,970,560) (122,827,875) Shares issued upon conversion from Class B.......................... 9,099,955 79,924,887 Shares reacquired upon conversion into Class Z..................... (1,559,278) (14,231,482) ----------- ------------- Net decrease in shares outstanding...................... (6,429,883) $ (57,134,470) ----------- ------------- ----------- ------------- Class B - ----------------------------------- Year ended February 28, 1998: Shares sold........................ 3,258,103 $ 29,057,734 Shares issued in reinvestment of dividends........................ 1,549,463 13,738,189 Shares reacquired.................. (12,601,925) (111,722,746) ----------- ------------- Net decrease in shares outstanding before conversion................ (7,794,359) (68,926,823) Shares reacquired upon conversion into Class A..................... (6,647,245) (58,526,575) ----------- ------------- Net decrease in shares outstanding...................... (14,441,604) $(127,453,398) ----------- ------------- ----------- ------------- Year ended February 28, 1997: Shares sold........................ 4,648,727 $ 40,926,466 Shares issued in reinvestment of dividends........................ 2,285,644 20,127,506 Shares reacquired.................. (16,152,439) (142,246,190) ----------- ------------- Net decrease in shares outstanding before conversion................ (9,218,068) (81,192,218) Shares reacquired upon conversion into Class A..................... (9,099,955) (79,924,887) ----------- ------------- Net decrease in shares outstanding...................... (18,318,023) $(161,117,105) ----------- ------------- ----------- ------------- Class C - ----------------------------------- Year ended February 28, 1998: Shares sold........................ 178,009 $ 1,593,648 Shares issued in reinvestment of dividends........................ 13,542 120,330 Shares reacquired.................. (170,795) (1,515,242) ----------- ------------- Net increase in shares outstanding...................... 20,756 $ 198,736 ----------- ------------- ----------- ------------- Year ended February 28, 1997: Shares sold........................ 165,423 $ 1,461,600 Shares issued in reinvestment of dividends........................ 13,603 119,788 Shares reacquired.................. (85,011) (747,770) ----------- ------------- Net increase in shares outstanding...................... 94,015 $ 833,618 ----------- ------------- ----------- -------------
- -------------------------------------------------------------------------------- B-40 NOTES TO FINANCIAL STATEMENTS PRUDENTIAL GOVERNMENT INCOME FUND, INC. - --------------------------------------------------------------------------------
Class Z SHARES AMOUNT - ----------------------------------- ----------- ------------- Year ended February 28, 1998: Shares sold........................ 7,680,888 $ 68,981,620 Shares issued in reinvestment of dividends........................ 533,884 4,728,818 Shares reacquired.................. (7,221,547) (64,479,191) ----------- ------------- Net increase in shares outstanding...................... 993,225 $ 9,231,247 ----------- ------------- ----------- ------------- March 4, 1996* through February 28, 1997: Shares sold**...................... 8,380,612 $ 72,933,807 Shares issued in reinvestment of dividends........................ 299,172 2,638,604 Shares reacquired.................. (1,855,597) (16,377,605) ----------- ------------- Net increase in shares outstanding before conversion from Class A... 6,824,187 59,194,806 Shares issued upon conversion from Class A.......................... 1,559,278 14,231,482 ----------- ------------- Net increase in shares outstanding...................... 8,383,465 $ 73,426,288 ----------- ------------- ----------- -------------
- --------------- * Commencement of offering of Class Z shares. ** Includes 6,698,193 shares issued for the acquisition of The Prudential Institutional Fund, Income Fund. - -------------------------------------------------------------------------------- B-41 FINANCIAL HIGHLIGHTS PRUDENTIAL GOVERNMENT INCOME FUND, INC. - --------------------------------------------------------------------------------
CLASS A ----------------------------------------------------------- YEAR ENDED FEBRUARY 29/28, ----------------------------------------------------------- 1998 1997 1996 1995 1994 -------- -------- -------- -------- ------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of year.................. $ 8.76 $ 9.04 $ 8.59 $ 9.13 $ 9.40 -------- -------- -------- -------- ------- INCOME FROM INVESTMENT OPERATIONS Net investment income............................... 0.58 0.60 0.60 0.59 0.61 Net realized and unrealized gain (loss) on investment transactions.......................... 0.29 (0.28) 0.45 (0.54) (0.25) -------- -------- -------- -------- ------- Total from investment operations................. 0.87 0.32 1.05 0.05 0.36 -------- -------- -------- -------- ------- LESS DISTRIBUTIONS Dividends from net investment income................ (0.58) (0.60) (0.60) (0.59) (0.61) Distributions in excess of accumulated gains........ -- -- -- -- (0.02) -------- -------- -------- -------- ------- Total distributions.............................. (0.58) (0.60) (0.60) (0.59) (0.63) -------- -------- -------- -------- ------- Net asset value, end of year........................ $ 9.05 $ 8.76 $ 9.04 $ 8.59 $ 9.13 -------- -------- -------- -------- ------- -------- -------- -------- -------- ------- TOTAL RETURN(a):.................................... 10.26% 3.70% 12.41% .83% 3.90% RATIOS/SUPPLEMENTAL DATA: Net assets, end of year (000)....................... $819,536 $860,319 $945,038 $871,145 $51,673 Average net assets (000)............................ $842,431 $884,862 $909,169 $ 95,560 $55,921 Ratios to average net assets: Expenses, including distribution fees............ 0.86% 0.90% 0.91% 0.98% 0.84% Expenses, excluding distribution fees............ 0.71% 0.75% 0.76% 0.83% 0.69% Net investment income............................ 6.52% 6.78% 6.65% 7.45% 6.48% For Class A, B, C and Z shares: Portfolio turnover rate.......................... 88% 107% 123% 206% 80%
- --------------- (a) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each year reported and includes reinvestment of dividends and distributions. - -------------------------------------------------------------------------------- See Notes to Financial Statements. B-42 FINANCIAL HIGHLIGHTS PRUDENTIAL GOVERNMENT INCOME FUND, INC. - --------------------------------------------------------------------------------
CLASS B ---------------------------------------------------------------- YEAR ENDED FEBRUARY 29/28, ---------------------------------------------------------------- 1998 1997 1996 1995 1994 -------- -------- -------- ---------- ---------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of year.................. $ 8.77 $ 9.04 $ 8.60 $ 9.13 $ 9.40 -------- -------- -------- ---------- ---------- INCOME FROM INVESTMENT OPERATIONS Net investment income............................... 0.52 0.54 0.54 0.53 0.53 Net realized and unrealized gain (loss) on investment transactions.......................... 0.28 (0.27) 0.44 (0.53) (0.25) -------- -------- -------- ---------- ---------- Total from investment operations................. 0.80 0.27 0.98 -- 0.28 -------- -------- -------- ---------- ---------- LESS DISTRIBUTIONS Dividends from net investment income................ (0.52) (0.54) (0.54) (0.53) (0.53) Distributions in excess of accumulated gains........ -- -- -- -- (0.02) -------- -------- -------- ---------- ---------- Total distributions.............................. (0.52) (0.54) (0.54) (0.53) (0.55) -------- -------- -------- ---------- ---------- Net asset value, end of year........................ $ 9.05 $ 8.77 $ 9.04 $ 8.60 $ 9.13 -------- -------- -------- ---------- ---------- -------- -------- -------- ---------- ---------- TOTAL RETURN(a):.................................... 9.40% 3.12% 11.54% .24% 3.03% RATIOS/SUPPLEMENTAL DATA: Net assets, end of year (000)....................... $346,059 $461,988 $641,946 $ 705,732 $2,202,555 Average net assets (000)............................ $385,145 $543,796 $647,515 $1,735,413 $2,487,990 Ratios to average net assets: Expenses, including distribution fees............ 1.53% 1.57% 1.58% 1.66% 1.68% Expenses, excluding distribution fees............ 0.71% 0.75% 0.76% 0.80% 0.69% Net investment income............................ 5.85% 6.11% 5.99% 6.17% 5.64%
- --------------- (a) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each year reported and includes reinvestment of dividends and distributions. - -------------------------------------------------------------------------------- See Notes to Financial Statements. B-43 FINANCIAL HIGHLIGHTS PRUDENTIAL GOVERNMENT INCOME FUND, INC. - --------------------------------------------------------------------------------
CLASS C CLASS Z --------------------------------------------------- ----------- AUGUST 1, YEAR ENDED YEAR ENDED 1994(C) ENDED FEBRUARY 29/28, THROUGH FEBRUARY ---------------------------------- FEBRUARY 28, 28, 1998 1997 1996 1995 1998 ------ ------------ ------ ------------ ----------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period................ $ 8.77 $ 9.04 $ 8.60 $ 8.69 $ 8.76 ------ ----- ------ ----- ----------- INCOME FROM INVESTMENT OPERATIONS Net investment income............................... 0.53 0.54 0.54 0.31 0.59 Net realized and unrealized gain (loss) on investment transactions.......................... 0.28 (0.27) 0.44 (0.09) 0.28 ------ ----- ------ ----- ----------- Total from investment operations................. 0.81 0.27 0.98 0.22 0.87 ------ ----- ------ ----- ----------- LESS DISTRIBUTIONS Dividends from net investment income................ (0.53) (0.54) (0.54) (0.31) (0.59) ------ ----- ------ ----- ----------- Net asset value, end of period...................... $ 9.05 $ 8.77 $ 9.04 $ 8.60 $ 9.04 ------ ----- ------ ----- ----------- ------ ----- ------ ----- ----------- TOTAL RETURN(a):.................................... 9.48% 3.20% 11.63% 2.75% 10.30% RATIOS/SUPPLEMENTAL DATA: Net assets, end of period (000)..................... $2,840 $2,569 $1,799 $ 204 $84,733 Average net assets (000)............................ $2,523 $2,440 $ 765 $ 111 $71,425 Ratios to average net assets: Expenses, including distribution fees............ 1.46% 1.50% 1.51% 1.63%(b) 0.71% Expenses, excluding distribution fees............ 0.71% 0.75% 0.76% 0.88%(b) 0.71% Net investment income............................ 5.92% 6.19% 5.99% 6.69%(b) 6.67% MARCH 4, 1996(D) THROUGH FEBRUARY 28, 1997 ------------ PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period................ $ 9.13 ------ INCOME FROM INVESTMENT OPERATIONS Net investment income............................... 0.61 Net realized and unrealized gain (loss) on investment transactions.......................... (0.37) ------ Total from investment operations................. 0.24 ------ LESS DISTRIBUTIONS Dividends from net investment income................ (0.61) ------ Net asset value, end of period...................... $ 8.76 ------ ------ TOTAL RETURN(a):.................................... 3.16% RATIOS/SUPPLEMENTAL DATA: Net assets, end of period (000)..................... $ 73,411 Average net assets (000)............................ $ 39,551 Ratios to average net assets: Expenses, including distribution fees............ 0.75%(b) Expenses, excluding distribution fees............ 0.75%(b) Net investment income............................ 6.76%(b)
- --------------- (a) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. Total returns for periods of less than a full year are not annualized. (b) Annualized. (c) Commencement of offering of Class C shares. (d) Commencement of offering of Class Z shares. - -------------------------------------------------------------------------------- See Notes to Financial Statements. B-44 REPORT OF INDEPENDENT ACCOUNTANTS PRUDENTIAL GOVERNMENT INCOME FUND, INC. - -------------------------------------------------------------------------------- To the Shareholders and Board of Directors of Prudential Government Income Fund, Inc. In our opinion, the accompanying statement of assets and liabilities, including the portfolio of investments, and the related statements of operations and of changes in net assets and the financial highlights present fairly, in all material respects, the financial position of Prudential Government Income Fund, Inc. (the "Fund") at February 28, 1998, and the results of its operations, the changes in its net assets and the financial highlights for the year then ended, in conformity with generally accepted accounting principles. These financial statements and financial highlights (hereafter referred to as "financial statements") are the responsibility of the Fund's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these financial statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit, which included confirmation of securities at February 28, 1998 by correspondence with the custodian and brokers and the application of alternative auditing procedures where confirmations from brokers were not received, provides a reasonable basis for the opinion expressed above. The accompanying statement of changes in net assets for the year ended February 28, 1997, and the financial highlights for the periods other than the year ended February 28, 1998 were audited by other independent accountants, whose opinion dated April 11, 1997 was unqualified. PRICEWATERHOUSECOOPERS LLP 1177 Avenue of the Americas New York, New York April 9, 1998 CHANGE OF AUDITORS PRUDENTIAL GOVERNMENT INCOME FUND, INC. - -------------------------------------------------------------------------------- Effective March 1, 1997, Deloitte & Touche LLP was terminated as the Fund's auditors. For the years ended February 28, 1994 through February 28, 1997, Deloitte & Touche LLP expressed an unqualified opinion on the Fund's financial statements. There were no disagreements between Fund management and Deloitte & Touche LLP prior to their termination. The Board of Directors approved the termination of Deloitte & Touche LLP and the appointment of PricewaterhouseCoopers LLP as the Fund's independent accountants. - -------------------------------------------------------------------------------- B-45 IMPORTANT NOTICE FOR CERTAIN SHAREHOLDERS PRUDENTIAL GOVERNMENT INCOME FUND, INC. - ------------------------------------------------------------------------------- We are required by Massachusetts, Missouri and Oregon to inform you that dividends which have been derived from interest on federal obligations are not taxable to shareholders providing the mutual fund meets certain requirements mandated by the respective state's taxing authorities. We are pleased to report that 28% of the dividends paid by Prudential Government Income Fund qualify for such deduction. For more detailed information regarding your state and local taxes, you should contact your tax adviser or the state/local taxing authorities. - -------------------------------------------------------------------------------- B-46 APPENDIX I--HISTORICAL PERFORMANCE DATA The historical performance data contained in this Appendix relies on data obtained from statistical services, reports and other services believed by the Manager to be reliable. The information has not been independently verified by the Manager. This chart shows the long-term performance of various asset classes and the rate of inflation. EACH INVESTMENT PROVIDES A DIFFERENT OPPORTUNITY (VALUE OF $1 INVESTED ON 12/31/25) [CHART] Source: Stocks, Bonds, Bills, and Inflation 1997 Yearbook, Ibbotson Associates, Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). Used with permission. All rights reserved. This chart is for illustrative purposes only and is not indicative of the past, present, or future performance of any asset class or any Prudential Mutual Fund. Generally, stock returns are attributable to capital appreciation and the reinvestment of distributions. Bond returns are attributable mainly to the reinvestment of distributions. Also, stock prices are usually more volatile than bond prices over the long-term. Small stock returns for 1926-1989 are those of stocks comprising the 5th quintile of the New York Stock Exchange. Thereafter, returns are those of the Dimensional Fund Advisors (DFA) Small Company Fund. Common stock returns are based on the S&P Composite Index, a market-weighted, unmanaged index of 500 stocks (currently) in a variety of industries. It is often used as a broad measure of stock market performance. Long-term government bond returns are represented by a portfolio that contains only one bond with a maturity of roughly 20 years. At the beginning of each year a new bond with a then-current coupon replaces the old bond. Treasury bill returns are for a one-month bill. Treasuries are guaranteed by the government as to the timely payment of principal and interest; equities are not. Inflation is measured by the consumer price index (CPI). IMPACT OF INFLATION. The "real" rate of investment return is that which exceeds the rate of inflation, the percentage change in the value of consumer goods and the general cost of living. A common goal of long-term investors is to outpace the erosive impact of inflation on investment returns. I-1 Set forth below is historical performance data relating to various sectors of the fixed-income securities markets. The chart shows the historical total returns of U.S. Treasury bonds, U.S. mortgage securities, U.S. corporate bonds, U.S. high yield bonds and world government bonds on an annual basis from 1987 through 1997. The total returns of the indices include accrued interest, plus the price changes (gains or losses) of the underlying securities during the period mentioned. The data is provided to illustrate the varying historical total returns and investors should not consider this performance data as an indication of the future performance of the Fund or of any sector in which the Fund invests. All information relies on data obtained from statistical services, reports and other services believed by the Manager to be reliable. Such information has not been verified. The figures do not reflect the operating expenses and fees of a mutual fund. See "Fund Expenses" in the Prospectus. The net effect of the deduction of the operating expenses of a mutual fund on these historical total returns, including the compounded effect over time, could be substantial. HISTORICAL TOTAL RETURNS OF DIFFERENT BOND MARKET SECTORS
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 - ---------------------------------------------------------------------------------------------------------------------------- U.S. GOVERNMENT TREASURY BONDS(1) 2.0% 7.0% 14.4% 8.5% 15.3% 7.2% 10.7% (3.4)% 18.4% 2.7% - ---------------------------------------------------------------------------------------------------------------------------- U. S. GOVERNMENT MORTGAGE SECURITIES(2) 4.3% 8.7% 15.4% 10.7% 15.7% 7.0% 6.8% (1.6)% 16.8% 5.4% - ---------------------------------------------------------------------------------------------------------------------------- U.S. INVESTMENT GRADE CORPORATE BONDS(3) 2.6% 9.2% 14.1% 7.1% 18.5% 8.7% 12.2% (3.9)% 22.3% 3.3% - ---------------------------------------------------------------------------------------------------------------------------- U.S. HIGH YIELD CORPORATE BONDS(4) 5.0% 12.5% 0.8% (9.6)% 46.2% 15.8% 17.1% (1.0)% 19.2% 11.4% - ---------------------------------------------------------------------------------------------------------------------------- WORLD GOVERNMENT BONDS(5) 35.2% 2.3% (3.4)% 15.3% 16.2% 4.8% 15.1% 6.0% 19.6% 4.1% - ---------------------------------------------------------------------------------------------------------------------------- DIFFERENCE BETWEEN HIGHEST AND LOWEST RETURN PERCENT 33.2% 10.2% 18.8% 24.9% 30.9% 11.0% 10.3% 9.9% 5.5% 8.7% 1997 - ----------------------------------- U.S. GOVERNMENT TREASURY BONDS(1) 9.6% - ----------------------------------- U. S. GOVERNMENT MORTGAGE SECURITIES(2) 9.5% - ----------------------------------- U.S. INVESTMENT GRADE CORPORATE BONDS(3) 10.2% - ----------------------------------- U.S. HIGH YIELD CORPORATE BONDS(4) 12.8% - ----------------------------------- WORLD GOVERNMENT BONDS(5) (4.3)% - ----------------------------------- DIFFERENCE BETWEEN HIGHEST AND LOWEST RETURN PERCENT 17.1%
(1)LEHMAN BROTHERS TREASURY BOND INDEX is an unmanaged index made up of over 150 public issues of the U.S. Treasury having maturities of at least one year. (2)LEHMAN BROTHERS MORTGAGE-BACKED SECURITIES INDEX is an unmanaged index that includes over 600 15- and 30-year fixed-rate mortgage-backed securities of the Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC). (3)LEHMAN BROTHERS CORPORATE BOND INDEX includes over 3,000 public fixed-rate, nonconvertible investment-grade bonds. All bonds are U.S. dollar-denominated issues and include debt issued or guaranteed by foreign sovereign governments, municipalities, governmental agencies or international agencies. All bonds in the index have maturities of at least one year. (4)LEHMAN BROTHERS HIGH YIELD BOND INDEX is an unmanaged index comprising over 750 public, fixed-rate, nonconvertible bonds that are rated Ba1 or lower by Moody's Investors Service (or rated BB+ or lower by Standard & Poor's or Fitch Investors Service). All bonds in the index have maturities of at least one year. (5)SALOMON BROTHERS WORLD GOVERNMENT INDEX (NON U.S.) includes over 800 bonds issued by various foreign governments or agencies, excluding those in the U.S., but including those in Japan, Germany, France, the U.K., Canada, Italy, Australia, Belgium, Denmark, the Netherlands, Spain, Sweden, and Austria. All bonds in the index have maturities of at least one year. I-2 This chart below shows the historical volatility of general interest rates as measured by the long U.S. Treasury Bond. LONG U.S. TREASURY BOND YIELD IN PERCENT (1926-1997) [LOGO] - ------- Source: Stocks, Bonds, Bills, and Inflation 1997 Yearbook, Ibbotson Associates, Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). Used with permission. All rights reserved. The chart illustrates the historical yield of the long-term U.S. Treasury Bond from 1926-1997. Yields represent that of an annually renewed one-bond portfolio with a remaining maturity of approximately 20 years. This chart is for illustrative purposes and should not be construed to represent the yields of any Prudential Mutual Fund. I-3 APPENDIX II--GENERAL INVESTMENT INFORMATION The following terms are used in mutual fund investing. ASSET ALLOCATION Asset allocation is a technique for reducing risk, providing balance. Asset allocation among different types of securities within an overall investment portfolio helps to reduce risk and to potentially provide stable returns, while enabling investors to work toward their financial goal(s). Asset allocation is also a strategy to gain exposure to better performing asset classes while maintaining investment in other asset classes. DIVERSIFICATION Diversification is a time-honored technique for reducing risk, providing "balance" to an overall portfolio and potentially achieving more stable returns. Owning a portfolio of securities mitigates the individual risks (and returns) of any one security. Additionally, diversification among types of securities reduces the risks (and general returns) of any one type of security. DURATION Debt securities have varying levels of sensitivity to interest rates. As interest rates fluctuate, the value of a bond (or a bond portfolio) will increase or decrease. Longer-term bonds are generally more sensitive to changes in interest rates. When interest rates fall, bond prices generally rise. Conversely, when interest rates rise, bond prices generally fall. Duration is an approximation of the price sensitivity of a bond (or a bond portfolio) to interest rate changes. It measures the weighted average maturity of a bond's (or a bond portfolio's) cash flows, I.E., principal and interest rate payments. Duration is expressed as a measure of time in years--the longer the duration of a bond (or a bond portfolio), the greater the impact of interest rate changes on the bond's (or the bond portfolio's) price. Duration differs from effective maturity in that duration takes into account call provisions, coupon rates and other factors. Duration measures interest rate risk only and not other risks such as credit risk and, in the case of non-U.S. dollar denominated securities, currency risk. Effective maturity measures the final maturity dates of a bond (or a bond portfolio). MARKET TIMING Market timing--buying securities when prices are low and selling them when prices are relatively higher may not work for many investors because it is impossible to predict with certainty how the price of a security will fluctuate. However, owning a security for a long period of time may help investors offset short-term price volatility and realize positive returns. POWER OF COMPOUNDING Over time, the compounding of returns can significantly impact investment returns. Compounding is the effect of continuous investment on long-term investment results, by which the proceeds of capital appreciation (and income distributions, if elected) are reinvested to contribute to the overall growth of assets. The long-term investment results of compounding may be greater than that of an equivalent initial investment in which the proceeds of capital appreciation and income distributions are taken in cash. STANDARD DEVIATION Standard deviation is an absolute (non-relative) measure of volatility which, for a mutual fund, depicts how widely the returns varied over a certain period of time. When a fund has a high standard deviation, its range of performance has been very wide, implying greater volatility potential. Standard deviation is only one of several measures of a fund's volatility. II-1 APPENDIX III--INFORMATION RELATING TO THE PRUDENTIAL Set forth below is information relating to The Prudential Insurance Company of America (Prudential) and its subsidiaries as well as information relating to the Prudential Mutual Funds. See "How the Fund is Managed--Manager" in the Prospectus. The data will be used in sales materials relating to the Prudential Mutual Funds. Unless otherwise indicated, the information is as of December 31, 1996 and is subject to change thereafter. All information relies on data provided by The Prudential Investment Corporation (PIC) or from other sources believed by the Manager to be reliable. Such information has not been verified by the Fund. INFORMATION ABOUT PRUDENTIAL The Manager and PIC(1) are subsidiaries of Prudential, which is one of the largest diversified financial services institutions in the world and, based on total assets, the largest insurance company in North America as of December 31, 1996. Its primary business is to offer a full range of products and services in three areas: insurance, investments and home ownership for individuals and families; health-care management and other benefit programs for employees of companies and members of groups; and asset management for institutional clients and their associates. Prudential (together with its subsidiaries) employs more than 81,000 persons worldwide, and maintains a sales force of approximately 11,500 agents and 6,400 financial advisors. Prudential is a major issuer of annuities, including variable annuities. Prudential seeks to develop innovative products and services to meet consumer needs in each of its business areas. Prudential uses the rock of Gibraltar as its symbol. The Prudential rock is a recognized brand name throughout the world. INSURANCE. Prudential has been engaged in the insurance business since 1875. It insures or provides financial services to more than 50 million people worldwide--one of every five people in the United States. Long one of the largest issuers of individual life insurance, the Prudential has 22 million life insurance policies in force today with a face value of $1 trillion. Prudential has the largest capital base ($12.1 billion) of any life insurance company in the United States. The Prudential provides auto insurance for more than 1.6 million cars and insures more than 1.2 million homes. MONEY MANAGEMENT. The Prudential is one of the largest pension fund managers in the country, providing pension services to 1 in 3 Fortune 500 firms. It manages $36 billion of individual retirement plan assets, such as 401(k) plans. As of December 31, 1996, Prudential had more than $322 billion in assets under management. Prudential Investments, a business group of Prudential (of which Prudential Mutual Funds is a key part) manages over $190 billion in assets of institutions and individuals. In PENSIONS & INVESTMENTS, May 12, 1996, Prudential was ranked third in terms of total assets under management. REAL ESTATE. The Prudential Real Estate Affiliates, the fourth largest real estate brokerage network in the United States, has more than 37,000 brokers and agents across the United States.(2) HEALTHCARE. Over two decades ago, the Prudential introduced the first federally-funded, for-profit HMO in the country. Today, almost 4.6 million Americans receive healthcare from a Prudential managed care membership. FINANCIAL SERVICES. The Prudential Bank, a wholly-owned subsidiary of the Prudential, has nearly $1 billion in assets and serves nearly 1.5 million customers across 50 states. INFORMATION ABOUT THE PRUDENTIAL MUTUAL FUNDS As of October 31, 1997, Prudential Mutual Fund Management was the 17th largest mutual fund companies in the country, with over 2.5 million shareholders invested in more than 50 mutual fund portfolios and variable annuities with more than 3.7 million shareholder accounts. The Prudential Mutual Funds have over 30 portfolio managers who manage over $55 billion in mutual fund and variable annuity assets. Some of Prudential's portfolio managers have over 20 years of experience managing investment portfolios. - ------------ (1) The Prudential Investment Corporation (PIC) serves as the Subadviser to substantially all of the Prudential Mutual Funds. Wellington Management Company serves as the subadviser to Global Utility Fund, Inc., Nicholas-Applegate Capital Management as subadviser to Nicholas-Applegate Fund, Inc., Jennison Associates Capital Corp. as the subadviser to Prudential Jennison Series Fund, Inc. and Mercator Asset Management LP. as Subadviser to International Stock Series, a portfolio of Prudential World Fund. There are multiple subadvisers for The Target Portfolio Trust. (2) As of December 31, 1996. III-1 From time to time, there may be media coverage of portfolio managers and other investment professionals associated with the Manager and the Subadviser in national and regional publications, on television and in other media. Additionally, individual mutual fund portfolios are frequently cited in surveys conducted by national and regional publications and media organizations such as THE WALL STREET JOURNAL, THE NEW YORK TIMES, BARRON'S and USA TODAY. EQUITY FUNDS. Forbes magazine listed Prudential Equity Fund among twenty mutual funds on its Honor Roll in its mutual fund issue of August 28, 1995. Honorees are chosen annually among mutual funds (excluding sector funds) which are open to new investors and have had the same management for at least five years. Forbes considers, among other criteria, the total return of a mutual fund in both bull and bear markets as well as a fund's risk profile. Prudential Equity Fund is managed with a "value" investment style by PIC. In 1995, Prudential Securities introduced Prudential Jennison Fund, a growth-style equity fund managed by Jennison Associates Capital Corp., a premier institutional equity manager and a subsidiary of Prudential. HIGH YIELD FUNDS. Investing in high yield bonds is a complex and research intensive pursuit. A separate team of high yield bond analysts monitor approximately 200 issues held in the Prudential High Yield Fund (currently the largest fund of its kind in the country) along with 100 or so other high yield bonds, which may be considered for purchase.(3) Non-investment grade bonds, also known as junk bonds or high yield bonds, are subject to a greater risk of loss of principal and interest including default risk than higher-rated bonds. Prudential high yield portfolio managers and analysts meet face-to-face with almost every bond issuer in the High Yield Fund's portfolio annually, and have additional telephone contact throughout the year. Prudential's portfolio managers are supported by a large and sophisticated research organization. Fourteen investment grade bond analysts monitor the financial viability of approximately 1,750 different bond issuers in the investment grade corporate and municipal bond markets--from IBM to small municipalities, such as Rockaway Township, New Jersey. These analysts consider among other things sinking fund provisions and interest coverage ratios. Prudential's portfolio managers and analysts receive research services from almost 200 brokers and market service vendors. They also receive nearly 100 trade publications and newspapers--from PULP AND PAPER FORECASTER to WOMEN'S WEAR DAILY--to keep them informed of the industries they follow. Prudential Mutual Funds' traders scan over 100 computer monitors to collect detailed information on which to trade. From natural gas prices in the Rocky Mountains to the results of local municipal elections, a Prudential portfolio manager or trader is able to monitor it if it's important to a Prudential mutual fund. Prudential Mutual Funds trade approximately $31 billion in U.S. and foreign government securities a year. PIC seeks information from government policy makers. In 1995, Prudential's portfolio managers met with several senior U.S. and foreign government officials, on issues ranging from economic conditions in foreign countries to the viability of index-linked securities in the United States. Prudential Mutual Funds' portfolio managers and analysts met with over 1,200 companies in 1995, often with the Chief Executive Officer (CEO) or Chief Financial Officer (CFO). They also attended over 250 industry conferences. Prudential Mutual Fund global equity managers conducted many of their visits overseas, often holding private meetings with a company in a foreign language (our global equity managers speak 7 different languages, including Mandarin Chinese). TRADING DATA.(4) On an average day, Prudential Mutual Funds' U.S. and foreign equity trading desks traded $77 million in securities representing over 3.8 million shares with nearly 200 different firms. Prudential Mutual Funds' bond trading desks traded $157 million in government and corporate bonds on an average day. That represents more in daily trading than most bond funds tracked by Lipper even have in assets.(5) Prudential Mutual Funds' money market desk traded $3.2 - ------------ (3) As of December 31, 1995. The number of bonds and the size of the Fund are subject to change. (4) Trading data represents average daily transactions for portfolios of the Prudential Mutual Funds for which PIC serves as the subadviser, portfolios of the Prudential Series Fund and institutional and non-US accounts managed by Prudential Mutual Fund Investment Management, a division of PIC, for the year ended December 31, 1995. (5) Based on 559 funds in Lipper Analytical Services categories of Short U.S. Treasury, Short U.S. Government, Intermediate U.S. Treasury, Intermediate U.S. Government, Short Investment Grade Debt, Intermediate Investment Grade Debt, General U.S. Treasury, General U.S. Government and Mortgage funds. III-2 billion in money market securities on an average day, or over $800 billion a year. They made a trade every 3 minutes of every trading day. In 1994, the Prudential Mutual Funds effected more than 40,000 trades in money market securities and held on average $20 billion of money market securities.(6) Based on complex-wide data, on an average day, over 7,250 shareholders telephoned Prudential Mutual Fund Services, Inc., the Transfer Agent of the Prudential Mutual Funds, on the Prudential Mutual Funds' toll-free number. On an annual basis, that represents approximately 1.8 million telephone calls answered. INFORMATION ABOUT PRUDENTIAL SECURITIES Prudential Securities is the fifth largest retail brokerage firm in the United States with approximately 5,600 financial advisors. It offers to its clients a wide range of products, including Prudential Mutual Funds and annuities. As of December 31, 1995, assets held by Prudential Securities for its clients approximated $168 billion. During 1994, over 28,000 new customer accounts were opened each month at PSI.(7) Prudential Securities has a two-year Financial Advisor training program plus advanced education programs, including Prudential Securities "university," which provides advanced education in a wide array of investment areas. Prudential Securities is the only Wall Street firm to have its own in-house Certified Financial Planner (CFP) program. In the December 1995 issue of REGISTERED REP, an industry publication, Prudential Securities' Financial Advisor training programs received a grade of A- (compared to an industry average of B+) . In 1995, Prudential Securities' equity research team ranked 8th in INSTITUTIONAL INVESTOR magazine's 1995 "All America Research Team" survey. Five Prudential Securities' analysts were ranked as first-team finishers.(8) In addition to training, Prudential Securities provides its financial advisors with access to firm economists and market analysts. It has also developed proprietary tools for use by financial advisors, including the Financial ArchitectSM, a state-of-the-art asset allocation software program which helps Financial Advisors to evaluate a client's objectives and overall financial plan, and a comprehensive mutual fund information and analysis system that compares different mutual funds. For more complete information about any of the Prudential Mutual Funds, including charges and expenses, call your Prudential Securities financial adviser or Pruco/Prudential representative for a free prospectus. Read it carefully before you invest or send money. - ------------ (6) As of December 31, 1994. (7) As of December 31, 1994. (8) On an annual basis, INSTITUTIONAL INVESTOR magazine surveys more than 700 institutional money managers, chief investment officers and research directors, asking them to evaluate analysts in 76 industry sectors. Scores are produced by taking the number of votes awarded to an individual analyst and weighting them based on the size of the voting institution. In total, the magazine sends its survey to approximately 2,000 institutions and a group of European and Asian institutions. III-3 Portfolio of Investments as of PRUDENTIAL GOVERNMENT INCOME February 28, 1998 FUND, INC. - ---------------------------------------------------------------------------- - ----------------------------------------------------------------------------
Principal Amount (000) Description Value (Note 1) - ------------------------------------------------------------------- LONG-TERM INVESTMENTS--95.3% - ------------------------------------------------------------------- U.S. Government Agency Mortgage Pass-Throughs--26.1% Federal Home Loan Mortgage Corp., $1,005 7.50%, 2/01/22 - 4/01/25 $ 1,033,630 6,828 8.00%, 1/01/22 - 5/01/23 7,114,140 4,390 8.50%, 6/01/07 - 4/01/20 4,641,347 2,001 11.50%, 10/01/19 2,287,437 Federal National Mortgage Assoc., 22,510 6.50%, 5/01/11 - 6/01/24 22,403,627 47,731 7.00%, 7/01/03 - 9/01/26 48,418,547 31,638 7.125%, 2/01/07 33,111,104 43,100(a) 7.50%, 4/01/07 - 1/01/2099 44,500,297 33,873 8.50%, 6/01/17 - 3/01/25 35,618,750 8,284 9.00%, 8/01/24 - 4/01/25 8,811,168 1,681 9.50%, 10/01/19 - 3/01/25 1,800,031 Government National Mortgage Assoc., 56,499 7.00%, 2/15/09 - 1/15/28 57,272,946 19,479 7.50%, 5/15/02 - 11/15/24 20,038,802 1,100 8.00%, 7/15/16 - 3/15/24 1,147,652 17,262 9.00%, 4/15/01 - 7/15/21 18,165,122 16,211 9.50%, 10/15/09 - 12/15/17 17,674,119 Government National Mortgage Assoc. II, 2,740 9.50%, 5/20/18 - 8/20/21 2,954,496 -------------- Total U.S. Government Agency Mortgage Pass-Throughs (cost $310,558,520) 326,993,215 - ------------------------------------------------------------------- U.S. Government Obligations--21.4% United States Treasury Bonds, 21,000(d) 6.125%, 11/15/27 21,587,370 10,000 6.625%, 2/15/27 10,882,800 3,000(c) 7.625%, 2/15/25 3,651,090 25,000 8.125%, 8/15/19 31,363,250 1,860 12.00%, 8/15/13 2,744,374 45,000(c) 12.50%, 8/15/14 69,581,250 20,000(c) 12.75%, 11/15/10 28,550,000 United States Treasury Notes, $32,000(b) 5.50%, 2/29/00 $ 31,975,040 11,000(d) 5.50%, 1/31/03 10,953,580 18,000(d) 6.125%, 8/15/07 18,565,380 10,000 6.25%, 10/31/01 10,207,800 20,000(c) 12.375%, 5/15/04 26,937,400 United States Treasury Strips, 800 Zero Coupon, 8/15/08 437,272 700 Zero Coupon, 8/15/11 315,490 500 Zero Coupon, 11/15/11 221,945 -------------- Total U.S. Government Obligations (cost $265,905,749) 267,974,041 - ------------------------------------------------------------------- U.S. Government Agency Securities--20.3% Federal Home Loan Bank, 1,000 6.78%, 7/24/02 1,000,940 Federal National Mortgage Assoc., 42,350 5.70%, 1/22/03 41,820,625 20,000 6.30%, 9/25/02 20,115,600 51,125 6.56%, 8/27/04 51,851,934 Small Business Administration, 19,346 Series 1995-20B, 8.15%, 2/01/15 20,973,087 22,952 Series 1995-20L, 6.45%, 12/01/15 23,108,382 32,940 Series 1996-20H, 7.25%, 8/01/16 34,484,746 19,171 Series 1996-20K, 6.95%, 11/01/16 19,798,009 10,125 Series 1997-20A, 7.15%, 1/01/17 10,611,786 Tennessee Valley Authority, 600 Series 1993-D, 7.25%, 7/15/43 625,440 30,000(c) Series 1995-B, 6.235%, 7/15/45 30,513,000 -------------- Total U.S. Government Agency Securities (cost $251,045,078) 254,903,549 - ------------------------------------------------------------------- Collateralized Mortgage Obligations--5.7% Federal National Mortgage Assoc., 37,000 6.425%, 2/17/30 37,138,750 GMAC Commercial Mortgage Securities, Inc., Series 1997-C1, 20,000 Class A3, 6.869%, 8/15/07 20,706,250 Resolution Trust Corp., Series 1994-1, Class B2, 5,125 7.75%, 9/25/29 5,291,838
- -------------------------------------------------------------------------------- See Notes to Financial Statements. 3 Portfolio of Investments as of PRUDENTIAL GOVERNMENT INCOME February 28, 1998 FUND, INC. - ---------------------------------------------------------------------------- - ----------------------------------------------------------------------------
Principal Amount (000) Description Value (Note 1) - ------------------------------------------------------------------- Ryland Mortgage Participation Securities, Series 1993-3, Class A-3, $2,643 7.54%, 9/25/24, (ARM) $ 2,668,906 Structured Asset Securities Corp., Series 1995-C1, Class C, 5,000 7.375%, 9/25/24 5,039,453 -------------- Total Collateralized Mortgage Obligations (cost $69,839,190) 70,845,197 - ------------------------------------------------------------------- U.S. Government Agency - Stripped Securities--6.2% Federal National Mortgage Assoc., 9,045 Zero Coupon, 10/08/06 5,438,306 6,045 Zero Coupon, 10/08/07 3,396,504 4,745 Zero Coupon, 4/08/08 2,586,025 9,045 Zero Coupon, 4/08/10 4,317,541 Financing Corp., 5,000 Zero Coupon, 3/07/04 3,516,450 Israel AID, 46,100 Zero Coupon, 2/15/09 23,997,816 25,584 Zero Coupon, 8/15/09 12,898,429 37,600 Zero Coupon, 5/15/15 13,854,848 46,100 Zero Coupon, 2/15/26 8,229,772 -------------- Total U.S. Government Agency - Stripped Securities (cost $67,162,168) 78,235,691 - ------------------------------------------------------------------- Supranational Bond--1.0% International Bank For Reconstruction & Development, 8.625%, 10/15/16 10,000(c) (cost $12,400,900) 12,458,100 - ------------------------------------------------------------------- Asset Backed Securities--0.8% Aesop Funding II LLC, Series 1997-1, Class A2, 6.40%, 10/20/03 (cost $9,998,438) 10,109,677 10,000 Corporate Bonds--13.8% Associates Corp. of North America, $15,000 5.96%, 5/15/37 $ 15,225,000 Ford Motor Credit Corp., 25,000(c) 7.32%, 5/23/02 25,250,000 Merck and Co., 17,000 5.76%, 5/03/37 17,340,000 New Jersey Economic Development Authority, 105,000(c) Series A, 7.425%, 2/15/29 115,024,245 -------------- Total corporate bonds (cost $167,478,100) 172,839,245 Total long-term investments (cost $1,154,388,143) 1,194,358,715 SHORT-TERM INVESTMENT--4.8% - ------------------------------------------------------------------- Repurchase Agreement Joint Repurchase Agreement Account, 5.63%, 3/02/98 60,446 (cost $60,446,000; Note 5) 60,446,000 - ------------------------------------------------------------------- Total Investments--100.1% (cost $1,214,834,143; Note 4) 1,254,804,715 Liabilities in excess of other assets--(0.1%) (1,636,959) -------------- Net Assets--100% $1,253,167,756 -------------- --------------
- --------------- AID--Agency for International Development ARM--Adjusted Rate Mortgage (a) Partial principal amount of $5,500,000 represents a to-be-announced ("TBA") mortgage dollar roll, see Note 1 and Note 4. (b) Represents a when-issued security. (c) Partial principal amount pledged as collateral for mortgage dollar roll, financial futures contracts and when-issued security. (d) Portion of securities on loan, see Note 4. - -------------------------------------------------------------------------------- See Notes to Financial Statements. 4 Statement of Assets and Liabilities PRUDENTIAL GOVERNMENT INCOME FUND, INC. - --------------------------------------------------------------------------------
Assets February 28, 1998 ----------------- Investments, at value (cost $1,214,834,143).............................................................. $ 1,254,804,715 Receivable for investments sold.......................................................................... 69,727,147 Interest receivable...................................................................................... 9,232,873 Receivable for Fund shares sold.......................................................................... 1,306,597 Prepaid expenses and other assets........................................................................ 29,109 ----------------- Total assets.......................................................................................... 1,335,100,441 ----------------- Liabilities Bank overdraft........................................................................................... 38,809,104 Payable for investments purchased........................................................................ 32,025,711 Payable for dollar roll.................................................................................. 5,679,896 Payable for Fund shares reacquired....................................................................... 2,024,294 Accrued expenses......................................................................................... 1,886,660 Dividends payable........................................................................................ 656,503 Management fee payable................................................................................... 483,797 Distribution fee payable................................................................................. 317,201 Due to broker - variation margin......................................................................... 49,519 ----------------- Total liabilities..................................................................................... 81,932,685 ----------------- Net Assets............................................................................................... $ 1,253,167,756 ----------------- ----------------- Net assets were comprised of: Common stock, at par.................................................................................. $ 1,385,232 Paid-in capital in excess of par...................................................................... 1,342,841,205 ----------------- 1,344,226,437 Accumulated net realized losses on investments........................................................ (131,040,581) Net unrealized appreciation on investments............................................................ 39,981,900 ----------------- Net assets at February 28, 1998.......................................................................... $ 1,253,167,756 ----------------- ----------------- Class A: Net asset value and redemption price per share ($819,536,440 / 90,606,290 shares of common stock issued and outstanding).......................... $9.05 Maximum sales charge (4.0% of offering price)......................................................... .38 ----------------- Maximum offering price to public...................................................................... $9.43 ----------------- ----------------- Class B: Net asset value, offering price and redemption price per share ($346,059,079 / 38,226,563 shares of common stock issued and outstanding).......................... $9.05 ----------------- ----------------- Class C: Net asset value, offering price and redemption price per share ($2,839,723 / 313,687 shares of common stock issued and outstanding)............................... $9.05 ----------------- ----------------- Class Z: Net asset value, offering price and redemption price per share ($84,732,514 / 9,376,690 shares of common stock issued and outstanding)............................ $9.04 ----------------- -----------------
- -------------------------------------------------------------------------------- See Notes to Financial Statements. 5 PRUDENTIAL GOVERNMENT INCOME FUND, INC. Statement of Operations - ------------------------------------------------------------
Year Ended Net Investment Income February 28, 1998 ----------------- Income Interest................................. $ 96,024,178 ----------------- Expenses Management fee........................... 6,507,621 Distribution fee--Class A................ 1,263,646 Distribution fee--Class B................ 3,177,448 Distribution fee--Class C................ 18,923 Transfer agent's fees and expenses....... 2,008,000 Reports to shareholders.................. 305,000 Custodian's fees and expenses............ 175,000 Legal fees and expenses.................. 88,000 Audit fee and expenses................... 44,000 Directors' fees.......................... 44,000 Registration fees........................ 40,000 Insurance expense........................ 23,000 Miscellaneous............................ 11,610 ----------------- Total expenses........................ 13,706,248 ----------------- Net investment income...................... 82,317,930 ----------------- Realized and Unrealized Gain (Loss) on Investments Net realized gain (loss) on: Investment transactions.................. 12,654,531 Financial futures contracts.............. (5,079,275) ----------------- 7,575,256 ----------------- Net change in unrealized appreciation on: Investments.............................. 32,404,595 Financial futures contracts.............. 11,328 ----------------- 32,415,923 ----------------- Net gain on investments.................... 39,991,179 ----------------- Net Increase in Net Assets Resulting from Operations.................. $ 122,309,109 ----------------- -----------------
PRUDENTIAL GOVERNMENT INCOME FUND, INC. Statement of Changes in Net Assets - ------------------------------------------------------------
Increase (Decrease) Year Ended February 28 in Net Assets -------------------------------------- 1998 1997 ----------------- ----------------- Operations Net investment income...... $ 82,317,930 $ 96,065,519 Net realized gain (loss) on investment transactions............ 7,575,256 (20,189,194) Net change in unrealized appreciation/depreciation on investments.......... 32,415,923 (26,314,444) ----------------- ----------------- Net increase in net assets resulting from operations.............. 122,309,109 49,561,881 ----------------- ----------------- Dividends from net investment income (Note 1) Class A................. (54,904,893) (60,005,745) Class B................. (22,493,247) (33,204,797) Class C................. (149,286) (151,010) Class Z................. (4,770,504) (2,703,967) ----------------- ----------------- (82,317,930) (96,065,519) ----------------- ----------------- Fund share transactions (net of share conversions) (Note 6) Net proceeds from shares subscribed.............. 236,235,904 326,332,216 Net asset value of shares issued in reinvestment of dividends............ 51,329,375 57,955,409 Cost of shares reacquired.............. (472,675,912) (528,279,294) ----------------- ----------------- Net decrease in net assets from Fund share transactions............ (185,110,633) (143,991,669) ----------------- ----------------- Total decrease............... (145,119,454) (190,495,307) Net Assets Beginning of year............ 1,398,287,210 1,588,782,517 ----------------- ----------------- End of year.................. $ 1,253,167,756 $ 1,398,287,210 ----------------- ----------------- ----------------- -----------------
- -------------------------------------------------------------------------------- See Notes to Financial Statements. 6 Notes to Financial Statements PRUDENTIAL GOVERNMENT INCOME FUND, INC. - -------------------------------------------------------------------------------- Prudential Government Income Fund, (the "Fund") is registered under the Investment Company Act of 1940 as a diversified, open-end management investment company. Investment operations commenced on April 22, 1985. The Fund's investment objective is to seek a high current return. The Fund will seek to achieve this objective by investing primarily in U.S. Government Securities, including U.S. Treasury Bills, Notes, Bonds and other debt securities issued by the U.S. Treasury, and obligations issued or guaranteed by U.S. Government agencies or instrumentalities, and by engaging in various derivative transactions such as the purchase and sale of put and call options. - ------------------------------------------------------------ Note 1. Accounting Policies The following is a summary of significant accounting policies followed by the Fund in the preparation of its financial statements. Security Valuation: The Fund values portfolio securities (including commitments to purchase such securities on a "when-issued" basis) on the basis of current market quotations provided by dealers or by a pricing service approved by the Board of Directors, which uses information such as quotations from dealers, market transactions in comparable securities, various relationships between securities and calculations on yield to maturity in determining values. Options and financial futures contracts listed on exchanges are valued at their closing price on the applicable exchange. When market quotations are not readily available, a security is valued at fair value as determined in good faith by or under the direction of the Board of Directors. Short-term securities which mature in more than 60 days are valued at current market quotations. Short-term securities which mature in 60 days or less are valued at amortized cost. In connection with repurchase agreements with U.S. financial institutions, it is the Fund's policy that its custodian, or designated subcustodians as the case may be under triparty repurchase agreements, takes possession of the underlying collateral securities, the value of which exceeds the principal amount of the repurchase agreement transaction, including accrued interest. To the extent that any repurchase agreement transaction exceeds one business day, the value of the collateral is marked-to-market on a daily basis to ensure the adequacy of the collateral. If the seller defaults and the value of the collateral declines or if bankruptcy proceedings are commenced with respect to the seller of the security, realization of the collateral by the Fund may be delayed or limited. Financial Futures Contracts: A financial futures contract is an agreement to purchase (long) or sell (short) an agreed amount of securities at a set price for delivery on a future date. Upon entering into a financial futures contract, the Fund is required to pledge to the broker an amount of cash and/or other assets equal to a certain percentage of the contract amount. This amount is known as the "initial margin." Subsequent payments, known as "variation margin," are made or received by the Fund each day, depending on the daily fluctuation in the value of the underlying security. Such variation margin is recorded for financial statement purposes on a daily basis as unrealized gain or loss. When the contract expires or is closed, the gain or loss is realized and is presented in the statement of operations as net realized gain (loss) on financial futures contracts. The Fund invests in financial futures contracts in order to hedge its existing portfolio securities, or securities the Fund intends to purchase, against fluctuations in value caused by changes in prevailing interest rates. Should interest rates move unexpectedly, the Fund may not achieve the anticipated benefits of the financial futures contracts and may realize a loss. The use of futures transactions involves the risk of imperfect correlation in movements in the price of futures contracts, interest rates and the underlying hedged assets. Dollar Rolls: The Fund enters into mortgage dollar rolls in which the Fund sells mortgage securities for delivery in the current month, realizing a gain or loss and simultaneously contracts to repurchase somewhat similar (same type, coupon and maturity) securities on a specified future date. During the roll period, the Fund forgoes principal and interest paid on the securities. The Fund is compensated by the interest earned on the cash proceeds of the initial sale and by the lower repurchase price at the future date. The difference between the sales proceeds and the lower repurchase price is recorded as interest income. The Fund maintains a segregated account, the dollar value of which is at least equal to its obligations, in respect of dollar rolls. Securities Lending: The Fund may lend its U.S. Government securities to broker-dealers or government securities dealers. The loans are secured by collateral at least equal at all times to the market value of the securities loaned. The Fund may bear the risk of delay in recovery of, or even loss of rights in, the securities loaned should the borrower of the securities fail financially. The Fund receives compensation for lending its securities in the form of fees or it retains a portion of interest on the investment of any cash received as collateral. The Fund also continues to receive interest on the securities loaned and any gain or loss in the market price of the securities loaned that may occur during the term of the loan will be for the account of the Fund. Securities Transactions and Net Investment Income: Securities transactions are recorded on the trade date. Realized gains or losses on sales of securities are calculated on the identified cost basis. Interest income is recorded - -------------------------------------------------------------------------------- 7 Notes to Financial Statements PRUDENTIAL GOVERNMENT INCOME FUND, INC. - -------------------------------------------------------------------------------- on the accrual basis. The Fund accretes original issue discount on portfolio securities as adjustments to interest income. Net investment income (other than distribution fees) and unrealized and realized gains or losses are allocated daily to each class of shares based upon the relative proportion of net assets of each class at the beginning of the day. Expenses are recorded on the accrual basis which may require the use of certain estimates by management. Reclassification of Capital Accounts: The Fund accounts and reports for distributions to shareholders in accordance with Statement of Position 93-2: Determination, Disclosure and Financial Statement Presentation of Income, Capital Gain and Return of Capital Distributions by Investment Companies. The effect of applying this statement was to decrease paid-in capital in excess of par by $1,419,491 and decrease accumulated net realized losses on investments by $1,419,491. The current year effect of applying the Statement of Position was due to capital loss carryforward expired unused. Net investment income, net realized gains and net assets were not affected by this change. Dividends and Distributions: The Fund declares daily and pays monthly dividends from net investment income. The Fund will distribute at least annually any net capital gains in excess of loss carryforwards, if any. Dividends and distributions are recorded on the ex-dividend date. Income distributions and capital gain distributions are determined in accordance with income tax regulations which may differ from generally accepted accounting principles. Federal Income Taxes: It is the Fund's policy to continue to meet the requirements of the Internal Revenue Code applicable to regulated investment companies and to distribute all of its taxable net income to its shareholders. Therefore, no federal income tax provision is required. - ------------------------------------------------------------ Note 2. Agreements The Fund has a management agreement with Prudential Investments Fund Management, LLC ("PIFM"). Pursuant to this agreement, PIFM has responsibility for all investment advisory services and supervises the subadviser's performance of such services. PIFM has entered into a subadvisory agreement with The Prudential Investment Corporation ("PIC"); PIC furnishes investment advisory services in connection with the management of the Fund. PIFM pays for the cost of the subadviser's services, the compensation of officers of the Fund, occupancy and certain clerical and bookkeeping costs of the Fund. The Fund bears all other costs and expenses. The management fee paid PIFM is computed daily and payable monthly, at an annual rate of .50 of 1% of the Fund's average daily net assets up to $3 billion and .35 of 1% of the average daily net assets of the Fund in excess of $3 billion. The Fund has a distribution agreement with Prudential Securities Incorporated ("PSI"), which acts as the distributor of the Class A, Class B, Class C and Class Z shares of the Fund. The Fund compensates PSI for distributing and servicing the Fund's Class A, Class B and Class C shares, pursuant to plans of distribution (the "Class A, B and C Plans"), regardless of expenses actually incurred by them. The distribution fees for Class A, B and C shares are accrued daily and payable monthly. No distribution or service fees are paid to PSI as distributor of the Class Z shares of the Fund. Pursuant to the Class A Plan, the Fund compensates PSI for its distribution-related expenses with respect to Class A shares, at an annual rate of up to .30 of 1% of the average daily net assets of the Class A shares. Such expenses under the Class A Plan were .15 of 1% of the average daily net assets of the Class A shares for the year ended February 28, 1998. Pursuant to the Class B Plan, the Fund compensates PSI for its distribution-related expenses with respect to Class B shares at an annual rate of up to 1% of the average daily net assets up to $3 billion, .80 of 1% of the next $1 billion of such net assets and .50 of 1% over $4 billion of the average daily net assets of the Class B shares. Such expenses under the Class B Plan were charged at an effective rate of .825 of 1% of the average daily net assets of the Class B shares for the year ended February 28, 1998. Pursuant to the Class C Plan, the Fund compensates PSI for its distribution-related expenses with respect to Class C shares at an annual rate of up to .825 of 1% of the average daily net assets up to $3 billion, .80 of 1% of the next $1 billion of such net assets and .50 of 1% over $4 billion of the average daily net assets of the Class C shares. Such expenses under the Class C Plan were charged at an effective rate of .75 of 1% of the average daily net assets of the Class C shares for the year ended February 28, 1998. PSI advised the Fund that it received approximately $294,300 in front-end sales charges resulting from sales of Class A shares during the year ended February 28, 1998. From these fees, PSI paid such sales charges to Pruco Securities Corporation, an affiliated broker-dealer, which in turn paid commissions to salespersons and incurred other distribution costs. PSI has advised the Fund that for the year ended February 28, 1998 it received approximately $781,400 and $400 in contingent deferred sales - -------------------------------------------------------------------------------- 8 Notes to Financial Statements PRUDENTIAL GOVERNMENT INCOME FUND, INC. - -------------------------------------------------------------------------------- charges imposed upon redemptions by certain Class B and Class C shareholders, respectively. PSI, PIFM and PIC are indirect, wholly owned subsidiaries of The Prudential Insurance Company of America. The Fund, along with other affiliated registered investment companies (the "Funds"), has a credit agreement (the "Agreement") with an unaffiliated lender. The maximum commitment under the Agreement is $200,000,000. Interest on any such borrowings outstanding will be at market rates. The purpose of the Agreement is to serve as an alternative source of funding for capital share redemptions. The Fund did not borrow any amounts pursuant to the Agreement during the year ended February 28, 1998. The Funds pay a commitment fee at an annual rate of .055 of 1% on the unused portion of the credit facility. The commitment fee is accrued and paid quarterly on a pro rata basis by the Funds. The Agreement expired on December 30, 1997 and has been extended through December 29, 1998 under the same terms. - ------------------------------------------------------------ Note 3. Other Transactions With Affiliates Prudential Mutual Fund Services LLC ("PMFS"), a wholly owned subsidiary of PIFM, serves as the Fund's transfer agent. During year ended February 28, 1998, the Fund incurred fees of approximately $1,832,500 for the services of PMFS. As of February 28, 1998, approximately $151,900 of such fees were due to PMFS. Transfer agent fees and expenses in the Statement of Operations also include certain out of pocket expenses paid to nonaffiliates. - ------------------------------------------------------------ Note 4. Portfolio Securities Purchases and sales of investment securities, other than short-term investments, for the year ended February 28, 1998, were $1,109,606,649 and $1,263,542,179, respectively. During the year ended February 28, 1998, the Fund entered into financial future contracts. Details of open contracts at February 28, 1998 are as follows:
Value at Value at Unrealized Number of Expiration Trade February 28, Appreciation Contracts Type Date Date 1998 (Depreciation) - --------- ----------- ----------- ------------ ------------ -------------- Short positions: 30 yr. June 131 T-Note 1998 $15,893,984 $15,781,406 $ 112,578 10 yr. June 10 T-Note 1998 1,123,125 1,123,125 -- 10 yr. March 90 T-Bond 1998 10,040,625 10,141,875 (101,250) -------------- $ 11,328 -------------- --------------
The federal income tax basis of the Fund's investments at February 28, 1998 was $1,214,912,655 and, accordingly, net unrealized appreciation for federal income tax purposes was $39,892,060 (gross unrealized appreciation-$41,154,658; gross unrealized depreciation-$1,262,598). The Fund had a capital loss carryforward as of February 28, 1998 of approximately $131,130,000 of which $41,964,000 expires in 1999, $1,736,000 expires in 2001, $2,920,000 expires in 2002, $66,560,000 expires in 2003 and $17,950,000 expires in 2005. Such carryforward is after utilization of approximately $4,981,000 to offset net taxable gains realized and recognized during the fiscal year ended February 28, 1998. Accordingly, no capital gains distribution is expected to be paid to shareholders until net gains have been realized in excess of such amounts. During the fiscal year ended February 28, 1998, approximately $7,409,000 of the capital loss carryforward expired unused. The average balance of dollar rolls outstanding during the year ended February 28, 1998 was approximately $6,459,000. The amount of dollar rolls outstanding at February 28, 1998 was $5,645,313, which was 0.4% of total assets. As of February 28, 1998, the Fund had securities on loan with an aggregate market value of $39,798,660. As of this date, the collateral held for securities on loan was comprised of U.S. government securities with an aggregate market value of $41,001,991. - ------------------------------------------------------------ Note 5. Joint Repurchase Agreement Account The Fund, along with other affiliated registered investment companies, transfers uninvested cash balances into a single joint account, the daily aggregate balance of which is invested in one or more repurchase agreements collateralized by U.S. Treasury or federal agency obligations. As of February 28, 1998, the Fund had a 4.60% undivided interest in the repurchase agreements in the joint account. This undivided interest represented $60,446,000 in principal amount. As of such date, the repurchase agreements in the joint account and the value of the collateral therefore were as follows: Bear, Stearns & Co., 5.65%, in the principal amount of $360,000,000, repurchase price $360,169,500, due 3/2/98. The value of the collateral including accrued interest was $369,861,965. Credit Suisse First Boston Corp., 5.58%, in the principal amount of $78,125,000, repurchase price $78,161,328, due 3/2/98. The value of the collateral including accrued interest was $80,423,029. - -------------------------------------------------------------------------------- 9 Notes to Financial Statements PRUDENTIAL GOVERNMENT INCOME FUND, INC. - -------------------------------------------------------------------------------- Credit Suisse First Boston Corp., 5.65%, in the principal amount of $300,000,000, repurchase price $300,141,250, due 3/2/98. The value of the collateral including accrued interest was $310,827,022. Merrill Lynch, Pierce, Fenner & Smith, Inc., 5.55% in the principal amount of $156,252,000, repurchase price $156,324,266, due 3/2/98. The value of the collateral including accrued interest was $159,381,768. Morgan Stanley, Dean Witter, Discover & Co., 5.65%, in the principal amount of $60,000,000, repurchase price $60,028,250, due 3/2/98. The value of the collateral including accrued interest was $61,200,403. Salomon Smith Barney Inc., 5.65%, in the principal amount of $360,000,000, repurchase price $360,169,500, due 3/2/98. The value of the collateral including accrued interest was $367,376,399. - ------------------------------------------------------------ Note 6. Capital The Fund offers Class A, Class B, Class C and Class Z shares. Class A shares are sold with a front-end sales charge of up to 4%. Class B shares are sold with a contingent deferred sales charge which declines from 5% to zero depending on the period of time the shares are held. Class C shares are sold with a contingent deferred sales charge of 1% during the first year. Class B shares automatically convert to Class A shares on a quarterly basis approximately seven years after purchase. Class Z shares are not subject to any sales charge and are offered exclusively for sale to a limited group of investors. There are 2 billion shares of common stock, $.01 par value per share, divided into four classes, designated Class A, B, C and Class Z common stock, each of which consists of 500,000,000 authorized shares. Transactions in shares of common stock were as follows:
Class A Shares Amount - ----------------------------------- ----------- ------------- Year ended February 28, 1998: Shares sold........................ 15,454,541 $ 136,602,902 Shares issued in reinvestment of dividends........................ 3,691,357 32,742,038 Shares reacquired.................. (33,350,895) (294,958,733) ----------- ------------- Net decrease in shares outstanding before conversion................ (14,204,997) (125,613,793) Shares issued upon conversion from Class B.......................... 6,652,848 58,526,575 ----------- ------------- Net decrease in shares outstanding...................... (7,552,149) $ (67,087,218) ----------- ------------- ----------- ------------- Class A Shares Amount - ----------------------------------- ----------- ------------- Year ended February 28, 1997: Shares sold........................ 23,880,421 $ 211,010,343 Shares issued in reinvestment of dividends........................ 3,985,757 35,069,511 Shares reacquired.................. (41,836,738) (368,907,729) ----------- ------------- Net decrease in shares outstanding before conversion................ (13,970,560) (122,827,875) Shares issued upon conversion from Class B.......................... 9,099,955 79,924,887 Shares reacquired upon conversion into Class Z..................... (1,559,278) (14,231,482) ----------- ------------- Net decrease in shares outstanding...................... (6,429,883) $ (57,134,470) ----------- ------------- ----------- ------------- Class B - ----------------------------------- Year ended February 28, 1998: Shares sold........................ 3,258,103 $ 29,057,734 Shares issued in reinvestment of dividends........................ 1,549,463 13,738,189 Shares reacquired.................. (12,601,925) (111,722,746) ----------- ------------- Net decrease in shares outstanding before conversion................ (7,794,359) (68,926,823) Shares reacquired upon conversion into Class A..................... (6,647,245) (58,526,575) ----------- ------------- Net decrease in shares outstanding...................... (14,441,604) $(127,453,398) ----------- ------------- ----------- ------------- Year ended February 28, 1997: Shares sold........................ 4,648,727 $ 40,926,466 Shares issued in reinvestment of dividends........................ 2,285,644 20,127,506 Shares reacquired.................. (16,152,439) (142,246,190) ----------- ------------- Net decrease in shares outstanding before conversion................ (9,218,068) (81,192,218) Shares reacquired upon conversion into Class A..................... (9,099,955) (79,924,887) ----------- ------------- Net decrease in shares outstanding...................... (18,318,023) $(161,117,105) ----------- ------------- ----------- ------------- Class C - ----------------------------------- Year ended February 28, 1998: Shares sold........................ 178,009 $ 1,593,648 Shares issued in reinvestment of dividends........................ 13,542 120,330 Shares reacquired.................. (170,795) (1,515,242) ----------- ------------- Net increase in shares outstanding...................... 20,756 $ 198,736 ----------- ------------- ----------- ------------- Year ended February 28, 1997: Shares sold........................ 165,423 $ 1,461,600 Shares issued in reinvestment of dividends........................ 13,603 119,788 Shares reacquired.................. (85,011) (747,770) ----------- ------------- Net increase in shares outstanding...................... 94,015 $ 833,618 ----------- ------------- ----------- -------------
- -------------------------------------------------------------------------------- 10 Notes to Financial Statements PRUDENTIAL GOVERNMENT INCOME FUND, INC. - --------------------------------------------------------------------------------
Class Z Shares Amount - ----------------------------------- ----------- ------------- Year ended February 28, 1998: Shares sold........................ 7,680,888 $ 68,981,620 Shares issued in reinvestment of dividends........................ 533,884 4,728,818 Shares reacquired.................. (7,221,547) (64,479,191) ----------- ------------- Net increase in shares outstanding...................... 993,225 $ 9,231,247 ----------- ------------- ----------- ------------- March 4, 1996* through February 28, 1997: Shares sold**...................... 8,380,612 $ 72,933,807 Shares issued in reinvestment of dividends........................ 299,172 2,638,604 Shares reacquired.................. (1,855,597) (16,377,605) ----------- ------------- Net increase in shares outstanding before conversion from Class A... 6,824,187 59,194,806 Shares issued upon conversion from Class A.......................... 1,559,278 14,231,482 ----------- ------------- Net increase in shares outstanding...................... 8,383,465 $ 73,426,288 ----------- ------------- ----------- -------------
- --------------- * Commencement of offering of Class Z shares. ** Includes 6,698,193 shares issued for the acquisition of The Prudential Institutional Fund, Income Fund. - -------------------------------------------------------------------------------- 11 Financial Highlights PRUDENTIAL GOVERNMENT INCOME FUND, INC. - --------------------------------------------------------------------------------
Class A ----------------------------------------------------------- Year Ended February 29/28, ----------------------------------------------------------- 1998 1997 1996 1995 1994 -------- -------- -------- -------- ------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of year.................. $ 8.76 $ 9.04 $ 8.59 $ 9.13 $ 9.40 -------- -------- -------- -------- ------- Income from investment operations Net investment income............................... 0.58 0.60 0.60 0.59 0.61 Net realized and unrealized gain (loss) on investment transactions.......................... 0.29 (0.28) 0.45 (0.54) (0.25) -------- -------- -------- -------- ------- Total from investment operations................. 0.87 0.32 1.05 0.05 0.36 -------- -------- -------- -------- ------- Less distributions Dividends from net investment income................ (0.58) (0.60) (0.60) (0.59) (0.61) Distributions in excess of accumulated gains........ -- -- -- -- (0.02) -------- -------- -------- -------- ------- Total distributions.............................. (0.58) (0.60) (0.60) (0.59) (0.63) -------- -------- -------- -------- ------- Net asset value, end of year........................ $ 9.05 $ 8.76 $ 9.04 $ 8.59 $ 9.13 -------- -------- -------- -------- ------- -------- -------- -------- -------- ------- TOTAL RETURN(a):.................................... 10.26% 3.70% 12.41% .83% 3.90% RATIOS/SUPPLEMENTAL DATA: Net assets, end of year (000)....................... $819,536 $860,319 $945,038 $871,145 $51,673 Average net assets (000)............................ $842,431 $884,862 $909,169 $ 95,560 $55,921 Ratios to average net assets: Expenses, including distribution fees............ 0.86% 0.90% 0.91% 0.98% 0.84% Expenses, excluding distribution fees............ 0.71% 0.75% 0.76% 0.83% 0.69% Net investment income............................ 6.52% 6.78% 6.65% 7.45% 6.48% For Class A, B, C and Z shares: Portfolio turnover rate.......................... 88% 107% 123% 206% 80%
- --------------- (a) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each year reported and includes reinvestment of dividends and distributions. - -------------------------------------------------------------------------------- See Notes to Financial Statements. 12 Financial Highlights PRUDENTIAL GOVERNMENT INCOME FUND, INC. - --------------------------------------------------------------------------------
Class B ---------------------------------------------------------------- Year Ended February 29/28, ---------------------------------------------------------------- 1998 1997 1996 1995 1994 -------- -------- -------- ---------- ---------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of year.................. $ 8.77 $ 9.04 $ 8.60 $ 9.13 $ 9.40 -------- -------- -------- ---------- ---------- Income from investment operations Net investment income............................... 0.52 0.54 0.54 0.53 0.53 Net realized and unrealized gain (loss) on investment transactions.......................... 0.28 (0.27) 0.44 (0.53) (0.25) -------- -------- -------- ---------- ---------- Total from investment operations................. 0.80 0.27 0.98 -- 0.28 -------- -------- -------- ---------- ---------- Less distributions Dividends from net investment income................ (0.52) (0.54) (0.54) (0.53) (0.53) Distributions in excess of accumulated gains........ -- -- -- -- (0.02) -------- -------- -------- ---------- ---------- Total distributions.............................. (0.52) (0.54) (0.54) (0.53) (0.55) -------- -------- -------- ---------- ---------- Net asset value, end of year........................ $ 9.05 $ 8.77 $ 9.04 $ 8.60 $ 9.13 -------- -------- -------- ---------- ---------- -------- -------- -------- ---------- ---------- TOTAL RETURN(a):.................................... 9.40% 3.12% 11.54% .24% 3.03% RATIOS/SUPPLEMENTAL DATA: Net assets, end of year (000)....................... $346,059 $461,988 $641,946 $ 705,732 $2,202,555 Average net assets (000)............................ $385,145 $543,796 $647,515 $1,735,413 $2,487,990 Ratios to average net assets: Expenses, including distribution fees............ 1.53% 1.57% 1.58% 1.66% 1.68% Expenses, excluding distribution fees............ 0.71% 0.75% 0.76% 0.80% 0.69% Net investment income............................ 5.85% 6.11% 5.99% 6.17% 5.64%
- --------------- (a) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each year reported and includes reinvestment of dividends and distributions. - -------------------------------------------------------------------------------- See Notes to Financial Statements. 13 Financial Highlights PRUDENTIAL GOVERNMENT INCOME FUND, INC. - --------------------------------------------------------------------------------
Class C --------------------------------------------------- August 1, Year Ended 1994(c) February 29/28, Through ---------------------------------- February 28, 1998 1997 1996 1995 ------ ------------ ------ ------------ PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period................ $ 8.77 $ 9.04 $ 8.60 $ 8.69 ------ ----- ------ ----- Income from investment operations Net investment income............................... 0.53 0.54 0.54 0.31 Net realized and unrealized gain (loss) on investment transactions.......................... 0.28 (0.27) 0.44 (0.09) ------ ----- ------ ----- Total from investment operations................. 0.81 0.27 0.98 0.22 ------ ----- ------ ----- Less distributions Dividends from net investment income................ (0.53) (0.54) (0.54) (0.31) ------ ----- ------ ----- Net asset value, end of period...................... $ 9.05 $ 8.77 $ 9.04 $ 8.60 ------ ----- ------ ----- ------ ----- ------ ----- TOTAL RETURN(a):.................................... 9.48% 3.20% 11.63% 2.75% RATIOS/SUPPLEMENTAL DATA: Net assets, end of period (000)..................... $2,840 $2,569 $1,799 $ 204 Average net assets (000)............................ $2,523 $2,440 $ 765 $ 111 Ratios to average net assets: Expenses, including distribution fees............ 1.46% 1.50% 1.51% 1.63%(b) Expenses, excluding distribution fees............ 0.71% 0.75% 0.76% 0.88%(b) Net investment income............................ 5.92% 6.19% 5.99% 6.69%(b) Class Z ------------------------- Year Ended March 4, Ended 1996(d) February Through 28, February 28, 1998 1997 ----------- ------------ PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period................ $ 8.76 $ 9.13 ----------- ------ Income from investment operations Net investment income............................... 0.59 0.61 Net realized and unrealized gain (loss) on investment transactions.......................... 0.28 (0.37) ----------- ------ Total from investment operations................. 0.87 0.24 ----------- ------ Less distributions Dividends from net investment income................ (0.59) (0.61) ----------- ------ Net asset value, end of period...................... $ 9.04 $ 8.76 ----------- ------ ----------- ------ TOTAL RETURN(a):.................................... 10.30% 3.16% RATIOS/SUPPLEMENTAL DATA: Net assets, end of period (000)..................... $84,733 $ 73,411 Average net assets (000)............................ $71,425 $ 39,551 Ratios to average net assets: Expenses, including distribution fees............ 0.71% 0.75%(b) Expenses, excluding distribution fees............ 0.71% 0.75%(b) Net investment income............................ 6.67% 6.76%(b)
- --------------- (a) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. Total returns for periods of less than a full year are not annualized. (b) Annualized. (c) Commencement of offering of Class C shares. (d) Commencement of offering of Class Z shares. - -------------------------------------------------------------------------------- See Notes to Financial Statements. 14 Report of Independent Accountants PRUDENTIAL GOVERNMENT INCOME FUND, INC. - -------------------------------------------------------------------------------- To the Shareholders and Board of Directors of Prudential Government Income Fund, Inc. In our opinion, the accompanying statement of assets and liabilities, including the portfolio of investments, and the related statements of operations and of changes in net assets and the financial highlights present fairly, in all material respects, the financial position of Prudential Government Income Fund, Inc. (the "Fund") at February 28, 1998, and the results of its operations, the changes in its net assets and the financial highlights for the year then ended, in conformity with generally accepted accounting principles. These financial statements and financial highlights (hereafter referred to as "financial statements") are the responsibility of the Fund's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these financial statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit, which included confirmation of securities at February 28, 1998 by correspondence with the custodian and brokers and the application of alternative auditing procedures where confirmations from brokers were not received, provides a reasonable basis for the opinion expressed above. The accompanying statement of changes in net assets for the year ended February 28, 1997, and the financial highlights for the periods other than the year ended February 28, 1998 were audited by other independent accountants, whose opinion dated April 11, 1997 was unqualified. PRICEWATERHOUSECOOPERS LLP 1177 Avenue of the Americas New York, New York April 9, 1998 Change of Auditors PRUDENTIAL GOVERNMENT INCOME FUND, INC. - -------------------------------------------------------------------------------- Effective March 1, 1997, Deloitte & Touche LLP was terminated as the Fund's auditors. For the years ended February 28, 1994 through February 28, 1997, Deloitte & Touche LLP expressed an unqualified opinion on the Fund's financial statements. There were no disagreements between Fund management and Deloitte & Touche LLP prior to their termination. The Board of Directors approved the termination of Deloitte & Touche LLP and the appointment of PricewaterhouseCoopers LLP as the Fund's independent accountants. - -------------------------------------------------------------------------------- 15 Important Notice for Certain Shareholders PRUDENTIAL GOVERNMENT INCOME FUND, INC. - ------------------------------------------------------------------------------- We are required by Massachusetts, Missouri and Oregon to inform you that dividends which have been derived from interest on federal obligations are not taxable to shareholders providing the mutual fund meets certain requirements mandated by the respective state's taxing authorities. We are pleased to report that 28% of the dividends paid by Prudential Government Income Fund qualify for such deduction. For more detailed information regarding your state and local taxes, you should contact your tax adviser or the state/local taxing authorities. - -------------------------------------------------------------------------------- 16 Portfolio of Investments as of December 31, 1997 PRUDENTIAL MORTGAGE INCOME FUND, INC. - ------------------------------------------------------------
