497 1 nif497.txt PROSPECTUS September 30, 2002 T. ROWE PRICE New Income Fund--Advisor Class A bond fund investing primarily in investment-grade bonds to achieve an attractive level of income. This class of shares is sold only through financial intermediaries. (R) The Securities and Exchange Commission has not approved or disapproved these securities or passed upon the adequacy of this prospectus. Any representation to the contrary is a criminal offense. T. Rowe Price New Income Fund, Inc. T. Rowe Price New Income Fund--Advisor Class Prospectus September 30, 2002
ABOUT THE FUND 1 Objective, Strategy, Risks, and Expenses 1 ----------------------------------------------- Other Information About the Fund 6 ----------------------------------------------- Some Basics of Fixed-Income 8 Investing ----------------------------------------------- INFORMATION ABOUT ACCOUNTS IN T. ROWE PRICE 2 FUNDS Pricing Shares and Receiving 10 Sale Proceeds ----------------------------------------------- Useful Information on Distributions 11 and Taxes ----------------------------------------------- Transaction Procedures and 13 Special Requirements ----------------------------------------------- MORE ABOUT THE FUND 3 Organization and Management 15 ----------------------------------------------- Understanding Performance Information 17 ----------------------------------------------- Investment Policies and Practices 18 ----------------------------------------------- Financial Highlights 27 ----------------------------------------------- INVESTING WITH T. ROWE PRICE 4 Account Requirements 29 and Transaction Information ----------------------------------------------- Purchasing Additional Shares 30 ----------------------------------------------- Exchanging and Redeeming Shares 30 ----------------------------------------------- Rights Reserved by the Fund 30 s ----------------------------------------------- T. Rowe Price 32 Privacy Policy -----------------------------------------------
Founded in 1937 by the late Thomas Rowe Price, Jr., T. Rowe Price Associates, Inc., and its affiliates managed $148.8 billion for more than eight million individual and institutional investor accounts as of June 30, 2002. Mutual fund shares are not deposits or obligations of, or guaranteed by, any depository institution. Shares are not insured by the FDIC, Federal Reserve, or any other government agency, and are subject to investment risks, including possible loss of the principal amount invested. ABOUT THE FUND OBJECTIVE, STRATEGY, RISKS, AND EXPENSES ---------------------------------------------------------- A word about the fund's name and structure. New Income Fund - Advisor Class is a share class of T. Rowe Price New Income Fund. The Advisor Class is not a separate mutual fund. It is sold only through brokers, dealers, banks, insurance companies, and other financial intermediaries that provide various distribution and administrative services. What is the fund's objective? The fund seeks the highest level of income consistent with the preservation of capital over time by investing primarily in marketable debt securities. What is the fund's principal investment strategy? The fund will invest at least 80% of the fund's total assets in income-producing securities, which may include U.S. government and agency obligations, mortgage- and asset-backed securities, corporate bonds, foreign securities, collateralized mortgage obligations (CMOs), and others, including, on occasion, equities. All debt securities purchased by the fund must be rated investment grade (AAA, AA, A, or BBB) by at least one major credit rating agency or, if unrated, must have a T. Rowe Price equivalent rating. Up to 15% of total assets may be invested in "split-rated securities," or those rated investment grade by at least one rating agency, but below investment grade by others. However, none of the fund's remaining assets can be invested in bonds rated below investment grade by Standard & Poor's, Moody's, or Fitch IBCA, Inc. The fund has considerable flexibility in seeking high yield for the fund. There are no maturity restrictions, so we can purchase longer-term bonds, which tend to have higher yields than shorter-term issues. However, the portfolio's weighted average maturity is expected to be between four and 15 years. In addition, when there is a large yield difference between the various quality levels, we may move down the credit scale and purchase lower-rated bonds with higher yields. When the difference is small or the outlook warrants, we may concentrate investments in higher-rated issues. The fund may also invest in other securities, including futures, options, and swaps, in keeping with its objective. The fund may sell holdings for a variety of reasons, such as to adjust the portfolio's average maturity or quality or to shift assets into higher-yielding securities or different sectors. . For details about the fund's investment program, please see the Investment Policies and Practices section. What are the main risks of investing in the fund? . Interest rate risk Investors should be concerned primarily with this risk. An increase in interest rates will likely cause the fund's share price to fall, resulting in a loss of principal (see Table 3). That's because the bonds and notes in the fund's portfolio become less attractive to other investors when securities with higher yields become available. Even GNMAs and other securities whose principal and interest payments are guaranteed can decline in price if rates rise. Generally speaking, the longer a bond's maturity, the greater its potential for price declines if rates rise and for price gains if rates fall. Because the fund may invest in bonds of any maturity, it carries more interest rate risk than short-term bond funds. . Credit risk This is the chance that any of the fund's holdings will have their credit ratings downgraded or will default (fail to make scheduled interest or principal payments), potentially reducing the fund's income level and share price. While the fund's overall credit quality is generally high, it can own BBB securities, which are more susceptible to adverse economic conditions and may have speculative characteristics. Investment-grade (AAA to BBB) securities have relatively low financial risk and a relatively high probability of future payment. However, securities rated BBB are more susceptible to adverse economic conditions and may have speculative characteristics. Securities rated below investment-grade (junk or high yield bonds) should be regarded as speculative because their issuers are more susceptible to financial setbacks and recession than more creditworthy companies. . The fund may continue to hold a security that has been downgraded or loses its investment-grade rating after purchase. . Foreign investing risk To the extent the fund holds foreign bonds, it will be subject to special risks whether the bonds are denominated in U.S. dollars or foreign currencies. These risks include potentially adverse political and economic developments overseas, greater volatility, lower liquidity, and the possibility that foreign currencies will decline against the dollar, lowering the value of securities denominated in those currencies and possibly the fund's share price. . Prepayment risk and extension risk A mortgage-backed bond, unlike most other bonds, can be hurt when interest rates fall, because homeowners tend to refinance and prepay principal. Receiving increasing prepayments in a falling interest rate environment causes the average maturity of the portfolio to shorten, reducing its potential for price gains. It also requires the fund to reinvest proceeds at lower interest rates, which reduces the portfolio's total return, reduces its yield, and may even cause certain bonds' prices to fall below what the fund paid for them, resulting in a capital loss. Any of these developments could cause a decrease in the fund's income, share price, or total return. Extension risk refers to a rise in interest rates that causes a fund's average maturity to lengthen unexpectedly due to a drop in mortgage prepayments. This would increase the fund's sensitivity to rising rates and its potential for price declines. . Derivatives risk Shareholders are also exposed to derivatives risk, the potential that our investments in these complex and volatile instruments could affect the fund's share price. In addition to CMOs and better-known instruments such as swaps and futures, other derivatives that may be used in limited fashion by the fund include interest-only (IO) and principal-only (PO) securities known as "strips." The value of these instruments is derived from an underlying pool of mortgage-backed securities or a CMO. Some of these instruments can be highly volatile, and their value can fall dramatically in response to rapid or unexpected changes in the mortgage, interest rate, or economic environment. As with any mutual fund, there can be no guarantee the fund will achieve its objective. . The share price and income level of the fund will fluctuate with changing market conditions and interest rate levels. When you sell your shares, you may lose money. How can I tell if the fund is appropriate for me? Consider your investment goals, your time horizon for achieving them, and your tolerance for risk. If you are investing through an intermediary, seeking an attractive level of income and are willing to accept the risk of a declining share price when interest rates rise, the New Income Fund-Advisor Class may be appropriate. Steadily reinvesting the fund's income is a conservative strategy for building capital over time. If you are investing primarily for safety and liquidity, you should consider a money market fund. The fund can be used in both regular and tax-deferred accounts, such as IRAs. . The fund should not represent your complete investment program or be used for short-term trading purposes. How has the fund performed in the past? New Income Fund-Advisor Class began operations on September 30, 2002, and does not have a full calendar year of performance history. As a point of comparison, however, the following bar chart and table show calendar year returns for the oldest existing class of the New Income Fund. Because the New Income Fund-Advisor Class is expected to have higher expenses than the oldest exist- ing class of the New Income Fund, its performance, had it existed over the periods shown, would have been lower. The oldest existing class of the New Income Fund and the New Income Fund-Advisor Class share the same portfolio. Shares of each class of the fund are offered in separate prospectuses. The bar chart showing calendar year returns and the average annual total return table indicate risk by illustrating how much returns can differ from one year to the next and how fund performance compares with that of a comparable market index. Fund past returns (before and after taxes) are not necessarily an indication of future performance. The fund can also experience short-term performance swings, as shown by the best and worst calendar quarter returns during the years depicted. In addition, the average annual total return table shows hypothetical after-tax returns to suggest how taxes paid by the shareholder may influence returns. Actual after-tax returns depend on each investor's situation and may differ from those shown. After-tax returns are not relevant if the shares are held in a tax-deferred account, such as a 401(k) or IRA. During periods of fund losses, the post-liquidation after-tax return may exceed the fund's other returns because the loss generates a tax benefit that is factored into the result.
Calendar Year Total Returns "92" "93" "94" "95" "96" "97" "98" "99" "00" "01" ---------------------------------------------------------------------------- 4.96 9.58 -2.22 18.36 2.38 9.32 5.04 -1.58 11.13 8.15 ---------------------------------------------------------------------------
The fund's return for the six months ended 6/30/02 was 2.69%. Table 1 Average Annual Total Returns
Periods ended December 31, 2001 1 year 5 years 10 years ------------------------------------------------------------------------------ New Income Fund Returns before taxes 8.15% 6.32% 6.35% Returns after taxes on distributions 5.75 3.66 3.69 Returns after taxes on distributions and sale of fund shares 4.92 3.74 3.78 Lehman Brothers U.S. Aggregate Index 8.44 7.43 7.23 Lipper Corporate Debt Funds A Rated 7.47 6.24 6.74 Average ------------------------------------------------------------------------------
Returns are based on changes in principal value, reinvested dividends, and capital gain distributions, if any. Returns before taxes do not reflect effects of any income or capital gains taxes. All after-tax returns are calculated using the historical highest individual federal marginal income tax and capital gains rates. They do not reflect the impact of state and local taxes. Returns after taxes on distributions reflect the taxed return on the payment of dividends and capital gains. Returns after taxes on distributions and sale of fund shares assume the shares were sold at period-end, and, therefore, are also adjusted for any capital gains or losses incurred by the shareholder. Market indexes do not include expenses, which are deducted from fund returns, or taxes. What fees or expenses will I pay? The numbers in the next table provide an estimate of how much it will cost to operate the Advisor Class for a year. These are costs you pay indirectly because they are deducted from net assets before the daily share price is calculated. Table 2 Fees and Expenses of the Advisor Class*
Annual fund operating expenses (expenses that are deducted from fund assets) ---------------------------------------------------------------------------------------------------- Management fee 0.47% ----------------------------------------------- Distribution and service (12b-1) fees 0.25% ----------------------------------------------- Other expenses 0.35%/a/ ----------------------------------------------- Total annual fund operating expenses 1.07% ----------------------------------------------- Fee waiver/reimbursement 0.17%/b/ ----------------------------------------------- Net expenses 0.90%/b/ ----------------------------------------------------------------------------------------------------
* Redemption proceeds of less than $5,000 sent by wire are subject to a $5 fee paid to the fund. /a/ Other expenses are estimated. /b/To limit the class's expenses during its initial period of operations, T. Rowe Price is contractually obligated to bear any expenses (other than management fees and certain other portfolio level expenses) through September 30, 2004, that would cause the class's ratio of expenses to average net assets to exceed 0.90%. Expenses paid or assumed under this agreement are subject to reimbursement to T. Rowe Price by the fund whenever the class's expense ratio is below 0.90%; however, no reimbursement will be made after September 30, 2006, or if it would result in the expense ratio exceeding 0.90%. Any amounts reimbursed will have the effect of increasing fees otherwise paid by the class. Example. The following table gives you an idea of how expense ratios may translate into dollars and helps you to compare the cost of investing in this class with that of other mutual funds. Although your actual costs may be higher or lower, the table shows how much you would pay if operating expenses remain the same, the expense limitation currently in place is not renewed, you invest $10,000, earn a 5% annual return, and hold the investment for the following periods and then redeem:
1 year 3 years 5 years 10 years ---------------------------------------------------- $92 $285 $492 $1,088 ----------------------------------------------------
OTHER INFORMATION ABOUT THE FUND ---------------------------------------------------------- What are the fund's potential rewards? The fund can provide an attractive level of income to investors who want only a moderate level of risk. It should offer higher yields than money market and short-term bond funds and generally less volatility than longer-term bond funds. In addition, the portfolio is widely diversified among various fixed-income securities, thus reducing the effect of a single bond's price fluctuations on the fund's share price or total return. How does the portfolio manager try to reduce risk? Consistent with the fund's objective, the portfolio manager uses various tools to try to reduce risk and increase total return, including: . Diversification of assets to reduce the impact of a single holding or sector on the fund's net asset value. . Thorough credit research by our own analysts. . Adjustment of fund duration to try to reduce the drop in price when interest rates rise or to benefit from the rise in price when rates fall. Duration is a measure of a fund's sensitivity to interest rate changes. Is the fund a substitute for a money market fund? No. Money market funds, which have an average maturity under one year, ordinarily generate lower income in return for stability of net asset value. The fund's total return is expected to fluctuate more than a money market fund's and, as such, it should be viewed as a longer-term and riskier investment. Do mortgage-backed securities differ from other high-quality bonds? Yes, in one major respect. Non-mortgage bonds generally repay principal (face value of the bond) when their maturity date is reached, but most mortgage-backed securities repay principal continually as homeowners make mortgage payments. Homeowners have the option of paying either part or all of the loan balance before maturity, perhaps to refinance or buy a new home. As a result, the effective maturity of a mortgage-backed security is virtually always shorter than its stated maturity. For example, a new GNMA certificate backed by 30-year, fixed-rate mortgages will generally have a far shorter life than 30 years - probably 12 or less. Therefore, it will usually be about as volatile as a 10-year Treasury note. It is possible to estimate the average life of an entire mortgage pool backing a particular security with some accuracy, but not with certainty. Why are yields on mortgage-backed securities higher than yields on Treasuries of similar maturity? The structure of mortgage-backed securities is much more complex, and their effective maturities are uncertain because of unscheduled prepayments. Higher yields compensate investors for these potentially negative features. See the previous discussion of prepayment risk and extension risk. What are derivatives and can the fund invest in them? A derivative is a financial instrument whose value is derived from an underlying security, such as a stock or bond, or from a market benchmark such as an interest rate index. Many types of investments representing a wide range of risks and potential rewards are derivatives, including conventional instruments such as futures and options, as well as more exotic investments such as swaps and structured notes. Investment managers have used derivatives for many years. We invest in derivatives only if the expected risks and rewards are consistent with the fund's objective, policies, and overall risk profile as described in this prospectus. We use derivatives in situations where they may enable the fund to increase yield, hedge against a decline in principal, invest in other asset classes more efficiently, or adjust duration. We will not invest in any high-risk, highly leveraged derivative that we believe would cause the portfolio to be more volatile than a long-term, investment-grade bond. Is there other information I can review before making a decision? Investment Policies and Practices in Section 3 discusses various types of portfolio securities the fund may purchase as well as types of management practices the fund may use. SOME BASICS OF FIXED-INCOME INVESTING ---------------------------------------------------------- Is a fund's yield fixed or will it vary? It will vary. The yield is calculated every day by dividing a fund's net income per share, expressed at annual rates, by the share price. Since both income and share price will fluctuate, a fund's yield will also vary. (Although money fund prices are stable, income is variable.) Is yield the same as total return? Not for bond funds. A fund's total return is the result of reinvested distributions from income and capital gains and the change in share price for a given period. Income is always a positive contributor to total return and can either enhance a rise in share price or help offset a price decline. What is credit quality and how does it affect yield? Credit quality refers to a bond issuer's expected ability to make all required interest and principal payments on time. Because highly rated issuers represent less risk, they can borrow at lower interest rates than less creditworthy issuers. Therefore, a fund investing in high-quality securities should have a lower yield than an otherwise comparable fund investing in lower-quality securities. What is meant by a bond fund's maturity? Every bond has a stated maturity date when the issuer must repay the bond's entire principal value to the investor. However, many bonds are "callable," meaning their principal can be repaid earlier, on, or after specified call dates. Bonds are most likely to be called when interest rates are falling because the issuer can refinance at a lower rate, just as a homeowner refinances a mortgage. In that environment, a bond's "effective maturity" is usually its nearest call date. For example, the rate at which homeowners pay down their mortgage principal determines the effective maturity of mortgage-backed bonds. A bond mutual fund has no real maturity, but it does have a weighted average maturity and a weighted average effective maturity. Each of these numbers is an average of the stated or effective maturities of the underlying bonds, with each bond's maturity "weighted" by the percentage of fund assets it represents. Some funds target effective maturities rather than stated maturities when computing the average. This provides additional flexibility in portfolio management. What is meant by a bond fund's duration? Duration is a calculation that seeks to measure the price sensitivity of a bond or a bond fund to changes in interest rates. It is expressed in years, like maturity, but it is a better indicator of price sensitivity than maturity because it takes into account the time value of cash flows generated over the bond's life. Future inter- est and principal payments are discounted to reflect their present value and then are multiplied by the number of years they will be received to produce a value expressed in years - the duration. "Effective" duration takes into account call features and sinking fund payments that may shorten a bond's life. Since duration can also be computed for bond funds, you can estimate the effect of interest rates on share prices by multiplying fund duration by an expected change in interest rates. For example, the price of a bond fund with a duration of five years would be expected to fall approximately 5% if rates rose by one percentage point. (T. Rowe Price shareholder reports show duration.) How is a bond's price affected by changes in interest rates? When interest rates rise, a bond's price usually falls, and vice versa. In general, the longer a bond's maturity, the greater the price increase or decrease in response to a given change in rates, as shown in Table 3. Table 3 How Interest Rates May Affect Bond Prices
Price of a $1,000 face value bond if interest rates: Bond maturity Coupon Increase Decrease 1 percent 2 percent 1 percent 2 perc 2 years 2.81% $981 $962 $1,020 $1,0 ------------------------------------------------------------------------ 5 years 4.03 956 915 1,046 1,0 ------------------------------------------------------------------------ 10 years 4.80 925 857 1,083 1,1 ------------------------------------------------------------------------ 30 years 5.51 869 763 1,164 1,3 -----------------------------------------------------------------------------------------------------------------------------------
Coupons reflect yields on Treasury securities as of June 30, 2002. The table may not be representative of price changes for mortgage-backed securities because of prepayments. This is an illustration and does not represent expected yields or share price changes of any T. Rowe Price fund. INFORMATION ABOUT ACCOUNTS IN T. ROWE PRICE FUNDS As a T. Rowe Price shareholder, you will want to know about the following policies and procedures that apply to all Advisor Class accounts (excluding Tax-Free Income Fund-Advisor Class). PRICING SHARES AND RECEIVING SALE PROCEEDS ---------------------------------------------------------- How and when shares are priced The share price (also called "net asset value" or NAV per share) for each class of shares is calculated at the close of the New York Stock Exchange, normally 4 p.m. ET, each day the New York Stock Exchange is open for business. To calculate the NAV, the fund's assets are valued and totaled, liabilities are subtracted, and each class's proportionate share of the balance, called net assets, is divided by the number of shares outstanding of that class. Market values are used to price stocks and bonds. The securities of funds investing in foreign markets are usually valued on the basis of the most recent closing market prices at 4 p.m. ET. Most foreign markets close before that time. For securities primarily traded in the Far East, for example, the most recent closing prices may be as much as 15 hours old at 4 p.m. Normally, developments that could affect the values of portfolio securities that occur between the close of the foreign market and 4 p.m. ET will not be reflected in a fund NAV. However, if a fund determines that such developments are so significant that they will, in its judgment, clearly and materially affect the value of the fund's securities, the fund may adjust the previous closing prices to reflect what it believes to be the fair value of the securities as of 4 p.m. ET. A fund may fair value securities in other situations, for example, when a particular foreign market is closed but the fund is open. How your purchase, sale, or exchange price is determined Advisor Class shares are intended for purchase and may be held only through various third-party intermediaries including brokers, dealers, banks, insurance companies, retirement plan recordkeepers, and others. Consult your intermediary to find out about how to purchase, sell, or exchange your shares, cut-off times, and other applicable procedures for these transactions. The intermediary may charge a fee for its services. The fund may have an agreement with your intermediary that permits the intermediary to accept orders on behalf of the fund until 4 p.m. ET. In such cases, if your order is received by the intermediary in good form by 4 p.m. ET and trans- mitted to the fund and paid for in accordance with the agreement, it will be priced at the next NAV computed after the intermediary received your order. Note: The time at which transactions and shares are priced and the time until which orders are accepted by the fund or an intermediary may be changed in case of an emergency or if the New York Stock Exchange closes at a time other than 4 p.m. ET. How proceeds are received Normally, the fund transmits proceeds to intermediaries for redemption orders received in good form on either the next or third business day after receipt, depending on the arrangement with the intermediary. Under certain circumstances and when deemed to be in the fund's best interests, proceeds may not be sent for up to seven calendar days after receipt of the redemption order. You must contact your intermediary about procedures for receiving your redemption proceeds. USEFUL INFORMATION ON DISTRIBUTIONS AND TAXES ---------------------------------------------------------- . All net investment income and realized capital gains are distributed to shareholders. Dividends and Other Distributions Dividend and capital gain distributions are reinvested in additional fund shares in your account unless you select another option on your New Account Form. Reinvesting distributions results in compounding, that is, receiving income dividends and capital gain distributions on a rising number of shares. No interest will accrue on amounts represented by uncashed distribution or redemption checks. Income dividends . The funds declare and pay dividends (if any) quarterly for the Equity Income Fund-Advisor Class; declare daily and pay monthly for the High Yield Fund-Advisor Class, International Bond Fund-Advisor Class, and New Income Fund-Advisor Class; and declare and pay annually for all other Advisor Classes. . A portion of fund dividends (other than High Yield Fund-Advisor Class, New Income Fund-Advisor Class, and International Stock Fund-Advisor Class) may be eligible for the 70% deduction for dividends received by corporations to the extent the funds' income consists of dividends paid by U.S. corporations. . The dividends of High Yield Fund-Advisor Class, New Income Fund-Advisor Class, and International Stock Fund-Advisor Class will not be eligible for the 70% deduction for dividends received by corporations, if, as expected, none of the funds' income consists of dividends paid by U.S. corporations. Capital gains payments . A capital gain or loss is the difference between the purchase and sale price of a security. . If a fund has net capital gains for the year (after subtracting any capital losses), they are usually declared and paid in December to shareholders of record on a specified date that month. If a second distribution is necessary, it is paid the following year. Tax Information You should contact your intermediary for the tax information that will be sent to you and reported to the IRS. If you invest in the fund through a tax-deferred retirement account, you will not be subject to tax on dividends and distributions from the fund or the sale of fund shares if those amounts remain in the tax-deferred account. If you invest in the fund through a taxable account, you need to be aware of the possible tax consequences when: . You sell fund shares, including an exchange from one fund to another. . The fund makes a distribution to your account. Taxes on fund redemptions When you sell shares in any fund, you may realize a gain or loss. An exchange from one fund to another is still a sale for tax purposes. Taxes on fund distributions The tax treatment of a capital gain distribution is determined by how long the fund held the portfolio securities, not how long you held shares in the fund. Short-term (one year or less) capital gain distributions are taxable at the same rate as ordinary income and long-term gains on securities held more than 12 months are taxed at a maximum rate of 20%. If you realized a loss on the sale or exchange of fund shares that you held six months or less, your short-term loss must be reclassified to a long-term loss to the extent of any long-term capital gain distribution received during the period you held the shares. Gains and losses from the sale of foreign currencies and the foreign currency gain or loss resulting from the sale of a foreign debt security can increase or decrease an ordinary income dividend. Net foreign currency losses may cause monthly or quarterly dividends to be reclassified as a return of capital. If the fund qualifies and elects to pass through nonrefundable foreign taxes paid to foreign governments during the year, your portion of such taxes will be reported to you as taxable income. However, you may be able to claim an offset- ting credit or deduction on your tax return for those amounts. There can be no assurance that a fund will be able to meet the requirements to pass through foreign income taxes paid. Tax consequences of hedging For funds investing in foreign securities, distributions resulting from the sale of certain foreign currencies, currency contracts, and debt securities are taxed as ordinary income. Net foreign currency losses may cause monthly or quarterly dividends to be reclassified as a return of capital. Entering into certain options, futures, swaps, and forward foreign exchange contracts and transactions may result in the application of the mark-to-market and straddle provisions of the Internal Revenue Code. These provisions could result in a fund being required to distribute gains on such transactions even though it did not close the contracts during the year or receive cash to pay such distributions. A fund may not be able to reduce its distributions for losses on such transactions to the extent of unrealized gains in offsetting positions. . Distributions are taxable whether reinvested in additional shares or received in cash. Tax effect of buying shares before a capital gain or dividend distribution If you buy shares shortly before or on the "record date" - the date that establishes you as the person to receive the upcoming distribution - you will receive a portion of the money you just invested in the form of a taxable distribution. Therefore, you may wish to find out a fund's record date before investing. Of course, a fund's share price may, at any time, reflect undistributed capital gains or income and unrealized appreciation, which may result in future taxable distributions. Such distributions can occur even in a year when the fund has a negative return. TRANSACTION PROCEDURES AND SPECIAL REQUIREMENTS ---------------------------------------------------------- Purchase Conditions for Intermediaries Nonpayment If the fund receives a check or ACH transfer that does not clear or the payment is not received in a timely manner, your purchase may be canceled. Any losses or expenses incurred by the fund or transfer agent will be the responsibility of the intermediary. The fund and its agents have the right to reject or cancel any purchase, exchange, or redemption due to nonpayment. U.S. dollars All purchases must be paid for in U.S. dollars; checks must be drawn on U.S. banks. Sale (Redemption) Conditions Holds on immediate redemptions: 10-day hold If an intermediary sells shares that it just purchased and paid for by check or ACH transfer, the fund will process the redemption but will generally delay sending the proceeds for up to 10 calendar days to allow the check or transfer to clear. (The 10-day hold does not apply to purchases paid for by bank wire.) Redemptions over $250,000 Large redemptions can adversely affect a portfolio manager's ability to implement a fund's investment strategy by causing the premature sale of securities that would otherwise be held. If, in any 90-day period, you redeem (sell) more than $250,000, or your sale amounts to more than 1% of fund net assets, the fund has the right to pay the difference between the redemption amount and the lesser of the two previously mentioned figures with securities from the fund. Excessive Trading . T. Rowe Price may bar excessive traders from purchasing shares. Frequent trades or market timing in your account or accounts controlled by you can disrupt management of the fund and raise its expenses. To deter such activity, each fund has adopted the following excessive trading policy. You can make one purchase and one sale or one sale and one purchase involving the same fund within any 120-day period. If you exceed this limit or if you hold fund shares for less than 60 calendar days, you may be barred indefinitely and without further notice from further purchases of the T. Rowe Price funds. Systematic purchases and redemptions are exempt from this policy. Transactions accepted by intermediaries in violation of this excessive trading policy or from persons believed to be market timers are subject to rejection or cancellation by the funds. Signature Guarantees An intermediary may need to obtain a signature guarantee in certain situations and should consult its T. Rowe Price Financial Institution Services representative. You can obtain a signature guarantee from most banks, savings institutions, broker-dealers, and other guarantors acceptable to T. Rowe Price. We cannot accept guarantees from notaries public or organizations that do not provide reimbursement in the case of fraud. MORE ABOUT THE FUND ORGANIZATION AND MANAGEMENT ---------------------------------------------------------- How is the fund organized? The fund was incorporated in Maryland in 1973 and is a "diversified, open-end investment company," or mutual fund. Mutual funds pool money received from shareholders of each class into a single portfolio and invest it to try to achieve specified objectives. In 2002, the fund issued two separate share classes known as the Advisor Class and R Class. . Shareholders benefit from T. Rowe Price's 65 years of investment management experience. What is meant by "shares"? As with all mutual funds, investors purchase shares when they put money in a fund. These shares are part of a fund's authorized capital stock, but share certificates are not issued. Each share and fractional share entitles the shareholder to: . Receive a proportional interest in income and capital gain distributions of the class. The income dividends for New Income Fund-Advisor Class shares will generally differ from those of the New Income Fund and New Income Fund-R Class shares to the extent that the expense ratio of classes differs. . Cast one vote per share on certain fund matters, including the election of fund directors, changes in fundamental policies, or approval of changes in the fund's management contract. Shareholders of each class have exclusive voting rights on matters affecting only that class. Do T. Rowe Price funds have annual shareholder meetings? The funds are not required to hold annual meetings and, to avoid unnecessary costs to fund shareholders, do not do so except when certain matters, such as a change in fundamental policies, must be decided. In addition, shareholders representing at least 10% of all eligible votes may call a special meeting, if they wish, for the purpose of voting on the removal of any fund director or trustee. If a meeting is held and you cannot attend, you can vote by proxy. Before the meeting, the fund will send you proxy materials that explain the issues to be decided and include instructions on voting by mail or telephone, or on the Internet. Who runs the fund? General Oversight The fund is governed by a Board of Directors that meets regularly to review the fund's investments, performance, expenses, and other business affairs. The Board elects the fund's officers. The majority of Board members are independent of T. Rowe Price Associates, Inc. (T. Rowe Price). . All decisions regarding the purchase and sale of fund investments are made by T. Rowe Price - specifically by the fund's portfolio managers. Portfolio Management The fund has an Investment Advisory Committee with the following members: William T. Reynolds, Chairman, Connice A. Bavely, Brian J. Brennan, Patrick S. Cassidy, Alan D. Levenson, Edmund M. Notzon III, Vernon A. Reid, Jr., Robert M. Rubino, and Daniel O. Shackelford. The committee chairman has day-to-day responsibility for managing the fund and works with the committee in developing and executing the fund's investment program. Mr. Reynolds became chairman of the fund's committee in 1998. He joined T. Rowe Price in 1981 and has been managing investments since 1978. The Management Fee This fee has two parts - an "individual fund fee," which reflects a fund's particular characteristics, and a "group fee." The group fee, which is designed to reflect the benefits of the shared resources of the T. Rowe Price investment management complex, is calculated daily based on the combined net assets of all T. Rowe Price funds (except the Spectrum Funds, and any institutional, index, or private label mutual funds). The group fee schedule (shown below) is graduated, declining as the asset total rises, so shareholders benefit from the overall growth in mutual fund assets. Group Fee Schedule
0.334%* First $50 billion 0.305% Next $30 billion 0.300% Next $40 billion 0.295% Thereafter -------------------------------------
* Represents a blended group fee rate containing various break points. The fund's portion of the group fee is determined by the ratio of its daily net assets to the daily net assets of all the T. Rowe Price funds described previously. Based on combined T. Rowe Price fund assets of over $94 billion at May 31, . 2002, the group fee was 0.32%. . The individual fund fee is 0.15%. Distribution, Shareholder Servicing, and Recordkeeping Fees New Income Fund-Advisor Class has adopted a 12b-1 plan under which it pays a fee at the rate of up to 0.25% of its daily net assets per year to various intermediaries for distribution and servicing of its shares. These payments may be more or less than the costs incurred by the intermediaries. Because the fees are paid from the Advisor Class net assets on an ongoing basis, they will increase the cost of your investment and, over time, could result in your paying more than with other types of sales charges. The Advisor Class may also separately compensate intermediaries at a rate of up to 0.10% of daily net assets per year for various recordkeeping and transfer agent services they perform. UNDERSTANDING PERFORMANCE INFORMATION ---------------------------------------------------------- This section should help you understand the terms used to describe fund performance. Total Return This tells you how much an investment has changed in value over a given time period. It reflects any net increase or decrease in the share price and assumes that all dividends and capital gains (if any) paid during the period were reinvested in additional shares. Therefore, total return numbers include the effect of compounding. Advertisements may include cumulative or average annual total return figures, which may be compared with various indices, other performance measures, or other mutual funds. Cumulative Total Return This is the actual return of an investment for a specified period. A cumulative return does not indicate how much the value of the investment may have fluctuated during the period. For example, an investment could have a 10-year positive cumulative return despite experiencing some negative years during that time. Average Annual Total Return This is always hypothetical and should not be confused with actual year-by-year results. It smooths out all the variations in annual performance to tell you what constant year-by-year return would have produced the investment's actual cumulative return. This gives you an idea of an investment's annual contribution to your portfolio, provided you held it for the entire period. Yield The current or "dividend" yield on a fund or any investment tells you the relationship between the investment's current level of annual income and its price on a particular day. The dividend yield reflects the actual income paid to shareholders for a given period, annualized, and divided by the price at the end of the period. For example, a fund providing $5 of annual income per share and a price of $50 has a current yield of 10%. Yields can be calculated for any time period. The advertised or SEC yield is found by determining the net income per share (as defined by the Securities and Exchange Commission) earned by a fund during a 30-day base period and dividing this amount by the per share price on the last day of the base period. The SEC yield-also called the standardized yield-may differ from the dividend yield. INVESTMENT POLICIES AND PRACTICES ---------------------------------------------------------- This section takes a detailed look at some of the types of fund securities and the various kinds of investment practices that may be used in day-to-day portfolio management. Fund investments are subject to further restrictions and risks described in the Statement of Additional Information. Shareholder approval is required to substantively change fund objectives and certain investment restrictions noted in the following section as "fundamental policies." The managers also follow certain "operating policies" which can be changed without shareholder approval. However, significant changes are discussed with shareholders in fund reports. Fund investment restrictions and policies apply at the time of investment. A later change in circumstances will not require the sale of an investment if it was proper at the time it was made. Fund holdings of certain kinds of investments cannot exceed maximum percentages of total assets, which are set forth in this prospectus. For instance, fund investments in hybrid instruments are limited to 10% of total assets. While these restrictions provide a useful level of detail about fund investments, investors should not view them as an accurate gauge of the potential risk of such investments. For example, in a given period, a 5% investment in hybrid instruments could have significantly more of an impact on a fund's share price than its weighting in the portfolio. The net effect of a particular investment depends on its volatility and the size of its overall return in relation to the performance of all other fund investments. Changes in fund holdings, fund performance, and the contribution of various investments are discussed in the shareholder reports sent to you. . Fund managers have considerable leeway in choosing investment strategies and selecting securities they believe will help achieve fund objectives. Types of Portfolio Securities In seeking to meet its investment objective, the fund may invest in any type of security or instrument (including certain potentially high-risk derivatives described in this section) whose investment characteristics are consistent with its investment program. The following pages describe various types of fund securities and investment management practices. Fundamental policy The fund will not purchase a security if, as a result, with respect to 75% of its total assets, more than 5% of its total assets would be invested in securities of a single issuer, or if more than 10% of the outstanding voting securities of the issuer would be held by the fund. These limitations do not apply to the fund's purchase of securities issued or guaranteed by the U.S. government, its agencies, or instrumentalities. Bonds A bond is an interest-bearing security. The issuer has a contractual obligation to pay interest at a stated rate on specific dates and to repay principal (the bond's face value) on a specified date. An issuer may have the right to redeem or "call" a bond before maturity, and the investor may have to reinvest the proceeds at lower market rates. A bond's annual interest income, set by its coupon rate, is usually fixed for the life of the bond. Its yield (income as a percent of current price) will fluctuate to reflect changes in interest rate levels. A bond's price usually rises when interest rates fall, and vice versa, so its yield stays consistent with current market conditions. Bonds may be unsecured (backed by the issuer's general creditworthiness only) or secured (also backed by specified collateral). Bonds include asset- and mortgage-backed securities. Certain bonds have interest rates that are adjusted periodically. These interest rate adjustments tend to minimize fluctuations in the bonds' principal values. The maturity of those securities may be shortened under certain specified conditions. Bonds may be designated as senior or subordinated obligations. Senior obligations generally have the first claim on a corporation's earnings and assets and, in the event of liquidation, are paid before subordinated debt. Common and Preferred Stocks Stocks represent shares of ownership in a company. Generally, preferred stock has a specified dividend and ranks after bonds and before common stocks in its claim on income for dividend payments and on assets should the company be liquidated. After other claims are satisfied, common stockholders participate in company profits on a pro-rata basis; profits may be paid out in dividends or reinvested in the company to help it grow. Increases and decreases in earnings are usually reflected in a company's stock price, so common stocks generally have the greatest appreciation and depreciation potential of all corporate securities. While most preferred stocks pay a dividend, preferred stock may be purchased where the issuer has omitted, or is in danger of omitting, payment of its dividend. Such investments would be made primarily for their capital appreciation potential. Convertible Securities and Warrants Investments may be made in debt or preferred equity securities convertible into, or exchangeable for, equity securities. Traditionally, convertible securities have paid dividends or interest at rates higher than common stocks but lower than nonconvertible securities. They generally participate in the appreciation or depreciation of the underlying stock into which they are convertible, but to a lesser degree. In recent years, convertibles have been developed which combine higher or lower current income with options and other features. Warrants are options to buy a stated number of shares of common stock at a specified price anytime during the life of the warrants (generally, two or more years). Warrants can be highly volatile, have no voting rights, and pay no dividends. Operating policy Without regard to quality, the fund may invest up to 25% of its total assets (not including cash) in preferred and common stocks and convertible securities, convertible into or which carry warrants for common stocks or other equity securities. Foreign Securities Investments may be made in foreign securities. These include nondollar- denominated securities traded outside of the U.S. and dollar-denominated securities of foreign issuers traded in the U.S. (such as Yankee bonds). Such investments increase a portfolio's diversification and may enhance return, but they also involve some special risks such as exposure to potentially adverse local, political, and economic developments; nationalization and exchange controls; potentially lower liquidity and higher volatility; possible problems arising from accounting, disclosure, settlement, and regulatory practices that differ from U.S. standards; and the chance that fluctuations in foreign exchange rates will decrease the investment's value (favorable changes can increase its value). These risks are heightened for investments in developing countries. Operating policy There is no limit on fund investments in U.S. dollar-denominated debt securities issued by foreign issuers, foreign branches of U.S. banks, and U.S. branches of foreign banks. The fund may also invest up to 20% of its total assets (excluding reserves) in non-U.S. dollar-denominated fixed-income securities. Asset-Backed Securities An underlying pool of assets, such as credit card or automobile trade receivables or corporate loans or bonds, backs these bonds and provides the interest and principal payments to investors. On occasion, the pool of assets may also include a swap obligation, which is used to change the cash flows on the underlying assets. As an example, a swap may be used to allow floating rate assets to back a fixed-rate obligation. Credit quality depends primarily on the quality of the underlying assets, the level of credit support, if any, provided by the structure or by a third-party insurance wrap, and the credit quality of the swap counterparty, if any. The underlying assets (i.e., loans) are sometimes subject to prepayments, which can shorten the security's weighted average life and may lower its return. The value of these securities also may change because of actual or perceived changes in the creditworthiness of the originator, the servicing agent, the financial institution providing the credit support, or the swap counterparty. There is no limit on fund investments in these securities. Mortgage-Backed Securities The fund may invest in a variety of mortgage-backed securities. Mortgage lenders pool individual home mortgages with similar characteristics to back a certificate or bond, which is sold to investors such as the fund. Interest and principal payments generated by the underlying mortgages are passed through to the investors. The "big three" issuers are the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac). GNMA certificates are backed by the full faith and credit of the U.S. government, while others, such as Fannie Mae and Freddie Mac certificates, are only supported by the ability to borrow from the U.S. Treasury or by the credit of the agency. Private mortgage bankers and other institutions also issue mortgage-backed securities. Mortgage-backed securities are subject to scheduled and unscheduled principal payments as homeowners pay down or prepay their mortgages. As these payments are received, they must be reinvested when interest rates may be higher or lower than on the original mortgage security. Therefore, these securities are not an effective means of locking in long-term interest rates. In addition, when interest rates fall, the pace of mortgage prepayments picks up. These refinanced mortgages are paid off at face value (par), causing a loss for any investor who may have purchased the security at a price above par. In such an environment, this risk limits the potential price appreciation of these securities and can negatively affect the fund's net asset value. When rates rise, the prices of mortgage-backed securities can be expected to decline, although historically these securities have experienced smaller price declines than comparable quality bonds. In addition, when rates rise and prepayments slow, the effective duration of mortgage-backed securities extends, resulting in increased volatility. . There is no limit on fund investments in mortgage-backed securities. Additional mortgage-backed securities in which the fund may invest include: . Collateralized Mortgage Obligations (CMOs) CMOs are debt securities that are fully collateralized by a portfolio of mortgages or mortgage-backed securities. All interest and principal payments from the underlying mortgages are passed through to the CMOs in such a way as to create some classes with more stable average lives than the underlying mortgages and other classes with more volatile average lives. CMO classes may pay fixed or variable rates of interest, and certain classes have priority over others with respect to the receipt of prepayments. . Stripped Mortgage Securities Stripped mortgage securities (a type of potentially high-risk derivative) are created by separating the interest and principal payments generated by a pool of mortgage-backed securities or a CMO to create additional classes of securities. Generally, one class receives only interest payments (IOs), and another receives principal payments (POs). Unlike with other mortgage-backed securities and POs, the value of IOs tends to move in the same direction as interest rates. The fund can use IOs as a hedge against falling prepayment rates (interest rates are rising) and/or a bear market environment. POs can be used as a hedge against rising prepayment rates (interest rates are falling) and/or a bull market environment. IOs and POs are acutely sensitive to interest rate changes and to the rate of principal prepayments. A rapid or unexpected increase in prepayments can severely depress the price of IOs, while a rapid or unexpected decrease in prepayments could have the same effect on POs. Of course, under the opposite conditions these securities may appreciate in value. These securities can be very volatile in price and may have lower liquidity than most other mortgage-backed securities. Certain non-stripped CMO classes may also exhibit these qualities, especially those that pay variable rates of interest that adjust inversely with, and more rapidly than, short-term interest rates. In addition, if interest rates rise rapidly and prepayment rates slow more than expected, certain CMO classes, in addition to losing value, can exhibit characteristics of longer-term securities and become more volatile. There is no guarantee that fund investments in CMOs, IOs, or POs will be successful, and fund total return could be adversely affected as a result. Operating policy Fund investments in stripped mortgage securities are limited to 10% of total assets. . Commercial Mortgage-Backed Securities (CMBS) CMBS are securities created from a pool of commercial mortgage loans, such as loans for hotels, shopping centers, office buildings, apartment buildings, etc. Interest and principal payments from the loans are passed on to the investor according to a schedule of payments. Credit quality depends primarily on the quality of the loans themselves and on the structure of the particular deal. Generally, deals are structured with senior and subordinate classes. The amount of subordination is determined by the rating agencies who rate the individual classes of the structure. Commercial mortgages are generally structured with prepayment penalties, which greatly reduces prepayment risk to the investor. However, the value of these securities may change because of actual or perceived changes in the creditworthiness of the individual borrowers, their tenants, the servicing agents, or the general state of commercial real estate. There is no limit on fund investments in these securities. Hybrid Instruments These instruments (a type of potentially high-risk derivative) can combine the characteristics of securities, futures, and options. For example, the principal amount or interest rate of a hybrid could be tied (positively or negatively) to the price of some commodity, currency, or securities index or another interest rate (each a "benchmark"). Hybrids can be used as an efficient means of pursuing a variety of investment goals, including currency hedging, duration management, and increased total return. Hybrids may or may not bear interest or pay dividends. The value of a hybrid or its interest rate may be a multiple of a benchmark and, as a result, may be leveraged and move (up or down) more steeply and rapidly than the benchmark. These benchmarks may be sensitive to economic and political events, such as commodity shortages and currency devaluations, which cannot be readily foreseen by the purchaser of a hybrid. Under certain conditions, the redemption value of a hybrid could be zero. Thus, an investment in a hybrid may entail significant market risks that are not associated with a similar investment in a traditional, U.S. dollar-denominated bond that has a fixed principal amount and pays a fixed rate or floating rate of interest. The purchase of hybrids also exposes the fund to the credit risk of the issuer of the hybrid. These risks may cause significant fluctuations in the net asset value of the fund. . Hybrids can have volatile prices and limited liquidity, and their use may not be successful. Operating policy Fund investments in hybrid instruments are limited to 10% of total assets. Deferrable Subordinated Securities These are securities with long maturities that are deeply subordinated in the issuer's capital structure. They generally have 30-year maturities and permit the issuer to defer distributions for up to five years. These characteristics give the issuer more financial flexibility than is typically the case with traditional bonds. As a result, the securities may be viewed as possessing certain "equity-like" features by rating agencies and bank regulators. However, the securities are treated as debt securities by market participants, and the fund intends to treat them as such as well. These securities may offer a mandatory put or remarketing option that creates an effective maturity date significantly shorter than the stated one. Fund investments will be made in these securities to the extent their yield, credit, and maturity characteristics are consistent with the fund's investment objective and program. Private Placements These securities are sold directly to a small number of investors, usually institutions. Unlike public offerings, such securities are not registered with the SEC. Although certain of these securities may be readily sold, for example, under Rule 144A, others may be illiquid, and their sale may involve substantial delays and additional costs. Operating policy Fund investments in illiquid securities are limited to 15% of net assets. Utility Industry Concentration The fund may, under certain circumstances, invest a substantial amount of its assets in the utility industry. Investments in this industry may be affected by environmental conditions, energy conservation programs, fuel shortages, availability of capital to finance operations and construction programs, and federal and state legislative and regulatory actions. T. Rowe Price believes that any risk to the fund which might result from concentrating in any such industry will be minimized by diversification of the fund's investments. Operating policy The fund has no current intention of concentrating in the utility industry. Fundamental policy The fund will, under certain conditions, invest up to 50% of its assets in any one of the following industries: gas utility, gas transmission utility, electric utility, telephone utility, and petroleum. Types of Investment Management Practices Reserve Position A certain portion of fund assets will be held in money market reserves. Fund reserve positions are expected to consist primarily of shares of