Principal Amount (000) Description Value (Note 1) - ---------------------------------------------------------------- LONG-TERM INVESTMENTS--98.3% - ---------------------------------------------------------------- U.S Government Obligations--4.4% United States Treasury Bonds, $ 3,000 12.375%, 5/15/04 $ 4,043,430 2,000 7.125%, 2/15/23 2,283,120 United States Treasury Note, 1,000 6.125%, 8/15/07 1,027,660 ------------ Total U.S. government obligations (cost $7,193,600) 7,354,210 ------------ - ---------------------------------------------------------------- U.S. Government Agency Mortgage Pass-through Obligations--66.4% Federal National Mortgage Association, 7 7.00%, 4/01/08 7,051 25,401 7.50%, 6/01/10 - 12/01/24 26,157,687 19 8.00%, 10/01/24 19,780 Government National Mortgage Association, 18,310 7.50%, 7/15/07 - 7/15/24 18,850,358 48,733 8.00%, 2/15/04 - 11/15/25 50,984,702 12,648 9.00%, 4/15/01 - 4/15/25 13,691,652 ------------ Total U.S. government agency mortgage pass-through obligations (cost $107,200,983) 109,711,230 ------------ - ---------------------------------------------------------------- Collateralized Mortgage Obligations--9.9% Federal National Mortgage Association, 6,500 6.997%, 12/25/21, REMIC 6,719,375 ICI Funding Corp. Secured Asset Corp., 4,913 Ser. 97-2 1A4, 7.60%, 7/25/28 5,008,189 Merrill Lynch Mortgage Investors, Inc., 52,761 Ser. 96-C2, 1.535%, 11/21/28, I/O 4,591,875 ------------ Total collateralized mortgage obligations (cost $15,936,176) 16,319,439 ------------ - ---------------------------------------------------------------- Asset-Backed Securities--14.5% Chase Manhattan Credit Card Trust, 1,400 Ser. 96-2 Class A, 5.955%, 12/15/02 1,405,250 Federal Home Loan Mortgage Corp., $ 4,000 Ser. 97-B C, 7.40%, 9/15/19 $ 4,106,250 Contimortgage Home Equity Loan, 2,875 Ser. 97-1 M2, 7.67%, 3/15/28 2,960,352 Green Tree Financial Corporation, 2,000 Ser. 97-1 B2, 7.76%, 3/15/28 2,012,500 7,000 Ser. 97-6 B2, 7.75%, 1/15/29 7,039,375 Money Store Home Impvt. Ln. Trust, 6,125 Ser. 97-1 M2, 8.07%, 5/15/23 6,433,164 ------------ Total asset-backed securities (cost $23,458,245) 23,956,891 ------------ - ---------------------------------------------------------------- Corporate Bonds--3.1% Merck and Co., 5,000 5.76%, 5/03/37 (cost $5,000,000) 5,125,000 ------------ Total long-term investments (cost $158,789,004) 162,466,770 ------------ SHORT-TERM INVESTMENT--1.4% - ---------------------------------------------------------------- Repurchase Agreement 2,242 Joint Repurchase Agreement Account, 6.63%, 1/02/98 (cost $2,242,000; Note 5) 2,242,000 ------------ - ---------------------------------------------------------------- Total Investments--99.7% (cost $161,031,004; Note 4) 164,708,770 Other assets in excess of liabilities--0.3% 538,805 ------------ Net Assets--100% $165,247,575 ------------ ------------
- --------------- I/O--Interest Only R.E.M.I.C.--Real Estate Mortgage Investment Conduit - -------------------------------------------------------------------------------- See Notes to Financial Statements. 3 Statement of Assets and Liabilities PRUDENTIAL MORTGAGE INCOME FUND, INC. - --------------------------------------------------------------------------------
Assets December 31, 1997 ----------------- Investments, at value (cost $161,031,004)............................................................... $ 164,708,770 Cash.................................................................................................... 202 Interest receivable..................................................................................... 1,113,020 Receivable for Fund shares sold......................................................................... 17,493 Other assets............................................................................................ 4,520 ----------------- Total assets......................................................................................... 165,844,005 ----------------- Liabilities Accrued expenses........................................................................................ 345,618 Management fee payable.................................................................................. 70,574 Distribution fee payable................................................................................ 59,631 Payable for Fund shares reacquired...................................................................... 56,176 Deferred Director's fees................................................................................ 38,130 Dividends payable....................................................................................... 26,301 ----------------- Total liabilities.................................................................................... 596,430 ----------------- Net Assets.............................................................................................. $ 165,247,575 ----------------- ----------------- Net assets were comprised of: Common stock, at par................................................................................. $ 113,842 Paid-in capital in excess of par..................................................................... 180,553,925 ----------------- 180,667,767 Undistributed net investment income.................................................................. 764,243 Accumulated net realized loss on investments......................................................... (19,862,201) Net unrealized appreciation on investments........................................................... 3,677,766 ----------------- Net assets, December 31, 1997........................................................................... $ 165,247,575 ----------------- ----------------- Class A: Net asset value and redemption price per share ($90,639,252 / 6,237,712 shares of common stock issued and outstanding)........................... $14.53 Maximum sales charge (4% of offering price).......................................................... .61 ----------------- Maximum offering price to public..................................................................... $15.14 ----------------- ----------------- Class B: Net asset value, offering price and redemption price per share ($73,665,312 / 5,081,464 shares of common stock issued and outstanding)........................... $14.50 ----------------- ----------------- Class C: Net asset value, offering price and redemption price per share ($904,171 / 62,370 shares of common stock issued and outstanding)................................. $14.50 ----------------- ----------------- Class Z: Net asset value, offering price and redemption price per share ($38,840 / 2,670 shares of common stock issued and outstanding)................................... $14.54 ----------------- -----------------
- -------------------------------------------------------------------------------- See Notes to Financial Statements. 4 PRUDENTIAL MORTGAGE INCOME FUND, INC. Statement of Operations - ------------------------------------------------------------
Year Ended Net Investment Income December 31, 1997 ----------------- Income Interest.............................. $13,380,233 ----------------- Expenses Management fee........................ 879,039 Distribution fee--Class A............. 136,641 Distribution fee--Class B............. 628,860 Distribution fee--Class C............. 6,428 Transfer agent's fees and expenses.... 350,000 Custodian's fees and expenses......... 170,000 Reports to shareholders............... 91,000 Registration fees..................... 74,000 Legal fees and expenses............... 34,000 Audit fee............................. 28,000 Directors' fees and expenses.......... 28,000 Miscellaneous......................... 14,814 ----------------- Total expenses..................... 2,440,782 Less: Management fee waiver.............. (238,812) ----------------- Net expenses....................... 2,201,970 ----------------- Net investment income.................... 11,178,263 ----------------- Realized and Unrealized Gain (Loss) on Investments Net realized gain (loss) on: Investment transactions............... 873,036 Futures transactions.................. (199,073) ----------------- 673,963 ----------------- Net change in unrealized appreciation of investments........................... 1,996,049 ----------------- Net gain on investments.................. 2,670,012 ----------------- Net Increase in Net Assets Resulting from Operations................ $13,848,275 ----------------- -----------------
PRUDENTIAL MORTGAGE INCOME FUND, INC. Statement of Changes in Net Assets - ------------------------------------------------------------
Increase (Decrease) Year Ended December 31, in Net Assets ---------------------------- 1997 1996 ------------ ------------ Operations Net investment income.......... $ 11,178,263 $ 12,727,289 Net realized gain on investments................. 673,963 186,036 Net change in unrealized appreciation (depreciation) of investments.............. 1,996,049 (6,315,745) ------------ ------------ Net increase in net assets resulting from operations... 13,848,275 6,597,580 ------------ ------------ Dividends and distributions (Note 1) Dividends to shareholders from net investment income Class A..................... (5,736,643) (5,930,278) Class B..................... (4,768,059) (6,261,553) Class C..................... (48,744) (42,633) Class Z..................... (571) -- ------------ ------------ (10,554,017) (12,234,464) ------------ ------------ Fund share transactions (net of share conversions) (Note 6) Proceeds from shares sold...... 6,513,533 8,736,035 Net asset value of shares issued in reinvestment of dividends... 6,604,996 7,670,064 Cost of shares reacquired...... (41,590,299) (45,644,609) ------------ ------------ Net decrease in net assets from Fund share transactions..... (28,471,770) (29,238,510) ------------ ------------ Total decrease.................... (25,177,512) (34,875,394) Net Assets Beginning of year................. 190,425,087 225,300,481 ------------ ------------ End of year....................... $165,247,575 $190,425,087 ------------ ------------ ------------ ------------
- -------------------------------------------------------------------------------- See Notes to Financial Statements. 5 Notes to Financial Statements PRUDENTIAL MORTGAGE INCOME FUND, INC. - -------------------------------------------------------------------------------- The Prudential Mortgage Income Fund, Inc. (the "Fund"), is registered under the Investment Company Act of 1940 as a diversified, open-end management investment company. The investment objective of the Fund is to achieve a high level of income over the long-term consistent with providing reasonable safety by investing primarily in mortgage-related instruments, including securities guaranteed as to timely payment of principal and interest by the Government National Mortgage Association (GNMA), other mortgage-backed securities issued or guaranteed by agencies or instrumentalities of the U.S. Government, and non-agency mortgage instruments, along with obligations using mortgages as collateral. The ability of issuers of debt securities, held by the Fund, other than those issued or guaranteed by the U.S. Government, to meet their obligations may be affected by economic developments in a specific industry or region. - ------------------------------------------------------------ Note 1. Accounting Policies The following is a summary of significant accounting policies followed by the Fund in the preparation of its financial statements. Security Valuation: The Fund values portfolio securities on the basis of prices provided by dealers or by a pricing service which uses information such as market values, maturities, yields, call features and developments relating to specific securities in determining values. Short-term securities which mature in more than 60 days are valued at current market quotations. Short-term securities which mature in 60 days or less are valued at amortized cost which approximates market value. In connection with transactions in repurchase agreements with U.S. financial institutions, it is the Fund's policy that its custodian or designated subcustodians, as the case may be under triparty repurchase agreements, takes possession of the underlying collateral securities, the value of which exceeds the principal amount of the repurchase transaction, including accrued interest. If the seller defaults and the value of the collateral declines or if bankruptcy proceedings are commenced with respect to the seller of the security, realization of the collateral by the Fund may be delayed or limited. Securities Transactions and Net Investment Income: Securities transactions are recorded on the trade date. Since certain mortgage-backed securities, such as GNMAs, only settle on one day each month, there can be occasions when, pending settlement, there may be substantial short-term securities in the portfolio available to fund the purchases of these mortgage-backed securities. Realized gains and losses on sales of investments are calculated on the identified cost basis. Interest income is recorded on the accrual basis. The Fund amortizes original issue discount paid on purchases of portfolio securities as adjustments to interest income. Expenses are recorded on the accural basis which may require the use of certain estimates by management. Net investment income (other than distribution fees) and unrealized and realized gains or losses are allocated daily to each class of shares based upon the relative proportion of net assets of each class at the beginning of the day. Financial Futures Contracts: A financial futures contract is an agreement to purchase (long) or sell (short) an agreed amount of securities at a set price for delivery on a future date. Upon entering into a financial futures contract, the Series is required to pledge to the broker an amount of cash and/or other assets equal to a certain percentage of the contract amount. This amount is known as the "initial margin". Subsequent payments, known as "variation margin", are made or received by the Series each day, depending on the daily fluctuations in the value of the underlying security. Such variation margin is recorded for financial statement purposes on a daily basis as unrealized gain or loss. When the contract expires or is closed, the gain or loss is realized and is presented in the statement of operations as net realized gain (loss) on financial futures contracts. Dollar Rolls: The Fund enters into mortgage dollar rolls in which the Fund sells mortgage securities for delivery in the current month, realizing a gain or loss, and simultaneously contracts to repurchase somewhat similar (same type, coupon and maturity) securities on a specified future date. During the roll period the Fund forgoes principal and interest paid on the securities. The Fund is compensated by the interest earned on the cash proceeds of the initial sale and by the lower repurchase price at the future date. The difference between the sale proceeds and the lower repurchase price is taken into income. The Fund maintains a segregated account, the dollar value of which is equal to its obligations, in respect of dollar rolls. Federal Income Taxes: It is the Fund's policy to continue to meet the requirements of the Internal Revenue Code applicable to regulated investment companies and to distribute all of its taxable net income and net capital gains, if any, to its shareholders. Therefore, no federal income tax provision is required. Dividends and Distributions: Dividends from net investment income are declared daily and paid monthly. The Fund will distribute at least annually any net capital gains in excess of loss carryforwards. Dividends and distributions are recorded on the ex-dividend date. Income distributions and capital gain distributions are determined in accordance with income tax regulations which may differ from generally accepted accounting principles. - -------------------------------------------------------------------------------- 6 Notes to Financial Statements PRUDENTIAL MORTGAGE INCOME FUND, INC. - -------------------------------------------------------------------------------- Reclassification of Capital Accounts: The Fund accounts and reports for distributions to shareholders in accordance with American Institute of Certified Public Accountants' Statement of Position 93-2: Determination, Disclosure, and Financial Statement Presentation of Income, Capital Gain, and Return of Capital Distributions by Investment Companies. The effect of applying this statement was to decrease accumulated net realized losses by $4,346,167, and decrease paid in capital in excess of par by $4,346,167 which represents the expiration of a portion of the capital loss carryforward. Net realized gains and net assets were not affected by this change. - ------------------------------------------------------------ Note 2. Agreements The Fund has a management agreement with Prudential Investments Fund Management LLC ("PIFM"). Pursuant to this agreement, PIFM has responsibility for all investment advisory services and supervises the subadviser's performance of such services. PIFM has entered into a subadvisory agreement with The Prudential Investment Corporation ("PIC"); PIC furnishes investment advisory services in connection with the management of the Fund. PIFM pays for the cost of the subadviser's services, the compensation of officers of the Fund, occupancy and certain clerical and bookkeeping costs of the Fund. The Fund bears all other costs and expenses. The management fee paid PIFM is computed daily and payable monthly, at an annual rate of .50 of 1% of the average daily net assets of the Fund. Prior to September 1, 1997, PIFM agreed to waive a portion (.20 of 1% of the Fund's average daily net assets) of its management fee, which amounted to $238,812 ($0.02 per share; .20% of average net assets, annualized) for the year ended December 31, 1997. The Fund is not required to reimburse PIFM for such waiver. Effective September 1, 1997, PIFM eliminated its management fee waiver. The Fund has a distribution agreement with Prudential Securities Incorporated ("PSI") which acts as the distributor of the Class A, Class B, Class C and Class Z shares of the Fund. The Fund compensates PSI for distributing and servicing the Fund's Class A, Class B and Class C shares, pursuant to plans of distribution, (the "Class A, B and C Plans"), regardless of expenses actually incurred by them. The distribution fees for Class A, B and C shares are accrued daily and payable monthly. No distribution or service fees are paid to PSI as distributor of the Class Z shares of the Fund. Pursuant to the Class A, B and C Plans, the Fund compensates PSI for its distribution related activities at an annual rate of up to .30 of 1%, .75 of 1% and 1%, of the average daily net assets of the Class A, B and C shares, respectively. Such expenses under the Class A Plan were .15 of 1% of the average daily net assets of Class A shares and under the Class B and C Plans, .75 of 1% of the average daily net assets of both the Class B and Class C shares, respectively, for the year ended December 31, 1997. PSI has advised the Fund that it has received approximately $14,100 in front-end sales charges resulting from sales of Class A shares for the year ended December 31, 1997. From these fees, PSI paid such sales charges to dealers, which in turn paid commissions to salespersons and incurred other distribution costs. PSI advised the Fund that for the year ended December 31, 1997, it received approximately $162,100 in contingent deferred sales charges imposed upon certain redemptions by Class B and C shareholders. PSI, PIFM and PIC are indirect, wholly owned subsidiaries of The Prudential Insurance Company of America. The Fund, along with other affiliated registered investment companies (the "Funds"), has a credit agreement (the "Agreement") with an unaffiliated lender. The maximum commitment under the Agreement is $200,000,000. Interest on any such borrowings outstanding will be at market rates. The purpose of the Agreement is to serve as an alternative source of funding for capital share redemptions. The Fund has not borrowed any amounts pursuant to the Agreement during the year ended December 31, 1997. The Funds pay a commitment fee at an annual rate of .055 of 1% on the unused portion of the credit facility. The commitment fee is accrued and paid quarterly on a pro rata basis by the Funds. The Agreement expired on December 30, 1997 and has been extended through December 29, 1998 under the same terms. - ------------------------------------------------------------ Note 3. Other Transactions with Affiliates Prudential Mutual Fund Services LLC ("PMFS"), a wholly owned subsidiary of PIFM, serves as the Fund's transfer agent and during the year ended December 31, 1997, the Fund incurred fees of approximately $269,000 for the services of PMFS. As of December 31, 1997, approximately $21,000 of such fees were due to PMFS. Transfer agent fees and expenses in the Statement of Operations include certain out-of-pocket expenses paid to nonaffiliates. - ------------------------------------------------------------ Note 4. Portfolio Securities Purchases and sales of investment securities, other than short-term investments and dollar rolls, for the year ended December 31, 1997 aggregated $307,844,145 and $322,635,143, respectively. The cost basis of investments for federal income tax purposes at December 31, 1997 was $161,299,285 and, accordingly, net unrealized appreciation of investments for federal income tax purposes was $3,409,485 (gross - -------------------------------------------------------------------------------- 7 Notes to Financial Statements PRUDENTIAL MORTGAGE INCOME FUND, INC. - -------------------------------------------------------------------------------- unrealized appreciation--$3,636,659; gross unrealized depreciation--$227,174). The Fund had a capital loss carryforward as of December 31, 1997 of approximately $19,586,200 of which $2,647,800 expires in 1998, $16,220,800 expires in 2002 and $717,600 expires in 2005. Accordingly, no capital gains distribution is expected to be paid to shareholders until net gains have been realized in excess of such carryforward. During the fiscal year ended December 31, 1997, approximately $3,073,700 of capital loss carryforward expired unused. - ------------------------------------------------------------ Note 5. Joint Repurchase Agreement Account The Fund, along with other affiliated registered investment companies, transfers uninvested cash balances into a single joint account, the daily aggregate balance of which is invested in one or more repurchase agreements collateralized by U.S. Treasury or federal agency obligations. As of December 31, 1997, the Fund has a .19% undivided interest in the joint account. The undivided interest for the Fund represents $2,242,000 in the principal amount. As of such date, each repurchase agreement in the joint account and the collateral therefor were as follows: Credit Suisse First Boston Corp., 6.75%, in the principal amount of $342,000,000, repurchase price $342,128,250, due 1/2/98. The value of the collateral including accrued interest is $353,486,750. Deutsche Morgan Grenfell Inc., 6.80%, in the principal amount of $200,000,000, repurchase price $200,075,555, due 1/2/98. The value of the collateral including accrued interest is $204,003,314. SBC Warburg Dillon Read Inc., 6.55%, in the principal amount of $142,000,000, repurchase price $142,051,672, due 1/2/98. The value of the collateral including accrued interest is $144,862,841. Morgan Stanley, Dean Witter, Discover & Co., 5.95%, in the principal amount of $151,553,000, repurchase price $151,603,097, due 1/2/98. The value of the collateral including accrued interest is $154,584,932. Salomon Smith Barney Inc., 6.75%, in the principal amount of $342,000,000, repurchase price $342,128,250, due 1/2/98. The value of the collateral including accrued interest is $350,295,372. - ------------------------------------------------------------ Note 6. Capital The Fund offers Class A, Class B, Class C and Class Z shares. Class A shares are sold with a front-end sales charge of up to 4%. Class B shares are sold with a contingent deferred sales charge which declines from 5% to zero depending on the period of time the shares are held. Class C shares are sold with a contingent deferred sales charge of 1% during the first year. Class B shares will automatically convert to Class A shares on a quarterly basis approximately seven years after purchase. A special exchange privilege is also available for shareholders who qualified to purchase Class A shares at net asset value. Effective March 18, 1997 the Fund commenced offering Class Z shares. Class Z shares are not subject to any sales or redemption charge and are offered exclusively for sale to a limited group of investors. Each class of shares has equal rights as to earnings, assets and voting privileges except that each class bears different distribution expenses and has exclusive voting rights with respect to its distribution plan. The Fund has authorized 500 million shares of common stock, $.01 par value per share, equally divided into four classes, designated Class A, Class B, Class C and Class Z. Transactions in shares of common stock were as follows:
Class A Shares Amount - ------------------------------------ ---------- ------------- Year ended December 31, 1997: Shares sold......................... 196,213 $ 2,817,711 Shares issued in reinvestment of dividends and distributions....... 272,081 3,897,976 Shares reacquired................... (1,350,280) (19,341,070) ---------- ------------- Net decrease in shares outstanding before conversion................. (881,986) (12,625,383) Shares issued upon conversion from Class B........................... 554,627 7,950,244 ---------- ------------- Net decrease in shares outstanding....................... (327,359) $ (4,675,139) ---------- ------------- ---------- ------------- Year ended December 31, 1996: Shares sold......................... 223,806 $ 3,184,988 Shares issued in reinvestment of dividends and distributions....... 287,916 4,090,240 Shares reacquired................... (1,327,376) (18,847,332) ---------- ------------- Net decrease in shares outstanding before conversion................. (815,654) (11,572,104) Shares issued upon conversion from Class B........................... 590,405 8,336,520 ---------- ------------- Net decrease in shares outstanding....................... (225,249) $ (3,235,584) ---------- ------------- ---------- ------------- Class B - ------------------------------------ Year ended December 31, 1997: Shares sold......................... 243,748 $ 3,481,986 Shares issued in reinvestment of dividends and distributions....... 188,146 2,687,530 Shares reacquired................... (1,548,780) (22,088,732) ---------- ------------- Net decrease in shares outstanding before conversion................. (1,116,886) (15,919,216) Shares reacquired upon conversion into Class A...................... (556,068) (7,950,244) ---------- ------------- Net decrease in shares outstanding....................... (1,672,954) $ (23,869,460) ---------- ------------- ---------- -------------
- -------------------------------------------------------------------------------- 8 Notes to Financial Statements PRUDENTIAL MORTGAGE INCOME FUND, INC. - --------------------------------------------------------------------------------
Class B Shares Amount - ------------------------------------ ---------- ------------- Year ended December 31, 1996: Shares sold......................... 375,530 $ 5,342,866 Shares issued in reinvestment of dividends and distributions....... 251,545 3,565,389 Shares reacquired................... (1,892,789) (26,787,821) ---------- ------------- Net decrease in shares outstanding before conversion................. (1,265,714) (17,879,566) Shares reacquired upon conversion into Class A...................... (592,011) (8,336,520) ---------- ------------- Net decrease in shares outstanding....................... (1,857,725) $ (26,216,086) ---------- ------------- ---------- ------------- Class C - ------------------------------------ Year ended December 31, 1997: Shares sold......................... 11,549 $ 166,049 Shares issued in reinvestment of dividends and distributions....... 1,325 18,937 Shares reacquired................... (10,595) (150,716) ---------- ------------- Net increase in shares outstanding....................... 2,279 $ 34,270 ---------- ------------- ---------- ------------- Year ended December 31, 1996: Shares sold......................... 14,791 $ 208,181 Shares issued in reinvestment of dividends and distributions....... 1,020 14,435 Shares reacquired................... (665) (9,456) ---------- ------------- Net decrease in shares outstanding....................... (15,146) $ (213,160) ---------- ------------- ---------- ------------- Class Z - ------------------------------------ March 18, 1997(a) through December 31, 1997: Shares sold......................... 3,313 $ 47,787 Shares issued in reinvestment of dividends and distributions....... 38 553 Shares reacquired................... (681) (9,781) ---------- ------------- Net increase in shares outstanding....................... 2,670 $ 38,559 ---------- ------------- ---------- -------------
- --------------- (a) Commencement of offering of Class Z shares. - -------------------------------------------------------------------------------- 9 Financial Highlights PRUDENTIAL MORTGAGE INCOME FUND, INC. - --------------------------------------------------------------------------------
Class A ------------------------------------------------------- Year Ended December 31, ------------------------------------------------------- 1997 1996 1995(a) 1994(a) 1993(a) ------- ------- ------- ------- ------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of year.................. $ 14.25 $ 14.61 $ 13.50 $14.75 $ 15.07 ------- ------- ------- ------- ------- Income from investment operations Net investment income............................... .95(c) .93(c) .89 .90 .95 Net realized and unrealized gain (loss) on investment transactions.......................... .23 (.39) 1.18 (1.19) (.21) ------- ------- ------- ------- ------- Total from investment operations................. 1.18 .54 2.07 (.29) .74 ------- ------- ------- ------- ------- Less distributions Dividends to shareholders from net investment income........................................... (.90) (.90) (.89) (.90) (.95) Dividends to shareholders in excess of net investment income................................ -- -- (.07) -- (.11) Tax return of capital distributions................. -- -- -- (.06) -- ------- ------- ------- ------- ------- Total distributions.............................. (.90) (.90) (.96) (.96) (1.06) ------- ------- ------- ------- ------- Net asset value, end of year........................ $ 14.53 $ 14.25 $ 14.61 $13.50 $ 14.75 ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- TOTAL RETURN(b):.................................... 8.57% 4.12% 15.53% (2.01)% 4.97% RATIOS TO AVERAGE NET ASSETS: Net assets, end of year (000)....................... $90,639 $93,555 $99,183 $8,762 $10,863 Average net assets (000)............................ $91,094 $93,766 $90,854 $9,874 $10,199 Ratios to average net assets: Expenses, including distribution fees............ .96%(c) 1.12%(c) 1.27% 1.13% 1.00% Expenses, excluding distribution fees............ .81%(c) .97%(c) 1.12% .98% .85% Net investment income............................ 6.65%(c) 6.56%(c) 6.27% 6.42% 6.42% For Class A, B, C and Z Shares: Portfolio turnover rate............................. 178% 65% 193% 560% 134%
- --------------- (a) Based on average shares outstanding, by class. (b) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. (c) Net of management fee waiver. - -------------------------------------------------------------------------------- See Notes to Financial Statements. 10 Financial Highlights PRUDENTIAL MORTGAGE INCOME FUND, INC. - --------------------------------------------------------------------------------
Class B ----------------------------------------------------------- Year Ended December 31, ----------------------------------------------------------- 1997 1996 1995(a) 1994(a) 1993(a) ------- -------- -------- -------- -------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of year.................. $ 14.22 $ 14.57 $ 13.47 $ 14.71 $ 15.04 ------- -------- -------- -------- -------- Income from investment operations Net investment income............................... .88(c) .85(c) .82 .82 .87 Net realized and unrealized gain (loss) on investment transactions.......................... .21 (.39) 1.15 (1.19) (.23) ------- -------- -------- -------- -------- Total from investment operations................. 1.09 .46 1.97 (.37) .64 ------- -------- -------- -------- -------- Less distributions Dividends to shareholders from net investment income........................................... (.81) (.81) (.82) (.82) (.87) Dividends to shareholders in excess of net investment income................................ -- -- (.05) -- (.10) Tax return of capital distributions................. -- -- -- (.05) -- ------- -------- -------- -------- -------- Total distributions.............................. (.81) (.81) (.87) (.87) (.97) ------- -------- -------- -------- -------- Net asset value, end of year........................ $ 14.50 $ 14.22 $ 14.57 $ 13.47 $ 14.71 ------- -------- -------- -------- -------- ------- -------- -------- -------- -------- TOTAL RETURN(b): 7.84% 3.53% 14.78% (2.57)% 4.29% RATIOS TO AVERAGE NET ASSETS: Net assets, end of year (000)....................... $73,665 $96,016 $125,463 $245,437 $319,401 Average net assets (000)............................ $83,848 $109,812 $146,290 $279,946 $332,731 Ratios to average net assets: Expenses, including distribution fees............ 1.56%(c) 1.72%(c) 1.87% 1.73% 1.60% Expenses, excluding distribution fees............ .81%(c) .97%(c) 1.12% .98% .85% Net investment income............................ 6.05%(c) 5.95%(c) 5.82% 5.82% 5.82%
- --------------- (a) Based on average shares outstanding, by class. (b) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. (c) Net of management fee waiver. - -------------------------------------------------------------------------------- See Notes to Financial Statements. 11 Financial Highlights PRUDENTIAL MORTGAGE INCOME FUND, INC. - --------------------------------------------------------------------------------
Class C Class Z -------------------------------------------------- ------------ August 1, March 18, 1994(c) 1997(d) Year Ended December 31, through through --------------------------------- December 31, December 31, 1997 1996 1995(a) 1994(a) 1997 ------- -------- -------- ------------ ------------ PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of year.................. $ 14.22 $ 14.57 $ 13.47 $ 14.01 $ 14.13 ------- -------- -------- ------ ------ Income from investment operations Net investment income............................... .87(f) .85(f) .81 .30 .74(f) Net realized and unrealized gain (loss) on investment transactions.......................... .22 (.39) 1.16 (.49) .39 ------- -------- -------- ------ ------ Total from investment operations................. 1.09 .46 1.97 (.19) 1.13 ------- -------- -------- ------ ------ Less distributions Dividends to shareholders from net investment income........................................... (.81) (.81) (.81) (.30) (.72) Dividends to shareholders in excess of net investment income................................ -- -- (.06) -- -- Tax return of capital distributions................. -- -- -- (.05) -- ------- -------- -------- ------ ------ Total distributions.............................. (.81) (.81) (.87) (.35) (.72) ------- -------- -------- ------ ------ Net asset value, end of year........................ $ 14.50 $ 14.22 $ 14.57 $ 13.47 $ 14.54 ------- -------- -------- ------ ------ ------- -------- -------- ------ ------ TOTAL RETURN(b): 7.84% 3.53% 14.78% (1.32)% 8.18% RATIOS TO AVERAGE NET ASSETS: Net assets, end of year (000)....................... $904 $854 $655 $515 $39 Average net assets (000)............................ $857 $746 $599 $460 $9 Ratios to average net assets: Expenses, including distribution fees............ 1.56%(f) 1.72%(f) 1.87% 1.82%(e) .81%(e)(f) Expenses, excluding distribution fees............ .81%(f) .97%(f) 1.12% 1.08%(e) .81%(e)(f) Net investment income............................ 6.05%(f) 5.95%(f) 5.72% 5.32%(e) 6.88%(e)(f)
- --------------- (a) Based on average shares outstanding, by class. (b) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. Total returns for periods of less than a full year are not annualized. (c) Commencement of offering of Class C shares. (d) Commencement of offering of Class Z shares. (e) Annualized. (f) Net of management fee waiver. - -------------------------------------------------------------------------------- See Notes to Financial Statements. 12 Report of Independent Accountants PRUDENTIAL MORTGAGE INCOME FUND, INC. - -------------------------------------------------------------------------------- To the Shareholders and Board of Directors of Prudential Mortgage Income Fund, Inc. In our opinion, the accompanying statement of assets and liabilities, including the portfolio of investments, and the related statements of operations and of changes in net assets and the financial highlights present fairly, in all material respects, the financial position of Prudential Mortgage Income Fund, Inc. (the "Fund") at December 31, 1997, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended and the financial highlights for each of the periods presented, in conformity with generally accepted accounting principles. These financial statements and financial highlights (hereafter referred to as "financial statements") are the responsibility of the Fund's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits, which included confirmation of securities at December 31, 1997 by correspondence with the custodian and brokers, provide a reasonable basis for the opinion expressed above. PRICEWATERHOUSECOOPERS LLP 1177 Avenue of the Americas New York, New York February 13, 1998 Tax Information PRUDENTIAL MORTGAGE INCOME FUND, INC. - -------------------------------------------------------------------------------- We are required by Massachusetts, Missouri and Oregon to inform you that dividends which have been derived from interest on federal obligations are not taxable to shareholders providing the Mutual Fund meets certain requirements mandated by the respective state's taxing authorities. We are pleased to report that 4.83% of the dividends paid by Prudential Mortgage Income Fund, Inc. qualifies for such deduction. We wish to advise you that the corporate dividends received deduction for the Fund is zero. Only funds that invest in U.S. equity securities are entitled to pass-through a corporate dividends received deduction. - -------------------------------------------------------------------------------- 13 Portfolio of Investments as of June 30, 1998 (Unaudited) PRUDENTIAL MORTGAGE INCOME FUND, INC. - -------------------------------------------------------------------------------
Principal Amount (000) Description Value (Note 1) - ---------------------------------------------------------------- LONG-TERM INVESTMENTS--93.9% - ---------------------------------------------------------------- Asset-Backed Securities--12.3% ContiMortgage Home Equity Loan Trust, $ 2,875(b) Ser. 97-1 M2, 7.67%, 3/15/28 $ 2,954,961 Federal Home Loan Mortgage Corp. Loan Receivables Trust, 34,495 Ser. 97-A, AX, 2.783%, 4/15/19, I/O 5,174,211 4,000 Ser. 97-B, C, 7.40%, 9/15/19 4,163,750 Money Store Home Improvement Ln. Trust, 6,125(b) Ser. 97-1 M2, 8.07%, 5/15/23 6,419,766 ------------ Total asset-backed securities (cost $23,278,984) 18,712,688 - ---------------------------------------------------------------- Collateralized Mortgage Obligations--7.6% Bayview Financial Acquisition Trust, 5,000 Ser. 98-1 AI, 7.01%, 5/25/29 5,018,750 Federal Home Loan Mortgage Corp., 6,500(b) Ser. 98 C, 6.425%, 2/17/30, REMIC 6,542,656 ------------ Total collateralized mortgage obligations (cost $6,569,063) 11,561,406 - ---------------------------------------------------------------- Corporate Bonds--3.4% Merck and Co., 5,000(b) 5.76%, 5/3/37 (cost $5,000,000) 5,150,000 - ---------------------------------------------------------------- U.S. Government Agency Mortgage Pass-through Obligations--56.4% Federal Home Loan Mortgage Corp. (Gold), 7,430 9.00%, 1/1/20 7,884,772 Federal National Mortgage Association, 21,000 6.50%, 12/1/99 20,914,530 6 7.00%, 4/1/08 6,358 17,603 7.50%, 6/1/10 - 12/1/99 18,077,915 16(b) 8.00%, 10/1/24 16,162 18,108(b) 10.00%, 12/1/20 19,918,744 Government National Mortgage Association, $ 16,249(b) 7.50%, 7/15/07 - 7/15/24 $ 16,762,897 1,897 9.00%, 4/15/01 - 1/15/10 1,980,008 ------------ Total U.S. government agency mortgage pass-through obligations (cost $85,098,520) 85,561,386 - ---------------------------------------------------------------- U.S. Government Obligations--14.2% United States Treasury Bond, 3,000(b) 12.375%, 5/15/04 4,012,980 United States Treasury Notes, 3,280 6.50%, 5/31/01 3,364,034 6,000(b) 5.50%, 1/31/03 5,995,320 3,000 5.50%, 5/31/03 3,000,480 5,000(c) 6.125%, 8/15/07 5,202,350 ------------ Total U.S. government obligations (cost $21,790,406) 21,575,164 ------------ Total long-term investments (cost $141,736,973) 142,560,644 ------------ SHORT-TERM INVESTMENTS--13.8% - ---------------------------------------------------------------- U.S. Government Agency Mortgage Pass-through Obligations--2.8% Federal Home Loan Mortgage Corp., 4,313 5.85%, 7/1/98 (cost $4,313,000) 4,313,000 - ---------------------------------------------------------------- Repurchase Agreements--11.0% Merrill Lynch, Pierce, Fenner & Smith, Inc., 1,663 5.75%, dated 6/30/98, due 7/7/98 in the amount of $1,664,859 (cost $1,663,000; the value of collateral including accrued interest is $1,702,844) 1,663,000
- ---------------------------------------------------------------- See Notes to Financial Statements. 3 PRUDENTIAL MORTGAGE INCOME FUND, INC. Portfolio of Investments as of June 30, 1998 (Unaudited) - -------------------------------------------------------------------------------
Principal Amount (000) Description Value (Note 1) - ---------------------------------------------------------------- Repurchase Agreements (cont'd.) Salomon Smith Barney Inc., 6.00%, $ 15,000 dated 6/30/98, due 7/2/98 in the amount of $15,005,000 (cost $15,000,000; the value of collateral including accrued interest is $15,300,001) $ 15,000,000 ------------ Total repurchase agreements (cost $16,663,000) 16,663,000 ------------ OUTSTANDING CALL OPTIONS PURCHASED Contracts(a) - --------------- U. S. Treasury Bond, 300 5.625%, 5/15/08 @ 102.34, expires 7/27/98 (cost $75,000) 67,969 ------------ Total short-term investments (cost $21,051,000) 21,043,969 ------------ - ---------------------------------------------------------------- Total Investments Before Outstanding Put Options Written--107.7% (cost $162,787,973; Note 4) 163,604,613 - ---------------------------------------------------------------- OUTSTANDING PUT OPTIONS WRITTEN U.S. Treasury Bond, 300 5.625%, 5/15/08 @ 99.34, expires 7/27/98 (premium received $30,469) (28,125) ------------ - ---------------------------------------------------------------- Total investments, net of outstanding put options written--107.7% 163,576,488 Liabilities in excess of other assets--(7.7%) (11,804,020) ------------ Net Assets--100% $151,772,468 ------------ ------------
- --------------- I/O--Interest Only REMIC--Real Estate Mortgage Investment Conduit (a) One contract equals $1,000 face value. (b) All or portion of securities segregated as collateral for options on futures and dollar rolls. (c) Security on loan (Note 1). - -------------------------------------------------------------------------------- See Notes to Financial Statements. 4 Statement of Assets and Liabilities (Unaudited) PRUDENTIAL MORTGAGE INCOME FUND, INC. - -------------------------------------------------------------------------------
Assets June 30, 1998 Investments, at value (cost $162,787,973)................................................................... $163,604,613 Cash........................................................................................................ 89,645 Receivable for investments sold............................................................................. 33,598,075 Interest receivable......................................................................................... 1,115,628 Receivable for Fund shares sold............................................................................. 44,635 Receivable for options written.............................................................................. 30,469 Stock loan receivable....................................................................................... 2,360 Other assets................................................................................................ 3,031 ------------- Total assets............................................................................................. 198,488,456 ------------- Liabilities Put options written, at value (premium received $30,469).................................................... 28,125 Payable for investments purchased........................................................................... 45,605,854 Accrued expenses............................................................................................ 383,517 Payable for Fund shares reacquired.......................................................................... 240,670 Dividends payable........................................................................................... 228,217 Payable for options purchased............................................................................... 75,000 Management fee payable...................................................................................... 63,288 Distribution fee payable.................................................................................... 50,575 Deferred Director's fees.................................................................................... 40,742 ------------- Total liabilities........................................................................................ 46,715,988 ------------- Net Assets.................................................................................................. $151,772,468 ------------- ------------- Net assets were comprised of: Common stock, at par..................................................................................... $ 105,737 Paid-in capital in excess of par......................................................................... 168,894,343 ------------- 169,000,080 Undistributed net investment income...................................................................... 842,352 Accumulated net realized loss on investments............................................................. (18,888,948) Net unrealized appreciation on investments............................................................... 818,984 ------------- Net assets, June 30, 1998................................................................................... $151,772,468 ------------- ------------- Class A: Net asset value and redemption price per share ($89,480,635 / 6,228,212 shares of common stock issued and outstanding)............................... $14.37 Maximum sales charge (4% of offering price).............................................................. .60 ------------- Maximum offering price to public......................................................................... $14.97 ------------- ------------- Class B: Net asset value, offering price and redemption price per share ($60,987,782 / 4,254,543 shares of common stock issued and outstanding)............................... $14.33 ------------- ------------- Class C: Net asset value, offering price and redemption price per share ($1,189,831 / 83,004 shares of common stock issued and outstanding)................................... $14.33 ------------- ------------- Class Z: Net asset value, offering price and redemption price per share ($114,220 / 7,939 shares of common stock issued and outstanding)...................................... $14.39 ------------- -------------
- -------------------------------------------------------------------------------- See Notes to Financial Statements. 5 PRUDENTIAL MORTGAGE INCOME FUND, INC. Statement of Operations (Unaudited) - ------------------------------------------------------------
Six Months Ended Net Investment Income June 30, 1998 ------------- Income Interest................................... $ 5,808,901 Income from securities lending............. 27,585 ------------- 5,836,486 ------------- Expenses Management fee............................. 395,850 Distribution fee--Class A.................. 67,171 Distribution fee--Class B.................. 253,861 Distribution fee--Class C.................. 3,706 Transfer agent's fees and expenses......... 135,700 Custodian's fees and expenses.............. 66,800 Reports to shareholders.................... 31,200 Registration fees.......................... 21,500 Audit fee.................................. 14,000 Directors' fees and expenses............... 10,500 Legal fees and expenses.................... 8,700 Miscellaneous.............................. 8,516 ------------- Total expenses.......................... 1,017,504 ------------- Net investment income......................... 4,818,982 ------------- Realized and Unrealized Gain (Loss) on Investments Net realized gain (loss) on: Investment transactions.................... 990,281 Futures transactions....................... (17,028) ------------- 973,253 ------------- Net change in unrealized appreciation (depreciation) of: Investment transactions.................... (2,861,126) Written options transactions............... 2,344 ------------- (2,858,782) ------------- Net loss on investments....................... (1,885,529) ------------- Net Increase in Net Assets Resulting from Operations..................... $ 2,933,453 ------------- -------------
PRUDENTIAL MORTGAGE INCOME FUND, INC. Statement of Changes in Net Assets (Unaudited) - ------------------------------------------------------------
Six Months Ended Year Ended Increase (Decrease) June 30, December 31, in Net Assets 1998 1997 ------------- ------------- Operations Net investment income........ $ 4,818,982 $ 11,178,263 Net realized gain on investments............... 973,253 673,963 Net change in unrealized appreciation (depreciation) of investments............... (2,858,782) 1,996,049 ------------- ------------- Net increase in net assets resulting from operations................ 2,933,453 13,848,275 ------------- ------------- Dividends and distributions (Note 1) Dividends to shareholders from net investment income Class A................... (2,803,491) (5,736,643) Class B................... (1,906,422) (4,768,059) Class C................... (27,940) (48,744) Class Z................... (3,020) (571) ------------- ------------- (4,740,873) (10,554,017) ------------- ------------- Fund share transactions (net of share conversions) (Note 5) Proceeds from shares sold.... 11,215,897 6,513,533 Net asset value of shares issued in reinvestment of dividends................. 2,853,940 6,604,996 Cost of shares reacquired.... (25,737,524) (41,590,299) ------------- ------------- Net decrease in net assets from Fund share transactions.............. (11,667,687) (28,471,770) ------------- ------------- Total decrease.................. (13,475,107) (25,177,512) Net Assets Beginning of period............. 165,247,575 190,425,087 ------------- ------------- End of period(a)................ $ 151,772,468 $ 165,247,575 ------------- ------------- ------------- ------------- - --------------- (a) Includes undistributed net investment income of......... $ 842,352 $ 764,243 ------------- -------------
- -------------------------------------------------------------------------------- See Notes to Financial Statements. 6 Notes to Financial Statements (Unaudited) PRUDENTIAL MORTGAGE INCOME FUND, INC. - -------------------------------------------------------------------------------- The Prudential Mortgage Income Fund, Inc. (the "Fund"), is registered under the Investment Company Act of 1940 as a diversified, open-end management investment company. The investment objective of the Fund is to achieve a high level of income over the long-term consistent with providing reasonable safety by investing primarily in mortgage-related instruments, including securities guaranteed as to timely payment of principal and interest by the Government National Mortgage Association (GNMA), other mortgage-backed securities issued or guaranteed by agencies or instrumentalities of the U.S. Government, and non-agency mortgage instruments, along with obligations using mortgages as collateral. The ability of issuers of debt securities, held by the Fund, other than those issued or guaranteed by the U.S. Government, to meet their obligations may be affected by economic developments in a specific industry or region. - ------------------------------------------------------------ Note 1. Accounting Policies The following is a summary of significant accounting policies followed by the Fund in the preparation of its financial statements. Security Valuation: The Fund values portfolio securities on the basis of prices provided by dealers or by a pricing service which uses information such as market values, maturities, yields, call features and developments relating to specific securities in determining values. Short-term securities which mature in more than 60 days are valued at current market quotations. Short-term securities which mature in 60 days or less are valued at amortized cost which approximates market value. In connection with transactions in repurchase agreements with U.S. financial institutions, it is the Fund's policy that its custodian or designated subcustodians, as the case may be under triparty repurchase agreements, takes possession of the underlying collateral securities, the value of which exceeds the principal amount of the repurchase transaction, including accrued interest. If the seller defaults and the value of the collateral declines or if bankruptcy proceedings are commenced with respect to the seller of the security, realization of the collateral by the Fund may be delayed or limited. Securities Transactions and Net Investment Income: Securities transactions are recorded on the trade date. Since certain mortgage-backed securities, such as GNMAs, only settle on one day each month, there can be occasions when, pending settlement, there may be substantial short-term securities in the portfolio available to fund the purchases of these mortgage-backed securities. Realized gains and losses on sales of investments are calculated on the identified cost basis. Interest income is recorded on the accrual basis. The Fund amortizes original issue discount paid on purchases of portfolio securities as adjustments to interest income. Expenses are recorded on the accural basis which may require the use of certain estimates by management. Net investment income (other than distribution fees) and unrealized and realized gains or losses are allocated daily to each class of shares based upon the relative proportion of net assets of each class at the beginning of the day. Securities Lending: The Fund may lend its portfolio securities to brokers or dealers, banks or other recognized institutional borrowers of securities, provided that the borrower at all times maintains cash or other liquid assets or secures an irrevocable letter of credit in favor of the Fund in an amount equal to at least 100% of the market value of the securities loaned. During the time portfolio securities are on loan, the borrower will pay the Fund an amount equivalent to any dividend or interest paid on such securities and the Fund may invest the cash collateral and earn additional income, or it may receive an agreed-upon amount of interest income from the borrower. In these transactions, there are risks of delay in recovery and in some cases even loss of rights in the collateral should the borrower of the securities fail financially. Loans are subject to termination at the option of the borrower or the Fund. The Fund may pay reasonable finders', administrative and custodial fees in connection with a loan of its securities and may share the interest earned on the collateral with the borrower. Options: The Fund may either purchase or write options in order to hedge against adverse market movements or fluctuations in value caused by changes in prevailing interest rates with respect to securities which the Fund currently owns or intends to purchase. The Fund's principal reason for writing options is to realize, through receipt of premiums, a greater current return than would be realized on the underlying security alone. When the Fund purchases an option, it pays a premium and an amount equal to that premium is recorded as an investment. When the Fund writes an option, it receives a premium and an amount equal to that premium is recorded as a liability. The investment or liability is adjusted daily to reflect the current market value of the option. If an option expires unexercised, the Fund realizes a gain or loss to the extent of the premium received or paid. If an option is exercised, the premium received or paid is an adjustment to the proceeds from the sale or the cost of the purchase in determining whether the Fund has realized a gain or loss. The difference between the premium and the amount received or paid on effecting a closing purchase or sale transaction is also treated as a realized gain or loss. Gain or loss on purchased options is included in net realized gain - -------------------------------------------------------------------------------- 7 Notes to Financial Statements (Unaudited) PRUDENTIAL MORTGAGE INCOME FUND, INC. - -------------------------------------------------------------------------------- (loss) on investment transactions. Gain or loss on written options is presented separately as net realized gain (loss) on written option transactions. The Fund, as a writer of an option, may have no control over whether the underlying securities may be sold (called) or purchased (put). As a result, the Fund bears the market risk of an unfavorable change in the price of the security underlying the written option. The Fund, as purchaser of an option, bears the risk of the potential inability of the counterparties to meet the terms of their contracts. Dollar Rolls: The Fund enters into mortgage dollar rolls in which the Fund sells mortgage securities for delivery in the current month, realizing a gain or loss, and simultaneously contracts to repurchase somewhat similar (same type, coupon and maturity) securities on a specified future date. During the roll period the Fund forgoes principal and interest paid on the securities. The Fund is compensated by the interest earned on the cash proceeds of the initial sale and by the lower repurchase price at the future date. The difference between the sale proceeds and the lower repurchase price is taken into income. The Fund maintains a segregated account, the dollar value of which is equal to its obligations, in respect of dollar rolls. Federal Income Taxes: It is the Fund's policy to continue to meet the requirements of the Internal Revenue Code applicable to regulated investment companies and to distribute all of its taxable net income and net capital gains, if any, to its shareholders. Therefore, no federal income tax provision is required. Dividends and Distributions: Dividends from net investment income are declared daily and paid monthly. The Fund will distribute at least annually any net capital gains in excess of loss carryforwards. Dividends and distributions are recorded on the ex-dividend date. Income distributions and capital gain distributions are determined in accordance with income tax regulations which may differ from generally accepted accounting principles. - ------------------------------------------------------------ Note 2. Agreements The Fund has a management agreement with Prudential Investments Fund Management LLC ("PIFM"). Pursuant to this agreement, PIFM has responsibility for all investment advisory services and supervises the subadviser's performance of such services. PIFM has entered into a subadvisory agreement with The Prudential Investment Corporation ("PIC"); PIC furnishes investment advisory services in connection with the management of the Fund. PIFM pays for the cost of the subadviser's services, the compensation of officers of the Fund, occupancy and certain clerical and bookkeeping costs of the Fund. The Fund bears all other costs and expenses. The management fee paid PIFM is computed daily and payable monthly, at an annual rate of .50 of 1% of the average daily net assets of the Fund. The Fund has a distribution agreement with Prudential Securities Incorporated ("PSI") which acts as the distributor of the Class A, Class B, Class C and Class Z shares of the Fund. The Fund compensates PSI for distributing and servicing the Fund's Class A, Class B and Class C shares, pursuant to plans of distribution, (the "Class A, B and C Plans"), regardless of expenses actually incurred by them. The distribution fees for Class A, B and C shares are accrued daily and payable monthly. No distribution or service fees are paid to PSI as distributor of the Class Z shares of the Fund. Effective July 1, 1998, Prudential Investment Management Services LLC will become the distributor of the Fund and will serve the Fund under the same terms and conditions as under the arrangement with PSI. Pursuant to the Class A, B and C Plans, the Fund compensates PSI for its distribution related activities at an annual rate of up to .30 of 1%, .75 of 1% and 1%, of the average daily net assets of the Class A, B and C shares, respectively. Such expenses under the Class A Plan were .15 of 1% of the average daily net assets of Class A shares and under the Class B and C Plans, .75 of 1% of the average daily net assets of both the Class B and Class C shares, respectively, for the six months ended June 30, 1998. PSI has advised the Fund that it has received approximately $15,100 in front-end sales charges resulting from sales of Class A shares for the six months ended June 30, 1998. From these fees, PSI paid such sales charges to dealers, which in turn paid commissions to salespersons and incurred other distribution costs. PSI advised the Fund that for the six months ended June 30, 1998, it received approximately $51,400 and $1,700 in contingent deferred sales charges imposed upon certain redemptions by Class B and C shareholders, respectively. PSI, PIFM and PIC are indirect, wholly owned subsidiaries of The Prudential Insurance Company of America. The Fund, along with other affiliated registered investment companies (the "Funds"), has a credit agreement (the "Agreement") with an unaffiliated lender. The maximum commitment under the Agreement is $200,000,000. Interest on any such borrowings outstanding will be at market rates. The purpose of the Agreement is to serve as an alternative - -------------------------------------------------------------------------------- 8 Notes to Financial Statements (Unaudited) PRUDENTIAL MORTGAGE INCOME FUND, INC. - -------------------------------------------------------------------------------- source of funding for capital share redemptions. The Fund has not borrowed any amounts pursuant to the Agreement during the six months ended June 30, 1998. The Funds pay a commitment fee at an annual rate of .055 of 1% on the unused portion of the credit facility. The commitment fee is accrued and paid quarterly on a pro rata basis by the Funds. The Agreement expired on December 30, 1997 and has been extended through December 29, 1998 under the same terms. - ------------------------------------------------------------ Note 3. Other Transactions with Affiliates Prudential Mutual Fund Services LLC ("PMFS"), a wholly owned subsidiary of PIFM, serves as the Fund's transfer agent and during the six months ended June 30, 1998, the Fund incurred fees of approximately $128,000 for the services of PMFS. As of June 30, 1998, approximately $21,000 of such fees were due to PMFS. Transfer agent fees and expenses in the Statement of Operations include certain out-of-pocket expenses paid to nonaffiliates. - ------------------------------------------------------------ Note 4. Portfolio Securities Purchases and sales of investment securities, other than short-term investments and dollar rolls, for the six months ended June 30, 1998 aggregated $272,103,112 and $277,112,865, respectively. The average balance of dollar rolls outstanding during the six months ended June 30, 1998 was approximately $12,773,900. The amount of dollar rolls outstanding at June 30, 1998 was $33,221,970, which was .2% of total assets. As of June 30, 1998, the Fund had securities on loan with an aggregate market value of $5,202,350. As of this date, the collateral held for securities on loan was comprised of U.S. cash with an aggregate market value of $5,418,064. The cost basis of investments for federal income tax purposes at June 30, 1998 was substantially the same as for financial reporting purposes and, accordingly, net unrealized appreciation of investments for federal income tax purposes was $818,984 (gross unrealized appreciation--$1,388,127; gross unrealized depreciation--$569,143). The Fund had a capital loss carryforward as of December 31, 1997 of approximately $19,586,200 of which $2,647,800 expires in 1998, $16,220,800 expires in 2002 and $717,600 expires in 2005. Accordingly, no capital gains distribution is expected to be paid to shareholders until net gains have been realized in excess of such carryforward. Transactions in options written during the six months ended June 30, 1998 were as follows:
Number of Premiums Contracts Received --------- -------- Options outstanding at December 31, 1997................................ -- -- Options written....................... 300 $30,469 Options terminated in closing purchase transactions........................ -- -- --- -------- Options outstanding at June 30, 1998................................ 300 $30,469 --- -------- --- --------
- ------------------------------------------------------------ Note 5. Capital The Fund offers Class A, Class B, Class C and Class Z shares. Class A shares are sold with a front-end sales charge of up to 4%. Class B shares are sold with a contingent deferred sales charge which declines from 5% to zero depending on the period of time the shares are held. Class C shares are sold with a contingent deferred sales charge of 1% during the first year. Class B shares will automatically convert to Class A shares on a quarterly basis approximately seven years after purchase. A special exchange privilege is also available for shareholders who qualified to purchase Class A shares at net asset value. Effective March 18, 1997 the Fund commenced offering Class Z shares. Class Z shares are not subject to any sales or redemption charge and are offered exclusively for sale to a limited group of investors. Each class of shares has equal rights as to earnings, assets and voting privileges except that each class bears different distribution expenses and has exclusive voting rights with respect to its distribution plan. The Fund has authorized 500 million shares of common stock, $.01 par value per share, equally divided into four classes, designated Class A, Class B, Class C and Class Z. Transactions in shares of common stock were as follows:
Class A Shares Amount - ------------------------------------ ---------- ------------- Six months ended June 30, 1998: Shares sold......................... 592,706 $ 8,563,886 Shares issued in reinvestment of dividends and distributions....... 124,112 1,791,609 Shares reacquired................... (912,137) (13,165,541) ---------- ------------- Net decrease in shares outstanding before conversion................. (195,319) (2,810,046) Shares issued upon conversion from Class B........................... 185,819 2,684,330 ---------- ------------- Net decrease in shares outstanding....................... (9,500) $ (125,716) ---------- ------------- ---------- -------------
- -------------------------------------------------------------------------------- 9 Notes to Financial Statements (Unaudited) PRUDENTIAL MORTGAGE INCOME FUND, INC. - --------------------------------------------------------------------------------
Class A Shares Amount - ------------------------------------ ---------- ------------- Year ended December 31, 1997: Shares sold......................... 196,213 $ 2,817,711 Shares issued in reinvestment of dividends and distributions....... 272,081 3,897,976 Shares reacquired................... (1,350,280) (19,341,070) ---------- ------------- Net decrease in shares outstanding before conversion................. (881,986) (12,625,383) Shares issued upon conversion from Class B........................... 554,627 7,950,244 ---------- ------------- Net decrease in shares outstanding....................... (327,359) $ (4,675,139) ---------- ------------- ---------- ------------- Class B - ------------------------------------ Six months ended June 30, 1998: Shares sold......................... 129,694 $ 1,867,803 Shares issued in reinvestment of dividends and distributions....... 72,551 1,045,374 Shares reacquired................... (842,831) (12,143,806) ---------- ------------- Net decrease in shares outstanding before conversion................. (640,586) (9,230,629) Shares reacquired upon conversion into Class A...................... (186,335) (2,684,330) ---------- ------------- Net decrease in shares outstanding....................... (826,921) $ (11,914,959) ---------- ------------- ---------- ------------- Year ended December 31, 1997: Shares sold......................... 243,748 $ 3,481,986 Shares issued in reinvestment of dividends and distributions....... 188,146 2,687,530 Shares reacquired................... (1,548,780) (22,088,732) ---------- ------------- Net decrease in shares outstanding before conversion................. (1,116,886) (15,919,216) Shares reacquired upon conversion into Class A...................... (556,068) (7,950,244) ---------- ------------- Net decrease in shares outstanding....................... (1,672,954) $ (23,869,460) ---------- ------------- ---------- ------------- Class C Shares Amount - ------------------------------------ ---------- ------------- Six months ended June 30, 1998: Shares sold......................... 47,488 $ 682,763 Shares issued in reinvestment of dividends and distributions....... 988 14,220 Shares reacquired................... (27,842) (400,606) ---------- ------------- Net increase in shares outstanding....................... 20,634 $ 296,377 ---------- ------------- ---------- ------------- Year ended December 31, 1997: Shares sold......................... 11,549 $ 166,049 Shares issued in reinvestment of dividends and distributions....... 1,325 18,937 Shares reacquired................... (10,595) (150,716) ---------- ------------- Net increase in shares outstanding....................... 2,279 $ 34,270 ---------- ------------- ---------- ------------- Class Z - ------------------------------------ Six months ended June 30, 1998: Shares sold......................... 6,992 $ 101,445 Shares issued in reinvestment of dividends and distributions....... 190 2,737 Shares reacquired................... (1,913) (27,571) ---------- ------------- Net increase in shares outstanding....................... 5,269 $ 76,611 ---------- ------------- ---------- ------------- March 18, 1997(a) through December 31, 1997: Shares sold......................... 3,313 $ 47,787 Shares issued in reinvestment of dividends and distributions....... 38 553 Shares reacquired................... (681) (9,781) ---------- ------------- Net increase in shares outstanding....................... 2,670 $ 38,559 ---------- ------------- ---------- -------------
- --------------- (a) Commencement of offering of Class Z shares. - -------------------------------------------------------------------------------- 10 Financial Highlights (Unaudited) PRUDENTIAL MORTGAGE INCOME FUND, INC. - --------------------------------------------------------------------------------
Class A ------------------------------------------------------------------------- Six Months Ended Year Ended December 31, June 30, --------------------------------------------------------- 1998 1997 1996 1995(a) 1994(a) 1993(a) ----------- ------- ------- ------- --------- ------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period................ $ 14.53 $ 14.25 $ 14.61 $ 13.50 $ 14.75 $ 15.07 ----- ------- ------- ------- --------- ------- Income from investment operations Net investment income............................... .46 .95(c) .93(c) .89 .90 .95 Net realized and unrealized gain (loss) on investment transactions.......................... (.17) .23 (.39) 1.18 (1.19) (.21) ----- ------- ------- ------- --------- ------- Total from investment operations................. .29 1.18 .54 2.07 (.29) .74 ----- ------- ------- ------- --------- ------- Less distributions Dividends to shareholders from net investment income........................................... (.45) (.90) (.90) (.89) (.90) (.95) Dividends to shareholders in excess of net investment income................................ -- -- -- (.07) -- (.11) Tax return of capital distributions................. -- -- -- -- (.06) -- ----- ------- ------- ------- --------- ------- Total distributions.............................. (.45) (.90) (.90) (.96) (.96) (1.06) ----- ------- ------- ------- --------- ------- Net asset value, end of period...................... $ 14.37 $ 14.53 $ 14.25 $ 14.61 $ 13.50 $ 14.75 ----- ------- ------- ------- --------- ------- ----- ------- ------- ------- --------- ------- TOTAL RETURN(b):.................................... 1.87% 8.57% 4.12% 15.53% (2.01)% 4.97% RATIOS TO AVERAGE NET ASSETS: Net assets, end of period (000)..................... $89,480 $90,639 $93,555 $99,183 $8,762 $10,863 Average net assets (000)............................ $90,304 $91,094 $93,766 $90,854 $9,874 $10,199 Ratios to average net assets: Expenses, including distribution fees............ 1.03%(d) .96%(c) 1.12%(c) 1.27% 1.13% 1.00% Expenses, excluding distribution fees............ .88%(d) .81%(c) .97%(c) 1.12% .98% .85% Net investment income............................ 6.35%(d) 6.65%(c) 6.56%(c) 6.27% 6.42% 6.42% For Class A, B, C and Z Shares: Portfolio turnover rate............................. 171% 178% 65% 193% 560% 134%
- --------------- (a) Based on average shares outstanding, by class. (b) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. Total returns for periods of less than a full year are not annualized. (c) Net of management fee waiver. (d) Annualized. - -------------------------------------------------------------------------------- See Notes to Financial Statements. 11 Financial Highlights (Unaudited) PRUDENTIAL MORTGAGE INCOME FUND, INC. - --------------------------------------------------------------------------------
Class B --------------------------------------------------------------------- Six Months Ended Year Ended December 31, June 30, --------------------------------------------------------- 1998 1997 1996 1995(a) 1994(a) 1993(a) ----------- ------- -------- -------- ------- --------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period................... $ 14.50 $ 14.22 $ 14.57 $ 13.47 $ 14.71 15.04 ----- ------- -------- -------- -------- -------- Income from investment operations Net investment income.................................. .43 .88(c) .85(c) .82 .82 .87 Net realized and unrealized gain (loss) on investment transactions........................................ (.19) .21 (.39) 1.15 (1.19) (.23) ----- ------- -------- -------- -------- -------- Total from investment operations.................... .24 1.09 .46 1.97 (.37) .64 ----- ------- -------- -------- -------- -------- Less distributions Dividends to shareholders from net investment income... (.41) (.81) (.81) (.82) (.82) (.87) Dividends to shareholders in excess of net investment income.............................................. -- -- -- (.05) -- (.10) Tax return of capital distributions.................... -- -- -- -- (.05) -- ----- ------- -------- -------- -------- -------- Total distributions................................. (.41) (.81) (.81) (.87) (.87) (.97) ----- ------- -------- -------- -------- -------- Net asset value, end of period......................... $ 14.33 $ 14.50 $ 14.22 $ 14.57 $ 13.47 $ 14.71 ----- ------- -------- -------- -------- -------- ----- ------- -------- -------- -------- -------- TOTAL RETURN(b): 1.64% 7.84% 3.53% 14.78% (2.57)% 4.29% RATIOS TO AVERAGE NET ASSETS: Net assets, end of period (000)........................ $60,988 $73,665 $96,016 $125,463 $245,437 $319,401% Average net assets (000)............................... $68,257 $83,848 $109,812 $146,290 $279,946 $332,731% Ratios to average net assets: Expenses, including distribution fees............... 1.63%(d) 1.56%(c) 1.72%(c) 1.87% 1.73% 1.60% Expenses, excluding distribution fees............... .88%(d) .81%(c) .97%(c) 1.12% .98% .85% Net investment income............................... 5.74%(d) 6.05%(c) 5.95%(c) 5.82% 5.82% 5.82%
- --------------- (a) Based on average shares outstanding, by class. (b) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. Total returns for periods of less than a full year are not annualized. (c) Net of management fee waiver. (d) Annualized. - -------------------------------------------------------------------------------- See Notes to Financial Statements. 12 Financial Highlights (Unaudited) PRUDENTIAL MORTGAGE INCOME FUND, INC. - --------------------------------------------------------------------------------
Class C ------------------------------------------------------------------------ August 1, Six Months 1994(c) Ended Year Ended December 31, Through June 30, ------------------------------------- December 31, 1998 1997 1996 1995(a) 1994(a) ------------- ------ ------------ --------- ------------ PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period................... $ 14.50 $14.22 $14.57 $ 13.47 $14.01 ----- ------ ----- --------- ----- Income from investment operations Net investment income.................................. .43 .87(f) .85(f) .81 .30 Net realized and unrealized gain (loss) on investment transactions........................................ (.19) .22 (.39) 1.16 (.49) ----- ------ ----- --------- ----- Total from investment operations.................... .24 1.09 .46 1.97 (.19) ----- ------ ----- --------- ----- Less distributions Dividends to shareholders from net investment income... (.41) (.81) (.81) (.81) (.30) Dividends to shareholders in excess of net investment income.............................................. -- -- -- (.06) -- Tax return of capital distributions.................... -- -- -- -- (.05) ----- ------ ----- --------- ----- Total distributions................................. (.41) (.81) (.81) (.87) (.35) ----- ------ ----- --------- ----- Net asset value, end of period......................... $ 14.33 $14.50 $14.22 $ 14.57 $13.47 ----- ------ ----- --------- ----- ----- ------ ----- --------- ----- TOTAL RETURN(b): 1.64% 7.84% 3.53% 14.78% (1.32)% RATIOS TO AVERAGE NET ASSETS: Net assets, end of period (000)........................ $1,190 $904 $854 $655 $515 Average net assets (000)............................... $997 $857 $746 $599 $460 Ratios to average net assets: Expenses, including distribution fees............... 1.63%(e) 1.56%(f) 1.72%(f) 1.87% 1.82%(e) Expenses, excluding distribution fees............... .88%(e) .81%(f) .97%(f) 1.12% 1.08%(e) Net investment income............................... 5.74%(e) 6.05%(f) 5.95%(f) 5.72% 5.32%(e) Class Z ------------------------------ March 18, Six Months 1997(d) Ended Through June 30, December 31, 1998 1997 ------------- ------------ PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period................... $ 14.54 $14.13 ----- ----- Income from investment operations Net investment income.................................. .46 .74(f) Net realized and unrealized gain (loss) on investment transactions........................................ (.15) .39 ----- ----- Total from investment operations.................... .31 1.13 ----- ----- Less distributions Dividends to shareholders from net investment income... (.46) (.72) Dividends to shareholders in excess of net investment income.............................................. -- -- Tax return of capital distributions.................... -- -- ----- ----- Total distributions................................. (.46) (.72) ----- ----- Net asset value, end of period......................... $ 14.39 $14.54 ----- ----- ----- ----- TOTAL RETURN(b): 2.01% 8.18% RATIOS TO AVERAGE NET ASSETS: Net assets, end of period (000)........................ $114 $39 Average net assets (000)............................... $94 $9 Ratios to average net assets: Expenses, including distribution fees............... .88%(e) .81%(e)(f) Expenses, excluding distribution fees............... .88%(e) .81%(e)(f) Net investment income............................... 6.56%(e) 6.88%(e)(f)
- --------------- (a) Based on average shares outstanding, by class. (b) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. Total returns for periods of less than a full year are not annualized. (c) Commencement of offering of Class C shares. (d) Commencement of offering of Class Z shares. (e) Annualized. (f) Net of management fee waiver. - -------------------------------------------------------------------------------- See Notes to Financial Statements. 13 PART C OTHER INFORMATION ITEM 15. INDEMNIFICATION. As permitted by Section 17(h) and (i) of the Investment Company Act of 1940, as amended (the 1940 Act) and pursuant to Article VII of the Fund's By-Laws (Exhibit 2 to the Registration Statement), officers, directors, employees and agents of the Registrant will not be liable to the Registrant, any shareholder, officer, director, employee, agent or other person for any action or failure to act, except for bad faith, willful misfeasance, gross negligence or reckless disregard of duties, and those individuals may be indemnified against liabilities in connection with the Registrant, subject to the same exceptions. Section 67 of Massachusetts Business Corporation Law permits indemnification of directors who acted in good faith and reasonably believed that the conduct was in the best interests of the Registrant. As permitted by Section 17(i) of the 1940 Act, pursuant to Section 10 of each Distribution Agreement (Exhibit 7 to the Registration Statement), the Distributor of the Registrant may be indemnified against liabilities which it may incur, except liabilities arising from bad faith, gross negligence, willful misfeasance or reckless disregard of duties. Insofar as indemnification for liabilities arising under the Securities Act of 1933, as amended (Securities Act) may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the 1940 Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer, or controlling person of the Registrant in connection with the successful defense of any action, suit or proceeding) is asserted against the Registrant by such director, officer or controlling person in connection with the shares being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the 1940 Act and will be governed by the final adjudication of such issue. The Registrant maintains an insurance policy insuring its officers and directors against liabilities, and certain costs of defending claims against such officers and directors, to the extent such officers and directors are not found to have committed conduct constituting willful misfeasance, bad faith, gross negligence or reckless disregard in the performance of their duties. The insurance policy also insures the Registrant against the cost of indemnification payments to officers and directors under certain circumstances. Section 9 of the Management Agreement (Exhibit 6(a) to the Registration Statement) and Section 4 of the Subadvisory Agreement (Exhibit 6(b) to the Registration Statement) limit the liability of Prudential Investments Fund Management LLC (PIFM) and The Prudential Investment Corporation (PIC), respectively, to liabilities arising from willful misfeasance, bad faith or gross negligence in the performance of their respective duties or from reckless disregard by them of their respective obligations and duties under the agreements. The Registrant hereby undertakes that it will apply the indemnification provisions of its By-Laws and its Agreements in a manner consistent with Release No. 11330 of the Securities and Exchange Commission under the 1940 Act so long as the interpretation of Sections 17(h) and 17(i) of such Act remain in effect and are consistently applied. ITEM 16. EXHIBITS. 1. Articles of Restatement incorporated by reference to Exhibit 1 to Post-Effective Amendment No. 22 to Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 2. Amended and Restated By-laws of the Registrant, incorporated by reference to Exhibit 2 to Post-Effective Amendment No. 15 to Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 3. Not applicable. 4. Plan of Reorganization filed herewith as Appendix B to the Prospectus and Proxy Statement.* 5. Instruments defining rights of holders of securities being offered, incorporated by reference to Exhibit 4 to Post-Effective Amendment No. 15 to Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 6. (a) Management Agreement between the Registrant and Prudential Mutual Fund Management, Inc. incorporated by reference to Exhibit 5(a) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR.