one or more T. Rowe Price internal money market funds. Short-term, high-quality U.S. and foreign dollar-denominated money market securities, including repurchase agreements, may also be held. For temporary, defensive purposes, there is no limit on fund investments in money market reserves. The effect of taking such a position is that the fund may not achieve its investment objective. The reserve position provides flexibility in meeting redemptions, paying expenses, and in the timing of new investments and can serve as a short-term defense during periods of unusual market volatility. Borrowing Money and Transferring Assets Fund borrowings may be made from banks and other T. Rowe Price funds for temporary emergency purposes to facilitate redemption requests, or for other purposes consistent with fund policies as set forth in this prospectus. Such borrowings may be collateralized with fund assets, subject to restrictions. Fundamental policy Borrowings may not exceed 33/1//\\/3/\\% of total assets. Operating policy Fund transfers of portfolio securities as collateral will not be made except as necessary in connection with permissible borrowings or investments, and then such transfers may not exceed 33/1//\\/3/\\% of total assets. Fund purchases of additional securities will not be made when borrowings exceed 5% of total assets. Futures and Options Futures, a type of potentially high-risk derivative, are often used to manage or hedge risk because they enable the investor to buy or sell an asset in the future at an agreed-upon price. Options, another type of potentially high-risk derivative, give the investor the right (where the investor purchases the option), or the obligation (where the investor "writes" or sells the option), to buy or sell an asset at a predetermined price in the future. Futures and options contracts may be bought or sold for any number of reasons, including: to manage fund exposure to changes in interest rates, bond prices, and foreign currencies; as an efficient means of adjusting fund overall exposure to certain markets; in an effort to enhance income; to protect the value of portfolio securities; as a cash manage ment tool; and to adjust portfolio duration. Call or put options may be purchased or sold on securities, financial indices, and foreign currencies. Futures contracts and options may not always be successful hedges; their prices can be highly volatile; using them could lower fund total return; and the potential loss from the use of futures can exceed a fund's initial investment in such contracts. Operating policies Futures: Initial margin deposits and premiums on options used for nonhedging purposes will not exceed 5% of fund net asset value. Options on securities: The total market value of securities covering call or put options may not exceed 25% of fund total assets. No more than 5% of fund total assets will be committed to premiums when purchasing call or put options. . Swaps The fund may enter into interest rate, index, total return, and credit swap agreements. The fund may also enter into options on swap agreements or swap options. All of these agreements are considered derivatives and, in certain cases, high-risk derivatives. Swap agreements are two-party contracts under which the fund and a counterparty, such as a broker or dealer, agree to exchange the returns (or differentials in rates of return) earned or realized on particular predetermined investments or indices. Swaps and swap options can be used for a variety of purposes, including: to manage fund exposure to changes in interest rates and credit quality; as an efficient means of adjusting fund overall exposure to certain markets; to enhance income or total return; to protect the value of portfolio securities; to serve as a cash management tool; and to adjust portfolio duration. There are risks in the use of swaps and swap options. Swaps could result in losses if interest rate or credit quality are not correctly anticipated by the fund. Total return swaps could result in losses if the reference index, security, or investments do not perform as anticipated by the fund. Credit default swaps could result in losses if the fund does not correctly evaluate the creditworthiness of the company on which the credit default swap is based. Swaps and swap options may not always be successful hedges; using them could lower fund total return and the other party to a swap agreement could default on its obligations or refuse to cash out the fund's investment at a reasonable price, which could turn an expected gain into a loss. Operating policies The fund will not enter into a swap agreement with any single counterparty if the net amount owed or to be received under existing contracts with that party would exceed 5% of total assets, or if the net amount owed or to be received by the fund under all outstanding swap agreements will exceed 10% of total assets. The total market value of securities covering call or put options may not exceed 25% of total assets. No more than 5% of total assets will be committed to premiums when purchasing call or put options. Managing Foreign Exchange Risk Investors in foreign securities may attempt to "hedge" their exposure to potentially unfavorable currency changes. The primary means of doing this is through the use of "forwards"- contracts to exchange one currency for another on some future date at a specified exchange rate. However, futures, swaps, and options on these instruments may also be used. In certain circumstances, a "proxy currency" may be substituted for the currency in which the investment is denominated, a strategy known as "proxy hedging." The fund may also use these instruments to create a synthetic bond issued in one currency, but with the currency component transformed into another currency. If the fund were to engage in any of these foreign currency transactions, they would be used primarily to protect the fund's foreign securities from adverse currency movements relative to the dollar. Such transactions involve the risk that anticipated currency movements will not occur, and the fund's total return could be reduced. Operating policy The fund will not commit more than 20% of its total assets to any combination of foreign currency instruments. Lending of Portfolio Securities Fund securities may be lent to broker-dealers, other institutions, or other persons to earn additional income. Risks include the potential insolvency of the broker-dealer or other borrower that could result in delays in recovering securities and capital losses. Additionally, losses could result from the reinvestment of collateral received on loaned securities. Fundamental policy The value of loaned securities may not exceed 33/1//\\/3/\\% of total assets. When-Issued Securities and Forward Commitment Contracts The fund may purchase securities on a when-issued or delayed delivery basis or may purchase or sell securities on a forward commitment basis. There is no limit on fund investments in these securities. The price of these securities is fixed at the time of the commitment to buy, but delivery and payment can take place a month or more later. During the interim period, the market value of the securities can fluctuate, and no interest accrues to the purchaser. At the time of delivery, the value of the securities may be more or less than the purchase or sale price. To the extent the fund remains fully or almost fully invested (in securities with a remaining maturity of more than one year) at the same time it purchases these securities, there will be greater fluctuations in the fund's net asset value than if the fund did not purchase them. Portfolio Turnover Turnover is an indication of frequency of trading. The fund will not generally trade in securities for short-term profits, but, when circumstances warrant, securities may be purchased and sold without regard to the length of time held. A high turnover rate may increase transaction costs, result in additional capital gain distributions, and reduce fund total return. The fund's portfolio turnover rates are shown in the Financial Highlights table. FINANCIAL HIGHLIGHTS ---------------------------------------------------------- New Income Fund-Advisor Class first issued shares on September 30, 2002, and therefore has no financial history. As a point of comparison, however, Table 4 provides historical information about the New Income Fund because New Income Fund-Advisor Class has the same management program and investment portfolio. (Prior to the inception of New Income Fund-Advisor Class, New Income Fund had no other share class.) This information is based on a single share of the New Income Fund outstanding throughout each of its fiscal years. New Income Fund-Advisor Class first issued shares on September 30, 2002, and therefore has no financial history. As a point of comparison, however, Table 4 provides historical information about the New Income Fund because New Income Fund-Advisor Class has the same management program and investment portfolio. (Prior to the inception of New Income Fund-Advisor Class, New Income Fund had no other share class.) This information is based on a single share of the New Income Fund outstanding throughout each of its fiscal years. This table is part of the New Income Fund's financial statements, which are included in its annual report and are incorporated by reference into the Statement of Additional Information (available upon request). The total returns in the table represent the rate that an investor would have earned or lost on an investment in the fund (assuming reinvestment of all dividends and distributions). The financial statements in the annual report were audited by the fund's independent accountants, PricewaterhouseCoopers LLP. Had the New Income Fund-Advisor Class existed during the period reflected in the table, some financial information would be different because of its higher anticipated expense ratio. Table 4 Financial Highlights
Year ended May 31 1998 1999 2000 2001 2002 ------------------------------------------------------------------------------- Net asset value, beginning of period $ 8.77 $ 9.09 $ 8.50 $ 8.07 $ 8.53 Income From Investment Operations Net investment income 0.57 0.54 0.52 0.53 0.47 --------------------------------------------- Net gains or losses on securities (both realized 0.36 (0.45) (0.43) 0.46 0.17 and unrealized) --------------------------------------------- Total from investment operations 0.93 0.09 0.09 0.99 0.64 Less Distributions Dividends (from net (0.57) (0.54) (0.52) (0.53) (0.47) investment income) --------------------------------------------- Distributions (from (0.04) (0.14) -- -- -- capital gains) --------------------------------------------- Returns of capital -- -- -- -- -- --------------------------------------------- Total distributions (0.61) (0.68) (0.52) (0.53) (0.47) --------------------------------------------- Net asset value, $ 9.09 $ 8.50 $ 8.07 $ 8.53 $ 8.70 end of period --------------------------------------------- Total return 10.84% 1.02% 1.13% 12.54% 7.68% Ratios/Supplemental Data Net assets, end of period $2,076 $1,942 $1,633 $1,684 $1,863 (in millions) --------------------------------------------- Ratio of expenses to 0.71% 0.72% 0.73% 0.73% 0.72% average net assets --------------------------------------------- Ratio of net income to 6.31% 6.16% 6.32% 6.30% 5.38% average net assets --------------------------------------------- Portfolio turnover rate 147.3% 94.3% 83.6% 112.1% 222.0% -------------------------------------------------------------------------------
INVESTING WITH T. ROWE PRICE ACCOUNT REQUIREMENTS AND TRANSACTION INFORMATION ---------------------------------------------------------- Tax Identification Number The intermediary must provide us with its certified Social Security or tax identification number (TIN). Otherwise, federal law requires the funds to withhold a percentage (currently 30%) of dividends, capital gain distributions, and redemptions, and may subject the intermediary or account holder to an IRS fine. If this information is not received within 60 days after the account is established, the account may be redeemed at the fund's NAV on the redemption date. The information in this section is for use by intermediaries only. Shareholders should contact their intermediary for information regarding the intermediary's policies on purchasing, exchanging, and redeeming fund shares as well as initial and subsequent investment minimums. All initial and subsequent investments by intermediaries must be made by bank wire. Opening a New Account $2,500 minimum initial investment; $1,000 for retirement plans or gifts or transfers to minors (UGMA/UTMA) accounts Intermediaries should call Financial Institution Services for an account number and assignment to a dedicated service representative and give the following wire information to their bank: Receiving Bank: PNC Bank, N.A. (Pittsburgh) Receiving Bank ABA#: 043000096 Beneficiary: T. Rowe Price [fund name] Beneficiary Account: 1004397951 Originator to Beneficiary Information (OBI): name of owner(s) and account number Complete a New Account Form and mail it to one of the appropriate addresses listed below. Intermediaries must also enter into a separate agreement with the fund or its agent. via U.S. Postal Service T. Rowe Price Financial Institution Services P.O. Box 17603 Baltimore, MD 21297-1603 via private carriers/overnight services T. Rowe Price Financial Institution Services Mail Code: OM-17603 4515 Painters Mill Road Owings Mills, MD 21117-4842 PURCHASING ADDITIONAL SHARES ---------------------------------------------------------- $100 minimum additional purchase; $50 minimum for retirement plans, Automatic Asset Builder, and gifts or transfers to minors (UGMA/UTMA) accounts By Wire Intermediaries should call Financial Institution Services or use the wire instructions listed in Opening a New Account. EXCHANGING AND REDEEMING SHARES ---------------------------------------------------------- Exchange Service You can move money from one account to an existing identically registered account or open a new identically registered account. Intermediaries should call their Financial Institution Services representative. Redemptions Unless otherwise indicated, redemption proceeds will be wired to the intermediary's designated bank. Intermediaries should contact their Financial Institution Services representative. RIGHTS RESERVED BY THE FUNDS ---------------------------------------------------------- T. Rowe Price funds and their agents reserve the following rights: (1) to refuse any purchase or exchange order; (2) to cancel or rescind any purchase or exchange order (including, but not limited to, orders deemed to result in excessive trading, market timing, fraud, or 5% ownership) upon notice to the intermediary within five business days of the trade or if the written confirmation has not been received by the shareholder, whichever is sooner; (3) to cease offering fund shares at any time to all or certain groups of investors; (4) to freeze any account and suspend account services when notice has been received of a dispute between the registered or beneficial account owners or there is reason to believe a fraudulent transaction may occur; (5) to otherwise modify the conditions of purchase and any services at any time; and (6) to act on instructions reasonably believed to be genuine. These actions will be taken when, in the sole discretion of management, they are deemed to be in the best interest of the fund. In an effort to protect T. Rowe Price funds from the possible adverse effects of a substantial redemption in a large account, as a matter of general policy, no shareholder or group of shareholders controlled by the same person or group of persons will knowingly be permitted to purchase in excess of 5% of the outstanding shares of a fund, except upon approval of the fund's management. T. ROWE PRICE PRIVACY POLICY ---------------------------------------------------------- In the course of doing business with T. Rowe Price, you share personal and financial information with us. We treat this information as confidential and recognize the importance of protecting access to it. You may provide information when communicating or transacting with us in writing, electronically, or by phone. For instance, information may come from applications, requests for forms or literature, and your transactions and account positions with us. On occasion, such information may come from consumer reporting agencies and those providing services to us. We do not sell information about current or former customers to any third parties, and we do not disclose it to third parties unless necessary to process a transaction, service an account, or as otherwise permitted by law. We may share information within the T. Rowe Price family of companies in the course of providing or offering products and services to best meet your investing needs. We may also share that information with companies that perform administrative or marketing services for T. Rowe Price, with a research firm we have hired, or with a business partner, such as a bank or insurance company with whom we are developing or offering investment products. When we enter into such a relationship, our contracts restrict the companies' use of our customer information, prohibiting them from sharing or using it for any purposes other than those for which they were hired. We maintain physical, electronic, and procedural safeguards to protect your personal information. Within T. Rowe Price, access to such information is limited to those who need it to perform their jobs, such as servicing your accounts, resolving problems, or informing you of new products or services. Finally, our Code of Ethics, which applies to all employees, restricts the use of customer information and requires that it be held in strict confidence. This Privacy Policy applies to the following T. Rowe Price family of companies: T. Rowe Price Associates, Inc.; T. Rowe Price Advisory Services, Inc.; T. Rowe Price Investment Services, Inc.; T. Rowe Price Savings Bank; T. Rowe Price Trust Company; and the T. Rowe Price Funds. T. Rowe Price Associates, Inc. 100 East Pratt Street Baltimore, MD 21202 A fund Statement of Additional Information has been filed with the Securities and Exchange Commission and is incorporated by reference into this prospectus. Further information about fund investments, including a review of market conditions and the manager's recent strategies and their impact on performance, is available in the annual and semiannual shareholder reports. To obtain free copies of any of these documents, call your intermediary. Fund information and Statements of Additional Information are also available from the Public Reference Room of the Securities and Exchange Commission. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-202-942-8090. Fund reports and other fund information are available on the EDGAR Database on the SEC's Internet site at http://www.sec.gov. Copies of this information may be obtained, after paying a duplicating fee, by electronic request at publicinfo@sec.gov, or by writing the Public Reference Room, Washington D.C. 20549-0102. 1940 Act File No. 811-2396 E243-040 9/30/02 PROSPECTUS September 30, 2002 T. ROWE PRICE New Income Fund--R Class A bond fund investing primarily in investment-grade bonds to achieve an attractive level of income. This class of shares is sold only through financial intermediaries. (R) The Securities and Exchange Commission has not approved or disapproved these securities or passed upon the adequacy of this prospectus. Any representation to the contrary is a criminal offense. T. Rowe Price New Income Fund, Inc. T. Rowe Price New Income Fund--R Class Prospectus September 30, 2002
ABOUT THE FUND 1 Objective, Strategy, Risks, and Expenses 1 ----------------------------------------------- Other Information About the Fund 6 ----------------------------------------------- Some Basics of Fixed-Income 8 Investing ----------------------------------------------- INFORMATION ABOUT ACCOUNTS IN T. ROWE PRICE 2 FUNDS Pricing Shares and Receiving 10 Sale Proceeds ----------------------------------------------- Useful Information on Distributions 11 and Taxes ----------------------------------------------- Transaction Procedures and 13 Special Requirements ----------------------------------------------- MORE ABOUT THE FUND 3 Organization and Management 15 ----------------------------------------------- Understanding Performance Information 17 ----------------------------------------------- Investment Policies and Practices 18 ----------------------------------------------- Financial Highlights 27 ----------------------------------------------- INVESTING WITH T. ROWE PRICE 4 Account Requirements 29 and Transaction Information ----------------------------------------------- Purchasing Additional Shares 30 ----------------------------------------------- Exchanging and Redeeming Shares 30 ----------------------------------------------- Rights Reserved by the Fund 30 s ----------------------------------------------- T. Rowe Price 32 Privacy Policy -----------------------------------------------
Founded in 1937 by the late Thomas Rowe Price, Jr., T. Rowe Price Associates, Inc., and its affiliates managed $148.8 billion for more than eight million individual and institutional investor accounts as of June 30, 2002. Mutual fund shares are not deposits or obligations of, or guaranteed by, any depository institution. Shares are not insured by the FDIC, Federal Reserve, or any other government agency, and are subject to investment risks, including possible loss of the principal amount invested. ABOUT THE FUND OBJECTIVE, STRATEGY, RISKS, AND EXPENSES ---------------------------------------------------------- A word about the fund's name and structure. New Income Fund - R Class is a share class of T. Rowe Price New Income Fund. The R Class is not a separate mutual fund. R Class shares are designed to be sold only through various third-party intermediaries that offer employer-sponsored retirement plans, including brokers, dealers, banks, insurance companies, retirement plan recordkeepers, and others. What is the fund's objective? The fund seeks the highest level of income consistent with the preservation of capital over time by investing primarily in marketable debt securities. What is the fund's principal investment strategy? The fund will invest at least 80% of the fund's total assets in income-producing securities, which may include U.S. government and agency obligations, mortgage- and asset-backed securities, corporate bonds, foreign securities, collateralized mortgage obligations (CMOs), and others, including, on occasion, equities. All debt securities purchased by the fund must be rated investment grade (AAA, AA, A, or BBB) by at least one major credit rating agency or, if unrated, must have a T. Rowe Price equivalent rating. Up to 15% of total assets may be invested in "split-rated securities," or those rated investment grade by at least one rating agency, but below investment grade by others. However, none of the fund's remaining assets can be invested in bonds rated below investment grade by Standard & Poor's, Moody's, or Fitch IBCA, Inc. The fund has considerable flexibility in seeking high yield for the fund. There are no maturity restrictions, so we can purchase longer-term bonds, which tend to have higher yields than shorter-term issues. However, the portfolio's weighted average maturity is expected to be between four and 15 years. In addition, when there is a large yield difference between the various quality levels, we may move down the credit scale and purchase lower-rated bonds with higher yields. When the difference is small or the outlook warrants, we may concentrate investments in higher-rated issues. The fund may also invest in other securities, including futures, options, and swaps, in keeping with its objective. The fund may sell holdings for a variety of reasons, such as to adjust the portfolio's average maturity or quality or to shift assets into higher-yielding securities or different sectors. . For details about the fund's investment program, please see the Investment Policies and Practices section. What are the main risks of investing in the fund? . Interest rate risk Investors should be concerned primarily with this risk. An increase in interest rates will likely cause the fund's share price to fall, resulting in a loss of principal (see Table 3). That's because the bonds and notes in the fund's portfolio become less attractive to other investors when securities with higher yields become available. Even GNMAs and other securities whose principal and interest payments are guaranteed can decline in price if rates rise. Generally speaking, the longer a bond's maturity, the greater its potential for price declines if rates rise and for price gains if rates fall. Because the fund may invest in bonds of any maturity, it carries more interest rate risk than short-term bond funds. . Credit risk This is the chance that any of the fund's holdings will have their credit ratings downgraded or will default (fail to make scheduled interest or principal payments), potentially reducing the fund's income level and share price. While the fund's overall credit quality is generally high, it can own BBB securities, which are more susceptible to adverse economic conditions and may have speculative characteristics. Investment-grade (AAA to BBB) securities have relatively low financial risk and a relatively high probability of future payment. However, securities rated BBB are more susceptible to adverse economic conditions and may have speculative characteristics. Securities rated below investment-grade (junk or high yield bonds) should be regarded as speculative because their issuers are more susceptible to financial setbacks and recession than more creditworthy companies. . The fund may continue to hold a security that has been downgraded or loses its investment-grade rating after purchase. . Foreign investing risk To the extent the fund holds foreign bonds, it will be subject to special risks whether the bonds are denominated in U.S. dollars or foreign currencies. These risks include potentially adverse political and economic developments overseas, greater volatility, lower liquidity, and the possibility that foreign currencies will decline against the dollar, lowering the value of securities denominated in those currencies and possibly the fund's share price. . Prepayment risk and extension risk A mortgage-backed bond, unlike most other bonds, can be hurt when interest rates fall, because homeowners tend to refinance and prepay principal. Receiving increasing prepayments in a falling interest rate environment causes the average maturity of the portfolio to shorten, reducing its potential for price gains. It also requires the fund to reinvest proceeds at lower interest rates, which reduces the portfolio's total return, reduces its yield, and may even cause certain bonds' prices to fall below what the fund paid for them, resulting in a capital loss. Any of these developments could cause a decrease in the fund's income, share price, or total return. Extension risk refers to a rise in interest rates that causes a fund's average maturity to lengthen unexpectedly due to a drop in mortgage prepayments. This would increase the fund's sensitivity to rising rates and its potential for price declines. . Derivatives risk Shareholders are also exposed to derivatives risk, the potential that our investments in these complex and volatile instruments could affect the fund's share price. In addition to CMOs and better-known instruments such as swaps and futures, other derivatives that may be used in limited fashion by the fund include interest-only (IO) and principal-only (PO) securities known as "strips." The value of these instruments is derived from an underlying pool of mortgage-backed securities or a CMO. Some of these instruments can be highly volatile, and their value can fall dramatically in response to rapid or unexpected changes in the mortgage, interest rate, or economic environment. As with any mutual fund, there can be no guarantee the fund will achieve its objective. . The share price and income level of the fund will fluctuate with changing market conditions and interest rate levels. When you sell your shares, you may lose money. How can I tell if the fund is appropriate for me? Consider your investment goals, your time horizon for achieving them, and your tolerance for risk. If you are investing through an intermediary, seeking an attractive level of income and are willing to accept the risk of a declining share price when interest rates rise. Steadily reinvesting the fund's income is a conservative strategy for building capital over time. If you are investing primarily for safety and liquidity, you should consider a money market fund. . The fund should not represent your complete investment program or be used for short-term trading purposes. How has the fund performed in the past? New Income Fund-R Class began operations on September 30, 2002, and does not have a full calendar year of performance history. As a point of comparison, however, the following bar chart and table show calendar year returns for the oldest existing class of the New Income Fund. Because the New Income Fund-R Class is expected to have higher expenses than the oldest existing class of the New Income Fund, its performance, had it existed over the periods shown, would have been lower. The oldest existing class of the New Income Fund and the New Income Fund-R Class share the same portfolio. Shares of each class of the fund are offered in separate prospectuses. The bar chart showing calendar year returns and the average annual total return table indicate risk by illustrating how much returns can differ from one year to the next and how fund performance compares with that of a comparable market index. Fund past returns (before and after taxes) are not necessarily an indication of future performance. The fund can also experience short-term performance swings, as shown by the best and worst calendar quarter returns during the years depicted. In addition, the average annual total return table shows hypothetical after-tax returns to suggest how taxes paid by the shareholder may influence returns. Actual after-tax returns depend on each investor's situation and may differ from those shown. After-tax returns are not relevant if the shares are held in a tax-deferred account, such as a 401(k) or IRA. During periods of fund losses, the post-liquidation after-tax return may exceed the fund's other returns because the loss generates a tax benefit that is factored into the result.