C-1 (b) Subadvisory Agreement between Prudential Mutual Fund Management, Inc. and The Prudential Investment Corporation incorporated by reference to Exhibit 5(b) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 7. (a) Selected Dealer Agreement.* (b) Distribution Agreement.* 8. Not Applicable. 9. (a) Revised Custodian Agreement between the Registrant and State Street Bank and Trust Company incorporated by reference to Exhibit 8(a) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. (b) Special Custody Agreement among the Registrant, State Street Bank and Trust Company, and Goldman, Sachs & Co. incorporated by reference to Exhibit 8(b) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. (c) Customer Agreement between the Registrant and Goldman, Sachs & Co. incorporated by reference to Exhibit 8(c) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. (d) Form of Amendment to Revised Custodian Agreement incorporated by reference to Exhibit 8(d) to Post-Effective Amendment No. 19 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 10. Transfer Agency Agreement between the Registrant and Prudential Mutual Fund Services, Inc. incorporated by reference to Exhibit 9 to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 11. Opinions and Consents of Counsel.* 12. Tax Opinion of Counsel.* 13. Purchase Agreement incorporated by reference to Exhibit 13 to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 14. (a) Consent of PricewaterhouseCoopers LLP. * (b) Consent and Report of Deloitte & Touche LLP. * 15. (a) Distribution and Service Plan for Class A shares.* (b) Distribution and Service Plan for Class B shares.* (c) Distribution and Service Plan for Class C shares.* 16. (a) Schedule of computation of performance (Class A) incorporated by reference to Exhibit 16(a) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. (b) Schedule of computation of performance (Class B) incorporated by reference to Exhibit 16(b) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. (c) Schedule of computation of performance (Class C), incorporated by reference to Exhibit 16(c) to Post-Effective Amendment No. 18 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. (d) Schedule of computation of performance (Class Z) incorporated by reference to Exhibit 16(d) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 17. (a) Proxy.* (b) Prospectus of Registrant dated April 30, 1998, as supplemented on July 1, 1998 and September 1, 1998.* (c) Prospectus of Prudential Mortgage Income Fund, Inc. dated March 3, 1998, as supplemented on July 1, 1998, August 27, 1998 and September 1, 1998.* (d) President's Letter.*
C-2 18. Rule 18f-3 Plan, incorporated by reference to Exhibit 18 to Post-Effective Amendment No. 21 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR.
- -------------- *Filed herewith. ITEM 17. UNDERTAKINGS. (1) The undersigned registrant agrees that prior to any public reoffering of the securities registered through the use of a prospectus which is a part of this registration statement by any person or party who is deemed to be an underwriter within the meaning of Rule 145(c) of the Securities Act, the reoffering prospectus will contain the information called for by the applicable registration form for reofferings by persons who may be deemed underwriters, in addition to the information called for by the other items of the applicable form. (2) The undersigned registrant agrees that every prospectus that is filed under paragraph (1) above will be filed as a part of an amendment to the registration statement and will not be used until the amendment is effective, and that, in determining any liability under the 1933 Act, each post-effective amendment shall be deemed to be a new registration statement for the securities offered therein, and the offering of the securities at that time shall be deemed to be the initial bona fide offering of them. C-3 SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Newark, and State of New Jersey, on the 30th day of September, 1998. PRUDENTIAL GOVERNMENT INCOME FUND /s/ Richard A. Redeker ------------------------------------------------------ (RICHARD A. REDEKER, PRESIDENT) Pursuant to the requirements of the Securities Act of 1933, this Registration Statement has been signed by the following persons in the capacities and on the dates indicated.
SIGNATURE TITLE DATE - ------------------------------ ---------------------------------------- ------------------ /s/ Edward D. Beach Director September 30, 1998 - ------------------------------ EDWARD D. BEACH /s/ Eugene C. Dorsey Director September 30, 1998 - ------------------------------ EUGENE C. DORSEY /s/ Delayne Dedrick Gold Director September 30, 1998 - ------------------------------ DELAYNE DEDRICK GOLD /s/ Robert F. Gunia Director September 30, 1998 - ------------------------------ ROBERT F. GUNIA /s/ Harry A. Jacobs, Jr. Director September 30, 1998 - ------------------------------ HARRY A. JACOBS, JR. /s/ Mendel A. Melzer Director September 30, 1998 - ------------------------------ MENDEL A. MELZER /s/ Thomas T. Mooney Director September 30, 1998 - ------------------------------ THOMAS T. MOONEY /s/ Thomas H. O'Brien Director September 30, 1998 - ------------------------------ THOMAS H. O'BRIEN /s/ Richard A. Redeker President and Director September 30, 1998 - ------------------------------ RICHARD A. REDEKER /s/ Nancy Hays Teeters Director September 30, 1998 - ------------------------------ NANCY HAYS TEETERS /s/ Louis A. Weil, III Director September 30, 1998 - ------------------------------ LOUIS A. WEIL, III /s/ Grace C. Torres Principal Financial and September 30, 1998 - ------------------------------ Accounting Officer GRACE C. TORRES
EXHIBIT INDEX
EXHIBIT NUMBER - --------- 1. Articles of Restatement incorporated by reference to Exhibit 1 to Post-Effective Amendment No. 22 to Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 2. Amended and Restated By-laws of the Registrant, incorporated by reference to Exhibit 2 to Post-Effective Amendment No. 15 to Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 3. Not applicable. 4. Plan of Reorganization filed herewith as Appendix B to the Prospectus and Proxy Statement.* 5. Instruments defining rights of holders of securities being offered, incorporated by reference to Exhibit 4 to Post-Effective Amendment No. 15 to Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 6. (a) Management Agreement between the Registrant and Prudential Mutual Fund Management, Inc. incorporated by reference to Exhibit 5(a) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. (b) Subadvisory Agreement between Prudential Mutual Fund Management, Inc. and The Prudential Investment Corporation incorporated by reference to Exhibit 5(b) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 7. (a) Selected Dealer Agreement.* (b) Distribution Agreement.* 8. Not Applicable. 9. (a) Revised Custodian Agreement between the Registrant and State Street Bank and Trust Company incorporated by reference to Exhibit 8(a) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. (b) Special Custody Agreement among the Registrant, State Street Bank and Trust Company, and Goldman, Sachs & Co. incorporated by reference to Exhibit 8(b) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. (c) Customer Agreement between the Registrant and Goldman, Sachs & Co. incorporated by reference to Exhibit 8(c) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. (d) Form of Amendment to Revised Custodian Agreement incorporated by reference to Exhibit 8(d) to Post-Effective Amendment No. 19 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 10. Transfer Agency Agreement between the Registrant and Prudential Mutual Fund Services, Inc. incorporated by reference to Exhibit 9 to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 11. Opinions and Consents of Counsel.* 12. Tax Opinion of Counsel.* 13. Purchase Agreement incorporated by reference to Exhibit 13 to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 14. (a) Consent of PricewaterhouseCoopers LLP. * (b) Consent and Report of Deloitte & Touche LLP. * 15. (a) Distribution and Service Plan for Class A shares.* (b) Distribution and Service Plan for Class B shares.* (c) Distribution and Service Plan for Class C shares.* 16. (a) Schedule of computation of performance (Class A) incorporated by reference to Exhibit 16(a) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR.
(b) Schedule of computation of performance (Class B) incorporated by reference to Exhibit 16(b) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. (c) Schedule of computation of performance (Class C), incorporated by reference to Exhibit 16(c) to Post-Effective Amendment No. 18 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. (d) Schedule of computation of performance (Class Z) incorporated by reference to Exhibit 16(d) to Post-Effective Amendment No. 24 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR. 17. (a) Proxy.* (b) Prospectus of Registrant dated April 30, 1998, as supplemented on July 1, 1998 and September 1, 1998.* (c) Prospectus of Prudential Mortgage Income Fund, Inc. dated March 3, 1998, as supplemented on July 1, 1998, August 27, 1998 and September 1, 1998.* (d) President's Letter.* 18. Rule 18f-3 Plan, incorporated by reference to Exhibit 18 to Post-Effective Amendment No. 21 to the Registration Statement on Form N-1A (File No. 2-82976) filed via EDGAR.
- -------------- *Filed herewith. EX-99.4 2 EXHIBIT 99.4 AGREEMENT AND PLAN OF REORGANIZATION Agreement and Plan of Reorganization (Agreement) made as of the day of October, 1998, by and between, Prudential Mortgage Income Fund, Inc. (Mortgage Income Fund) and Prudential Government Income Fund (Government Income Fund) (Mortgage Income Fund and Government Income Fund collectively, the Funds and each individually, a Fund). Mortgage Income Fund and Government Income Fund are both corporations organized under the laws of the State of Maryland. Each Fund maintains its principal place of business at Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077. Shares of both Funds are divided into four classes, designated as Class A, Class B, Class C and Class Z. This Agreement is intended to be, and is adopted as, a plan of reorganization pursuant to Section 368(a)(1)(C) of the Internal Revenue Code of 1986, as amended (Internal Revenue Code). Upon receipt of such representations from each of the Funds as Swidler Berlin Shereff Friedman, LLP may require, Swidler Berlin Shereff Friedman, LLP will deliver the opinion referenced in paragraph 8.6 herein. The reorganization will comprise the transfer of the assets of Mortgage Income Fund in exchange for shares of Government Income Fund, and Government Income Fund's assumption of Mortgage Income Fund's liabilities, if any, and the constructive distribution, after the Closing Date hereinafter referred to, as a liquidating distribution of such shares of Government Income Fund to the shareholders of Mortgage Income Fund, and the termination of Mortgage Income Fund as provided herein, all upon the terms and conditions as hereinafter set forth. In consideration of the premises and of the covenants and agreements set forth herein, the parties covenant and agree as follows: 1. TRANSFER OF ASSETS OF MORTGAGE INCOME FUND IN EXCHANGE FOR SHARES OF GOVERNMENT INCOME FUND AND ASSUMPTION OF LIABILITIES, IF ANY, AND TERMINATION OF MORTGAGE INCOME FUND 1.1 Subject to the terms and conditions herein set forth and on the basis of the representations and warranties contained herein, Mortgage Income Fund agrees to sell, assign, transfer and deliver all its assets, as set forth in paragraph 1.2, to Government Income Fund, and Government Income Fund agrees (a) to issue and deliver to Mortgage Income Fund in exchange therefor the number of shares in Government Income Fund determined by dividing the net asset value of the Mortgage Income Fund allocable to Class A, Class B, Class C and Class Z shares and shares of Common Stock (computed in the manner and as of the time and date set forth in paragraph 2.1) by the net asset value allocable to a Class A, Class B, Class C and Class Z shares of Government Income Fund (rounded to the third decimal place) (computed in the manner and as of the time and date set forth in paragraph 2.2) and (b) to assume all of Mortgage Income Fund's liabilities, if any, as set forth in paragraph 1.3. Such transactions shall take place at the closing provided for in paragraph 3 (Closing). 1.2 The assets of Mortgage Income Fund to be acquired by Government Income Fund shall include without limitation all cash, cash equivalents, securities, receivables (including interest and dividends receivable) and other property of any kind owned by Mortgage Income Fund and any deferred or prepaid expenses shown as assets on the books of Mortgage Income Fund on the closing date provided in paragraph 3 (Closing Date). Government Income Fund has no plan or intent to sell or otherwise dispose of significant assets of Mortgage Income Fund, other than in the ordinary course of business. 1 1.3 Except as otherwise provided herein, Government Income Fund will assume all debts, liabilities, obligations and duties of Mortgage Income Fund of whatever kind or nature, whether absolute, accrued, contingent or otherwise, whether or not determinable as of the Closing Date and whether or not specifically referred to in this Agreement; provided, however, that Mortgage Income Fund agrees to utilize its best efforts, to the extent practicable, to cause such Trust to discharge all of its known debts, liabilities, obligations and duties prior to the Closing Date. 1.4 On or immediately prior to the Closing Date, Mortgage Income Fund will declare and pay to its shareholders of record dividends and/or other distributions so that it will have distributed substantially all (and in any event not less than ninety-eight percent) of such Fund's investment company taxable income (computed without regard to any deduction for dividends paid), net tax-exempt interest income, if any, and realized net capital gains, if any, for all taxable years through its termination. 1.5 On a date (Termination Date), as soon after the Closing Date as is conveniently practicable but in any event within 30 days of the Closing Date, Mortgage Income Fund will distribute PRO RATA to its Class A, Class B, Class C and Class Z shareholders of record, determined as of the close of business on the Closing Date, the Class A, Class B, Class C and Class Z shares of Government Income Fund received by Mortgage Income Fund pursuant to paragraph 1.1 in exchange for their interest in Mortgage Income Fund. Such distribution will be accomplished by opening accounts on the books of Government Income Fund in the names of Mortgage Income Fund's shareholders and transferring thereto the shares credited to the account of Mortgage Income Fund on the books of Government Income Fund. Each account opened shall be credited with the respective PRO RATA number of Government Income Fund Class A, Class B, Class C and Class Z shares due Mortgage Income Fund's Class A, Class B, Class C and Class Z shareholders, respectively. Fractional shares of Government Income Fund shall be rounded to the third decimal place. Upon the receipt of an order from the Securities and Exchange Commission (SEC) indicating acceptance of the Form N-8F that Mortgage Income Fund must file pursuant to the Investment Company Act of 1940, as amended (Investment Company Act) to deregister as an investment company, Mortgage Income Fund will file with the Secretary of State of the State of Maryland a Certificate of Termination terminating Mortgage Income Fund , but in any event such termination will be completed within twelve months following the Closing Date. 1.6 Government Income Fund shall not issue certificates representing its shares in connection with such exchange. With respect to any Mortgage Income Fund shareholder holding Mortgage Income Fund certificates for shares of Common Stock as of the Closing Date, until Government Income Fund is notified by Mortgage Income Fund's transfer agent that such shareholder has surrendered his or her outstanding certificates for shares of Common Stock or, in the event of lost, stolen or destroyed certificates for shares of Common Stock, posted adequate bond or submitted a lost certificate form, as the case may be, Government Income Fund will not permit such shareholder to (1) receive dividends or other distributions on Government Income Fund shares in cash (although such dividends and distributions shall be credited to the account of such shareholder established on Government Income Fund's books pursuant to paragraph 1.5, as provided in the next sentence), (2) exchange Government Income Fund shares credited to such shareholder's account for shares of other Prudential Mutual Funds, or (3) pledge or redeem such shares. In the event that a shareholder is not permitted to receive dividends or other distributions on Government Income Fund shares in cash as provided in the preceding sentence, Government Income Fund shall pay such dividends or other distributions in additional Government Income Fund shares, notwithstanding any election such shareholder shall have made previously with respect to the payment of dividends or other distributions on shares of 2 Mortgage Income Fund. Mortgage Income Fund will, at its expense, request its shareholders to surrender their outstanding Mortgage Income Fund certificates for shares of beneficial interest, post adequate bond or submit a lost certificate form, as the case may be. 1.7 Ownership of Government Income Fund shares will be shown on the books of the Government Income Fund's transfer agent. Shares of Government Income Fund will be issued in the manner described in Government Income Fund's then current prospectus and statement of additional information. 1.8 Any transfer taxes payable upon issuance of shares of Government Income Fund in exchange for shares of Mortgage Income Fund in a name other than that of the registered holder of the shares being exchanged on the books of Mortgage Income Fund as of that time shall be paid by the person to whom such shares are to be issued as a condition to the registration of such transfer. 1.9 Any reporting responsibility with the SEC or any state securities commission of Mortgage Income Fund is, and shall remain, the responsibility of Mortgage Income Fund up to and including the Termination Date. 1.10 All books and records of Mortgage Income Fund, including all books and records required to be maintained under the Investment Company Act and the rules and regulations thereunder, shall be available to Government Income Fund from and after the Closing Date and shall be turned over to Government Income Fund on or prior to the Termination Date. 2. VALUATION 2.1 The value of Mortgage Income Fund's assets and liabilities to be acquired and assumed, respectively, by Government Income Fund shall be the net asset value computed as of 4:15 p.m., New York time, on the Closing Date (such time and date being hereinafter called the Valuation Time), using the valuation procedures set forth in Mortgage Income Fund's then current prospectus and statement of additional information. 2.2 The net asset value of Class A, Class B, Class C and Class Z shares of Government Income Fund shall be the net asset value for Class A, Class B, Class C and Class Z shares as of the Valuation Time, using the valuation procedures set forth in Government Income Fund's then current prospectus and Government Income Fund's statement of additional information. 2.3 The number of Government Income Fund shares to be issued (including fractional shares, if any) in exchange for Mortgage Income Fund's net assets shall be calculated as set forth in paragraph 1.1. 2.4 All computations of net asset value shall be made by or under the direction of Prudential Investments Fund Management LLC (PIFM) in accordance with its regular practice as manager of the Funds. 3. CLOSING AND CLOSING DATE 3.1 The Closing Date shall be December 4, 1998 or such later date as the parties may agree. All acts taking place at the Closing shall be deemed to take place simultaneously as of the close of business on the Closing Date unless otherwise provided. The Closing shall be at the office of Government Income Fund or at such other place as the parties may agree. 3.2 State Street Bank and Trust Company (State Street), as custodian for Mortgage Income Fund, shall deliver to Government Income Fund at the Closing a certificate of an authorized officer of State Street stating that (a) Mortgage Income Fund's portfolio securities, cash and any other assets have been transferred in proper form to Government Income Fund on the Closing Date and (b) all necessary taxes, if any, have been paid, or provision for payment has been made, in conjunction with the transfer of portfolio securities. 3 3.3 In the event that immediately prior to the Valuation Time (a) the New York Stock Exchange (NYSE) or other primary exchange is closed to trading or trading thereon is restricted or (b) trading or the reporting of trading on the NYSE or other primary exchange or elsewhere is disrupted so that accurate appraisal of the value of the net assets of Mortgage Income Fund and of the net asset value per share of Government Income Fund is impracticable, the Closing Date shall be postponed until the first business day after the date when such trading shall have been fully resumed and such reporting shall have been restored. 3.4 Mortgage Income Fund shall deliver to Government Income Fund on or prior to the Termination Date the names and addresses of each of the shareholders of Mortgage Income Fund and the number of outstanding shares owned by each such shareholder, all as of the close of business on the Closing Date, certified by the Secretary or Assistant Secretary of Mortgage Income Fund. Government Income Fund shall issue and deliver to Mortgage Income Fund at the Closing a confirmation or other evidence satisfactory to Mortgage Income Fund that shares of Government Income Fund have been or will be credited to Mortgage Income Fund's account on the books of Government Income Fund. At the Closing each party shall deliver to the other such bills of sale, checks, assignments, share certificates, receipts and other documents as such other party or its counsel may reasonably request to effect the transactions contemplated by this Agreement. 4. REPRESENTATIONS AND WARRANTIES 4.1 Mortgage Income Fund represents and warrants as follows: 4.1.1 Mortgage Income Fund is a business trust duly organized and validly existing under the laws of the State of Maryland. 4.1.2 Mortgage Income Fund is an open-end, management investment company duly registered under the Investment Company Act, and such registration is in full force and effect; 4.1.3 Mortgage Income Fund is not, and the execution, delivery and performance of this Agreement will not result, in violation of any provision of the Articles of Incorporation or By-Laws of Mortgage Income Fund or of any material agreement, indenture, instrument, contract, lease or other undertaking to which Mortgage Income Fund is a party or by which Mortgage Income Fund is bound; 4.1.4 All material contracts or other commitments to which Mortgage Income Fund, or the properties or assets of Mortgage Income Fund, is subject, or by which Mortgage Income Fund is bound except this Agreement will be terminated on or prior to the Closing Date without Mortgage Income Fund or Government Income Fund incurring any liability or penalty with respect thereto; 4.1.5 No material litigation or administrative proceeding or investigation of or before any court or governmental body is presently pending or to its knowledge threatened against Mortgage Income Fund or any of its properties or assets. Mortgage Income Fund knows of no facts that might form the basis for the institution of such proceedings, and is not a party to or subject to the provisions of any order, decree or judgment of any court or governmental body that materially and adversely affects its business or its ability to consummate the transactions herein contemplated; 4.1.6 The Portfolio of Investments, Statement of Assets and Liabilities, Statement of Operations, Statement of Cash Flows, Statement of Changes in Net Assets, and Financial Highlights of Mortgage Income Fund at December 31, 1997 and for the year then ended and the Notes thereto (copies of which have been furnished to Government Income Fund) have been audited by PricewaterhouseCoopers LLP, independent accountants, in accordance with generally accepted auditing standards. Such financial statements are prepared in accordance with generally accepted accounting principles and present fairly, 4 in all material respects, the financial condition, results of operations, changes in net assets and financial highlights of Mortgage Income Fund as of and for the period ended on such date, and there are no material known liabilities of Mortgage Income Fund (contingent or otherwise) not disclosed therein; 4.1.7 Since , 1998, there has not been any material adverse change in Mortgage Income Fund's financial condition, assets, liabilities or business other than changes occurring in the ordinary course of business, or any incurrence by Mortgage Income Fund of indebtedness maturing more than one year from the date such indebtedness was incurred, except as otherwise disclosed to and accepted by Government Income Fund. For the purposes of this paragraph 4.1.7, a decline in net assets or change in the number of shares outstanding shall not constitute a material adverse change; 4.1.8 At the date hereof and at the Closing Date, all federal and other tax returns and reports of Mortgage Income Fund required by law to have been filed on or before such dates shall have been timely filed, and all federal and other taxes shown as due on said returns and reports shall have been paid insofar as due, or provision shall have been made for the payment thereof, and, to the best of Mortgage Income Fund's knowledge, all federal or other taxes required to be shown on any such return or report have been shown on such return or report, no such return is currently under audit and no assessment has been asserted with respect to such returns; 4.1.9 For each past taxable year since it commenced operations, Mortgage Income Fund has met the requirements of Subchapter M of the Internal Revenue Code for qualification and treatment as a regulated investment company and has elected to be treated as such and Mortgage Income Fund intends to meet those requirements for the current taxable year; and, for each past calendar year since it commenced operations, Mortgage Income Fund has made such distributions as are necessary to avoid the imposition of federal excise tax or has paid or provided for the payment of any excise tax imposed; 4.1.10 All issued and outstanding shares of Mortgage Income Fund are, and at the Closing Date will be, duly and validly authorized, issued and outstanding, fully paid and non-assessable. All issued and outstanding shares of Mortgage Income Fund will, at the Closing Date, be held in the name of the persons and in the amounts set forth in the list of shareholders submitted to Government Income Fund in accordance with the provisions of paragraph 3.4. Mortgage Income Fund does not have outstanding any options, warrants or other rights to subscribe for or purchase any shares, nor is there outstanding any security convertible into any of its shares, except for Class B shares of Mortgage Income Fund which have the conversion feature described in Mortgage Income Fund's Prospectus dated March 3, 1998; 4.1.11 At the Closing Date, the Mortgage Income Fund will have good and marketable title to the assets to be transferred to Government Income Fund pursuant to paragraph 1.1, and full right, power and authority to sell, assign, transfer and deliver such assets hereunder free of any liens, claims, charges or other encumbrances, and, upon delivery and payment for such assets, Government Income Fund will acquire good and marketable title thereto; 4.1.12 The execution, delivery and performance of this Agreement has been duly authorized by the Board of Trustees of Mortgage Income Fund and by all necessary action, other than shareholder approval, on the part of Mortgage Income Fund, and this Agreement constitutes a valid and binding obligation, subject to shareholder approval, of Mortgage Income Fund; 4.1.13 The information furnished and to be furnished by Mortgage Income Fund for use in applications for orders, registration statements, proxy materials and other documents that may be necessary in 5 connection with the transactions contemplated hereby is and shall be accurate and complete in all material respects and is in compliance and shall comply in all material respects with applicable federal securities and other laws and regulations; and 4.1.14 On the effective date of the registration statement filed with the SEC by Government Income Fund on Form N-14 relating to the shares of Government Income Fund issuable hereunder, and any supplement or amendment thereto (Registration Statement), at the time of the meeting of the shareholders of Mortgage Income Fund and on the Closing Date, the Proxy Statement of Mortgage Income Fund, the Prospectus of Government Income Fund, and the Statement of Additional Information of Government Income Fund to be included in the Registration Statement (collectively, Proxy Statement) (i) will comply in all material respects with the provisions and regulations of the Securities Act of 1933, as amended (1933 Act), the Securities Exchange Act of 1934, as amended (1934 Act) and the Investment Company Act, and the rules and regulations under such Acts and (ii) will not contain any untrue statement of a material fact or omit to state a material fact required to be stated therein in light of the circumstances under which they were made or necessary to make the statements therein not misleading; provided, however, that the representations and warranties in this paragraph 4.1.14 shall not apply to statements in or omissions from the Proxy Statement and Registration Statement made in reliance upon and in conformity with information furnished by Government Income Fund for use therein. 4.2 Government Income Fund represents and warrants as follows: 4.2.1 Government Income Fund is a corporation duly organized and validly existing under the laws of the State of Maryland; 4.2.2 Government Income Fund is an open-end, management investment company duly registered under the Investment Company Act, and such registration is in full force and effect; 4.2.3 Government Income Fund is not, and the execution, delivery and performance of this Agreement will not result, in violation of any provision of the Articles of Incorporation or By-Laws of Government Income Fund or of any material agreement, indenture, instrument, contract, lease or other undertaking to which Government Income Fund is a party or by which Government Income Fund is bound; 4.2.4 No material litigation or administrative proceeding or investigation of or before any court or governmental body is presently pending or threatened against Government Income Fund or any of its properties or assets, except as previously disclosed in writing to Mortgage Income Fund. Except as previously disclosed in writing to Mortgage Income Fund, Government Income Fund knows of no facts that might form the basis for the institution of such proceedings, and Government Income Fund is not a party to or subject to the provisions of any order, decree or judgment of any court or governmental body that materially and adversely affects its business or its ability to consummate the transactions herein contemplated; 4.2.5 The Portfolio of Investments, Statement of Assets and Liabilities, Statement of Operations, Statement of Changes in Net Assets, and Financial Highlights of Government Income Fund at February 28, 1998, and for the fiscal year then ended and the Notes thereto (copies of which have been furnished to Mortgage Income Fund) have been audited by PricewaterhouseCoopers LLP, independent accountants, in accordance with generally accepted auditing standards. Such financial statements are prepared in accordance with generally accepted accounting principles and present fairly, in all material 6 respects, the financial condition, results of operations, changes in net assets and financial highlights of Government Income Fund as of and for the period ended on such date, and there are no material known liabilities of Government Income Fund (contingent or otherwise) not disclosed therein; 4.2.6 Since February 28, 1998, there has not been any material adverse change in Government Income Fund's financial condition, assets, liabilities or business other than changes occurring in the ordinary course of business, or any incurrence by Government Income Fund of indebtedness maturing more than one year from the date such indebtedness was incurred, except as otherwise disclosed to and accepted by Mortgage Income Fund. For the purposes of this paragraph, a decline in net asset value per share or a decrease in the number of shares outstanding shall not constitute a material adverse change; 4.2.7 At the date hereof and at the Closing Date, all federal and other tax returns and reports of Government Income Fund required by law to have been filed on or before such dates shall have been filed, and all federal and other taxes shown as due on said returns and reports shall have been paid insofar as due, or provision shall have been made for the payment thereof, and, to the best of Government Income Fund's knowledge, all federal or other taxes required to be shown on any such return or report are shown on such return or report, no such return is currently under audit and no assessment has been asserted with respect to such returns; 4.2.8 For each past taxable year since it commenced operations, Government Income Fund has met the requirements of Subchapter M of the Internal Revenue Code for qualification and treatment as a regulated investment company and has elected to be treated as such and Government Income Fund intends to meet those requirements for the current taxable year; and, for each past calendar year since it commenced operations, Government Income Fund has made such distributions as are necessary to avoid the imposition of federal excise tax or has paid or provided for the payment of any excise tax imposed; 4.2.9 All issued and outstanding shares of Government Income Fund are, and at the Closing Date will be, duly and validly authorized, issued and outstanding, fully paid and non-assessable. Except as contemplated by this Agreement, Government Income Fund does not have outstanding any options, warrants or other rights to subscribe for or purchase any of its shares nor is there outstanding any security convertible into any of its shares, except for the Class B shares which have a conversion feature described in Government Income Fund's Prospectus dated April 30, 1998; 4.2.10 The execution, delivery and performance of this Agreement has been duly authorized by the Board of Directors of Government Income Fund and by all necessary corporate action on the part of Government Income Fund, and this Agreement constitutes a valid and binding obligation of Government Income Fund; 4.2.11 The shares of Government Income Fund to be issued and delivered to Mortgage Income Fund pursuant to this Agreement will, at the Closing Date, have been duly authorized and, when issued and delivered as provided in this Agreement, will be duly and validly issued and outstanding shares of Government Income Fund, fully paid and non-assessable; 4.2.12 The information furnished and to be furnished by Government Income Fund for use in applications for orders, registration statements, proxy materials and other documents which may be necessary in connection with the transactions contemplated hereby is and shall be accurate and complete in all material respects and is and shall comply in all material respects with applicable federal securities and other laws and regulations; and 7 4.2.13 On the effective date of the Registration Statement, at the time of the meeting of the shareholders of Mortgage Income Fund and on the Closing Date, the Proxy Statement and the Registration Statement (i) will comply in all material respects with the provisions of the 1933 Act, the 1934 Act and the Investment Company Act and the rules and regulations under such Acts, (ii) will not contain any untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein not misleading and (iii) with respect to the Registration Statement, at the time it becomes effective, it will not contain an untrue statement of a material fact or omit to state a material fact necessary to make the statements therein in the light of the circumstances under which they were made, not misleading; provided, however, that the representations and warranties in this paragraph 4.2.13 shall not apply to statements in or omissions from the Proxy Statement and the Registration Statement made in reliance upon and in conformity with information furnished by Mortgage Income Fund for use therein. 5. COVENANTS OF GOVERNMENT INCOME FUND AND MORTGAGE INCOME FUND 5.1 Mortgage Income Fund and Government Income Fund each covenants to operate its respective business in the ordinary course between the date hereof and the Closing Date, it being understood that the ordinary course of business will include declaring and paying customary dividends and other distributions and such changes in operations as are contemplated by the normal operations of the Funds, except as may otherwise be allowed by paragraph 1.2 hereof or required by paragraph 1.4 hereof. 5.2 Mortgage Income Fund covenants to call a meeting of its shareholders to consider and act upon this Agreement and to take all other action necessary to obtain approval of the transactions contemplated hereby (including the determinations of its Directors as set forth in Rule 17a-8(a) under the Investment Company Act). 5.3 Mortgage Income Fund covenants that Government Income Fund shares to be received for and on behalf of Mortgage Income Fund in accordance herewith are not being acquired for the purpose of making any distribution thereof other than in accordance with the terms of this Agreement. 5.4 Mortgage Income Fund covenants that it will assist Government Income Fund in obtaining such information as Government Income Fund reasonably requests concerning the beneficial ownership of Mortgage Income Fund's shares. 5.5 Subject to the provisions of this Agreement, each Fund will take, or cause to be taken, all action, and will do, or cause to be done, all things, reasonably necessary, proper or advisable to consummate and make effective the transactions contemplated by this Agreement. 5.6 Mortgage Income Fund covenants to prepare the Proxy Statement in compliance with the 1934 Act, the Investment Company Act and the rules and regulations under each Act. 5.7 Mortgage Income Fund covenants that it will, from time to time, as and when requested by Government Income Fund, execute and deliver or cause to be executed and delivered all such assignments and other instruments, and will take or cause to be taken such further action, as Government Income Fund may deem necessary or desirable in order to vest in and confirm to Government Income Fund title to and possession of all the assets of Mortgage Income Fund to be sold, assigned, transferred and delivered hereunder and otherwise to carry out the intent and purpose of this Agreement. 8 5.8 Government Income Fund covenants to use all reasonable efforts to obtain the approvals and authorizations required by the 1933 Act, the Investment Company Act (including the determinations of its Board of Directors as set forth in Rule 17a-8(a) thereunder) and such of the state Blue Sky or securities laws as it may deem appropriate in order to continue its operations after the Closing Date. 5.9 Government Income Fund covenants that it will, from time to time, as and when requested by Mortgage Income Fund, execute and deliver or cause to be executed and delivered all such assignments and other instruments, and will take and cause to be taken such further action, as Government Income Fund may deem necessary or desirable in order to (i) vest in and confirm to the Mortgage Income Fund title to and possession of all the shares of Government Income Fund to be transferred to the shareholders of Mortgage Income Fund pursuant to this Agreement and (ii) assume all of the liabilities of Mortgage Income Fund in accordance with this Agreement. 6. CONDITIONS PRECEDENT TO OBLIGATIONS OF MORTGAGE INCOME FUND The obligations of Mortgage Income Fund to consummate the transactions provided for herein shall be subject to the performance by Government Income Fund of all the obligations to be performed by them hereunder on or before the Closing Date and the following further conditions: 6.1 All representations and warranties of Government Income Fund contained in this Agreement shall be true and correct in all material respects as of the date hereof and, except as they may be affected by the transaction contemplated by this Agreement, as of the Closing Date with the same force and effect as if made on and as of the Closing Date. 6.2 Government Income Fund shall have delivered to Mortgage Income Fund on the Closing Date a certificate executed in its name by the President or a Vice President of Government Income Fund, in form and substance satisfactory to Mortgage Income Fund and dated as of the Closing Date, to the effect that the representations and warranties of Government Income Fund in this Agreement are true and correct at and as of the Closing Date, except as they may be affected by the transaction contemplated by this Agreement, and as to such other matters as Mortgage Income Fund shall reasonably request. 6.3 Mortgage Income Fund shall have received on the Closing Date a favorable opinion from Swidler Berlin Shereff Friedman, LLP, counsel to Government Income Fund, dated as of the Closing Date, to the effect that: 6.3.1 Government Income Fund is a corporation duly organized and validly existing under the laws of the State of Maryland with power under its Articles of Incorporation to own all of its properties and assets and, to the knowledge of such counsel, to carry on its business as presently conducted; 6.3.2 This Agreement has been duly authorized, executed and delivered by Government Income Fund and, assuming due authorization, execution and delivery of the Agreement by Mortgage Income Fund, is a valid and binding obligation of Government Income Fund enforceable in accordance with its terms, subject to bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and similar laws of general applicability relating to or affecting creditors' rights and to general equity principles; 6.3.3 The shares of the Government Income Fund to be distributed to the shareholders of Mortgage Income Fund under this Agreement, assuming their due authorization, execution and delivery as contemplated by this Agreement, will be validly issued and outstanding and fully paid and non-assessable, and no shareholder of Government Income Fund has any pre-emptive right to subscribe therefor or purchase such shares; 9 6.3.4 The execution and delivery of this Agreement did not, and the consummation of the transactions contemplated hereby will not, (i) conflict with Government Income Fund's Declaration of Trust or By-Laws or (ii) result in a default or a breach of (a) the Management Agreement dated July 1, 1988 between Government Income Fund and Prudential Investments Fund Management LLC, as successor to Prudential Mutual Fund Management, Inc., (b) the Custodian Contract dated July 31, 1990 between Government Income Fund and State Street Bank and Trust Company, (c) the Distribution Agreement dated April 10, 1996 between Government Income Fund and Prudential Securities Incorporated and (d) the Transfer Agency and Service Agreement dated January 1, 1990 between Government Income Fund and Prudential Mutual Fund Services LLC, as successor to Prudential Mutual Fund Services, Inc.; provided, however, that such counsel may state that they express no opinion as to bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and similar laws of general applicability relating to or affecting creditors' rights and to general equity principles; 6.3.5 To the knowledge of such counsel, no consent, approval, authorization, filing or order of any court or governmental authority is required for the consummation by Government Income Fund of the transactions contemplated herein, except such as have been obtained under the 1933 Act, the 1934 Act and the Investment Company Act and such as may be required under state Blue Sky or securities laws; 6.3.6 Government Income Fund is registered with the SEC as an investment company, and, to the knowledge of such counsel, no order has been issued or proceeding instituted to suspend such registration; and 6.3.7 Such counsel knows of no litigation or government proceeding instituted or threatened against Government Income Fund that could be required to be disclosed in its registration statement on Form N-1A and is not so disclosed. Such opinion may rely on an opinion of Maryland Counsel to the extent it addresses Maryland law. 7. CONDITIONS PRECEDENT TO OBLIGATIONS OF GOVERNMENT INCOME FUND The obligations of Government Income Fund to complete the transactions provided for herein shall be subject to the performance by Mortgage Income Fund of all the obligations to be performed by it hereunder on or before the Closing Date and the following further conditions: 7.1 All representations and warranties of Mortgage Income Fund contained in this Agreement shall be true and correct in all material respects as of the date hereof and, except as they may be affected by the transaction contemplated by this Agreement, as of the Closing Date with the same force and effect as if made on and as of the Closing Date. 7.2 Mortgage Income Fund shall have delivered to Government Income Fund on the Closing Date a statement of the assets and liabilities, which shall be prepared in accordance with generally accepted accounting principles consistently applied, together with a list of the portfolio securities of Mortgage Income Fund showing the adjusted tax base of such securities by lot, as of the Closing Date, certified by the Treasurer of Mortgage Income Fund. 7.3 Mortgage Income Fund shall have delivered to Government Income Fund on the Closing Date a certificate executed in its name by its President or one of its Vice Presidents, in form and substance 10 satisfactory to Government Income Fund and dated as of the Closing Date, to the effect that the representations and warranties of Mortgage Income Fund made in this Agreement are true and correct at and as of the Closing Date except as they may be affected by the transaction contemplated by this Agreement, and as to such other matters as Government Income Fund shall reasonably request. 7.4 On or immediately prior to the Closing Date, Mortgage Income Fund shall have declared and paid to its shareholders of record one or more dividends and/or other distributions so that it will have distributed substantially all (and in any event not less than ninety-eight percent) each of such Fund's investment company taxable income (computed without regard to any deduction for dividends paid), net tax-exempt interest income, if any, and realized net capital gain, if any, of Mortgage Income Fund for all completed taxable years from the inception of such Fund through December 31, 1997, and for the period from and after December 31, 1997 through the Closing Date. 7.5 Government Income Fund shall have received on the Closing Date a favorable opinion from Swidler Berlin Shereff Friedman, LLP, counsel to Mortgage Income Fund, dated as of the Closing Date, to the effect that: 7.5.1 Mortgage Income Fund is duly organized and validly existing under the laws of the State of Maryland with power under its Articles of Incorporation to own all of its properties and assets and, to the knowledge of such counsel, to carry on its business as presently conducted; 7.5.2 This Agreement has been duly authorized, executed and delivered by Mortgage Income Fund and constitutes a valid and legally binding obligation of Mortgage Income Fund enforceable against the assets of such Fund in accordance with its terms, subject to bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and similar laws of general applicability relating to or affecting creditors' rights and to general equity principles; 7.5.3 The execution and delivery of the Agreement did not, and the performance by Mortgage Income Fund of its obligations hereunder will not, (i) violate Mortgage Income Fund's Articles of Incorporation or By-Laws or (ii) result in a default or a breach of (a) the Management Agreement, dated May 2, 1988 between Mortgage Income Fund and Prudential Investments Fund Management LLC, as successor to Prudential Mutual Fund Management, Inc., (b) the Custodian Contract dated August 1, 1990 between Mortgage Income Fund and State Street Bank and Trust Company, (c) the Distribution Agreement dated May 9, 1996 between Mortgage Income Fund and Prudential Securities Incorporated and (d) the Transfer Agency and Service Agreement dated January 1, 1990 between Mortgage Income Fund and Prudential Mutual Fund Services LLC, as successor to Prudential Mutual Fund Services, Inc.; provided, however, that such counsel may state that insofar as performance by Mortgage Income Fund of its obligations under this Agreement is concerned they express no opinion as to bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and similar laws of general applicability relating to or affecting creditors' rights and to general equity principles; 7.5.4 All regulatory consents, authorizations and approvals required to be obtained by Mortgage Income Fund under the federal laws of the United States and the laws of the State of Maryland for the consummation of the transactions contemplated by this Agreement have been obtained; 7.5.5 Such counsel knows of no litigation or any governmental proceeding instituted or threatened against Mortgage Income Fund that would be required to be disclosed in its Registration Statement on Form N-1A and is not so disclosed; and 11 7.5.6 Mortgage Income Fund is registered with the SEC as an investment company, and, to the knowledge of such counsel, no order has been issued or proceeding instituted to suspend such registration. Such opinion may rely on an opinion of Maryland counsel to the extent it addresses Maryland law, and may assume for purposes of the opinion given pursuant to paragraph 7.5.2 that New York law is the same as Illinois law. 8. FURTHER CONDITIONS PRECEDENT TO OBLIGATIONS OF GOVERNMENT INCOME FUND The obligations of Government Income Fund and Mortgage Income Fund hereunder are subject to the further conditions that on or before the Closing Date: 8.1 This Agreement and the transactions contemplated herein shall have been approved by the requisite vote of (a) the Boards of Directors of Government Income Fund and Mortgage Income Fund, as to the determinations set forth in Rule 17a-8(a) under the Investment Company Act, (b) the Board of Directors of Government Income Fund as to the assumption by Government Income Fund of the liabilities of Mortgage Income Fund and (c) the holders of the outstanding shares of Mortgage Income Fund in accordance with the provisions of Mortgage Income Fund's Articles of Incorporation and By-Laws, and certified copies of the resolutions evidencing such approvals shall have been delivered to Government Income Fund and Mortgage Income Fund, as applicable. 8.2 Any proposed change to Government Income Fund's operations that may be approved by the Board of Directors of Government Income Fund subsequent to the date of this Agreement but in connection with and as a condition to implementing the transactions contemplated by this Agreement, for which the approval of Government Income Fund shareholders is required pursuant to the Investment Company Act or otherwise, shall have been approved by the requisite vote of the holders of the outstanding shares of Government Income Fund in accordance with the Investment Company Act and the provisions of Maryland law, and certified copies of the resolution evidencing such approval shall have been delivered to Mortgage Income Fund. 8.3 On the Closing Date no action, suit or other proceeding shall be pending before any court or governmental agency in which it is sought to restrain or prohibit, or obtain damages or other relief in connection with, this Agreement or the transactions contemplated herein. 8.4 All consents of other parties and all consents, orders and permits of federal, state and local regulatory authorities (including those of the SEC and of state Blue Sky or securities authorities, including "no-action" positions of such authorities) deemed necessary by Government Income Fund or Mortgage Income Fund to permit consummation, in all material respects, of the transactions contemplated hereby shall have been obtained, except where failure to obtain any such consent, order or permit would not involve a risk of a material adverse effect on the assets or properties of Government Income Fund or Mortgage Income Fund, provided, that either party hereto may for itself waive any part of this condition. 8.5 The Registration Statement shall have become effective under the 1933 Act, and no stop order suspending the effectiveness thereof shall have been issued, and to the best knowledge of the parties hereto, no investigation or proceeding under the 1933 Act for that purpose shall have been instituted or be pending, threatened or contemplated. 12 8.6 The Funds shall have received on or before the Closing Date an opinion of Swidler Berlin Shereff Friedman, LLP with respect to Mortgage Income Fund satisfactory to each of them, substantially to the effect that for federal income tax purposes: 8.6.1 The acquisition by Government Income Fund of the assets of Mortgage Income Fund solely in exchange for voting shares of Government Income Fund and the assumption by Government Income Fund of Mortgage Income Fund's liabilities, if any, followed by the distribution of Government Income Fund's voting shares as a liquidating distribution pro rata to Mortgage Income Fund's shareholders and the termination of Mortgage Income Fund pursuant to the Plan and constructively in exchange for Mortgage Income Fund's shares, will constitute a reorganization within the meaning of Section 368(a)(1)(C) of the Internal Revenue Code, and each Fund will be "a party to a reorganization" within the meaning of Section 368(b) of the Internal Revenue Code; 8.6.2 No gain or loss will be recognized by the shareholders of the Mortgage Income Fund upon receipt of the Government Income Fund Class A, Class B, Class C and Class Z shares solely in exchange for and in cancellation of the Mortgage Income Fund shares of Common Stock, as described above and in the Agreement; 8.6.3 No gain or loss will be recognized to the Mortgage Income Fund upon the transfer of all of its assets to the Government Income Fund solely in exchange for Class A, Class B, Class C and Class Z shares of the Government Income Fund and the assumption by the Government Income Fund of the liabilities, if any, of the Mortgage Income Fund. In addition, no gain or loss will be recognized to the Mortgage Income Fund on the distribution of such shares to the Mortgage Income Fund's shareholders in liquidation by terminating the Mortgage Income Fund; 8.6.4 No gain or loss will be recognized to Government Income Fund upon the acquisition of the assets of the Mortgage Income Fund solely in exchange for Class A shares of the Government Income Fund and the assumption of the Mortgage Income Fund's liabilities, if any; 8.6.5 The basis of the Mortgage Income Fund assets in the hands of the Government Income Fund will be the same as the basis of such assets in the hands of the Mortgage Income Fund immediately prior to the Reorganization; 8.6.6 The holding period of the Mortgage Income Fund assets in the hands of the Government Income Fund will include the period during which such assets were held by the Mortgage Income Fund immediately prior to the Reorganization; 8.6.7 The basis of the Government Income Fund Class A, Class B, Class C and Class Z shares to be received by shareholders of the Mortgage Income Fund will, in each instance, be the same as the basis of the Class A, Class B, Class C and Class Z shares of beneficial interest of the Mortgage Income Fund held by such shareholders and canceled in the Reorganization; and 8.6.8 The holding period of the Government Income Fund shares to be received by the shareholders of the Mortgage Income Fund will include the holding period of the shares of Common Stock of the Mortgage Income Fund canceled pursuant to the Reorganization, provided that the Government Income Fund shares were held as capital assets on the date of the Reorganization. 9. FINDER'S FEES AND EXPENSES 9.1 Each Fund represents and warrants to the other that there are no finder's fees payable in connection with the transactions provided for herein. 13 9.2 The expenses incurred in connection with the entering into and carrying out of the provisions of this Agreement shall be allocated to Government Income Fund and Mortgage Income Fund pro rata in a fair and equitable manner in proportion to its assets. 10. ENTIRE AGREEMENT; SURVIVAL OF WARRANTIES 10.1 This Agreement constitutes the entire agreement between the Funds. 10.2 The representations, warranties and covenants contained in this Agreement or in any document delivered pursuant hereto or in connection herewith shall survive the consummation of the transactions contemplated hereunder. 11. TERMINATION Government Income Fund or Mortgage Income Fund may at its option terminate this Agreement at or prior to the Closing Date because of: 11.1 A material breach by the other of any representation, warranty or covenant contained herein to be performed at or prior to the Closing Date; or 11.2 A condition herein expressed to be precedent to the obligations of either party not having been met and it reasonably appearing that it will not or cannot be met; or 11.3 A mutual written agreement of Mortgage Income Fund and Government Income Fund. In the event of any such termination, there shall be no liability for damages on the part of either Fund (other than the liability of the Funds to pay their allocated expenses pursuant to paragraph 9.2) or any Director or officer of either Government Income Fund or Mortgage Income Fund. 12. AMENDMENT This Agreement may be amended, modified or supplemented only in writing by the parties; provided, however, that following the shareholders' meeting called by Mortgage Income Fund pursuant to paragraph 5.2, no such amendment may have the effect of changing the provisions for determining the number of shares of Government Income Fund to be distributed to Mortgage Income Fund's shareholders under this Agreement to the detriment of such shareholders without their further approval. 13. NOTICES Any notice, report, demand or other communication required or permitted by any provision of this Agreement shall be in writing and shall be given by hand delivery, or prepaid certified mail or overnight service addressed to Prudential Investments Fund Management LLC, Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102, Attention: S. Jane Rose. 14. HEADINGS; COUNTERPARTS; GOVERNING LAW; ASSIGNMENT 14.1 The paragraph headings contained in this Agreement are for reference purposes only and shall not affect in any way the meaning or interpretation of this Agreement. 14.2 This Agreement may be executed in any number of counterparts, each of which will be deemed an original. 14.3 This Agreement shall be governed by and construed in accordance with the laws of the State of New York. 14 14.4 This Agreement shall bind and inure to the benefit of the parties and their respective successors and assigns, and no assignment or transfer hereof or of any rights or obligations hereunder shall be made by either party without the written consent of the other party. Nothing herein expressed or implied is intended or shall be construed to confer upon or give any person, firm or corporation other than the parties and their respective successors and assigns any rights or remedies under or by reason of this Agreement. 15. NO PERSONAL LIABILITY Each Fund's Articles of Incorporation provides that no shareholder of the Fund shall be subject to any personal liability whatsoever to any person in connection with the Fund's property, or the acts, obligations or affairs of the Fund. No Director, officer, employee or agent of the Fund shall be subject to any personal liability whatsoever to any person, other than the Fund or its shareholders, in connection with the Fund's property or the affairs of the Fund, save only that arising from bad faith, willful misfeasance, gross negligence or reckless disregard of his or its duty to such person; and all persons shall look solely to the Fund's property for satisfaction of claims of any nature arising in connection with the affairs of the Fund. If any shareholder, Director, officer, employee or agent, as such, of the Fund is made a party to any suit or proceeding to enforce any such liability, he or it shall not, on account thereof, be held to any personal liability. IN WITNESS WHEREOF, each of the parties has caused this Agreement to be executed by the President of each Fund. Prudential Mortgage Income Fund, Inc. By /s/ Richard A. Redeker --------------------------------- PRESIDENT Prudential Government Income Fund, Inc. By /s/ Richard A. Redeker --------------------------------- PRESIDENT 15 EX-99.7(A) 3 EXHIBIT 99.7(A) DEALER AGREEMENT PRUDENTIAL INVESTMENT MANAGEMENT SERVICES LLC Prudential Investment Management Services LLC ("Distributor") and _________________ ("Dealer") have agreed that Dealer will participate in the distribution of shares ("Shares") of all the funds and series thereof (as they may exist from time to time) comprising the Prudential Mutual Fund Family (each a "Fund" and collectively the "Funds") and any classes thereof for which Distributor now or in the future serves as principal underwriter and distributor, subject to the terms of this Dealer Agreement ("Agreement"). Any such additional Funds will be included in this Agreement upon Distributor's written notification to Dealer. 1. LICENSING a. Dealer represents and warrants that it is: (i) a broker-dealer registered with the Securities and Exchange Commission ("SEC"); (ii) a member in good standing of the National Association of Securities Dealers, Inc. ("NASD"); and (iii) licensed by the appropriate regulatory agency of each state or other jurisdiction in which Dealer will offer and sell Shares of the Funds, to the extent necessary to perform the duties and activities contemplated by this Agreement. b. Dealer represents and warrants that each of its partners, directors, officers, employees, and agents who will be utilized by Dealer with respect to its duties and activities under this Agreement is either appropriately licensed or exempt from such licensing requirements by the appropriate regulatory agency of each state or other jurisdiction in which Dealer will offer and sell Shares of the Funds. c. Dealer agrees that: (i) termination or suspension of its registration with the SEC; (ii) termination or suspension of its membership with the NASD; or (iii) termination or suspension of its license to do business by any state or other jurisdiction or federal regulatory agency shall immediately cause the termination of this Agreement. Dealer further agrees to immediately notify Distributor in writing of any such action or event. d. Dealer agrees that this Agreement is in all respects subject to the Conduct Rules of the NASD and such Conduct Rules shall control any provision to the contrary in this Agreement. e. Dealer agrees to be bound by and to comply with all applicable state and federal laws and all rules and regulations promulgated thereunder generally affecting the sale or distribution of mutual fund shares. 2. ORDERS a. Dealer agrees to offer and sell Shares of the Funds (including those of each of its classes) only at the regular public offering price applicable to such Shares and in effect at the time of each transaction. The procedures relating to all orders and the handling of each order (including the manner of computing the net asset value of Shares and the effective time of orders received from Dealer) are subject to: (i) the terms of the then current prospectus and statement of 1 additional information (including any supplements, stickers or amendments thereto) relating to each Fund, as filed with the SEC ("Prospectus"); (ii) the new account application for each Fund, as supplemented or amended from time to time; and (iii) Distributor's written instructions and multiple class pricing procedures and guidelines, as provided to Dealer from time to time. To the extent that the Prospectus contains provisions that are inconsistent with this Agreement or any other document, the terms of the Prospectus shall be controlling. b. Distributor reserves the right at any time, and without notice to Dealer, to suspend the sale of Shares or to withdraw or limit the offering of Shares. Distributor reserves the unqualified right not to accept any specific order for the purchase or sale of Shares. c. In all offers and sales of the Shares to the public, Dealer is not authorized to act as broker or agent for, or employee of, Distributor, any Fund or any other dealer, and Dealer shall not in any manner represent to any third party that Dealer has such authority or is acting in such capacity. Rather, Dealer agrees that it is acting as principal for Dealer's own account or as agent on behalf of Dealer's customers in all transactions in Shares, except as provided in Section 3.i. hereof. Dealer acknowledges that it is solely responsible for all suitability determinations with respect to sales of Shares of the Funds to Dealer's customers and that Distributor has no responsibility for the manner of Dealer's performance of, or for Dealer's acts or omissions in connection with, the duties and activities Dealer provides under this Agreement. d. All orders are subject to acceptance by Distributor in its sole discretion and become effective only upon confirmation by Distributor. e. Distributor agrees that it will accept from Dealer orders placed through a remote terminal or otherwise electronically transmitted via the National Securities Clearing Corporation ("NSCC") Fund/Serv Networking program, provided, however, that appropriate documentation thereof and agreements relating thereto are executed by both parties to this Agreement, including in particular the standard NSCC Networking Agreement and any other related agreements between Distributor and Dealer deemed appropriate by Distributor, and that all accounts opened or maintained pursuant to that program will be governed by applicable NSCC rules and procedures. Both parties further agree that, if the NSCC Fund/Serv Networking program is used to place orders, the standard NSCC Networking Agreement will control insofar as there is any conflict between any provision of the Dealer Agreement and the standard NSCC Networking Agreement. 3. DUTIES OF DEALER a. Dealer agrees to purchase Shares only from Distributor or from Dealer's customers. b. Dealer agrees to enter orders for the purchase of Shares only from Distributor and only for the purpose of covering purchase orders Dealer has already received from its customers or for Dealer's own bona fide investment. c. Dealer agrees to date and time stamp all orders received by Dealer and promptly, upon receipt of any and all orders, to transmit to Distributor all orders received prior to 2 the time described in the Prospectus for the calculation of each Fund's net asset value so as to permit Distributor to process all orders at the price next determined after receipt by Dealer, in accordance with the Prospectus. Dealer agrees not to withhold placing orders for Shares with Distributor so as to profit itself as a result of such inaction. d. Dealer agrees to maintain records of all purchases and sales of Shares made through Dealer and to furnish Distributor or regulatory authorities with copies of such records upon request. In that regard, Dealer agrees that, unless Dealer holds Shares as nominee for its customers or participates in the NSCC Fund/Serv Networking program, at certain matrix levels, it will provide Distributor with all necessary information to comply properly with all federal, state and local reporting requirements and backup and nonresident alien withholding requirements for its customer accounts including, without limitation, those requirements that apply by treating Shares issued by the Funds as readily tradable instruments. Dealer represents and agrees that all Taxpayer Identification Numbers ("TINs") provided are certified, and that no account that requires a certified TIN will be established without such certified TIN. With respect to all other accounts, including Shares held by Dealer in omnibus accounts and Shares purchased or sold through the NSCC Fund/Serv Networking program, at certain matrix levels, Dealer agrees to perform all federal, state and local tax reporting with respect to such accounts, including without limitation redemptions and exchanges. e. Dealer agrees to distribute or cause to be delivered to its customers Prospectuses, proxy solicitation materials and related information and proxy cards, semi-annual and annual shareholder reports and any other materials in compliance with applicable legal requirements, except to the extent that Distributor expressly undertakes to do so in writing. f. Dealer agrees that if any Share is repurchased by any Fund or is tendered for redemption within seven (7) business days after confirmation by Distributor of the original purchase order from Dealer, Dealer shall forfeit its right to any concession or commission received by Dealer with respect to such Share and shall forthwith refund to Distributor the full concession allowed to Dealer or commission paid to Dealer on the original sale. Distributor agrees to notify Dealer of such repurchase or redemption within a reasonable time after settlement. Termination or cancellation of this Agreement shall not relieve Dealer from its obligation under this provision. g. Dealer agrees that payment for Shares ordered from Distributor shall be in Fed Funds, New York clearinghouse or other immediately available funds and that such funds shall be received by Distributor by the earlier of: (i) the end of the third (3rd) business day following Dealer's receipt of the customer's order to purchase such Shares; or (ii) the settlement date established in accordance with Rule 15c6-1 under the Securities Exchange Act of 1934, as amended. If such payment is not received by Distributor by such date, Dealer shall forfeit its right to any concession or commission with respect to such order, and Distributor reserves the right, without notice, forthwith to cancel the sale, or, at its option, to sell the Shares ordered back to the Fund, in which case Distributor may hold Dealer responsible for any loss, including loss of profit, suffered by Distributor resulting from Dealer's failure to make payment as aforesaid. If a purchase is made by check, the purchase is deemed made upon conversion of the purchase instrument into Fed Funds, New York clearinghouse or other immediately available funds. 3 h. Dealer agrees that it: (i) shall assume responsibility for any loss to the Fund caused by a correction to any order placed by Dealer that is made subsequent to the trade date for the order, provided such order correction was not based on any negligence on Distributor's part; and (ii) will immediately pay such loss to the Fund upon notification. i. Dealer agrees that in connection with orders for the purchase of Shares on behalf of any IRAs, 401(k) plans or other retirement plan accounts, by mail, telephone, or wire, Dealer shall act as agent for the custodian or trustee of such plans (solely with respect to the time of receipt of the application and payments), and Dealer shall not place such an order with Distributor until it has received from its customer payment for such purchase and, if such purchase represents the first contribution to such a retirement plan account, the completed documents necessary to establish the retirement plan. Dealer agrees to indemnify Distributor and its affiliates for any claim, loss, or liability resulting from incorrect investment instructions received by Distributor from Dealer. j. Dealer agrees that it will not make any conditional orders for the purchase or redemption of Shares and acknowledges that Distributor will not accept conditional orders for Shares. k. Dealer agrees that all out-of-pocket expenses incurred by it in connection with its activities under this Agreement will be borne by Dealer. l. Dealer agrees that it will keep in force appropriate broker's blanket bond insurance policies covering any and all acts of Dealer's partners, directors, officers, employees, and agents adequate to reasonably protect and indemnify the Distributor and the Funds against any loss which any party may suffer or incur, directly or indirectly, as a result of any action by Dealer or Dealer's partners, directors, officers, employees, and agents. m. Dealer agrees that it will maintain the required net capital as specified by the rules and regulations of the SEC, NASD and other regulatory authorities. 4. DEALER COMPENSATION a. On each purchase of Shares by Dealer from Distributor, the total sales charges and dealer concessions or commissions, if any, payable to Dealer shall be as stated on Schedule A to this Agreement, which may be amended by Distributor from time to time. Distributor reserves the right, without prior notice, to suspend or eliminate such dealer concession or commissions by amendment, sticker or supplement to the then current Prospectus for each Fund. Such sales charges and dealer concessions or commissions, are subject to reduction under a variety of circumstances as described in each Fund's then current Prospectus. For an investor to obtain any reduction, Distributor must be notified at the time of the sale that the sale qualifies for the reduced sales charge. If Dealer fails to notify Distributor of the applicability of a reduction in the sales charge at the time the trade is placed, neither Distributor nor any Fund will be liable for amounts necessary to reimburse any investor for the reduction that should have been effected. Dealer acknowledges that no sales charge or concession or commission will be paid to Dealer on the reinvestment of dividends or capital gains reinvestment or on Shares acquired in exchange for Shares of another Fund, or class thereof, having the same sales charge structure as the Fund, or class thereof, from which the exchange was made, in accordance with the Prospectus. 4 b. In accordance with the Funds' Prospectuses, Distributor or any affiliate may, but is not obligated to, make payments to dealers from Distributor's own resources as compensation for certain sales that are made at net asset value ("Qualifying Sales"). If Dealer notifies Distributor of a Qualifying Sale, Distributor may make a contingent advance payment up to the maximum amount available for payment on the sale. If any of the Shares purchased in a Qualifying Sale are redeemed within twelve (12) months of the end of the month of purchase, Distributor shall be entitled to recover any advance payment attributable to the redeemed Shares by reducing any account payable or other monetary obligation Distributor may owe to Dealer or by making demand upon Dealer for repayment in cash. Distributor reserves the right to withhold advances to Dealer, if for any reason Distributor believes that it may not be able to recover unearned advances from Dealer. c. With respect to any Fund that offers Shares for which distribution plans have been adopted under Rule 12b-1 under the Investment Company Act of 1940, as amended ("Rule 12b-1 Plans"), Distributor also is authorized to pay the Dealer continuing distribution and/or service fees, as specified in Schedule A and the relevant Fund Prospectus, with respect to Shares of any such Fund, to the extent that Dealer provides distribution, marketing, administrative and other services and activities regarding the promotion of such Shares and the maintenance of related shareholder accounts. d. In connection with the receipt of distribution fees and/or service fees under Rule 12b-1 Plans applicable to Shares purchased by Dealer's customers, Distributor directs Dealer to provide enhanced shareholder services such as: processing purchase and redemption transactions; establishing shareholder accounts; and providing certain information and assistance with respect to the Funds. (Redemption levels of shareholder accounts assigned to Dealer will be considered in evaluating Dealer's continued ability to receive payments of distribution and/or service fees.) In addition, Dealer agrees to support Distributor's marketing efforts by, among other things, granting reasonable requests for visits to Dealer's office by Distributor's wholesalers and marketing representatives, including all Funds covered by a Rule 12b-1 Plan on Dealer's "approved," "preferred" or other similar product lists, if applicable, and otherwise providing satisfactory product, marketing and sales support. Further, Dealer agrees to provide Distributor with supporting documentation concerning the shareholder services provided, as Distributor may reasonably request from time to time. e. All Rule 12b-1 Plan distribution and/or servicing fees shall be based on the value of Shares attributable to Dealer's customers and eligible for such payment, and shall be calculated on the basis of and at the rates set forth in the compensation schedule then in effect. Without prior approval by a majority of the outstanding shares of a Fund, the aggregate annual fees paid to Dealer pursuant to any Rule 12b-1 Plan shall not exceed the amounts stated as the "annual maximums" in each Fund's Prospectus, which amount shall be a specified percent of the value of the Fund's net assets held in Dealer's customers' accounts that are eligible for payment pursuant to the Rule 12b-1 Plans (determined in the same manner as each Fund uses to compute its net assets as set forth in its then current Prospectus). f. The provisions of any Rule 12b-1 Plan between the Funds and the Distributor shall control over this Agreement in the event of any inconsistency. Each Rule 12b-1 Plan in effect on the date of this Agreement is described in the relevant Fund's Prospectus. Dealer 5 hereby acknowledges that all payments under Rule 12b-1 Plans are subject to limitations contained in such Rule 12b-1 Plans and may be varied or discontinued at any time. 5. REDEMPTIONS, REPURCHASES AND EXCHANGES a. The Prospectus for each Fund describes the provisions whereby the Fund, under all ordinary circumstances, will redeem Shares held by shareholders on demand. Dealer agrees that it will not make any representations to shareholders relating to the redemption of their Shares other than the statements contained in the Prospectus and the underlying organizational documents of the Fund, to which it refers, and that Dealer will pay as redemption proceeds to shareholders the net asset value, minus any applicable deferred sales charge or redemption fee, determined after receipt of the order as discussed in the Prospectus. b. Dealer agrees not to repurchase any Shares from its customers at a price below that next quoted by the Fund for redemption or repurchase, I.E., at the net asset value of such Shares, less any applicable deferred sales charge, or redemption fee, in accordance with the Fund's Prospectus. Dealer shall, however, be permitted to sell Shares for the account of the customer or record owner to the Funds at the repurchase price then currently in effect for such Shares and may charge the customer or record owner a fair service fee or commission for handling the transaction, provided Dealer discloses the fee or commission to the customer or record owner. Nevertheless, Dealer agrees that it shall not under any circumstances maintain a secondary market in such repurchased Shares. c. Dealer agrees that, with respect to a redemption order it has made, if instructions in proper form, including any outstanding certificates, are not received by Distributor within the time customary or the time required by law, the redemption may be canceled forthwith without any responsibility or liability on Distributor's part or on the part of any Fund, or Distributor, at its option, may buy the shares redeemed on behalf of the Fund, in which latter case Distributor may hold Dealer responsible for any loss, including loss of profit, suffered by Distributor resulting from Distributor's failure to settle the redemption. d. Dealer agrees that it will comply with any restrictions and limitations on exchanges described in each Fund's Prospectus, including any restrictions or prohibitions relating to frequent purchases and redemptions (i.e., market timing). 6. MULTIPLE CLASSES OF SHARES Distributor may, from time to time, provide Dealer with written guidelines or standards relating to the sale or distribution of Funds offering multiple classes of Shares with different sales charges and distribution-related operating expenses. 7. FUND INFORMATION a. Dealer agrees that neither it nor any of its partners, directors, officers, employees, and agents is authorized to give any information or make any representations concerning Shares of any Fund except those contained in the Fund's then current Prospectus or in materials provided by Distributor. 6 b. Distributor will supply to Dealer Prospectuses, reasonable quantities of sales literature, sales bulletins, and additional sales information as provided by Distributor. Dealer agrees to use only advertising or sales material relating to the Funds that: (i) is supplied by Distributor, or (ii) conforms to the requirements of all applicable laws or regulations of any government or authorized agency having jurisdiction over the offering or sale of Shares of the Funds and is approved in writing by Distributor in advance of its use. Such approval may be withdrawn by Distributor in whole or in part upon written notice to Dealer, and Dealer shall, upon receipt of such notice, immediately discontinue the use of such sales literature, sales bulletins and advertising. Dealer is not authorized to modify or translate any such materials without Distributor's prior written consent. 8. SHARES a. Distributor acts solely as agent for the Fund and Distributor shall have no obligation or responsibility with respect to Dealer's right to purchase or sell Shares in any state or jurisdiction. b. Distributor shall periodically furnish Dealer with information identifying the states or jurisdictions in which it is believed that all necessary notice, registration or exemptive filings for Shares have been made under applicable securities laws such that offers and sales of Shares may be made in such states or jurisdictions. Distributor shall have no obligation to make such notice, registration or exemptive filings with respect to Shares in any state or jurisdiction. c. Dealer agrees not to transact orders for Shares in states or jurisdictions in which it has been informed that Shares may not be sold or in which it and its personnel are not authorized to sell Shares. d. Distributor shall have no responsibility, under the laws regulating the sale of securities in the United States or any foreign jurisdiction, with respect to the qualification or status of Dealer or Dealer's personnel selling Fund Shares. Distributor shall not, in any event, be liable or responsible for the issue, form, validity, enforceability and value of such Shares or for any matter in connection therewith. e. Dealer agrees that it will make no offers or sales of Shares in any foreign jurisdiction, except with the express written consent of Distributor. 9. INDEMNIFICATION a. Dealer agrees to indemnify, defend and hold harmless Distributor and the Funds and their predecessors, successors, and affiliates, each current or former partner, officer, director, employee, shareholder or agent and each person who controls or is controlled by Distributor from any and all losses, claims, liabilities, costs, and expenses, including attorney fees, that may be assessed against or suffered or incurred by any of them howsoever they arise, and as they are incurred, which relate in any way to: (i) any alleged violation of any statute or regulation (including without limitation the securities laws and regulations of the United States or any state or foreign country) or any alleged tort or breach of contract, related to the offer or sale by Dealer of Shares of the Funds pursuant to this Agreement (except to the extent that Distributor's negligence or failure to follow correct instructions received from Dealer is the cause of such loss, 7 claim, liability, cost or expense); (ii) any redemption or exchange pursuant to instructions received from Dealer or its partners, affiliates, officers, directors, employees or agents; or (iii) the breach by Dealer of any of its representations and warranties specified herein or the Dealer's failure to comply with the terms and conditions of this Agreement, whether or not such action, failure, error, omission, misconduct or breach is committed by Dealer or its predecessor, successor, or affiliate, each current or former partner, officer, director, employee or agent and each person who controls or is controlled by Dealer. b. Distributor agrees to indemnify, defend and hold harmless Dealer and its predecessors, successors and affiliates, each current or former partner, officer, director, employee or agent, and each person who controls or is controlled by Dealer from any and all losses, claims, liabilities, costs and expenses, including attorney fees, that may be assessed against or suffered or incurred by any of them which arise, and which relate to any untrue statement of or omission to state a material fact contained in the Prospectus or any written sales literature or other marketing materials provided by the Distributor to the Dealer, required to be stated therein or necessary to make the statements therein not misleading. c. Dealer agrees to notify Distributor, within a reasonable time, of any claim or complaint or any enforcement action or other proceeding with respect to Shares offered hereunder against Dealer or its partners, affiliates, officers, directors, employees or agents, or any person who controls Dealer, within the meaning of Section 15 of the Securities Act of 1933, as amended. d. Dealer further agrees promptly to send Distributor copies of (i) any report filed pursuant to NASD Conduct Rule 3070, including, without limitation quarterly reports filed pursuant to Rule 3070(c), (ii) reports filed with any other self-regulatory organization in lieu of Rule 3070 reports pursuant to Rule 3070(e) and (iii) amendments to Dealer's Form BD. e. Each party's obligations under these indemnification provisions shall survive any termination of this Agreement. 10. TERMINATION; AMENDMENT a. In addition to the automatic termination of this Agreement specified in Section 1.c. of this Agreement, each party to this Agreement may unilaterally cancel its participation in this Agreement by giving thirty (30) days prior written notice to the other party. In addition, each party to this Agreement may terminate this Agreement immediately by giving written notice to the other party of that other party's material breach of this Agreement. Such notice shall be deemed to have been given and to be effective on the date on which it was either delivered personally to the other party or any officer or member thereof, or was mailed postpaid or delivered to a telegraph office for transmission to the other party's designated person at the addresses shown herein or in the most recent NASD Manual. b. This Agreement shall terminate immediately upon the appointment of a Trustee under the Securities Investor Protection Act or any other act of insolvency by Dealer. c. The termination of this Agreement by any of the foregoing means shall have no effect upon transactions entered into prior to the effective date of termination and shall 8 not relieve Dealer of its obligations, duties and indemnities specified in this Agreement. A trade placed by Dealer subsequent to its voluntary termination of this Agreement will not serve to reinstate the Agreement. Reinstatement, except in the case of a temporary suspension of Dealer, will only be effective upon written notification by Distributor. d. This Agreement is not assignable or transferable and will terminate automatically in the event of its "assignment," as defined in the Investment Company Act of 1940, as amended and the rules, regulations and interpretations thereunder. The Distributor may, however, transfer any of its duties under this Agreement to any entity that controls or is under common control with Distributor. e. This Agreement may be amended by Distributor at any time by written notice to Dealer. Dealer's placing of an order or accepting payment of any kind after the effective date and receipt of notice of such amendment shall constitute Dealer's acceptance of such amendment. 11. DISTRIBUTOR'S REPRESENTATIONS AND WARRANTIES Distributor represents and warrants that: a. It is a limited liability company duly organized and existing and in good standing under the laws of the state of Delaware and is duly registered or exempt from registration as a broker-dealer in all states and jurisdictions in which it provides services as principal underwriter and distributor for the Funds. b. It is a member in good standing of the NASD. c. It is empowered under applicable laws and by Distributor's charter and by-laws to enter into this Agreement and perform all activities and services of the Distributor provided for herein and that there are no impediments, prior or existing, regulatory, self-regulatory, administrative, civil or criminal matters affecting Distributor's ability to perform under this Agreement. d. All requisite actions have been taken to authorize Distributor to enter into and perform this Agreement. 12. ADDITIONAL DEALER REPRESENTATIONS AND WARRANTIES In addition to the representations and warranties found elsewhere in this Agreement, Dealer represents and warrants that: a. It is duly organized and existing and in good standing under the laws of the state, commonwealth or other jurisdiction in which Dealer is organized and that Dealer will not offer Shares of any Fund for sale in any state or jurisdiction where such Shares may not be legally sold or where Dealer is not qualified to act as a broker-dealer. 9 b. It is empowered under applicable laws and by Dealer's organizational documents to enter into this Agreement and perform all activities and services of the Dealer provided for herein and that there are no impediments, prior or existing, regulatory, self-regulatory, administrative, civil or criminal matters affecting Dealer's ability to perform under this Agreement. c. All requisite actions have been taken to authorize Dealer to enter into and perform this Agreement. d. It is not, at the time of the execution of this Agreement, subject to any enforcement or other proceeding with respect to its activities under state or federal securities laws, rules or regulations. 13. SETOFF; DISPUTE RESOLUTION; GOVERNING LAW a. Should any of Dealer's concession accounts with Distributor have a debit balance, Distributor shall be permitted to offset and recover the amount owed from any other account Dealer has with Distributor, without notice or demand to Dealer. b. In the event of a dispute concerning any provision of this Agreement, either party may require the dispute to be submitted to binding arbitration under the commercial arbitration rules and procedures of the NASD. The parties agree that, to the extent permitted under such arbitration rules and procedures, the arbitrators selected shall be from the securities industry. Judgment upon any arbitration award may be entered by any state or federal court having jurisdiction. c. This Agreement shall be governed and construed in accordance with the laws of the state of New Jersey, not including any provision which would require the general application of the law of another jurisdiction. 14. INVESTIGATIONS AND PROCEEDINGS The parties to this Agreement agree to cooperate fully in any securities regulatory investigation or proceeding or judicial proceeding with respect to each's activities under this Agreement and promptly to notify the other party of any such investigation or proceeding. 15. CAPTIONS All captions used in this Agreement are for convenience only, are not a party hereof, and are not to be used in construing or interpreting any aspect hereof. 16. ENTIRE UNDERSTANDING This Agreement contains the entire understanding of the parties hereto with respect to the subject matter contained herein and supersedes all previous agreements. This Agreement shall be binding upon the parties hereto when signed by Dealer and accepted by Distributor. 