Calendar Year Total Returns "92" "93" "94" "95" "96" "97" "98" "99" "00" "01" ---------------------------------------------------------------------------- 4.96 9.58 -2.22 18.36 2.38 9.32 5.04 -1.58 11.13 8.15 ---------------------------------------------------------------------------
The fund's return for the six months ended 6/30/02 was 2.69%. Table 1 Average Annual Total Returns
Periods ended December 31, 2001 1 year 5 years 10 years ------------------------------------------------------------------------------ New Income Fund Returns before taxes 8.15% 6.32% 6.35% Returns after taxes on distributions 5.75 3.66 3.69 Returns after taxes on distributions and sale of fund shares 4.92 3.74 3.78 Lehman Brothers U.S. Aggregate Index 8.44 7.43 7.23 Lipper Corporate Debt Funds A Rated 7.47 6.24 6.74 Average ------------------------------------------------------------------------------
Returns are based on changes in principal value, reinvested dividends, and capital gain distributions, if any. Returns before taxes do not reflect effects of any income or capital gains taxes. All after-tax returns are calculated using the historical highest individual federal marginal income tax and capital gains rates. They do not reflect the impact of state and local taxes. Returns after taxes on distributions reflect the taxed return on the payment of dividends and capital gains. Returns after taxes on distributions and sale of fund shares assume the shares were sold at period-end, and, therefore, are also adjusted for any capital gains or losses incurred by the shareholder. Market indexes do not include expenses, which are deducted from fund returns, or taxes. What fees or expenses will I pay? The numbers in the next table provide an estimate of how much it will cost to operate the R Class for a year. These are costs you pay indirectly because they are deducted from net assets before the daily share price is calculated. Table 2 Fees and Expenses of the R Class*
Annual fund operating expenses (expenses that are deducted from fund assets) ---------------------------------------------------------------------------------------------- Management fee 0.47% ----------------------------------------------- Distribution and service (12b-1) fees 0.50% ----------------------------------------------- Other expenses 0.29%/a/ ----------------------------------------------- Total annual fund operating expenses 1.26% ----------------------------------------------- Fee waiver/reimbursement 0.11%/b/ ----------------------------------------------- Net expenses 1.15%/b/ ----------------------------------------------------------------------------------------------
* Redemption proceeds of less than $5,000 sent by wire are subject to a $5 fee paid to the fund. /a/ Other expenses are estimated. /b/To limit the class's expenses during its initial period of operations, T. Rowe Price is contractually obligated to bear any expenses (other than management fees and certain other portfolio level expenses) through September 30, 2004, that would cause the class's ratio of expenses to average net assets to exceed 1.15%. Expenses paid or assumed under this agreement are subject to reimbursement to T. Rowe Price by the fund whenever the class's expense ratio is below 1.15%; however, no reimbursement will be made after September 30, 2006, or if it would result in the expense ratio exceeding 1.15%. Any amounts reimbursed will have the effect of increasing fees otherwise paid by the class. Example. The following table gives you an idea of how expense ratios may translate into dollars and helps you to compare the cost of investing in this class with that of other mutual funds. Although your actual costs may be higher or lower, the table shows how much you would pay if operating expenses remain the same, the expense limitation currently in place is not renewed, you invest $10,000, earn a 5% annual return, and hold the investment for the following periods and then redeem:
1 year 3 years 5 years 10 years ---------------------------------------------------- $117 $364 $630 $1,388 ----------------------------------------------------
OTHER INFORMATION ABOUT THE FUND ---------------------------------------------------------- What are the fund's potential rewards? The fund can provide an attractive level of income to investors who want only a moderate level of risk. It should offer higher yields than money market and short-term bond funds and generally less volatility than longer-term bond funds. In addition, the portfolio is widely diversified among various fixed-income securities, thus reducing the effect of a single bond's price fluctuations on the fund's share price or total return. How does the portfolio manager try to reduce risk? Consistent with the fund's objective, the portfolio manager uses various tools to try to reduce risk and increase total return, including: . Diversification of assets to reduce the impact of a single holding or sector on the fund's net asset value. . Thorough credit research by our own analysts. . Adjustment of fund duration to try to reduce the drop in price when interest rates rise or to benefit from the rise in price when rates fall. Duration is a measure of a fund's sensitivity to interest rate changes. Is the fund a substitute for a money market fund? No. Money market funds, which have an average maturity under one year, ordinarily generate lower income in return for stability of net asset value. The fund's total return is expected to fluctuate more than a money market fund's and, as such, it should be viewed as a longer-term and riskier investment. Do mortgage-backed securities differ from other high-quality bonds? Yes, in one major respect. Non-mortgage bonds generally repay principal (face value of the bond) when their maturity date is reached, but most mortgage-backed securities repay principal continually as homeowners make mortgage payments. Homeowners have the option of paying either part or all of the loan balance before maturity, perhaps to refinance or buy a new home. As a result, the effective maturity of a mortgage-backed security is virtually always shorter than its stated maturity. For example, a new GNMA certificate backed by 30-year, fixed-rate mortgages will generally have a far shorter life than 30 years - probably 12 or less. Therefore, it will usually be about as volatile as a 10-year Treasury note. It is possible to estimate the average life of an entire mortgage pool backing a particular security with some accuracy, but not with certainty. Why are yields on mortgage-backed securities higher than yields on Treasuries of similar maturity? The structure of mortgage-backed securities is much more complex, and their effective maturities are uncertain because of unscheduled prepayments. Higher yields compensate investors for these potentially negative features. See the previous discussion of prepayment risk and extension risk. What are derivatives and can the fund invest in them? A derivative is a financial instrument whose value is derived from an underlying security, such as a stock or bond, or from a market benchmark such as an interest rate index. Many types of investments representing a wide range of risks and potential rewards are derivatives, including conventional instruments such as futures and options, as well as more exotic investments such as swaps and structured notes. Investment managers have used derivatives for many years. We invest in derivatives only if the expected risks and rewards are consistent with the fund's objective, policies, and overall risk profile as described in this prospectus. We use derivatives in situations where they may enable the fund to increase yield, hedge against a decline in principal, invest in other asset classes more efficiently, or adjust duration. We will not invest in any high-risk, highly leveraged derivative that we believe would cause the portfolio to be more volatile than a long-term, investment-grade bond. Is there other information I can review before making a decision? Investment Policies and Practices in Section 3 discusses various types of portfolio securities the fund may purchase as well as types of management practices the fund may use. SOME BASICS OF FIXED-INCOME INVESTING ---------------------------------------------------------- Is a fund's yield fixed or will it vary? It will vary. The yield is calculated every day by dividing a fund's net income per share, expressed at annual rates, by the share price. Since both income and share price will fluctuate, a fund's yield will also vary. (Although money fund prices are stable, income is variable.) Is yield the same as total return? Not for bond funds. A fund's total return is the result of reinvested distributions from income and capital gains and the change in share price for a given period. Income is always a positive contributor to total return and can either enhance a rise in share price or help offset a price decline. What is credit quality and how does it affect yield? Credit quality refers to a bond issuer's expected ability to make all required interest and principal payments on time. Because highly rated issuers represent less risk, they can borrow at lower interest rates than less creditworthy issuers. Therefore, a fund investing in high-quality securities should have a lower yield than an otherwise comparable fund investing in lower-quality securities. What is meant by a bond fund's maturity? Every bond has a stated maturity date when the issuer must repay the bond's entire principal value to the investor. However, many bonds are "callable," meaning their principal can be repaid earlier, on, or after specified call dates. Bonds are most likely to be called when interest rates are falling because the issuer can refinance at a lower rate, just as a homeowner refinances a mortgage. In that environment, a bond's "effective maturity" is usually its nearest call date. For example, the rate at which homeowners pay down their mortgage principal determines the effective maturity of mortgage-backed bonds. A bond mutual fund has no real maturity, but it does have a weighted average maturity and a weighted average effective maturity. Each of these numbers is an average of the stated or effective maturities of the underlying bonds, with each bond's maturity "weighted" by the percentage of fund assets it represents. Some funds target effective maturities rather than stated maturities when computing the average. This provides additional flexibility in portfolio management. What is meant by a bond fund's duration? Duration is a calculation that seeks to measure the price sensitivity of a bond or a bond fund to changes in interest rates. It is expressed in years, like maturity, but it is a better indicator of price sensitivity than maturity because it takes into account the time value of cash flows generated over the bond's life. Future inter- est and principal payments are discounted to reflect their present value and then are multiplied by the number of years they will be received to produce a value expressed in years - the duration. "Effective" duration takes into account call features and sinking fund payments that may shorten a bond's life. Since duration can also be computed for bond funds, you can estimate the effect of interest rates on share prices by multiplying fund duration by an expected change in interest rates. For example, the price of a bond fund with a duration of five years would be expected to fall approximately 5% if rates rose by one percentage point. (T. Rowe Price shareholder reports show duration.) How is a bond's price affected by changes in interest rates? When interest rates rise, a bond's price usually falls, and vice versa. In general, the longer a bond's maturity, the greater the price increase or decrease in response to a given change in rates, as shown in Table 3. Table 3 How Interest Rates May Affect Bond Prices
Price of a $1,000 face value bond if interest rates: Bond maturity Coupon Increase Decrease 1 percent 2 percent 1 percent 2 perc 2 years 2.81% $981 $962 $1,020 $1,0 ------------------------------------------------------------------------ 5 years 4.03 956 915 1,046 1,0 ------------------------------------------------------------------------ 10 years 4.80 925 857 1,083 1,1 ------------------------------------------------------------------------ 30 years 5.51 869 763 1,164 1,3 -----------------------------------------------------------------------------------------------------------------------------------
Coupons reflect yields on Treasury securities as of June 30, 2002. The table may not be representative of price changes for mortgage-backed securities because of prepayments. This is an illustration and does not represent expected yields or share price changes of any T. Rowe Price fund. INFORMATION ABOUT ACCOUNTS IN T. ROWE PRICE FUNDS As a T. Rowe Price shareholder, you will want to know about the following policies and procedures that apply to all R Class accounts. PRICING SHARES AND RECEIVING SALE PROCEEDS ---------------------------------------------------------- How and when shares are priced The share price (also called "net asset value" or NAV per share) for each class of shares is calculated at the close of the New York Stock Exchange, normally 4 p.m. ET, each day the New York Stock Exchange is open for business. To calculate the NAV, the fund's assets are valued and totaled, liabilities are subtracted, and each class's proportionate share of the balance, called net assets, is divided by the number of shares outstanding of that class. Market values are used to price stocks and bonds. The securities of funds investing in foreign markets are usually valued on the basis of the most recent closing market prices at 4 p.m. ET. Most foreign markets close before that time. For securities primarily traded in the Far East, for example, the most recent closing prices may be as much as 15 hours old at 4 p.m. Normally, developments that could affect the values of portfolio securities that occur between the close of the foreign market and 4 p.m. ET will not be reflected in a fund NAV. However, if a fund determines that such developments are so significant that they will, in its judgment, clearly and materially affect the value of the fund's securities, the fund may adjust the previous closing prices to reflect what it believes to be the fair value of the securities as of 4 p.m. ET. A fund may fair value securities in other situations, for example, when a particular foreign market is closed but the fund is open. How your purchase, sale, or exchange price is determined R Class shares are intended for purchase and may be held only through various third-party intermediaries that offer employer-sponsored retirement plans, including brokers, dealers, banks, insurance companies, retirement plan recordkeepers, and others. Consult your intermediary to find out about how to purchase, sell, or exchange your shares, cut-off times, and other applicable procedures for these transactions. The intermediary may charge a fee for its services. The fund may have an agreement with your intermediary that permits the intermediary to accept orders on behalf of the fund until 4 p.m. ET. In such cases, if your order is received by the intermediary in good form by 4 p.m. ET and transmitted to the fund and paid for in accordance with the agreement, it will be priced at the next NAV computed after the intermediary received your order. Note: The time at which transactions and shares are priced and the time until which orders are accepted by the fund or an intermediary may be changed in case of an emergency or if the New York Stock Exchange closes at a time other than 4 p.m. ET. How proceeds are received Normally, the fund transmits proceeds to intermediaries for redemption orders received in good form on either the next or third business day after receipt, depending on the arrangement with the intermediary. Under certain circumstances and when deemed to be in the fund's best interests, proceeds may not be sent for up to seven calendar days after receipt of the redemption order. You must contact your intermediary about procedures for receiving your redemption proceeds. USEFUL INFORMATION ON DISTRIBUTIONS AND TAXES ---------------------------------------------------------- . All net investment income and realized capital gains are distributed to shareholders. Dividends and Other Distributions Dividend and capital gain distributions are reinvested in additional fund shares in your account unless you select another option on your New Account Form. Reinvesting distributions results in compounding, that is, receiving income dividends and capital gain distributions on a rising number of shares. No interest will accrue on amounts represented by uncashed distribution or redemption checks. Income dividends . The funds declare and pay dividends (if any) quarterly for the Equity Income Fund-R Class; declare daily and pay monthly for the New Income Fund-R Class; and declare and pay annually for all other R Classes. . A portion of fund dividends (other than New Income Fund-R Class, International Stock Fund-R Class, and International Growth & Income Fund-R Class) may be eligible for the 70% deduction for dividends received by corporations to the extent the funds' income consists of dividends paid by U.S. corporations. . The dividends of New Income Fund-R Class, International Stock Fund-R Class, and International Growth & Income Fund-R Class will not be eligible for the 70% deduction for dividends received by corporations, if, as expected, none of the funds' income consists of dividends paid by U.S. corporations. Capital gains payments . A capital gain or loss is the difference between the purchase and sale price of a security. . If a fund has net capital gains for the year (after subtracting any capital losses), they are usually declared and paid in December to shareholders of record on a specified date that month. If a second distribution is necessary, it is paid the following year. Tax Information You should contact your intermediary for the tax information that will be sent to you and reported to the IRS. If you invest in the fund through a tax-deferred retirement account, you will not be subject to tax on dividends and distributions from the fund or the sale of fund shares if those amounts remain in the tax-deferred account. If you invest in the fund through a taxable account, you need to be aware of the possible tax consequences when: . You sell fund shares, including an exchange from one fund to another. . The fund makes a distribution to your account. Taxes on fund redemptions When you sell shares in any fund, you may realize a gain or loss. An exchange from one fund to another is still a sale for tax purposes. Taxes on fund distributions The tax treatment of a capital gain distribution is determined by how long the fund held the portfolio securities, not how long you held shares in the fund. Short-term (one year or less) capital gain distributions are taxable at the same rate as ordinary income and long-term gains on securities held more than 12 months are taxed at a maximum rate of 20%. If you realized a loss on the sale or exchange of fund shares that you held six months or less, your short-term loss must be reclassified to a long-term loss to the extent of any long-term capital gain distribution received during the period you held the shares. Gains and losses from the sale of foreign currencies and the foreign currency gain or loss resulting from the sale of a foreign debt security can increase or decrease an ordinary income dividend. Net foreign currency losses may cause monthly or quarterly dividends to be reclassified as a return of capital. If the fund qualifies and elects to pass through nonrefundable foreign taxes paid to foreign governments during the year, your portion of such taxes will be reported to you as taxable income. However, you may be able to claim an offsetting credit or deduction on your tax return for those amounts. There can be no assurance that a fund will be able to meet the requirements to pass through foreign income taxes paid. Tax consequences of hedging For funds investing in foreign securities, distributions resulting from the sale of certain foreign currencies, currency contracts, and debt securities are taxed as ordinary income. Net foreign currency losses may cause monthly or quarterly dividends to be reclassified as a return of capital. Entering into certain options, futures, swaps, and forward foreign exchange contracts and transactions may result in the application of the mark-to-market and straddle provisions of the Internal Revenue Code. These provisions could result in a fund being required to distribute gains on such transactions even though it did not close the contracts during the year or receive cash to pay such distributions. A fund may not be able to reduce its distributions for losses on such transactions to the extent of unrealized gains in offsetting positions. . Distributions are taxable whether reinvested in additional shares or received in cash. Tax effect of buying shares before a capital gain or dividend distribution If you buy shares shortly before or on the "record date" - the date that establishes you as the person to receive the upcoming distribution - you will receive a portion of the money you just invested in the form of a taxable distribution. Therefore, you may wish to find out a fund's record date before investing. Of course, a fund's share price may, at any time, reflect undistributed capital gains or income and unrealized appreciation, which may result in future taxable distributions. Such distributions can occur even in a year when the fund has a negative return. TRANSACTION PROCEDURES AND SPECIAL REQUIREMENTS ---------------------------------------------------------- Purchase Conditions for Intermediaries Nonpayment If the fund receives a check or ACH transfer that does not clear or the payment is not received in a timely manner, your purchase may be canceled. Any losses or expenses incurred by the fund or transfer agent will be the responsibility of the intermediary. The fund and its agents have the right to reject or cancel any purchase, exchange, or redemption due to nonpayment. U.S. dollars All purchases must be paid for in U.S. dollars; checks must be drawn on U.S. banks. Sale (Redemption) Conditions Holds on immediate redemptions: 10-day hold If an intermediary sells shares that it just purchased and paid for by check or ACH transfer, the fund will process the redemption but will generally delay sending the proceeds for up to 10 calendar days to allow the check or transfer to clear. (The 10-day hold does not apply to purchases paid for by bank wire.) Redemptions over $250,000 Large redemptions can adversely affect a portfolio manager's ability to implement a fund's investment strategy by causing the premature sale of securities that would otherwise be held. If, in any 90-day period, you redeem (sell) more than $250,000, or your sale amounts to more than 1% of fund net assets, the fund has the right to pay the difference between the redemption amount and the lesser of the two previously mentioned figures with securities from the fund. Excessive Trading . T. Rowe Price may bar excessive traders from purchasing shares. Frequent trades or market timing in your account or accounts controlled by you can disrupt management of the fund and raise its expenses. To deter such activity, each fund has adopted the following excessive trading policy. You can make one purchase and one sale or one sale and one purchase involving the same fund within any 120-day period. If you exceed this limit or if you hold fund shares for less than 60 calendar days, you may be barred indefinitely and without further notice from further purchases of the T. Rowe Price funds. Systematic purchases and redemptions are exempt from this policy. Transactions accepted by intermediaries in violation of this excessive trading policy or from persons believed to be market timers are subject to rejection or cancellation by the funds. Signature Guarantees An intermediary may need to obtain a signature guarantee in certain situations and should consult its T. Rowe Price Financial Institution Services representative. You can obtain a signature guarantee from most banks, savings institutions, broker-dealers, and other guarantors acceptable to T. Rowe Price. We cannot accept guarantees from notaries public or organizations that do not provide reimbursement in the case of fraud. MORE ABOUT THE FUND ORGANIZATION AND MANAGEMENT ---------------------------------------------------------- How is the fund organized? The fund was incorporated in Maryland in 1973 and is a "diversified, open-end investment company," or mutual fund. Mutual funds pool money received from shareholders of each class into a single portfolio and invest it to try to achieve specified objectives. In 2002, the fund issued two separate share classes known as the Advisor Class and R Class. . Shareholders benefit from T. Rowe Price's 65 years of investment management experience. What is meant by "shares"? As with all mutual funds, investors purchase shares when they put money in a fund. These shares are part of a fund's authorized capital stock, but share certificates are not issued. Each share and fractional share entitles the shareholder to: . Receive a proportional interest in income and capital gain distributions of the class. The income dividends for New Income Fund-R Class shares will generally differ from those of the New Income Fund and New Income Fund-Advisor Class shares to the extent that the expense ratio of the classes differ. . Cast one vote per share on certain fund matters, including the election of fund directors, changes in fundamental policies, or approval of changes in the fund's management contract. Shareholders of each class have exclusive voting rights on matters affecting only that class. Do T. Rowe Price funds have annual shareholder meetings? The funds are not required to hold annual meetings and, to avoid unnecessary costs to fund shareholders, do not do so except when certain matters, such as a change in fundamental policies, must be decided. In addition, shareholders representing at least 10% of all eligible votes may call a special meeting, if they wish, for the purpose of voting on the removal of any fund director or trustee. If a meeting is held and you cannot attend, you can vote by proxy. Before the meeting, the fund will send you proxy materials that explain the issues to be decided and include instructions on voting by mail or telephone, or on the Internet. Who runs the fund? General Oversight The fund is governed by a Board of Directors that meets regularly to review the fund's investments, performance, expenses, and other business affairs. The Board elects the fund's officers. The majority of Board members are independent of T. Rowe Price Associates, Inc. (T. Rowe Price). . All decisions regarding the purchase and sale of fund investments are made by T. Rowe Price - specifically by the fund's portfolio managers. Portfolio Management The fund has an Investment Advisory Committee with the following members: William T. Reynolds, Chairman, Connice A. Bavely, Brian J. Brennan, Patrick S. Cassidy, Alan D. Levenson, Edmund M. Notzon III, Vernon A. Reid, Jr., Robert M. Rubino, and Daniel O. Shackelford. The committee chairman has day-to-day responsibility for managing the fund and works with the committee in developing and executing the fund's investment program. Mr. Reynolds became chairman of the fund's committee in 1998. He joined T. Rowe Price in 1981 and has been managing investments since 1978. The Management Fee This fee has two parts - an "individual fund fee," which reflects a fund's particular characteristics, and a "group fee." The group fee, which is designed to reflect the benefits of the shared resources of the T. Rowe Price investment management complex, is calculated daily based on the combined net assets of all T. Rowe Price funds (except the Spectrum Funds, and any institutional, index, or private label mutual funds). The group fee schedule (shown below) is graduated, declining as the asset total rises, so shareholders benefit from the overall growth in mutual fund assets. Group Fee Schedule
0.334%* First $50 billion 0.305% Next $30 billion 0.300% Next $40 billion 0.295% Thereafter -------------------------------------
* Represents a blended group fee rate containing various break points. The fund's portion of the group fee is determined by the ratio of its daily net assets to the daily net assets of all the T. Rowe Price funds described previously. Based on combined T. Rowe Price fund assets of over $94 billion at May 31, . 2002, the group fee was 0.32%. . The individual fund fee is 0.15%. Distribution, Shareholder Servicing, and Recordkeeping Fees New Income Fund-R Class has adopted a 12b-1 plan under which it pays a fee at the rate of up to 0.50% of its daily net assets per year to various intermediaries for distribution and servicing of its shares. These payments may be more or less than the costs incurred by the intermediaries. Because the fees are paid from the R Class net assets on an ongoing basis, they will increase the cost of your investment and, over time, could result in your paying more than with other types of sales charges. The R Class may also separately compensate intermediaries at a rate of up to 0.10% of daily net assets per year for various recordkeeping and transfer agent services they perform. UNDERSTANDING PERFORMANCE INFORMATION ---------------------------------------------------------- This section should help you understand the terms used to describe fund performance. Total Return This tells you how much an investment has changed in value over a given time period. It reflects any net increase or decrease in the share price and assumes that all dividends and capital gains (if any) paid during the period were reinvested in additional shares. Therefore, total return numbers include the effect of compounding. Advertisements may include cumulative or average annual total return figures, which may be compared with various indices, other performance measures, or other mutual funds. Cumulative Total Return This is the actual return of an investment for a specified period. A cumulative return does not indicate how much the value of the investment may have fluctuated during the period. For example, an investment could have a 10-year positive cumulative return despite experiencing some negative years during that time. Average Annual Total Return This is always hypothetical and should not be confused with actual year-by-year results. It smooths out all the variations in annual performance to tell you what constant year-by-year return would have produced the investment's actual cumulative return. This gives you an idea of an investment's annual contribution to your portfolio, provided you held it for the entire period. Yield The current or "dividend" yield on a fund or any investment tells you the relationship between the investment's current level of annual income and its price on a particular day. The dividend yield reflects the actual income paid to shareholders for a given period, annualized, and divided by the price at the end of the period. For example, a fund providing $5 of annual income per share and a price of $50 has a current yield of 10%. Yields can be calculated for any time period. The advertised or SEC yield is found by determining the net income per share (as defined by the Securities and Exchange Commission) earned by a fund during a 30-day base period and dividing this amount by the per share price on the last day of the base period. The SEC yield-also called the standardized yield-may differ from the dividend yield. INVESTMENT POLICIES AND PRACTICES ---------------------------------------------------------- This section takes a detailed look at some of the types of fund securities and the various kinds of investment practices that may be used in day-to-day portfolio management. Fund investments are subject to further restrictions and risks described in the Statement of Additional Information. Shareholder approval is required to substantively change fund objectives and certain investment restrictions noted in the following section as "fundamental policies." The managers also follow certain "operating policies" which can be changed without shareholder approval. However, significant changes are discussed with shareholders in fund reports. Fund investment restrictions and policies apply at the time of investment. A later change in circumstances will not require the sale of an investment if it was proper at the time it was made. Fund holdings of certain kinds of investments cannot exceed maximum percentages of total assets, which are set forth in this prospectus. For instance, fund investments in hybrid instruments are limited to 10% of total assets. While these restrictions provide a useful level of detail about fund investments, investors should not view them as an accurate gauge of the potential risk of such investments. For example, in a given period, a 5% investment in hybrid instruments could have significantly more of an impact on a fund's share price than its weighting in the portfolio. The net effect of a particular investment depends on its volatility and the size of its overall return in relation to the performance of all other fund investments. Changes in fund holdings, fund performance, and the contribution of various investments are discussed in the shareholder reports sent to you. . Fund managers have considerable leeway in choosing investment strategies and selecting securities they believe will help achieve fund objectives. Types of Portfolio Securities In seeking to meet its investment objective, the fund may invest in any type of security or instrument (including certain potentially high-risk derivatives described in this section) whose investment characteristics are consistent with its investment program. The following pages describe various types of fund securities and investment management practices. Fundamental policy The fund will not purchase a security if, as a result, with respect to 75% of its total assets, more than 5% of its total assets would be invested in securities of a single issuer, or if more than 10% of the outstanding voting securities of the issuer would be held by the fund. These limitations do not apply to the fund's purchase of securities issued or guaranteed by the U.S. government, its agencies, or instrumentalities. Bonds A bond is an interest-bearing security. The issuer has a contractual obligation to pay interest at a stated rate on specific dates and to repay principal (the bond's face value) on a specified date. An issuer may have the right to redeem or "call" a bond before maturity, and the investor may have to reinvest the proceeds at lower market rates. A bond's annual interest income, set by its coupon rate, is usually fixed for the life of the bond. Its yield (income as a percent of current price) will fluctuate to reflect changes in interest rate levels. A bond's price usually rises when interest rates fall, and vice versa, so its yield stays consistent with current market conditions. Bonds may be unsecured (backed by the issuer's general creditworthiness only) or secured (also backed by specified collateral).Bonds include asset- and mortgage-backed securities. Certain bonds have interest rates that are adjusted periodically. These interest rate adjustments tend to minimize fluctuations in the bonds' principal values. The maturity of those securities may be shortened under certain specified conditions. Bonds may be designated as senior or subordinated obligations. Senior obligations generally have the first claim on a corporation's earnings and assets and, in the event of liquidation, are paid before subordinated debt. Common and Preferred Stocks Stocks represent shares of ownership in a company. Generally, preferred stock has a specified dividend and ranks after bonds and before common stocks in its claim on income for dividend payments and on assets should the company be liquidated. After other claims are satisfied, common stockholders participate in company profits on a pro-rata basis; profits may be paid out in dividends or reinvested in the company to help it grow. Increases and decreases in earnings are usually reflected in a company's stock price, so common stocks generally have the greatest appreciation and depreciation potential of all corporate securities. While most preferred stocks pay a dividend, preferred stock may be purchased where the issuer has omitted, or is in danger of omitting, payment of its dividend. Such investments would be made primarily for their capital appreciation potential. Convertible Securities and Warrants Investments may be made in debt or preferred equity securities convertible into, or exchangeable for, equity securities. Traditionally, convertible securities have paid dividends or interest at rates higher than common stocks but lower than nonconvertible securities. They generally participate in the appreciation or depreciation of the underlying stock into which they are convertible, but to a lesser degree. In recent years, convertibles have been developed which combine higher or lower current income with options and other features. Warrants are options to buy a stated number of shares of common stock at a specified price anytime during the life of the warrants (generally, two or more years). Warrants can be highly volatile, have no voting rights, and pay no dividends. Operating policy Without regard to quality, the fund may invest up to 25% of its total assets (not including cash) in preferred and common stocks and convertible securities, convertible into or which carry warrants for common stocks or other equity securities. Foreign Securities Investments may be made in foreign securities. These include nondollar- denominated securities traded outside of the U.S. and dollar-denominated securities of foreign issuers traded in the U.S. (such as Yankee bonds). Such investments increase a portfolio's diversification and may enhance return, but they also involve some special risks such as exposure to potentially adverse local, political, and economic developments; nationalization and exchange controls; potentially lower liquidity and higher volatility; possible problems arising from accounting, disclosure, settlement, and regulatory practices that differ from U.S. standards; and the chance that fluctuations in foreign exchange rates will decrease the investment's value (favorable changes can increase its value). These risks are heightened for investments in developing countries. Operating policy There is no limit on fund investments in U.S. dollar-denominated debt securities issued by foreign issuers, foreign branches of U.S. banks, and U.S. branches of foreign banks. The fund may also invest up to 20% of its total assets (excluding reserves) in non-U.S. dollar-denominated fixed-income securities. Asset-Backed Securities An underlying pool of assets, such as credit card or automobile trade receivables or corporate loans or bonds, backs these bonds and provides the interest and principal payments to investors. On occasion, the pool of assets may also include a swap obligation, which is used to change the cash flows on the underlying assets. As an example, a swap may be used to allow floating rate assets to back a fixed-rate obligation. Credit quality depends primarily on the quality of the underlying assets, the level of credit support, if any, provided by the structure or by a third-party insurance wrap, and the credit quality of the swap counterparty, if any. The underlying assets (i.e., loans) are sometimes subject to prepayments, which can shorten the security's weighted average life and may lower its return. The value of these securities also may change because of actual or perceived changes in the creditworthiness of the originator, the servicing agent, the financial institution providing the credit support, or the swap counterparty. There is no limit on fund investments in these securities. Mortgage-Backed Securities The fund may invest in a variety of mortgage-backed securities. Mortgage lenders pool individual home mortgages with similar characteristics to back a certificate or bond, which is sold to investors such as the fund. Interest and principal payments generated by the underlying mortgages are passed through to the investors. The "big three" issuers are the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac). GNMA certificates are backed by the full faith and credit of the U.S. government, while others, such as Fannie Mae and Freddie Mac certificates, are only supported by the ability to borrow from the U.S. Treasury or by the credit of the agency. Private mortgage bankers and other institutions also issue mortgage-backed securities. Mortgage-backed securities are subject to scheduled and unscheduled principal payments as homeowners pay down or prepay their mortgages. As these payments are received, they must be reinvested when interest rates may be higher or lower than on the original mortgage security. Therefore, these securities are not an effective means of locking in long-term interest rates. In addition, when interest rates fall, the pace of mortgage prepayments picks up. These refinanced mortgages are paid off at face value (par), causing a loss for any investor who may have purchased the security at a price above par. In such an environment, this risk limits the potential price appreciation of these securities and can negatively affect the fund's net asset value. When rates rise, the prices of mortgage-backed securities can be expected to decline, although historically these securities have experienced smaller price declines than comparable quality bonds. In addition, when rates rise and prepayments slow, the effective duration of mortgage-backed securities extends, resulting in increased volatility. . There is no limit on fund investments in mortgage-backed securities. Additional mortgage-backed securities in which the fund may invest include: . Collateralized Mortgage Obligations (CMOs) CMOs are debt securities that are fully collateralized by a portfolio of mortgages or mortgage-backed securities. All interest and principal payments from the underlying mortgages are passed through to the CMOs in such a way as to create some classes with more stable average lives than the underlying mortgages and other classes with more volatile average lives. CMO classes may pay fixed or variable rates of interest, and certain classes have priority over others with respect to the receipt of prepayments. . Stripped Mortgage Securities Stripped mortgage securities (a type of potentially high-risk derivative) are created by separating the interest and principal payments generated by a pool of mortgage-backed securities or a CMO to create additional classes of securities. Generally, one class receives only interest payments (IOs), and another receives principal payments (POs). Unlike with other mortgage-backed securities and POs, the value of IOs tends to move in the same direction as interest rates. The fund can use IOs as a hedge against falling prepayment rates (interest rates are rising) and/or a bear market environment. POs can be used as a hedge against rising prepayment rates (interest rates are falling) and/or a bull market environment. IOs and POs are acutely sensitive to interest rate changes and to the rate of principal prepayments. A rapid or unexpected increase in prepayments can severely depress the price of IOs, while a rapid or unexpected decrease in prepayments could have the same effect on POs. Of course, under the opposite conditions these securities may appreciate in value. These securities can be very volatile in price and may have lower liquidity than most other mortgage-backed securities. Certain non-stripped CMO classes may also exhibit these qualities, especially those that pay variable rates of interest that adjust inversely with, and more rapidly than, short-term interest rates. In addition, if interest rates rise rapidly and prepayment rates slow more than expected, certain CMO classes, in addition to losing value, can exhibit characteristics of longer-term securities and become more volatile. There is no guarantee that fund investments in CMOs, IOs, or POs will be successful, and fund total return could be adversely affected as a result. Operating policy Fund investments in stripped mortgage securities are limited to 10% of total assets. . Commercial Mortgage-Backed Securities (CMBS) CMBS are securities created from a pool of commercial mortgage loans, such as loans for hotels, shopping centers, office buildings, apartment buildings, etc. Interest and principal payments from the loans are passed on to the investor according to a schedule of payments. Credit quality depends primarily on the quality of the loans themselves and on the structure of the particular deal. Generally, deals are structured with senior and subordinate classes. The amount of subordination is determined by the rating agencies who rate the individual classes of the structure. Commercial mortgages are generally structured with prepayment penalties, which greatly reduces prepayment risk to the investor. However, the value of these securities may change because of actual or perceived changes in the creditworthiness of the individual borrowers, their tenants, the servicing agents, or the general state of commercial real estate. There is no limit on fund investments in these securities. Hybrid Instruments These instruments (a type of potentially high-risk derivative) can combine the characteristics of securities, futures, and options. For example, the principal amount or interest rate of a hybrid could be tied (positively or negatively) to the price of some commodity, currency, or securities index or another interest rate (each a "benchmark"). Hybrids can be used as an efficient means of pursuing a variety of investment goals, including currency hedging, duration management, and increased total return. Hybrids may or may not bear interest or pay dividends. The value of a hybrid or its interest rate may be a multiple of a benchmark and, as a result, may be leveraged and move (up or down) more steeply and rapidly than the benchmark. These benchmarks may be sensitive to economic and political events, such as commodity shortages and currency devaluations,which cannot be readily foreseen by the purchaser of a hybrid. Under certain conditions, the redemption value of a hybrid could be zero. Thus, an investment in a hybrid may entail significant market risks that are not associated with a similar investment in a traditional, U.S. dollar-denominated bond that has a fixed principal amount and pays a fixed rate or floating rate of interest. The purchase of hybrids also exposes the fund to the credit risk of the issuer of the hybrid. These risks may cause significant fluctuations in the net asset value of the fund. . Hybrids can have volatile prices and limited liquidity, and their use may not be successful. Operating policy Fund investments in hybrid instruments are limited to 10% of total assets. Deferrable Subordinated Securities These are securities with long maturities that are deeply subordinated in the issuer's capital structure. They generally have 30-year maturities and permit the issuer to defer distributions for up to five years. These characteristics give the issuer more financial flexibility than is typically the case with traditional bonds. As a result, the securities may be viewed as possessing certain "equity-like" features by rating agencies and bank regulators. However, the securities are treated as debt securities by market participants, and the fund intends to treat them as such as well. These securities may offer a mandatory put or remarketing option that creates an effective maturity date significantly shorter than the stated one. Fund investments will be made in these securities to the extent their yield, credit, and maturity characteristics are consistent with the fund's investment objective and program. Private Placements These securities are sold directly to a small number of investors, usually institutions. Unlike public offerings, such securities are not registered with the SEC. Although certain of these securities may be readily sold, for example, under Rule 144A, others may be illiquid, and their sale may involve substantial delays and additional costs. Operating policy Fund investments in illiquid securities are limited to 15% of net assets. Utility Industry Concentration The fund may, under certain circumstances, invest a substantial amount of its assets in the utility industry. Investments in this industry may be affected by environmental conditions, energy conservation programs, fuel shortages, availability of capital to finance operations and construction programs, and federal and state legislative and regulatory actions. T. Rowe Price believes that any risk to the fund which might result from concentrating in any such industry will be minimized by diversification of the fund's investments. Operating policy The fund has no current intention of concentrating in the utility industry. Fundamental policy The fund will, under certain conditions, invest up to 50% of its assets in any one of the following industries: gas utility, gas transmission utility, electric utility, telephone utility, and petroleum. Types of Investment Management Practices Reserve Position A certain portion of fund assets will be held in money market reserves. Fund reserve positions are expected to consist primarily of shares of one or more T. Rowe Price internal money market funds. Short-term, high-quality U.S. and foreign dollar-denominated money market securities, including repurchase agreements, may also be held. For temporary, defensive purposes, there is no limit on fund investments in money market reserves. The effect of taking such a position is that the fund may not achieve its investment objective. The reserve position provides flexibility in meeting redemptions, paying expenses, and in the timing of new investments and can serve as a short-term defense during periods of unusual market volatility. Borrowing Money and Transferring Assets Fund borrowings may be made from banks and other T. Rowe Price funds for temporary emergency purposes to facilitate redemption requests, or for other purposes consistent with fund policies as set forth in this prospectus. Such borrowings may be collateralized with fund assets, subject to restrictions. Fundamental policy Borrowings may not exceed 33/1//\\/3/\\% of total assets. Operating policy Fund transfers of portfolio securities as collateral will not be made except as necessary in connection with permissible borrowings or investments, and then such transfers may not exceed 33/1//\\/3/\\% of total assets. Fund purchases of additional securities will not be made when borrowings exceed 5% of total assets. Futures and Options Futures, a type of potentially high-risk derivative, are often used to manage or hedge risk because they enable the investor to buy or sell an asset in the future at an agreed-upon price. Options, another type of potentially high-risk derivative, give the investor the right (where the investor purchases the option), or the obligation (where the investor "writes" or sells the option), to buy or sell an asset at a predetermined price in the future. Futures and options contracts may be bought or sold for any number of reasons, including: to manage fund exposure to changes in interest rates, bond prices, and foreign currencies; as an efficient means of adjusting fund overall exposure to certain markets; in an effort to enhance income; to protect the value of portfolio securities; as a cash manage ment tool; and to adjust portfolio duration. Call or put options may be purchased or sold on securities, financial indices, and foreign currencies. Futures contracts and options may not always be successful hedges; their prices can be highly volatile; using them could lower fund total return; and the potential loss from the use of futures can exceed a fund's initial investment in such contracts. Operating policies Futures: Initial margin deposits and premiums on options used for nonhedging purposes will not exceed 5% of fund net asset value. Options on securities: The total market value of securities covering call or put options may not exceed 25% of fund total assets. No more than 5% of fund total assets will be committed to premiums when purchasing call or put options. . Swaps The fund may enter into interest rate, index, total return, and credit swap agreements. The fund may also enter into options on swap agreements or swap options. All of these agreements are considered derivatives and, in certain cases, high-risk derivatives. Swap agreements are two-party contracts under which the fund and a counterparty, such as a broker or dealer, agree to exchange the returns (or differentials in rates of return) earned or realized on particular predetermined investments or indices. Swaps and swap options can be used for a variety of purposes, including: to manage fund exposure to changes in interest rates and credit quality; as an efficient means of adjusting fund overall exposure to certain markets; to enhance income or total return; to protect the value of portfolio securities; to serve as a cash management tool; and to adjust portfolio duration. There are risks in the use of swaps and swap options. Swaps could result in losses if interest rate or credit quality are not correctly anticipated by the fund. Total return swaps could result in losses if the reference index, security, or investments do not perform as anticipated by the fund. Credit default swaps could result in losses if the fund does not correctly evaluate the creditworthiness of the company on which the credit default swap is based. Swaps and swap options may not always be successful hedges; using them could lower fund total return and the other party to a swap agreement could default on its obligations or refuse to cash out the fund's investment at a reasonable price, which could turn an expected gain into a loss. Operating policies The fund will not enter into a swap agreement with any single counterparty if the net amount owed or to be received under existing contracts with that party would exceed 5% of total assets, or if the net amount owed or to be received by the fund under all outstanding swap agreements will exceed 10% of total assets. The total market value of securities covering call or put options may not exceed 25% of total assets. No more than 5% of total assets will be committed to premiums when purchasing call or put options. Managing Foreign Exchange Risk Investors in foreign securities may attempt to "hedge" their exposure to potentially unfavorable currency changes. The primary means of doing this is through the use of "forwards"- contracts to exchange one currency for another on some future date at a specified exchange rate. However, futures, swaps, and options on these instruments may also be used. In certain circumstances, a "proxy currency" may be substituted for the currency in which the investment is denominated, a strategy known as "proxy hedging." The fund may also use these instruments to create a synthetic bond issued in one currency, but with the currency component transformed into another currency. If the fund were to engage in any of these foreign currency transactions, they would be used primarily to protect the fund's foreign securities from adverse currency movements relative to the dollar. Such transactions involve the risk that anticipated currency movements will not occur, and the fund's total return could be reduced. Operating policy The fund will not commit more than 20% of its total assets to any combination of foreign currency instruments. Lending of Portfolio Securities Fund securities may be lent to broker-dealers, other institutions, or other persons to earn additional income. Risks include the potential insolvency of the broker-dealer or other borrower that could result in delays in recovering securities and capital losses. Additionally, losses could result from the reinvestment of collateral received on loaned securities. Fundamental policy The value of loaned securities may not exceed 33/1//\\/3/\\% of total assets. When-Issued Securities and Forward Commitment Contracts The fund may purchase securities on a when-issued or delayed delivery basis or may purchase or sell securities on a forward commitment basis. There is no limit on fund investments in these securities. The price of these securities is fixed at the time of the commitment to buy, but delivery and payment can take place a month or more later. During the interim period, the market value of the securities can fluctuate, and no interest accrues to the purchaser. At the time of delivery, the value of the securities may be more or less than the purchase or sale price. To the extent the fund remains fully or almost fully invested (in securities with a remaining maturity of more than one year) at the same time it purchases these securities, there will be greater fluctuations in the fund's net asset value than if the fund did not purchase them. Portfolio Turnover Turnover is an indication of frequency of trading. The fund will not generally trade in securities for short-term profits, but, when circumstances warrant, securities may be purchased and sold without regard to the length of time held. A high turnover rate may increase transaction costs, result in additional capital gain distributions, and reduce fund total return. The fund's portfolio turnover rates are shown in the Financial Highlights table. FINANCIAL HIGHLIGHTS ---------------------------------------------------------- New Income Fund-R Class first issued shares on September 30, 2002, and therefore has no financial history. As a point of comparison, however, Table 4 provides historical information about the New Income Fund because New Income Fund-R Class has the same management program and investment portfolio. (Prior to the inception of New Income Fund-R Class, New Income Fund had no other share class.) This information is based on a single share of the New Income Fund outstanding throughout each of its fiscal years. This table is part of the New Income Fund's financial statements, which are included in its annual report and are incorporated by reference into the Statement of Additional Information (available upon request). The total returns in the table represent the rate that an investor would have earned or lost on an investment in the fund (assuming reinvestment of all dividends and distributions). The financial statements in the annual report were audited by the fund's independent accountants, PricewaterhouseCoopers LLP. Had the New Income Fund-R Class existed during the period reflected in the table, some financial information would be different because of its higher anticipated expense ratio. Table 4 Financial Highlights
Year ended May 31 1998 1999 2000 2001 2002 ------------------------------------------------------------------------------- Net asset value, beginning of period $ 8.77 $ 9.09 $ 8.50 $ 8.07 $ 8.53 Income From Investment Operations Net investment income 0.57 0.54 0.52 0.53 0.47 --------------------------------------------- Net gains or losses on securities (both realized 0.36 (0.45) (0.43) 0.46 0.17 and unrealized) --------------------------------------------- Total from investment operations 0.93 0.09 0.09 0.99 0.64 Less Distributions Dividends (from net (0.57) (0.54) (0.52) (0.53) (0.47) investment income) --------------------------------------------- Distributions (from (0.04) (0.14) -- -- -- capital gains) --------------------------------------------- Returns of capital -- -- -- -- -- --------------------------------------------- Total distributions (0.61) (0.68) (0.52) (0.53) (0.47) --------------------------------------------- Net asset value, $ 9.09 $ 8.50 $ 8.07 $ 8.53 $ 8.70 end of period --------------------------------------------- Total return 10.84% 1.02% 1.13% 12.54% 7.68% Ratios/Supplemental Data Net assets, end of period $2,076 $1,942 $1,633 $1,684 $1,863 (in millions) --------------------------------------------- Ratio of expenses to 0.71% 0.72% 0.73% 0.73% 0.72% average net assets --------------------------------------------- Ratio of net income to 6.31% 6.16% 6.32% 6.30% 5.38% average net assets --------------------------------------------- Portfolio turnover rate 147.3% 94.3% 83.6% 112.1% 222.0% -------------------------------------------------------------------------------
INVESTING WITH T. ROWE PRICE ACCOUNT REQUIREMENTS AND TRANSACTION INFORMATION ---------------------------------------------------------- Tax Identification Number The intermediary must provide us with its certified Social Security or tax identification number (TIN). Otherwise, federal law requires the funds to withhold a percentage (currently 30%) of dividends, capital gain distributions, and redemptions, and may subject the intermediary or account holder to an IRS fine. If this information is not received within 60 days after the account is established, the account may be redeemed at the fund's NAV on the redemption date. The information in this section is for use by intermediaries only. Shareholders should contact their intermediary for information regarding the intermediary's policies on purchasing, exchanging, and redeeming fund shares as well as initial and subsequent investment minimums. All initial and subsequent investments by intermediaries must be made by bank wire. Opening a New Account $2,500 minimum initial investment; $1,000 for retirement plans or gifts or transfers to minors (UGMA/UTMA) accounts Intermediaries should call Financial Institution Services for an account number and assignment to a dedicated service representative and give the following wire information to their bank: Receiving Bank: PNC Bank, N.A. (Pittsburgh) Receiving Bank ABA#: 043000096 Beneficiary: T. Rowe Price [fund name] Beneficiary Account: 1004397951 Originator to Beneficiary Information (OBI): name of owner(s) and account number Complete a New Account Form and mail it to one of the appropriate addresses listed below. Intermediaries must also enter into a separate agreement with the fund or its agent. via U.S. Postal Service T. Rowe Price Financial Institution Services P.O. Box 17603 Baltimore, MD 21297-1603 via private carriers/overnight services T. Rowe Price Financial Institution Services Mail Code: OM-17603 4515 Painters Mill Road Owings Mills, MD 21117-4842 PURCHASING ADDITIONAL SHARES ---------------------------------------------------------- $100 minimum additional purchase; $50 minimum for retirement plans, Automatic Asset Builder, and gifts or transfers to minors (UGMA/UTMA) accounts By Wire Intermediaries should call Financial Institution Services or use the wire instructions listed in Opening a New Account. EXCHANGING AND REDEEMING SHARES ---------------------------------------------------------- Exchange Service You can move money from one account to an existing identically registered account or open a new identically registered account. Intermediaries should call their Financial Institution Services representative. Redemptions Unless otherwise indicated, redemption proceeds will be wired to the intermediary's designated bank. Intermediaries should contact their Financial Institution Services representative. RIGHTS RESERVED BY THE FUNDS ---------------------------------------------------------- T. Rowe Price funds and their agents reserve the following rights: (1) to refuse any purchase or exchange order; (2) to cancel or rescind any purchase or exchange order (including, but not limited to, orders deemed to result in excessive trading, market timing, fraud, or 5% ownership) upon notice to the intermediary within five business days of the trade or if the written confirmation has not been received by the shareholder, whichever is sooner; (3) to cease offering fund shares at any time to all or certain groups of investors; (4) to freeze any account and suspend account services when notice has been received of a dispute between the registered or beneficial account owners or there is reason to believe a fraudulent transaction may occur; (5) to otherwise modify the conditions of purchase and any services at any time; and (6) to act on instructions reasonably believed to be genuine. These actions will be taken when, in the sole discretion of management, they are deemed to be in the best interest of the fund. In an effort to protect T. Rowe Price funds from the possible adverse effects of a substantial redemption in a large account, as a matter of general policy, no shareholder or group of shareholders controlled by the same person or group of persons will knowingly be permitted to purchase in excess of 5% of the outstanding shares of a fund, except upon approval of the fund's management. T. ROWE PRICE PRIVACY POLICY ---------------------------------------------------------- In the course of doing business with T. Rowe Price, you share personal and financial information with us. We treat this information as confidential and recognize the importance of protecting access to it. You may provide information when communicating or transacting with us in writing, electronically, or by phone. For instance, information may come from applications, requests for forms or literature, and your transactions and account positions with us. On occasion, such information may come from consumer reporting agencies and those providing services to us. We do not sell information about current or former customers to any third parties, and we do not disclose it to third parties unless necessary to process a transaction, service an account, or as otherwise permitted by law. We may share information within the T. Rowe Price family of companies in the course of providing or offering products and services to best meet your investing needs. We may also share that information with companies that perform administrative or marketing services for T. Rowe Price, with a research firm we have hired, or with a business partner, such as a bank or insurance company with whom we are developing or offering investment products. When we enter into such a relationship, our contracts restrict the companies' use of our customer information, prohibiting them from sharing or using it for any purposes other than those for which they were hired. We maintain physical, electronic, and procedural safeguards to protect your personal information. Within T. Rowe Price, access to such information is limited to those who need it to perform their jobs, such as servicing your accounts, resolving problems, or informing you of new products or services. Finally, our Code of Ethics, which applies to all employees, restricts the use of customer information and requires that it be held in strict confidence. This Privacy Policy applies to the following T. Rowe Price family of companies: T. Rowe Price Associates, Inc.; T. Rowe Price Advisory Services, Inc.; T. Rowe Price Investment Services, Inc.; T. Rowe Price Savings Bank; T. Rowe Price Trust Company; and the T. Rowe Price Funds. T. Rowe Price Associates, Inc. 100 East Pratt Street Baltimore, MD 21202 A fund Statement of Additional Information has been filed with the Securities and Exchange Commission and is incorporated by reference into this prospectus. Further information about fund investments, including a review of market conditions and the manager's recent strategies and their impact on performance, is available in the annual and semiannual shareholder reports. To obtain free copies of any of these documents, call your intermediary. Fund information and Statements of Additional Information are also available from the Public Reference Room of the Securities and Exchange Commission. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-202-942-8090. Fund reports and other fund information are available on the EDGAR Database on the SEC's Internet site at http://www.sec.gov. Copies of this information may be obtained, after paying a duplicating fee, by electronic request at publicinfo@sec.gov, or by writing the Public Reference Room, Washington D.C. 20549-0102. 1940 Act File No. 811-2396 E443-040 9/30/02 STATEMENT OF ADDITIONAL INFORMATION The date of this Statement of Additional Information is September 30, 2002. T. ROWE PRICE CORPORATE INCOME FUND, INC. T. ROWE PRICE GNMA FUND T. ROWE PRICE HIGH YIELD FUND, INC. T. Rowe Price High Yield Fund-Advisor Class T. ROWE PRICE INSTITUTIONAL INCOME FUNDS, INC. T. Rowe Price Institutional High Yield Fund T. ROWE PRICE NEW INCOME FUND, INC. T. Rowe Price New Income Fund-Advisor Class T. Rowe Price New Income Fund-R Class T. ROWE PRICE PERSONAL STRATEGY FUNDS, INC. T. Rowe Price Personal Strategy Balanced Fund T. Rowe Price Personal Strategy Growth Fund T. Rowe Price Personal Strategy Income Fund T. ROWE PRICE PRIME RESERVE FUND, INC. T. Rowe Price Prime Reserve Fund T. Rowe Price Prime Reserve Fund-PLUS Class T. ROWE PRICE RESERVE INVESTMENT FUNDS, INC. T. Rowe Price Government Reserve Investment Fund T. Rowe Price Reserve Investment Fund T. ROWE PRICE SHORT-TERM BOND FUND, INC. and T. ROWE PRICE U.S. TREASURY FUNDS, INC. U.S. Treasury Intermediate Fund U.S. Treasury Long-Term Fund U.S. Treasury Money Fund ------------------------------------------------------------------------------- Mailing Address: T. Rowe Price Investment Services, Inc. 100 East Pratt Street Baltimore, Maryland 21202 1-800-638-5660 Throughout this Statement of Additional Information, "the fund" is intended to refer to each fund listed on the cover page, unless otherwise indicated. For convenience, the term "director" is used to refer to both directors of funds that are corporations and to trustees of funds that are Massachusetts business trusts. This Statement of Additional Information is not a prospectus but should be read in conjunction with the appropriate fund prospectus dated October 1, 2002 (or September 30, 2002 for New Income Fund-Advisor Class and New Income Fund-R Class), which may be obtained from T. Rowe Price Investment Services, Inc. ("Investment Services"). Each fund'sfinancial statements for the fiscal period ended May 31, 2002, and the report of independent accountants are included in each fund's Annual Report and incorporated by reference into this Statement of Additional Information. If you would like a prospectus or an annual or semiannual shareholder report for a fund of which you are not a shareholder, please call 1-800-638-5660 and they will be sent to you at no charge. Please read them carefully. C22-043 9/30/02 Government Reserve Investment Fund ("GRF") and Reserve Investment Fund ("RIF") are not available for direct purchase by members of the public.