10 17. SEVERABILITY Whenever possible, each provision of this Agreement shall be interpreted in such manner as to be effective and valid under applicable law. If, however, any provision of this Agreement is held under applicable law to be invalid, illegal, or unenforceable in any respect, such provision shall be ineffective only to the extent of such invalidity, and the validity, legality and enforceability of the remaining provisions of this Agreement shall not be affected or impaired in any way. 18. ENTIRE AGREEMENT This Agreement contains the entire understanding of the parties hereto with respect to the subject matter contained herein and supersedes all previous agreements and/or understandings of the parties. This Agreement shall be binding upon the parties hereto when signed by Dealer and accepted by Distributor. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be duly executed as of the day and year set forth below. PRUDENTIAL INVESTMENT MANAGEMENT SERVICES LLC By: ------------------------------------- Name: ----------------------------------- Title: ---------------------------------- Date: ----------------------------------- DEALER: --------------------------------- By: ------------------------------------- (Signature) Name: ----------------------------------- Title: ---------------------------------- Address: -------------------------------- -------------------------------- -------------------------------- Telephone: ------------------------------ NASD CRD # ---------------------------- Prudential Dealer # (Internal Use Only) -------------------- Date: ----------------------------------- 11 EX-99.7(B) 4 EXHIBIT 99.7(B) PRUDENTIAL GOVERNMENT INCOME FUND, INC. DISTRIBUTION AGREEMENT Agreement made as of June 1, 1998, Prudential Government Income Fund, Inc. (the Fund), and Prudential Investment Management Services LLC, a Delaware limited liability company (the Distributor). WITNESSETH WHEREAS, the Fund is registered under the Investment Company Act of 1940, as amended (the Investment Company Act), as a diversified, open-end, management investment company and it is in the interest of the Fund to offer its shares for sale continuously; WHEREAS, the shares of the Fund may be divided into classes and/or series (all such shares being referred to herein as Shares) and the Fund currently is authorized to offer Class A, Class B, Class C and Class Z Shares; WHEREAS, the Distributor is a broker-dealer registered under the Securities Exchange Act of 1934, as amended, and is engaged in the business of selling shares of registered investment companies either directly or through other broker-dealers; WHEREAS, the Fund and the Distributor wish to enter into an agreement with each other, with respect to the continuous offering of the Fund's Shares from and after the date hereof in order to promote the growth of the Fund and facilitate the distribution of its Shares; and WHEREAS, the Fund has adopted a plan (or plans) of distribution pursuant to Rule 12b-1 under the Investment Company Act with respect to certain of its classes and/or series of Shares (the Plans) authorizing payments by the Fund to the Distributor with respect to the distribution of such classes and/or series of Shares and the maintenance of related shareholder accounts. NOW, THEREFORE, the parties agree as follows: Section 1. APPOINTMENT OF THE DISTRIBUTOR The Fund hereby appoints the Distributor as the principal underwriter and distributor of the Shares of the Fund to sell Shares to the public on behalf of the Fund and the Distributor hereby accepts such appointment and agrees to act hereunder. The Fund hereby agrees during the term of this Agreement to sell Shares of the Fund through the Distributor on the terms and conditions set forth below. Section 2. EXCLUSIVE NATURE OF DUTIES The Distributor shall be the exclusive representative of the Fund to act as principal underwriter and distributor of the Fund's Shares, except that: 2.1 The exclusive rights granted to the Distributor to sell Shares of the Fund shall not apply to Shares of the Fund issued in connection with the merger or consolidation of any other investment company or personal holding company with the Fund or the acquisition by purchase or otherwise of all (or substantially all) the assets or the outstanding shares of any such company by the Fund. 2.2 Such exclusive rights shall not apply to Shares issued by the Fund pursuant to reinvestment of dividends or capital gains distributions or through the exercise of any conversion feature or exchange privilege. 2.3 Such exclusive rights shall not apply to Shares issued by the Fund pursuant to the reinstatement privilege afforded redeeming shareholders. 2.4 Such exclusive rights shall not apply to purchases made through the Fund's transfer and dividend disbursing agent in the manner set forth in the currently effective Prospectus of the Fund. The term "Prospectus" shall mean the Prospectus and Statement of Additional Information included as part of the Fund's Registration Statement, as such Prospectus and Statement of Additional Information may be amended or supplemented from time to time, and the term "Registration Statement" shall mean the Registration Statement filed by the Fund with the Securities and Exchange Commission and effective under the Securities Act of 1933, as amended (Securities Act), and the Investment Company Act, as such Registration Statement is amended from time to time. Section 3. PURCHASE OF SHARES FROM THE FUND 3.1 The Distributor shall have the right to buy from the Fund on behalf of investors the Shares needed, but not more than the Shares needed (except for clerical errors in transmission) to fill unconditional orders for Shares placed with the Distributor by investors or registered and qualified securities dealers and other financial institutions (selected dealers). 3.2 The Shares shall be sold by the Distributor on behalf of the Fund and delivered by the Distributor or selected dealers, as described in Section 6.4 hereof, to investors at the offering price as set forth in the Prospectus. 3.3 The Fund shall have the right to suspend the sale of any or all classes and/or series of its Shares at times when redemption is suspended pursuant to 2 the conditions in Section 4.3 hereof or at such other times as may be determined by the Board. The Fund shall also have the right to suspend the sale of any or all classes and/or series of its Shares if a banking moratorium shall have been declared by federal or New Jersey authorities. 3.4 The Fund, or any agent of the Fund designated in writing by the Fund, shall be promptly advised of all purchase orders for Shares received by the Distributor. Any order may be rejected by the Fund; provided, however, that the Fund will not arbitrarily or without reasonable cause refuse to accept or confirm orders for the purchase of Shares. The Fund (or its agent) will confirm orders upon their receipt, will make appropriate book entries and upon receipt by the Fund (or its agent) of payment therefor, will deliver deposit receipts for such Shares pursuant to the instructions of the Distributor. Payment shall be made to the Fund in New York Clearing House funds or federal funds. The Distributor agrees to cause such payment and such instructions to be delivered promptly to the Fund (or its agent). Section 4. REPURCHASE OR REDEMPTION OF SHARES BY THE FUND 4.1 Any of the outstanding Shares may be tendered for redemption at any time, and the Fund agrees to repurchase or redeem the Shares so tendered in accordance with its Declaration of Trust as amended from time to time, and in accordance with the applicable provisions of the Prospectus. The price to be paid to redeem or repurchase the Shares shall be equal to the net asset value determined as set forth in the Prospectus. All payments by the Fund hereunder shall be made in the manner set forth in Section 4.2 below. 4.2 The Fund shall pay the total amount of the redemption price as defined in the above paragraph pursuant to the instructions of the Distributor on or before the seventh day subsequent to its having received the notice of redemption in proper form. The proceeds of any redemption of Shares shall be paid by the Fund as follows: (i) in the case of Shares subject to a contingent deferred sales charge, any applicable contingent deferred sales charge shall be paid to the Distributor, and the balance shall be paid to or for the account of the redeeming shareholder, in each case in accordance with applicable provisions of the Prospectus; and (ii) in the case of all other Shares, proceeds shall be paid to or for the account of the redeeming shareholder, in each case in accordance with applicable provisions of the Prospectus. 4.3 Redemption of any class and/or series of Shares or payment may be suspended at times when the New York Stock Exchange is closed for other than customary weekends and holidays, when trading on said Exchange is restricted, when an emergency exists as a result of which disposal by the Fund of securities owned by it is not reasonably practicable or it is not reasonably practicable for the Fund fairly to determine the value of its net assets, or during any other period when the Securities and Exchange Commission, by order, so permits. 3 Section 5. DUTIES OF THE FUND 5.1 Subject to the possible suspension of the sale of Shares as provided herein, the Fund agrees to sell its Shares so long as it has Shares of the respective class and/or series available. 5.2 The Fund shall furnish the Distributor copies of all information, financial statements and other papers which the Distributor may reasonably request for use in connection with the distribution of Shares, and this shall include one certified copy, upon request by the Distributor, of all financial statements prepared for the Fund by independent public accountants. The Fund shall make available to the Distributor such number of copies of its Prospectus and annual and interim reports as the Distributor shall reasonably request. 5.3 The Fund shall take, from time to time, but subject to the necessary approval of the Board and the shareholders, all necessary action to register the same under the Securities Act, to the end that there will be available for sale such number of Shares as the Distributor reasonably may expect to sell. The Fund agrees to file from time to time such amendments, reports and other documents as may be necessary in order that there will be no untrue statement of a material fact in the Registration Statement, or necessary in order that there will be no omission to state a material fact in the Registration Statement which omission would make the statements therein misleading. 5.4 The Fund shall use its best efforts to notify such states as the Distributor and the Fund may approve of its intention to sell any appropriate number of its Shares; provided that the Fund shall not be required to amend its Declaration of Trust or By-Laws to comply with the laws of any state, to maintain an office in any state, to change the terms of the offering of its Shares in any state from the terms set forth in its Registration Statement, to qualify as a foreign corporation in any state or to consent to service of process in any state other than with respect to claims arising out of the offering of its Shares. Any such notification may be withheld, terminated or withdrawn by the Fund at any time in its discretion. As provided in Section 9 hereof, the expense of notification and maintenance of notification shall be borne by the Fund. The Distributor shall furnish such information and other material relating to its affairs and activities as may be required by the Fund in connection with such notifications. 4 Section 6. DUTIES OF THE DISTRIBUTOR 6.1 The Distributor shall devote reasonable time and effort to effect sales of Shares, but shall not be obligated to sell any specific number of Shares. Sales of the Shares shall be on the terms described in the Prospectus. The Distributor may enter into like arrangements with other investment companies. The Distributor shall compensate the selected dealers as set forth in the Prospectus. 6.2 In selling the Shares, the Distributor shall use its best efforts in all respects duly to conform with the requirements of all federal and state laws relating to the sale of such securities. Neither the Distributor nor any selected dealer nor any other person is authorized by the Fund to give any information or to make any representations, other than those contained in the Registration Statement or Prospectus and any sales literature approved by appropriate officers of the Fund. 6.3 The Distributor shall adopt and follow procedures for the confirmation of sales to investors and selected dealers, the collection of amounts payable by investors and selected dealers on such sales and the cancellation of unsettled transactions, as may be necessary to comply with the requirements of Securities Exchange Act Rule 10b-10 and the rules of the National Association of Securities Dealers, Inc. (NASD). 6.4 The Distributor shall have the right to enter into selected dealer agreements with registered and qualified securities dealers and other financial institutions of its choice for the sale of Shares, provided that the Fund shall approve the forms of such agreements. Within the United States, the Distributor shall offer and sell Shares only to such selected dealers as are members in good standing of the NASD or are institutions exempt from registration under applicable federal securities laws. Shares sold to selected dealers shall be for resale by such dealers only at the offering price determined as set forth in the Prospectus. Section 7. PAYMENTS TO THE DISTRIBUTOR 7.1 With respect to classes and/or series of Shares which impose a front-end sales charge, the Distributor shall receive and may retain any portion of any front-end sales charge which is imposed on such sales and not reallocated to selected dealers as set forth in the Prospectus, subject to the limitations of Rule 2830 of the Conduct Rules of the NASD. Payment of these amounts to the Distributor is not contingent upon the adoption or continuation of any applicable Plans. 7.2 With respect to classes and/or series of Shares which impose a contingent deferred sales charge, the Distributor shall receive and may retain any contingent deferred sales charge which is imposed on such sales as set forth in the Prospectus, subject to the limitations of Rule 2830 of the Conduct Rules of the NASD. 5 Payment of these amounts to the Distributor is not contingent upon the adoption or continuation of any Plan. Section 8. PAYMENT OF THE DISTRIBUTOR UNDER THE PLAN 8.1 The Fund shall pay to the Distributor as compensation for services under any Plans adopted by the Fund and this Agreement a distribution and service fee with respect to the Fund's classes and/or series of Shares as described in each of the Fund's respective Plans and this Agreement. 8.2 So long as a Plan or any amendment thereto is in effect, the Distributor shall inform the Board of the commissions and account servicing fees with respect to the relevant class and/or series of Shares to be paid by the Distributor to account executives of the Distributor and to broker-dealers, financial institutions and investment advisers which have dealer agreements with the Distributor. So long as a Plan (or any amendment thereto) is in effect, at the request of the Board or any agent or representative of the Fund, the Distributor shall provide such additional information as may reasonably be requested concerning the activities of the Distributor hereunder and the costs incurred in performing such activities with respect to the relevant class and/or series of Shares. Section 9. ALLOCATION OF EXPENSES The Fund shall bear all costs and expenses of the continuous offering of its Shares (except for those costs and expenses borne by the Distributor pursuant to a Plan and subject to the requirements of Rule 12b-1 under the Investment Company Act), including fees and disbursements of its counsel and auditors, in connection with the preparation and filing of any required Registration Statements and/or Prospectuses under the Investment Company Act or the Securities Act, and all amendments and supplements thereto, and preparing and mailing annual and periodic reports and proxy materials to shareholders (including but not limited to the expense of setting in type any such Registration Statements, Prospectuses, annual or periodic reports or proxy materials). The Fund shall also bear the cost of expenses of making notice filings for the Shares for sale, and, if necessary or advisable in connection therewith, of qualifying the Fund as a broker or dealer, in such states of the United States or other jurisdictions as shall be selected by the Fund and the Distributor pursuant to Section 5.4 hereof and the cost and expense payable to each such state for continuing notification therein until the Fund decides to discontinue such notification pursuant to Section 5.4 hereof. As set forth in Section 8 above, the Fund shall also bear the expenses it assumes pursuant to any Plan, so long as such Plan is in effect. 6 Section 10. INDEMNIFICATION 10.1 The Fund agrees to indemnify, defend and hold the Distributor, its officers and directors and any person who controls the Distributor within the meaning of Section 15 of the Securities Act, free and harmless from and against any and all claims, demands, liabilities and expenses (including the cost of investigating or defending such claims, demands or liabilities and any reasonable counsel fees incurred in connection therewith) which the Distributor, its officers, members or any such controlling person may incur under the Securities Act, or under common law or otherwise, arising out of or based upon any untrue statement of a material fact contained in the Registration Statement or Prospectus or arising out of or based upon any alleged omission to state a material fact required to be stated in either thereof or necessary to make the statements in either thereof not misleading, except insofar as such claims, demands, liabilities or expenses arise out of or are based upon any such untrue statement or omission or alleged untrue statement or omission made in reliance upon and in conformity with information furnished by the Distributor to the Fund for use in the Registration Statement or Prospectus; provided, however, that this indemnity agreement shall not inure to the benefit of any such officer, member or controlling person unless a court of competent jurisdiction shall determine in a final decision on the merits, that the person to be indemnified was not liable by reason of willful misfeasance, bad faith or gross negligence in the performance of its duties, or by reason of its reckless disregard of its obligations under this Agreement (disabling conduct), or, in the absence of such a decision, a reasonable determination, based upon a review of the facts, that the indemnified person was not liable by reason of disabling conduct, by (a) a vote of a majority of a quorum of directors or directors who are neither "interested persons" of the Fund as defined in Section 2(a)(19) of the Investment Company Act nor parties to the proceeding, or (b) an independent legal counsel in a written opinion. The Fund's agreement to indemnify the Distributor, its officers and members and any such controlling person as aforesaid is expressly conditioned upon the Fund's being promptly notified of any action brought against the Distributor, its officers or members, or any such controlling person, such notification to be given by letter or telegram addressed to the Fund at its principal business office. The Fund agrees promptly to notify the Distributor of the commencement of any litigation or proceedings against it or any of its officers or directors in connection with the issue and sale of any Shares. 10.2 The Distributor agrees to indemnify, defend and hold the Fund, its officers and directors and any person who controls the Fund, if any, within the meaning of Section 15 of the Securities Act, free and harmless from and against any and all claims, demands, liabilities and expenses (including the cost of investigating or defending against such claims, demands or liabilities and any reasonable counsel fees incurred in connection therewith) which the Fund, its officers and directors or any such controlling person may incur under the Securities Act or under common law or otherwise, but only to the extent that such liability or expense incurred by the Fund, its 7 directors or officers or such controlling person resulting from such claims or demands shall arise out of or be based upon any alleged untrue statement of a material fact contained in information furnished by the Distributor to the Fund for use in the Registration Statement or Prospectus or shall arise out of or be based upon any alleged omission to state a material fact in connection with such information required to be stated in the Registration Statement or Prospectus or necessary to make such information not misleading. The Distributor's agreement to indemnify the Fund, its officers and directors and any such controlling person as aforesaid, is expressly conditioned upon the Distributor's being promptly notified of any action brought against the Fund, its officers and directors or any such controlling person, such notification being given to the Distributor at its principal business office. Section 11. DURATION AND TERMINATION OF THIS AGREEMENT 11.1 This Agreement shall become effective as of the date first above written and shall remain in force for two years from the date hereof and thereafter, but only so long as such continuance is specifically approved at least annually by (a) the Board of the Fund, or by the vote of a majority of the outstanding voting securities of the applicable class and/or series of the Fund, and (b) by the vote of a majority of those directors who are not parties to this Agreement or interested persons of any such parties and who have no direct or indirect financial interest in this Agreement or in the operation of any of the Fund's Plans or in any agreement related thereto (Independent directors), cast in person at a meeting called for the purpose of voting upon such approval. 11.2 This Agreement may be terminated at any time, without the payment of any penalty, by a majority of the independent directors or by vote of a majority of the outstanding voting securities of the applicable class and/or series of the Fund, or by the Distributor, on sixty (60) days' written notice to the other party. This Agreement shall automatically terminate in the event of its assignment. 11.3 The terms "affiliated person," "assignment," "interested person" and "vote of a majority of the outstanding voting securities", when used in this Agreement, shall have the respective meanings specified in the Investment Company Act. Section 12. AMENDMENTS TO THIS AGREEMENT This Agreement may be amended by the parties only if such amendment is specifically approved by (a) the Board of the Fund, or by the vote of a majority of the outstanding voting securities of the applicable class and/or series of the Fund, and (b) by the vote of a majority of the independent directors cast in person at a meeting called for the purpose of voting on such amendment. 8 Section 13. SEPARATE AGREEMENT AS TO CLASSES AND/OR SERIES The amendment or termination of this Agreement with respect to any class and/or series shall not result in the amendment or termination of this Agreement with respect to any other class and/or series unless explicitly so provided. Section 14. GOVERNING LAW The provisions of this Agreement shall be construed and interpreted in accordance with the laws of the State of New Jersey as at the time in effect and the applicable provisions of the Investment Company Act. To the extent that the applicable law of the State of New Jersey, or any of the provisions herein, conflict with the applicable provisions of the Investment Company Act, the latter shall control. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the day and year above written. Prudential Investment Management Services LLC By: /s/ Mark R. Fetting ---------------------------------------- Mark R. Fetting Executive Vice President Prudential Government Income Fund, Inc. By: /s/ Richard A. Redeker ---------------------------------------- Richard A. Redeker President 9 EX-99.11 5 EXHIBIT 99.11 SWIDLER BERLIN SHEREFF FRIEDMAN, LLP 919 THIRD AVENUE NEW YORK, NEW YORK 10022-9998 September 23, 1998 Prudential Government Income Fund, Inc. Gateway Center Three Newark, New Jersey 07102 Ladies and Gentlemen: We have acted as counsel for Prudential Government Income Fund, Inc. (the "Fund") in connection with the proposed acquisition by the Fund of all of the assets of Mortgage Income Fund, Inc. ("Mortgage Fund"), in exchange for Class A, Class B, Class C and Class Z shares of the Fund and the Fund's assumption of all of the liabilities, if any, of Mortgage Fund (the "Reorganization"). This opinion is furnished in connection with the Fund's Registration Statement on Form N-14 under the Securities Act of 1933, as amended (the "Registration Statement"), relating to Class A, Class B, Class C and Class Z shares of common stock, par value $0.01 per share, of the Fund (the "Shares"), to be issued in the Reorganization. As counsel for the Fund, we are familiar with the proceedings taken by it and to be taken by it in connection with the authorization, issuance and sale of the Shares. In addition, we have examined and are familiar with the Articles of Incorporation of the Fund, as amended and supplemented, the By-Laws of the Fund, as amended, a certificate issued by the State Department of Assessments and Taxation of the State of Maryland, certifying the existence and good standing of the Fund, an opinion of Piper & Marbury, L.L.P., dated the date hereof, and attached as Annex A hereto and such other documents as we have deemed relevant to the matters referred to in this opinion. Based upon the foregoing, we are of the opinion that subsequent to the approval of the Agreement and Plan of Reorganization between the Fund and Mortgage Fund set forth in the proxy statement and prospectus constituting a part of the Registration Statement (the "Proxy Statement and Prospectus"), the Shares, upon issuance in the manner referred to in the Registration Statement, for consideration not less than the par value thereof, will be legally issued, fully paid and non-assessable shares of common stock of the Fund. We are members of the Bar of the State of New York and are not members of the Bar of, or authorized to practice law in, any other jurisdiction. Insofar as any opinion expressed herein involves the laws of the State of Maryland, we have relied on the opinion of Piper & Prudential Government Income Fund, Inc. Page 2 Marbury, L.L.P. referenced above and our opinion is subject to the same qualifications and limitations with respect to such matters as are contained in such opinion of Piper & Marbury, L.L.P. We hereby consent to the filing of this opinion as an exhibit to the Registration Statement and to the use of our name in the Proxy Statement and Prospectus constituting a part thereof. Very truly yours, /s/ Swidler Berlin Shereff Friedman, LLP Swidler Berlin Shereff Friedman, LLP SBSF:MKN:JLS:RDB:GNB:MGM PIPER & MARBURY LETTERHEAD September 23, 1998 Prudential Government Income Fund, Inc. Gateway Center Three 100 Mulberry Street Newark, New Jersey 07102-4077 Re: Registration Statement on Form N-14 Ladies and Gentlemen: We have acted as special Maryland counsel to Prudential Government Income Fund, Inc. (the "Fund") in connection with the registration by the Fund of certain shares of its Common Stock (the "Shares"), pursuant to a registration statement on Form N-14, as amended (the "Registration Statement") under the Securities Act of 1933, as amended. In this capacity, we have examined the Fund's charter and by-laws, the proceedings of the Board of Directors of the Fund authorizing the issuance of the Shares in accordance with the Registration Statement, and such other statutes, certificates, instruments and documents relating to the Fund and matters of law as we have deemed necessary to the issuance of this opinion. In such examination, we have assumed the genuineness of all signatures, the conformity of final documents in all material respects to the versions thereof submitted to us in draft form, the authenticity of all documents submitted to us as originals, and the conformity with originals of all documents submitted to us as copies. Based upon the foregoing, and limited in all respects to applicable Maryland law, we are of the opinion and advise you that: 1. The Fund has been duly incorporated and is validly existing as a corporation under the laws of the State of Maryland. Prudential Government Income Fund, Inc. September 23, 1998 Page 2 2. The Shares to be issued by the Fund pursuant to the Registration Statement have been duly authorized and, when issued as contemplated in the Registration Statement in an amount not to exceed the number of Shares authorized by the charter but unissued, will be legally issued, fully paid and nonassessable. Swidler Berlin Shereff Friendman, LLP are authorized to rely upon this opinion in rendering any opinion to the Fund which is to be filed as an exhibit to the Registration Statement. We hereby consent to the filing of this opinion as an exhibit to the Registration Statement. Very truly yours, /s/ Piper & Marbury L.L.P. ------------------------------------ EX-99.12 6 EXHIBIT 99.12 [LETTERHEAD] September 18, 1998 Prudential Government Income Fund, Inc. Gateway Center Three Newark, New Jersey 07102 Prudential Mortgage Income Fund, Inc. Gateway Center Three Newark, New Jersey 07102 Dear Sirs: We are acting as counsel to Prudential Government Income Fund, Inc., a Maryland corporation ("Government Income Fund") and Prudential Mortgage Income Fund, Inc., a Maryland corporation ("Mortgage Income Fund"), in connection with the proposed transfer of the assets of Mortgage Income Fund to Government Income Fund and the assumption by Government Income Fund of Mortgage Income Fund's liabilities, if any, in exchange for shares of the Government Income Fund (the "Shares") pursuant to an Agreement and Plan of Reorganization (the "Agreement"). The transactions contemplated by the Agreement are collectively referred to herein as the "Reorganization." We have participated in the preparation of the Government Income Fund's Registration Statement on Form N-14 (the "Registration Statement") relating, among other things, to the Shares of Government Income Fund to be offered in exchange for the assets and the assumption of the liabilities of Mortgage Income Fund, and containing the Prospectus and Proxy Statement relating to the Reorganization (collectively, the "Prospectus"), filed with the Securities and Exchange Commission (the "Commission") pursuant to the provisions of the Securities Act of 1933, as amended (the "Securities Act"), and the rules and regulations of the Commission thereunder. In addition, in connection with rendering the opinions expressed herein, we have examined originals or copies, certified or otherwise identified to our satisfaction, of such other documents, records and instruments as we have deemed necessary or appropriate for the purpose of rendering this opinion, including the form of the Agreement included as Appendix B to the Prospectus. In our examination of the foregoing documents, we have assumed the genuineness of all signatures, the authority of each signatory, the due execution and delivery of all documents by all parties, the authenticity of all agreements, documents, certificates and instruments submitted to Prudential Government Income Fund, Inc. Prudential Mortgage Income Fund, Inc. September 18, 1998 Page 2 us as originals, the conformity of the Agreement as executed and delivered by the parties with the form of the Agreement contained in the Prospectus, and the conformity with originals of all agreements, documents, certificates and instruments submitted to us as copies. In rendering the opinions expressed herein, we have assumed that the transactions contemplated by the Agreement will be consummated in accordance therewith and as described in the Prospectus. As to other questions of fact material to this opinion, we have assumed, with your approval and without independent investigation or verification, that the following facts will be accurate and complete as of the consummation of the Reorganization (the "Closing Date"). 1. The fair market value of the Shares to be received by each Mortgage Income Fund shareholder will be equal to the fair market value of the shares of Mortgage Income Fund surrendered in exchange therefor upon the liquidation of Mortgage Income Fund. 2. There will be no plan or intention by any shareholder of Mortgage Income Fund who owns 5 percent or more of Mortgage Income Fund shares, and to the best of the knowledge of management of Mortgage Income Fund, there will be no plan or intention on the part of the remaining shareholders of Mortgage Income Fund, to sell, exchange, or otherwise dispose of a number of Shares received in the Reorganization that would reduce Mortgage Income Fund shareholders' ownership of Shares of Government Income Fund to a number of Shares having a value, as of the Closing Date, of less than 50 percent of the value of all formerly outstanding shares of Mortgage Income Fund as of the same date. For purposes hereof, shares of Mortgage Income Fund exchanged for cash or other property, surrendered by dissenters, or exchanged for cash in lieu of fractional Shares of Government Income Fund will be treated as outstanding shares of Mortgage Income Fund at the Closing Date of the Reorganization. Moreover, shares of Mortgage Income Fund and Shares of Government Income Fund held by Mortgage Income Fund shareholders and otherwise sold, redeemed, or disposed or prior or subsequent to the Reorganization and as part of the Reorganization will be considered in making this assumption. 3. Pursuant to the Agreement, Mortgage Income Fund will distribute in complete liquidation of Mortgage Income Fund, the Shares of Government Income Fund received by Mortgage Income Fund in the Reorganization. 4. The liabilities of Mortgage Income Fund assumed by Government Income Fund pursuant to the Reorganization, plus the liabilities, if any, to which assets transferred pursuant to the Reorganization will be subject, constitute less than 20% of the total consideration for the Reorganization, all such liabilities will have been incurred by Mortgage Income Fund in the ordinary course of its business, and Government Income Fund will pay no other consideration, except for the Shares, in connection with the Reorganization. Prudential Government Income Fund, Inc. Prudential Mortgage Income Fund, Inc. September 18, 1998 Page 3 5. All expenses incurred by Mortgage Income Fund with respect to the Reorganization will be borne by Mortgage Income Fund. Each shareholder of Mortgage Income Fund will pay its respective share of the expenses, if any, incurred in connection with the Reorganization. Government Income Fund will pay the expenses, if any, incurred by it in connection with the Reorganization. 6. No intercorporate indebtedness will exist between Government Income Fund and Mortgage Income Fund that was issued, acquired, or will be settled at a discount. 7. Mortgage Income Fund will not own, directly or indirectly, nor will it have owned during the five years preceding the Closing Date, directly or indirectly, any stock of Government Income Fund. 8. The assets of Mortgage Income Fund transferred to Government Income Fund will include all assets owned by Mortgage Income Fund at fair market value on the Closing Date subject to all known liabilities of Mortgage Income Fund at such time. 9. In accordance with the terms of the Agreement, Mortgage Income Fund will transfer all of its business and will transfer assets to Government Income Fund representing at least 90% of the fair market value of the net assets, and at least 70% of the fair market value of the gross assets, held by Mortgage Income Fund immediately prior to the Reorganization. For purposes of this assumption, amounts paid by Mortgage Income Fund to shareholders who receive cash or other property, amounts paid to dissenters, amounts used by Mortgage Income Fund to pay its reorganization expenses and all redemptions and distributions (other than regular, normal redemptions and dividends) made by Mortgage Income Fund immediately preceding the Reorganization will be included as assets of Mortgage Income Fund held immediately prior to the Reorganization. 10. The fair market value of the assets of Mortgage Income Fund transferred to Government Income Fund will equal or exceed the sum of liabilities assumed by Government Income Fund, plus the amount of liabilities, if any, to which the transferred assets will be subject. 11. Mortgage Income Fund will not be under the jurisdiction of a court in a Title 11 or similar case within the meaning of Section 368(a)(3)(A) of the Internal Revenue Code of 1986, as amended (the "Code"). 12. No cash will be paid to the shareholders of Mortgage Income Fund in lieu of fractional Shares. Prudential Government Income Fund, Inc. Prudential Mortgage Income Fund, Inc. September 18, 1998 Page 4 13. For federal income tax purposes, Mortgage Income Fund will qualify as a regulated investment company (as defined in Code Section 851) and will have so qualified since its formation. The provisions of Code Sections 851 through 855 apply to Mortgage Income Fund and will continue to apply through the Closing Date. 14. As of the Closing Date, Mortgage Income Fund will have declared to its shareholders of record a dividend or dividends payable prior to closing, which together with all previous such dividends will have the effect of distributing all of Mortgage Income Fund's investment company taxable income plus the excess of its interest income, if any, excludable from gross income under Code Section 103(a) (including by virtue of prior Section 853(b)(5)(C) of the Code) over its deductions disallowed under Sections 265 and 171(a)(2) for the taxable year of Mortgage Income Fund ending on the Closing Date and all its net capital gain realized in such taxable year. 15. Except to the extent necessary to comply with its legal obligation to redeem its own shares, Government Income Fund will have no plan or intention to reacquire any of the Shares issued in the Reorganization. 16. Aside from an initial realignment of the portfolio of Mortgage Income Fund in which Government Income Fund will dispose of not more than 66 2/3% of Mortgage Income Fund's assets acquired in the Reorganization, Government Income Fund will have no plan or intention to sell or otherwise dispose of any of the assets of the Mortgage Income Fund acquired in the Reorganization, other than dispositions made in the ordinary course of business. 17. Following the Reorganization, Government Income Fund will continue the historic business of Mortgage Income Fund or use a significant portion of Mortgage Income Fund's historic business assets in its business. 18. Government Income Fund will not own, directly or indirectly, nor will it have owned during the five years preceding the Closing Date, directly or indirectly, any shares of beneficial interest of Mortgage Income Fund. 19. Government Income Fund will not be under the jurisdiction of a court in a Title 11 or similar case within the meaning of Code Section 368(a)(3)(A). 20. For federal income tax purposes, Government Income Fund will qualify as a regulated investment company (as defined in Code Section 851) and will have so qualified since its formation. The provisions of Code Sections 851 through 855 apply to Government Income Fund prior to the Reorganization and will continue to apply after the Closing Date. Prudential Government Income Fund, Inc. Prudential Mortgage Income Fund, Inc. September 18, 1998 Page 5 21. No compensation received by any shareholder-employee of Mortgage Income Fund will be separate consideration for the Reorganization; none of the Shares of Government Income Fund received by any shareholder-employee will be separate consideration for, or allocable to, any employment agreement; and any compensation paid to any shareholder-employee will be for services actually rendered and will be commensurate with amounts paid to other parties bargaining at arm's length for similar services. We note that we are members of the Bar of the State of New York and that our opinion is expressly limited to the federal laws of the United States. Based on the foregoing and subject to the assumptions and limitations set forth above and such examination of law as we have deemed necessary, we are of the opinion that: 1. The Reorganization will constitute a reorganization within the meaning of Section 368(a)(1)(C) of the Code; 2. Mortgage Income Fund and Government Income Fund will each be a "party to a reorganization" within the meaning of Section 368(b) of the Code; 3. Pursuant to Sections 361(a) and 357(a) of the Code, no gain or loss will be recognized by Mortgage Income Fund upon the transfer of its assets to Government Income Fund in exchange solely for Shares of Government Income Fund as a result of the Reorganization and the assumption by Government Income Fund of Mortgage Income Fund's liabilities, if any, or upon the distribution (whether actual or constructive) of the Shares of Government Income Fund in complete liquidation of Mortgage Income Fund; 4. Pursuant to Section 1032(a) of the Code, no gain or loss will be recognized by Government Income Fund upon its acquisition of Mortgage Income Fund's assets solely in exchange for Shares of Government Income Fund and the assumption by Government Income Fund of the liabilities of Mortgage Income Fund; 5. Pursuant to Section 362(b) of the Code, the basis of the assets of Mortgage Income Fund acquired by Government Income Fund will be the same as the basis of such assets when held by Mortgage Income Fund immediately prior to the Reorganization; 6. Pursuant to Section 1223(2) of the Code, the holding period of the assets of Mortgage Income Fund acquired by Government Income Fund will include the Prudential Government Income Fund, Inc. Prudential Mortgage Income Fund, Inc. September 18, 1998 Page 6 period during which such assets were held by Mortgage Income Fund; 7. Pursuant to Section 354(a)(1) of the Code, no gain or loss will be recognized by a shareholder of Mortgage Income Fund upon the exchange of his or her shares solely for Shares of Government Income Fund, including fractional Shares, in liquidation of Mortgage Income Fund; 8. Pursuant to Section 358(a)(1) of the Code, the basis of the Shares of Government Income Fund received by former Mortgage Income Fund shareholders will be the same as the basis of Mortgage Income Fund shares surrendered in exchange therefor; and 9. Pursuant to Section 1223(1) of the Code, the holding period for Shares of Government Income Fund received by each shareholder of Mortgage Income Fund in exchange for his or her shares of Mortgage Income Fund will include the period during which such shareholder held shares of Mortgage Income Fund (provided Mortgage Income Fund shares were held as capital assets on the date of the exchange). The opinions expressed herein are based upon currently applicable statutes and regulations and existing judicial and administrative interpretations. We can provide no assurance that such statutes or regulations, or existing judicial or administrative interpretations thereof, will not be amended, revoked or modified (possibly prior to the Closing Date) in a manner which would affect any of our conclusions. Finally, we note that this opinion is solely for the benefit of the addressees hereof in connection with the transaction described herein and, except as otherwise provided herein, should not be referred to, used, relied upon or quoted (with or without specific reference to our firm) in any documents, reports, financial statements or otherwise, without our prior written consent. We hereby consent to the filing of this opinion as an exhibit to the Registration Statement and to the use of our name and to any reference to our firm in the Registration Statement or in the Prospectus constituting part thereof. Very truly yours, /s/ Swidler Berlin Shereff Friedman, LLP Swidler Berlin Shereff Friedman, LLP Prudential Government Income Fund, Inc. Prudential Mortgage Income Fund, Inc. September 18, 1998 Page 7 SBSF:JHN:MKN:RDB:SDB:GNB EX-99.14(A) 7 EXHIBIT 99.14(A) CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus and Proxy Statement and Statement of Additional Information constituting parts of this registration statement on Form N-14 (the "N-14 Registration Statement") of our report dated April 9, 1998, relating to the financial statements and financial highlights appearing in the February 28, 1998 Annual Report to Shareholders of Prudential Government Income Fund, Inc. (the "Fund") which is incorporated by reference into the N-14 Registration Statement. We also consent to the use of such report and to the reference to us under the heading "Custodian and Transfer and Dividend Disbursing Agent and Independent Accountants" in the Statement of Additional Information of Post-Effective Amendment No. 25 to the registration statement on Form N-1A of the Fund (the "N-1A Registration Statement"), which is incorporated by reference in the Statement of Additional Information and the Prospectus and Proxy Statement constituting part of such N-14 Registration Statement. We also consent to the reference to us under the heading "Financial Highlights" in the Prospectus of such N-1A Registration Statement, which is incorporated by reference in the Prospectus and Proxy Statement of the N-14 Registration Statement. We also consent to the use of our report dated February 13, 1998, relating to the financial statements and financial highlights appearing in the December 31, 1997 Annual Report to Shareholders of Prudential Mortgage Income Fund, Inc. (the "Mortgage Income Fund") which is incorporated by reference in the Statement of Additional Information and in the Prospectus and Proxy Statement. We also consent to the use of such report and the reference to us under the heading "Custodian and Transfer and Dividend Disbursing Agent and Independent Accountants" included in the Statement of Additional Information of Post-Effective Amendment No. 24 to the registration statement on Form N-1A of the Mortgage Income Fund (the "Mortgage Income N-1A Registration Statement"), which is incorporated by reference in the Prospectus constituting part of such Mortgage Income N-1A Registration Statement. PricewaterhouseCoopers LLP 1177 Avenue of the Americas New York, NY 10036 September 25, 1998 EX-99.14(B) 8 EXHIBIT 99.14(B) CONSENT OF INDEPENDENT AUDITORS We consent to the use in this Registration Statement on Form N-14 of Prudential Government Income Fund, Inc. of our report on the financial statement of the Prudential Government Income Fund, Inc. dated April 11, 1997 (the "Fund"), which is included in Exhibit 14(b) and is a part of such Registration Statement, and to the references to us under the heading "Financial Highlights" in the Prospectus of the Fund, which is also a part of such Registration Statement and under the heading "Change of Auditors" which is included in the Statement of Additional Information of such Registration Statement and is also part of such Registration Statement of the Fund. /s/ Deloitte & Touche LLP - ------------------------- Deloitte & Touche LLP New York, New York September 29, 1998 PRUDENTIAL GOVERNMENT Independent Auditors' Report INCOME FUND, INC. - ------------------------------------------------------------------------------- The Shareholders and Board of Trustees Prudential Government Income Fund, Inc. We have audited the accompanying statement of changes in net assets for the year ended February 28, 1997 of Prudential Government Income Fund, Inc., and the financial highlights for the years ended February 28, 1994 through February 28, 1997. This financial statement and these financial highlights are the responsibility of the Fund's management. Our responsibility is to express an opinion on this financial statement and these 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 statement 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 statement. An audit also 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, such financial statement and financial highlights present fairly, in all material respects, the changes in the net assets of Prudential Government Income Fund, Inc. as of February 28, 1997, and its financial highlights for the respective stated periods in conformity with generally accepted accounting principles. DELOITTE & TOUCHE LLP New York, New York April 11, 1997 EX-99.15(A) 9 EXHIBIT 99.15(A) Prudential Government Income Fund, Inc. Amended and Restated Distribution and Service Plan (CLASS A SHARES) INTRODUCTION The Distribution and Service Plan (the Plan) set forth below which is designed to conform to the requirements of Rule 12b-1 under the Investment Company Act of 1940 (the Investment Company Act) and Rule 2830 of the Conduct Rules of the National Association of Securities Dealers, Inc. (NASD) has been adopted by Prudential Government Income Fund, Inc. (the Fund) and by Prudential Investment Management Services LLC, the Fund's distributor (the Distributor). The Fund has entered into a distribution agreement pursuant to which the Fund will employ the Distributor to distribute Class A shares issued by the Fund (Class A shares). Under the Plan, the Fund intends to pay to the Distributor, as compensation for its services, a distribution and service fee with respect to Class A shares. A majority of the Board of Directors/Trustees of the Fund, including a majority of those Directors/Trustees who are not "interested persons" of the Fund (as defined in the Investment Company Act) and who have no direct or indirect financial interest in the operation of this Plan or any agreements related to it (the Rule 12b-1 Directors/Trustees), have determined by votes cast in person at a meeting called for the purpose of voting on this Plan that there is a reasonable likelihood that adoption and continuation of this Plan will benefit the Fund and its shareholders. Expenditures under this Plan by the Fund for Distribution Activities (defined below) are primarily 1 intended to result in the sale of Class A shares of the Fund within the meaning of paragraph (a)(2) of Rule 12b-1 promulgated under the Investment Company Act. The purpose of the Plan is to create incentives to the Distributor and/or other qualified broker-dealers and their account executives to provide distribution assistance to their customers who are investors in the Fund, to defray the costs and expenses associated with the preparation, printing and distribution of prospectuses and sales literature and other promotional and distribution activities and to provide for the servicing and maintenance of shareholder accounts. THE PLAN The material aspects of the Plan are as follows: 1. DISTRIBUTION ACTIVITIES The Fund shall engage the Distributor to distribute Class A shares of the Fund and to service shareholder accounts using all of the facilities of the Distributor's distribution network, including sales personnel and branch office and central support systems, and also using such other qualified broker-dealers and financial institutions as the Distributor may select, including Prudential Securities Incorporated (Prudential Securities) and Pruco Securities Corporation (Prusec). Services provided and activities undertaken to distribute Class A shares of the Fund are referred to herein as "Distribution Activities." 2. PAYMENT OF SERVICE FEE The Fund shall pay to the Distributor as compensation for providing personal service and/or maintaining shareholder accounts a service fee of .25 of 1% per annum of the average daily net assets of the Class A shares (service fee). The Fund shall 2 calculate and accrue daily amounts payable by the Class A shares of the Fund hereunder and shall pay such amounts monthly or at such other intervals as the Board of Directors/Trustees may determine. 3. PAYMENT FOR DISTRIBUTION ACTIVITIES The Fund shall pay to the Distributor as compensation for its services a distribution fee, together with the service fee (described in Section 2 hereof), of .30 of 1% per annum of the average daily net assets of the Class A shares of the Fund for the performance of Distribution Activities. The Fund shall calculate and accrue daily amounts payable by the Class A shares of the Fund hereunder and shall pay such amounts monthly or at such other intervals as the Board of Directors/Trustees may determine. Amounts payable under the Plan shall be subject to the limitations of Rule 2830 of the NASD Conduct Rules. Amounts paid to the Distributor by the Class A shares of the Fund will not be used to pay the distribution expenses incurred with respect to any other class of shares of the Fund except that distribution expenses attributable to the Fund as a whole will be allocated to the Class A shares according to the ratio of the sales of Class A shares to the total sales of the Fund's shares over the Fund's fiscal year or such other allocation method approved by the Board of Directors/Trustees. The allocation of distribution expenses among classes will be subject to the review of the Board of Directors/Trustees. The Distributor shall spend such amounts as it deems appropriate on Distribution Activities which include, among others: 3 (a) sales commissions and trailer commissions paid to, or on account of, account executives of the Distributor; (b) indirect and overhead costs of the Distributor associated with Distribution Activities, including central office and branch expenses; (c) amounts paid to Prudential Securities or Prusec for performing services under a selected dealer agreement between Prudential Securities or Prusec and the Distributor for sale of Class A shares of the Fund, including sales commissions, trailer commissions paid to, or on account of, agents and indirect and overhead costs associated with Distribution Activities; (d) advertising for the Fund in various forms through any available medium, including the cost of printing and mailing Fund prospectuses, statements of additional information and periodic financial reports and sales literature to persons other than current shareholders of the Fund; and (e) sales commissions (including trailer commissions) paid to, or on account of, broker-dealers and financial institutions (other than Prudential Securities or Prusec) which have entered into selected dealer agreements with the Distributor with respect to Class A shares of the Fund. 4. QUARTERLY REPORTS; ADDITIONAL INFORMATION An appropriate officer of the Fund will provide to the Board of Directors/Trustees of the Fund for review, at least quarterly, a written report specifying in reasonable detail the amounts expended for Distribution Activities (including payment of the service fee) and the purposes for which such expenditures were made in compliance with the requirements of Rule 12b-1. The Distributor will provide to the Board of Directors/Trustees of the Fund such additional information as the Board shall from time to time reasonably request, including information about Distribution Activities undertaken or to be undertaken by the Distributor. 4 The Distributor will inform the Board of Directors/Trustees of the Fund of the commissions and account servicing fees to be paid by the Distributor to account executives of the Distributor and to broker-dealers and financial institutions which have selected dealer agreements with the Distributor. 5. EFFECTIVENESS; CONTINUATION The Plan shall not take effect until it has been approved by a vote of a majority of the outstanding voting securities (as defined in the Investment Company Act) of the Class A shares of the Fund. If approved by a vote of a majority of the outstanding voting securities of the Class A shares of the Fund, the Plan shall, unless earlier terminated in accordance with its terms, continue in full force and effect thereafter for so long as such continuance is specifically approved at least annually by a majority of the Board of Directors/Trustees of the Fund and a majority of the Rule 12b-1 Directors/Trustees by votes cast in person at a meeting called for the purpose of voting on the continuation of the Plan. 6. TERMINATION This Plan may be terminated at any time by vote of a majority of the Rule 12b-1 Directors/Trustees, or by vote of a majority of the outstanding voting securities (as defined in the Investment Company Act) of the Class A shares of the Fund. 7. AMENDMENTS The Plan may not be amended to change the combined service and distribution fees to be paid as provided for in Sections 2 and 3 hereof so as to increase materially the amounts payable under this Plan unless such amendment shall be approved by the 5 vote of a majority of the outstanding voting securities (as defined in the Investment Company Act) of the Class A shares of the Fund. All material amendments of the Plan shall be approved by a majority of the Board of Directors/Trustees of the Fund and a majority of the Rule 12b-1 Directors/Trustees by votes cast in person at a meeting called for the purpose of voting on the Plan. 8. RULE 12B-1 DIRECTORS/TRUSTEES While the Plan is in effect, the selection and nomination of the Directors/Trustees shall be committed to the discretion of the Rule 12b-1 Directors/Trustees. 9. RECORDS The Fund shall preserve copies of the Plan and any related agreements and all reports made pursuant to Section 4 hereof, for a period of not less than six years from the date of effectiveness of the Plan, such agreements or reports, and for at least the first two years in an easily accessible place. Dated: June 1, 1998 6 EX-99.15(B) 10 EXHIBIT 99.15(B) Prudential Government Income Fund, Inc. Amended and Restated Distribution and Service Plan (CLASS B SHARES) INTRODUCTION The Distribution and Service Plan (the Plan) set forth below which is designed to conform to the requirements of Rule 12b-1 under the Investment Company Act of 1940 (the Investment Company Act) and Rule 2830 of the Conduct Rules of the National Association of Securities Dealers, Inc. (NASD) has been adopted by Prudential Government Income Fund, Inc. (the Fund) and by Prudential Investment Management Services LLC, the Fund's distributor (the Distributor). The Fund has entered into a distribution agreement pursuant to which the Fund will employ the Distributor to distribute Class B shares issued by the Fund (Class B shares). Under the Plan, the Fund wishes to pay to the Distributor, as compensation for its services, a distribution and service fee with respect to Class B shares. A majority of the Board of Directors/Trustees of the Fund, including a majority who are not "interested persons" of the Fund (as defined in the Investment Company Act) and who have no direct or indirect financial interest in the operation of this Plan or any agreements related to it (the Rule 12b-1 Directors/Trustees), have determined by votes cast in person at a meeting called for the purpose of voting on this Plan that there is a reasonable likelihood that adoption and continuation of this Plan will benefit the Fund and its shareholders. Expenditures under this Plan by the Fund for Distribution Activities (defined below) are primarily intended to result in the sale of Class B shares 1 of the Fund within the meaning of paragraph (a)(2) of Rule 12b-1 promulgated under the Investment Company Act. The purpose of the Plan is to create incentives to the Distributor and/or other qualified broker-dealers and their account executives to provide distribution assistance to their customers who are investors in the Fund, to defray the costs and expenses associated with the preparation, printing and distribution of prospectuses and sales literature and other promotional and distribution activities and to provide for the servicing and maintenance of shareholder accounts. THE PLAN The material aspects of the Plan are as follows: 1. DISTRIBUTION ACTIVITIES The Fund shall engage the Distributor to distribute Class B shares of the Fund and to service shareholder accounts using all of the facilities of the Distributor's distribution network including sales personnel and branch office and central support systems, and also using such other qualified broker-dealers and financial institutions as the Distributor may select, including Prudential Securities Incorporated (Prudential Securities) and Pruco Securities Corporation (Prusec). Services provided and activities undertaken to distribute Class B shares of the Fund are referred to herein as "Distribution Activities." 2. PAYMENT OF SERVICE FEE The Fund shall pay to the Distributor as compensation for providing personal service and/or maintaining shareholder accounts a service fee of .25 of 1% per annum of the average daily net assets of the Class B shares (service fee). The Fund shall 2 calculate and accrue daily amounts payable by the Class B shares of the Fund hereunder and shall pay such amounts monthly or at such other intervals as the Board of Directors/Trustees may determine. 3. PAYMENT FOR DISTRIBUTION ACTIVITIES The Fund shall pay to the Distributor as compensation for its services a distribution fee of .75 of 1% per annum of the average daily net assets of the Class B shares of the Fund for the performance of Distribution Activities. The Fund shall calculate and accrue daily amounts payable by the Class B shares of the Fund hereunder and shall pay such amounts monthly or at such other intervals as the Board of Directors/Trustees may determine. Amounts payable under the Plan shall be subject to the limitations of Rule 2830 of the NASD Conduct Rules. Amounts paid to the Distributor by the Class B shares of the Fund will not be used to pay the distribution expenses incurred with respect to any other class of shares of the Fund except that distribution expenses attributable to the Fund as a whole will be allocated to the Class B shares according to the ratio of the sale of Class B shares to the total sales of the Fund's shares over the Fund's fiscal year or such other allocation method approved by the Board of Directors/Trustees. The allocation of distribution expenses among classes will be subject to the review of the Board of Directors/Trustees. Payments hereunder will be applied to distribution expenses in the order in which they are incurred, unless otherwise determined by the Board of Directors/Trustees. The Distributor shall spend such amounts as it deems appropriate on Distribution Activities which include, among others: 3 (a) sales commissions (including trailer commissions) paid to, or on account of, account executives of the Distributor; (b) indirect and overhead costs of the Distributor associated with performance of Distribution Activities including central office and branch expenses; (c) amounts paid to Prudential Securities or Prusec for performing services under a selected dealer agreement between Prudential Securities or Prusec and the Distributor for sale of Class B shares of the Fund, including sales commissions and trailer commissions paid to, or on account of, agents and indirect and overhead costs associated with Distribution Activities; (d) advertising for the Fund in various forms through any available medium, including the cost of printing and mailing Fund prospectuses, statements of additional information and periodic financial reports and sales literature to persons other than current shareholders of the Fund; and (e) sales commissions (including trailer commissions) paid to, or on account of, broker-dealers and other financial institutions (other than Prudential Securities or Prusec) which have entered into selected dealer agreements with the Distributor with respect to Class B shares of the Fund. 4. QUARTERLY REPORTS; ADDITIONAL INFORMATION An appropriate officer of the Fund will provide to the Board of Directors/Trustees of the Fund for review, at least quarterly, a written report specifying in reasonable detail the amounts expended for Distribution Activities (including payment of the service fee) and the purposes for which such expenditures were made in compliance with the requirements of Rule 12b-1. The Distributor will provide to the Board of Directors/Trustees of the Fund such additional information as they shall from time to time reasonably request, including information about Distribution Activities undertaken or to be undertaken by the Distributor. 4 The Distributor will inform the Board of Directors/Trustees of the Fund of the commissions and account servicing fees to be paid by the Distributor to account executives of the Distributor and to broker-dealers and other financial institutions which have selected dealer agreements with the Distributor. 5. EFFECTIVENESS; CONTINUATION The Plan shall not take effect until it has been approved by a vote of a majority of the outstanding voting securities (as defined in the Investment Company Act) of the Class B shares of the Fund. If approved by a vote of a majority of the outstanding voting securities of the Class B shares of the Fund, the Plan shall, unless earlier terminated in accordance with its terms, continue in full force and effect thereafter for so long as such continuance is specifically approved at least annually by a majority of the Board of Directors/Trustees of the Fund and a majority of the Rule 12b-1 Directors/Trustees by votes cast in person at a meeting called for the purpose of voting on the continuation of the Plan. 6. TERMINATION This Plan may be terminated at any time by vote of a majority of the Rule 12b-1 Directors/Trustees, or by vote of a majority of the outstanding voting securities (as defined in the Investment Company Act) of the Class B shares of the Fund. 7. AMENDMENTS The Plan may not be amended to change the combined service and distribution expenses to be paid as provided for in Sections 2 and 3 hereof so as to increase materially the amounts payable under this Plan unless such amendment shall be 5 approved by the vote of a majority of the outstanding voting securities (as defined in the Investment Company Act) of the Class B shares of the Fund. All material amendments of the Plan shall be approved by a majority of the Board of Directors/Trustees of the Fund and a majority of the Rule 12b-1 Directors/Trustees by votes cast in person at a meeting called for the purpose of voting on the Plan. 8. RULE 12B-1 DIRECTORS/TRUSTEES While the Plan is in effect, the selection and nomination of the Rule 12b-1 Directors/Trustees shall be committed to the discretion of the Rule 12b-1 Directors/Trustees. 9. RECORDS The Fund shall preserve copies of the Plan and any related agreements and all reports made pursuant to Section 4 hereof, for a period of not less than six years from the date of effectiveness of the Plan, such agreements or reports, and for at least the first two years in an easily accessible place. Dated:June 1, 1998 6 EX-99.15(C) 11 EXHIBIT 99.15(C) Prudential Government Income Fund, Inc. Distribution and Service Plan (CLASS C SHARES) INTRODUCTION The Distribution and Service Plan (the Plan) set forth below which is designed to conform to the requirements of Rule 12b-1 under the Investment Company Act of 1940 (the Investment Company Act) and Rule 2830 of the Conduct Rules of the National Association of Securities Dealers, Inc. (NASD) has been adopted by Prudential Government Income Fund, Inc.(the Fund) and by Prudential Investment Management Services LLC, the Fund's distributor (the Distributor). The Fund has entered into a distribution agreement pursuant to which the Fund will employ the Distributor to distribute Class C shares issued by the Fund (Class C shares). Under the Plan, the Fund wishes to pay to the Distributor, as compensation for its services, a distribution and service fee with respect to Class C shares. A majority of the Board of Directors/Trustees of the Fund, including a majority who are not "interested persons" of the Fund (as defined in the Investment Company Act) and who have no direct or indirect financial interest in the operation of this Plan or any agreements related to it (the Rule 12b-1 Directors/Trustees), have determined by votes cast in person at a meeting called for the purpose of voting on this Plan that there is a reasonable likelihood that adoption and continuation of this Plan will benefit the Fund and its shareholders. Expenditures under this Plan by the Fund for Distribution Activities (defined below) are primarily intended to result in the sale of Class C shares of the Fund within the meaning of paragraph (a)(2) of Rule 12b-1 promulgated under 1 the Investment Company Act. The purpose of the Plan is to create incentives to the Distributor and/or other qualified broker-dealers and their account executives to provide distribution assistance to their customers who are investors in the Fund, to defray the costs and expenses associated with the preparation, printing and distribution of prospectuses and sales literature and other promotional and distribution activities and to provide for the servicing and maintenance of shareholder accounts. THE PLAN The material aspects of the Plan are as follows: 1. DISTRIBUTION ACTIVITIES The Fund shall engage the Distributor to distribute Class C shares of the Fund and to service shareholder accounts using all of the facilities of the Distributor's distribution network including sales personnel and branch office and central support systems, and also using such other qualified broker-dealers and financial institutions as the Distributor may select, including Prudential Securities Incorporated (Prudential Securities) and Pruco Securities Corporation (Prusec). Services provided and activities undertaken to distribute Class C shares of the Fund are referred to herein as "Distribution Activities." 2. PAYMENT OF SERVICE FEE The Fund shall pay to the Distributor as compensation for providing personal service and/or maintaining shareholder accounts a service fee of .25 of 1% per annum of the average daily net assets of the Class C shares (service fee). The Fund shall calculate and accrue daily amounts payable by the Class C shares of the Fund 2 hereunder and shall pay such amounts monthly or at such other intervals as the Board of Directors/Trustees may determine. 3. PAYMENT FOR DISTRIBUTION ACTIVITIES The Fund shall pay to the Distributor as compensation for its services a distribution fee of .75 of 1% per annum of the average daily net assets of the Class C shares of the Fund for the performance of Distribution Activities. The Fund shall calculate and accrue daily amounts payable by the Class C shares of the Fund hereunder and shall pay such amounts monthly or at such other intervals as the Board of Directors/Trustees may determine. Amounts payable under the Plan shall be subject to the limitations of Rule 2830 of the NASD Conduct Rules. Amounts paid to the Distributor by the Class C shares of the Fund will not be used to pay the distribution expenses incurred with respect to any other class of shares of the Fund except that distribution expenses attributable to the Fund as a whole will be allocated to the Class C shares according to the ratio of the sale of Class C shares to the total sales of the Fund's shares over the Fund's fiscal year or such other allocation method approved by the Board of Directors/Trustees. The allocation of distribution expenses among classes will be subject to the review of the Board of Directors/Trustees. Payments hereunder will be applied to distribution expenses in the order in which they are incurred, unless otherwise determined by the Board of Directors/Trustees. The Distributor shall spend such amounts as it deems appropriate on Distribution Activities which include, among others: (a) sales commissions (including trailer commissions) paid to, or on 3 account of, account executives of the Distributor; (b) indirect and overhead costs of the Distributor associated with performance of Distribution Activities including central office and branch expenses; (c) amounts paid to Prudential Securities or Prusec for performing services under a selected dealer agreement between Prudential Securities or Prusec and the Distributor for sale of Class C shares of the Fund, including sales commissions and trailer commissions paid to, or on account of, agents and indirect and overhead costs associated with Distribution Activities; (d) advertising for the Fund in various forms through any available medium, including the cost of printing and mailing Fund prospectuses, statements of additional information and periodic financial reports and sales literature to persons other than current shareholders of the Fund; and (e) sales commissions (including trailer commissions) paid to, or on account of, broker-dealers and other financial institutions (other than Prudential Securities or Prusec) which have entered into selected dealer agreements with the Distributor with respect to Class C shares of the Fund. 4. QUARTERLY REPORTS; ADDITIONAL INFORMATION An appropriate officer of the Fund will provide to the Board of Directors/Trustees of the Fund for review, at least quarterly, a written report specifying in reasonable detail the amounts expended for Distribution Activities (including payment of the service fee) and the purposes for which such expenditures were made in compliance with the requirements of Rule 12b-1. The Distributor will provide to the Board of Directors/Trustees of the Fund such additional information as they shall from time to time reasonably request, including information about Distribution Activities undertaken or to be undertaken by the Distributor. The Distributor will inform the Board of Directors/Trustees of the Fund of the 4 commissions and account servicing fees to be paid by the Distributor to account executives of the Distributor and to broker-dealers and other financial institutions which have selected dealer agreements with the Distributor. 5. EFFECTIVENESS; CONTINUATION The Plan shall not take effect until it has been approved by a vote of a majority of the outstanding voting securities (as defined in the Investment Company Act) of the Class C shares of the Fund. If approved by a vote of a majority of the outstanding voting securities of the Class C shares of the Fund, the Plan shall, unless earlier terminated in accordance with its terms, continue in full force and effect thereafter for so long as such continuance is specifically approved at least annually by a majority of the Board of Directors/Trustees of the Fund and a majority of the Rule 12b-1 Directors/Trustees by votes cast in person at a meeting called for the purpose of voting on the continuation of the Plan. 6. TERMINATION This Plan may be terminated at any time by vote of a majority of the Rule 12b-1 Directors/Trustees, or by vote of a majority of the outstanding voting securities (as defined in the Investment Company Act) of the Class C shares of the Fund. 7. AMENDMENTS The Plan may not be amended to change the combined service and distribution expenses to be paid as provided for in Sections 2 and 3 hereof so as to increase materially the amounts payable under this Plan unless such amendment shall be approved by the vote of a majority of the outstanding voting securities (as defined in the 5 Investment Company Act) of the Class C shares of the Fund. All material amendments of the Plan shall be approved by a majority of the Board of Directors/Trustees of the Fund and a majority of the Rule 12b-1 Directors/Trustees by votes cast in person at a meeting called for the purpose of voting on the Plan. 8. RULE 12B-1 DIRECTORS/TRUSTEES While the Plan is in effect, the selection and nomination of the Rule 12b-1 Directors/Trustees shall be committed to the discretion of the Rule 12b-1 Directors/Trustees. 9. RECORDS The Fund shall preserve copies of the Plan and any related agreements and all reports made pursuant to Section 4 hereof, for a period of not less than six years from the date of effectiveness of the Plan, such agreements or reports, and for at least the first two years in an easily accessible place. Dated:June 1, 1998 6 EX-99.17(A) 12 EXHIBIT 99.17(A) [LOGO] EXHIBIT 99.17(a) PROXY PRUDENTIAL MORTGAGE INCOME FUND, INC. GATEWAY CENTER THREE 100 MULBERRY STREET NEWARK, NEW JERSEY 07102-4077 THIS PROXY IS SOLICITED ON BEHALF OF THE BOARD OF DIRECTORS The undersigned hereby appoints S. Jane Rose, Deborah A. Docs and Grace Torres as Proxies, each with the power of substitution, and hereby authorizes each of them to represent and to vote, as designated below, all the shares of Prudential Mortgage Income Fund, Inc., held of record by the undersigned on October 15, 1998, at the Special Meeting of Shareholders to be held on December 3, 1998, or any adjournment thereof. THE BOARD OF DIRECTORS RECOMMENDS A VOTE "FOR" THE FOLLOWING PROPOSAL. 1. Approval or disapproval of the Agreement and Plan of Reorganization and Liquidation. / / APPROVE / / DISAPPROVE / / ABSTAIN 2. IN THEIR DISCRETION, THE PROXIES ARE AUTHORIZED TO VOTE UPON SUCH OTHER BUSINESS AS MAY PROPERLY COME BEFORE THE MEETING. (over) 1 (Continued from other side) PLEASE MARK, SIGN, DATE AND RETURN THE PROXY CARD PROMPTLY, USING THE ENCLOSED ENVELOPE. THIS PROXY WHEN EXECUTED WILL BE VOTED IN THE MANNER DESCRIBED HEREIN BY THE UNDERSIGNED SHAREHOLDER. IF EXECUTED AND NO DIRECTION IS MADE, THIS PROXY WILL BE VOTED FOR PROPOSAL 1. Please sign exactly as name appears below. When shares are held by joint tenants, both should sign. When signing as attorney, executor, administrator, trustee or guardian, please give full title as such. If a corporation, please sign in full corporate name by president or other authorized officer. If a partnership, please sign in partnership name by authorized person. Dated , 1998 ------------------ ----------------------------- Signature ----------------------------- Signature if held jointly EX-99.17(B) 13 PROS DATED APRIL 30, 1998 PRUDENTIAL GOVERNMENT INCOME FUND, INC. - ------------------------------------ PROSPECTUS DATED APRIL 30, 1998 - ---------------------------------------------------------------- Prudential Government Income Fund, Inc. (the Fund), is an open-end, diversified, management investment company, or mutual fund, which has as its investment objective the seeking of a high current return. The Fund will seek to achieve this objective primarily by investing in U.S. Government securities, including U.S. Treasury Bills, Notes, Bonds and other debt securities issued by the U.S. Treasury, and obligations issued or guaranteed by U.S. Government agencies or instrumentalities, and by engaging in various derivative transactions such as the purchase and sale of put and call options. In an effort to hedge against changes in interest rates and thus preserve its capital, the Fund may also engage in transactions involving futures contracts on U.S. Government securities and options on such futures. See "How the Fund Invests--Investment Objective and Policies." There can be no assurance that the Fund's investment objective will be achieved. The Fund's address is Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077, and its telephone number is (800) 225-1852. This Prospectus sets forth concisely the information about the Fund that a prospective investor should know before investing and is available at the Web site of the Prudential Insurance Company of America (http://www.prudential.com). Additional information about the Fund has been filed with the Securities and Exchange Commission (the Commission) in a Statement of Additional Information, dated April 30, 1998, which information is incorporated herein by reference (is legally considered a part of this Prospectus) and is available without charge upon request to the Fund at the address or telephone number noted above. The Commission maintains a Web site (http://www.sec.gov) that contains the Statement of Additional Information, material incorporated by reference and other information regarding the Fund. - -------------------------------------------------------------------------------- INVESTORS ARE ADVISED TO READ THIS PROSPECTUS AND RETAIN IT FOR FUTURE REFERENCE. - -------------------------------------------------------------------------------- THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION NOR HAS THE COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. FUND HIGHLIGHTS The following summary is intended to highlight certain information contained in this Prospectus and is qualified in its entirety by the more detailed information appearing elsewhere herein. WHAT IS PRUDENTIAL GOVERNMENT INCOME FUND, INC.? Prudential Government Income Fund, Inc. is a mutual fund. A mutual fund pools the resources of investors by selling its shares to the public and investing the proceeds of such sale in a portfolio of securities designed to achieve its investment objective. Technically, the Fund is an open-end, diversified, management investment company. WHAT IS THE FUND'S INVESTMENT OBJECTIVE? The Fund's investment objective is to seek a high current return. The Fund seeks to achieve its objective primarily by investing in U.S. Government securities, including U.S. Treasury Bills, Notes, Bonds, and other debt securities issued by the U.S. Treasury, and obligations issued or guaranteed by U.S. Government agencies or instrumentalities. The Fund may also write covered call options and covered put options and purchase put and call options. There can be no assurance that the Fund's investment objective will be achieved. See "How the Fund Invests--Investment Objective and Policies" at page 9. WHAT ARE THE FUND'S RISK FACTORS AND SPECIAL CHARACTERISTICS? The Fund may engage in short selling and use leverage, including reverse repurchase agreements, dollar rolls and bank borrowings, which entail additional risks to the Fund. See "How the Fund Invests--Other Investment Information" at page 15. The Fund may also engage in various hedging and income enhancement strategies, including derivative transactions such as the purchase and sale of put and call options on U.S. Government securities, transactions involving futures contracts on U.S. Government securities and options on such futures contracts and in interest rate swap transactions. See "How the Fund Invests--Other Investments and Policies" at page 11. As with an investment in any mutual fund, an investment in this Fund can decrease in value and you can lose money. WHO MANAGES THE FUND? Prudential Investments Fund Management LLC (PIFM or the Manager) is the Manager of the Fund and is compensated for its services at an annual rate of .50 of 1% of the Fund's average daily net assets up to $3 billion and .35 of 1% of the average daily net assets in excess of $3 billion. As of March 31, 1998, PIFM served as manager or administrator to 65 investment companies, including 43 mutual funds, with aggregate assets of approximately $64.8 billion. The Prudential Investment Corporation (PIC), doing business as Prudential Investments (the Subadviser), furnishes investment advisory services in connection with the management of the Fund under a Subadvisory Agreement with PIFM. See "How the Fund is Managed--Manager" at page 17. WHO DISTRIBUTES THE FUND'S SHARES? Prudential Securities Incorporated (Prudential Securities or the Distributor), a major securities underwriter and securities and commodities broker, acts as the Distributor of the Fund's shares. The Distributor is paid an annual distribution and service fee which is currently being charged at an annual rate of .15 of 1% of the average daily net assets of the Class A shares, at an annual rate of .825 of 1% of the average daily net assets of the Class B shares and at an annual rate of .75 of 1% of the average daily net assets of the Class C shares. The Distributor incurs the expense of distributing the Fund's Class Z shares under a Distribution Agreement with the Fund, none of which is reimbursed or paid for by the Fund. See "How the Fund is Managed--Distributor" at page 18. 2 WHAT IS THE MINIMUM INVESTMENT? The minimum initial investment is $1,000 for Class A and Class B shares per class and $5,000 for Class C shares. The minimum subsequent investment is $100 for Class A, Class B and Class C shares. Class Z shares are not subject to any minimum investment requirements. There is no minimum investment requirement for certain retirement and employee savings plans or custodial accounts for the benefit of minors. For purchases made through the Automatic Savings Accumulation Plan, the minimum initial and subsequent investment is $50. See "Shareholder Guide--How to Buy Shares of the Fund" at page 24 and "Shareholder Guide--Shareholder Services" at page 33. HOW DO I PURCHASE SHARES? You may purchase shares of the Fund through Prudential Securities, Pruco Securities Corporation (Prusec) or directly from the Fund, through its transfer agent, Prudential Mutual Fund Services LLC (PMFS or the Transfer Agent) at the net asset value per share (NAV) next determined after receipt of your purchase order by the Transfer Agent or Prudential Securities plus a sales charge which may be imposed either (i) at the time of purchase (Class A shares) or (ii) on a deferred basis (Class B or Class C shares). Class Z shares are offered to a limited group of investors at NAV without any sales charge. See "How the Fund Values its Shares" at page 20 and "Shareholder Guide--How to Buy Shares of the Fund" at page 24. WHAT ARE MY PURCHASE ALTERNATIVES? The Fund offers four classes of shares: - Class A Shares: Sold with an initial sales charge of up to 4% of the offering price. - Class B Shares: Sold without an initial sales charge but are subject to a contingent deferred sales charge or CDSC (declining from 5% to zero of the lower of the amount invested or the redemption proceeds) which will be imposed on certain redemptions made within six years of purchase. Although Class B shares are subject to higher ongoing distribution-related expenses than Class A shares, Class B shares will automatically convert to Class A shares (which are subject to lower ongoing distribution-related expenses) approximately seven years after purchase. - Class C Shares: Sold without an initial sales charge and for one year after purchase, are subject to a 1% CDSC on redemptions. Class C shares are subject to higher ongoing distribution-related expenses than Class A shares but, unlike Class B shares, do not convert to another class. - Class Z Shares: Sold without either an initial sales charge or CDSC to a limited group of investors. Class Z shares are not subject to any ongoing service or distribution expenses. See "Shareholder Guide--Alternative Purchase Plan" at page 25. HOW DO I SELL MY SHARES? You may redeem your shares at any time at the NAV next determined after Prudential Securities or the Transfer Agent receives your sell order. However, the proceeds of redemptions of Class B and Class C shares may be subject to a CDSC. See "Shareholder Guide--How to Sell Your Shares" at page 28. Participants in programs sponsored by Prudential Retirement Services should contact their client representative for more information about selling their Class Z shares. HOW ARE DIVIDENDS AND DISTRIBUTIONS PAID? The Fund expects to declare daily and pay monthly dividends of net investment income and make distributions of any net capital gains at least annually. Dividends and distributions will be automatically reinvested in additional shares of the Fund at NAV without a sales charge unless you request that they be paid to you in cash. See "Taxes, Dividends and Distributions" at page 21. 3 FUND EXPENSES
CLASS A SHARES CLASS B SHARES CLASS C SHARES CLASS Z SHARES -------------- ------------------------------ --------------------------- -------------- SHAREHOLDER TRANSACTION EXPENSES+ Maximum Sales Load Imposed on Purchases (as a percentage of offering price)..................... 4% None None None Maximum Sales Load Imposed on Reinvested Dividends.... None None None None Maximum Deferred Sales Load (as a percentage of original purchase price or redemption proceeds, whichever is lower)........ None 5% during the first year, 1% on redemptions made None decreasing by within one year of purchase 1% annually to 1% in the fifth and sixth years and 0% in the seventh year* Redemption Fees............. None None None None Exchange Fee................ None None None None
CLASS A SHARES CLASS B SHARES CLASS C SHARES CLASS Z SHARES -------------- -------------- -------------- --------------- ANNUAL FUND OPERATING EXPENSES (as a percentage of average net assets) Management Fees..................... .50% .50% .50% .50% 12b-1 Fees (After Reduction)........ .15%++ .825%++ .75%++ None Other Expenses...................... .21% .21% .21% .21% --- ----- --- --- Total Fund Operating Expenses (After Reduction)......................... .86% 1.535% 1.46% .71% --- ----- --- --- --- ----- --- ---
1 YEAR 3 YEARS 5 YEARS 10 YEARS ------ ------- ------- -------- EXAMPLE You would pay the following expenses on a $1,000 investment, assuming (1) 5% annual return and (2) redemption at the end of each time period: Class A............................. $48 $66 $ 86 $142 Class B............................. $66 $78 $ 94 $156 Class C............................. $25 $46 $ 80 $175 Class Z............................. $ 7 $23 $ 40 $ 88 You would pay the following expenses on the same investment, assuming no redemption: Class A............................. $48 $66 $ 86 $142 Class B............................. $16 $48 $ 84 $156 Class C............................. $15 $46 $ 80 $175 Class Z............................. $ 7 $23 $ 40 $ 88
The above example is based on data for the Fund's fiscal year ended February 28, 1998. THE EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF PAST OR FUTURE EXPENSES. ACTUAL EXPENSES MAY BE GREATER OR LESS THAN THOSE SHOWN. The purpose of this table is to assist investors in understanding the various costs and expenses that an investor in the Fund will bear, whether directly or indirectly. For more complete descriptions of the various costs and expenses, see "How the Fund is Managed." "Other Expenses" include operating expenses of the Fund, such as Directors' and professional fees, registration fees, reports to shareholders and transfer agency and custodian fees. - --------------- * Class B shares will automatically convert to Class A shares approximately seven years after purchase. See "Shareholder Guide--Conversion Feature-- Class B Shares." + Pursuant to rules of the National Association of Securities Dealers, Inc., the aggregate initial sales charges, deferred sales charges and asset-based sales charges on shares of the Fund may not exceed 6.25% of total gross sales, subject to certain exclusions. This 6.25% limitation is imposed on each class of the Fund rather than on a per shareholder basis. Therefore, long-term shareholders of the Fund may pay more in total sales charges than the economic equivalent of 6.25% of such shareholders' investment in such shares. See "How the Fund is Managed--Distributor." ++ Although the Class A, Class B and Class C Distribution and Service Plans provide that the Fund may pay a distribution fee of up to .30 of 1% per annum of the average daily net assets of the Class A shares, up to 1% per annum of the average daily net assets of the Class B shares up to $3 billion, .80 of 1% of the next $1 billion, and .50 of 1% of assets in excess of $4 billion, and up to 1% of the Class C shares, the Distributor has agreed to limit its distribution fees with respect to Class A shares of the Fund to no more than .15 of 1% of the average daily net assets of the Class A shares, to no more than .825 of 1% of the average daily net assets of the Class B shares and to no more than .75 of 1% of the average daily net assets of the Class C shares for the fiscal year ending February 28, 1999. Total Fund Operating Expenses without such limitations would be 1.01% for Class A shares and 1.71% for Class B and Class C shares. See "How the Fund is Managed--Distributor." 4 FINANCIAL HIGHLIGHTS (FOR A SHARE OUTSTANDING THROUGHOUT EACH OF THE PERIODS INDICATED) (CLASS A SHARES) The following financial highlights for the fiscal year ended February 28, 1998, have been audited by PricewaterhouseCoopers LLP, independent accountants, and by Deloitte & Touche LLP, independent auditors, for the periods ended February 28, 1997. Each of the respective reports by PricewaterhouseCoopers LLP and Deloitte & Touche LLP on such financial highlights were unqualified. This information should be read in conjunction with the financial statements and the notes thereto, which appear in the Statement of Additional Information. The financial highlights contain selected data for a Class A share of common stock outstanding, total return, ratios to average net assets and other supplemental data for the periods indicated. The information has been determined based on data contained in the financial statements. Further performance information is contained in the annual report, which may be obtained without charge. See "Shareholder Guide--Shareholder Services--Reports to Shareholders."