TABLE OF CONTENTS ----------------- Page Page ---- ---- Capital Stock 77 Management of the Fund 3 8 ------------------------------ -------------------------------------------- Code of Ethics Net Asset Value 64 p 72 er Share ------------------------------ -------------------------------------------- Custodian 64 Portfolio Management Practices 19 ------------------------------ -------------------------------------------- Distributor for the 63 Portfolio Transactions 65 Fund ------------------------------ -------------------------------------------- Dividends and 73 Pricing of Securities 70 Distributions ------------------------------ -------------------------------------------- Federal Registration 79 Principal Holders of Securities 56 of Shares ------------------------------ -------------------------------------------- Independent 79 Ratings of Commercial Paper 81 Accountants ------------------------------ -------------------------------------------- Investment Management 58 Ratings of Corporate Debt Securities 82 Services ------------------------------ -------------------------------------------- Investment Objectives 2 Risk Factors 2 and Policies ------------------------------ -------------------------------------------- Investment Performance 75 Services 62 by Outside Parties ------------------------------ -------------------------------------------- Investment Program 7 Tax Status 73 ------------------------------ -------------------------------------------- Investment 34 Yield Information 74 Restrictions ------------------------------ -------------------------------------------- Legal Counsel 79 ------------------------------ --------------------------------------------
INVESTMENT OBJECTIVES AND POLICIES ------------------------------------------------------------------------------- The following information supplements the discussion of each fund's investment objectives and policies discussed in each fund's prospectus. Shareholder approval is required to substantively change fund objectives. Unless otherwise specified, the investment programs and restrictions of the funds are not fundamental policies. Each fund's operating policies are subject to change by each Board of Directors without shareholder approval. However, shareholders will be notified of a material change in an operating policy. Each fund's fundamental policies may not be changed without the approval of at least a majority of the outstanding shares of the fund or, if it is less, 67% of the shares represented at a meeting of shareholders at which the holders of 50% or more of the shares are represented. References to the following are as indicated: Investment Company Act of 1940 ("1940 Act") Securities and Exchange Commission ("SEC") T. Rowe Price Associates, Inc. ("T. Rowe Price") Moody's Investors Service, Inc. ("Moody's") Standard & Poor's Corporation ("S&P") Internal Revenue Code of 1986 ("Code") T. Rowe Price International, Inc. ("T. Rowe Price International") RISK FACTORS ------------------------------------------------------------------------------- Reference is also made to the sections entitled "Investment Program" and "Portfolio Management Practices" for discussions of the risks associated with the investments and practices described therein as they apply to the fund. 2 All funds Debt Obligations Yields on short-, intermediate-, and long-term debt securities are dependent on a variety of factors, including the general conditions of the money and bond markets, the maturity of the obligation, and the credit quality and rating of the issue. Debt securities with longer maturities tend to have higher yields and are generally subject to potentially greater capital appreciation and depreciation than obligations with shorter maturities and lower yields. The market prices of debt securities usually vary, depending upon available yields. An increase in interest rates will generally reduce the value of portfolio debt securities, and a decline in interest rates will generally increase the value of portfolio debt securities. The ability of the fund to achieve its investment objective is also dependent on the continuing ability of the issuers of the debt securities in which the fund invests to meet their obligations for the payment of interest and principal when due. Although the fund seeks to reduce risk by portfolio diversification, credit analysis, and attention to trends in the economy, industries, and financial markets, such efforts will not eliminate all risk. There can, of course, be no assurance that the fund will achieve its investment objective. After purchase by the fund, a debt security may cease to be rated or its rating may be reduced below the minimum required for purchase by the fund. Neither event will require a sale of such security by the fund. However, T. Rowe Price will consider such events in its determination of whether the fund should continue to hold the security. To the extent that the ratings given by Moody's or S&P may change as a result of changes in such organizations or their rating systems, the fund will attempt to use comparable ratings as standards for investments in accordance with the investment policies contained in the prospectus. When purchasing unrated securities, T. Rowe Price, under the supervision of the fund's Board of Directors, determines whether the unrated security is of a quality comparable to that which the fund is allowed to purchase. Government Reserve Investment, Prime Reserve, Reserve Investment, and U.S. Treasury Money Funds There can be no assurance that the fund will achieve its investment objective or be able to maintain its net asset value per share at $1.00. The price of the fund is not guaranteed or insured by the U.S. government and its yield is not fixed. An increase in interest rates could reduce the value of the fund's portfolio investments, and a decline in interest rates could increase the value. All funds except Government Reserve Investment, Prime Reserve, Reserve Investment, and U.S. Treasury Money Funds Because of its investment policy, the fund may or may not be suitable or appropriate for any particular investor. The fund is not a money market fund and is not an appropriate investment for those whose primary objective is principal stability. The value of the portfolio securities of the fund will fluctuate based upon market conditions. Although the fund seeks to reduce risk by investing in a diversified portfolio, such diversification does not eliminate all risk. Mortgage-backed securities differ from conventional bonds in that principal is paid back over the life of the security rather than at maturity. As a result, the holder of a mortgage-backed security (i.e., the fund) receives monthly scheduled payments of principal and interest, and may receive unscheduled principal payments representing prepayments on the underlying mortgages. The incidence of unscheduled principal prepayments is also likely to increase in mortgage pools owned by the fund when prevailing mortgage loan rates fall below the mortgage rates of the securities underlying the individual pool. The effect of such prepayments in a falling rate environment is to (1) cause the fund to reinvest principal payments at the then lower prevailing interest rate, and (2) reduce the potential for capital appreciation beyond the face amount of the security. Conversely, the fund may realize a gain on prepayments of mortgage pools trading at a discount. Such prepayments will provide an early return of principal which may then be reinvested at the then higher prevailing interest rate. The market value of adjustable rate mortgage securities ("ARMs"), 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. Because of their periodic adjustment feature, ARMs should be more sensitive to short-term interest rates than long-term rates. They should also display less volatility than long-term mortgage-backed securities. Thus, while having less risk of a decline during periods of rapidly rising rates, 3 ARMs may also have less potential for capital appreciation than other investments of comparable maturities. Interest rate caps on mortgages underlying ARM securities may prevent income on the ARM from increasing to prevailing interest rate levels and cause the securities to decline in value. In addition, to the extent ARMs are purchased at a premium, mortgage foreclosures and unscheduled principal prepayments may result in some loss of the holders' principal investment to the extent of the premium paid. On the other hand, if ARMs are purchased at a discount, both a scheduled payment of principal and an unscheduled prepayment of principal will increase current and total returns and will accelerate the recognition of income which, when distributed to shareholders, will be taxable as ordinary income. Corporate Income, High Yield, Institutional High Yield, and Personal Strategy Funds Special Risks of Investing in Junk Bonds The following special considerations are additional risk factors associated with the fund's investments in lower-rated debt securities. . Youth and Growth of the Lower-Rated Debt Securities Market The market for lower-rated debt securities is relatively new and its growth has paralleled a long economic expansion. Past experience may not, therefore, provide an accurate indication of future performance of this market, particularly during periods of economic recession. An economic downturn or increase in interest rates is likely to have a greater negative effect on this market, the value of lower-rated debt securities in the fund's portfolio, the fund's net asset value and the ability of the bonds' issuers to repay principal and interest, meet projected business goals, and obtain additional financing than on higher-rated securities. These circumstances also may result in a higher incidence of defaults than with respect to higher-rated securities. An investment in the fund is more risky than investment in shares of a fund which invests only in higher-rated debt securities. . Sensitivity to Interest Rate and Economic Changes Prices of lower-rated debt securities may be more sensitive to adverse economic changes or corporate developments than higher-rated investments. Debt securities with longer maturities, which may have higher yields, may increase or decrease in value more than debt securities with shorter maturities. Market prices of lower-rated debt securities structured as zero-coupon or pay-in-kind securities are affected to a greater extent by interest rate changes and may be more volatile than securities which pay interest periodically and in cash. Where it deems it appropriate and in the best interests of fund shareholders, the fund may incur additional expenses to seek recovery on a debt security on which the issuer has defaulted and to pursue litigation to protect the interests of security holders of its portfolio companies. . Liquidity and Valuation Because the market for lower-rated securities may be thinner and less active than for higher-rated securities, there may be market price volatility for these securities and limited liquidity in the resale market. Nonrated securities are usually not as attractive to as many buyers as rated securities are, a factor which may make nonrated securities less marketable. These factors may have the effect of limiting the availability of the securities for purchase by the fund and may also limit the ability of the fund to sell such securities at their fair value either to meet redemption requests or in response to changes in the economy or the financial markets. Adverse publicity and investor perceptions, whether or not based on fundamental analysis, may decrease the values and liquidity of lower-rated debt securities, especially in a thinly traded market. To the extent the fund owns or may acquire illiquid or restricted lower-rated securities, these securities may involve special registration responsibilities, liabilities, costs, and liquidity and valuation difficulties. Changes in values of debt securities which the fund owns will affect its net asset value per share. If market quotations are not readily available for the fund's lower-rated or nonrated securities, these securities will be valued by a method that the fund's Board of Directors believes accurately reflects fair value. Judgment plays a greater role in valuing lower-rated debt securities than with respect to securities for which more external sources of quotations and last sale information are available. . Taxation Special tax considerations are associated with investing in lower-rated debt securities structured as zero-coupon or pay-in-kind securities. The fund accrues income on these securities prior to the receipt of cash payments. The fund must distribute substantially all of its income to its shareholders to qualify for pass-through treatment under the tax laws and may, therefore, have to dispose of its portfolio securities to satisfy distribution requirements. 4 Corporate Income, High Yield, Institutional High Yield, New Income, Personal Strategy, and Short-Term Bond Funds . Risk Factors of Foreign Investing There are special risks in foreign investing. Certain of these risks are inherent in any mutual fund while others relate more to the countries in which the fund will invest. Many of the risks are more pronounced for investments in developing or emerging market countries, such as many of the countries of Asia, Latin America, Eastern Europe, Russia, Africa, and the Middle East. Although there is no universally accepted definition, a developing country is generally considered to be a country which is in the initial stages of its industrialization cycle with a per capita gross national product of less than $8,000. . Political and Economic Factors Individual foreign economies of some countries differ favorably or unfavorably from the United States' economy in such respects as growth of gross national product, rate of inflation, capital reinvestment, resource self-sufficiency, and balance of payments position. The internal politics of some foreign countries are not as stable as in the United States. For example, in 1991, the existing government in Thailand was overthrown in a military coup. In 1994-1995, the Mexican peso plunged in value, setting off a severe crisis in the Mexican economy. Asia is still coming to terms with its own crisis and recessionary conditions sparked by widespread currency weakness in late 1997. In 1998, there was substantial turmoil in markets throughout the world. In 1999, the democratically elected government of Pakistan was overthrown by a military coup. The Russian government also defaulted on all its domestic debt. In addition, significant external political risks currently affect some foreign countries. Both Taiwan and China still claim sovereignty of one another and there is a demilitarized border and hostile relations between North and South Korea. In 2001, Argentina defaulted on its foreign-owned debt and had the peso devalued, resulting in the resignation of its president and deadly riots in December in response to government-mandated austerity measures. Governments in certain foreign countries continue to participate to a significant degree, through ownership interest or regulation, in their respective economies. Action by these governments could have a significant effect on market prices of securities and payment of dividends. The economies of many foreign countries are heavily dependent upon international trade and are accordingly affected by protective trade barriers and economic conditions of their trading partners. The enactment by these trading partners of protectionist trade legislation could have a significant adverse effect upon the securities markets of such countries. . Currency Fluctuations The fund invests in securities denominated in various currencies. Accordingly, a change in the value of any such currency against the U.S. dollar will result in a corresponding change in the U.S. dollar value of the fund's assets denominated in that currency. Such changes will also affect the fund's income. Generally, when a given currency appreciates against the dollar (the dollar weakens), the value of the fund's securities denominated in that currency will rise. When a given currency depreciates against the dollar (the dollar strengthens), the value of the fund's securities denominated in that currency would be expected to decline. . Investment and Repatriation Restrictions Foreign investment in the securities markets of certain foreign countries is restricted or controlled to varying degrees. These restrictions limit and, at times, preclude investment in certain of such countries and increase the cost and expenses of the fund. Investments by foreign investors are subject to a variety of restrictions in many developing countries. These restrictions may take the form of prior governmental approval, limits on the amount or type of securities held by foreigners, and limits on the types of companies in which foreigners may invest. Additional or different restrictions may be imposed at any time by these or other countries in which the fund invests. In addition, the repatriation of both investment income and capital from several foreign countries is restricted and controlled under certain regulations, including in some cases the need for certain government consents. For example, capital invested in Chile normally cannot be repatriated for one year. In 1998, the government of Malaysia imposed currency controls which effectively made it impossible for foreign investors to convert Malaysian ringgits to foreign currencies. . Market Characteristics It is contemplated that most foreign securities will be purchased in over-the-counter markets or on securities exchanges located in the countries in which the respective principal offices of the issuers of the various securities are located, if that is the best available market. Investments in certain markets may be made through American Depository Receipts ("ADRs") and Global Depository Receipts ("GDRs") traded in the United States or on foreign exchanges. Foreign securities markets are generally not as developed 5 or efficient as, and more volatile than, those in the United States. While growing in volume, they usually have substantially less volume than U.S. markets and the fund's portfolio securities may be less liquid and subject to more rapid and erratic price movements than securities of comparable U.S. companies. Securities may trade at price/earnings multiples higher than comparable United States securities and such levels may not be sustainable. Commissions on foreign securities trades are generally higher than commissions on United States exchanges, and while there are an increasing number of overseas securities markets that have adopted a system of negotiated rates, a number are still subject to an established schedule of minimum commission rates. There is generally less government supervision and regulation of foreign securities exchanges, brokers, and listed companies than in the United States. Moreover, settlement practices for transactions in foreign markets may differ from those in United States markets. Such differences include delays beyond periods customary in the United States and practices, such as delivery of securities prior to receipt of payment, which increase the likelihood of a "failed settlement." Failed settlements can result in losses to the fund. . Investment Funds The fund may invest in investment funds which have been authorized by the governments of certain countries specifically to permit foreign investment in securities of companies listed and traded on the stock exchanges in these respective countries. The fund's investment in these funds is subject to the provisions of the 1940 Act. If the fund invests in such investment funds, the fund's shareholders will bear not only their proportionate share of the expenses of the fund (including operating expenses and the fees of the investment manager), but also will indirectly bear similar expenses of the underlying investment funds. In addition, the securities of these investment funds may trade at a premium over their net asset value. . Information and Supervision There is generally less publicly available information about foreign companies comparable to reports and ratings that are published about companies in the United States. Foreign companies are also generally not subject to uniform accounting, auditing and financial reporting standards, practices, and requirements comparable to those applicable to United States companies. It also is often more difficult to keep currently informed of corporate actions which affect the prices of portfolio securities. . Taxes The dividends and interest payable on certain of the fund's foreign portfolio securities may be subject to foreign withholding taxes, thus reducing the net amount of income available for distribution to the fund's shareholders. . Other With respect to certain foreign countries, especially developing and emerging ones, there is the possibility of adverse changes in investment or exchange control regulations, expropriation or confiscatory taxation, limitations on the removal of funds or other assets of the fund, political or social instability, or diplomatic developments which could affect investments by U.S. persons in those countries. . Eastern Europe and Russia Changes occurring in Eastern Europe and Russia today could have long-term potential consequences. As restrictions fall, this could result in rising standards of living, lower manufacturing costs, growing consumer spending, and substantial economic growth. However, investment in most countries of Eastern Europe and Russia is highly speculative at this time. Political and economic reforms are too recent to establish a definite trend away from centrally planned economies and state-owned industries. In many of the countries of Eastern Europe and Russia, there is no stock exchange or formal market for securities. Such countries may also have government exchange controls, currencies with no recognizable market value relative to the established currencies of western market economies, little or no experience in trading in securities, no financial reporting standards, a lack of a banking and securities infrastructure to handle such trading, and a legal tradition which does not recognize rights in private property. In addition, these countries may have national policies which restrict investments in companies deemed sensitive to the country's national interest. Further, the governments in such countries may require governmental or quasi-governmental authorities to act as custodian of the fund's assets invested in such countries, and these authorities may not qualify as a foreign custodian under the 1940 Act and exemptive relief from such Act may be required. All of these considerations are among the factors which result in significant risks and uncertainties when investing in Eastern Europe and Russia. . Latin America Inflation Most Latin American countries have experienced, at one time or another, severe and persistent levels of inflation, including, in some cases, hyperinflation. This has, in turn, led to high interest rates, extreme 6 measures by governments to keep inflation in check, and a generally debilitating effect on economic growth. Although inflation in many countries has lessened, there is no guarantee it will remain at lower levels. Political Instability The political history of certain Latin American countries has been characterized by political uncertainty, intervention by the military in civilian and economic spheres, and political corruption. Such developments, if they were to reoccur, could reverse favorable trends toward market and economic reform, privatization, and removal of trade barriers, and result in significant disruption in securities markets. Foreign Currency Certain Latin American countries may experience sudden and large adjustments in their currency which, in turn, can have a disruptive and negative effect on foreign investors. For example, in late 1994 the Mexican peso lost more than one-third of its value relative to the dollar. In 1999, the Brazilian real lost 30% of its value against the U.S. dollar. Certain Latin American countries may impose restrictions on the free conversion of their currency into foreign currencies, including the U.S. dollar. There is no significant foreign exchange market for many currencies and it would, as a result, be difficult for the fund to engage in foreign currency transactions designed to protect the value of the fund's interests in securities denominated in such currencies. Sovereign Debt A number of Latin American countries are among the largest debtors of developing countries. There have been moratoria on, and reschedulings of, repayment with respect to these debts. Such events can restrict the flexibility of these debtor nations in the international markets and result in the imposition of onerous conditions on their economies. INVESTMENT PROGRAM ------------------------------------------------------------------------------- Types of Securities Set forth below is additional information about certain of the investments described in each fund's prospectus. Debt Securities Fixed-income securities in which the fund may invest include, but are not limited to, those described below. All funds . U.S. Government Obligations Bills, notes, bonds, and other debt securities issued by the U.S. Treasury. These are direct obligations of the U.S. government and differ mainly in the length of their maturities. . U.S. Government Agency Securities Issued or guaranteed by U.S. government-sponsored enterprises and federal agencies. These include securities issued by the Federal National Mortgage Association ("Fannie Mae" or "FNMA"), Government National Mortgage Association ("Ginnie Mae" or "GNMA"), Federal Home Loan Bank, Federal Land Banks, Farmers Home Administration, Banks for Cooperatives, Federal Intermediate Credit Banks, Federal Financing Bank, Farm Credit Banks, the Small Business Association, and the Tennessee Valley Authority. Some of these securities are supported by the full faith and credit of the U.S. Treasury; the remainder are supported only by the credit of the instrumentality, which may or may not include the right of the issuer to borrow from the Treasury. The GNMA, Government Reserve Investment, U.S. Treasury Intermediate, U.S. Treasury Long-Term, and U.S. Treasury Money Funds may only invest in these securities if they are supported by the full faith and credit of the U.S. government. All funds except GNMA, Government Reserve Investment, U.S. Treasury Intermediate, U.S. Treasury Long-Term, and U.S. Treasury Money Funds . Bank Obligations Certificates of deposit, banker's acceptances, and other short-term debt obligations. Certificates of deposit are short-term obligations of commercial banks. A banker's acceptance is a time draft drawn on a commercial bank by a borrower, usually in connection with international commercial transactions. Certificates of deposit may have fixed or variable rates. The fund may invest in U.S. banks, foreign branches of U.S. banks, U.S. branches of foreign banks, and foreign branches of foreign banks. 7 . Corporate Debt Securities Outstanding corporate debt securities (e.g., bonds and debentures). Corporate notes may have fixed, variable, or floating rates. . Commercial Paper and Commercial Notes Short-term promissory notes issued by corporations primarily to finance short-term credit needs. Certain notes may have floating or variable rates and may contain options, exercisable by either the buyer or the seller, that extend or shorten the maturity of the note. . Foreign Government Securities Issued or guaranteed by a foreign government, province, instrumentality, political subdivision, or similar unit thereof. . Savings and Loan Obligations Negotiable certificates of deposit and other short-term debt obligations of savings and loan associations. . Supranational Agencies Securities of certain supranational entities, such as the International Development Bank. All funds except Government Reserve Investment, Prime Reserve, Reserve Investment, and U.S. Treasury Money Funds Mortgage-Related Securities Mortgage-related securities in which the fund may invest include, but are not limited to, those described below. The GNMA, U.S. Treasury Intermediate, and U.S. Treasury Long-Term Funds may only invest in these securities to the extent they are backed by the full faith and credit of the U.S. government. . Mortgage-Backed Securities Mortgage-backed securities are securities representing an interest in a pool of mortgages. The mortgages may be of a variety of types, including adjustable rate, conventional 30-year fixed rate, graduated payment, and 15-year. Principal and interest payments made on the mortgages in the underlying mortgage pool are passed through to the fund. This is in contrast to traditional bonds where principal is normally paid back at maturity in a lump sum. Unscheduled prepayments of principal shorten the securities' weighted average life and may lower their total return. (When a mortgage in the underlying mortgage pool is prepaid, an unscheduled principal prepayment is passed through to the fund. This principal is returned to the fund at par. As a result, if a mortgage security were trading at a premium, its total return would be lowered by prepayments, and if a mortgage security were trading at a discount, its total return would be increased by prepayments.) The value of these securities also may change because of changes in the market's perception of the creditworthiness of the federal agency that issued them. In addition, the mortgage securities market in general may be adversely affected by changes in governmental regulation or tax policies. . U.S. Government Agency Mortgage-Backed Securities These are obligations issued or guaranteed by the United States government or one of its agencies or instrumentalities, such as GNMA, FNMA, the Federal Home Loan Mortgage Corporation ("Freddie Mac" or "FHLMC"), and the Federal Agricultural Mortgage Corporation ("Farmer Mac" or "FAMC"). FNMA, FHLMC, and FAMC obligations are not backed by the full faith and credit of the U.S. government as GNMA certificates are, but they are supported by the instrumentality's right to borrow from the United States Treasury. U.S. Government Agency Mortgage-Backed Certificates provide for the pass-through to investors of their pro-rata share of monthly payments (including any prepayments) made by the individual borrowers on the pooled mortgage loans, net of any fees paid to the guarantor of such securities and the servicer of the underlying mortgage loans. Each of GNMA, FNMA, FHLMC, and FAMC guarantees timely distributions of interest to certificate holders. GNMA and FNMA guarantee timely distributions of scheduled principal. FHLMC has in the past guaranteed only the ultimate collection of principal of the underlying mortgage loan; however, FHLMC now issues mortgage-backed securities (FHLMC Gold PCS) which also guarantee timely payment of monthly principal reductions. . Ginnie Mae Certificates Ginnie Mae is a wholly owned corporate instrumentality of the United States within the Department of Housing and Urban Development. The National Housing Act of 1934, as amended (the "Housing Act"), authorizes Ginnie Mae to guarantee the timely payment of the principal of and interest on certificates that are based on and backed by a pool of mortgage loans insured by the Federal Housing Administration under the Housing Act, or Title V of the Housing Act of 1949 ("FHA Loans"), or guaranteed by the Department of Veterans Affairs under the Servicemen's Readjustment Act of 1944, as amended ("VA Loans"), or by pools of other eligible mortgage loans. The Housing Act provides that the full faith and credit of the United States government is pledged to the payment of all amounts that may be required to be paid 8 under any guaranty. In order to meet its obligations under such guaranty, Ginnie Mae is authorized to borrow from the United States Treasury with no limitations as to amount. . Fannie Mae Certificates Fannie Mae is a federally chartered and privately owned corporation organized and existing under the Federal National Mortgage Association Charter Act of 1938. FNMA Certificates represent a pro-rata interest in a group of mortgage loans purchased by Fannie Mae. FNMA guarantees the timely payment of principal and interest on the securities it issues. The obligations of FNMA are not backed by the full faith and credit of the U.S. government. . Freddie Mac Certificates Freddie Mac is a corporate instrumentality of the United States created pursuant to the Emergency Home Finance Act of 1970, as amended ("FHLMC Act"). Freddie Mac Certificates represent a pro-rata interest in a group of mortgage loans purchased by Freddie Mac. Freddie Mac guarantees timely payment of interest and principal on certain securities it issues and timely payment of interest and eventual payment of principal on other securities it issues. The obligations of Freddie Mac are obligations solely of Freddie Mac and are not backed by the full faith and credit of the U.S. government. . Farmer Mac Certificates Farmer Mac is a federally chartered instrumentality of the United States established by Title VIII of the Farm Credit Act of 1971, as amended ("Charter Act"). Farmer Mac was chartered primarily to attract new capital for financing of agricultural real estate by making a secondary market in certain qualified agricultural real estate loans. Farmer Mac provides guarantees of timely payment of principal and interest on securities representing interests in, or obligations backed by, pools of mortgages secured by first liens on agricultural real estate. Similar to Fannie Mae and Freddie Mac, Farmer Mac Certificates are not supported by the full faith and credit of the U.S. government; rather, Farmer Mac may borrow from the U.S. Treasury to meet its guaranty obligations. As discussed above, prepayments on the underlying mortgages and their effect upon the rate of return of a mortgage-backed security is the principal investment risk for a purchaser of such securities, like the fund. Over time, any pool of mortgages will experience prepayments due to a variety of factors, including (1) sales of the underlying homes (including foreclosures), (2) refinancings of the underlying mortgages, and (3) increased amortization by the mortgagee. These factors, in turn, depend upon general economic factors, such as level of interest rates and economic growth. Thus, investors normally expect prepayment rates to increase during periods of strong economic growth or declining interest rates, and to decrease in recessions and rising interest rate environments. Accordingly, the life of the mortgage-backed security is likely to be substantially shorter than the stated maturity of the mortgages in the underlying pool. Because of such variation in prepayment rates, it is not possible to predict the life of a particular mortgage-backed security, but FHA statistics indicate that 25- to 30-year single family dwelling mortgages have an average life of approximately 12 years. The majority of Ginnie Mae Certificates are backed by mortgages of this type, and, accordingly, the generally accepted practice treats Ginnie Mae Certificates as 30-year securities which prepay in full in the 12th year. FNMA and Freddie Mac Certificates may have differing prepayment characteristics. Fixed-rate mortgage-backed securities bear a stated "coupon rate" which represents the effective mortgage rate at the time of issuance, less certain fees to GNMA, FNMA, and FHLMC for providing the guarantee, and the issuer for assembling the pool and for passing through monthly payments of interest and principal. Payments to holders of mortgage-backed securities consist of the monthly distributions of interest and principal less the applicable fees. The actual yield to be earned by a holder of mortgage-backed securities is calculated by dividing interest payments by the purchase price paid for the mortgage-backed securities (which may be at a premium or a discount from the face value of the certificate). Monthly distributions of interest, as contrasted to semiannual distributions which are common for other fixed interest investments, have the effect of compounding and thereby raising the effective annual yield earned on mortgage-backed securities. Because of the variation in the life of the pools of mortgages which back various mortgage-backed securities, and because it is impossible to anticipate the rate of interest at which future principal payments may be reinvested, the actual yield earned from a portfolio of mortgage-backed securities will differ significantly from the yield estimated by using an assumption of a certain life for each mortgage-backed security included in such a portfolio as described above. 9 . Collateralized Mortgage Obligations ("CMOs") CMOs are bonds that are collateralized by whole loan mortgages or mortgage pass-through securities. The bonds issued in a CMO deal are divided into groups, and each group of bonds is referred to as a "tranche." Under the traditional CMO structure, the cash flows generated by the mortgages or mortgage pass-through securities in the collateral pool are used to first pay interest and then pay principal to the CMO bondholders. The bonds issued under such a CMO structure are retired sequentially as opposed to the pro-rata return of principal found in traditional pass-through obligations. Subject to the various provisions of individual CMO issues, the cash flow generated by the underlying collateral (to the extent it exceeds the amount required to pay the stated interest) is used to retire the bonds. Under the CMO structure, the repayment of principal among the different tranches is prioritized in accordance with the terms of the particular CMO issuance. The "fastest-pay" tranche of bonds, as specified in the prospectus for the issuance, would initially receive all principal payments. When that tranche of bonds is retired, the next tranche, or tranches, in the sequence, as specified in the prospectus, receive all of the principal payments until they are retired. The sequential retirement of bond groups continues until the last tranche, or group of bonds, is retired. Accordingly, the CMO structure allows the issuer to use cash flows of long maturity, monthly-pay collateral to formulate securities with short, intermediate, and long final maturities and expected average lives. In recent years, new types of CMO tranches have evolved. These include floating-rate CMOs, planned amortization classes, accrual bonds, and CMO residuals. These newer structures affect the amount and timing of principal and interest received by each tranche from the underlying collateral. Under certain of these new structures, given classes of CMOs have priority over others with respect to the receipt of prepayments on the mortgages. Therefore, depending on the type of CMOs in which the fund invests, the investment may be subject to a greater or lesser risk of prepayment than other types of mortgage-related securities. The primary risk of any mortgage security is the uncertainty of the timing of cash flows. For CMOs, the primary risk results from the rate of prepayments on the underlying mortgages serving as collateral and from the structure of the deal (priority of the individual tranches). An increase or decrease in prepayment rates (resulting from a decrease or increase in mortgage interest rates) will affect the yield, average life, and price of CMOs. The prices of certain CMOs, depending on their structure and the rate of prepayments, can be volatile. Some CMOs may also not be as liquid as other securities. . U.S. Government Agency Multi-Class Pass-Through Securities Unlike CMOs, U.S. Government Agency Multi-Class Pass-Through Securities, which include FNMA Guaranteed REMIC Pass-Through Certificates and FHLMC Multi-Class Mortgage Participation Certificates, are ownership interests in a pool of Mortgage Assets. Unless the context indicates otherwise, all references herein to CMOs include multi-class pass-through securities. . Multi-Class Residential Mortgage Securities Such securities represent interests in pools of mortgage loans to residential home buyers made by commercial banks, savings and loan associations, or other financial institutions. Unlike GNMA, FNMA, and FHLMC securities, the payment of principal and interest on Multi-Class Residential Mortgage Securities is not guaranteed by the U.S. government or any of its agencies. Accordingly, yields on Multi-Class Residential Mortgage Securities have been historically higher than the yields on U.S. government mortgage securities. However, the risk of loss due to default on such instruments is higher since they are not guaranteed by the U.S. government or its agencies. Additionally, pools of such securities may be divided into senior or subordinated segments. Although subordinated mortgage securities may have a higher yield than senior mortgage securities, the risk of loss of principal is greater because losses on the underlying mortgage loans must be borne by persons holding subordinated securities before those holding senior mortgage securities. . Privately Issued Mortgage-Backed Certificates These are pass-through certificates issued by nongovernmental issuers. Pools of conventional residential or commercial mortgage loans created by such issuers generally offer a higher rate of interest than government and government-related pools because there are no direct or indirect government guarantees of payment. Timely payment of interest and principal of these pools is, however, generally supported by various forms of insurance or guarantees, including individual loan, title, pool, and hazard insurance. The insurance and guarantees are issued by government entities, private insurance, or the mortgage poolers. Such insurance and guarantees and the creditworthiness of the issuers thereof will be considered in determining whether a mortgage-related security meets the fund's quality standards. The fund 10 may buy mortgage-related securities without insurance or guarantees if through an examination of the loan experience and practices of the poolers, the investment manager determines that the securities meet the fund's quality standards. . Stripped Mortgage-Backed Securities These instruments are a type of potentially high-risk derivative. They represent interests in a pool of mortgages, the cash flow of which has been separated into its interest and principal components. Interest only securities ("IOs") receive the interest portion of the cash flow while principal only securities ("POs") receive the principal portion. IOs and POs are usually structured as tranches of a CMO. Stripped Mortgage-Backed Securities may be issued by U.S. government agencies or by private issuers similar to those described above with respect to CMOs and privately issued mortgage-backed certificates. As interest rates rise and fall, the value of IOs tends to move in the same direction as interest rates. The value of the other mortgage-backed securities described herein, like other debt instruments, will tend to move in the opposite direction compared to interest rates. Under the Code, POs may generate taxable income from the current accrual of original issue discount, without a corresponding distribution of cash to the fund. The cash flows and yields on IO and PO classes are extremely sensitive to the rate of principal payments (including prepayments) on the related underlying mortgage assets. In the case of IOs, prepayments affect the amount, but not the timing, of cash flows provided to the investor. In contrast, prepayments on the mortgage pool affect the timing, but not the amount, of cash flows received by investors in POs. For example, a rapid or slow rate of principal payments may have a material adverse effect on the prices of IOs or POs, respectively. If the underlying mortgage assets experience greater than anticipated prepayments of principal, an investor may fail to fully recoup his/her initial investment in an IO class of a stripped mortgage-backed security, even if the IO class is rated AAA or Aaa or is derived from a full faith and credit obligation. Conversely, if the underlying mortgage assets experience slower than anticipated prepayments of principal, the price on a PO class will be affected more severely than would be the case with a traditional mortgage-backed security. The staff of the SEC has advised the fund that it believes the fund should treat IOs and POs, other than government-issued IOs or POs backed by fixed-rate mortgages, as illiquid securities and, accordingly, limit its investments in such securities, together with all other illiquid securities, to 15% of the fund's net assets. Under the staff's position, the determination of whether a particular government-issued IO or PO backed by fixed-rate mortgages is liquid may be made on a case by case basis under guidelines and standards established by the fund's Board of Directors. The fund's Board of Directors has delegated to T. Rowe Price the authority to determine the liquidity of these investments based on the following guidelines: the type of issuer; type of collateral, including age and prepayment characteristics; rate of interest on coupon relative to current market rates and the effect of the rate on the potential for prepayments; complexity of the issue's structure, including the number of tranches; and size of the issue and the number of dealers who make a market in the IO or PO. . Adjustable Rate Mortgage Securities ARMs, like fixed-rate mortgages, have a specified maturity date, and the principal amount of the mortgage is repaid over the life of the mortgage. Unlike fixed-rate mortgages, the interest rate on ARMs is adjusted at regular intervals based on a specified, published interest rate "index" such as a Treasury rate index. The new rate is determined by adding a specific interest amount, the "margin," to the interest rate of the index. Investment in ARM securities allows the fund to participate in changing interest rate levels through regular adjustments in the coupons of the underlying mortgages, resulting in more variable current income and lower price volatility than longer-term fixed-rate mortgage securities. ARM securities are a less effective means of locking in long-term rates than fixed-rate mortgages since the income from adjustable rate mortgages will increase during periods of rising interest rates and decline during periods of falling rates. . Other Mortgage-Related Securities The fund expects that governmental, government-related, or private entities may create mortgage loan pools offering pass-through investments in addition to those described above. The mortgages underlying these securities may be alternative mortgage instruments, that is, mortgage instruments whose principal or interest payments may vary or whose terms to maturity may differ from customary long-term fixed-rate mortgages. As new types of mortgage-related securities are developed and offered to investors, the investment manager will, consistent with the fund's objective, policies, and quality standards, consider making investments in such new types of securities. 11 All funds except GNMA, Government Reserve Investment, U.S. Treasury Intermediate, U.S. Treasury Long-Term, and U.S. Treasury Money Funds Asset-Backed Securities The credit quality of most asset-backed securities depends primarily on the credit quality of the assets underlying such securities, how well the entity issuing the security is insulated from the credit risk of the originator or any other affiliated entities, and the amount and quality of any credit support provided to the securities. The rate of principal payment on asset-backed securities generally depends on the rate of principal payments received on the underlying assets, which in turn may be affected by a variety of economic and other factors. As a result, the yield on any asset-backed security is difficult to predict with precision and actual yield to maturity may be more or less than the anticipated yield to maturity. Asset-backed securities may be classified as pass-through certificates or collateralized obligations. Pass-through certificates are asset-backed securities which represent an undivided fractional ownership interest in an underlying pool of assets. Pass-through certificates usually provide for payments of principal and interest received to be passed through to their holders, usually after deduction for certain costs and expenses incurred in administering the pool. Because pass-through certificates represent an ownership interest in the underlying assets, the holders thereof directly bear the risk of any defaults by the obligors on the underlying assets not covered by any credit support. Asset-backed securities issued in the form of debt instruments, also known as collateralized obligations, are generally issued as the debt of a special purpose entity organized solely for the purpose of owning such assets and issuing such debt. Such assets are most often trade, credit card, or automobile receivables. The assets collateralizing such asset-backed securities are pledged to a trustee or custodian for the benefit of the holders thereof. Such issuers generally hold no assets other than those underlying the asset-backed securities and any credit support provided. As a result, although payments on such asset-backed securities are obligations of the issuers, in the event of defaults on the underlying assets not covered by any credit support, the issuing entities are unlikely to have sufficient assets to satisfy their obligations on the related asset-backed securities. . Methods of Allocating Cash Flows While many asset-backed securities are issued with only one class of security, many asset-backed securities are issued in more than one class, each with different payment terms. Multiple class asset-backed securities are issued for two main reasons. First, multiple classes may be used as a method of providing credit support. This is accomplished typically through creation of one or more classes whose right to payments on the asset-backed security is made subordinate to the right to such payments of the remaining class or classes. Second, multiple classes may permit the issuance of securities with payment terms, interest rates, or other characteristics differing both from those of each other and from those of the underlying assets. Examples include so-called "strips" (asset-backed securities entitling the holder to disproportionate interests with respect to the allocation of interest and principal of the assets backing the security), and securities with a class or classes having characteristics which mimic the characteristics of non-asset-backed securities, such as floating interest rates (i.e., interest rates which adjust as a specified benchmark changes) or scheduled amortization of principal. Asset-backed securities in which the payment streams on the underlying assets are allocated in a manner different than those described above may be issued in the future. The fund may invest in such asset-backed securities if such investment is otherwise consistent with its investment objectives and policies and with the investment restrictions of the fund. . Types of Credit Support Asset-backed securities are often backed by a pool of assets representing the obligations of a number of different parties. To lessen the effect of failures by obligors on underlying assets to make payments, such securities may contain elements of credit support. Such credit support falls into two classes: liquidity protection and protection against ultimate default by an obligor on the underlying assets. Liquidity protection refers to the provision of advances, generally by the entity administering the pool of assets, to ensure that scheduled payments on the underlying pool are made in a timely fashion. Protection against ultimate default ensures ultimate payment of the obligations on at least a portion of the assets in the pool. Such protection may be provided through guarantees, insurance policies, or letters of credit obtained from third parties, "external credit enhancement," through various means of structuring the transaction, 12 "internal credit enhancement," or through a combination of such approaches. Examples of asset-backed securities with credit support arising out of the structure of the transaction include "senior-subordinated securities" (multiple class asset-backed securities with certain classes subordinate to other classes as to the payment of principal thereon, with the result that defaults on the underlying assets are borne first by the holders of the subordinated class) and asset-backed securities that have "reserve funds" (where cash or investments, sometimes funded from a portion of the initial payments on the underlying assets, are held in reserve against future losses) or that have been "over collateralized" (where the scheduled payments on, or the principal amount of, the underlying assets substantially exceeds that required to make payment of the asset-backed securities and pay any servicing or other fees). The degree of credit support provided on each issue is based generally on historical information respecting the level of credit risk associated with such payments. Depending upon the type of assets securitized, historical information on credit risk and prepayment rates may be limited or even unavailable. Delinquency or loss in excess of that anticipated could adversely affect the return on an investment in an asset-backed security. . Automobile Receivable Securities The fund may invest in asset-backed securities which are backed by receivables from motor vehicle installment sales contracts or installment loans secured by motor vehicles ("Automobile Receivable Securities"). Since installment sales contracts for motor vehicles or installment loans related thereto ("Automobile Contracts") typically have shorter durations and lower incidences of prepayment, Automobile Receivable Securities generally will exhibit a shorter average life and are less susceptible to prepayment risk. Most entities that issue Automobile Receivable Securities create an enforceable interest in their respective Automobile Contracts only by filing a financing statement and by having the servicer of the Automobile Contracts, which is usually the originator of the Automobile Contracts, take custody thereof. In such circumstances, if the servicer of the Automobile Contracts were to sell the same Automobile Contracts to another party, in violation of its obligation not to do so, there is a risk that such party could acquire an interest in the Automobile Contracts superior to that of the holders of Automobile Receivable Securities. Also, although most Automobile Contracts grant a security interest in the motor vehicle being financed, in most states the security interest in a motor vehicle must be noted on the certificate of title to create an enforceable security interest against competing claims of other parties. Due to the large number of vehicles involved, however, the certificate of title to each vehicle financed, pursuant to the Automobile Contracts underlying the Automobile Receivable Security, usually is not amended to reflect the assignment of the seller's security interest for the benefit of the holders of the Automobile Receivable Securities. Therefore, there is the possibility that recoveries on repossessed collateral may not, in some cases, be available to support payments on the securities. In addition, various state and federal securities laws give the motor vehicle owner the right to assert against the holder of the owner's Automobile Contract certain defenses such owner would have against the seller of the motor vehicle. The assertion of such defenses could reduce payments on the Automobile Receivable Securities. . Credit Card Receivable Securities The fund may invest in asset-backed securities backed by receivables from revolving credit card agreements ("Credit Card Receivable Securities"). Credit balances on revolving credit card agreements ("Accounts") are generally paid down more rapidly than are Automobile Contracts. Most of the Credit Card Receivable Securities issued publicly to date have been pass-through certificates. In order to lengthen the maturity of Credit Card Receivable Securities, most such securities provide for a fixed period during which only interest payments on the underlying Accounts are passed through to the security holder and principal payments received on such Accounts are used to fund the transfer to the pool of assets supporting the related Credit Card Receivable Securities of additional credit card charges made on an Account. The initial fixed period usually may be shortened upon the occurrence of specified events which signal a potential deterioration in the quality of the assets backing the security, such as the imposition of a cap on interest rates. The ability of the issuer to extend the life of an issue of Credit Card Receivable Securities thus depends upon the continued generation of additional principal amounts in the underlying account during the initial period and the non-occurrence of specified events. An acceleration in cardholders' payment rates or any other event which shortens the period during which additional credit card charges on an Account may be transferred to the pool of assets supporting the related Credit Card Receivable Security could shorten the weighted average life and yield of the Credit Card Receivable Security. 