CLASS A ---------------------------------------------------------------------------------------- JANUARY 22, 1990(a) YEARS ENDED FEBRUARY 28/29, THROUGH -------------------------------------------------------------------------- FEBRUARY 28, 1998 1997 1996 1995 1994 1993 1992 1991 1990 -------- -------- -------- -------- -------- ------- ------- ------- ------------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period.... $ 8.76 $ 9.04 $ 8.59 $ 9.13 $ 9.40 $ 9.17 $ 9.02 $ 9.00 $ 9.17 -------- -------- -------- -------- -------- ------- ------- ------- ------ INCOME FROM INVESTMENT OPERATIONS Net investment income................... 0.58 0.60 0.60 0.59 0.61 0.66 0.68 0.69 0.06 Net realized and unrealized gain (loss) on investment transactions............ 0.29 (0.28) 0.45 (0.54) (0.25) 0.35 0.37 0.26 (0.11) -------- -------- -------- -------- -------- ------- ------- ------- ------ Total from investment operations........ 0.87 0.32 1.05 0.05 0.36 1.01 1.05 0.95 (0.05) -------- -------- -------- -------- -------- ------- ------- ------- ------ LESS DISTRIBUTIONS Dividends from net investment income.... (0.58) (0.60) (0.60) (0.59) (0.61) (0.66) (0.68) (0.69) (0.06) Distributions in excess of accumulated gains................................. -- -- -- -- (0.02) -- -- -- -- Distributions from paid-in capital in excess of par......................... -- -- -- -- -- (0.12) (0.22) (0.24) (0.06) -------- -------- -------- -------- -------- ------- ------- ------- ------ Total distributions..................... (0.58) (0.60) (0.60) (0.59) (0.63) (0.78) (0.90) (0.93) (0.12) -------- -------- -------- -------- -------- ------- ------- ------- ------ Net asset value, end of period.......... $ 9.05 $ 8.76 $ 9.04 $ 8.59 $ 9.13 $ 9.40 $ 9.17 $ 9.02 $ 9.00 -------- -------- -------- -------- -------- ------- ------- ------- ------ -------- -------- -------- -------- -------- ------- ------- ------- ------ TOTAL RETURN(B):........................ 10.26% 3.70% 12.41% .83% 3.90% 11.55% 12.18% 11.21% (0.54)% RATIOS/SUPPLEMENTAL DATA: Net assets, end of period (000)......... $819,536 $860,319 $945,038 $871,145 $ 51,673 $61,297 $33,181 $28,971 $1,961 Average net assets (000)................ $842,431 $884,862 $909,169 $ 95,560 $ 55,921 $46,812 $29,534 $23,428 $ 501 Ratios to average net assets: Expenses, including distribution fees................................. 0.86% 0.90% 0.91% 0.98% 0.84% 0.84% 0.86% 0.85% 0.92%(c) Expenses, excluding distribution fees................................. 0.71% 0.75% 0.76% 0.83% 0.69% 0.69% 0.71% 0.70% 0.76%(c) Net investment income................. 6.52% 6.78% 6.65% 7.45% 6.48% 7.17% 7.51% 7.76% 9.11%(c) Portfolio turnover rate................. 88% 107% 123% 206% 80% 36% 187% 213% 329%
- --------------- (a) Commencement of offering of Class A shares. (b) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. Total returns for periods of less than a full year are not annualized. (c) Annualized. 5 FINANCIAL HIGHLIGHTS (FOR A SHARE OUTSTANDING THROUGHOUT EACH OF THE YEARS INDICATED) (CLASS B SHARES) The following financial highlights, for the fiscal year ended February 28, 1998, have been audited by PricewaterhouseCoopers LLP, independent accountants, and by Deloitte & Touche LLP, independent auditors, for the periods ended February 28, 1997. Each of the respective reports by PricewaterhouseCoopers LLP and Deloitte & Touche LLP on such financial highlights were unqualified. This information should be read in conjunction with the financial statements and the notes thereto, which appear in the Statement of Additional Information. The financial highlights contain selected data for a Class B share of common stock outstanding, total return, ratios to average net assets and other supplemental data for the years indicated. This information has been determined based on data contained in the financial statements. Further performance information is contained in the annual report, which may be obtained without charge. See "Shareholder Guide--Shareholder Services--Reports to Shareholders."
CLASS B --------------------------------------------------------------------- YEARS ENDED FEBRUARY 28/29, --------------------------------------------------------------------- 1998 1997 1996 1995 1994 1993 -------- -------- -------- ---------- ---------- ---------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of year................ $ 8.77 $ 9.04 $ 8.60 $ 9.13 $ 9.40 $ 9.17 -------- -------- -------- ---------- ---------- ---------- INCOME FROM INVESTMENT OPERATIONS Net investment income............................. 0.52 0.54 0.54 0.53 0.53 0.58 Net realized and unrealized gain (loss) on investment transactions......................... 0.28 (0.27) 0.44 (0.53) (0.25) 0.35 -------- -------- -------- ---------- ---------- ---------- Total from investment operations.................. 0.80 0.27 0.98 -- 0.28 0.93 -------- -------- -------- ---------- ---------- ---------- LESS DISTRIBUTIONS Dividends from net investment income.............. (0.52) (0.54) (0.54) (0.53) (0.53) (0.58) Distributions in excess of accumulated gains...... -- -- -- -- (0.02) -- Distributions from paid-in capital in excess of par............................................. -- -- -- -- -- (0.12) -------- -------- -------- ---------- ---------- ---------- Total distributions............................... (0.52) (0.54) (0.54) (0.53) (0.55) (0.70) -------- -------- -------- ---------- ---------- ---------- Net asset value, end of year...................... $ 9.05 $ 8.77 $ 9.04 $ 8.60 $ 9.13 $ 9.40 -------- -------- -------- ---------- ---------- ---------- -------- -------- -------- ---------- ---------- ---------- TOTAL RETURN:(A).................................. 9.40% 3.12% 11.54% .24% 3.03% 10.61% RATIOS/SUPPLEMENTAL DATA: Net assets, end of year (000)..................... $346,059 $461,988 $641,946 $ 705,732 $2,202,555 $2,680,259 Average net assets (000).......................... $385,145 $543,796 $647,515 $1,735,413 $2,487,990 $2,670,924 Ratios to average net assets: Expenses, including distribution fees........... 1.53% 1.57% 1.58% 1.66% 1.68% 1.69% Expenses, excluding distribution fees........... 0.71% 0.75% 0.76% 0.80% 0.69% 0.69% Net investment income........................... 5.85% 6.11% 5.99% 6.17% 5.64% 6.32% Portfolio turnover rate........................... 88% 107% 123% 206% 80% 36% 1992 1991 1990 1989 ---------- ---------- ---------- ---------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of year................ $ 9.02 $ 9.00 $ 9.09 $ 9.85 ---------- ---------- ---------- ---------- INCOME FROM INVESTMENT OPERATIONS Net investment income............................. 0.60 0.62 0.68 0.69 Net realized and unrealized gain (loss) on investment transactions......................... 0.37 0.26 0.15 (0.49) ---------- ---------- ---------- ---------- Total from investment operations.................. 0.97 0.88 0.83 0.20 ---------- ---------- ---------- ---------- LESS DISTRIBUTIONS Dividends from net investment income.............. (0.60) (0.62) (0.68) (0.69) Distributions in excess of accumulated gains...... -- -- -- -- Distributions from paid-in capital in excess of par............................................. (0.22) (0.24) (0.24) (0.27) ---------- ---------- ---------- ---------- Total distributions............................... (0.82) (0.86) (0.92) (0.96) ---------- ---------- ---------- ---------- Net asset value, end of year...................... $ 9.17 $ 9.02 $ 9.00 $ 9.09 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- TOTAL RETURN:(A).................................. 11.27% 10.35% 10.49% 2.32% RATIOS/SUPPLEMENTAL DATA: Net assets, end of year (000)..................... $2,724,428 $3,127,587 $3,760,003 $3,814,945 Average net assets (000).......................... $2,903,704 $3,432,948 $3,814,455 $3,984,300 Ratios to average net assets: Expenses, including distribution fees........... 1.71% 1.67% 1.49% 1.35% Expenses, excluding distribution fees........... 0.71% 0.70% 0.64% 0.63% Net investment income........................... 6.66% 6.94% 7.46% 7.61% Portfolio turnover rate........................... 187% 213% 329% 278%
- ----------------- (a) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each year reported and includes reinvestment of dividends and distributions. 6 FINANCIAL HIGHLIGHTS (FOR A SHARE OUTSTANDING THROUGHOUT EACH OF THE PERIODS INDICATED) (CLASS C SHARES) The following financial highlights, for the fiscal year ended February 28, 1998, have been audited by PricewaterhouseCoopers LLP, independent accountants, and by Deloitte & Touche LLP, independent auditors, for the period ended February 28, 1997. Each of the respective reports by PricewaterhouseCoopers LLP and Deloitte & Touche LLP on such financial highlights were unqualified. This information should be read in conjunction with the financial statements and the notes thereto, which appear in the Statement of Additional Information. The financial highlights contain selected data for a Class C share of common stock outstanding, total return, ratios to average net assets and other supplemental data for the periods indicated. This information has been determined based on data contained in the financial statements. Further performance information is contained in the annual report, which may be obtained without charge. See "Shareholder Guide--Shareholder Services--Reports to Shareholders."
CLASS C --------------------------------------------- AUGUST 1, 1994 (a) YEARS ENDED FEBRUARY 28, THROUGH ----------------------------- FEBRUARY 28, 1998 1997 1996 1995 -------- -------- ------- ------------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period.............. $ 8.77 $ 9.04 $ 8.60 $ 8.69 -------- -------- ------- ----- INCOME FROM INVESTMENT OPERATIONS Net investment income............................. 0.53 0.54 0.54 0.31 Net realized and unrealized gain (loss) on investment transactions......................... 0.28 (0.27) 0.44 (0.09) -------- -------- ------- ----- Total from investment operations.................. 0.81 0.27 0.98 0.22 -------- -------- ------- ----- LESS DISTRIBUTIONS Dividends from net investment income.............. (0.53) (0.54) (0.54) (0.31) -------- -------- ------- ----- Net asset value, end of period.................... $ 9.05 $ 8.77 $ 9.04 $ 8.60 -------- -------- ------- ----- -------- -------- ------- ----- TOTAL RETURN (B):................................. 9.48% 3.20% 11.63% 2.75% RATIOS/SUPPLEMENTAL DATA: Net assets, end of period (000)................... $ 2,840 $ 2,569 $ 1,799 $ 204 Average net assets (000).......................... $ 2,523 $ 2,440 $ 765 $ 111 Ratios to average net assets: Expenses, including distribution fees........... 1.46% 1.50% 1.51% 1.63%(c) Expenses, excluding distribution fees........... 0.71% 0.75% 0.76% 0.88%(c) Net investment income........................... 5.92% 6.19% 5.99% 6.69%(c) Portfolio turnover rate........................... 88% 107% 123% 206%
- ------------ (a) Commencement of offering of Class C shares. (b) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of the period reported and includes reinvestment of dividends and distributions. Total returns for periods of less than a full year are not annualized. (c) Annualized. 7 FINANCIAL HIGHLIGHTS (FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD INDICATED) (CLASS Z SHARES) The following financial highlights, for the fiscal year ended February 28, 1998, have been audited by PricewaterhouseCoopers LLP, independent accountants, and by Deloitte & Touche LLP, independent auditors, for the period from March 1, 1996 through February 28, 1997. Each of the respective reports by PricewaterhouseCoopers LLP and Deloitte & Touche LLP on such financial highlights were unqualified. This information should be read in conjunction with the financial statements and the notes thereto, which appear in the Statement of Additional Information. The financial highlights contain selected data for a Class Z share of common stock outstanding, total return, ratios to average net assets and other supplemental data for the period indicated. This information has been determined based on data contained in the financial statements. Further performance information is contained in the annual report, which may be obtained without charge. See "Shareholder Guide--Shareholder Services--Reports to Shareholders."
CLASS Z ------------------------------- MARCH 1, 1996 (a) YEAR ENDED THROUGH FEBRUARY 28, FEBRUARY 28, 1998 1997 -------------- -------------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period..................... $ 8.76 $ 9.13 ------- ------- INCOME FROM INVESTMENT OPERATIONS Net investment income.................................... 0.59 0.61 Net realized and unrealized gain (loss) on investment transactions........................................... 0.28 (0.37) ------- ------- Total from investment operations......................... 0.87 0.24 ------- ------- LESS DISTRIBUTIONS Dividends from net investment income..................... (0.59) (0.61) ------- ------- Net asset value, end of period........................... $ 9.04 $ 8.76 ------- ------- ------- ------- TOTAL RETURN (B):........................................ 10.30% 3.16% RATIOS/SUPPLEMENTAL DATA: Net assets, end of period (000).......................... $84,733 $73,411 Average net assets (000)................................. $71,425 $39,551 Ratios to average net assets: Expenses............................................... 0.71% 0.75%(c) Net investment income.................................. 6.67% 6.76%(c) Portfolio turnover rate.................................. 88% 107%
- ------------ (a) Commencement of offering of Class Z shares. (b) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of the period reported and includes reinvestment of dividends and distributions. Total returns for periods of less than a full year are not annualized. (c) Annualized. 8 HOW THE FUND INVESTS INVESTMENT OBJECTIVE AND POLICIES THE FUND'S INVESTMENT OBJECTIVE IS TO SEEK A HIGH CURRENT RETURN. THERE CAN BE NO ASSURANCE THAT THE FUND'S INVESTMENT OBJECTIVE WILL BE ACHIEVED. THE FUND WILL SEEK TO ACHIEVE ITS OBJECTIVE PRIMARILY BY INVESTING IN U.S. GOVERNMENT SECURITIES, INCLUDING U.S. TREASURY BILLS, NOTES, BONDS AND OTHER DEBT SECURITIES ISSUED BY THE U.S. TREASURY, AND OBLIGATIONS ISSUED OR GUARANTEED BY U.S. GOVERNMENT AGENCIES OR INSTRUMENTALITIES; WRITING COVERED CALL OPTIONS AND COVERED PUT OPTIONS AND PURCHASING PUT AND CALL OPTIONS. THESE GUARANTEES APPLY ONLY TO THE PAYMENT OF PRINCIPAL AND INTEREST ON THESE SECURITIES AND DO NOT EXTEND TO THE SECURITIES' YIELD OR VALUE, WHICH ARE LIKELY TO VARY WITH FLUCTUATIONS IN INTEREST RATES, NOR DO THE GUARANTEES EXTEND TO THE YIELD OR VALUE OF THE FUND'S SHARES. SEE "INVESTMENT OBJECTIVE AND POLICIES--U.S. GOVERNMENT SECURITIES--MORTGAGE-RELATED SECURITIES ISSUED BY U.S. GOVERNMENT AGENCIES AND INSTRUMENTALITIES" BELOW. UNDER NORMAL MARKET CONDITIONS, AT LEAST 65% OF THE TOTAL ASSETS OF THE FUND WILL BE INVESTED IN U.S. GOVERNMENT SECURITIES. THE FUND HAS NO LIMITATIONS WITH RESPECT TO THE MATURITIES OF PORTFOLIO SECURITIES IN WHICH IT MAY INVEST. HIGH CURRENT RETURN MEANS THE RETURN RECEIVED FROM INTEREST INCOME FROM U.S. GOVERNMENT AND OTHER DEBT SECURITIES AND FROM NET GAINS REALIZED FROM SALES OF PORTFOLIO SECURITIES. THE FUND MAY ALSO REALIZE INCOME FROM PREMIUMS FROM COVERED PUT AND CALL OPTIONS WRITTEN BY THE FUND ON U.S. GOVERNMENT SECURITIES AS WELL AS OPTIONS ON FUTURES CONTRACTS ON U.S. GOVERNMENT SECURITIES AND NET GAINS FROM CLOSING PURCHASE AND SALES TRANSACTIONS WITH RESPECT TO THESE OPTIONS. The writing of options on U.S. Government securities and options on futures contracts on U.S. Government securities may limit the Fund's potential for capital gains on its portfolio. See "Investment Objective and Policies" in the Statement of Additional Information. AS WITH AN INVESTMENT IN ANY MUTUAL FUND, AN INVESTMENT IN THIS FUND CAN DECREASE IN VALUE AND YOU CAN LOSE MONEY. THE FUND'S INVESTMENT OBJECTIVE IS A FUNDAMENTAL POLICY AND, THEREFORE, MAY NOT BE CHANGED WITHOUT THE APPROVAL OF THE HOLDERS OF A MAJORITY OF THE FUND'S OUTSTANDING VOTING SECURITIES AS DEFINED IN THE INVESTMENT COMPANY ACT OF 1940, AS AMENDED (THE INVESTMENT COMPANY ACT). FUND POLICIES THAT ARE NOT FUNDAMENTAL MAY BE MODIFIED BY THE BOARD OF DIRECTORS. The Fund's NAV will vary with changes in the values of the Fund's portfolio securities, which values will generally vary inversely with changes in interest rates. For temporary defensive purposes the Fund may invest up to 100% of its assets in cash, U.S. Government securities and high quality money market instruments. U.S. GOVERNMENT SECURITIES U.S. TREASURY SECURITIES THE FUND WILL INVEST IN U.S. TREASURY SECURITIES, INCLUDING BILLS, NOTES, BONDS AND OTHER DEBT SECURITIES ISSUED BY THE U.S. TREASURY. These instruments are direct obligations of the U.S. Government and, as such, are backed by the full faith and credit of the United States. They differ primarily in their interest rates, the lengths of their maturities and the dates of their issuances. SECURITIES ISSUED OR GUARANTEED BY U.S. GOVERNMENT AGENCIES AND INSTRUMENTALITIES THE FUND WILL INVEST IN SECURITIES ISSUED BY AGENCIES OF THE U.S. GOVERNMENT OR INSTRUMENTALITIES OF THE U.S. GOVERNMENT. These obligations, including those which are guaranteed by federal agencies or instrumentalities, may or may not be backed by the full faith and credit of the United States. Obligations of the Government National Mortgage Association (GNMA), the Farmers Home Administration and the Export-Import Bank are backed by the full faith and credit of the United States. In the 9 case of securities not backed by the full faith and credit of the United States, the Fund must look principally to the agency issuing or guaranteeing the obligation for ultimate repayment and may not be able to assert a claim against the United States if the agency or instrumentality does not meet its commitments. Securities in which the Fund may invest which are not backed by the full faith and credit of the United States include obligations such as those issued by the Tennessee Valley Authority, the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC) and the United States Postal Service, each of which has the right to borrow from the United States Treasury to meet its obligations, and obligations of the Federal Farm Credit Bank and the Federal Home Loan Bank, the obligations of which may only be satisfied by the individual credit of the issuing agency. GNMA, FNMA and FHLMC investments may include collateralized mortgage obligations. See "Other Investments and Policies." OBLIGATIONS ISSUED OR GUARANTEED AS TO PRINCIPAL AND INTEREST BY THE UNITED STATES GOVERNMENT MAY BE ACQUIRED BY THE FUND IN THE FORM OF CUSTODIAL RECEIPTS THAT EVIDENCE OWNERSHIP OF FUTURE INTEREST PAYMENTS, PRINCIPAL PAYMENTS OR BOTH ON CERTAIN UNITED STATES TREASURY NOTES OR BONDS. Such notes and bonds are held in custody by a bank on behalf of the owners. These custodial receipts are commonly referred to as Treasury strips. MORTGAGE-RELATED SECURITIES ISSUED BY U.S. GOVERNMENT AGENCIES AND INSTRUMENTALITIES THE FUND WILL INVEST IN MORTGAGE-BACKED SECURITIES, INCLUDING THOSE REPRESENTING AN UNDIVIDED OWNERSHIP INTEREST IN A POOL OF MORTGAGES, E.G., GNMA, FNMA AND FHLMC CERTIFICATES. The U.S. Government or the issuing agency guarantees the payment of interest and principal of these securities. However, the guarantees do not extend to the securities' yield or value, which are likely to vary inversely with fluctuations in interest rates, nor do the guarantees extend to the yield or value of the Fund's shares. See "Investment Objective and Policies--U.S. Government Securities--Mortgage-Related Securities Issued by U.S. Government Instrumentalities" in the Statement of Additional Information. These certificates are in most cases pass-through instruments, through which the holder receives a share of all interest and principal payments from the mortgages underlying the certificate, net of certain fees. Because the prepayment characteristics of the underlying mortgages vary, it is not possible to predict accurately the average life of a particular issue of pass-through certificates. Mortgage-backed securities are often subject to more rapid repayment than their stated maturity date would indicate as a result of the pass-through of prepayments of principal on the underlying mortgage obligations. During periods of declining interest rates, prepayment of mortgages underlying mortgage-backed securities can be expected to accelerate. The Fund's ability to maintain a portfolio of high-yielding mortgage-backed securities will be adversely affected to the extent that prepayments of mortgages must be reinvested in securities which have lower yields than the prepaid mortgages. Moreover, prepayments of mortgages which underlie securities purchased at a premium could result in capital losses. During periods of rising interest rates, the rate of prepayment of mortgages underlying mortgage-backed securities can be expected to decline, extending the projected average maturity of the mortgage-backed securities. This maturity extension risk may effectively change a security which was considered short- or intermediate-term at the time of purchase into a long-term security. Long-term securities generally fluctuate more widely in response to changes in interest rates than short- or intermediate-term securities. THE FUND MAY ALSO INVEST IN BALLOON PAYMENT MORTGAGE-BACKED SECURITIES. A balloon payment mortgage-backed security is an amortizing mortgage security with installments of principal and interest, the last installment of which is predominantly principal. THE FUND MAY ALSO INVEST IN MORTGAGE PASS-THROUGH SECURITIES WHERE ALL INTEREST PAYMENTS GO TO ONE CLASS OF HOLDERS (INTEREST ONLY SECURITIES OR IOS) AND ALL PRINCIPAL PAYMENTS GO TO A SECOND CLASS OF HOLDERS (PRINCIPAL ONLY SECURITIES OR POS). These securities are commonly referred to as mortgage-backed securities strips or MBS strips. The yields to maturity on IOs are very sensitive to the rate of principal payments (including prepayments) on the related underlying mortgage assets, and a rapid rate of principal payments may have a material adverse effect on yield to maturity. If the underlying mortgage assets experience greater than anticipated prepayments of principal, the Fund may not fully recoup its initial investment in these securities. Conversely, if the underlying mortgage assets experience less than anticipated prepayments of principal, the yield on POs could be materially adversely affected. 10 OTHER INVESTMENTS AND POLICIES AT LEAST 65% OF THE TOTAL ASSETS OF THE FUND WILL BE INVESTED IN U.S. GOVERNMENT SECURITIES, AS DESCRIBED ABOVE. U.S. Government securities which are purchased pursuant to repurchase agreements or on a when-issued or delayed delivery basis will be treated as U.S. Government securities for purposes of this calculation. See "Repurchase Agreements" and "When-Issued and Delayed Delivery Securities." UP TO 35% OF THE TOTAL ASSETS OF THE FUND MAY BE COMMITTED TO INVESTMENTS OTHER THAN U.S. GOVERNMENT SECURITIES. These investments would include the securities described in this subsection as well as purchased put and call options and purchased put options on futures contracts. See "Options Transactions" and "Transactions in Futures Contracts on U.S. Government Securities and Options Thereon." THE FUND IS PERMITTED TO INVEST UP TO 20% OF ITS TOTAL ASSETS IN HIGH QUALITY MONEY MARKET INSTRUMENTS, INCLUDING COMMERCIAL PAPER OF DOMESTIC CORPORATIONS AND CERTIFICATES OF DEPOSIT, BANKERS' ACCEPTANCES AND OTHER OBLIGATIONS OF DOMESTIC AND FOREIGN BANKS. Such obligations will, at the time of purchase, be rated within the two highest quality grades as determined by a nationally recognized statistical rating organization (NRSRO) (such as Moody's Investors Service (Moody's) or Standard & Poor's Ratings Group (S&P) or, if unrated, will be of equivalent quality in the judgment of the Fund's investment adviser. THE FUND MAY INVEST IN OBLIGATIONS OF FOREIGN BANKS AND FOREIGN BRANCHES OF U.S. BANKS ONLY IF AFTER GIVING EFFECT TO SUCH INVESTMENT ALL SUCH INVESTMENTS WOULD CONSTITUTE LESS THAN 10% OF THE FUND'S TOTAL ASSETS (DETERMINED AT THE TIME OF INVESTMENT). These investments may be subject to certain risks, including future political and economic developments, the possible imposition of withholding taxes on interest income, the seizure or nationalization of foreign deposits and foreign exchange controls or other restrictions. In addition, there may be less publicly available information about a foreign bank or foreign branch of a U.S. bank than about a domestic bank and such entities may not be subject to the same accounting, auditing and financial recordkeeping standards and requirements as domestic banks. THE FUND MAY ALSO PURCHASE OBLIGATIONS OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT (THE WORLD BANK). Obligations of the World Bank are supported by appropriated but unpaid commitments of its member countries, including the U.S., and there is no assurance these commitments will be undertaken or met in the future. THE FUND IS PERMITTED TO INVEST IN ADJUSTABLE RATE DEBT SECURITIES, including securities issued by U.S. Government agencies, whose interest rate is calculated by reference to a specified index such as the constant maturity Treasury rate, the T-bill rate or LIBOR (London Interbank Offered Rate) and is reset periodically. The value of adjustable rate securities will, like other debt securities, generally vary inversely with changes in prevailing interest rates. The value of adjustable rate securities is unlikely to rise in periods of declining interest rates to the same extent as fixed rate instruments. In periods of rising interest rates, changes in the coupon will lag behind changes in the market rate resulting in a lower NAV until the coupon resets to market rates. THE FUND MAY INVEST IN DEBT OBLIGATIONS RATED AT LEAST A BY S&P OR MOODY'S OR, IF UNRATED, DEEMED TO BE OF COMPARABLE CREDIT QUALITY BY THE FUND'S INVESTMENT ADVISER. These debt securities may have adjustable or fixed rates of interest and in certain instances may be secured by assets of the issuer. Adjustable rate corporate debt securities may have features similar to those of adjustable rate mortgage-backed securities, but corporate debt securities, unlike mortgage-backed securities, are not subject to prepayment risk other than through contractual call provisions which generally impose a penalty for prepayment. Fixed rate debt securities may also be subject to call provisions. THE FUND MAY ALSO PURCHASE COLLATERALIZED MORTGAGE OBLIGATIONS (CMOS) AND REAL ESTATE MORTGAGE INVESTMENT CONDUITS (REMICS). A CMO is a security issued by a corporation or a U.S. Government instrumentality which is backed by a portfolio of mortgages or mortgage-backed securities. The issuer's obligation to make interest and principal payments is secured by the underlying portfolio of mortgages or mortgage-backed securities. CMOs are partitioned into several classes with a ranked priority by which the classes of obligations are redeemed. The Fund may invest in privately-issued CMOs which are collateralized by mortgage-backed securities issued or guaranteed by GNMA, FHLMC or FNMA or issued by any other agency or instrumentality of the U.S. Government. The Fund may also invest in privately-issued CMOs collateralized by whole loans or private mortgage pass-through securities and balloon payment mortgage-backed securities. The Fund will invest in CMOs rated at least A by S&P or Moody's or, if unrated, deemed to be of comparable credit quality by the Fund's investment adviser. A REMIC may be issued by a trust, partnership, corporation, association, or a segregated pool of mortgages, or an agency of the U.S. Government and, in 11 each case, must qualify and elect treatment as such under the Internal Revenue Code of 1986, as amended (The Internal Revenue Code). A REMIC must consist of one or more classes of regular interests, some of which may be adjustable rate, and a single class of residual interests. To qualify as a REMIC, substantially all the assets of the entity must be in assets directly or indirectly secured, principally by real property. The Fund does not intend to invest in residual interests and will only invest in REMICs rated at least A by S&P or Moody's or, if unrated, deemed to be of comparable credit quality by the Fund's investment adviser. CMOs and REMICs issued by an agency or instrumentality of the U.S. Government are considered U.S. Government securities for purposes of this Prospectus. In reliance on rules and interpretations of the Commission, the Fund's investments in certain qualifying CMOs and REMICs are not subject to the limitation of the Investment Company Act on acquiring interests in other investment companies. See "Investment Objective and Policies--Collateralized Mortgage Obligations" in the Statement of Additional Information. THE FUND MAY ALSO INVEST UP TO 20% OF ITS TOTAL ASSETS IN ASSET-BACKED SECURITIES. Through the use of trusts and special purpose subsidiaries, various types of assets, primarily home equity loans and automobile and credit card receivables, have been securitized in pass-through structures similar to mortgage pass-through structures or in a pay-through structure similar to the collateralized mortgage structure. The Fund may invest in these and other types of asset-backed securities which may be developed in the future. Asset-backed securities present certain risks that are not presented by mortgage-backed securities. Primarily, these securities do not have the benefit of the same security interest in the related collateral. Credit card receivables are generally unsecured. In connection with automobile receivables, the security interests in the underlying automobiles are often not transferred when the pool is created, with the resulting possibility that the collateral could be resold. In general, these types of loans are of shorter average life than mortgage loans and are less likely to have substantial prepayments. The Fund will only invest in asset-backed securities rated at least A by S&P or Moody's or, if unrated, of equivalent quality in the judgment of the Fund's investment adviser. OPTIONS TRANSACTIONS PURCHASING OPTIONS THE FUND MAY PURCHASE PUT AND CALL OPTIONS ON U.S. GOVERNMENT SECURITIES. The Fund may purchase a put option in an effort to protect the value of a security which it owns against a substantial decline in market value (protective puts), if the Fund's investment adviser believes that a defensive posture is warranted for a portion of the portfolio. The Fund may also purchase a put option to cover a put option it has written or to close an existing option position. The Fund may wish to protect certain portfolio securities against a decline in market value at a time when put options on those particular securities are not available for purchase. The Fund may therefore purchase a put option on securities other than those it wishes to protect even though it does not hold such other securities in its portfolio. While changes in the value of the put option should generally offset changes in the value of the securities being hedged, the correlation between the two values may not be as close in these transactions as in transactions in which the Fund purchases a put option on an underlying security it owns. THE FUND MAY PURCHASE CALL OPTIONS ON DEBT SECURITIES IT INTENDS TO ACQUIRE IN ORDER TO HEDGE AGAINST AN ANTICIPATED MARKET APPRECIATION IN THE PRICE OF THE UNDERLYING SECURITIES AT LIMITED RISK AND WITH A LIMITED CASH OUTLAY. If the market price does rise as anticipated, the Fund will benefit from that rise but only to the extent that the rise exceeds the premiums paid. If the anticipated rise does not occur or if it does not exceed the premium, the Fund will bear the expense of the option premiums and transaction costs without gaining an offsetting benefit. The Fund may also purchase a call option to close an existing option position. WRITING COVERED OPTIONS THE FUND MAY WRITE (I.E., SELL) COVERED PUT AND CALL OPTIONS ON U.S. GOVERNMENT SECURITIES. When the Fund writes an option, it receives a premium which it retains whether or not the option is exercised. The Fund's principal reason for writing options is to attempt to realize, through the receipt of premiums, a greater current return than would be realized on the underlying securities alone. THE PURCHASER OF A CALL OPTION HAS THE RIGHT, FOR A SPECIFIED PERIOD OF TIME, TO PURCHASE THE SECURITIES SUBJECT TO THE OPTION AT A SPECIFIED PRICE (THE EXERCISE PRICE). By writing a call option, the Fund becomes obligated during the term of the 12 option, upon exercise of the option, to sell the underlying securities to the purchaser against receipt of the exercise price. When the Fund writes a call option, the Fund loses the potential for gain on the underlying securities during the period that the option is open. CONVERSELY, THE PURCHASER OF A PUT OPTION HAS THE RIGHT, FOR A SPECIFIED PERIOD OF TIME, TO SELL THE SECURITIES SUBJECT TO THE OPTION TO THE WRITER OF THE PUT AT A SPECIFIED EXERCISE PRICE. By writing a put option, the Fund becomes obligated during the term of the option to purchase the securities underlying the option at the exercise price, upon exercise of the option. The Fund might, therefore, be obligated to purchase the underlying securities for more than their current market price. THE FUND MAY ALSO WRITE STRADDLES (I.E., A COMBINATION OF A CALL AND A PUT WRITTEN ON THE SAME SECURITY AT THE SAME STRIKE PRICE). In such cases, the same issue of the security is considered cover for both the put and the call and the Fund will also segregate or deposit cash or other liquid assets equivalent to the amount, if any, by which the put is "in the money." It is contemplated that the Fund's use of straddles will be limited to 5% of the Fund's net assets (meaning that the securities used for cover or segregated as described above will not exceed 5% of the Fund's net assets at the time the straddle is written). An exchange-traded option position may be closed out only on an exchange which provides a secondary market for an option of the same series. Although the Fund will generally purchase or write only those exchange-traded options for which there appears to be an active secondary market, there is no assurance that a liquid secondary market on an exchange will exist for any particular option at any particular time. If a secondary market does not exist, it might not be possible to effect a closing transaction in a particular option. If the Fund, as a covered call option writer, is unable to effect a closing purchase transaction, it will not be able to sell the underlying securities until the option expires or is exercised or it otherwise covers the position. The Fund will not purchase a put or call option on U.S. Government securities if, as a result of such purchase, more than 20% of its total assets would be invested in premiums for such options and on options on futures contracts on U.S. Government securities. OTHER CONSIDERATIONS ALL OPTIONS PURCHASED OR SOLD BY THE FUND WILL BE TRADED ON A U.S. SECURITIES EXCHANGE OR WILL BE PURCHASED OR SOLD BY A PRIMARY GOVERNMENT SECURITIES DEALER RECOGNIZED BY THE FEDERAL RESERVE BANK OF NEW YORK (OTC OPTIONS). While exchange-traded options are in effect guaranteed by The Options Clearing Corporation, the Fund relies on the dealer from whom it purchases an OTC option to perform if the option is exercised. The Fund's investment adviser monitors the creditworthiness of dealers with whom the Fund enters into OTC option transactions under the general supervision of the Fund's Board of Directors. TRANSACTIONS IN FUTURES CONTRACTS ON U.S. GOVERNMENT SECURITIES AND OPTIONS THEREON THE FUND MAY PURCHASE AND SELL FUTURES CONTRACTS ON U.S. GOVERNMENT SECURITIES (FUTURES CONTRACTS) THAT ARE TRADED ON U.S. COMMODITY EXCHANGES. A futures contract on a U.S. Government security, other than GNMA's which are cash settled, is an agreement to purchase or sell an agreed amount of such securities at a set price for delivery on an agreed future date. The Fund may purchase a futures contract as a hedge against an anticipated decline in interest rates, and resulting increase in market price, in securities the Fund intends to acquire. The Fund may sell a futures contract as a hedge against an anticipated increase in interest rates, and resulting decline in market price, in securities the Fund owns. THE FUND MAY ALSO PURCHASE AND WRITE (I.E., SELL) COVERED CALL AND PUT OPTIONS ON FUTURES CONTRACTS ON U.S. GOVERNMENT SECURITIES THAT ARE TRADED ON U.S. COMMODITY EXCHANGES. THE FUND WILL WRITE OPTIONS ON FUTURES CONTRACTS FOR HEDGING PURPOSES, AS WELL AS TO REALIZE THROUGH THE RECEIPT OF PREMIUM INCOME, A GREATER RETURN THAN WOULD BE REALIZED ON THE FUND'S PORTFOLIO SECURITIES ALONE. An option on a futures contract gives the purchaser the right, in return for the premium paid, to assume a position in a futures contract (a long position if the option is a call and a short position if the option is a put) at a specified exercise price at any time during the option exercise period. The writer of the option is required upon exercise to assume an offsetting futures position (a short position if the option is a call and a long position if the option is a put). Upon exercise of the option, the assumption of offsetting futures positions by the writer and holder of the option will be accompanied by delivery of the accumulated cash balance in the writer's futures margin account which represents the amount by which the market price of the futures contract, at exercise, exceeds, in the case of a call, or is less than, in the case of a put, the exercise price of the option on the futures contract. 13 THE FUND MAY ALSO FROM TIME TO TIME PURCHASE EURODOLLAR INSTRUMENTS TRADED ON THE CHICAGO MERCANTILE EXCHANGE. Eurodollar instruments are essentially U.S. dollar-denominated futures contracts or options thereon which are linked to the London Interbank Offered Rate (LIBOR). Eurodollar futures contracts enable purchasers to obtain a fixed rate for the lending of funds and sellers to obtain a fixed rate for borrowings. The Fund intends to use Eurodollar futures contracts and options thereon to hedge against changes in LIBOR, to which many interest rate swaps are linked. The use of these instruments is subject to the same limitations and risks as those applicable to the use of interest rate futures contracts and options thereon. THE FUND MAY ALSO ENTER INTO CLOSING TRANSACTIONS WITH RESPECT TO FUTURES CONTRACTS AND OPTIONS THEREON TO TERMINATE EXISTING POSITIONS. The Fund's ability to enter into transactions in futures contracts and options thereon may be limited by the Internal Revenue Code's requirements for qualification as a regulated investment company. In addition, the Fund may not purchase or sell futures contracts or related options for other than bona fide hedging purposes if immediately thereafter the sum of the amount of initial margin deposits on the Fund's existing futures and options on futures and for premiums paid for such related options would exceed 5% of the liquidation value of the Fund's total assets, after taking into account unrealized profits and unrealized losses on any such contracts the Fund has entered into; provided, however, that in the case of an option that is in-the-money at the time of purchase, the in-the-money amount may be excluded in computing such 5% limitation. CHARACTERISTICS AND PURPOSES OF INTEREST RATE FUTURES THE FUND WILL PURCHASE AND SELL FUTURES CONTRACTS PRIMARILY TO HEDGE ITS ACTUAL OR ANTICIPATED HOLDINGS OF U.S. GOVERNMENT SECURITIES. There is generally an inverse relationship between interest rates and bond prices. Generally, when interest rates increase, bond prices will decline; when interest rates decline, bond prices will increase. For example, if the Fund holds cash reserves or short-term debt securities at a time that interest rates are expected to decline, the Fund might purchase futures contracts as a hedge against anticipated increases in the price of the U.S. Government securities that the Fund intends to acquire (an anticipatory hedge). CHARACTERISTICS AND PURPOSES OF OPTIONS ON FUTURES CONTRACTS ON U.S. GOVERNMENT SECURITIES When an option on a futures contract is exercised, the writer of the option delivers the futures position as well as the accumulated balance in the writer's futures margin account, which represents the amount by which the market price of the futures contract, at exercise, exceeds, in the case of a call, or is less than, in the case of a put, the exercise price of the option on the futures contract. The Fund will be required to deposit initial and variation margin with respect to options on futures contracts written by it. The Fund will purchase put options on futures contracts primarily to hedge its portfolio of U.S. Government securities against the risk of rising interest rates, and the consequent decline in the prices of U.S. Government securities it owns. The Fund will purchase call options on futures contracts to hedge the Fund's portfolio against a possible market advance at a time when the Fund is not fully invested in U.S. Government securities (other than Treasury Bills). The Fund also will write call options on futures contracts as a hedge against a modest decline in prices of debt securities held in the Fund's portfolio and to earn additional income. If the futures price at expiration of the option is below the exercise price, the Fund will retain the full amount of the option premium thereby partially hedging against any decline that may have occurred in the Fund's holdings of debt securities. If the futures price when the option is exercised is above the exercise price, however, the Fund will incur a loss, which may be wholly or partially offset by the increase of the value of the securities in the Fund's portfolio which were being hedged. Writing a put option on a futures contract serves as a partial hedge against an increase in the value of debt securities the Fund intends to acquire. If the futures price at expiration of the option is above the exercise price, the Fund will retain the full amount of the option premium thereby partially hedging against any increase that may have occurred in the price of the debt securities the Fund intends to acquire. If the futures price when the option is exercised is below the exercise price, however, the Fund will incur a loss, which may be wholly or partially offset by the decrease of the price of the securities the Fund intends to acquire. The Fund will also write options on futures contracts in whole or in part to enhance its current return through the receipt of premium income. See "Investment Objective and Policies--Futures Contracts on U.S. Government Securities" in the Statement of Additional Information. 14 RISK CONSIDERATIONS PARTICIPATION IN THE FUTURES MARKETS INVOLVES INVESTMENT RISKS AND TRANSACTION COSTS TO WHICH THE FUND WOULD NOT BE SUBJECT ABSENT THE USE OF THIS STRATEGY. THE FUND, AND THUS THE INVESTOR, MAY LOSE MONEY THROUGH ANY UNSUCCESSFUL USE OF THIS STRATEGY. If the investment adviser's predictions of movements in the direction of the securities and interest rate markets are inaccurate, the adverse consequences to the Fund may leave the Fund in a worse position than if such strategies were not used. Risks inherent in the use of futures contracts and options on futures contracts include (1) dependence on the investment adviser's ability to predict correctly movements in the direction of interest rates and securities prices; (2) imperfect correlation between the price of futures contracts and options thereon and movements in the prices of the securities being hedged; (3) the fact that skills needed to use these strategies are different from those needed to select portfolio securities; (4) the possible absence of a liquid secondary market for any particular instrument at any time; and (5) the possible inability of the Fund to purchase or sell a portfolio security at a time that otherwise would be favorable for it to do so or the possible need for the Fund to sell a portfolio security at a disadvantageous time, due to the need for the Fund to maintain cover or to segregate securities in connection with hedging transactions. See "Investment Objective and Policies--Futures Contracts on U.S. Government Securities" and "--Options on Futures Contracts" and "Taxes, Dividends and Distributions" in the Statement of Additional Information. REPURCHASE AGREEMENTS The Fund may on occasion enter into repurchase agreements, whereby the seller agrees to repurchase a security from the Fund at a mutually agreed-upon time and price. The repurchase date is usually within a day or two of the original purchase date although it may extend over a number of months. The resale price is in excess of the purchase price, reflecting an agreed-upon rate of return effective for the period of time the Fund's money is invested in the repurchase agreement. The Fund's repurchase agreements will at all times be fully collateralized in an amount at least equal to the resale price. The instruments held as collateral are valued daily and, if the value of instruments declines, the Fund will require additional collateral. If the seller defaults and the value of the collateral securing the repurchase agreement declines, the Fund may incur a loss. The Fund participates in a joint repurchase account with other investment companies managed by PIFM pursuant to an order of the Commission. See "Investment Objective and Policies--Repurchase Agreements" in the Statement of Additional Information. SECURITIES LENDING The Fund may lend its portfolio securities to brokers or dealers, banks or other recognized institutional borrowers of securities, provided that the borrower at all times maintains cash or equivalent collateral or secures a letter of credit in favor of the Fund in an amount equal to at least 100% of the market value of the securities loaned. During the time portfolio securities are on loan, the borrower will pay the Fund an amount equivalent to any dividend or interest paid on such securities and the Fund may invest the cash collateral and earn additional income, or it may receive an agreed-upon amount of interest income from the borrower. As a matter of fundamental policy, the Fund cannot lend more than 30% of the value of its total assets. WHEN-ISSUED AND DELAYED DELIVERY SECURITIES The Fund may purchase or sell U.S. Government securities on a when-issued or delayed delivery basis. When-issued or delayed delivery transactions arise when securities are purchased or sold by the Fund with payment and delivery taking place as much as a month or more in the future in order to secure what is considered to be an advantageous price and yield to the Fund at the time of entering into the transaction. The Fund will maintain in a segregated account cash or other liquid assets, having a value equal to or greater than the Fund's purchase commitments. The securities so purchased are subject to market fluctuation and no interest accrues to the purchaser during the period between purchase and settlement. At the time of delivery of the securities the value may be more or less than the purchase price and an increase in the percentage of the Fund's assets committed to the purchase of securities on a when-issued or delayed delivery basis may increase the volatility of the Fund's NAV. OTHER INVESTMENT INFORMATION The Fund is permitted to use the following investment techniques, although it does not anticipate that any of them will constitute a significant component of its investment program. 15 ZERO COUPON BONDS The Fund may invest up to 5% of its total assets in zero coupon U.S. Government securities. Zero coupon bonds are purchased at a discount from the face amount because the buyer receives only the right to receive a fixed payment on a certain date in the future and does not receive any periodic interest payments. The effect of owning instruments which do not make current interest payments is that a fixed yield is earned not only on the original investment but also, in effect, on all discount accretion during the life of the obligations. This implicit reinvestment of earnings at the same rate eliminates the risk of being unable to reinvest distributions at a rate as high as the implicit yield on the zero coupon bond, but at the same time eliminates the holder's ability to reinvest at higher rates in the future. For this reason, zero coupon bonds are subject to substantially greater price fluctuations during periods of changing market interest rates than are comparable securities which pay interest currently, which fluctuation increases the longer the period to maturity. SHORT SALES AGAINST-THE-BOX The Fund may make short sales against-the-box for the purpose of deferring realization of gain or loss for federal income tax purposes. A short sale against-the-box is a short sale in which the Fund owns an equal amount of the securities sold short or securities convertible into or exchangeable, without payment of any further consideration, for securities of the same issue as, and equal in amount to, the securities sold short. The Fund may engage in such short sales only to the extent that not more than 10% of the Fund's net assets (determined at the time of the short sale) are held as collateral for such sales. BORROWING The Fund may borrow money in an amount up to 20% of the value of its total assets (calculated when the loan is made) for temporary, extraordinary or emergency purposes or for the clearance of transactions. The Fund may pledge up to 20% of the value of its total assets to secure such borrowings. The Fund will not purchase securities when borrowings exceed 5% of the value of its total assets. ILLIQUID SECURITIES The Fund may hold up to 15% of its net assets in illiquid securities, including repurchase agreements which have a maturity of longer than seven days, securities with legal or contractual restrictions on resale (restricted securities) and securities that are not readily marketable. Restricted securities eligible for resale pursuant to Rule 144A under the Securities Act of 1933, as amended (the Securities Act), and privately placed commercial paper that have a readily available market are not considered illiquid for purposes of this limitation. The Subadviser will monitor the liquidity of such restricted securities under the supervision of the Board of Directors. Investing in Rule 144A securities could, however, have the effect of increasing the level of Fund illiquidity to the extent that qualified institutional buyers become, for a limited time, uninterested in purchasing these securities. Repurchase agreements subject to demand are deemed to have a maturity equal to the applicable notice period. When the Fund enters into interest rate swaps on other than a net basis, the entire amount of the Fund's obligations, if any, with respect to such interest rate swaps will be treated as illiquid. To the extent that the Fund enters into interest rate swaps on a net basis, 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 treated as illiquid. REVERSE REPURCHASE AGREEMENTS AND DOLLAR ROLLS Reverse repurchase agreements involve sales by the Fund of portfolio assets concurrently with an agreement by the Fund to repurchase the same assets at a later date at a fixed price. During the reverse repurchase agreement period, the Fund continues to receive principal and interest payments on these securities. The Fund may enter into dollar rolls in which the Fund sells securities to be issued and delivered in the current month and simultaneously contracts to repurchase substantially similar (same type and coupon) securities on a specified future date from the same party. During the roll period, the Fund forgoes principal and interest paid on the securities. The Fund is compensated by the difference between the current sales price and the forward price for the future purchase (often referred to as the drop) as well as by the interest earned on the cash proceeds of the initial sale. A covered roll is a specific type of dollar roll for which there is an 16 offsetting cash position or a cash equivalent security position which matures on or before the forward settlement date of the dollar roll transaction. Reverse repurchase agreements and dollar rolls (other than covered rolls) are considered borrowings by the Fund for purposes of the percentage limitations applicable to borrowings. Covered rolls, however, are not treated as borrowings or other senior securities and will be excluded from the calculation of the Fund's borrowings and other senior securities. The Fund will establish a segregated account in which it will maintain cash or other liquid assets, equal in value to its obligations in respect of reverse repurchase agreements and dollar rolls. Reverse repurchase agreements and dollar rolls involve the risk that the market value of the securities retained by the Fund may decline below the price of the securities the Fund has sold but is obligated to repurchase under the agreement. In the event the buyer of securities under a dollar roll files for bankruptcy or becomes insolvent, the Fund's use of the proceeds of the agreement may be restricted pending a determination by the other party, or its trustee or receiver, whether to enforce the Fund's obligation to repurchase the securities. INTEREST RATE TRANSACTIONS The Fund may enter into interest rate swaps. Interest rate swaps involve the exchange by the Fund with another party of their respective commitments to pay or receive interest, E.G., an exchange of floating rate payments for fixed rate payments. The Fund expects to enter into these transactions primarily to preserve a return or spread on a particular investment or portion of its portfolio or to protect against any increase in the price of securities the Fund anticipates purchasing at a later date. The Fund intends to use these transactions as a hedge and not as a speculative investment. See "Investment Objective and Policies--Interest Rate Transactions" in the Statement of Additional Information. PORTFOLIO TURNOVER AND BROKERAGE Based on its experience in managing similar investment products, the investment adviser expects that, under normal circumstances, if the Fund writes substantial numbers of options, and those options are exercised, the Fund's portfolio turnover rate may be as high as 250% or higher. Such a rate would significantly exceed that of a fund invested exclusively in U.S. Government securities. See "Investment Objective and Policies--Options Transactions" and "--Portfolio Turnover" in the Statement of Additional Information. While the Fund will pay commissions in connection with its options and futures transactions, U.S. Government securities are generally traded on a net basis with dealers acting as principal for their own accounts without a stated commission. Nevertheless, high portfolio turnover may involve correspondingly greater brokerage commissions and other transaction costs, which will be borne directly by the Fund. See "Portfolio Transactions and Brokerage" in the Statement of Additional Information. INVESTMENT RESTRICTIONS The Fund is subject to certain investment restrictions which, like its investment objective, constitute fundamental policies. Fundamental policies cannot be changed without the approval of the holders of a majority of the Fund's outstanding voting securities, as defined in the Investment Company Act. See "Investment Restrictions" in the Statement of Additional Information. HOW THE FUND IS MANAGED THE FUND HAS A BOARD OF DIRECTORS WHICH, IN ADDITION TO OVERSEEING THE ACTIONS OF THE FUND'S MANAGER, SUBADVISER AND DISTRIBUTOR, AS SET FORTH BELOW, DECIDES UPON MATTERS OF GENERAL POLICY. THE FUND'S MANAGER CONDUCTS AND SUPERVISES THE DAILY BUSINESS OPERATIONS OF THE FUND. THE FUND'S SUBADVISER FURNISHES DAILY INVESTMENT ADVISORY SERVICES. For the fiscal year ended February 28, 1998, the total expenses as a percentage of average net assets for the Fund's Class A, Class B, Class C and Class Z shares were 0.86%, 1.53%, 1.46% and 0.71%, respectively. See "Financial Highlights." MANAGER PRUDENTIAL INVESTMENTS FUND MANAGEMENT LLC (PIFM OR THE MANAGER), GATEWAY CENTER THREE, 100 MULBERRY STREET, NEWARK, NEW JERSEY 07102-4077, IS THE MANAGER OF THE FUND AND IS COMPENSATED FOR ITS SERVICES AT AN 17 ANNUAL RATE OF .50 OF 1% OF THE FUND'S AVERAGE DAILY NET ASSETS UP TO $3 BILLION AND .35 OF 1% OF THE AVERAGE DAILY NET ASSETS IN EXCESS OF $3 BILLION. PIFM is organized in New York as a limited liability company. It is the successor to Prudential Mutual Fund Management, Inc., which transferred its assets to PIFM in September 1996. For the fiscal year ended February 28, 1998, the Fund paid management fees to PIFM of .50% of the Fund's average daily net assets. See "Manager" in the Statement of Additional Information. As of March 31, 1998, PIFM served as the manager to 43 open-end investment companies, constituting all of the Prudential Mutual Funds, and as manager or administrator to 22 closed-end investment companies with aggregate assets of approximately $64.8 billion. UNDER THE MANAGEMENT AGREEMENT WITH THE FUND, PIFM MANAGES THE INVESTMENT OPERATIONS OF THE FUND AND ALSO ADMINISTERS THE FUND'S CORPORATE AFFAIRS. See "Manager" in the Statement of Additional Information. UNDER THE SUBADVISORY AGREEMENT BETWEEN PIFM AND THE PRUDENTIAL INVESTMENT CORPORATION (PIC), DOING BUSINESS AS PRUDENTIAL INVESTMENTS (PI, THE SUBADVISER OR THE INVESTMENT ADVISER), THE SUBADVISER FURNISHES INVESTMENT ADVISORY SERVICES IN CONNECTION WITH THE MANAGEMENT OF THE FUND AND IS REIMBURSED BY PIFM FOR ITS REASONABLE COSTS AND EXPENSES INCURRED IN PROVIDING SUCH SERVICES. PIFM continues to have responsibility for all investment advisory services pursuant to the Management Agreement and supervises the Subadviser's performance of such services. The current portfolio managers of the Fund are Barbara L. Kenworthy and Sharon Fera. Ms. Kenworthy is a Managing Director and Senior Portfolio Manager and Ms. Fera is a Vice President and Portfolio Manager of Prudential Investments, a business group of PIC. Ms. Kenworthy has managed the Fund's portfolio since July 1994. Ms. Kenworthy joined Prudential Investments in July 1994, having previously been employed by the Dreyfus Corporation (from June 1985 to June 1994), where she served as President and Portfolio Manager for several Dreyfus fixed-income funds. Ms. Kenworthy also serves as the portfolio manager of Prudential Diversified Bond Fund, Inc., and is co-portfolio manager of Prudential Balanced Fund, Prudential Government Securities Trust--Short Intermediate Term Series and Prudential Mortgage Income Fund, Inc. and has 20 years of investment management experience in both U.S. and foreign securities and investment grade and high yield quality bonds. Ms. Kenworthy actively manages the fund's portfolio according to the investment adviser's interest rate outlook. Consistent with the Fund's investment objective and policies, she will, at times, invest in different sectors of the fixed-income markets seeking price discrepancies and more favorable interest rates. The investment adviser conducts extensive analysis of U.S. and overseas markets in an attempt to identify trends in interest rates, supply and demand and economic growth. The portfolio manager then selects the sectors, maturities and individual bonds she believes provide the best value under those conditions. Ms. Kenworthy is assisted by two credit analysis teams, one that specializes in investment grade bonds and one that specializes in high yield bonds. Ms. Fera joined Prudential Investments in May 1996 as a fixed-income portfolio manager. Prior thereto, she was employed by Aetna Life and Casualty (May 1993 to May 1996) as a Portfolio Manager responsible for the fixed-income portion of Aetna's Capital and Surplus Portfolio and as a fixed-income analyst responsible for the Capital Goods and Transportation sectors. Prior to joining Aetna, she was a fixed-income trader at Hartford Life Insurance Company (May 1992 to May 1993) and at Equitable Capital Management Corporation (August 1985 to May 1992). Ms. Fera also serves as the co-manager of Prudential Mortgage Income Fund, Inc. and Prudential Government Securities Trust (Short-Intermediate Term Series). PIFM and PIC are wholly-owned subsidiaries of The Prudential Insurance Company of America (Prudential) a major diversified insurance and financial services company. DISTRIBUTOR PRUDENTIAL SECURITIES INCORPORATED (PRUDENTIAL SECURITIES OR THE DISTRIBUTOR), ONE SEAPORT PLAZA, NEW YORK, NEW YORK 10292, IS A CORPORATION ORGANIZED UNDER THE LAWS OF THE STATE OF DELAWARE AND SERVES AS THE DISTRIBUTOR OF THE SHARES OF THE FUND. IT IS AN INDIRECT, WHOLLY-OWNED SUBSIDIARY OF PRUDENTIAL. UNDER SEPARATE DISTRIBUTION AND SERVICE PLANS (THE CLASS A PLAN, THE CLASS B PLAN AND THE CLASS C PLAN, COLLECTIVELY, THE PLANS) ADOPTED BY THE FUND UNDER RULE 12B-1 UNDER THE INVESTMENT COMPANY ACT AND A DISTRIBUTION AGREEMENT (THE DISTRIBUTION AGREEMENT), THE DISTRIBUTOR INCURS THE EXPENSES OF DISTRIBUTING THE FUND'S CLASS A, CLASS B AND CLASS C SHARES. THE DISTRIBUTOR ALSO INCURS THE EXPENSES OF DISTRIBUTING THE FUND'S CLASS Z SHARES UNDER THE DISTRIBUTION AGREEMENT, NONE OF WHICH ARE REIMBURSED BY OR PAID FOR BY THE FUND. These expenses include commissions and account servicing fees paid to, or on account of, financial advisers of the Distributor and representatives of 18 Pruco Securities Corporation (Prusec), an affiliated broker-dealer, commissions and account servicing fees paid to, or on account of, other broker-dealers or financial institutions (other than national banks) which have entered into agreements with the Distributor, advertising expenses, the cost of printing and mailing prospectuses to potential investors and indirect and overhead costs of the Distributor and Prusec associated with the sale of Fund shares, including lease, utility, communications and sales promotion expenses. Under the Plans, the Fund is obligated to pay distribution and/or service fees to the Distributor as compensation for its distribution and service activities, not as reimbursement for specific expenses incurred. If the Distributor's expenses exceed its distribution and service fees, the Fund will not be obligated to pay any additional expenses. If the Distributor's expenses are less than such distribution and service fees, it will retain its full fees and realize a profit. UNDER THE CLASS A PLAN, THE FUND MAY PAY THE DISTRIBUTOR FOR ITS DISTRIBUTION-RELATED ACTIVITIES WITH RESPECT TO CLASS A SHARES AT AN ANNUAL RATE OF UP TO .30 OF 1% OF THE AVERAGE DAILY NET ASSETS OF THE CLASS A SHARES. The Class A Plan provides that (i) up to .25 of 1% of the average daily net assets of the Class A shares may be used to pay for personal service and/or the maintenance of shareholder accounts (service fee) and (ii) total distribution fees (including the service fee of up to .25 of 1%) may not exceed .30 of 1% of the average daily net assets of the Class A shares. The Distributor has agreed to limit its distribution-related fees payable under the Class A Plan to .15 of 1% of the average daily net assets of the Class A shares for the fiscal year ending February 28, 1999. UNDER THE CLASS B PLAN, THE FUND MAY PAY THE DISTRIBUTOR FOR ITS DISTRIBUTION-RELATED ACTIVITIES WITH RESPECT TO CLASS B SHARES AT AN ANNUAL RATE OF UP TO 1% OF THE AVERAGE DAILY NET ASSETS OF THE CLASS B SHARES UP TO $3 BILLION, .80 OF 1% OF THE NEXT $1 BILLION OF SUCH NET ASSETS AND .50 OF 1% OF SUCH NET ASSETS IN EXCESS OF $4 BILLION. The Class B Plan provides for the payment to The Distributor of (i) an asset-based sales charge of up to .75 of 1% of the average daily net assets of the Class B shares up to $3 billion, .55 of 1% of the next $1 billion of such net assets and .25 of 1% of such net assets in excess of $4 billion, and (ii) a service fee of up to .25 of 1% of the average daily net assets of the Class B shares. UNDER THE CLASS C PLAN, THE FUND MAY PAY THE DISTRIBUTOR FOR ITS DISTRIBUTION-RELATED ACTIVITIES WITH RESPECT TO THE CLASS C SHARES AT AN ANNUAL RATE OF UP TO 1% OF AVERAGE DAILY NET ASSETS OF CLASS C SHARES. The Class C Plan provides for the payment to the Distributor of (i) an asset-based sales charge of up to .75 of 1% of the average daily net assets of the Class C shares, and (ii) a service fee of up to .25 of 1% of the average daily net assets of the Class C shares. The service fee is used to pay for personal service and/or the maintenance of shareholder accounts. The Distributor has agreed to limit its distribution-related fees payable under the Class B Plan to .825 of 1% of the average daily net assets of the Class B shares and under the Class C Plan to .75 of 1% of the average daily net assets of the Class C shares for the fiscal year ending February 28, 1999. The Distributor also receives contingent deferred sales charges from certain redeeming shareholders. See "Shareholder Guide--How to Sell Your Shares--Contingent Deferred Sales Charges." Distribution expenses attributable to the sale of Class A, Class B and Class C shares of the Fund will be allocated to each such class based upon the ratio of sales of each such class to the sales of Class A, Class B and Class C shares of the Fund other than expenses allocable to a particular class. The distribution fee and sales charge of one class will not be used to subsidize the sale of another class. Each Plan provides that it shall continue in effect from year to year provided that a majority of the Board of Directors of the Fund, including a majority of the Directors who are not interested persons of the Fund (as defined in the Investment Company Act) and who have no direct or indirect financial interest in the operation of the Plan or any agreement related to the Plan (the Rule 12b-1 Directors), vote annually to continue the Plan. Each Plan may be terminated at any time by vote of a majority of the Rule 12b-1 Directors or of a majority of the outstanding shares of the applicable class of the Fund. The Fund will not be obligated to pay distribution and service fees incurred under any plan if it is terminated or not continued. In addition to distribution and service fees paid by the Fund under the Class A, Class B and Class C Plans, the Manager (or one of its affiliates) may make payments out of its own resources to dealers (including Prudential Securities) and other persons who distribute shares of the Fund (including Class Z shares). Such payments may be calculated by reference to the NAV of shares sold by such persons or otherwise. The Distributor is subject to the rules of the National Association of Securities Dealers, Inc. (the NASD) governing maximum sales charges. See "Distributor" in the Statement of Additional Information. 19 FEE WAIVERS AND SUBSIDY PIFM may from time to time waive all or a portion of its management fee and subsidize all or a portion of the operating expenses of the Fund. Fee waivers and expense subsidies will increase the Fund's total return. See "Performance Information" in the Statement of Additional Information and "Fund Expenses." PORTFOLIO TRANSACTIONS Prudential Securities may act as a broker and/or futures commission merchant for the Fund provided that the commissions, fees or other remuneration it receives are fair and reasonable. See "Portfolio Transactions and Brokerage" in the Statement of Additional Information. CUSTODIAN AND TRANSFER AND DIVIDEND DISBURSING AGENT State Street Bank and Trust Company, One Heritage Drive, North Quincy, Massachusetts 02171, serves as Custodian for the Fund's portfolio securities and cash and, in that capacity, maintains certain financial and accounting books and records pursuant to an agreement with the Fund. Its mailing address is P .O. Box 1713, Boston, Massachusetts 02105. Prudential Mutual Fund Services LLC (PMFS or the Transfer Agent), Raritan Plaza One, Edison, New Jersey 08837, serves as Transfer Agent and Dividend Disbursing Agent and in those capacities maintains certain books and records for the Fund. Its mailing address is P .O. Box 15005, New Brunswick, New Jersey 08906-5005. PMFS is a wholly-owned subsidiary of PIFM. YEAR 2000 The services provided to the Fund and the shareholders by the Manager, the Distributor, the Transfer Agent and the Custodian depend on the smooth functioning of their computer systems and those of their outside service providers. Many computer software systems in use today cannot distinguish the year 2000 from the year 1900 because of the way dates are encoded and calculated. Such event could have a negative impact on handling securities trades, payments of interest and dividends, pricing and account services. Although at this time, there can be no assurance that there will be no adverse impact on the Fund, the Manager, the Distributor, the Transfer Agent and the Custodian have advised the Fund that they have been actively working on necessary changes to their computer systems to prepare for the year 2000 and expect that their systems, and those of their outside service providers, will be adapted in time for that event. HOW THE FUND VALUES ITS SHARES THE FUND'S NET ASSET VALUE PER SHARE OR NAV IS DETERMINED BY SUBTRACTING ITS LIABILITIES FROM THE VALUE OF ITS ASSETS AND DIVIDING THE REMAINDER BY THE NUMBER OF OUTSTANDING SHARES OF THE FUND. NAV IS CALCULATED SEPARATELY FOR EACH CLASS. THE BOARD OF DIRECTORS HAS FIXED THE SPECIFIC TIME OF DAY FOR THE COMPUTATION OF THE FUND'S NAV TO BE AS OF 4:15 P .M., NEW YORK TIME. Portfolio securities are valued based on market quotations or, if not readily available, at fair value as determined in good faith under procedures established by the Fund's Board of Directors. For valuation purposes, quotations of foreign securities in a foreign currency are converted to U.S. dollar equivalents. See "Net Asset Value" in the Statement of Additional Information. The Fund will compute its NAV once daily on days that the New York Stock Exchange is open for trading except on days on which no orders to purchase, sell or redeem shares have been received by the Fund or days on which changes in the value of the Fund's portfolio securities do not materially affect the NAV. Although the legal rights of each class of shares are substantially identical, the different expenses borne by each class will result in different NAVs and dividends. The NAV of Class B and Class C shares will generally be lower than the NAV of Class A shares as a result of the larger distribution-related fee to which Class B and Class C shares are subject. The NAV of Class Z shares will generally be higher than the NAV of the other three classes because Class Z shares are not subject to any distribution and/or service fees. It is expected, however, that the NAV of the four classes will tend to converge immediately after the recording of dividends, if any, which will differ by approximately the amount of the distribution and/or service fee expense accrual differential among the classes. 20 HOW THE FUND CALCULATES PERFORMANCE FROM TIME TO TIME THE FUND MAY ADVERTISE ITS YIELD AND TOTAL RETURN (INCLUDING AVERAGE ANNUAL TOTAL RETURN AND AGGREGATE TOTAL RETURN) IN ADVERTISEMENTS AND SALES LITERATURE. YIELD AND TOTAL RETURN ARE CALCULATED SEPARATELY FOR CLASS A, CLASS B, CLASS C AND CLASS Z SHARES. THESE FIGURES ARE BASED ON HISTORICAL EARNINGS AND ARE NOT INTENDED TO INDICATE FUTURE PERFORMANCE. The total return shows how much an investment in the Fund would have increased (decreased) over a specified period of time (I.E., one, five or ten years or since inception of the Fund) assuming that all distributions and dividends by the Fund were reinvested on the reinvestment dates during the period and less all recurring fees. The aggregate total return reflects actual performance over a stated period of time. Average annual total return is a hypothetical rate of return that, if achieved annually, would have produced the same aggregate total return if performance had been constant over the entire period. Average annual total return smooths out variations in performance and takes into account any applicable initial or contingent deferred sales charges. Neither average annual total return nor aggregate total return takes into account any federal or state income taxes which may be payable upon redemption. The yield refers to the income generated by an investment in the Fund over a one-month or 30-day period. This income is then annualized that is, the amount of income generated by the investment during that 30-day period is assumed to be generated each 30-day period for twelve periods and is shown as a percentage of the investment. The income earned on the investment is also assumed to be reinvested at the end of the sixth 30-day period. The Fund also may include comparative performance information in advertising or marketing the Fund's shares. Such performance information may include data from Lipper Analytical Services, Inc., Morningstar Publications, Inc., other industry publications, business periodicals and market indices. See "Performance Information" in the Statement of Additional Information. Further performance information is contained in the Fund's annual and semi-annual reports to shareholders, which may be obtained without charge. See "Shareholder Guide--Shareholder Services--Reports to Shareholders". TAXES, DIVIDENDS AND DISTRIBUTIONS TAXATION OF THE FUND THE FUND HAS QUALIFIED AND INTENDS TO REMAIN QUALIFIED AS A REGULATED INVESTMENT COMPANY UNDER THE INTERNAL REVENUE CODE. ACCORDINGLY, THE FUND WILL NOT BE SUBJECT TO FEDERAL INCOME TAXES ON ITS NET INVESTMENT INCOME AND CAPITAL GAINS, IF ANY, THAT IT DISTRIBUTES TO ITS SHAREHOLDERS. See "Taxes, Dividends and Distributions" in the Statement of Additional Information. TAXATION OF SHAREHOLDERS All dividends out of net investment income, together with distributions of short-term capital gains, will be taxable as ordinary income to the shareholder whether or not reinvested. Any net long-term capital gains (I.E., the excess of net capital gains from the sale of assets held for more than 12 months over net short-term capital losses) distributed to shareholders will be taxable as such to the shareholders, whether or not reinvested and regardless of the length of time a shareholder has owned his or her shares. The maximum capital gains rate for individuals currently is 28% with respect to the securities held by the Fund for more than 12 months, but not more than 18 months, and 20% with respect to securities held by the Fund for more than 18 months. The maximum tax rate for ordinary income is 39.6%. The maximum long-term capital gains rate for corporate shareholders currently is the same as the 35% maximum tax rate for ordinary income. Any gain or loss realized upon a sale, exchange or redemption of shares by a shareholder who is not a dealer in securities will be treated as a capital gain. Any such capital gain derived by an individual will be subject to tax at the reduced rates described above depending upon the shareholders holding period of the shares sold. Any such loss will be long-term capital loss if the shares have been held more than one year and otherwise as short-term capital gain or loss. Any loss, however, on the sale, exchange or redemption of shares that are held for six months or less will be treated as a long-term capital loss to the extent of any capital gain distributions received by the shareholder. 21 A shareholder who acquires shares of the Fund and sells or otherwise disposes of such shares within 90 days of acquisition may not be allowed to include certain sales charges incurred in acquiring such shares for purposes of calculating gain or loss realized upon a sale or exchange of shares of the Fund. The Fund has obtained opinions of counsel to the effect that neither (i) the conversion of Class B shares into Class A shares nor (ii) the exchange of any class of the Fund's shares for any other class of its shares constitutes a taxable event for federal income tax purposes. However, such opinions are not binding on the Internal Revenue Service. WITHHOLDING TAXES Under the Internal Revenue Code, the Fund is required to withhold and remit to the U.S. Treasury 31% of dividends, capital gain income and redemption proceeds payable to individuals and certain noncorporate shareholders who fail to furnish correct tax identification numbers on IRS Form W-9 (or IRS Form W-8 in the case of certain foreign shareholders) with the required certifications regarding the shareholder's status under federal income tax law. Dividends of net investment income and short-term capital gains to a foreign shareholder will generally be subject to U.S. withholding tax at the rate of 30% (or lower treaty rate). Shareholders are advised to consult their own tax advisers regarding specific questions as to federal, state or local taxes. See "Taxes, Dividends and Distributions" in the Statement of Additional Information. DIVIDENDS AND DISTRIBUTIONS THE FUND EXPECTS TO DECLARE DAILY AND PAY MONTHLY DIVIDENDS OF NET INVESTMENT INCOME, IF ANY, AND MAKE DISTRIBUTIONS AT LEAST ANNUALLY OF ANY NET CAPITAL GAINS. In determining the amount of capital gains to be distributed, the amount of any capital loss carryforwards from prior years will be offset against capital gains. As of February 28, 1998, the Fund had a capital loss carryforward for federal income tax purposes of approximately $131,130,000. Accordingly, no capital gains distribution is expected to be paid to shareholders until net gains have been realized in excess of such carryforward. Dividends paid by the Fund with respect to each class of shares, to the extent any dividends are paid, will be calculated in the same manner, at the same time, on the same day and will be in the same amount except that Class A, Class B and Class C shares will bear their own distribution charges, generally resulting in lower dividends for Class B and Class C shares in relation to Class A and Class Z shares and lower dividends for Class A shares in relation to Class Z shares. Distributions of net capital gains, if any, will be paid in the same amount for each class of shares. See "How the Fund Values its Shares." Shares will begin earning daily dividends on the day following the date on which the shares are issued, the date of issuance customarily being the settlement date. Shares continue to earn daily dividends until they are redeemed. In the event an investor redeems all the shares in his or her account at any time during the month, all daily dividends declared to the date of redemption will be paid at the time of redemption. DIVIDENDS AND DISTRIBUTIONS WILL BE PAID IN ADDITIONAL FUND SHARES, BASED ON THE NAV OF EACH CLASS ON THE PAYMENT AND RECORD DATE, RESPECTIVELY, OR SUCH OTHER DATE AS THE BOARD OF DIRECTORS MAY DETERMINE, UNLESS THE SHAREHOLDER ELECTS IN WRITING NOT LESS THAN FIVE BUSINESS DAYS PRIOR TO THE PAYMENT DATE TO RECEIVE SUCH DIVIDENDS AND DISTRIBUTIONS IN CASH. Such election should be submitted to Prudential Mutual Fund Services LLC, Attention: Account Maintenance, P .O. Box 15015, New Brunswick, New Jersey 08906-5015. The Fund will notify each shareholder after the close of the Fund's taxable year of both the dollar amount and the taxable status of that year's dividends and distributions on a per share basis. To the extent that, in a given year, distributions to shareholders exceed recognized net investment income and recognized short-term and long-term capital gains for the year, shareholders will receive a return of capital in respect of such year and, in an annual statement, will be notified of the amount of any return of capital for such year. Any distributions paid shortly after a purchase by an investor will have the effect of reducing the NAV of the investor's shares by the per share amount of the distributions. Such distributions, although in effect a return of invested principal, are subject to federal income taxes. Accordingly, prior to purchasing shares of the Fund, an investor should carefully consider the impact of capital gains distributions which are expected to be or have been announced. If you hold shares through Prudential Securities you should contact your financial adviser to elect to receive dividends and distributions in cash. WHEN THE FUND GOES EX-DIVIDEND, ITS NAV IS REDUCED BY THE AMOUNT OF THE DIVIDEND OR DISTRIBUTION. IF YOU BUY SHARES JUST PRIOR TO THE EX-DIVIDEND DATE (WHICH GENERALLY OCCURS FOUR BUSINESS DAYS PRIOR TO THE RECORD DATE) THE 22 PRICE YOU PAY WILL INCLUDE THE DIVIDEND OR DISTRIBUTION AND A PORTION OF YOUR INVESTMENT WILL BE RETURNED TO YOU AS A TAXABLE DISTRIBUTION. YOU SHOULD, THEREFORE, CONSIDER THE TIMING OF DIVIDENDS AND DISTRIBUTIONS WHEN MAKING YOUR PURCHASES. GENERAL INFORMATION DESCRIPTION OF COMMON STOCK THE FUND WAS INCORPORATED IN MARYLAND ON APRIL 8, 1983. THE FUND IS AUTHORIZED TO ISSUE TWO BILLION SHARES OF COMMON STOCK, $.01 PAR VALUE PER SHARE, DIVIDED INTO FOUR CLASSES, DESIGNATED CLASS A, CLASS B, CLASS C AND CLASS Z COMMON STOCK, EACH OF WHICH CONSISTS OF 500 MILLION AUTHORIZED SHARES. Each class of common stock represents an interest in the same assets of the Fund and is identical in all respects except that, (i) each class is subject to different sales charges and distribution and/or service fees (except for Class Z shares which are not subject to any distribution and/or service fees) which may affect performance, (ii) each class has exclusive voting rights on any matter submitted to shareholders that relates solely to its arrangement and has separate voting rights on any matter submitted to shareholders in which the interests of one class differ from the interests of any other class, (iii) each class has a different exchange privilege, (iv) only Class B shares have a conversion feature and (v) Class Z shares are offered exclusively for sale to a group of limited investors. See "How the Fund is Managed--Distributor." In accordance with the Fund's Articles of Incorporation, the Board of Directors may authorize the creation of additional series of common stock and classes within such series, with such preferences, privileges, limitations and voting and dividend rights as the Board may determine. Currently, the Fund is offering four classes, designated as Class A, Class B, Class C and Class Z shares. The Board of Directors may increase or decrease the number of authorized shares without approval by shareholders. Shares of the Fund, when issued, are fully paid, nonassessable, fully transferable and redeemable at the option of the holder. Shares are also redeemable at the option of the Fund under certain circumstances as described under "Shareholder Guide--How to Sell Your Shares." Each share of each class of common stock is equal as to earnings, assets and voting privileges, except as noted above, and each class (with the exception of Class Z shares, which are not subject to any distribution or service fees) bears the expenses related to the distribution of its shares. Except for the conversion feature applicable to the Class B shares, there are no conversion, preemptive or other subscription rights. In the event of liquidation, each share of common stock of the Fund is entitled to its portion of all of the Fund's assets after all debt and expenses of the Fund have been paid. Since Class B and Class C shares generally bear higher distribution expenses than Class A shares, the liquidation proceeds to shareholders of those classes are likely to be lower than to Class A shareholders and to Class Z shareholders, whose shares are not subject to any distribution and/ or service fees. The Fund's shares do not have cumulative voting rights for the election of Directors. THE FUND DOES NOT INTEND TO HOLD ANNUAL MEETINGS OF SHAREHOLDERS UNLESS OTHERWISE REQUIRED BY LAW. THE FUND WILL NOT BE REQUIRED TO HOLD MEETINGS OF SHAREHOLDERS UNLESS, FOR EXAMPLE, THE ELECTION OF DIRECTORS IS REQUIRED TO BE ACTED ON BY SHAREHOLDERS UNDER THE INVESTMENT COMPANY ACT. SHAREHOLDERS HAVE CERTAIN RIGHTS, INCLUDING THE RIGHT TO CALL A MEETING UPON A VOTE OF 10% OF THE FUND'S OUTSTANDING SHARES FOR THE PURPOSE OF VOTING ON THE REMOVAL OF ONE OR MORE DIRECTORS OR TO TRANSACT ANY OTHER BUSINESS. ADDITIONAL INFORMATION This Prospectus, including the Statement of Additional Information which has been incorporated by reference herein, does not contain all the information set forth in the Registration Statement filed by the Fund with the Commission under the Securities Act of 1933. Copies of the Registration Statement may be obtained at a reasonable charge from the Commission or may be examined, without charge, at the office of the Commission in Washington, D.C. 23 SHAREHOLDER GUIDE HOW TO BUY SHARES OF THE FUND YOU MAY PURCHASE SHARES OF THE FUND THROUGH THE DISTRIBUTOR, PRUSEC OR DIRECTLY FROM THE FUND, THROUGH ITS TRANSFER AGENT, PRUDENTIAL MUTUAL FUND SERVICES LLC (PMFS OR THE TRANSFER AGENT), ATTENTION: INVESTMENT SERVICES, P.O. BOX 15020, NEW BRUNSWICK, NEW JERSEY 08906-5020. The purchase price is the NAV next determined following receipt of an order by the Transfer Agent or the Distributor plus a sales charge which, at your option, may be imposed either (i) at the time of purchase (Class A shares) or (ii) on a deferred basis (Class B or Class C shares). Class Z shares are offered to a limited group of investors at NAV without any sales charge. Participants in programs sponsored by Prudential Retirement Services should contact their client representative for more information about Class Z shares. Payments may be made by cash, wire, check or through your brokerage account. See "Alternative Purchase Plan" below. See also "How the Fund Values its Shares." The minimum initial investment for Class A and Class B shares is $1,000 per class and $5,000 for Class C shares. There is no minimum investment requirement for Class Z shares. The minimum subsequent investment is $100 for all classes, except for Class Z shares, for which there is no such minimum. All minimum investment requirements are waived for certain retirement and employee savings plans or custodial accounts for the benefit of minors. For purchases made through the Automatic Savings Accumulation Plan, the minimum initial and subsequent investment is $50. See "Shareholder Services" below. Application forms can be obtained from PMFS, Prudential Securities or Prusec. If a stock certificate is desired, it must be requested in writing for each transaction. Certificates are issued only for full shares. Shareholders who hold their shares through Prudential Securities will not receive stock certificates. The Fund reserves the right to reject any purchase order (including an exchange into the Fund) or to suspend or modify the continuous offering of its shares. See "How to Sell Your Shares." Your dealer is responsible for forwarding payment promptly to the Fund. The Distributor reserves the right to cancel any purchase order for which payment has not been received by the fifth business day following the investment. Transactions in Fund shares may be subject to postage and handling charges imposed by your dealer. PURCHASE BY WIRE. For an initial purchase of shares of the Fund by wire, you must first telephone PMFS at (800) 225-1852 (toll-free) to receive an account number. The following information will be requested: your name, address, tax identification number, class election, dividend distribution election, amount being wired and wiring bank. Instructions should then be given by you to your bank to transfer funds by wire to State Street Bank and Trust Company, Boston, Massachusetts, Custody and Shareholder Services Division, Attention: Prudential Government Income Fund, Inc., specifying on the wire the account number assigned by PMFS and your name and identifying the class in which you are eligible to invest (Class A, Class B, Class C or Class Z shares). If you arrange for receipt by State Street of Federal Funds prior to 4:15 P .M., New York time, on a business day, you may purchase shares of the Fund as of that day. See "Net Asset Value" in the Statement of Additional Information. In making a subsequent purchase order by wire, you should wire State Street directly and should be sure that the wire specifies Prudential Government Income Fund, Inc., Class A, Class B, Class C or Class Z shares and your name and individual account number. It is not necessary to call PMFS to make subsequent purchase orders utilizing Federal Funds. The minimum amount which may be invested by wire is $1,000. 24 ALTERNATIVE PURCHASE PLAN THE FUND OFFERS FOUR CLASSES OF SHARES (CLASS A, CLASS B, CLASS C AND CLASS Z) WHICH ALLOWS YOU TO CHOOSE THE MOST BENEFICIAL SALES CHARGE STRUCTURE FOR YOUR INDIVIDUAL CIRCUMSTANCES GIVEN THE AMOUNT OF THE PURCHASE, THE LENGTH OF TIME YOU EXPECT TO HOLD THE SHARES AND OTHER RELEVANT CIRCUMSTANCES (THE ALTERNATIVE PURCHASE PLAN).
ANNUAL 12B-1 FEES (AS A % OF AVERAGE SALES CHARGE DAILY NET ASSETS) OTHER INFORMATION ----------------------------------- ----------------------------------- ----------------------------------- CLASS A Maximum initial sales charge of 4% .30 of 1% (Currently being charged Initial sales charge waived or of the public offering price at a rate of .15 of 1%) reduced for certain purchases CLASS B Maximum contingent deferred sales 1% (Currently being charged at a Shares convert to Class A shares charge or CDSC of 5% of the lesser rate of .825 of 1%) approximately seven years after of the amount invested or the purchase redemption proceeds; declines to zero after six years CLASS C Maximum CDSC of 1% of the lesser of 1% (Currently being charged at a Shares do not convert to another the amount invested or the rate of .75 of 1%) class redemption proceeds on redemptions made within one year of purchase CLASS Z None None Sold to a limited group of investors
The four classes of shares represent an interest in the same portfolio of investments of the Fund and have the same rights, except that (i) each class is subject to different sales charges and distribution and/or service fees (with the exception of Class Z shares, which are not subject to any distribution or service fees), which may affect performance, (ii) each class has exclusive voting rights on any matter submitted to shareholders that relates solely to its arrangement and has separate voting rights on any matter submitted to shareholders in which the interests of one class differs from the interests of any other class and (iii) only Class B shares have a conversion feature. The four classes also have separate exchange privileges. See "How to Exchange Your Shares" below. The income attributable to each class and the dividends payable on the shares of each class will be reduced by the amount of the distribution fee (if any) of each class. Class B and Class C shares bear the expenses of a higher distribution fee which will generally cause them to have higher expense ratios and to pay lower dividends than the Class A and Class Z shares. Financial advisers and other sales agents who sell shares of the Fund will receive different compensation for selling Class A, Class B, Class C and Class Z shares and will generally receive more compensation initially for selling Class A and Class B shares than for selling Class C or Class Z shares. IN SELECTING A PURCHASE ALTERNATIVE, YOU SHOULD CONSIDER, AMONG OTHER THINGS, (1) the length of time you expect to hold your investment, (2) the amount of any applicable sales charge (whether imposed at the time of purchase or redemption) and distribution-related fees, as noted above, (3) whether you qualify for any reduction or waiver of any applicable sales charge, (4) the various exchange privileges among the different classes of shares (see "How to Exchange Your Shares" below) and (5) that Class B shares automatically convert to Class A shares approximately seven years after purchase (see "Conversion Feature--Class B Shares" below). The following is provided to assist you in determining which method of purchase best suits your individual circumstances and is based on current fees and expenses being charged to the Fund: If you intend to hold your investment in the Fund for less than 7 years and do not qualify for a reduced sales charge on Class A shares, since Class A shares are subject to a maximum initial sales charge of 4% and Class B shares are subject to a CDSC of 5% which declines to zero over a 6 year period, you should consider purchasing Class C shares over either Class A or Class B shares. 25 If you intend to hold your investment for 7 years or more and do not qualify for a reduced sales charge on Class A shares, since Class B shares convert to Class A shares approximately 7 years after purchase and because all of your money would be invested initially in the case of Class B shares, you should consider purchasing Class B shares over either Class A or Class C shares. If you qualify for a reduced sales charge on Class A shares, it may be more advantageous for you to purchase Class A shares over either Class B or Class C shares regardless of how long you intend to hold your investment. However, unlike Class B and Class C shares, you would not have all of your money invested initially because the sales charge on Class A shares is deducted at the time of purchase. If you do not qualify for a reduced sales charge on Class A shares and you purchase Class B or Class C shares, you would have to hold your investment for more than 5 years in the case of Class B shares and 6 years in the case of Class C shares for the higher cumulative annual distribution-related fee on those shares to exceed the initial sales charge plus cumulative annual distribution- related fee on Class A shares. This does not take into account the time value of money, which further reduces the impact of the higher Class B or Class C distribution-related fee on the investment, fluctuations in NAV, the effect of the return on the investment over this period of time or redemptions when the CDSC is applicable. ALL PURCHASES OF $1 MILLION OR MORE, EITHER AS PART OF A SINGLE INVESTMENT OR UNDER RIGHTS OF ACCUMULATION OR LETTERS OF INTENT, MUST BE FOR CLASS A SHARES UNLESS THE PURCHASER IS ELIGIBLE TO PURCHASE CLASS Z SHARES. See "Reduction and Waiver of Initial Sales Charges" and "Class Z Shares" below. CLASS A SHARES The offering price of Class A shares for investors choosing the initial sales charge alternative is the next determined NAV plus a sales charge (expressed as a percentage of the offering price and of the amount invested) as shown in the following table:
SALES CHARGE AS SALES CHARGE AS DEALER CONCESSION PERCENTAGE OF PERCENTAGE OF AS PERCENTAGE OF AMOUNT OF PURCHASE OFFERING PRICE AMOUNT INVESTED OFFERING PRICE ------------------------ --------------- --------------- ----------------- $0 to $49,999 4.00% 4.17% 3.75% $50,000 to $99,999 3.50 3.83 3.25 $100,000 to $249,999 2.75 2.83 2.50 $250,000 to $499,999 2.00 2.04 1.90 $500,000 to $999,999 1.50 1.52 1.40 $1,000,000 and above None None None
The Distributor may reallow the entire initial sales charge to dealers. Selling dealers may be deemed to be underwriters, as that term is defined in the Securities Act. In connection with the sale of Class A shares at NAV (without payment of an initial sales charge), the Manager, the Distributor or one of their affiliates will pay dealers, financial advisers and other persons which distribute shares a finders' fee based on a percentage of the NAV shares sold by such persons. REDUCTION AND WAIVER OF INITIAL SALES CHARGES. Reduced sales charges are available through Rights of Accumulation and Letters of Intent. Shares of the Fund and shares of other Prudential Mutual Funds (excluding money market funds other than those acquired pursuant to the exchange privilege) may be aggregated to determine the applicable reduction. See "Purchase and Redemption of Fund Shares--Reduction and Waiver of Initial Sales Charges--Class A Shares" in the Statement of Additional Information. BENEFIT PLANS. Class A shares may be purchased at NAV, without payment of an initial sales charge, by pension, profit-sharing or other employee benefit plans qualified under Section 401 of the Internal Revenue Code and deferred compensation and annuity plans under Sections 457 and 403(b)(7) of the Internal Revenue Code (collectively, Benefit Plans), provided that the Benefit Plan has existing assets of at least $1 million invested in shares of Prudential Mutual Funds (excluding money market funds other than those acquired pursuant to the exchange privilege) or 250 eligible employees or participants. In the case of Benefit Plans whose accounts are held directly with the Transfer Agent or Prudential Securities and for which the Transfer Agent or Prudential Securities 26 does individual account recordkeeping (Direct Account Benefit Plans) and Benefit Plans sponsored by Prudential Securities or its subsidiaries (Prudential Securities or Subsidiary Prototype Benefit Plans), Class A shares may be purchased at NAV by participants who are repaying loans made from such plans to the participant. PRUDENTIAL RETIREMENT PROGRAMS. Class A shares may be purchased at NAV by certain savings, retirement and deferred compensation plans, qualified or non-qualified under the Internal Revenue Code, for which Prudential serves as the plan administrator or recordkeeper, provided that (i) the plan has at least $1 million in existing assets or 250 eligible employees and (ii) the Fund is an available investment option. These plans include pension, profit-sharing, stock-bonus or other employee benefit plans under Section 401 of the Internal Revenue Code, deferred compensation and annuity plans under Sections 457 or 403(b)(7) of the Internal Revenue Code and plans that participate in the Transfer Agent's PruArray and SmartPath Programs (benefit plan recordkeeping services) (hereafter referred to as a PruArray or SmartPath Plan). All plans of a company for which Prudential serves as plan administrator or recordkeeper are aggregated in meeting the $1 million threshold. The term existing assets as used herein includes stock issued by a plan sponsor, shares of Prudential Mutual Funds and shares of certain unaffiliated mutual funds that participate in the PruArray or SmartPath Program (Participating Funds). Existing Assets also include monies invested in The Guaranteed Interest Account (GIA), a group annuity insurance product issued by Prudential, and units of The Stable Value Fund (SVF), an unaffiliated bank collective fund. Class A shares may also be purchased at NAV by plans that have monies invested in GIA and SVF, provided (i) the purchase is made with the proceeds of a redemption from either GIA or SVF and (ii) Class A shares are an investment option of the plan. PRUARRAY ASSOCIATION BENEFIT PLANS. Class A shares are also offered at NAV to Benefit Plans or non-qualified plans sponsored by employers which are members of a common trade, professional or membership association (Association) that participate in the PruArray Program provided that the Association enters into a written agreement with Prudential. Such Benefit Plans or non-qualified plans may purchase Class A shares at NAV without regard to the assets or number of participants in the individual employer's qualified Plan(s) or non-qualified Plans so long as the employers in the Association (i) have retirement plan assets in the aggregate of at least $1 million or 250 participants in the aggregate and (ii) maintain their accounts with the Transfer agent. PRUARRAY SAVINGS PROGRAM. Class A shares are also offered at NAV to employees of companies that enter into a written agreement with Prudential Retirement Services to participate in the PruArray Savings Program. Under this Program, a limited number of Prudential Mutual Funds are available for purchase at NAV by Individual Retirement Accounts and Savings Accumulation Plans of the company's employees. The Program is available only to (i) employees who open an IRA or Savings Accumulation Plan account with the Transfer agent and (ii) spouses of employees who open an IRA account with the Transfer agent. The program is offered to companies that have at least 250 eligible employees. SPECIAL RULES APPLICABLE TO RETIREMENT PLANS. After a Benefit Plan, or PruArray or SmarthPath Plan qualifies to purchase Class A shares at NAV, all subsequent purchases will be made at NAV. OTHER WAIVERS. In addition, Class A shares may be purchased at NAV, through Prudential Securities or the Transfer Agent, by the following persons: (a) officers of the Prudential Mutual Funds (including the Fund), (b) employees of Prudential Securities and PIFM and their subsidiaries and members of the families of such persons who maintain an employee related account at Prudential Securities or the Transfer Agent, (c) employees of subadvisers of the Prudential Mutual Funds provided that purchases at NAV are permitted by such person's employer, (d) Prudential employees and special agents of Prudential and its subsidiaries and all persons who have retired directly from active service with Prudential or one of its subsidiaries, (e) registered representatives and employees of dealers who have entered into a selected dealer agreement with Prudential Securities provided that purchases at NAV are permitted by such person's employer, (f) investors who have a business relationship with a financial adviser who joined Prudential Securities from another investment firm, provided that (i) the purchase is made within 90 days of the commencement of the financial adviser's employment at Prudential Securities, (ii) the purchase is made with proceeds of a redemption of shares of any open-end, non-money market fund sponsored by the financial adviser's previous employer (other than a fund which imposes a distribution or service fee of .25 of 1% or less) and (iii) the financial adviser served as the client's broker on the previous purchase and (g) investors in Individual Retirement Accounts, provided the purchase is made with the proceeds of a tax-free rollover of assets from a Benefit Plan for which Prudential Investments serves as the recordkeeper or administrator. You must notify the Transfer Agent either directly or through Prudential Securities or Prusec at the time of purchase that you are entitled to a reduction or waiver of the sales charge. The reduction or waiver will be granted subject to confirmation of your 27 entitlement. No initial sales charges are imposed upon Class A shares acquired upon the reinvestment of dividends and distributions. See "Purchase and Redemption of Fund Shares--Reduction and Waiver of Initial Sales Charges--Class A Shares" in the Statement of Additional Information. CLASS B AND CLASS C SHARES The offering price of Class B and Class C shares for investors choosing one of the deferred sales charge alternatives is the NAV next determined following receipt of an order by the Transfer Agent or Prudential Securities. Although there is no sales charge imposed at the time of purchase, redemptions of Class B and Class C shares may be subject to a CDSC. See "How to Sell Your Shares--Contingent Deferred Sales Charges." The Distributor will pay, from its own resources, sales commissions of up to 4% of the purchase price of Class B shares to dealers, financial advisers and other persons who sell Class B shares at the time of sale from its own resources. This facilitates the ability of the Fund to sell the Class B shares without an initial sales charge being deducted at the time of purchase. The Distributor anticipates that it will recoup its advancement of sales commissions from the combination of the CDSC and the distribution fee. See "How the Fund is Managed--Distributor." In connection with the sale of Class C shares, the Distributor will pay, from its own resources, dealers, financial advisers and other persons which distribute Class C shares a sales commission of up to 1% of the purchase price at the time of the sale. CLASS Z SHARES Class Z shares of the Fund are currently available for purchase by the following categories of investors: (i) pension, profit-sharing or other employee benefit plans qualified under Section 401 of the Internal Revenue Code, deferred compensation plans and annuity plans under Sections 457 and 403(b)(7) of the Internal Revenue Code, and non-qualified plans for which the Fund is an available option (collectively, Benefit Plans), provided that such Benefit Plans (in combination with other plans sponsored by the same employer or group of related employers) have at least $50 million in defined contribution assets; (ii) participants in any fee-based program or trust program or trust program sponsored by Prudential Securities, The Prudential Savings Bank, F.S.B. or any affiliate which includes mutual funds as investment options and for which the Fund is an available option; (iii) certain participants in the MEDLEY Program (group variable annuity contracts) sponsored by Prudential for whom Class Z shares of the Prudential Mutual Funds are an available investment option; (iv) Benefit Plans for which Prudential Retirement Services serves as record keeper and, as of September 20, 1996, (a) were Class Z shareholders of the Prudential Mutual Funds, or (b) executed a letter of intent to purchase Class Z shares of the Prudential Mutual Funds; (v) current and former Directors/Trustees of the Prudential Mutual Funds (including the Fund); and (vi) employees of Prudential and/or Prudential Securities who participate in a Prudential-sponsored employee saving plan. In connection with the sale of Class Z shares, the Manager, the Distributor or one of their affiliates may pay dealers, financial advisers and other persons which distribute shares a finders' fee, from its own resources, based on a percentage of the NAV sold by such persons. HOW TO SELL YOUR SHARES YOU CAN REDEEM YOUR SHARES AT ANY TIME AT THE NAV NEXT DETERMINED AFTER THE REDEMPTION REQUEST IS RECEIVED IN PROPER FORM BY THE TRANSFER AGENT OR PRUDENTIAL SECURITIES. SEE "HOW THE FUND VALUES ITS SHARES." In certain cases, however, redemption proceeds will be reduced by the amount of any applicable CDSC, as described below. See "Waiver of Contingent Deferred Sales Charges--Class B Shares." IF YOU HOLD SHARES OF THE FUND THROUGH PRUDENTIAL SECURITIES, YOU MUST REDEEM YOUR SHARES THROUGH PRUDENTIAL SECURITIES. PLEASE CONTACT YOUR PRUDENTIAL SECURITIES FINANCIAL ADVISER. IF YOU HOLD SHARES IN NON-CERTIFICATE FORM, A WRITTEN REQUEST FOR REDEMPTION SIGNED BY YOU EXACTLY AS THE ACCOUNT IS REGISTERED IS REQUIRED. IF YOU HOLD CERTIFICATES, THE CERTIFICATES, SIGNED IN THE NAME(S) SHOWN ON THE FACE OF THE CERTIFICATES, MUST BE RECEIVED BY THE TRANSFER AGENT IN ORDER FOR THE REDEMPTION REQUEST TO BE PROCESSED. IF REDEMPTION IS REQUESTED BY A CORPORATION, PARTNERSHIP, TRUST OR FIDUCIARY, WRITTEN EVIDENCE OF AUTHORITY ACCEPTABLE TO THE TRANSFER AGENT MUST BE SUBMITTED BEFORE SUCH REQUEST WILL BE ACCEPTED. All correspondence and documents concerning redemptions should be sent to the Fund in care of its Transfer Agent, Prudential Mutual Fund Services LLC, Attention: Redemption Services, P .O. Box 15010, New Brunswick, New Jersey 08906-5010. 28 If the proceeds of the redemption (a) exceed $50,000, (b) are to be paid to a person other than the record owner, (c) are to be sent to an address other than the address on the Transfer Agent's records, or (d) are to be paid to a corporation, partnership, trust or fiduciary, the signature(s) on the redemption request and on the certificates, if any, or stock power must be guaranteed by an eligible guarantor institution. An eligible guarantor institution includes any bank, broker, dealer or credit union. The Transfer Agent reserves the right to request additional information from, and make reasonable inquiries of, any eligible guarantor institution. For clients of Prusec, a signature guarantee may be obtained from the agency or office manager of most Prudential Insurance and Financial Services or Prudential Preferred Financial Services Offices. In the case of redemptions from a PruArray or SmartPath Plan, if the proceeds of the redemption are invested in another investment option of the Plan in the name of the record holder and at the same address as reflected in the Transfer Agent's records, a signature guarantee is not required. PAYMENT FOR SHARES PRESENTED FOR REDEMPTION WILL BE MADE BY CHECK WITHIN SEVEN DAYS AFTER RECEIPT BY THE TRANSFER AGENT OF THE CERTIFICATE AND/OR WRITTEN REQUEST EXCEPT AS INDICATED BELOW. IF YOU HOLD SHARES THROUGH PRUDENTIAL SECURITIES, PAYMENT FOR SHARES PRESENTED FOR REDEMPTION WILL BE CREDITED TO YOUR PRUDENTIAL SECURITIES ACCOUNT, UNLESS YOU INDICATE OTHERWISE. Such payment may be postponed or the right of redemption suspended at times (a) when the New York Stock Exchange is closed for other than customary weekends and holidays, (b) when trading on such Exchange is restricted, (c) when an emergency exists as a result of which disposal by the Fund of securities owned by it is not reasonably practicable or it is not reasonably practicable for the Fund fairly to determine the value of its net assets, or (d) during any other period when the Commission, by order, so permits; provided that applicable rules and regulations of the Commission shall govern as to whether the conditions prescribed in (b), (c) or (d) exist. PAYMENT FOR REDEMPTION OF RECENTLY PURCHASED SHARES WILL BE DELAYED UNTIL THE FUND OR ITS TRANSFER AGENT HAS BEEN ADVISED THAT THE PURCHASE CHECK HAS BEEN HONORED, UP TO 10 CALENDAR DAYS FROM THE TIME OF RECEIPT OF THE PURCHASE CHECK BY THE TRANSFER AGENT. SUCH DELAY MAY BE AVOIDED BY PURCHASING SHARES BY WIRE OR BY CERTIFIED OR CASHIER'S CHECK. REDEMPTION IN KIND. If the Board of Directors determines that it would be detrimental to the best interests of the remaining shareholders of the Fund to make payment wholly or partly in cash, the Fund may pay the redemption price in whole or in part by a distribution in kind of securities from the investment portfolio of the Fund, in lieu of cash, in conformity with applicable rules of the Commission. Securities will be readily marketable and will be valued in the same manner as in a regular redemption. See "How the Fund Values Its Shares." If your shares are redeemed in kind, you would incur transaction costs in converting the assets into cash. The Fund, however, has elected to be governed by Rule 18f-1 under the Investment Company Act, under which the Fund is obligated to redeem shares solely in cash up to the lesser of $250,000 or 1% of the NAV of the Fund during any 90-day period for any one shareholder. INVOLUNTARY REDEMPTION. In order to reduce expenses of the Fund, the Board of Directors may redeem all of the shares of any shareholder, other than a shareholder which is an IRA or other tax-deferred retirement plan, whose account has a NAV of less than $500 due to a redemption. The Fund will give such shareholders 60 days' prior written notice in which to purchase sufficient additional shares to avoid such redemption. No CDSC will be imposed on any involuntary redemption. 90-DAY REPURCHASE PRIVILEGE. If you redeem your shares and have not previously exercised the repurchase privilege, you may reinvest any portion or all of the proceeds of such redemption in shares of the Fund at the NAV next determined after the order is received, which must be within 90 days after the date of the redemption. Any contingent deferred sales charge or CDSC paid in connection with such redemption will be credited (in shares) to your account. If less than a full repurchase is made, the credit will be on a PRO RATA basis. You must notify the Transfer Agent, either directly or through Prudential Securities, at the time the repurchase privilege is exercised to adjust your account for the CDSC you previously paid. Thereafter, any redemptions will be subject to the CDSC applicable at the time of the redemption. See "Contingent Deferred Sales Charges" below. Exercise of the repurchase privilege may affect federal tax treatment of any gain or loss realized upon redemption. CONTINGENT DEFERRED SALES CHARGES Redemptions of Class B shares will be subject to a CDSC declining from 5% to zero over a six-year period. Class C shares redeemed within one year of purchase will be subject to a 1% CDSC. The CDSC will be deducted from the redemption proceeds and reduce the amount paid to you. The CDSC will be imposed on any redemptions by you which reduces the current value of your Class B or Class C shares to an amount which is lower than the amount of all payments by you for shares during the 29 preceding six years, in the case of Class B shares, and one year, in the case of Class C shares. A CDSC will be applied on the lesser of the original purchase price or the current value of the shares being redeemed. Increases in the value of your shares or shares acquired through reinvestment of dividends or distributions are not subject to a CDSC. The amount of any CDSC will be paid to and retained by the Distributor. See "How the Fund is Managed--Distributor" and "Waiver of Contingent Deferred Sales Charges--Class B Shares" below. The amount of the CDSC, if any, will vary depending on the number of years from the time of payment for the purchase of shares until the time of redemption of such shares. Solely for purposes of determining the number of years from the time of any payment for the purchase of shares, all payments during a month will be aggregated and deemed to have been made on the last day of the month. The CDSC will be calculated from the first day of the month after the initial purchase, excluding the time shares were held in a money market fund. See "How to Exchange Your Shares." The following table sets forth the rates of the CDSC applicable to redemptions of Class B shares.
CONTINGENT DEFERRED SALES CHARGE AS A PERCENTAGE YEAR SINCE PURCHASE OF DOLLARS INVESTED OR PAYMENT MADE REDEMPTION PROCEEDS - -------------------------------------------------- ---------------------- First............................................. 5.0% Second............................................ 4.0 Third............................................. 3.0 Fourth............................................ 2.0 Fifth............................................. 1.0 Sixth............................................. 1.0 Seventh........................................... None
In determining whether a CDSC is applicable to a redemption, the calculation will be made in a manner that generally results in the lowest possible rate. It will be assumed that the redemption is made first of amounts representing shares acquired pursuant to the reinvestment of dividends and distributions; then of amounts representing the increase in NAV above the total amount of payments for the purchase of Fund shares made during the preceding six years (five years for Class B shares purchased prior to January 22, 1990); then of amounts representing the cost of shares held beyond the applicable CDSC period; then of amounts representing the cost of shares acquired prior to July 1, 1985; and finally, of amounts representing the cost of shares held for the longest period of time within the applicable CDSC period. For example, assume you purchased 100 Class B shares at $10 per share for a cost of $1,000. Subsequently, you acquired 5 additional Class B shares through dividend reinvestment. During the second year after the purchase you decided to redeem $500 of your investment. Assuming at the time of the redemption the NAV had appreciated to $12 per share, the value of your Class B shares would be $1,260 (105 shares at $12 per share). The CDSC would not be applied to the value of the reinvested dividend shares and the amount which represents appreciation ($260). Therefore, $240 of the $500 redemption proceeds ($500 minus $260) would be charged at a rate of 4% (the applicable rate in the second year after purchase) for a total CDSC of $9.60. For federal income tax purposes, the amount of the CDSC will reduce the gain or increase the loss, as the case may be, on the amount recognized on the redemption of shares. WAIVER OF CONTINGENT DEFERRED SALES CHARGES--CLASS B SHARES. The CDSC will be waived in the case of a redemption following the death or disability of a shareholder or, in the case of a trust account, following the death or disability of the grantor. The waiver is available for total or partial redemptions of shares owned by a person, either individually or in joint tenancy (with rights of survivorship), at the time of death or initial determination of disability, provided that the shares were purchased prior to death or disability. The CDSC will also be waived in the case of a total or partial redemption in connection with certain distributions made without penalty under the Internal Revenue Code from a tax-deferred retirement plan, an IRA or Section 403(b) custodial account. These distributions include: (i) in the case of a tax-deferred retirement plan, a lump-sum or other distribution after retirement; (ii) in the case of an IRA or Section 403(b) custodial account, a lump-sum or other distribution after attaining age 59 1/2; and (iii) a tax-free return of an excess contribution or plan distributions following the death or disability of the shareholder, provided that the shares 30 were purchased prior to death or disability. The waiver does not apply in the case of a tax-free rollover or transfer of assets, other than one following a separation from service (I.E., following voluntary or involuntary termination of employment or following retirement). Under no circumstances will the CDSC be waived on redemptions resulting from the termination of a tax-deferred retirement plan, unless such redemptions otherwise qualify for a waiver as described above. In the case of Direct Account and Prudential Securities or Subsidiary Prototype Benefit Plans, the CDSC will be waived on redemptions which represent borrowings from such plans. Shares purchased with amounts used to repay a loan from such plans on which a CDSC was not previously deducted will thereafter be subject to a CDSC without regard to the time such amounts were previously invested. In the case of a 401(k) plan, the CDSC will also be waived upon the redemption of shares purchased with amounts used to repay loans made from the account to the participant and from which a CDSC was previously deducted. SYSTEMATIC WITHDRAWAL PLAN. The CDSC will be waived (or reduced) on certain redemptions from a Systematic Withdrawal Plan. On an annual basis, up to 12% of the total dollar amount subject to the CDSC may be redeemed without charge. The Transfer Agent will calculate the total amount available for this waiver annually on the anniversary date of your purchase or, for shares purchased prior to March 1, 1997, on March 1 of the current year. The CDSC will be waived (or reduced) on redemptions until this threshold 12% amount is reached. In addition, the CDSC will be waived on redemptions of shares held by a Director of the Fund. You must notify the Transfer Agent either directly or through Prudential Securities or Prusec, at the time of redemption, that you are entitled to waiver of the CDSC and provide the Transfer Agent with such supporting documentation as it may deem appropriate. The waiver will be granted subject to confirmation of your entitlement. See "Purchase and Redemption of Fund Shares--Waiver of the Contingent Deferred Sales Charge--Class B Shares" in the Statement of Additional Information. A quantity discount may apply to redemptions of Class B shares purchased prior to August 1, 1994. See "Purchase and Redemption of Fund Shares--Quantity Discount--Class B Shares Purchased Prior to August 1, 1994" in the Statement of Additional Information. WAIVER OF CONTINGENT DEFERRED SALES CHARGES--CLASS C SHARES PRUARRAY OR SMARTPATH PLANS. The CDSC will be waived on the following redemptions from qualified and non-qualified retirement and deferred compensation plans that participate in the Transfer Agent's PruArray and SmartPath Programs: (i) redemptions from a 403(b) or 457 plan; and (ii) redemptions from a qualified or non-qualified plan, provided that the investment options of the plan include shares of Prudential Mutual Funds and shares of non-affiliated mutual funds. CONVERSION FEATURE--CLASS B SHARES Class B shares will automatically convert to Class A shares on a quarterly basis approximately seven years after purchase. Conversions will be effected at relative NAV without the imposition of any additional sales charge. The first conversion of Class B shares occurred in February 1995, when the conversion feature was first implemented. Since the Fund tracks amounts paid rather than the number of shares bought on each purchase of Class B shares, the number of Class B shares eligible to convert to Class A shares (excluding shares acquired through the automatic reinvestment of dividends and other distributions) (the Eligible Shares) will be determined on each conversion date in accordance with the following formula: (i) the ratio of (a) the amounts paid for Class B shares purchased at least seven years prior to the conversion date to (b) the total amount paid for all Class B shares purchased and then held in your account (ii) multiplied by the total number of Class B shares purchased and then held in your account. Each time any Eligible Shares in your account convert to Class A shares, all shares or amounts representing Class B shares then in your account that were acquired through the automatic reinvestment of dividends and other distributions will convert to Class A shares. For purposes of determining the number of Eligible Shares, if the Class B shares in your account on any conversion date are the result of multiple purchases at different NAVs, the number of Eligible Shares calculated as described above will generally be either more or less than the number of shares actually purchased approximately seven years before such conversion date. For example, if 100 shares were initially purchased at $10 per share (for a total of $1,000) and a second purchase of 100 shares was subsequently made at $11 per share (for a total of $1,100), 95.24 shares would convert approximately seven years from the initial 31 purchase (I.E., $1,000 divided by $2,100 (47.62%) multiplied by 200 shares equals 95.24 shares). The Manager reserves the right to modify the formula for determining the number of Eligible Shares in the future as it deems appropriate on notice to shareholders. Since annual distribution-related fees are lower for Class A shares than Class B shares, the NAV of the Class A shares may be higher than that of the Class B shares at the time of conversion. Thus, although the aggregate dollar value will be the same, you may receive fewer Class A shares than Class B shares converted. See "How the Fund Values its Shares." For purposes of calculating the applicable holding period for conversions, all payments for Class B shares during a month will be deemed to have been made on the last day of the month, or for Class B shares acquired through exchange, or a series of exchanges, on the last day of the month in which the original payment for purchases of such Class B shares was made. For Class B shares previously exchanged for shares of a money market fund, the time period during which such shares were held in the money market fund will be excluded. For example, Class B shares held in a money market fund for one year will not convert to Class A shares until approximately eight years from purchase. For purposes of measuring the time period during which shares are held in a money market fund, exchanges will be deemed to have been made on the last day of the month. Class B shares acquired through exchange will convert to Class A shares after expiration of the conversion period applicable to the original purchase of such shares. The conversion feature may be subject to the continuing availability of opinions of counsel or rulings of the Internal Revenue Service (i) that the dividends and other distributions paid on Class A, Class B, Class C and Class Z shares will not constitute preferential dividends under the Internal Revenue Code and (ii) that the conversion of shares does not constitute a taxable event. The conversion of Class B shares into Class A shares may be suspended if such opinions or rulings are no longer available. If conversions are suspended, Class B shares of the Fund will continue to be subject, possibly indefinitely, to their higher annual distribution and service fee. HOW TO EXCHANGE YOUR SHARES AS A SHAREHOLDER OF THE FUND, YOU HAVE AN EXCHANGE PRIVILEGE WITH CERTAIN OTHER PRUDENTIAL MUTUAL FUNDS, INCLUDING ONE OR MORE SPECIFIED MONEY MARKET FUNDS, SUBJECT TO THE MINIMUM INVESTMENT REQUIREMENT OF SUCH FUNDS. CLASS A, CLASS B, CLASS C AND CLASS Z SHARES MAY BE EXCHANGED FOR CLASS A, CLASS B, CLASS C AND CLASS Z SHARES, RESPECTIVELY, OF ANOTHER FUND ON THE BASIS ON THE RELATIVE NAV. No sales charge will be imposed at the time of the exchange. Any applicable CDSC payable upon the redemption of shares exchanged will be calculated from the first day of the month after the initial purchase, excluding the time shares were held in a money market fund. Class B and Class C shares may not be exchanged into money market funds other than Prudential Special Money Market Fund, Inc. For purposes of calculating the holding period applicable to the Class B conversion feature, the time period during which Class B shares were held in a money market fund will be excluded. See "Conversion Feature--Class B Shares" above. An exchange will be treated as a redemption and purchase for tax purposes. See "Shareholder Investment Account--Exchange Privilege" in the Statement of Additional Information. IN ORDER TO EXCHANGE SHARES BY TELEPHONE, YOU MUST AUTHORIZE THE TELEPHONE EXCHANGE PRIVILEGE ON YOUR INITIAL APPLICATION FORM OR BY WRITTEN NOTICE TO THE TRANSFER AGENT AND HOLD SHARES IN NON-CERTIFICATE FORM. Thereafter, you may call the Fund at (800) 225-1852 to execute a telephone exchange of shares on weekdays, except holidays, between the hours of 8:00 A. M. and 6:00 P. M., New York time. For your protection and to prevent fraudulent exchanges, your telephone call will be recorded and you will be asked to provide your personal identification number. A written confirmation of the exchange transaction will be sent to you. NEITHER THE FUND NOR ITS AGENTS WILL BE LIABLE FOR ANY LOSS, LIABILITY OR COST WHICH RESULTS FROM ACTING UPON INSTRUCTIONS REASONABLY BELIEVED TO BE GENUINE UNDER THE FOREGOING PROCEDURES. All exchanges will be made on the basis of the relative NAV of the two funds next determined after the request is received in good order. The exchange privilege is available only in states where the exchange may legally be made. IF YOU HOLD SHARES THROUGH PRUDENTIAL SECURITIES OR THROUGH A DEALER WHICH HAS ENTERED INTO A SELECTED DEALER AGREEMENT WITH THE FUND'S DISTRIBUTOR, YOU MUST EXCHANGE YOUR SHARES BY CONTACTING YOUR FINANCIAL ADVISER. IF YOU HOLD CERTIFICATES, THE CERTIFICATES, SIGNED IN THE NAME(S) SHOWN ON THE FACE OF THE CERTIFICATES MUST BE RETURNED IN ORDER FOR THE SHARES TO BE EXCHANGED. SEE "HOW TO SELL YOUR SHARES" ABOVE. 32 You may also exchange shares by mail by writing to Prudential Mutual Fund Services LLC, Attention: Exchange Processing, P .O. Box 15010, New Brunswick, New Jersey 08906-5010. IN PERIODS OF SEVERE MARKET OR ECONOMIC CONDITIONS THE TELEPHONE EXCHANGE OF SHARES MAY BE DIFFICULT TO IMPLEMENT AND SHAREHOLDERS SHOULD MAKE EXCHANGES BY MAIL BY WRITING TO PRUDENTIAL MUTUAL FUND SERVICES LLC, AT THE ADDRESS NOTED ABOVE. SPECIAL EXCHANGE PRIVILEGES. A special exchange privilege is available for shareholders who qualify to purchase Class A shares at NAV (see "Alternative Purchase Plan--Class A Shares--Reduction and Waiver of Initial Sales Charges" above) and for shareholders who qualify to purchase Class Z shares (see "Alternative Purchase Plan--Class Z Shares" above). Under this exchange privilege, amounts representing any Class B and Class C shares (which are not subject to a CDSC) held in such a shareholder's account will be automatically exchanged for Class A shares for shareholders who qualify to purchase Class A shares at NAV on a quarterly basis, unless the shareholder elects otherwise. Similarly, shareholders who qualify to purchase Class Z shares will have their Class B and Class C shares which are not subject to a CDSC and their Class A shares exchanged for Class Z shares on a quarterly basis. Eligibility for this exchange privilege will be calculated on the business day prior to the date of the exchange. Amounts representing Class B or Class C shares which are not subject to a CDSC include the following: (1) amounts representing Class B or Class C shares acquired pursuant to the automatic reinvestment of dividends and distributions, (2) amounts representing the increase in the NAV above the total amount of payments for the purchase of Class B or Class C shares and (3) amounts representing Class B or Class C shares held beyond the applicable CDSC period. Class B and Class C shareholders must notify the Transfer Agent either directly or through Prudential Securities or Prusec that they are eligible for this special exchange privilege. Participants in any fee-based program for which the Fund is an available option will have their Class A shares, if any, exchanged for Class Z shares when they elect to have those assets become a part of the fee-based program. Upon leaving the program (whether voluntarily or not), such Class Z shares (and, to the extent provided for in the program, Class Z shares acquired through participation in the program) will be exchanged for Class A shares at NAV. Similarly, participants in Prudential Securities' 401(k) Plan for which the Fund's Class Z shares is an available option and who wish to transfer their Class Z shares out of the Prudential Securities 401(k) Plan following separation from service (I.E., voluntary or involuntary termination of employment or retirement) will have their Class Z shares exchanged for Class A shares at NAV. The exchange privilege is not a right and may be suspended, modified or terminated on 60 days' notice to shareholders. FREQUENT TRADING. The Fund and the other Prudential Mutual Funds are not intended to serve as vehicles for frequent trading in response to short-term fluctuations in the market. Due to the disruptive effect that market timing investment strategies and excessive trading can have on efficient portfolio management, each Prudential Mutual Fund, including the Fund, reserves the right to refuse purchase orders and exchanges by any person, group or commonly controlled accounts, if, in the Manager's sole judgment, such person, group or accounts were following a market timing strategy or were otherwise engaging in excessive trading (Market Timers). To implement this authority to protect the Fund and its shareholders from excessive trading, the Fund will reject all exchanges and purchases from a Market Timer unless the Market Timer has entered into a written agreement with the Fund or its affiliates pursuant to which the Market Timer has agreed to abide by certain procedures, which include a daily dollar limit on trading. The Fund may notify the Market Timer of rejection of an exchange or purchase order subsequent to the day on which the order was placed. SHAREHOLDER SERVICES In addition to the exchange privilege, as a shareholder in the Fund, you can take advantage of the following additional services and privileges: - AUTOMATIC REINVESTMENT OF DIVIDENDS AND/OR DISTRIBUTIONS WITHOUT A SALES CHARGE. For your convenience, all dividends or distributions are automatically reinvested in full and fractional shares of the Fund at NAV without a sales charge. You may direct the Transfer Agent in writing not less than 5 full business days prior to the record date to have subsequent dividends and/or distributions sent in cash rather than reinvested. If you hold shares through Prudential Securities, you should contact your financial adviser. 33 - AUTOMATIC SAVINGS ACCUMULATION PLAN (ASAP). Under ASAP you may make regular purchases of the Fund's shares in amounts as little as $50 via an automatic debit to a bank account or Prudential Securities account (including a Command Account). For additional information about this service, you may contact your Prudential Securities financial adviser, Prusec representative or the Transfer Agent directly. - TAX-DEFERRED RETIREMENT PLANS. Various tax-deferred retirement plans, including a 401(k) plan, self-directed individual retirement accounts and tax-sheltered accounts under Section 403(b)(7) of the Internal Revenue Code are available through the Distributor. These plans are for use by both self-employed individuals and corporate employers. These plans permit either self-direction of accounts by participants, or a pooled account arrangement. Information regarding the establishment of these plans, the administration, custodial fees and other details is available from Prudential Securities or the Transfer Agent. If you are considering adopting such a plan, you should consult with your own legal or tax adviser with respect to the establishment and maintenance of such a plan. - SYSTEMATIC WITHDRAWAL PLAN. A systematic withdrawal plan is available to shareholders which provides for monthly or quarterly checks. Withdrawal of Class B and Class C shares may be subject to a CDSC. See "How to Sell Your Shares-- Contingent Deferred Sales Charges." See also "Shareholder Investment Account--Systematic Withdrawal Plan" in the Statement of Additional Information. - REPORTS TO SHAREHOLDERS. The Fund will send you annual and semi-annual reports. The financial statements appearing in annual reports are audited by independent accountants. In order to reduce duplicate mailing and printing expenses, the Fund will provide one annual and semi-annual shareholder report and annual prospectus per household. You may request additional copies of such reports by calling (800) 225-1852 (toll-free) or by writing to the Fund at Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077. In addition, monthly unaudited financial data are available upon request from the Fund. - SHAREHOLDER INQUIRIES. Shareholder inquiries should be addressed to the Fund at Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077, or by telephone, at (800) 225-1852 (toll-free) or, from outside the U.S.A., at (908) 417-7555 (collect). For additional information regarding the services and privileges described above, see "Shareholder Investment Account" in the Statement of Additional Information. 34 THE PRUDENTIAL MUTUAL FUND FAMILY Prudential offers a broad range of mutual funds designed to meet your individual needs. We welcome you to review the investment options available through our family of funds. For more information on the Prudential Mutual Funds, including charges and expenses, contact your Prudential Securities financial adviser or Prusec representative or telephone the Funds at (800) 225-1852 for a free prospectus. Read the prospectus carefully before you invest or send money. TAXABLE BOND FUNDS -------------------------- Prudential Diversified Bond Fund, Inc. Prudential Government Income Fund, Inc. Prudential Government Securities Trust Short-Intermediate Term Series Prudential High Yield Fund, Inc. Prudential High Yield Total Return Fund, Inc. Prudential Mortgage Income Fund, Inc. Prudential Structured Maturity Fund, Inc. Income Portfolio TAX-EXEMPT BOND FUNDS ----------------------------- Prudential California Municipal Fund California Series California Income Series Prudential Municipal Bond Fund High Yield Series Insured Series Intermediate Series Prudential Municipal Series Fund Florida Series Maryland Series Massachusetts Series Michigan Series New Jersey Series New York Series North Carolina Series Ohio Series Pennsylvania Series Prudential National Municipals Fund, Inc. GLOBAL FUNDS -------------------- Prudential Europe Growth Fund, Inc. Prudential Global Genesis Fund, Inc. Prudential Global Limited Maturity Fund, Inc. Limited Maturity Portfolio Prudential Intermediate Global Income Fund, Inc. Prudential International Bond Fund, Inc. Prudential Natural Resources Fund, Inc. Prudential Pacific Growth Fund, Inc. Prudential World Fund, Inc. Global Series International Stock Series Global Utility Fund, Inc. The Global Total Return Fund, Inc. EQUITY FUNDS -------------------- Prudential Balanced Fund Prudential Distressed Securities Fund, Inc. Prudential Emerging Growth Fund, Inc. Prudential Equity Fund, Inc. Prudential Equity Income Fund Prudential Index Series Fund Prudential Stock Index Fund Prudential Bond Market Index Fund Prudential Europe Index Fund Prudential Pacific Index Fund Prudential Small-Cap Index Fund Prudential Stock Index Fund Prudential Jennison Series Fund, Inc. Prudential Active Balanced Fund Prudential Jennison Growth Fund Prudential Jennison Growth & Income Fund Prudential Multi-Sector Fund, Inc. Prudential Real Estate Securities Fund Prudential Small-Cap Quantum Fund, Inc. Prudential Small Company Value Fund, Inc. Prudential Utility Fund, Inc. Nicholas-Applegate Fund, Inc. Nicholas-Applegate Growth Equity Fund MONEY MARKET FUNDS -------------------------- - - TAXABLE MONEY MARKET FUNDS Cash Accumulation Trust Liquid Assets Fund National Money Market Fund Prudential Government Securities Trust Money Market Series U.S. Treasury Money Market Series Prudential Special Money Market Fund, Inc. Money Market Series Prudential MoneyMart Assets, Inc. - - TAX-FREE MONEY MARKET FUNDS Prudential Tax-Free Money Fund, Inc. Prudential California Municipal Fund California Money Market Series Prudential Municipal Series Fund Connecticut Money Market Series Massachusetts Money Market Series New Jersey Money Market Series New York Money Market Series - - COMMAND FUNDS Command Money Fund Command Government Fund Command Tax-Free Fund - - INSTITUTIONAL MONEY MARKET FUNDS Prudential Institutional Liquidity Portfolio, Inc. Institutional Money Market Series A-1 No dealer, sales representative or any other person has been authorized to give any information or to make any representations, other than those contained in this Prospectus, in connection with the offer contained herein, and, if given or made, such other information or representations must not be relied upon as having been authorized by the Fund or the Distributor. This Prospectus does not constitute an offer by the Fund or by the Distributor to sell or a solicitation of any offer to buy any of the securities offered hereby in any jurisdiction to any person to whom it is unlawful to make such offer in such jurisdiction. - ------------------------------------------- TABLE OF CONTENTS
PAGE --- FUND HIGHLIGHTS................................. 2 What are the Fund's Risk Factors and Special Characteristics?............................. 2 FUND EXPENSES................................... 4 FINANCIAL HIGHLIGHTS............................ 5 HOW THE FUND INVESTS............................ 9 Investment Objective and Policies............. 9 Other Investments and Policies................ 11 Other Investment Information.................. 15 Investment Restrictions....................... 17 HOW THE FUND IS MANAGED......................... 17 Manager....................................... 17 Distributor................................... 18 Fee Waivers and Subsidy....................... 20 Portfolio Transactions........................ 20 Custodian and Transfer and Dividend Disbursing Agent........................................ 20 Year 2000..................................... 20 HOW THE FUND VALUES ITS SHARES.................. 20 HOW THE FUND CALCULATES PERFORMANCE............. 21 TAXES, DIVIDENDS AND DISTRIBUTIONS.............. 21 GENERAL INFORMATION............................. 23 Description of Common Stock................... 23 Additional Information........................ 23 SHAREHOLDER GUIDE............................... 24 How to Buy Shares of the Fund................. 24 Alternative Purchase Plan..................... 25 How to Sell Your Shares....................... 28 Conversion Feature--Class B Shares............ 31 How to Exchange Your Shares................... 32 Shareholder Services.......................... 33 THE PRUDENTIAL MUTUAL FUND FAMILY............... A-1
- ------------------------------------------- MF128A Class A: 744339-10-2 Class B: 744339-20-1 CUSIP Nos.: Class C: 744339-30-0 Class Z: 744339-40-9 PRUDENTIAL GOVERNMENT INCOME FUND, INC. PROSPECTUS April 30, 1998 www.prudential.com ----------------- [LOGO] Supplement dated July 1, 1998 THE FOLLOWING INFORMATION SUPPLEMENTS YOUR PROSPECTUS: Effective July 1, 1998, Prudential Investment Management Services LLC, Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077, was appointed the exclusive Distributor of Fund shares. Shares continue to be offered through Prudential Securities Incorporated, Pruco Securities Corporation and other brokers and dealers. Prudential Investment Management Services is a wholly owned subsidiary of The Prudential Insurance Company of America and an affiliate of Prudential Securities Incorporated and Pruco Securities Corporation. All other arrangements with respect to the distribution of Fund shares described in the Prospectus remain unchanged. Supplement dated September 1, 1998 The following information should be added to the cover page of the Prospectus. AN INVESTMENT IN THE FUND IS NOT A DEPOSIT OF ANY BANK AND IS NOT INSURED OR GUARANTEED BY THE FEDERAL DEPOSIT INSURANCE CORPORATION OR ANY OTHER GOVERNMENT AGENCY. The following information should be added under the heading "Shareholder Guide--Shareholder Services." SHAREHOLDER GUIDE SHAREHOLDER SERVICES THE PRUTECTOR PROGRAM--OPTIONAL GROUP TERM LIFE INSURANCE. Prudential makes available optional group term life insurance coverage to purchasers of shares of certain Prudential Mutual Funds which are held in an eligible brokerage account. This insurance protects the value of your mutual fund investment for your beneficiaries against market downturns. The insurance benefit is based on the difference at the time of the insured's death between the "protected value" and the then current market value of the shares. This coverage is not available in all states and is subject to various restrictions and limitations. For more complete information about this program, including charges and expenses, please contact your Prudential representative. EX-99.17(C) 14 PROS DATED MARCH 3, 1998 Prudential Mortgage Income Fund, Inc. - -------------------------------- PROSPECTUS DATED MARCH 3, 1998 - ---------------------------------------------------------------- Prudential Mortgage Income Fund, Inc. (the Fund), formerly the Prudential GNMA Fund, Inc., is an open-end, diversified, management investment company whose investment objective is to achieve a high level of income over the long term consistent with providing reasonable safety in the value of each shareholder's investment. In pursuing this objective, the Fund will invest primarily in mortgage-related instruments, including mortgage-backed securities guaranteed as to timely payment of principal and interest by the Government National Mortgage Association (GNMA), other mortgage-backed securities issued or guaranteed by agencies or instrumentalities of the U.S. Government, and non-agency mortgage instruments, along with obligations using mortgages as collateral. The Fund may utilize other derivatives, including writing covered call and put options on U.S. Government securities and entering into closing purchase and sale transactions with respect to certain of such options. To hedge against changes in interest rates, the Fund may also purchase put options and engage in transactions involving interest rate futures contracts, options on such contracts and interest rate swap transactions. There can be no assurance that the Fund's investment objective will be achieved. See "How the Fund Invests--Investment Objective and Policies." The Fund's address is Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077, and its telephone number is (800) 225-1852. This Prospectus sets forth concisely the information about the Fund that a prospective investor should know before investing and is available at the Web site of the Prudential Insurance Company of America (http://www.prudential.com). Additional information about the Fund has been filed with the Securities and Exchange Commission (the Commission) in a Statement of Additional Information, dated March 3, 1998, which information is incorporated herein by reference (is legally considered to be a part of this Prospectus) and is available without charge upon request to the Fund at the address or telephone number noted above. The Commission maintains a Web site (http://www.sec.gov) that contains the Statement of Additional Information, material incorporated by reference and other information regarding the Fund. - -------------------------------------------------------------------------------- INVESTORS ARE ADVISED TO READ THIS PROSPECTUS AND RETAIN IT FOR FUTURE REFERENCE. - -------------------------------------------------------------------------------- THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION NOR HAS THE COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. FUND HIGHLIGHTS The following summary is intended to highlight certain information contained in this Prospectus and is qualified in its entirety by the more detailed information appearing elsewhere herein. WHAT IS PRUDENTIAL MORTGAGE INCOME FUND, INC.? Prudential Mortgage Income Fund, Inc. is a mutual fund. A mutual fund pools the resources of investors by selling its shares to the public and investing the proceeds of such sale in a portfolio of securities designed to achieve its investment objective. Technically, the Fund is an open-end, diversified, management investment company. WHAT IS THE FUND'S INVESTMENT OBJECTIVE? The Fund's investment objective is to achieve a high level of income over the long term consistent with providing reasonable safety in the value of each shareholder's investment. It seeks to achieve this objective by investing primarily in mortgage-related instruments, including securities guaranteed as to timely payment of principal and interest by the Government National Mortgage Association (GNMA), other mortgage-backed securities issued or guaranteed by agencies or instrumentalities of the U.S. Government, and non-agency mortgage instruments, along with obligations using mortgages as collateral. There can be no assurance that the Fund's objective will be achieved. See "How the Fund Invests--Investment Objective and Policies" at page 9. WHAT ARE THE FUND'S RISK FACTORS AND SPECIAL CHARACTERISTICS? The Fund will invest at least 65% of its total assets in mortgage-backed securities which may decrease in value as a result of increases in interest rates and may benefit less than other fixed-income securities from declining interest rates because of the risk of prepayment of the principal on the underlying mortgage loans. In seeking to achieve its investment objective, the Fund may also write covered call and put options on U.S. Government securities and enter into closing purchase and sale transactions with respect to certain of such options. To hedge against changes in interest rates, the Fund may also purchase put options and engage in transactions involving interest rate futures contracts and options on such contracts and engage in interest rate swap transactions. See "How the Fund Invests-- Investment Objective and Policies" at page 9. These various hedging and return enhancement strategies, including the use of derivatives, may be considered speculative and may result in higher risks and costs to the Fund. See "How the Fund Invests--Hedging and Return Enhancement Strategies--Risks of Hedging and Return Enhancement Strategies" at page 14. As with an investment in any mutual fund, an investment in this Fund can decrease in value and you can lose money. WHO MANAGES THE FUND? Prudential Investments Fund Management LLC (the Manager) is the Manager of the Fund and is compensated for its services at an annual rate of 0.50 of 1% of the Fund's average daily net assets. As of January 31, 1998, PIFM served as manager or administrator to 64 investment companies, including 42 mutual funds, with aggregate assets of approximately $63 billion. The Prudential Investment Corporation (PIC), doing business as Prudential Investments (the Subadviser), furnishes investment advisory services in connection with the management of the Fund under a Subadvisory Agreement with PIFM. See "How the Fund is Managed--Manager" at page 16. WHO DISTRIBUTES THE FUND'S SHARES? Prudential Securities Incorporated (Prudential Securities or the Distributor), a major securities underwriter and securities and commodities broker, acts as the distributor of the Fund's Class A, Class B, Class C and Class Z shares and is paid an annual distribution and service fee which is currently being charged at the rate of 0.15 of 1% of the average daily net assets of the Class A shares, an annual distribution and service fee at the rate of 0.75 of 1% of the average daily net assets of the Class B shares and an annual distribution and service fee which is currently being charged at the rate of 0.75 of 1% of the average daily net assets of the Class C shares. The Distributor incurs the expense of distributing the Fund's Class Z shares under a Distribution Agreement with the Fund, none of which is reimbursed or paid for by the Fund. See "How the Fund is Managed--Distributor" at page 17. 2 WHAT IS THE MINIMUM INVESTMENT? The minimum initial investment is $1,000 for Class A and Class B shares per class and $5,000 for Class C shares. The minimum subsequent investment is $100 for Class A, Class B and Class C shares. Class Z shares are not subject to any minimum investment requirements. There is no minimum investment requirement for certain retirement and employee savings plans or custodial accounts for the benefit of minors. For purchases made through the Automatic Savings Accumulation Plan, the minimum initial and subsequent investment is $50. See "Shareholder Guide--How to Buy Shares of the Fund" at page 23 and "Shareholder Guide--Shareholder Services" at page 33. HOW DO I PURCHASE SHARES? You may purchase shares of the Fund through Prudential Securities, Pruco Securities Corporation (Prusec) or directly from the Fund through its transfer agent, Prudential Mutual Fund Services LLC (Transfer Agent) at the net asset value per share (NAV) next determined after receipt of your purchase order by the Transfer Agent or Prudential Securities plus a sales charge which may be imposed either (i) at the time of purchase (Class A shares) or (ii) on a deferred basis (Class B or Class C shares). Class Z shares are offered to a limited group of investors at NAV without any sales charge. See "How the Fund Values its Shares" at page 19 and "Shareholder Guide--How to Buy Shares of the Fund" at page 23. WHAT ARE MY PURCHASE ALTERNATIVES? The Fund offers four classes of shares: - Class A Shares: Sold with an initial sales charge of up to 4% of the offering price. - Class B Shares: Sold without an initial sales charge but are subject to a contingent deferred sales charge or CDSC (declining from 5% to zero of the lower of the amount invested or the redemption proceeds) which will be imposed on certain redemptions made within six years of purchase. Although Class B shares are subject to higher ongoing distribution-related expenses than Class A shares, Class B shares will automatically convert to Class A shares (which are subject to lower ongoing distribution-related expenses) approximately seven years after purchase. - Class C Shares: Sold without an initial sales charge and, for one year after purchase, are subject to a 1% CDSC on redemptions. Class C shares are subject to higher ongoing distribution-related expenses than Class A shares but, unlike Class B shares, do not convert to another class. - Class Z Shares: Sold without either an initial sales charge or CDSC to a limited group of investors. Class Z shares are not subject to any ongoing service or distribution expenses. See "Shareholder Guide--Alternative Purchase Plan" at page 24. HOW DO I SELL MY SHARES? You may redeem your shares at any time at the NAV next determined after Prudential Securities or the Transfer Agent receives your sell order. However, the proceeds of redemptions of Class B and Class C shares may be subject to a CDSC. See "Shareholder Guide--How to Sell Your Shares" at page 27. Participants in programs sponsored by Prudential Retirement Services should contact their client representative for more information about selling their Class Z shares. HOW ARE DIVIDENDS AND DISTRIBUTIONS PAID? The Fund expects to declare daily and pay monthly dividends of net investment income, if any, and make distributions of any net capital gains at least annually. Dividends and distributions will be automatically reinvested in additional shares of the Fund at NAV without a sales charge unless you request that they be paid to you in cash. See "Taxes, Dividends and Distributions" at page 20. 3 FUND EXPENSES
CLASS A SHARES CLASS B SHARES CLASS C SHARES CLASS Z SHARES -------------- ------------------------------ --------------------------- -------------- SHAREHOLDER TRANSACTION EXPENSES+ Maximum Sales Load Imposed on Purchases (as a percentage of offering price)................... 4% None None None Maximum Sales Load Imposed on Reinvested Dividends.............. None None None None Maximum Deferred Sales Load (as a percentage of original purchase price or redemption proceeds, whichever is lower)............... None 5% during the first year, 1% on redemptions made None decreasing by 1% annually to within one year of purchase 1% in the fifth and sixth years and 0% the seventh year* Redemption Fees.................... None None None None Exchange Fee....................... None None None None
CLASS A SHARES CLASS B SHARES CLASS C SHARES CLASS Z SHARES -------------- -------------- -------------- --------------- ANNUAL FUND OPERATING EXPENSES** (as a percentage of average net assets) Management Fees..................... .50% .50% .50% .50% 12b-1 Fees (After Reduction)........ .15%++ .75% .75%++ None Other Expenses...................... .45% .45% .45% .45% ------ --- ------ --- Total Fund Operating Expenses (After Reduction)......................... 1.10% 1.70% 1.70% .95% ------ --- ------ --- ------ --- ------ ---
1 YEAR 3 YEARS 5 YEARS 10 YEARS ------ ------- ------- -------- EXAMPLE You would pay the following expenses on a $1,000 investment, assuming (1) 5% annual return and (2) redemption at the end of each time period: Class A............................ $ 51 $ 74 $ 98 $ 169 Class B............................ $ 67 $ 84 $ 102 $ 177 Class C............................ $ 27 $ 54 $ 92 $ 201 Class Z**.......................... $ 10 $ 30 $ 53 $ 117 You would pay the following expenses on the same investment, assuming no redemption: Class A............................ $ 51 $ 74 $ 98 $ 169 Class B............................ $ 17 $ 54 $ 92 $ 177 Class C............................ $ 17 $ 54 $ 92 $ 201 Class Z............................ $ 10 $ 30 $ 53 $ 117
The above example is based on data for the Fund's fiscal year ended December 31, 1997. THE EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF PAST OR FUTURE EXPENSES. ACTUAL EXPENSES MAY BE GREATER OR LESS THAN THOSE SHOWN. The purpose of this table is to assist investors in understanding the various costs and expenses that an investor in the Fund will bear, whether directly or indirectly. For more complete descriptions of the various costs and expenses, see "How the Fund is Managed." "Other Expenses" includes operating expenses of the Fund, such as Directors' and professional fees, registration fees, reports to shareholders, transfer agency and custodian fees and franchise taxes. - --------------- * Class B shares will automatically convert to Class A shares approximately seven years after purchase. See "Shareholder Guide--Conversion Feature-- Class B Shares." ** The expense information in the table has been restated to reflect current fees. Effective September 1, 1997, PIFM eliminated its management fee waiver (.20 of 1%). + Pursuant to rules of the National Association of Securities Dealers, Inc., the aggregate initial sales charges, deferred sales charges and asset-based sales charges on shares of the Fund may not exceed 6.25% of total gross sales, subject to certain exclusions. This 6.25% limitation is imposed on each class of shares of the Fund rather than on a per shareholder basis. Therefore, long-term shareholders of the Fund may pay more in total sales charges than the economic equivalent of 6.25% of such shareholders' investment in such shares. See "How the Fund is Managed--Distributor." ++ Although the Class A and Class C Distribution and Service Plans provide that the Fund may pay a distribution fee of up to 0.30 of 1% and 1% per annum of the average daily net assets of the Class A and Class C shares, respectively, the Distributor has agreed to limit its distribution fees with respect to Class A and Class C shares of the Fund to no more than 0.15 of 1% and 0.75 of 1% of the average daily net assets of the Class A and Class C shares, respectively, for the fiscal year ending December 31, 1998. Total Fund Operating Expenses without such limitation would be 1.25% and 1.95% for the Class A and Class C shares, respectively. See "How the Fund is Managed--Distributor." 4 FINANCIAL HIGHLIGHTS (FOR A SHARE OUTSTANDING THROUGHOUT EACH OF THE INDICATED PERIODS) (CLASS A SHARES) The following financial highlights, with respect to each of the five years in the period ended December 31, 1997, have been been audited by PricewaterhouseCoopers LLP, independent accountants, whose report thereon was unqualified. This information should be read in conjunction with the financial statements and notes thereto, which appear in the Statement of Additional Information. The following financial highlights contain selected data for a share of Class A common stock outstanding, total return, ratios to average net assets and other supplemental data for the periods indicated. The information is based on data contained in the financial statements. Further performance information is contained in the annual report, which may be obtained without charge. See "Shareholder Guide--Shareholder Services--Reports to Shareholders."
CLASS A ------------------------------------------------------------------------ YEAR ENDED DECEMBER 31, ------------------------------------------------------------------------ 1997 1996 1995 (a) 1994 (a) 1993 (a) 1992 (a) 1991 (a) -------- -------- -------- -------- -------- ------- ------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period.............. $ 14.25 $ 14.61 $ 13.50 $ 14.75 $ 15.07 $15.30 $14.84 -------- -------- -------- -------- -------- ------- ------- INCOME FROM INVESTMENT OPERATIONS Net investment income............................. .95(e) .93(e) .89 .90 .95 1.10 1.14 Net realized and unrealized gain (loss) on investment transactions......................... .23 (.39) 1.18 (1.19) (.21) (.15) .61 -------- -------- -------- -------- -------- ------- ------- Total from investment operations.................. 1.18 .54 2.07 (.29) .74 .95 1.75 -------- -------- -------- -------- -------- ------- ------- LESS DISTRIBUTIONS Dividends from net investment income.............. (.90) (.90) (.89) (.90) (.95) (1.10) (1.14) Dividends to shareholders in excess of net investment income............................... -- -- (.07) -- (.11) (.08) (.15) Tax return of capital distributions............... -- -- -- (.06) -- -- -- -------- -------- -------- -------- -------- ------- ------- Total distributions............................... (.90) (.90) (.96) (.96) (1.06) (1.18) (1.29) -------- -------- -------- -------- -------- ------- ------- Net asset value, end of period.................... $ 14.53 $ 14.25 $ 14.61 $ 13.50 $ 14.75 $15.07 $15.30 -------- -------- -------- -------- -------- ------- ------- -------- -------- -------- -------- -------- ------- ------- TOTAL RETURN (D).................................. 8.57% 4.12% 15.53% (2.01)% 4.97% 6.42% 12.48% RATIOS/SUPPLEMENTAL DATA: Net assets, end of period (000)................... $ 90,639 $ 93,555 $99,183 $ 8,762 $10,863 $9,045 $6,268 Average net assets (000).......................... $ 91,094 $ 93,766 $90,854 $ 9,874 $10,199 $6,651 $3,035 Ratios to average net assets: Expenses, including distribution fees........... .96%(e) 1.12%(e) 1.27% 1.13% 1.00% 1.00% 1.11% Expenses, excluding distribution fees........... .81%(e) .97%(e) 1.12% .98% .85% .85% .96% Net investment income (loss).................... 6.65%(e) 6.56%(e) 6.27% 6.42% 6.42% 7.26% 7.81% Portfolio turnover................................ 178% 65% 193% 560% 134% 33% 118% JANUARY 22, 1990 (b) THROUGH SEPTEMBER 30, 1990 (a) ------------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period.............. $ 14.73 ------ INCOME FROM INVESTMENT OPERATIONS Net investment income............................. 1.17 Net realized and unrealized gain (loss) on investment transactions......................... .15 ------ Total from investment operations.................. 1.32 ------ LESS DISTRIBUTIONS Dividends from net investment income.............. (1.17) Dividends to shareholders in excess of net investment income............................... (.04) Tax return of capital distributions............... -- ------ Total distributions............................... (1.21) ------ Net asset value, end of period.................... $ 14.84 ------ ------ TOTAL RETURN (D).................................. 9.41% RATIOS/SUPPLEMENTAL DATA: Net assets, end of period (000)................... $ 1,604 Average net assets (000).......................... $ 756 Ratios to average net assets: Expenses, including distribution fees........... 1.15%(c) Expenses, excluding distribution fees........... .99%(c) Net investment income (loss).................... 9.16%(c) Portfolio turnover................................ 481%
- --------------- (a) Based on average shares outstanding, by class. (b) Commencement of offering of Class A shares. (c) Annualized. (d) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. Total returns for periods of less than a full year are not annualized. (e) Net of management fee waiver. 5 FINANCIAL HIGHLIGHTS (FOR A SHARE OUTSTANDING THROUGHOUT EACH OF THE INDICATED PERIODS) (CLASS B SHARES) The following financial highlights, with respect to each of the five years in the period ended December 31, 1997, have been audited by PricewaterhouseCoopers LLP, independent accountants, whose report thereon was unqualified. This information should be read in conjunction with the financial statements and notes thereto, which appear in the Statement of Additional Information. The following financial highlights contain selected data for a share of Class B common stock outstanding, total return, ratios to average net assets and other supplemental data for the periods indicated. The information is based on data contained in the financial statements. Further performance information is contained in the annual report, which may be obtained without charge. See "Shareholder Guide--Shareholder Services--Reports to Shareholders."
CLASS B YEAR ENDED DECEMBER 31, ------------------------------------------------------------------------------------------------ 1997 1996 1995 (a) 1994 (a) 1993 (a) 1992 (a) 1991 (a) 1990 (a) 1989 (a) -------- -------- -------- -------- -------- -------- -------- -------- -------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of year...... $ 14.22 $ 14.57 $ 13.47 $ 14.71 $ 15.04 $ 15.27 $ 14.81 $ 14.86 $ 14.29 -------- -------- -------- -------- -------- -------- -------- -------- -------- INCOME FROM INVESTMENT OPERATIONS Net investment income.... .88(d) .85(d) .82 .82 .87 1.02 1.06 1.15 1.19 Net realized and unrealized gain (loss) on investment transactions........... .21 (.39) 1.15 (1.19) (.23) (.16) .60 (.01) .59 -------- -------- -------- -------- -------- -------- -------- -------- -------- Total from investment operations............. 1.09 .46 1.97 (.37) .64 .86 1.66 1.14 1.78 -------- -------- -------- -------- -------- -------- -------- -------- -------- LESS DISTRIBUTIONS Dividends to shareholders from net investment income................. (.81) (.81) (.82) (.82) (.87) (1.02) (1.06) (1.15) (1.19) Dividends to shareholders in excess of net investment income...... -- -- (.05) -- (.10) (.07) (.14) (.04) (.02) Tax return of capital distributions.......... -- -- -- (.05) -- -- -- -- -- -------- -------- -------- -------- -------- -------- -------- -------- -------- Total distributions...... (.81) (.81) (.87) (.87) (.97) (1.09) (1.20) (1.19) (1.21) -------- -------- -------- -------- -------- -------- -------- -------- -------- Net asset value, end of year $ 14.50 $ 14.22 $ 14.57 $ 13.47 $ 14.71 $ 15.04 $ 15.27 $ 14.81 $ 14.86 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- TOTAL RETURN (C):........ 7.84% 3.53% 14.78% (2.57)% 4.29% 5.80% 11.82% 8.10% 12.93% RATIOS/SUPPLEMENTAL DATA: Net assets, end of year (000).................. $ 73,666 $ 96,016 $125,463 $245,437 $319,401 $325,969 $272,661 $226,605 $221,938 Average net assets (000).................. $ 83,848 $109,812 $146,240 $279,946 $332,731 $295,255 $243,749 $218,749 $223,251 Ratios to average net assets: Expenses, including distribution fees..... 1.56%(d) 1.72%(d) 1.87% 1.73% 1.60% 1.60% 1.71% 1.74% 1.56% Expenses, excluding distribution fees..... .81%(d) .97%(d) 1.12% .98% .85% .85% .96% .99% .98% Net investment income................ 6.05%(d) 5.95%(d) 5.82% 5.82% 5.82% 6.66% 7.21% 7.96% 8.16% Portfolio turnover....... 178% 65% 193% 560% 134% 33% 118% 481% 200% 1988 (a)/(b) -------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of year...... $ 14.76 -------- INCOME FROM INVESTMENT OPERATIONS Net investment income.... 1.17 Net realized and unrealized gain (loss) on investment transactions........... (.48 ) -------- Total from investment operations............. .69 -------- LESS DISTRIBUTIONS Dividends to shareholders from net investment income................. (1.16 ) Dividends to shareholders in excess of net investment income...... -- Tax return of capital distributions.......... -- -------- Total distributions...... (1.16 ) -------- Net asset value, end of year $ 14.29 -------- -------- TOTAL RETURN (C):........ 4.80% RATIOS/SUPPLEMENTAL DATA: Net assets, end of year (000).................. $236,626 Average net assets (000).................. $252,814 Ratios to average net assets: Expenses, including distribution fees..... 1.52% Expenses, excluding distribution fees..... .91% Net investment income................ 7.83% Portfolio turnover....... 216%
- --------------- (a) Based on average shares outstanding, by class. (b) On May 2, 1988, Prudential Mutual Fund Management, Inc. succeeded The Prudential Insurance Company of America as investment adviser and since then has acted as manager of the Fund. (c) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. (d) Net of management fee waiver. 6 FINANCIAL HIGHLIGHTS (FOR A SHARE OUTSTANDING THROUGHOUT EACH OF THE INDICATED PERIODS) (CLASS C SHARES) The following financial highlights have been audited by PricewaterhouseCoopers LLP, independent accountants, whose report thereon was unqualified. This information should be read in conjunction with the financial statements and notes thereto, which appear in the Statement of Additional Information. The following financial highlights contain selected data for a Class C share of common stock outstanding, total return, ratios to average net assets and other supplemental data for the periods indicated. The information is based on data contained in the financial statements. Further performance information is contained in the annual report, which may be obtained without charge. See "Shareholder Guide--Shareholder Services--Reports to Shareholders."
CLASS C ---------------------------------------------- AUGUST 1, 1994 (c) YEAR ENDED DECEMBER 31, THROUGH ------------------------------ DECEMBER 31, 1997 1996 1995 (a) 1994 (a) -------- -------- -------- ------------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period.............. $ 14.22 $ 14.57 $13.47 $ 14.01 -------- -------- -------- ------ INCOME FROM INVESTMENT OPERATIONS Net investment income............................. .87(e) .85(e) .81 .30 Net realized and unrealized gain (loss) on investment transactions......................... .22 (.39) 1.16 (.49) -------- -------- -------- ------ Total from investment operations.................. 1.09 .46 1.97 (.19) LESS DISTRIBUTIONS Dividends from net investment income.............. (.81) (.81) (.81) (.30) Distributions to shareholders in excess of net investment income............................... -- -- (.06) -- Tax return of capital distributions............... -- -- -- (.05) -------- -------- -------- ------ Total distributions............................... (.81) (.81) (.87) (.35) -------- -------- -------- ------ Net asset value, end of period.................... $ 14.50 $ 14.22 $14.57 $ 13.47 -------- -------- -------- ------ -------- -------- -------- ------ TOTAL RETURN (D):................................. 7.84% 3.53% 14.78% (1.32)% RATIOS/SUPPLEMENTAL DATA: Net assets, end of period (000)................... $ 904 $ 854 $ 655 $ 515 Average net assets (000).......................... $ 857 $ 746 $ 599 $ 460 Ratios to average net assets: Expenses, including distribution fees........... 1.56%(e) 1.72%(e) 1.87% 1.82%(b) Expenses, excluding distribution fees........... .81%(e) .97%(e) 1.12% 1.08%(b) Net investment income........................... 6.05%(e) 5.95%(e) 5.72% 5.32%(b) Portfolio turnover................................ 178% %65 193% 560%
- --------------- (a) Based on average shares outstanding, by class. (b) Annualized. (c) Commencement of offering of Class C shares. (d) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. Total returns for periods of less than a full year are not annualized. (e) Net of management fee waiver. 7 FINANCIAL HIGHLIGHTS (FOR A SHARE OUTSTANDING THROUGHOUT EACH OF THE INDICATED PERIODS) (CLASS Z SHARES) The following financial highlights have been audited by PricewaterhouseCoopers LLP, independent accountants, whose report thereon was unqualified. This information should be read in conjunction with the financial statements and notes thereto, which appear in the Statement of Additional Information. The following financial highlights contain selected data for a Class Z share of common stock outstanding, total return, ratios to average net assets and other supplemental data for the periods indicated. The information is based on data contained in the financial statements. Further performance information is contained in the annual report, which may be obtained without charge. See "Shareholder Guide--Shareholder Services--Reports to Shareholders."
CLASS Z -------- MARCH 18, 1997 (b) THROUGH DECEMBER 31, 1997 -------- PER SHARE OPERATING PERFORMANCE: Net asset value, beginning of period.............. $14.13 -------- INCOME FROM INVESTMENT OPERATIONS Net investment income............................. .74(d) Net realized and unrealized gain (loss) on investment transactions......................... .39 -------- Total from investment operations.................. 1.13 LESS DISTRIBUTIONS Dividends from net investment income.............. (.72) -------- Net asset value, end of period.................... $14.54 -------- -------- TOTAL RETURN (C):................................. 8.18% RATIOS/SUPPLEMENTAL DATA: Net assets, end of period (000)................... $ 39 Average net assets (000).......................... $ 9 Ratios to average net assets: Expenses........................................ .81%(a)/(d) Net investment income........................... 6.88%(a)/(d) Portfolio turnover................................ 178%
- --------------- (a) Annualized. (b) Commencement of offering of Class Z shares. (c) Total return does not consider the effects of sales loads. Total return is calculated assuming a purchase of shares on the first day and a sale on the last day of each period reported and includes reinvestment of dividends and distributions. Total returns for periods of less than a full year are not annualized. (d) Net of management fee waiver. 8 HOW THE FUND INVESTS INVESTMENT OBJECTIVE AND POLICIES THE FUND'S INVESTMENT OBJECTIVE IS TO ACHIEVE A HIGH LEVEL OF INCOME OVER THE LONG TERM CONSISTENT WITH PROVIDING REASONABLE SAFETY IN THE VALUE OF EACH SHAREHOLDER'S INVESTMENT. IN PURSUING THIS OBJECTIVE, THE FUND WILL INVEST PRIMARILY IN READILY MARKETABLE FIXED-INCOME SECURITIES THAT PROVIDE ATTRACTIVE YIELDS BUT DO NOT INVOLVE SUBSTANTIAL RISK OF LOSS OF CAPITAL THROUGH DEFAULT, PRINCIPALLY MORTGAGE-RELATED INSTRUMENTS, INCLUDING SECURITIES GUARANTEED AS TO TIMELY PAYMENT OF PRINCIPAL AND INTEREST BY GNMA, OTHER MORTGAGE-BACKED SECURITIES ISSUED OR GUARANTEED BY AGENCIES OR INSTRUMENTALITIES OF THE U.S. GOVERNMENT, AND NON-AGENCY MORTGAGE INSTRUMENTS, ALONG WITH OBLIGATIONS USING MORTGAGES AS COLLATERAL. THERE CAN BE NO ASSURANCE THAT SUCH OBJECTIVE WILL BE ACHIEVED. See "Investment Objective and Policies" in the Statement of Additional Information. As with an investment in any mutual fund, an investment in this Fund can decrease in value and you can lose money. THE FUND'S INVESTMENT OBJECTIVE IS A FUNDAMENTAL POLICY AND, THEREFORE, MAY NOT BE CHANGED WITHOUT THE APPROVAL OF THE HOLDERS OF A MAJORITY OF THE FUND'S OUTSTANDING VOTING SECURITIES AS DEFINED IN THE INVESTMENT COMPANY ACT OF 1940, AS AMENDED (THE INVESTMENT COMPANY ACT). FUND POLICIES THAT ARE NOT FUNDAMENTAL MAY BE MODIFIED BY THE BOARD OF DIRECTORS. Under normal market conditions, the Fund will invest at least 65% of its total assets in mortgage-backed securities. The Fund will invest the remainder of its assets in U.S. Government securities, corporate bonds, notes and debentures and high quality money market instruments and engage in the hedging and return enhancement strategies described below. See "Hedging and Return Enhancement Strategies" below. The Fund may invest up to 35% of its net assets in securities rated at least A by Moody's Investors Service (Moody's) or Standard & Poor's Ratings Group (S&P) or similarly rated by another nationally recognized statistical rating organization (NRSRO) or in non-rated securities which, in the view of the Subadviser, are of comparable quality. The remainder of the portfolio will be rated at least Aa by Moody's or AA by S&P or similarly rated by another NRSRO or, if not so rated, of comparable quality in the view of the investment adviser. A description of security ratings is contained in an Appendix to the Statement of Additional Information. THE FUND MAY VARY THE PROPORTION OF ITS HOLDINGS OF LONG- AND SHORT-TERM DEBT SECURITIES IN ORDER TO REFLECT ITS ASSESSMENT OF PROSPECTIVE CHANGES IN INTEREST RATES EVEN IF SUCH ACTION MAY ADVERSELY AFFECT CURRENT INCOME. For example, if, in the opinion of the Subadviser, interest rates generally are expected to decline, the Fund may sell its shorter term securities and purchase longer term securities in order to benefit from greater expected relative price appreciation; the securities sold may have a higher current yield than those being purchased. The success of this strategy will depend on the Subadviser's ability to forecast changes in interest rates. Moreover, the Fund intends to manage its portfolio actively by taking advantage of trading opportunities such as sales of portfolio securities and purchases of higher yielding securities of similar quality due to distortions in normal yield differentials. MORTGAGE-BACKED SECURITIES Mortgage-backed securities are securities that directly or indirectly represent a participation in, or are secured by and payable from, mortgage loans secured by real property. There are currently three basic types of mortgage-backed securities: (i) those issued or guaranteed by the U.S. Government or one of its agencies or instrumentalities, such as GNMA, Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC); (ii) those issued by private issuers that represent an interest in or are collateralized by mortgage-backed securities issued or guaranteed by the U.S. Government or one of its agencies or instrumentalities; and (iii) those issued by private issuers that represent an interest in or are collateralized by whole 9 mortgage loans or mortgage-backed securities without a government guarantee but usually having some form of private credit enhancement. See "Private Mortgage Pass-Through Securities" below. The Fund may invest in adjustable rate and fixed rate mortgage securities. The Fund may invest in mortgage-backed securities and other derivative mortgage products, including those representing an undivided ownership interest in a pool of mortgages, E.G., GNMA, FNMA and FHLMC certificates where the U.S. Government or its agencies or instrumentalities guarantees the payment of interest and principal of these securities. These guarantees do not extend to the yield or value of the securities or the Fund's shares. See "Investment Objective and Policies--Mortgage-Backed Securities--Non-Agency Mortgage-Backed Securities" in the Statement of Additional Information. These certificates are in most cases pass-through instruments, through which the holder receives a share of all interest and principal payments from the mortgages underlying the certificate, net of certain fees. The value of these securities is likely to vary inversely with fluctuations in interest rates. Mortgage-backed securities are subject to the risk that the principal on the underlying mortgage loans may be prepaid at any time. Although the extent of prepayments on a pool of mortgage loans depends on various economic and other factors, as a general rule prepayments on fixed rate mortgage loans will increase during a period of falling interest rates and decrease during a period of rising interest rates. Accordingly, amounts available for reinvestment by the Fund are likely to be greater during a period of declining interest rates and, as a result, likely to be reinvested at lower interest rates than during a period of rising interest rates. Mortgage-backed securities may decrease in value as a result of increases in interest rates and may benefit less than other fixed income securities from declining interest rates because of the risk of prepayment. During periods of rising interest rates, the rate of prepayment of mortgages underlying mortgage-backed securities can be expected to decline, extending the projected average maturity of mortgage-backed securities. A decline in the rate of repayment may effectively change a security which was considered short- or intermediate-term at the time of purchase into a long-term security. Long-term securities generally fluctuate more widely in response to changes in interest rates than short- or intermediate-term securities. COLLATERALIZED MORTGAGE OBLIGATIONS AND MULTICLASS PASS-THROUGH SECURITIES A collateralized mortgage obligation (CMO) is a security issued by a corporation or U.S. Government agency or instrumentality which is backed by a portfolio of mortgages or mortgage-backed securities. The issuer's obligation to make interest and principal payments is secured by the underlying portfolio of mortgages or mortgage-backed securities. Multiclass pass-through securities are equity interests in a trust composed of mortgages or mortgage-backed securities. Payments of principal of and interest on the underlying mortgage assets, and any reinvestment income thereon, provide the funds to pay debt service on the CMOs or make scheduled distributions on the multiclass pass-through securities. CMOs may be issued by agencies or instrumentalities of the U.S. Government, or by private originators of, or investors in, mortgage loans, including depository institutions, mortgage banks, investment banks and special purpose subsidiaries of the foregoing. The issuer of a series of CMOs may elect to be treated as a Real Estate Mortgage Investment Conduit (REMIC). All future references to CMOs include securities issued by REMICs and multiclass pass-through securities. In a CMO, a series of bonds or certificates is issued in multiple classes. Each class of CMOs, often referred to as a tranche, is issued at a specific fixed or floating coupon rate and has a stated maturity or final distribution date. Principal prepayments on the underlying mortgage assets may cause the CMOs to be retired substantially earlier than their stated maturities or final distribution dates. Interest is paid or accrues on classes of the CMOs on a monthly, quarterly or semi-annual basis. The principal of and interest on the underlying mortgage assets may be allocated among the several classes of a CMO series in a number of different ways. Generally, the purpose of the allocation of the cash flow of a CMO to the various classes is to obtain a more predictable cash flow to the individual tranches than exists with the underlying collateral of the CMO. As a general rule, the more predictable the cash flow is on a CMO tranche, the lower the anticipated yield will be on that tranche at the time of issuance relative to prevailing market yields on mortgage-backed securities. Certain classes of CMOs may have priority over others with respect to the receipt of prepayments. 10 In reliance on rules and interpretations of the Commission, the Fund's investments in certain qualifying CMOs and REMICs are not subject to the Investment Company Act's limitation on acquiring interests in other investment companies. See "Investment Objective and Policies--Mortgage-Backed Securities--Collateralized Mortgage Obligations" in the Statement of Additional Information. STRIPPED MORTGAGE-BACKED SECURITIES The Fund may also invest in mortgage-backed security strips (MBS strips) (i) issued by the U.S. Government or its agencies or instrumentalities or (ii) issued by private originators of, or investors in, mortgage loans, including depository institutions, mortgage banks, investment banks and special purpose subsidiaries of the foregoing (derivative multiclass mortgage securities). MBS strips are usually structured with two classes that receive different proportions of the interest and principal distributions on a pool of mortgage assets. A common type of stripped mortgage security will have one class receiving some of the interest and most of the principal from the mortgage assets, while the other class will receive most of the interest and the remainder of the principal. In the most extreme case, one class will receive all of the interest (the interest-only or IO class), while the other class will receive all of the principal (the principal-only or PO class). The yields to maturity on IOs and POs are sensitive to the expected or anticipated rate of principal payments (including prepayments) on the related underlying mortgage assets, and principal payments may have a material effect on yield to maturity. 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 adversely affected. See "Investment Objective and Policies--Mortgage-Backed Securities" in the Statement of Additional Information. Derivative mortgage-backed securities such as MBS strips are highly sensitive to changes in prepayment and interest rates. PRIVATE MORTGAGE PASS-THROUGH SECURITIES Private mortgage pass-through securities are structured similarly to the GNMA, FNMA and FHLMC mortgage pass-through securities and are issued by originators of and investors in mortgage loans, including depository institutions, mortgage banks, investment banks and special purpose subsidiaries of the foregoing. These securities usually are backed by a pool of conventional fixed rate or adjustable rate mortgage loans. Since private mortgage pass-through securities typically are not guaranteed by an entity having the credit status of GNMA, FNMA and FHLMC, such securities generally are structured with one or more types of credit enhancement. OTHER FIXED-INCOME OBLIGATIONS IN ADDITION TO MORTGAGE-BACKED SECURITIES, THE FUND MAY INVEST IN U.S. GOVERNMENT AND CORPORATE BONDS, NOTES AND DEBENTURES AND MONEY MARKET INSTRUMENTS. The value of fixed-income securities generally fluctuates with changes in the creditworthiness of issuers and inversely with changes in interest rates. There are risks in any investment, including fixed-income securities, and there can be no assurance that the Fund will be able to achieve its investment objective. Obligations issued or guaranteed as to principal and interest by the U.S. Government may be acquired by the Fund in the form of custodial receipts that evidence ownership of future interest payments, principal payments or both on certain U.S. Treasury notes or bonds. Such notes and bonds are held in custody by a bank on behalf of the owners. These custodial receipts are commonly referred to as Treasury strips. Other fixed-income obligations that the Fund may invest in include certain U.S. dollar denominated debt securities of foreign issuers, provided that such investments do not, in the judgment of the Fund's Subadviser, entail substantial additional risk to the Fund. See "Investment Restrictions" in the Statement of Additional Information. Securities of foreign issuers may involve considerations and risks not present in domestic securities, such as the risk to the issuer of nationalization, confiscation or other 11 national restrictions. There may be less information about foreign issuers publicly available than is generally the case with respect to domestic issuers. Furthermore, foreign issuers are not generally subject to uniform accounting, auditing and financial reporting standards, practices and requirements comparable to those applicable to domestic issuers. ASSET-BACKED SECURITIES The Fund may invest in asset-backed securities. Through the use of trusts and special purpose corporations, various types of assets, primarily automobile and credit card receivables and home equity loans, have been securitized in pass-through structures similar to the mortgage pass-through structures or in a pay-through structure similar to the CMO structure. The Fund may invest in these and other types of asset-backed securities that may be developed in the future. Unlike mortgage-backed securities, asset-backed securities do not have the benefit of a security interest in the related collateral. Credit card receivables, for example, are generally unsecured and the debtors are entitled to the protection of a number of state and federal consumer credit laws, some of which may reduce the ability to obtain full payment. In the case of automobile receivables, the security interests in the underlying automobiles are often not transferred when the pool is created, with the resulting possibility that the collateral could be resold. In general, these types of loans are of shorter average life than mortgage loans and are less likely to have substantial prepayments. In many instances, asset-backed securities are over-collateralized to ensure the relative stability of their credit quality. ADJUSTABLE RATE SECURITIES The Fund is permitted to invest in adjustable rate or floating rate debt securities, including corporate securities, securities issued by U.S. Government agencies and mortgage-backed securities, whose interest rate is calculated by reference to a specified index such as the constant maturity Treasury rate, the T-bill rate or LIBOR (London Interbank Offered Rate) and is reset periodically. Adjustable rate securities allow the Fund to participate in increases in interest rates through these periodic adjustments. The value of adjustable or floating rate securities will, like other debt securities, generally vary inversely with changes in prevailing interest rates. The value of adjustable or floating rate securities is unlikely to rise in periods of declining interest rates to the same extent as fixed rate instruments of similar maturities. In periods of rising interest rates, changes in the coupon will lag behind changes in the market rate resulting in a lower net asset value until the coupon resets to market rates. HEDGING AND RETURN ENHANCEMENT STRATEGIES THE FUND ALSO MAY ENGAGE IN VARIOUS PORTFOLIO STRATEGIES, INCLUDING THE USE OF DERIVATIVES, TO REDUCE CERTAIN RISKS OF ITS INVESTMENTS AND TO ATTEMPT TO ENHANCE RETURN, BUT NOT FOR SPECULATION. THE FUND, AND THUS ITS INVESTORS, MAY LOSE MONEY THROUGH ANY UNSUCCESSFUL USE OF THESE STRATEGIES. These strategies currently include the use of options on U.S. Government securities and futures contracts and options thereon. The Fund's ability to use these strategies may be limited by market conditions, and regulatory limits, and there can be no assurance that any of these strategies will succeed. See "Investment Objective and Policies" in the Statement of Additional Information. New financial products and risk management techniques continue to be developed and the Fund may use these new investments and techniques to the extent consistent with its investment objective and policies. OPTIONS TRANSACTIONS THE FUND MAY PURCHASE AND WRITE (I.E., SELL) PUT AND CALL OPTIONS ON U.S. GOVERNMENT SECURITIES THAT ARE TRADED ON NATIONAL SECURITIES EXCHANGES OR IN THE OVER-THE-COUNTER MARKET WITH PRIMARY GOVERNMENT SECURITIES DEALERS RECOGNIZED BY THE BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM TO ENHANCE INCOME OR TO HEDGE THE FUND'S PORTFOLIO. THE FUND, AND THUS ITS INVESTORS, MAY LOSE MONEY THROUGH ANY UNSUCCESSFUL USE OF THESE STRATEGIES. The Fund may write covered put and call options to attempt to generate additional income through the receipt of premiums, purchase put options in an effort to protect the value of a security that it owns against a decline in market value and purchase call options in 12 an effort to protect against an increase in the price of securities it intends to purchase. The Fund may also purchase put and call options to offset previously written put and call options of the same series. See "Investment Objective and Policies--Option Writing and Related Risks" in the Statement of Additional Information. A CALL OPTION GIVES THE PURCHASER, IN EXCHANGE FOR A PREMIUM PAID, THE RIGHT, FOR A SPECIFIED PERIOD OF TIME, TO PURCHASE THE SECURITIES SUBJECT TO THE OPTION AT A SPECIFIED PRICE (THE EXERCISE PRICE OR STRIKE PRICE). The writer of a call option, in return for the premium, has the obligation, upon exercise of the option, to deliver, depending upon the terms of the option contract, the underlying securities or a specified amount of cash to the purchaser upon receipt of the exercise price. The premium paid by the purchaser of an option will reflect, among other things, the relationship of the exercise price to the market price and volatility of the underlying security, the remaining term of the option, supply and demand and interest rates. When the Fund writes a call option, the Fund gives up the potential for gain on the underlying securities in excess of the exercise price of the option during the period that the option is open. A PUT OPTION GIVES THE PURCHASER, IN RETURN FOR A PREMIUM, THE RIGHT, FOR A SPECIFIED PERIOD OF TIME, TO SELL THE SECURITIES SUBJECT TO THE OPTION TO THE WRITER OF THE PUT AT THE SPECIFIED EXERCISE PRICE. The writer of the put option, in return for the premium, has the obligation, upon exercise of the option, to acquire the securities underlying the option at the exercise price. The Fund might, therefore, be obligated to purchase the underlying securities for more than their current market price. THE FUND WILL WRITE ONLY COVERED OPTIONS. An option is covered if, so long as the Fund is obligated under the option, it owns an offsetting position in the underlying security or maintains cash or other liquid assets, marked-to-market daily, with a value sufficient at all times to cover its obligations in a segregated account. See "Investment Objective and Policies--Option Writing and Related Risks" in the Statement of Additional Information. THERE IS NO LIMITATION ON THE AMOUNT OF CALL OPTIONS THE FUND MAY WRITE. THE FUND WILL NOT PURCHASE AN OPTION IF, AS A RESULT OF SUCH PURCHASE, MORE THAN 10% OF ITS TOTAL ASSETS WOULD BE INVESTED IN PREMIUMS FOR OPTIONS. FUTURES CONTRACTS AND OPTIONS THEREON THE FUND MAY PURCHASE AND SELL FINANCIAL FUTURES CONTRACTS AND OPTIONS THEREON WHICH ARE TRADED ON A COMMODITIES EXCHANGE OR BOARD OF TRADE FOR CERTAIN HEDGING AND RISK MANAGEMENT PURPOSES AND TO ATTEMPT TO ENHANCE RETURN IN ACCORDANCE WITH REGULATIONS OF THE COMMODITY FUTURES TRADING COMMISSION. THE FUND, AND THUS ITS INVESTORS, MAY LOSE MONEY THROUGH ANY UNSUCCESSFUL USE OF THESE STRATEGIES. These futures contracts and options thereon will be on financial indices (including futures linked to LIBOR) and U.S. Government securities. A FINANCIAL FUTURES CONTRACT IS AN AGREEMENT TO PURCHASE OR SELL AN AGREED AMOUNT OF SECURITIES AT A SET PRICE FOR DELIVERY IN THE FUTURE. UNDER REGULATIONS OF THE COMMODITY EXCHANGE ACT, INVESTMENT COMPANIES REGISTERED UNDER THE INVESTMENT COMPANY ACT ARE EXEMPT FROM THE DEFINITION OF COMMODITY POOL OPERATOR, SUBJECT TO COMPLIANCE WITH CERTAIN CONDITIONS. THE EXEMPTION IS CONDITIONED UPON THE FUND'S PURCHASING AND SELLING FUTURES CONTRACTS AND OPTIONS THEREON FOR BONA FIDE HEDGING PURPOSES, EXCEPT THAT THE FUND MAY PURCHASE AND SELL FUTURES CONTRACTS AND OPTIONS THEREON FOR ANY OTHER PURPOSE TO THE EXTENT THAT THE AGGREGATE INITIAL MARGIN AND OPTION PREMIUMS DO NOT EXCEED 5% OF THE LIQUIDATION VALUE OF THE FUND'S TOTAL ASSETS. ALTHOUGH THERE ARE NO OTHER LIMITS APPLICABLE TO FUTURES CONTRACTS, THE VALUE OF ALL FUTURES CONTRACTS SOLD WILL NOT EXCEED THE TOTAL MARKET VALUE OF THE FUND'S PORTFOLIO. THE FUND'S SUCCESSFUL USE OF FUTURES CONTRACTS AND OPTIONS THEREON DEPENDS UPON THE SUBADVISER'S ABILITY TO PREDICT THE DIRECTION OF THE MARKET AND IS SUBJECT TO VARIOUS ADDITIONAL RISKS. The correlation between movements in the price of a futures contract and the price of the securities being hedged is imperfect and there is a risk that the value of the securities being hedged may increase or decrease at a greater rate than the related futures contract, resulting in losses to the 13 Fund. Certain futures exchanges or boards of trade have established daily limits on the amount that the price of a futures contract or option thereon may vary, either up or down, from the previous day's settlement price. These daily limits may restrict the Fund's ability to purchase or sell certain futures contracts or options thereon on any particular day. RISKS OF HEDGING AND RETURN ENHANCEMENT STRATEGIES PARTICIPATION IN THE OPTIONS AND FUTURES MARKETS INVOLVES INVESTMENT RISKS AND TRANSACTION COSTS TO WHICH THE FUND WOULD NOT BE SUBJECT ABSENT THE USE OF THESE STRATEGIES. THE FUND, AND THUS ITS INVESTORS, MAY LOSE MONEY THROUGH ANY UNSUCCESSFUL USE OF THESE STRATEGIES. If the Subadviser's predictions of movements in the direction of the securities and interest rate markets are inaccurate, the adverse consequences to the Fund may leave the Fund in a worse position than if such strategies were not used. Risks inherent in the use of options and futures contracts and options on futures contracts include (1) dependence on the Subadviser's ability to predict correctly movements in the direction of interest rates and securities prices; (2) imperfect correlation between the price of options and futures contracts and options thereon and movements in the prices of the securities being hedged; (3) the fact that skills needed to use these strategies are different from those needed to select portfolio securities; (4) the possible absence of a liquid secondary market for any particular instrument at any time; and (5) the possible inability of the Fund to purchase or sell a portfolio security at a time that otherwise would be favorable for it to do so, or the possible need for the Fund to sell a portfolio security at a disadvantageous time, due to the need for the Fund to maintain cover or to segregate securities in connection with hedging techniques. OTHER INVESTMENTS AND POLICIES ILLIQUID SECURITIES The Fund may hold up to 15% of its net assets in illiquid securities, including repurchase agreements which have a maturity of longer than seven days, securities with legal or contractual restrictions on resale (restricted securities) and securities that are not readily marketable. Restricted securities eligible for resale pursuant to Rule 144A under the Securities Act of 1933, as amended (the Securities Act), and privately placed commercial paper that have a readily available market are not considered illiquid for purposes of this limitation. The Subadviser will monitor the liquidity of such restricted securities under the supervision of the Board of Directors. Investing in Rule 144A securities could, however, have the effect of increasing the level of Fund illiquidity to the extent that qualified institutional buyers become, for a limited time, uninterested in purchasing these securities. Repurchase agreements subject to demand are deemed to have a maturity equal to the applicable notice period. WHEN-ISSUED AND DELAYED DELIVERY SECURITIES The Fund may purchase or sell securities on a when-issued or delayed delivery basis. When-issued or delayed delivery transactions arise when securities are purchased or sold by the Fund with payment and delivery taking place in the future in order to secure what is considered to be an advantageous price and yield to the Fund at the time of entering into the transaction. The Fund will maintain, in a segregated account, cash or other liquid assets, having a value equal to or greater than the Fund's purchase commitments. The value of securities so purchased are subject to market fluctuation and no interest accrues to the purchaser during the period between purchase and settlement. At the time of delivery of the securities the value may be more or less than the purchase price and an increase in the percentage of the Fund's assets committed to the purchase of securities on a when-issued or delayed delivery basis may increase the volatility of the Fund's NAV. REPURCHASE AGREEMENTS The Fund may on occasion enter into repurchase agreements, whereby the seller of a security agrees to repurchase that security from the Fund at a mutually agreed-upon time and price. The period of maturity is usually quite short, possibly overnight or a few 14 days, although it may not be for a number of months. The resale price is in excess of the purchase price, reflecting an agreed-upon rate of return effective for the period of time the Fund's money is invested in the repurchase agreement. The Fund's repurchase agreements will at all times be fully collateralized in an amount at least equal to the resale price. The instruments held as collateral are valued daily, and if the value of the instruments declines, the Fund will require additional collateral. If the seller defaults and the value of the collateral securing the repurchase agreement declines, the Fund may incur a loss. The Fund participates in a joint repurchase account with other investment companies managed by PIFM pursuant to an order of the Commission. See "Investment Objective and Policies--Repurchase Agreements" in the Statement of Additional Information. DOLLAR ROLLS The Fund may enter into dollar rolls in which the Fund sells securities to be issued and delivered in the current month and simultaneously contracts to repurchase substantially similar (same type and coupon) securities on a specified future date from the same party. During the roll period, the Fund forgoes principal and interest paid on the securities. The Fund is compensated by the difference between the current sales price and the forward price for the future purchase (often referred to as the drop) as well as by the interest earned on the cash proceeds of the initial sale. A covered roll is a specific type of dollar roll for which there is an offsetting cash position or a cash equivalent security position which matures on or before the forward settlement date of the dollar roll transaction. Dollar rolls (other than covered rolls) are considered borrowings by the Fund for purposes of the percentage limitations applicable to borrowings. Covered rolls, however, are not treated as borrowings or other senior securities and will be excluded from the calculation of the Fund's borrowings and other senior securities. The Fund will establish a segregated account in which it will maintain cash or other liquid assets, equal in value to its obligations in respect of dollar rolls. SECURITIES LENDING The Fund may lend its portfolio securities to brokers or dealers, banks or other recognized institutional borrowers of securities, provided that the borrower at all times maintains cash or equivalent collateral or secures a letter of credit in favor of the Fund in an amount equal to at least 100% of the market value of the securities loaned. During the time portfolio securities are on loan, the borrower will pay the Fund an amount equivalent to any dividend or interest paid on such securities and the Fund may invest the cash collateral and earn additional income, or it may receive an agreed upon amount of interest income from the borrower. See "Investment Objective and Policies--Lending of Portfolio Securities" in the Statement of Additional Information. BORROWING The Fund may borrow an amount equal to no more than 20% of the value of its total assets (calculated when the loan is made) from banks for temporary, extraordinary or emergency purposes or for the clearance of transactions. The Fund may pledge up to 20% of its total assets to secure these borrowings. INTEREST RATE SWAPS The Fund may enter into interest rate swaps. Interest rate swaps involve the exchange by the Fund with another party of their respective commitments to pay or receive interest (E.G., an exchange of floating rate payments for fixed rate payments). The Fund expects to enter into these transactions primarily to preserve a return or spread on a particular investment or portion of its portfolio or to protect against any increase in the price of securities the Fund anticipates purchasing at a later date. The Fund intends to use these transactions as a hedge and not as a speculative investment. 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 and will not exceed 5% of the Fund's net assets. 15 When the Fund enters into interest rate swaps on other than a net basis, the entire amount of the Fund's obligations, if any, with respect to such interest rate swaps will be treated as illiquid. To the extent that the Fund enters into interest rate swaps on a net basis, 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 treated as illiquid. See "Investment Objective and Policies--Interest Rate Transactions" in the Statement of Additional Information. PORTFOLIO TURNOVER Although the Fund has no fixed policy with respect to portfolio turnover, it may sell portfolio securities without regard to the length of time that they have been held in order to take advantage of new investment opportunities or yield differentials, or because the Fund desires to preserve gains or limit losses due to changing economic conditions. Accordingly, it is possible that the portfolio turnover rate of the Fund may reach, or even exceed, 350%. The portfolio turnover rate is computed by dividing the lesser of the amount of the securities purchased or securities sold (excluding all securities whose maturities at acquisition were one year or less) by the average monthly value of such securities owned during the year. A higher rate of turnover results in increased transaction costs to the Fund. See "Investment Objective and Policies--Portfolio Turnover" in the Statement of Additional Information. INVESTMENT RESTRICTIONS The Fund is subject to certain investment restrictions which, like its investment objectives, constitute fundamental policies. Such fundamental policies are those which cannot be changed without the approval of the holders of a majority of the Fund's outstanding voting securities, as defined in the Investment Company Act. See "Investment Restrictions" in the Statement of Additional Information. HOW THE FUND IS MANAGED THE FUND HAS A BOARD OF DIRECTORS WHICH, IN ADDITION TO OVERSEEING THE ACTIONS OF THE FUND'S MANAGER, SUBADVISER AND DISTRIBUTOR, AS SET FORTH BELOW, DECIDES UPON MATTERS OF GENERAL POLICY. PIFM CONDUCTS AND SUPERVISES THE DAILY BUSINESS OPERATIONS OF THE FUND. THE FUND'S SUBADVISER FURNISHES DAILY INVESTMENT ADVISORY SERVICES. For the fiscal year ended December 31, 1997, the Fund's total expenses as a percentage of average net assets for the Fund's Class A, Class B and Class C shares were .96%, 1.56% and 1.56%, respectively. For the period from March 18, 1997 (commencement of offering of Class Z shares) through December 31, 1997, the Fund's total expenses (annualized) as a percentage of average net assets for the Fund's Class Z shares was .81%. See "Financial Highlights." MANAGER PRUDENTIAL INVESTMENTS FUND MANAGEMENT LLC (PIFM OR THE MANAGER), GATEWAY CENTER THREE, 100 MULBERRY STREET, NEWARK, NEW JERSEY 07102-4077, IS THE MANAGER OF THE FUND AND IS COMPENSATED FOR ITS SERVICES AT AN ANNUAL RATE OF 0.50 OF 1% OF THE FUND'S AVERAGE DAILY NET ASSETS. PIFM is organized in New York as a limited liability company. For the fiscal year ended December 31, 1997, the Fund paid management fees to PIFM of 0.37 of 1% of the Fund's average net assets. See "Manager" in the Statement of Additional Information. 16 As of January 31, 1998, PIFM served as the manager to 42 open-end investment companies, constituting all of the Prudential Mutual Funds, and as manager or administrator to 22 closed-end investment companies with aggregate assets of approximately $63 billion. UNDER THE MANAGEMENT AGREEMENT WITH THE FUND, THE MANAGER MANAGES THE INVESTMENT OPERATIONS OF THE FUND AND ALSO ADMINISTERS THE FUND'S CORPORATE AFFAIRS. SEE "MANAGER" IN THE STATEMENT OF ADDITIONAL INFORMATION. UNDER A SUBADVISORY AGREEMENT BETWEEN THE MANAGER AND THE SUBADVISER, THE SUBADVISER FURNISHES INVESTMENT ADVISORY SERVICES IN CONNECTION WITH THE MANAGEMENT OF THE FUND AND IS REIMBURSED BY THE MANAGER FOR ITS REASONABLE COSTS AND EXPENSES INCURRED IN PROVIDING SUCH SERVICES. The Manager continues to have responsibility for all investment advisory services pursuant to the Management Agreement and supervises The Subadviser's performance of such services. The current portfolio managers of the Fund are Barbara L. Kenworthy and Sharon Fera. Ms. Kenworthy is a Managing Director and Senior Portfolio Manager and Ms. Fera is a Vice President and Portfolio Manager of Prudential Investments, a business group of the Subadviser. Ms. Fera is responsible for day-to-day management for the Fund under the supervision of Ms. Kenworthy, who remains responsible for overall portfolio strategy for the Fund. Ms. Kenworthy has managed the Fund's portfolio since May 1995. Ms. Kenworthy joined the Subadviser in July 1994, having previously been employed by the Dreyfus Corporation (from June 1985 to June 1994), where she served as President and portfolio manager for several Dreyfus fixed-income funds. Ms. Kenworthy also serves as portfolio manager of Prudential Diversified Bond Fund, Inc. and co-portfolio manager of Prudential Balanced Fund. In addition, she and Ms. Fera co-manage Prudential Government Income Fund, Inc. and Prudential Government Securities Trust -- Short-Intermediate Term Series. Ms. Fera joined Prudential Investments in May 1996 as a fixed-income portfolio manager. Prior thereto, she was employed by Aetna Life and Casualty (May 1993 to May 1996) as a portfolio manager responsible for the fixed-income portion of Aetna's Capital and Surplus Portfolio and as a fixed-income analyst responsible for the Capital Goods and Transportation sectors. Prior to joining Aetna, Ms. Fera was a fixed-income trader at Hartford Life Insurance Company (May 1992 to May 1993) and at Equitable Capital Management Corporation (August 1985 to May 1992). PIFM and PIC are wholly-owned subsidiaries of The Prudential Insurance Company of America ("Prudential"), a major diversified insurance and financial services company. DISTRIBUTOR PRUDENTIAL SECURITIES INCORPORATED (PRUDENTIAL SECURITIES OR THE DISTRIBUTOR), ONE SEAPORT PLAZA, NEW YORK, NEW YORK 10292, IS A CORPORATION ORGANIZED UNDER THE LAWS OF THE STATE OF DELAWARE AND SERVES AS THE DISTRIBUTOR OF THE CLASS A, CLASS B, CLASS C AND CLASS Z SHARES OF THE FUND. IT IS AN INDIRECT, WHOLLY-OWNED SUBSIDIARY OF PRUDENTIAL. UNDER SEPARATE DISTRIBUTION AND SERVICE PLANS (THE CLASS A PLAN, THE CLASS B PLAN AND THE CLASS C PLAN, COLLECTIVELY, THE PLANS) ADOPTED BY THE FUND UNDER RULE 12B-1 UNDER THE INVESTMENT COMPANY ACT AND A DISTRIBUTION AGREEMENT (THE DISTRIBUTION AGREEMENT), THE DISTRIBUTOR INCURS THE EXPENSES OF DISTRIBUTING THE FUND'S CLASS A, CLASS B AND CLASS C SHARES. The Distributor also incurs the expenses of distributing the Fund's Class Z shares under the Distribution Agreement, none of which is reimbursed by or paid for by the Fund. These expenses include commissions and account servicing fees paid to, or on account of, financial advisers of Prudential Securities and representatives of Prusec, an affiliated broker-dealer, commissions and account servicing fees paid to, or on account of, other broker-dealers or financial institutions (other than national banks) which have entered into agreements with the Distributor, advertising expenses, the cost of printing and mailing prospectuses to potential investors and indirect and overhead costs of Prudential Securities and Prusec associated with the sale of Fund shares, including lease, utility, communications and sales promotion expenses. 17 Under the Plans, the Fund is obligated to pay distribution and/or service fees to the Distributor as compensation for its distribution and service activities, not as reimbursement for specific expenses incurred. If the Distributor expenses exceed its distribution and service fees, the Fund will not be obligated to pay any additional expenses. If the Distributor expenses are less than such distribution and service fees, it will retain its full fees and realize a profit. UNDER THE CLASS A PLAN, THE FUND MAY PAY THE DISTRIBUTOR FOR ITS DISTRIBUTION-RELATED ACTIVITIES WITH RESPECT TO CLASS A SHARES AT AN ANNUAL RATE OF UP TO .30 OF 1% OF THE AVERAGE DAILY NET ASSETS OF THE CLASS A SHARES. The Class A Plan provides that (i) up to 0.25 of 1% of the average daily net assets of the Class A shares may be used to pay for personal service and/or the maintenance of shareholder accounts (service fee) and (ii) total distribution fees (including the service fee of 0.25 of 1%) may not exceed 0.30 of 1% of the average daily net assets of the Class A shares. It is expected that in the case of Class A shares, proceeds from the distribution fee will be used primarily to pay account servicing fees to financial advisers. The Distributor has agreed to limit its distribution-related fees payable under the Class A Plan to 0.15 of 1% of the average daily net assets of the Class A shares for the fiscal year ending December 31, 1998. UNDER THE CLASS B AND CLASS C PLANS, THE FUND MAY PAY THE DISTRIBUTOR FOR ITS DISTRIBUTION-RELATED ACTIVITIES WITH RESPECT TO CLASS B AND CLASS C SHARES AT AN ANNUAL RATE OF UP TO 0.75 OF 1% AND UP TO 1% OF THE AVERAGE DAILY NET ASSETS OF THE CLASS B AND CLASS C SHARES, RESPECTIVELY. The Class B Plan provides for the payment to Prudential Securities of (i) an asset-based sales charge of up to 0.75 of 1% of the average daily net assets of the Class B shares, and (ii) a service fee of up to 0.25 of 1% of the average daily net assets of the Class B shares; provided that the total distribution-related fee does not exceed 0.75 of 1%. The Class C Plan provides for the payment to the Distributor of (i) an asset-based sales charge of up to 0.75 of 1% of the average daily net assets of the Class C shares, and (ii) a service fee of up to 0.25 of 1% of the average daily net assets of the Class C shares. The service fee is used to pay for personal service and/or the maintenance of shareholder accounts. The Distributor has agreed to limit its distribution-related fees payable under the Class C Plan to 0.75 of 1% of the average daily net assets of the Class C shares for the fiscal year ending December 31, 1998. The Distributor also receives CDSCs from certain redeeming shareholders. See "Shareholder Guide--How to Sell Your Shares--Contingent Deferred Sales Charges." For the fiscal year ended December 31, 1997, the Fund paid distribution expenses of 0.15%, 0.75% and 0.75% of the average daily net assets of the Class A, Class B and Class C shares, respectively. The Fund records all payments made under the Plans as expenses in the calculation of net investment income. See "Distributor" in the Statement of Additional Information. Distribution expenses attributable to the sale of Class A, Class B and Class C shares of the Fund will be allocated to each such class based upon the ratio of sales of each such class to the sales of Class A, Class B and Class C shares of the Fund other than expenses allocable to a particular class. The distribution fee and sales charge of one class will not be used to subsidize the sale of another class. Each Plan provides that it shall continue in effect from year to year provided that a majority of the Board of Directors of the Fund, including a majority of the Directors who are not interested persons of the Fund (as defined in the Investment Company Act) and who have no direct or indirect financial interest in the operation of the Plan or any agreement related to the Plan (the Rule 12b-1 Directors), vote annually to continue the Plan. Each Plan may be terminated at any time by vote of a majority of the Rule 12b-1 Directors or of a majority of the outstanding shares of the applicable class of the Fund. The Fund will not be obligated to pay distribution and service fees incurred under any Plan if it is terminated or not continued. In addition to distribution and service fees paid by the Fund under the Class A, Class B and Class C Plans, PIFM (or one of its affiliates) may make payments out of its own resources to dealers (including Prudential Securities) and other persons which distribute shares of the Fund (including Class Z shares). Such payments may be calculated by reference to the NAV sold by such persons or otherwise. The Distributor is subject to the rules of the National Association of Securities Dealers, Inc. (NASD), governing maximum sales charges. See "Distributor" in the Statement of Additional Information. 18 FEE WAIVERS The Distributor has agreed to limit its distribution fee for the Class A and Class C shares as described above under "Distributor." Fee waivers will increase the Fund's total return. See "Performance Information" in the Statement of Additional Information and "Fund Expenses" above. PIFM may from time to time agree to waive all or a portion of its management fee and subsidize certain operating expenses of the Fund. Fee waivers and expense subsidies will increase the Fund's yield and total return. The Fund is not required to reimburse PIFM for such management fee waiver. Effective September 1, 1997, PIFM discontinued its management fee waiver (.20 of 1%). PORTFOLIO TRANSACTIONS Prudential Securities may also act as a broker or futures commission merchant for the Fund, provided that the commissions, fees or other remuneration it receives are fair and reasonable. See "Portfolio Transactions and Brokerage" in the Statement of Additional Information. CUSTODIAN AND TRANSFER AND DIVIDEND DISBURSING AGENT State Street Bank and Trust Company, One Heritage Drive, North Quincy, Massachusetts 02171, serves as custodian for the Fund's portfolio securities and cash and, in that capacity, maintains certain financial and accounting books and records pursuant to an agreement with the Fund. Its mailing address is P.O. Box 1713, Boston, Massachusetts 02105. Prudential Mutual Fund Services LLC, Raritan Plaza One, Edison, New Jersey 08837, serves as Transfer Agent and Dividend Disbursing Agent and in those capacities maintains certain books and records for the Fund. The Transfer Agent is a wholly-owned subsidiary of PIFM. Its mailing address is P.O. Box 15005, New Brunswick, New Jersey 08906-5005. YEAR 2000 The services provided to the Fund and the shareholders by the Manager, the Distributor, the Transfer Agent and the Custodian depend on the smooth functioning of their computer systems and those of their outside service providers. Many computer software systems in use today cannot distinguish the year 2000 from the year 1900 because of the way dates are encoded and calculated. Such event could have a negative impact on handling securities trades, payments of interest and dividends, pricing and account services. Although, at this time, there can be no assurance that there will be no adverse impact on the Fund, the Manager, the Distributor, the Transfer Agent and the Custodian have advised the Fund and they have been actively working on necessary changes to their computer systems to prepare for the year 2000 and expect that their systems, and those of their outside service providers, will be adapted in time for that event. HOW THE FUND VALUES ITS SHARES THE FUND'S NAV IS DETERMINED BY SUBTRACTING ITS LIABILITIES FROM THE VALUE OF ITS ASSETS AND DIVIDING THE REMAINDER BY THE NUMBER OF OUTSTANDING SHARES. NAV IS CALCULATED SEPARATELY FOR EACH CLASS. THE BOARD OF DIRECTORS HAS FIXED THE SPECIFIC TIME OF DAY FOR THE COMPUTATION OF THE FUND'S NAV TO BE AS OF 4:15 P.M., NEW YORK TIME. Portfolio securities are valued based on market quotations or, if not readily available, at fair value as determined in good faith under procedures established by the Fund's Board of Directors. For valuation purposes, quotations of foreign securities in a foreign currency are converted to U.S. dollar equivalents. See "Net Asset Value" in the Statement of Additional Information. 19 The Fund will compute its NAV once daily on days that the New York Stock Exchange is open for trading except on days on which no orders to purchase, sell or redeem shares have been received by the Fund or days on which changes in the value of the Fund's portfolio securities do not materially affect the NAV. Although the legal rights of each class of shares are substantially identical, the different expenses borne by each class will result in different dividends. As long as the Fund declares dividends daily, the NAV of the Class A, Class B, Class C and Class Z shares will generally be the same. It is expected, however, that the dividends will differ by approximately the amount of the distribution and/or service fee expense accrual differential among the classes. HOW THE FUND CALCULATES PERFORMANCE FROM TIME TO TIME THE FUND MAY ADVERTISE ITS AVERAGE ANNUAL TOTAL RETURN, AGGREGATE TOTAL RETURN AND YIELD IN ADVERTISEMENTS OR SALES LITERATURE. YIELD AND TOTAL RETURN ARE CALCULATED SEPARATELY FOR CLASS A, CLASS B, CLASS C AND CLASS Z SHARES. THESE FIGURES ARE BASED ON HISTORICAL EARNINGS AND ARE NOT INTENDED TO INDICATE FUTURE PERFORMANCE. The yield refers to the income generated by an investment in the Fund over a one-month or 30-day period. This income is then annualized; that is, the amount of income generated by the investment during that 30-day period is assumed to be generated each 30-day period for twelve periods and is shown as a percentage of the investment. The income earned on the investment is also assumed to be reinvested at the end of the sixth 30-day period. The total return shows how much an investment in the Fund would have increased (decreased) over a specified period of time (I.E., one, five or ten years or since inception of the Fund) assuming that all distributions and dividends by the Fund were reinvested on the reinvestment dates during the period and less all recurring fees. The aggregate total return reflects actual performance over a stated period of time. Average annual total return is a hypothetical rate of return that, if achieved annually, would have produced the same aggregate total return if performance had been constant over the entire period. Average annual total return smooths out variations in performance and takes into account any applicable initial or contingent deferred sales charges. Neither average annual total return nor aggregate total return takes into account any federal or state income taxes which may be payable upon redemption. The Fund also may include comparative performance information in advertising or marketing the Fund's shares. Such performance information may include data from Lipper Analytical Services, Inc., Morningstar Publications, Inc., other industry publications, business periodicals and market indices. See "Performance Information" in the Statement of Additional Information. Further performance information is contained in the Fund's annual and semi-annual reports to shareholders, which may be obtained without charge. See "Shareholder Guide--Shareholder Services--Reports to Shareholders." TAXES, DIVIDENDS AND DISTRIBUTIONS TAXATION OF THE FUND THE FUND HAS ELECTED TO QUALIFY AND INTENDS TO REMAIN QUALIFIED AS A REGULATED INVESTMENT COMPANY UNDER THE INTERNAL REVENUE CODE. ACCORDINGLY, THE FUND WILL NOT BE SUBJECT TO FEDERAL INCOME TAXES ON ITS NET INVESTMENT INCOME AND CAPITAL GAINS, IF ANY, THAT IT DISTRIBUTES TO ITS SHAREHOLDERS. See "Taxes, Dividends and Distributions" in the Statement of Additional Information. TAXATION OF SHAREHOLDERS Any dividends out of net investment income, together with distributions of net short-term gains (I.E., the excess of net short-term capital gains over net long-term capital losses), will be taxable as ordinary income to the shareholder whether or not reinvested. Any net capital gains (I.E., the excess of net capital gains from the sale of assets held for more than 12 months over net 20 short-term capital losses) distributed to shareholders will be taxable as long-term capital gains to the shareholders, whether or not reinvested and regardless of the length of time a shareholder has owned his or her shares. The maximum long-term capital gains rate for individual shareholders for securities held more than 12, but not more than 18, months currently is 28% and for securities held more than 18 months is 20%. The maximum tax rate for ordinary income is 39.6%. The maximum long-term capital gains rate for corporate shareholders currently is the same as the maximum tax rate for ordinary income. Any gain or loss realized upon a sale exchange or redemption of Fund shares by a shareholder who is not a dealer in securities generally will be treated as capital gain or loss. Any such capital gain derived by an individual will be subject to tax at the reduced rates described above depending upon the shareholder's holding period of the shares sold. Any such loss will be a long-term capital loss, if the shares have been held more than one year, and otherwise as short-term capital gain or loss. Any loss with respect to shares that are held for six months or less, however, will be treated as long-term capital loss to the extent of any capital gain distributions received by the shareholder. The Fund has obtained opinions of counsel to the effect that neither (i) the conversion of Class B shares into Class A shares nor (ii) the exchange of any class of the Fund's shares for any other class of its shares constitutes a taxable event for federal income tax purposes. However, such opinions are not binding on the Internal Revenue Service. Shareholders are advised to consult their own tax advisers regarding specific questions as to federal, state or local taxes. See "Taxes, Dividends and Distributions" in the Statement of Additional Information. WITHHOLDING TAXES Under the Internal Revenue Code, the Fund generally is required to withhold and remit to the U.S. Treasury 31% of dividends, capital gain distributions and redemption proceeds on the accounts of certain shareholders who fail to furnish their tax identification numbers on IRS Form W-9 (or IRS Form W-8 in the case of certain foreign shareholders) with the required certifications regarding the shareholder's status under the federal income tax law, or, generally, who otherwise are subject to backup withholding. Shareholders are advised to consult their own tax advisers regarding specific questions as to federal, state or local taxes. See "Taxes, Dividends and Distributions" in the Statement of Additional Information. Dividends of net investment income and net short-term capital gains paid to a foreign shareholder will generally be subject to U.S. withholding tax at the rate of 30% (or lower treaty rate). DIVIDEND AND DISTRIBUTIONS THE FUND INTENDS TO DECLARE DAILY AND PAY MONTHLY INCOME DIVIDENDS BASED ON ACTUAL NET INVESTMENT INCOME, IF ANY, DETERMINED IN ACCORDANCE WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES; HOWEVER, A PORTION OF SUCH DIVIDENDS MAY ALSO INCLUDE PROJECTED NET INVESTMENT INCOME. As of December 31, 1997, the Fund had a capital loss carryforward for federal income tax purposes of $19,586,200. Accordingly, no capital gains distribution is expected to be paid to shareholders until net gains have been realized in excess of such carryforward amount. Dividends paid by the Fund with respect to each class of shares, to the extent any dividends are paid, will be calculated in the same manner, at the same time, on the same day and will be in the same amount except that each class other than Class Z will bear its own distribution charges, generally resulting in lower dividends for Class B and Class C shares in relation to Class A shares and lower dividends for Class A shares in relation to Class Z shares. Distributions of net capital gains, if any, will be paid in the same amount per share for each class of shares. See "How the Fund Values its Shares." DIVIDENDS AND DISTRIBUTIONS WILL BE PAID IN ADDITIONAL FUND SHARES BASED ON THE NAV OF EACH CLASS ON THE RECORD DATE OR SUCH OTHER DATE AS THE BOARD OF DIRECTORS MAY DETERMINE, UNLESS THE SHAREHOLDER ELECTS IN WRITING NOT LESS THAN FIVE BUSINESS DAYS PRIOR TO THE RECORD DATE TO RECEIVE SUCH DIVIDENDS AND DISTRIBUTIONS IN CASH. Such election should be submitted to the Transfer Agent, Attention: Account Maintenance, P.O. Box 15015, New Brunswick, New Jersey 21 08906-5015. If you hold shares through Prudential Securities, you should contact your financial adviser to elect to receive dividends and distributions in cash. The Fund will notify each shareholder after the close of the Fund's taxable year of both the dollar amount and the taxable status of that year's dividends and distributions on a per share basis. To the extent that, in a given year, distributions to shareholders exceed recognized net investment income and recognized short-term and long-term capital gains for the year, shareholders will receive a return of capital in respect of such year and, in an annual statement, will be notified of the amount of any return of capital for such year. IF YOU BUY SHARES ON OR IMMEDIATELY BEFORE THE RECORD DATE (THE DATE THAT DETERMINES WHO RECEIVES THE DIVIDEND), YOU WILL RECEIVE A PORTION OF THE MONEY YOU INVESTED AS A TAXABLE DIVIDEND. THEREFORE, YOU SHOULD CONSIDER THE TIMING OF DIVIDENDS WHEN BUYING SHARES OF THE FUND. GENERAL INFORMATION DESCRIPTION OF COMMON STOCK THE FUND WAS INCORPORATED IN MARYLAND ON JANUARY 4, 1982. THE FUND IS AUTHORIZED TO ISSUE 500 MILLION SHARES OF COMMON STOCK, $.01 PAR VALUE PER SHARE, DIVIDED INTO FOUR CLASSES, DESIGNATED CLASS A, CLASS B, CLASS C AND CLASS Z COMMON STOCK, WHICH CONSISTS OF 125 MILLION AUTHORIZED CLASS A SHARES, 125 MILLION AUTHORIZED CLASS B SHARES, 125 MILLION AUTHORIZED CLASS C SHARES AND 125 MILLION AUTHORIZED CLASS Z SHARES. Each class of common stock represents an interest in the same assets of the Fund and is identical in all respects except that (i) each class is subject to different sales charges and distribution and/or service fees (except for Class Z shares, which are not subject to any sales charges or distribution and/or service fees), which may affect performance, (ii) each class has exclusive voting rights on any matter submitted to shareholders that relates solely to its arrangement and has separate voting rights on any matter submitted to shareholders in which the interests of one class differ from the interests of any other class, (iii) each class has a different exchange privilege, (iv) only Class B shares have a conversion feature and (v) Class Z shares are offered exclusively to a limited group of investors. See "How the Fund is Managed--Distributor." In accordance with the Fund's Articles of Incorporation, the Board of Directors may authorize the creation of additional series of common stock and classes within such series, with such preferences, privileges, limitations and voting and dividend rights as the Board may determine. The Board of Directors may increase or decrease the number of authorized shares without approval by the shareholders. Shares of the Fund, when issued, are fully paid, nonassessable, fully transferable and redeemable at the option of the holder. Shares are also redeemable at the option of the Fund under certain circumstances as described under "Shareholder Guide--How to Sell Your Shares." Each share of each class of common stock is equal as to earnings, assets and voting privileges, except as noted above, and each class (with the exception of Class Z shares, which are not subject to any distribution or service fees) bears the expenses related to the distribution of its shares. Except for the conversion feature applicable to the Class B shares, there are no conversion, preemptive or other subscription rights. In the event of liquidation, each share of common stock of the Fund is entitled to its portion of all of the Fund's assets after all debt and expenses of the Fund have been paid. Since Class B and Class C shares generally bear higher distribution expenses than Class A shares, the liquidation proceeds of these classes are likely to be lower than to Class A shareholders and to Class Z shareholders, whose shares are not subject to any distribution and/or service fees. The Fund's shares do not have cumulative voting rights for the election of Directors. THE FUND DOES NOT INTEND TO HOLD ANNUAL MEETINGS OF SHAREHOLDERS UNLESS OTHERWISE REQUIRED BY LAW. THE FUND WILL NOT BE REQUIRED TO HOLD MEETINGS OF SHAREHOLDERS UNLESS, FOR EXAMPLE, THE ELECTION OF DIRECTORS IS REQUIRED TO BE ACTED ON BY SHAREHOLDERS UNDER THE INVESTMENT COMPANY ACT. SHAREHOLDERS HAVE CERTAIN RIGHTS, INCLUDING THE RIGHT TO CALL A MEETING UPON A VOTE OF 10% OF THE FUND'S OUTSTANDING SHARES FOR THE PURPOSE OF VOTING ON THE REMOVAL OF ONE OR MORE DIRECTORS OR TO TRANSACT ANY OTHER BUSINESS. 22 ADDITIONAL INFORMATION This Prospectus, including the Statement of Additional Information which has been incorporated by reference herein, does not contain all the information set forth in the Registration Statement filed by the Fund with the Commission under the Securities Act. Copies of the Registration Statement may be obtained at a reasonable charge from the Commission or may be examined, without charge, at the office of the Commission in Washington, D.C. SHAREHOLDER GUIDE HOW TO BUY SHARES OF THE FUND YOU MAY PURCHASE SHARES OF THE FUND THROUGH THE DISTRIBUTOR, PRUSEC OR DIRECTLY FROM THE FUND THROUGH ITS TRANSFER AGENT, PRUDENTIAL MUTUAL FUND SERVICES LLC, ATTENTION: INVESTMENT SERVICES, P.O. BOX 15020, NEW BRUNSWICK, NEW JERSEY 08906-5020. The purchase price is the NAV next determined following receipt of an order by the Transfer Agent or the Distributor plus a sales charge which, at your option, may be imposed either (i) at the time of purchase (Class A shares) or (ii) on a deferred basis (Class B or Class C shares). Class Z shares are offered to a limited group of investors at NAV without any sales charge. Participants in programs sponsored by Prudential Retirement Services should contact their client representative for more information about Class Z shares. Payments may be made by cash, wire, check or through an investor's brokerage account. See "Alternative Purchase Plan" below. See also "How the Fund Values its Shares." The minimum initial investment for Class A and Class B shares is $1,000 per class and $5,000 for Class C shares. There is no minimum investment requirement for Class Z shares. The minimum subsequent investment is $100 for all classes, except for Class Z shares, for which there is no minimum. All minimum investment requirements are waived for certain retirement and employee savings plans or custodial accounts for the benefit of minors. For purchases made through the Automatic Savings Accumulation Plan, the minimum initial and subsequent investment is $50. See "Shareholder Services" below. Application forms can be obtained from the Transfer Agent, Prudential Securities or Prusec. If a stock certificate is desired, it must be requested in writing for each transaction. Certificates are issued only for full shares. Shareholders who hold their shares through Prudential Securities will not receive stock certificates. The Fund reserves the right to reject any purchase order (including an exchange into the Fund) or to suspend or modify the continuous offering of its shares. See "How to Sell Your Shares" below. Your dealer is responsible for forwarding payment promptly to the Fund. Prudential Securities reserves the right to cancel any purchase order for which payment has not been received by the third business day following the investment. Transactions in Fund shares may be subject to postage and handling charges imposed by your dealer. PURCHASE BY WIRE. For an initial purchase of shares of the Fund by wire, you must first telephone the Transfer Agent at (800) 225-1852 (toll-free) to receive an account number. The following information will be requested: your name, address, tax identification number, class election, dividend distribution election, amount being wired and wiring bank. Instructions should then be given by you to your bank to transfer funds by wire to the Custodian, State Street Bank and Trust Company, Boston, Massachusetts, Custody and Shareholder Services Division, Attention: Prudential Mortgage Income Fund, Inc., specifying on the wire the account number assigned by the Transfer Agent and your name and identifying the class in which you are eligible to invest (Class A, Class B, Class C or Class Z shares). If you arrange for receipt by the Custodian of Federal Funds prior to the calculation of NAV (4:15 P.M., New York time), on a business day, you may purchase shares of the Fund as of that day. See "Net Asset Value" in the Statement of Additional Information. 23 In making a subsequent purchase order by wire, you should wire the Custodian directly and should be sure that the wire specifies Prudential Mortgage Income Fund, Inc., Class A, Class B, Class C or Class Z shares and your name and individual account number. It is not necessary to call the Transfer Agent to make subsequent purchase orders utilizing Federal Funds. The minimum amount which may be invested by wire is $1,000. ALTERNATIVE PURCHASE PLAN THE FUND OFFERS FOUR CLASSES OF SHARES (CLASS A, CLASS B, CLASS C AND CLASS Z SHARES) WHICH ALLOWS YOU TO CHOOSE THE MOST BENEFICIAL SALES CHARGE STRUCTURE FOR YOUR INDIVIDUAL CIRCUMSTANCES GIVEN THE AMOUNT OF THE PURCHASE, THE LENGTH OF TIME YOU EXPECT TO HOLD THE SHARES AND OTHER RELEVANT CIRCUMSTANCES (ALTERNATIVE PURCHASE PLAN).
ANNUAL 12B-1 FEES (AS A % OF AVERAGE SALES CHARGE DAILY NET ASSETS) OTHER INFORMATION ----------------------------------- ----------------------------------- ----------------------------------- CLASS A Maximum initial sales charge of 4% 0.30 of 1% (Currently being charged Initial sales charge waived or of the public offering price at a rate of 0.15 of 1%) reduced for certain purchases CLASS B Maximum CDSC of 5% of the lesser of 0.75 of 1% Shares convert to Class A shares the amount invested or the approximately seven years after redemption proceeds; declines to purchase zero after six years CLASS C Maximum CDSC of 1% of the lesser of 1% (Currently being charged at a Shares do not convert to another the amount invested or the rate of 0.75 of 1%) class redemption proceeds on redemptions made within one year of purchase CLASS Z None None Sold to a limited group of investors
The four classes of shares represent an interest in the same portfolio of investments of the Fund and have the same rights, except that (i) each class is subject to different sales charges and distribution and/or service fees (with the exception of Class Z shares, which are not subject to any distribution or service fees), which may affect performance, (ii) each class has exclusive voting rights on any matter submitted to shareholders that relates solely to its arrangement and has separate voting rights on any matter submitted to shareholders in which the interests of one class differ from the interests of any other class, and (iii) only Class B shares have a conversion feature. The four classes also have separate exchange privileges. See "How to Exchange Your Shares" below. The income attributable to each class and the dividends payable on the shares of each class will be reduced by the amount of the distribution fee (if any) of each class. Class B and Class C shares bear the expenses of a higher distribution fee which will generally cause them to have higher expense ratios and to pay lower dividends than the Class A and Class Z shares. Financial advisers and other sales agents who sell shares of the Fund will receive different compensation for selling Class A, Class B, Class C and Class Z shares and will generally receive more compensation initially for selling Class A and Class B shares than for selling Class C or Class Z shares. IN SELECTING A PURCHASE ALTERNATIVE, YOU SHOULD CONSIDER, AMONG OTHER THINGS, (1) the length of time you expect to hold the investment, (2) the amount of any applicable sales charge (whether imposed at the time of purchase or redemption) and distribution-related fees, as noted above, (3) whether you qualify for any reduction or waiver of any applicable sales charge, (4) the various exchange privileges among the different classes of shares (see "How to Exchange Your Shares" below) and (5) the fact that Class B shares automatically convert to Class A shares approximately seven years after purchase (see "Conversion Feature--Class B Shares" below). The following is provided to assist you in determining which method of purchase best suits your individual circumstances and is based on current fees and expenses being charged to the Fund: If you intend to hold your investment in the Fund for less than 7 years and do not qualify for a reduced sales charge on Class A shares, since Class A shares are subject to a maximum initial sales charge of 4% and Class B shares are subject to a CDSC of 5% which declines to zero over a 6 year period, you should consider purchasing Class C shares over either Class A or Class B shares. 24 If you intend to hold your investment for more than 6 years, you should consider purchasing Class A shares over either Class B or Class C shares regardless of whether or not you qualify for a reduced sales charge on Class A shares. If you qualify for a reduced sales charge on Class A shares, it may be more advantageous for you to purchase Class A shares over either Class B or Class C shares regardless of how long you intend to hold your investment. However, unlike Class B and Class C shares, you would not have your entire purchase price invested initially because the sales charge on Class A shares is deducted at the time of purchase. If you do not qualify for a reduced sales charge on Class A shares and you purchase Class B or Class C shares, you would have to hold your investment for more than 6 years in the case of Class B shares and Class C shares for the higher cumulative annual distribution-related fee on those shares to exceed the initial sales charge plus cumulative annual distribution-related fee on Class A shares. This does not take into account the time value of money, which further reduces the impact of the higher Class B or Class C distribution-related fee on the investment, fluctuations in NAV, the effect of the return on the investment over this period of time or redemptions when the CDSC is applicable. ALL PURCHASES OF $1 MILLION OR MORE, EITHER AS PART OF A SINGLE INVESTMENT OR UNDER RIGHTS OF ACCUMULATION OR LETTERS OF INTENT, MUST BE FOR CLASS A SHARES UNLESS THE PURCHASER IS ELIGIBLE TO PURCHASE CLASS Z SHARES. SEE "REDUCTION AND WAIVER OF INITIAL SALES CHARGES" AND "CLASS Z SHARES" BELOW. CLASS A SHARES The offering price of Class A shares for investors choosing the initial sales charge alternative is the next determined NAV plus a sales charge (expressed as a percentage of the offering price and of the amount invested) as shown in the following table:
SALES CHARGE AS SALES CHARGE AS DEALER CONCESSION PERCENTAGE OF PERCENTAGE OF AS PERCENTAGE OF AMOUNT OF PURCHASE OFFERING PRICE AMOUNT INVESTED OFFERING PRICE ------------------------ --------------- --------------- ----------------- Less than $49,999 4.00% 4.17% 3.75% $50,000 to $99,999 3.50 3.63 3.25 $100,000 to $249,999 2.75 2.83 2.50 $250,000 to $499,999 2.00 2.04 1.90 $500,000 to $999,999 1.50 1.52 1.40 $1,000,000 and above None None None
Prudential Securities may reallow the entire initial sales charge to dealers. Selling dealers may be deemed to be underwriters, as that term is defined in the Securities Act. In connection with the sale of Class A shares at NAV (without payment of an initial sales charge), PIFM, Prudential Securities or one of their affiliates will pay dealers, financial advisers and other persons which distribute shares a finders' fee from its own resources based on a percentage of the NAV of shares sold by such persons. REDUCTION AND WAIVER OF INITIAL SALES CHARGES. Reduced sales charges are available through Rights of Accumulation and Letters of Intent. Shares of the Fund and shares of other Prudential Mutual Funds (excluding money market funds other than those acquired pursuant to the exchange privilege) may be aggregated to determine the applicable reduction. See "Purchase and Redemption of Fund Shares--Reduction and Waiver of Initial Sales Charges--Class A Shares" in the Statement of Additional Information. BENEFIT PLANS. Class A shares may be purchased at NAV, without payment of an initial sales charge, by pension, profit-sharing or other employee benefit plans qualified under Section 401 of the Internal Revenue Code and deferred compensation and annuity plans under Sections 457 and 403(b)(7) of the Internal Revenue Code (collectively, Benefit Plans), provided that the Benefit Plan has existing assets of at least $1 million invested in shares of Prudential Mutual Funds (excluding money market funds other than those acquired pursuant to the exchange privilege) or 250 eligible employees or participants. In the case of Benefit Plans whose 25 accounts are held directly with the Transfer Agent or Prudential Securities and for which the Transfer Agent or Prudential Securities does individual account recordkeeping (Direct Account Benefit Plans) and Benefit Plans sponsored by Prudential Securities or its subsidiaries (Prudential Securities or Subsidiary Prototype Benefit Plans), Class A shares may be purchased at NAV by participants who are repaying loans made from such plans to the participant. PRUDENTIAL RETIREMENT PROGRAMS. Class A shares may be purchased at NAV by certain savings, retirement and deferred compensation plans, qualified or non-qualified under the Internal Revenue Code, for which Prudential serves as the plan administrator or recordkeeper, provided that (i) the plan has at least $1 million in existing assets or 250 eligible employees and (ii) the Fund is an available investment option. These plans include pension, profit-sharing, stock-bonus or other employee benefit plans under Section 401 of the Internal Revenue Code, deferred compensation and annuity plans under Sections 457 and 403(b)(7) of the Internal Revenue Code and plans that participate in the Transfer Agent's PruArray and SmartPath Programs (benefit plan recordkeeping services)(hereafter referred to as a PruArray or SmartPath Plan). All plans of a company for which Prudential serves as plan administrator or recordkeeper are aggregated in meeting the $1 million threshold. The term existing assets as used herein includes stock issued by a plan sponsor, shares of Prudential Mutual Funds and shares of certain unaffiliated mutual funds that participate in the PruArray or SmartPath Programs (Participating Funds). Existing assets also include monies invested in The Guaranteed Interest Account (GIA), a group annuity insurance product issued by Prudential, and units of the The Stable Value Fund (SVF), an unaffiliated bank collective fund. Class A shares may also be purchased at NAV by plans that have monies invested in GIA and SVF, provided (i) the purchase is made with the proceeds of a redemption from either GIA or SVF and (ii) Class A shares are an investment option of the plan. PRUARRAY ASSOCIATION BENEFIT PLANS. Class A shares are also offered at NAV to Benefit Plans or non-qualified plans sponsored by employers which are members of a common trade, professional or membership association (Association) that participate in the PruArray Program provided that the Association enters into a written agreement with Prudential. Such Benefit Plans or non-qualified plans may purchase Class A shares at NAV without regard to the assets or number of participants in the individual employer's qualified Plan(s) or non-qualified Plans so long as the employers in the Association (i) have retirement plan assets in the aggregate of at least $1 million or 250 participants in the aggregate and (ii) maintain their accounts with the Transfer Agent. PRUARRAY SAVINGS PROGRAM. Class A shares are also offered at NAV to employees of companies that enter into a written agreement with Prudential Retirement Services to participate in the PruArray Savings Program. Under this Program, a limited number of Prudential Mutual Funds are available for purchase at NAV by Individual Retirement Accounts and Savings Accumulation Plans of the company's employees. The Program is available only to (i) employees who open an IRA or Savings Accumulation Plan account with the Transfer Agent and (ii) spouses of employees who open an IRA account with the Transfer Agent. The program is offered to companies that have at least 250 eligible employees. SPECIAL RULES APPLICABLE TO RETIREMENT PLANS. After a Benefit Plan or PruArray or SmartPath Plan qualifies to purchase Class A shares at NAV, all subsequent purchases will be made at NAV. OTHER WAIVERS. In addition, Class A shares may be purchased at NAV, through Prudential Securities or the Transfer Agent, by the following persons: (a) officers of the Prudential Mutual Funds (including the Fund), (b) employees of Prudential Securities and PIFM and their subsidiaries and members of the families of such persons who maintain an employee related account at Prudential Securities or the Transfer Agent, (c) employees of subadvisers of the Prudential Mutual Funds provided that purchases at NAV are permitted by such person's employer, (d) Prudential employees and special agents of Prudential and its subsidiaries and all persons who have retired directly from active service with Prudential or one of its subsidiaries, (e) registered representatives and employees of dealers who have entered into a selected dealer agreement with Prudential Securities provided that purchases at NAV are permitted by such person's employer and (f) investors who have a business relationship with a financial adviser who joined Prudential Securities from another investment firm, provided that (i) the purchase is made within 180 days of the commencement of the financial adviser's employment at Prudential Securities, or within one year in the case of Benefit Plans, (ii) the purchase is made with proceeds of a redemption of shares of any open-ended non-money market fund sponsored by the financial adviser's previous employer (other than a fund which imposes a distribution or service fee of .25 of 1% or less) and 26 (iii) the financial adviser served as the client's broker on the previous purchase, and (g) investors in Individual Retirement Accounts, provided the purchase is made with the proceeds of a tax-free rollover of assets from a Benefit Plan for which Prudential Investments serves as the recordkeeper of administrator. You must notify the Transfer Agent either directly or through Prudential Securities or Prusec that you are entitled to the reduction or waiver of the sales charge. The reduction or waiver will be granted subject to confirmation of your entitlement. No initial sales charges are imposed upon Class A shares acquired upon the reinvestment of dividends and distributions. See "Purchase and Redemption of Fund Shares--Reduction and Waiver of Initial Sales Charges--Class A Shares" in the Statement of Additional Information. CLASS B AND CLASS C SHARES The offering price of Class B and Class C shares for investors choosing one of the deferred sales charge alternatives is the NAV next determined following receipt of an order by the Transfer Agent or Prudential Securities. Although there is no sales charge imposed at the time of purchase, redemptions of Class B and Class C shares may be subject to a CDSC. See "How to Sell Your Shares--Contingent Deferred Sales Charges" below. Prudential Securities will pay, from its own resources, sales commissions of up to 4% of the purchase price of Class B shares to dealers, financial advisers and other persons who sell Class B shares at the time of sale. This facilitates the ability of the Fund to sell the Class B shares without an initial sales charge being deducted at the time of purchase. Prudential Securities anticipates that it will recoup its advancement of sales commissions from the combination of the CDSC and the distribution fee. See "How the Fund is Managed--Distributor." In connection with the sale of Class C shares, Prudential Securities will pay, from its own resources, dealers, financial advisers and other persons which distribute Class C shares a sales commission of up to 1% of the purchase price at the time of the sale. CLASS Z SHARES Class Z shares of the Fund are currently available for purchase by the following categories of investors: (i) pension, profit-sharing or other employee benefit plans qualified under Section 401 of the Internal Revsenue Code, deferred compensation and annuity plans under Sections 457 and 403(b)(7) of the Internal Revenue Code and non-qualified plans for which the Fund is an available option (collectively, Benefit Plans), provided such Benefit Plans (in combination with other plans sponsored by the same employer or group of related employers) have at least $50 million in defined contribution assets; (ii) participants in any fee-based program or trust program sponsored by Prudential Securities, The Prudential Savings Bank, F.S.B. or any affiliate which includes mutual funds as investment options and for which the Fund is an available option; (iii) certain participants in the MEDLEY Program (group variable annuity contracts) sponsored by Prudential for whom Class Z shares of the Prudential Mutual Funds are an available option; (iv) Benefit Plans for which Prudential Retirement Services serves as recordkeeper and as of September 20, 1996, (a) were Class Z shareholders of the Prudential Mutual Funds or (b) executed a letter of intent to purchase Class Z shares of the Prudential Mutual Funds; (v) current and former Directors/Trustees of the Prudential Mutual Funds (including the Fund); and (vi) employees of Prudential and/or Prudential Securities who participate in a Prudential-sponsored employee savings plan. In connection with the sale of Class Z shares, PIFM, Prudential Securities or one of their affiliates may pay dealers, financial advisers and other persons which distribute shares a finders' fee from its own resources based on a percentage of the NAV sold by such persons. HOW TO SELL YOUR SHARES YOU CAN REDEEM YOUR SHARES AT ANY TIME FOR CASH AT THE NAV NEXT DETERMINED AFTER THE REDEMPTION REQUEST IS RECEIVED IN PROPER FORM BY THE TRANSFER AGENT OR PRUDENTIAL SECURITIES. SEE "HOW THE FUND VALUES ITS SHARES." In certain cases, however, redemption proceeds will be reduced by the amount of any applicable CDSC, as described below. See "Contingent Deferred Sales Charges" below. 27 IF YOU HOLD SHARES OF THE FUND THROUGH PRUDENTIAL SECURITIES, YOU MUST REDEEM SHARES THROUGH PRUDENTIAL SECURITIES. PLEASE CONTACT YOUR PRUDENTIAL SECURITIES FINANCIAL ADVISER. IF YOU HOLD SHARES IN NON-CERTIFICATE FORM, A WRITTEN REQUEST FOR REDEMPTION SIGNED BY YOU EXACTLY AS THE ACCOUNT IS REGISTERED IS REQUIRED. IF YOU HOLD CERTIFICATES, THE CERTIFICATES, SIGNED IN THE NAME(S) SHOWN ON THE FACE OF THE CERTIFICATES, MUST BE RECEIVED BY THE TRANSFER AGENT IN ORDER FOR THE REDEMPTION REQUEST TO BE PROCESSED. IF REDEMPTION IS REQUESTED BY A CORPORATION, PARTNERSHIP, TRUST OR FIDUCIARY, WRITTEN EVIDENCE OF AUTHORITY ACCEPTABLE TO THE TRANSFER AGENT MUST BE SUBMITTED BEFORE SUCH REQUEST WILL BE ACCEPTED. All correspondence and documents concerning redemptions should be sent to the Fund in care of its Transfer Agent, Prudential Mutual Fund Services LLC, Attention: Redemption Services, P.O. Box 15010, New Brunswick, New Jersey 08906-5010. If the proceeds of the redemption (a) exceed $50,000, (b) are to be paid to a person other than the record owner, (c) are to be sent to an address other than the address on the Transfer Agent's records, or (d) are to be paid to a corporation, partnership, trust or fiduciary, the signature(s) on the redemption request and on the certificates, if any, or stock power must be guaranteed by an eligible guarantor institution. An eligible guarantor institution includes any bank, broker, dealer or credit union. The Transfer Agent reserves the right to request additional information from, and make reasonable inquiries of, any eligible guarantor institution. For clients of Prusec, a signature guarantee may be obtained from the agency or office manager of most Prudential Insurance and Financial Services or Preferred Services offices. In the case of redemptions from a PruArray or SmartPath Plan, if the proceeds of the redemption are invested in another investment option of the plan in the name of the record holder and at the same address as reflected in the Transfer Agent's records, a signature guarantee is not required. PAYMENT FOR SHARES PRESENTED FOR REDEMPTION WILL BE MADE BY CHECK WITHIN SEVEN DAYS AFTER RECEIPT BY THE TRANSFER AGENT OF THE CERTIFICATE AND/OR WRITTEN REQUEST, EXCEPT AS INDICATED BELOW. IF YOU HOLD SHARES THROUGH PRUDENTIAL SECURITIES, PAYMENT FOR SHARES PRESENTED FOR REDEMPTION WILL BE CREDITED TO YOUR PRUDENTIAL SECURITIES ACCOUNT, UNLESS YOU INDICATE OTHERWISE. Such payment may be postponed or the right of redemption suspended at times (a) when the New York Stock Exchange is closed for other than customary weekends and holidays, (b) when trading on such Exchange is restricted, (c) when an emergency exists as a result of which disposal by the Fund of securities owned by it is not reasonably practicable or it is not reasonably practicable for the Fund fairly to determine the value of its net assets, or (d) during any other period when the Commission, by order, so permits; provided that applicable rules and regulations of the Commission shall govern as to whether the conditions prescribed in (b), (c) or (d) exist. PAYMENT FOR REDEMPTION OF RECENTLY PURCHASED SHARES WILL BE DELAYED UNTIL THE FUND OR ITS TRANSFER AGENT HAS BEEN ADVISED THAT THE PURCHASE CHECK HAS BEEN HONORED, UP TO 10 CALENDAR DAYS FROM THE TIME OF RECEIPT OF THE PURCHASE CHECK BY THE TRANSFER AGENT. SUCH DELAY MAY BE AVOIDED BY PURCHASING SHARES BY WIRE OR BY CERTIFIED OR CASHIERS' CHECK. REDEMPTION IN KIND. If the Board of Directors determines that it would be detrimental to the best interests of the remaining shareholders of the Fund to make payment wholly or partly in cash, the Fund may pay the redemption price in whole or in part by a distribution in kind of securities from the investment portfolio of the Fund, in lieu of cash, in conformity with applicable rules of the Commission. Securities will be readily marketable and will be valued in the same manner as in a regular redemption. See "How the Fund Values its Shares." If your shares are redeemed in kind, you will incur transaction costs in converting the assets into cash. The Fund, however, has elected to be governed by Rule 18f-1 under the Investment Company Act, under which the Fund is obligated to redeem shares solely in cash up to the lesser of $250,000 or 1% of the NAV of the Fund during any 90-day period for any one shareholder. INVOLUNTARY REDEMPTION. In order to reduce expenses of the Fund, the Board of Directors may redeem all of the shares of any shareholder, other than a shareholder which is an IRA or other tax-deferred retirement plan, whose account has a NAV of less than $500 due to a redemption. The Fund will give such shareholders 60 days' prior written notice in which to purchase sufficient additional shares to avoid such redemption. No CDSC will be imposed on any such involuntary redemption. 90-DAY REPURCHASE PRIVILEGE. If you redeem your shares and have not previously exercised the repurchase privilege, you may reinvest any portion or all of the proceeds of such redemption in shares of the Fund at the NAV next determined after the order is 28 received, which must be within 90 days after the date of the redemption. Any CDSC paid in connection with such redemption will be credited (in shares) to your account. If less than a full repurchase is made, the credit will be on a pro rata basis. You must notify the Fund's Transfer Agent, either directly or through Prudential Securities, at the time the repurchase privilege is exercised to adjust the account for the CDSC previously paid. Thereafter, any redemptions will be subject to the CDSC applicable at the time of the redemption. See "Contingent Deferred Sales Charges" below. Exercise of the repurchase privilege may affect federal income tax treatment of any gain or loss realized upon redemption. CONTINGENT DEFERRED SALES CHARGES Redemptions of Class B shares will be subject to a CDSC declining from 5% to zero over a six-year period. Class C shares redeemed within one year of purchase will be subject to a 1% CDSC. The CDSC will be deducted from the redemption proceeds and reduce the amount paid to you. The CDSC will be imposed on any redemption by you which reduces the current value of your Class B or Class C shares to an amount which is lower than the amount of all payments by you for shares during the preceding six years, in the case of Class B shares, and one year, in the case of Class C shares. A CDSC will be applied on the lesser of the original purchase price or the current value of the shares being redeemed. Increases in the value of your shares or shares acquired through reinvestment of dividends or distributions are not subject to a CDSC. The amount of any CDSC will be paid to and retained by Prudential Securities. See "How the Fund is Managed--Distributor" and "Waiver of Contingent Deferred Sales Charges--Class B Shares" below. The amount of the CDSC, if any, will vary depending on the number of years from the time of payment for the purchase of shares until the time of redemption of such shares. Solely for purposes of determining the number of years from the time of any payment for the purchase of shares, all payments during a month will be aggregated and deemed to have been made on the last day of the month. The CDSC will be calculated from the first day of the month after the initial purchase, excluding the time shares were held in a money market fund. See "How to Exchange Your Shares" below. The following table sets forth the rates of the CDSC applicable to redemptions of Class B shares:
CONTINGENT DEFERRED SALES CHARGE AS A PERCENTAGE OF THE DOLLARS INVESTED YEAR SINCE PURCHASE OR PAYMENT MADE REDEMPTION PROCEEDS ------------------------------ ------------------------- First......................... 5.0 % Second........................ 4.0 Third......................... 3.0 Fourth........................ 2.0 Fifth......................... 1.0 Sixth......................... 1.0 Seventh....................... None
In determining whether a CDSC is applicable to a redemption, the calculation will be made in a manner that results in the lowest possible rate. It will be assumed that the redemption is made first of amounts representing shares acquired pursuant to the reinvestment of dividends and distributions; then of amounts representing the increase in NAV above the total amount of payments for the purchase of Fund shares made during the preceding six years (five years for Class B shares purchased prior to January 22, 1990); then of amounts representing the cost of shares held beyond the applicable CDSC period; then of amounts representing the cost of shares acquired prior to July 1, 1985; and finally, of amounts representing the cost of shares held for the longest period of time within the applicable CDSC period. For example, assume you purchased 100 Class B shares at $10 per share for a cost of $1,000. Subsequently, you acquired 5 additional Class B shares through dividend reinvestment. During the second year after the purchase you decided to redeem $500 of your investment. Assuming at the time of the redemption the NAV had appreciated to $12 per share, the value of your Class B shares 29 would be $1,260 (105 shares at $12 per share). The CDSC would not be applied to the value of the reinvested dividend shares and the amount which represents appreciation ($260). Therefore, $240 of the $500 redemption proceeds ($500 minus $260) would be charged at a rate of 4% (the applicable rate in the second year after purchase) for a total CDSC of $9.60. For federal income tax purposes, the amount of the CDSC will reduce the gain or increase the loss, as the case may be, on the amount recognized on the redemption of shares. WAIVER OF CONTINGENT DEFERRED SALES CHARGES--CLASS B SHARES. The CDSC will be waived in the case of a redemption following the death or disability of a shareholder or, in the case of a trust account, following the death or disability of the grantor. The waiver is available for total or partial redemptions of shares owned by a person, either individually or in joint tenancy (with rights of survivorship), at the time of death or initial determination of disability, provided that the shares were purchased prior to death or disability. The CDSC will also be waived in the case of a total or partial redemption in connection with certain distributions made without penalty under the Internal Revenue Code from a tax-deferred retirement plan, an IRA or Section 403(b) custodial account. These distributions include: (i) in the case of a tax-deferred retirement plan, a lump-sum or other distribution after retirement; (ii) in the case of an IRA or Section 403(b) custodial account, a lump-sum or other distribution after attaining age 59 1/2; and (iii) a tax-free return of an excess contribution or plan distributions following the death or disability of the shareholder, provided that the shares were purchased prior to death or disability. The waiver does not apply in the case of a tax-free rollover or transfer of assets, other than one following a separation from service (I.E., following voluntary or involuntary termination of employment or following retirement). Under no circumstances will the CDSC be waived on redemptions resulting from the termination of a tax-deferred retirement plan, unless such redemptions otherwise qualify for a waiver as described above. In the case of Direct Account and PSI or Subsidiary Prototype Benefit Plans, the CDSC will be waived on redemptions which represent borrowings from such plans. Shares purchased with amounts used to repay a loan from such plans on which a CDSC was not previously deducted will thereafter be subject to a CDSC without regard to the time such amounts were previously invested. In the case of a 401(k) plan, the CDSC will also be waived upon the redemption of shares purchased with amounts used to repay loans made from the account to the participant and from which a CDSC was previously deducted. SYSTEMATIC WITHDRAWAL PLAN. The CDSC will be waived (or reduced) on certain redemptions from a Systematic Withdrawal Plan. On an annual basis, up to 12% of the total dollar amount subject to the CDSC may be redeemed without charge. The Transfer Agent will calculate the total amount available for this waiver annually on the anniversary date of your purchase or, for shares purchased prior to March 1, 1997, on March 1 of the current year. The CDSC will be waived (or reduced) on redemptions until this threshold 12% is reached. In addition, the CDSC will be waived on redemptions of shares held by a Director of the Fund. You must notify the Transfer Agent either directly or through Prudential Securities or Prusec, at the time of redemption, that you are entitled to waiver of the CDSC and provide the Transfer Agent with such supporting documentation as it may deem appropriate. The waiver will be granted subject to confirmation of your entitlement. See "Purchase and Redemption of Fund Shares--Waiver of the Contingent Deferred Sales Charge--Class B Shares" in the Statement of Additional Information. A quantity discount may apply to redemptions of Class B shares purchased prior to August 1, 1994. See "Purchase and Redemption of Fund Shares--Quantity Discount--Class B Shares Purchased Prior to August 1, 1994" in the Statement of Additional Information. WAIVER OF CONTINGENT DEFERRED SALES CHARGES--CLASS C SHARES. PRUARRAY OR SMARTPATH PLANS. The CDSC will be waived on redemptions from qualified and non-qualified retirement and deferred compensation plans that participate in the Transfer Agent's PruArray and SmartPath Programs. 30 CONVERSION FEATURE--CLASS B SHARES Class B shares will automatically convert to Class A shares on a quarterly basis approximately seven years after purchase. Conversions will be effected at relative NAV without the imposition of any additional sales charge. Since the Fund tracks amounts paid rather than the number of shares bought on each purchase of Class B shares, the number of Class B shares eligible to convert to Class A shares (excluding shares acquired through the automatic reinvestment of dividends and other distributions) (the Eligible Shares) will be determined on each conversion date in accordance with the following formula: (i) the ratio of (a) the amounts paid for Class B shares purchased at least seven years prior to the conversion date to (b) the total amount paid for all Class B shares purchased and then held in your account (ii) multiplied by the total number of Class B shares purchased and then held in your account. Each time any Eligible Shares in your account convert to Class A shares, all shares or amounts representing Class B shares then in the account that were acquired through the automatic reinvestment of dividends and other distributions will convert to Class A shares. For purposes of determining the number of Eligible Shares, if the Class B shares in your account on any conversion date are the result of multiple purchases at different NAV per share, the number of Eligible Shares calculated as described above will generally be either more or less than the number of shares actually purchased approximately seven years before such conversion date. For example, if 100 shares were initially purchased at $10 per share (for a total of $1,000) and a second purchase of 100 shares was subsequently made at $11 per share (for a total of $1,100), 95.24 shares would convert approximately seven years from the initial purchase (I.E., $1,000 divided by $2,100 (47.62%) multiplied by 200 shares equals 95.24 shares). PIFM reserves the right to modify the formula for determining the number of Eligible Shares in the future as it deems appropriate on notice to shareholders. Since annual distribution-related fees are lower for Class A shares than Class B shares, the per share NAV of the Class A shares may be higher than that of the Class B shares at the time of conversion. Thus, although the aggregate dollar value will be the same, you may receive fewer Class A shares than Class B shares converted. See "How the Fund Values its Shares." For purposes of calculating the applicable holding period for conversions, all payments for Class B shares during a month will be deemed to have been made on the last day of the month, or for Class B shares acquired through exchange, or a series of exchanges, on the last day of the month in which the original payment for purchases of such Class B shares was made. For Class B shares previously exchanged for shares of a money market fund, the time period during which such shares were held in the money market fund will be excluded. For example, Class B shares held in a money market fund for one year will not convert to Class A shares until approximately eight years from purchase. For purposes of measuring the time period during which shares are held in a money market fund, exchanges will be deemed to have been made on the last day of the month. Class B shares acquired through exchange will convert to Class A shares after expiration of the conversion period applicable to the original purchase of such shares. The conversion feature may be subject to the continuing availability of opinions of counsel or rulings of the Internal Revenue Service that (i) the dividends and other distributions paid on Class A, Class B, Class C and Class Z shares will not constitute preferential dividends under the Internal Revenue Code and (ii) the conversion of shares does not constitute a taxable event. The conversion of Class B shares into Class A shares may be suspended if such opinions or rulings are no longer available. If conversions are suspended, Class B shares of the Fund will continue to be subject, possibly indefinitely, to their higher annual distribution and service fee. HOW TO EXCHANGE YOUR SHARES SHAREHOLDERS OF THE FUND HAVE AN EXCHANGE PRIVILEGE WITH CERTAIN OTHER PRUDENTIAL MUTUAL FUNDS (THE EXCHANGE PRIVILEGE), INCLUDING ONE OR MORE SPECIFIED MONEY MARKET FUNDS, SUBJECT TO THE MINIMUM INVESTMENT REQUIREMENTS OF SUCH FUNDS. CLASS A, CLASS B, CLASS C AND CLASS Z SHARES OF THE FUND MAY BE EXCHANGED FOR CLASS A, CLASS B, CLASS C AND CLASS Z SHARES, RESPECTIVELY, OF ANOTHER FUND ON THE BASIS OF THE RELATIVE NAV. No sales charge will be imposed at the time of the exchange. Any applicable CDSC payable upon the redemption of shares exchanged will be calculated from the first day of 31 the month after the initial purchase, excluding the time shares were held in a money market fund. Class B and Class C shares may not be exchanged into money market funds other than Prudential Special Money Market Fund, Inc. For purposes of calculating the holding period applicable to the Class B conversion feature, the time period during which Class B shares were held in a money market fund will be excluded. See "Conversion Feature--Class B Shares" above. An exchange will be treated as a redemption and purchase for tax purposes. See "Shareholder Investment Account--Exchange Privilege" in the Statement of Additional Information. IN ORDER TO EXCHANGE SHARES BY TELEPHONE, YOU MUST AUTHORIZE TELEPHONE EXCHANGES ON YOUR INITIAL APPLICATION FORM OR BY WRITTEN NOTICE TO THE TRANSFER AGENT AND HOLD SHARES IN NON-CERTIFICATE FORM. Thereafter, you may call the Fund at (800) 225-1852 to execute a telephone exchange of shares, on weekdays, except holidays, between the hours of 8:00 A. M. and 6:00 P. M., New York time. For your protection and to prevent fraudulent exchanges, telephone calls will be recorded and you will be asked to provide your personal identification number. A written confirmation of the exchange transaction will be sent to you. NEITHER THE FUND NOR ITS AGENTS WILL BE LIABLE FOR ANY LOSS, LIABILITY OR COST WHICH RESULTS FROM ACTING UPON INSTRUCTIONS REASONABLY BELIEVED TO BE GENUINE UNDER THE FOREGOING PROCEDURES. All exchanges will be made on the basis of the relative NAV of the two funds next determined after the request is received in good order. The Exchange Privilege is available only in states where the exchange may legally be made. IF YOU HOLD SHARES THROUGH PRUDENTIAL SECURITIES, YOU MUST EXCHANGE YOUR SHARES BY CONTACTING YOUR PRUDENTIAL SECURITIES FINANCIAL ADVISER. IF YOU HOLD CERTIFICATES, THE CERTIFICATES, SIGNED IN THE NAME(S) SHOWN ON THE FACE OF THE CERTIFICATES, MUST BE RETURNED IN ORDER FOR THE SHARES TO BE EXCHANGED. SEE "HOW TO SELL YOUR SHARES" ABOVE. You may also exchange shares by mail by writing to Prudential Mutual Fund Services LLC, Attention: Exchange Processing, P.O. Box 15010, New Brunswick, New Jersey 08906-5010. IN PERIODS OF SEVERE MARKET OR ECONOMIC CONDITIONS THE TELEPHONE EXCHANGE OF SHARES MAY BE DIFFICULT TO IMPLEMENT AND YOU SHOULD MAKE EXCHANGES BY MAIL BY WRITING TO PRUDENTIAL MUTUAL FUND SERVICES LLC AT THE ADDRESS NOTED ABOVE. SPECIAL EXCHANGE PRIVILEGES. A special exchange privilege is available for shareholders who qualify to purchase Class A shares at NAV (see "Alternative Purchase Plan--Class A Shares--Reduction and Waiver of Initial Sales Charges" above) and for shareholders who qualify to purchase Class Z shares (see "Alternative Purchase Plan--Class Z Shares" above). Under this exchange privilege, amounts representing any Class B and Class C shares (which are not subject to a CDSC) held in such a shareholder's account will be automatically exchanged for Class A shares for shareholders who qualify to purchase Class A shares at NAV on a quarterly basis, unless the shareholder elects otherwise. Similarly, shareholders who qualify to purchase Class Z shares will have their Class B and Class C shares which are not subject to a CDSC and their Class A shares exchanged for Class Z shares on a quarterly basis. Eligibility for this exchange privilege will be calculated on the business day prior to the date of the exchange. Amounts representing Class B or Class C shares which are not subject to a CDSC include the following: (1) amounts representing Class B or Class C shares acquired pursuant to the automatic reinvestment of dividends and distributions, (2) amounts representing the increase in the NAV above the total amount of payments for the purchase of Class B or Class C shares and (3) amounts representing Class B or Class C shares held beyond the applicable CDSC period. Class B and Class C shareholders must notify the Transfer Agent either directly or through Prudential Securities or Prusec that they are eligible for this special exchange privilege. Participants in any fee-based program for which the Fund is an available option will have their Class A shares, if any, exchanged for Class Z shares when they elect to have those assets become a part of the fee-based program. Upon leaving the program (whether voluntarily or not), such Class Z shares (and, to the extent provided for in the program, Class Z shares acquired through participation in the program) will be exchanged for Class A shares at NAV. Similarly, participants in Prudential Securities' 401(k) Plan for which the Fund's Class Z shares is an available option and who wish to transfer their Class Z shares out of the Prudential Securities' 401(k) Plan following separation from service (I.E., voluntary or involuntary termination of employment or retirement) will have their Class Z shares exchanged for Class A shares at NAV. 32 The exchange privilege is not a right and may be suspended, modified or terminated on 60 days' notice to shareholders. FREQUENT TRADING. The Fund and the other Prudential Mutual Funds are not intended to serve as vehicles for frequent trading in response to short-term fluctuations in the market. Due to the disruptive effect that market timing investment strategies and excessive trading can have on efficient portfolio management, the Fund reserves the right to refuse purchase orders and exchanges by any person, group or commonly controlled accounts, if, in the Manager's sole judgment, such person, group or accounts were following a market timing strategy or were otherwise engaging in excessive trading (Market Timers). To implement this authority to protect the Fund and its shareholders from excessive trading, the Fund will reject all exchanges and purchases from a Market Timer unless the Market Timer has entered into a written agreement with the Fund or its affiliates pursuant to which the Market Timer has agreed to abide by certain procedures, which include a daily dollar limit on trading. The Fund may notify the Market Timer of rejection of an exchange or purchase order subsequent to the day on which the order was placed. SHAREHOLDER SERVICES In addition to the exchange privilege, a shareholder in the Fund can take advantage of the following additional services and privileges: - AUTOMATIC REINVESTMENT OF DIVIDENDS AND/OR DISTRIBUTIONS WITHOUT A SALES CHARGE. For your convenience, all dividends and distributions are automatically reinvested in full and fractional shares of the Fund at NAV without a sales charge. You may direct the Transfer Agent in writing not less than 5 full business days prior to the record date to have subsequent dividends and/ or distributions sent in cash rather than reinvested. If you hold shares through Prudential Securities, you should contact your financial adviser. - AUTOMATIC SAVINGS ACCUMULATION PLAN (ASAP). Under ASAP you may make regular purchases of the Fund's shares in amounts as little as $50 via an automatic debit to a bank account or Prudential Securities account (including a Command Account). For additional information about this service, you should contact your Prudential Securities financial adviser, Prusec representative or the Transfer Agent directly. - TAX-DEFERRED RETIREMENT PLANS. Various tax-deferred retirement plans, including 401(k) plans, self-directed individual retirement accounts and tax-sheltered accounts under Section 403(b)(7) of the Internal Revenue Code are available through Prudential Securities. These plans are for use by both self-employed individuals and corporate employers. These plans permit either self-direction of accounts by participants, or a pooled account arrangement. Information regarding the establishment of these plans, the administration, custodial fees and other details is available from Prudential Securities or the Transfer Agent. If you are considering adopting such a plan, you should consult with your own legal or tax adviser with respect to the establishment and maintenance of such a plan. - SYSTEMATIC WITHDRAWAL PLAN. A systematic withdrawal plan is available to shareholders which provides for monthly or quarterly checks. Withdrawals of Class B and Class C shares may be subject to a CDSC. See "How to Sell Your Shares--Contingent Deferred Sales Charges" above. - REPORTS TO SHAREHOLDERS. The Fund will send you annual and semi-annual reports. The financial statements appearing in annual reports are audited by independent accountants. In order to reduce duplicate mailing and printing expenses, the Fund will provide one annual and semi-annual shareholder report and annual prospectus per household. You may request additional copies of such reports by calling (800) 225-1852 or by writing to the Fund at Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077. In addition, monthly unaudited financial data are available upon request from the Fund. - SHAREHOLDER INQUIRIES. Inquiries should be addressed to the Fund at Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077, or by telephone, at (800) 225-1852 (toll-free) or, from outside the U.S.A., at (908) 417-7555 (collect). For additional information regarding the services and privileges described above, see "Shareholder Investment Account" in the Statement of Additional Information. 33 THE PRUDENTIAL MUTUAL FUND FAMILY Prudential offers a broad range of mutual funds designed to meet your individual needs. We welcome you to review the investment options available through our family of funds. For more information on the Prudential Mutual Funds, including charges and expenses, contact your Prudential Securities financial adviser or Prusec representative or telephone the Funds at (800) 225-1852 for a free prospectus. Read the prospectus carefully before you invest or send money. TAXABLE BOND FUNDS -------------------------- Prudential Diversified Bond Fund, Inc. Prudential Government Income Fund, Inc. Prudential Government Securities Trust Short-Intermediate Term Series Prudential High Yield Fund, Inc. Prudential Mortgage Income Fund, Inc. Prudential Structured Maturity Fund, Inc. Income Portfolio TAX-EXEMPT BOND FUNDS ----------------------------- Prudential California Municipal Fund California Series California Income Series Prudential Municipal Bond Fund High Yield Series Insured Series Intermediate Series Prudential Municipal Series Fund Florida Series Maryland Series Massachusetts Series Michigan Series New Jersey Series New York Series North Carolina Series Ohio Series Pennsylvania Series Prudential National Municipals Fund, Inc. GLOBAL FUNDS -------------------- Prudential Europe Growth Fund, Inc. Prudential Global Genesis Fund, Inc. Prudential Global Limited Maturity Fund, Inc. Limited Maturity Portfolio Prudential Intermediate Global Income Fund, Inc. Prudential International Bond Fund, Inc. Prudential Natural Resources Fund, Inc. Prudential Pacific Growth Fund, Inc. Prudential World Fund, Inc. Global Series International Stock Series The Global Total Return Fund, Inc. Global Utility Fund, Inc. EQUITY FUNDS -------------------- Prudential Balanced Fund Prudential Distressed Securities Fund, Inc. Prudential Emerging Growth Fund, Inc. Prudential Equity Fund, Inc. Prudential Equity Income Fund Prudential Index Series Fund Prudential Bond Market Index Fund Prudential Europe Index Fund Prudential Pacific Index Fund Prudential Small Cap Index Fund Prudential Stock Index Fund Prudential Jennison Series Fund, Inc. Prudential Jennison Active Balanced Fund Prudential Jennison Growth Fund Prudential Jennison Growth & Income Fund Prudential Multi-Sector Fund, Inc. Prudential Small Cap Quantum Fund, Inc. Prudential Small Company Value Fund, Inc. Prudential Utility Fund, Inc. Nicholas-Applegate Fund, Inc. Nicholas-Applegate Growth Equity Fund MONEY MARKET FUNDS -------------------------- - - TAXABLE MONEY MARKET FUNDS Cash Accumulation Trust Liquid Assets Fund National Money Market Fund Prudential Government Securities Trust Money Market Series U.S. Treasury Money Market Series Prudential Special Money Market Fund, Inc. Money Market Series Prudential MoneyMart Assets, Inc. - - TAX-FREE MONEY MARKET FUNDS Prudential Tax-Free Money Fund, Inc. Prudential California Municipal Fund California Money Market Series Prudential Municipal Series Fund Connecticut Money Market Series Massachusetts Money Market Series New Jersey Money Market Series New York Money Market Series - - COMMAND FUNDS Command Money Fund Command Government Fund Command Tax-Free Fund - - INSTITUTIONAL MONEY MARKET FUNDS Prudential Institutional Liquidity Portfolio, Inc. Institutional Money Market Series A-1 No dealer, sales representative or any other person has been authorized to give any information or to make any representations, other than those contained in this Prospectus, in connection with the offer contained herein, and, if given or made, such other information or representations must not be relied upon as having been authorized by the Fund or the Distributor. This Prospectus does not constitute an offer by the Fund or by the Distributor to sell or a solicitation of any offer to buy any of the securities offered hereby in any jurisdiction to any person to whom it is unlawful to make such offer in such jurisdiction. - ------------------------------------------- TABLE OF CONTENTS
PAGE --- FUND HIGHLIGHTS................................. 2 What are the Fund's Risk Factors and Special Characteristics?............................. 2 FUND EXPENSES................................... 4 FINANCIAL HIGHLIGHTS............................ 5 HOW THE FUND INVESTS............................ 9 Investment Objective and Policies............. 9 Hedging and Return Enhancement Strategies..... 12 Other Investments and Policies................ 14 Investment Restrictions....................... 16 HOW THE FUND IS MANAGED......................... 16 Manager....................................... 16 Distributor................................... 17 Fee Waivers................................... 19 Portfolio Transactions........................ 19 Custodian and Transfer and Dividend Disbursing Agent........................................ 19 Year 2000..................................... 19 HOW THE FUND VALUES ITS SHARES.................. 19 HOW THE FUND CALCULATES PERFORMANCE............. 20 TAXES, DIVIDENDS AND DISTRIBUTIONS.............. 20 GENERAL INFORMATION............................. 22 Description of Common Stock................... 22 Additional Information........................ 23 SHAREHOLDER GUIDE............................... 23 How to Buy Shares of the Fund................. 23 Alternative Purchase Plan..................... 24 How to Sell Your Shares....................... 27 Conversion Feature--Class B Shares............ 31 How to Exchange Your Shares................... 31 Shareholder Services.......................... 33 THE PRUDENTIAL MUTUAL FUND FAMILY............... A-1
- ------------------------------------------- MF102A Class A: 743915-20-9 Class B: 743915-10-0 CUSIP No.: Class C: 743915-30-8 Class Z: 743915-40-7 PRUDENTIAL MORTGAGE INCOME FUND, INC. PROSPECTUS March 3, 1998 www.prudential.com ----------------- [LOGO] Supplement dated July 1, 1998 THE FOLLOWING INFORMATION SUPPLEMENTS YOUR PROSPECTUS: Effective July 1, 1998, Prudential Investment Management Services LLC, Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 07102-4077, was appointed the exclusive Distributor of Fund shares. Shares continue to be offered through Prudential Securities Incorporated, Pruco Securities Corporation and other brokers and dealers. Prudential Investment Management Services is a wholly owned subsidiary of The Prudential Insurance Company of America and an affiliate of Prudential Securities Incorporated and Pruco Securities Corporation. All other arrangements with respect to the distribution of Fund shares described in the Prospectus remain unchanged. Supplement dated September 1, 1998 The following information should be added to the cover page of the Prospectus. AN INVESTMENT IN THE FUND IS NOT A DEPOSIT OF ANY BANK AND IS NOT INSURED OR GUARANTEED BY THE FEDERAL DEPOSIT INSURANCE CORPORATION OR ANY OTHER GOVERNMENT AGENCY. The following information should be added under the heading "Shareholder Guide--Shareholder Services." SHAREHOLDER GUIDE SHAREHOLDER SERVICES THE PRUTECTOR PROGRAM--OPTIONAL GROUP TERM LIFE INSURANCE. Prudential makes available optional group term life insurance coverage to purchasers of shares of certain Prudential Mutual Funds which are held in an eligible brokerage account. This insurance protects the value of your mutual fund investment for your beneficiaries against market downturns. The insurance benefit is based on the difference at the time of the insured's death between the "protected value" and the then current market value of the shares. This coverage is not available in all states and is subject to various restrictions and limitations. For more complete information about this program, including charges and expenses, please contact your Prudential representative. PRUDENTIAL MORTGAGE INCOME FUND Supplement Dated August 27, 1998 to Prospectus Dated March 3, 1998 The Directors of Prudential Mortgage Income Fund, Inc. (the Fund) have recently approved a proposal to exchange the assets and liabilities of the Fund for shares of Prudential Government Income Fund, Inc. (Government Income Fund). Class A, Class B, Class C and Class Z shares of the Fund would be exchanged at relative net asset value for Class A, Class B, Class C and Class Z shares, respectively, of Government Income Fund. The transfer has been approved by the Board of Directors of the Fund and by the Board of Directors of Government Income Fund and is subject to approval by the shareholders of the Fund. It is anticipated that a proxy statement/prospectus relating to the transaction will be mailed to shareholders in late October 1998. Under the terms of the proposal, shareholders of the Fund would become shareholders of Government Income Fund. No sales charge would be imposed on the proposed transfer. The Fund anticipates obtaining an opinion of its counsel that the transaction would be a tax-free reorganization under the Internal Revenue Code and therefore no gain or loss for Federal income tax purposes would be recognized by shareholders of the Fund. EFFECTIVE IMMEDIATELY, THE FUND WILL NO LONGER ACCEPT ORDERS TO PURCHASE OR EXCHANGE INTO SHARES OF ANY CLASS EXCEPT FOR PURCHASES BY CERTAIN RETIREMENT AND EMPLOYEE PLANS (EXCLUDING IRA ACCOUNTS.) Existing shareholders may continue to acquire shares through dividend reinvestment. The current exchange privilege of obtaining shares of other Prudential Mutual Funds and the current redemption privilege will remain in effect until the transaction is consummated. Government Income Fund's investment objective is to seek high current return. EX-99.17(D) 15 EXHIBIT 99.17(D) [LOGO] PRUDENTIAL MORTGAGE INCOME FUND, INC. October , 1998 Dear Shareholder: You may be aware that the Directors of Prudential Mortgage Income Fund have recently approved a proposal to exchange the assets and liabilities of your Series for shares of Prudential Government Income Fund. The enclosed proxy materials describe this proposal in detail. If the proposal is approved by the shareholders and implemented, you will automatically receive shares of Prudential Government Income Fund in exchange for your shares of Prudential Mortgage Income Fund. THE TRUSTEES AND I STRONGLY RECOMMEND THAT YOU VOTE FOR THE PROPOSAL. WE BELIEVE THAT THIS TRANSACTION SERVES YOUR BEST INTERESTS. REASON FOR THE MERGER--GREATER FLEXIBILITY Mortgage-backed securities perform best in a stable interest rate environment. Interest rates would have to increase and remain stable for mortgage-backed securities to regain their attractiveness. Given the current interest rate environment, we believe that investors would be more interested in owning a portfolio that can adjust its mortgage exposure. As stated in the prospectus, Prudential Mortgage Income Fund must hold at least 65% of its assets in mortgage-backed securities. Prudential Government Income Fund is also allowed to hold mortgage-backed securities in its portfolio, however it is not restricted to a definitive amount. PRUDENTIAL GOVERNMENT INCOME FUND'S investment objective is to seek high current income by investing primarily in U.S. government securities--including U.S. Treasuries, U.S. Government agencies and mortgage-backed securities. Portfolio manager Barbara Kenworthy has over 30 years of investment experience investing all types of fixed-income securities. PLEASE READ THE ENCLOSED MATERIALS CAREFULLY FOR MORE COMPLETE INFORMATION. Your vote is important, no matter how many shares you own. Voting your shares early may permit your Series to avoid costly follow-up mail and telephone solicitation. After you have reviewed the enclosed materials, please complete, date and sign your proxy card and mail it in the enclosed postage-paid return envelope today. SAVE TIME AND POSTAGE COSTS. Help us save time and postage costs (savings that we can pass on to you) by voting through the internet or via a touch tone phone. Each method is generally available 24 hours per day. If you are voting via these methods, you do not need to return your proxy card. TO VOTE BY INTERNET, FOLLOW THESE INSTRUCTIONS: Read your proxy statement and have your proxy card available. Go to website www.proxyvote.com Enter your 12 digit control number found on your proxy card. Follow the simple instructions found at the website. TO VOTE BY TELEPHONE, FOLLOW THESE INSTRUCTIONS: Read your proxy statement and have your proxy card available. Call the toll free number shown on your proxy card. Enter your 12 digit control number found on your proxy card. Follow the simple recorded instructions SHAREHOLDERS ON SYSTEMATIC ACCUMULATION PLANS SHOULD CONTACT THEIR FINANCIAL ADVISOR OR CALL PRUDENTIAL MUTUAL FUNDS CUSTOMER SERVICE DIVISION (1-800-225-1852) TO CHANGE THEIR OPTIONS. IF NO CHANGE IS MADE BY NOV 20, 1998, FUTURE PURCHASES WILL BE MADE IN SHARES OF PRUDENTIAL GOVERNMENT INCOME FUND. SHAREHOLDERS WITH CERTIFICATES OUTSTANDING SHOULD CONTACT THEIR FINANCIAL ADVISOR OR CALL PRUDENTIAL MUTUAL FUNDS CUSTOMER SERVICE DIVISION (1-800-225-1852) TO DEPOSIT THEIR CERTIFICATES. We value your investment and thank you for the confidence you have placed in Prudential Mutual Funds. Sincerely, [SIGNATURE] Brian M. Storms PRESIDENT, Prudential Mutual Funds and Annuities Prudential Mortgage Income Fund, Gateway Center Three, 100 Mulberry Street, Newark, New Jersey 09102-4077 -----END PRIVACY-ENHANCED MESSAGE-----