13 Credit cardholders are entitled to the protection of a number of state and federal consumer credit laws, many of which give such holder the right to set off certain amounts against balances owed on the credit card, thereby reducing amounts paid on Accounts. In addition, unlike most other asset-backed securities, Accounts are unsecured obligations of the cardholder. . Other Assets Asset-backed securities backed by assets other than those described above, including, but not limited to, home equity loans, small-business loans and accounts receivable, equipment leases, commercial real estate loans, boat loans, and manufacturing housing loans. The fund may invest in such securities in the future if such investment is otherwise consistent with its investment objective and policies. There are, of course, other types of securities that are or may become available that are similar to the foregoing, and the fund may invest in these securities. High Yield and Institutional High Yield Funds Collateralized Bond or Loan Obligations Collateralized Bond Obligations ("CBOs") are bonds collateralized by corporate bonds, mortgages, or asset-backed securities and Collateralized Loan Obligations ("CLOs") are bonds collateralized by bank loans. CBOs and CLOs are structured into tranches, and payments are allocated such that each tranche has a predictable cash flow stream and average life. CBOs are fairly recent entrants to the fixed-income market. Most CBOs issued to date have been collateralized by high-yield bonds or loans, with heavy credit enhancement. Loan Participations and Assignments Loan participations and assignments (collectively "participations") will typically be participating interests in loans made by a syndicate of banks, represented by an agent bank which has negotiated and structured the loan, to corporate borrowers to finance internal growth, mergers, acquisitions, stock repurchases, leveraged buyouts, and other corporate activities. Such loans may also have been made to governmental borrowers, especially governments of developing countries which is referred to as Loans to Developing Countries debt ("LDC debt"). LDC debt will involve the risk that the governmental entity responsible for the repayment of the debt may be unable or unwilling to do so when due. The loans underlying such participations may be secured or unsecured, and the fund may invest in loans collateralized by mortgages on real property or which have no collateral. The loan participations themselves may extend for the entire term of the loan or may extend only for short "strips" that correspond to a quarterly or monthly floating-rate interest period on the underlying loan. Thus, a term or revolving credit that extends for several years may be subdivided into shorter periods. The loan participations in which the fund will invest will also vary in legal structure. Occasionally, lenders assign to another institution both the lender's rights and obligations under a credit agreement. Since this type of assignment relieves the original lender of its obligations, it is called a novation. More typically, a lender assigns only its right to receive payments of principal and interest under a promissory note, credit agreement, or similar document. A true assignment shifts to the assignee the direct debtor-creditor relationship with the underlying borrower. Alternatively, a lender may assign only part of its rights to receive payments pursuant to the underlying instrument or loan agreement. Such partial assignments, which are more accurately characterized as "participating interests," do not shift the debtor-creditor relationship to the assignee, who must rely on the original lending institution to collect sums due and to otherwise enforce its rights against the agent bank which administers the loan or against the underlying borrower. There may not be a recognizable, liquid public market for loan participations. To the extent this is the case, the fund would consider the loan participation as illiquid and subject to the fund's restriction on investing no more than 15% of its net assets in illiquid securities. Where required by applicable SEC positions, the fund will treat both the corporate borrower and the bank selling the participation interest as an issuer for purposes of its fundamental investment restriction on diversification. Various service fees received by the fund from loan participations may be treated as non-interest income depending on the nature of the fee (commitment, takedown, commission, service, or loan origination). To the extent the service fees are not interest income, they will not qualify as income under Section 851(b) of the 14 Code. Thus the sum of such fees plus any other nonqualifying income earned by the fund cannot exceed 10% of total income. Trade Claims Trade claims are non-securitized rights of payment arising from obligations other than borrowed funds. Trade claims typically arise when, in the ordinary course of business, vendors and suppliers extend credit to a company by offering payment terms. Generally, when a company files for bankruptcy protection, payments on these trade claims cease and the claims are subject to compromise along with the other debts of the company. Trade claims typically are bought and sold at a discount reflecting the degree of uncertainty with respect to the timing and extent of recovery. In addition to the risks otherwise associated with low-quality obligations, trade claims have other risks, including the possibility that the amount of the claim may be disputed by the obligor. Over the last few years a market for the trade claims of bankrupt companies has developed. Many vendors are either unwilling or lack the resources to hold their claim through the extended bankruptcy process with an uncertain outcome and timing. Some vendors are also aggressive in establishing reserves against these receivables, so that the sale of the claim at a discount may not result in the recognition of a loss. Trade claims can represent an attractive investment opportunity because these claims typically are priced at a discount to comparable public securities. This discount is a reflection of both a less liquid market, a smaller universe of potential buyers, and the risks peculiar to trade claim investing. It is not unusual for trade claims to be priced at a discount to public securities that have an equal or lower priority claim. As noted above, investing in trade claims does carry some unique risks which include: . Establishing the Amount of the Claim Frequently, the supplier's estimate of its receivable will differ from the customer's estimate of its payable. Resolution of these differences can result in a reduction in the amount of the claim. This risk can be reduced by only purchasing scheduled claims (claims already listed as liabilities by the debtor) and seeking representations from the seller. . Defenses to Claims The debtor has a variety of defenses that can be asserted under the bankruptcy code against any claim. Trade claims are subject to these defenses, the most common of which for trade claims relates to preference payments. (Preference payments are all payments made by the debtor during the 90 days prior to the filing. These payments are presumed to have benefited the receiving creditor at the expense of the other creditors. The receiving creditor may be required to return the payment unless it can show the payments were received in the ordinary course of business.) While none of these defenses can result in any additional liability of the purchaser of the trade claim, they can reduce or wipe out the entire purchased claim. This risk can be reduced by seeking representations and indemnification from the seller. . Documentation/Indemnification Each trade claim purchased requires documentation that must be negotiated between the buyer and seller. This documentation is extremely important since it can protect the purchaser from losses such as those described above. Legal expenses in negotiating a purchase agreement can be fairly high. Additionally, it is important to note that the value of an indemnification depends on the seller's credit. . Volatile Pricing Due to Illiquid Market There are only a handful of brokers for trade claims and the quoted price of these claims can be volatile. Generally, it is expected that Trade Claims would be considered illiquid investments. . No Current Yield/Ultimate Recovery Trade claims are almost never entitled to earn interest. As a result, the return on such an investment is very sensitive to the length of the bankruptcy, which is uncertain. Although not unique to trade claims, it is worth noting that the ultimate recovery on the claim is uncertain and there is no way to calculate a conventional yield to maturity on this investment. Additionally, the exit for this investment is a plan of reorganization which may include the distribution of new securities. These securities may be as illiquid as the original trade claim investment. . Tax Issue Although the issue is not free from doubt, it is likely that Trade Claims would be treated as non-securities investments. As a result, any gains would be considered "nonqualifying" under the Code. The fund may have up to 10% of its gross income (including capital gains) derived from nonqualifying sources. 15 Zero Coupon and Pay-in-Kind Bonds A zero-coupon security has no cash coupon payments. Instead, the issuer sells the security at a substantial discount from its maturity value. The interest received by the investor from holding this security to maturity is the difference between the maturity value and the purchase price. The advantage to the investor is that reinvestment risk of the income received during the life of the bond is eliminated. However, zero-coupon bonds, like other bonds, retain interest rate and credit risk and usually display more price volatility than those securities that pay a cash coupon. Pay-in-Kind ("PIK") Instruments are securities that pay interest in either cash or additional securities, at the issuer's option, for a specified period. PIKs, like zero coupon bonds, are designed to give an issuer flexibility in managing cash flow. PIK bonds can be either senior or subordinated debt and trade flat (i.e., without accrued interest). The price of PIK bonds is expected to reflect the market value of the underlying debt plus an amount representing accrued interest since the last payment. PIK's are usually less volatile than zero-coupon bonds, but more volatile than cash pay securities. For federal income tax purposes, these types of bonds will require the recognition of gross income each year even though no cash may be paid to the fund until the maturity or call date of the bond. The fund will nonetheless be required to distribute substantially all of this gross income each year to comply with the Internal Revenue Code, and such distributions could reduce the amount of cash available for investment by the fund. Corporate Income, High Yield, Institutional High Yield, New Income, and Personal Strategy Funds Warrants The fund may acquire warrants. Warrants can be highly volatile and have no voting rights, pay no dividends, and have no rights with respect to the assets of the corporation issuing them. Warrants basically are options to purchase securities at a specific price valid for a specific period of time. They do not represent ownership of the securities, but only the right to buy them. Warrants differ from call options in that warrants are issued by the issuer of the security which may be purchased on their exercise, whereas call options may be written or issued by anyone. The prices of warrants do not necessarily move parallel to the prices of the underlying securities. Corporate Income, High Yield, Institutional High Yield, New Income, Personal Strategy, and Short-Term Bond Funds Hybrid Instruments Hybrid instruments (a type of potentially high-risk derivative) have been developed and combine the elements of futures contracts or options with those of debt, preferred equity, or a depository instrument (hereinafter "hybrid instruments"). Generally, a hybrid instrument will be a debt security, preferred stock, depository share, trust certificate, certificate of deposit, or other evidence of indebtedness on which a portion of or all interest payments, and/or the principal or stated amount payable at maturity, redemption, or retirement is determined by reference to prices, changes in prices, or differences between prices of securities, currencies, intangibles, goods, articles, or commodities (collectively "underlying assets") or by another objective index, economic factor, or other measure, such as interest rates, currency exchange rates, commodity indices, and securities indices (collectively "benchmarks"). Thus, hybrid instruments may take a variety of forms, including, but not limited to, debt instruments with interest or principal payments or redemption terms determined by reference to the value of a currency or commodity or securities index at a future point in time, preferred stock with dividend rates determined by reference to the value of a currency, or convertible securities with the conversion terms related to a particular commodity. Hybrid instruments can be an efficient means of creating exposure to a particular market, or segment of a market, with the objective of enhancing total return. For example, a fund may wish to take advantage of expected declines in interest rates in several European countries, but avoid the transaction costs associated with buying and currency-hedging the foreign bond positions. One solution would be to purchase a U.S. dollar-denominated hybrid instrument whose redemption price is linked to the average three-year interest rate in a designated group of countries. The redemption price formula would provide for payoffs of greater than par if the average interest rate was lower than a specified level, and payoffs of less than par if rates were above 16 the specified level. Furthermore, the fund could limit the downside risk of the security by establishing a minimum redemption price so that the principal paid at maturity could not be below a predetermined minimum level if interest rates were to rise significantly. The purpose of this arrangement, known as a structured security with an embedded put option, would be to give the fund the desired European bond exposure while avoiding currency risk, limiting downside market risk, and lowering transaction costs. Of course, there is no guarantee that the strategy will be successful, and the fund could lose money if, for example, interest rates do not move as anticipated or credit problems develop with the issuer of the hybrid instruments. The risks of investing in hybrid instruments reflect a combination of the risks of investing in securities, options, futures, and currencies. Thus, an investment in a hybrid instrument may entail significant risks that are not associated with a similar investment in a traditional debt instrument that has a fixed principal amount, is denominated in U.S. dollars, or bears interest either at a fixed rate or a floating rate determined by reference to a common, nationally published benchmark. The risks of a particular hybrid instrument will, of course, depend upon the terms of the instrument, but may include, without limitation, the possibility of significant changes in the benchmarks or the prices of underlying assets to which the instrument is linked. Such risks generally depend upon factors which are unrelated to the operations or credit quality of the issuer of the hybrid instrument and which may not be readily foreseen by the purchaser, such as economic and political events, the supply of and demand for the underlying assets, and interest rate movements. In recent years, various benchmarks and prices for underlying assets have been highly volatile, and such volatility may be expected in the future. Reference is also made to the discussion of futures, options, and forward contracts herein for a discussion of the risks associated with such investments. Hybrid instruments are potentially more volatile and carry greater market risks than traditional debt instruments. Depending on the structure of the particular hybrid instrument, changes in a benchmark may be magnified by the terms of the hybrid instrument and have an even more dramatic and substantial effect upon the value of the hybrid instrument. Also, the prices of the hybrid instrument and the benchmark or underlying asset may not move in the same direction or at the same time. Hybrid instruments may bear interest or pay preferred dividends at below market (or even relatively nominal) rates. Alternatively, hybrid instruments may bear interest at above market rates but bear an increased risk of principal loss (or gain). The latter scenario may result if "leverage" is used to structure the hybrid instrument. Leverage risk occurs when the hybrid instrument is structured so that a given change in a benchmark or underlying asset is multiplied to produce a greater value change in the hybrid instrument, thereby magnifying the risk of loss as well as the potential for gain. Hybrid instruments may also carry liquidity risk since the instruments are often "customized" to meet the portfolio needs of a particular investor, and therefore, the number of investors that are willing and able to buy such instruments in the secondary market may be smaller than that for more traditional debt securities. In addition, because the purchase and sale of hybrid instruments could take place in an over-the-counter market without the guarantee of a central clearing organization or in a transaction between the fund and the issuer of the hybrid instrument, the creditworthiness of the counterparty or issuer of the hybrid instrument would be an additional risk factor which the fund would have to consider and monitor. Hybrid instruments also may not be subject to regulation by the Commodities Futures Trading Commission ("CFTC"), which generally regulates the trading of commodity futures by U.S. persons, the SEC, which regulates the offer and sale of securities by and to U.S. persons, or any other governmental regulatory authority. The various risks discussed above, particularly the market risk of such instruments, may in turn cause significant fluctuations in the net asset value of the fund. Accordingly, the fund will limit its investments in hybrid instruments to 10% of total assets. However, because of their volatility, it is possible that the fund's investment in hybrid instruments will account for more than 10% of the fund's return (positive or negative). All funds When-Issued Securities and Forward Commitment Contracts The price of such securities, which may be expressed in yield terms, is fixed at the time the commitment to purchase is made, but delivery and payment take place at a later date. Normally, the settlement date occurs within 90 days of the purchase for when-issueds, but may be substantially longer for forwards. During the 17 period between purchase and settlement, no payment is made by the fund to the issuer and no interest accrues to the fund. The purchase of these securities will result in a loss if their values decline prior to the settlement date. This could occur, for example, if interest rates increase prior to settlement. The longer the period between purchase and settlement, the greater the risks. At the time the fund makes the commitment to purchase these securities, it will record the transaction and reflect the value of the security in determining its net asset value. The fund will cover these securities by maintaining cash, liquid, high-grade debt securities, or other suitable cover as permitted by the SEC with its custodian bank equal in value to commitments for them during the time between the purchase and the settlement. Therefore, the longer this period, the longer the period during which alternative investment options are not available to the fund (to the extent of the securities used for cover). Such securities either will mature or, if necessary, be sold on or before the settlement date. To the extent the fund remains fully or almost fully invested (in securities with a remaining maturity of more than one year) at the same time it purchases these securities, there will be greater fluctuations in the fund's net asset value than if the fund did not purchase them. Additional Adjustable Rate Securities Certain securities may be issued with adjustable interest rates that are reset periodically by predetermined formulas or indexes in order to minimize movements in the principal value of the investment. Such securities may have long-term maturities, but may be treated as a short-term investment under certain conditions. Generally, as interest rates decrease or increase, the potential for capital appreciation or depreciation on these securities is less than for fixed-rate obligations. These securities may take the following forms: Variable Rate Securities Variable rate instruments are those whose terms provide for the adjustment of their interest rates on set dates and which, upon such adjustment, can reasonably be expected to have a market value that approximates its par value. A variable rate instrument, the principal amount of which is scheduled to be paid in 397 days or less, is deemed to have a maturity equal to the period remaining until the next readjustment of the interest rate. A variable rate instrument which is subject to a demand feature entitles the purchaser to receive the principal amount of the underlying security or securities, either (i) upon notice of no more than 30 days or (ii) at specified intervals not exceeding 397 days and upon no more than 30 days' notice, is deemed to have a maturity equal to the longer of the period remaining until the next readjustment of the interest rate or the period remaining until the principal amount can be recovered through demand. Floating-Rate Securities Floating-rate instruments are those whose terms provide for the adjustment of their interest rates whenever a specified interest rate changes and which, at any time, can reasonably be expected to have a market value that approximates its par value. The maturity of a floating-rate instrument is deemed to be the period remaining until the date (noted on the face of the instrument) on which the principal amount must be paid, or in the case of an instrument called for redemption, the date on which the redemption payment must be made. Floating-rate instruments with demand features are deemed to have a maturity equal to the period remaining until the principal amount can be recovered through demand. Put Option Bonds Long-term obligations with maturities longer than one year may provide purchasers an optional or mandatory tender of the security at par value at predetermined intervals, often ranging from one month to several years (e.g., a 30-year bond with a five-year tender period). These instruments are deemed to have a maturity equal to the period remaining to the put date. Corporate Income, High Yield, Institutional High Yield, New Income, Personal Strategy, Prime Reserve, Reserve Investment, and Short-Term Bond Funds Illiquid or Restricted Securities Restricted securities may be sold only in privately negotiated transactions or in a public offering with respect to which a registration statement is in effect under the Securities Act of 1933 (the "1933 Act"). Where registration is required, the fund may be obligated to pay all or part of the registration expenses, and a considerable period may elapse between the time of the decision to sell and the time the fund may be permitted to sell a security under an effective registration statement. If, during such a period, adverse market conditions were to develop, the fund might obtain a less favorable price than prevailed when it decided to sell. Restricted securities will be priced at fair value as determined in accordance with procedures prescribed by the fund's Board of Directors. If, through the appreciation of illiquid securities or the depreciation of liquid 18 securities, the fund should be in a position where more than 15% of the value of its net assets is invested in illiquid assets, including restricted securities, the fund will take appropriate steps to protect liquidity. Notwithstanding the above, the fund may purchase securities which, while privately placed, are eligible for purchase and sale under Rule 144A under the 1933 Act. This rule permits certain qualified institutional buyers, such as the fund, to trade in privately placed securities even though such securities are not registered under the 1933 Act. T. Rowe Price, under the supervision of the fund's Board of Directors, will consider whether securities purchased under Rule 144A are illiquid and thus subject to the fund's restriction of investing no more than 15% of its net assets in illiquid securities. A determination of whether a Rule 144A security is liquid or not is a question of fact. In making this determination, T. Rowe Price will consider the trading markets for the specific security, taking into account the unregistered nature of a Rule 144A security. In addition, T. Rowe Price could consider the following: (1) frequency of trades and quotes; (2) number of dealers and potential purchasers; (3) dealer undertakings to make a market; and (4) the nature of the security and of marketplace trades (e.g., the time needed to dispose of the security, the method of soliciting offers, and the mechanics of transfer). The liquidity of Rule 144A securities would be monitored and, if as a result of changed conditions it is determined that a Rule 144A security is no longer liquid, the fund's holdings of illiquid securities would be reviewed to determine what, if any, steps are required to assure that the fund does not invest more than 15% of its net assets in illiquid securities. Investing in Rule 144A securities could have the effect of increasing the amount of the fund's assets invested in illiquid securities if qualified institutional buyers are unwilling to purchase such securities. New Income and Short-Term Bond Funds Industry Concentration When the market for corporate debt securities is dominated by issues in the gas utility, gas transmission utility, electric utility, telephone utility, or petroleum industry, the fund will as a matter of fundamental policy concentrate 25% or more, but not more than 50%, of its assets, in any one such industry, if the fund has cash for such investment (i.e., the fund will not sell portfolio securities to raise cash) and, if in T. Rowe Price's judgment, the return available and the marketability, quality, and availability of the debt securities of such industry justifies such concentration in light of the fund's investment objectives. Domination would exist with respect to any one such industry, when, in the preceding 30-day period, more than 25% of all new-issue corporate debt offerings (within the four highest grades of Moody's or S&P's and with maturities of 10 years or less) of $25,000,000 or more consisted of issues in such industry. Although the fund will normally purchase corporate debt securities in the secondary market as opposed to new offerings, T. Rowe Price believes that the new issue-based dominance standard, as defined above, is appropriate because it is easily determined and represents an accurate correlation to the secondary market. Investors should understand that concentration in any industry may result in increased risk. Investments in any of these industries may be affected by environmental conditions, energy conservation programs, fuel shortages, difficulty in obtaining adequate return on capital in financing operations and large construction programs, and the ability of the capital markets to absorb debt issues. In addition, it is possible that the public service commissions which have jurisdiction over these industries may not grant future increases in rates sufficient to offset increases in operating expenses. These industries also face numerous legislative and regulatory uncertainties at both federal and state government levels. Management believes that any risk to the fund which might result from concentration in any industry will be minimized by the fund's practice of diversifying its investments in other respects. The fund's policy with respect to industry concentration is a fundamental policy. (For investment restriction on industry concentration, see "Investment Restrictions"). PORTFOLIO MANAGEMENT PRACTICES ------------------------------------------------------------------------------- Lending of Portfolio Securities Securities loans are made to broker-dealers, institutional investors, or other persons pursuant to agreements requiring that the loans be continuously secured by collateral at least equal at all times to the value of the securities lent, marked to market on a daily basis. The collateral received will consist of cash, U.S. government 19 securities, letters of credit, or such other collateral as may be permitted under its investment program. The collateral, in turn, is invested in short-term securities. While the securities are being lent, the fund will continue to receive the equivalent of the interest or dividends paid by the issuer on the securities, as well as a portion of the interest on the investment of the collateral. Normally, the fund employs an agent to implement its securities lending program and the agent receives a fee from the fund for its services. The fund has a right to call each loan and obtain the securities within such period of time coincides with the normal settlement period for purchases and sales of such securities in the respective markets. The fund will not have the right to vote on securities while they are being lent, but it will call a loan in anticipation of any important vote. The risks in lending portfolio securities, as with other extensions of secured credit, consist of a possible default by the borrower, delay in receiving additional collateral or in the recovery of the securities or possible loss of rights in the collateral, should the borrower fail financially. Loans will be made only to firms deemed by T. Rowe Price to be of good standing and will not be made unless, in the judgment of T. Rowe Price, the consideration to be earned from such loans would justify the risk. Additionally, the fund bears the risk that the reinvestment of collateral will result in a principal loss. Finally, there is also the risk that the price of the securities will increase while they are on loan and the collateral will not adequately cover their value. Interfund Borrowing and Lending The fund is a party to an exemptive order received from the SEC on December 8, 1998, amended on November 23, 1999, that permits it to borrow money from and/or lend money to other funds in the T. Rowe Price complex ("Price Funds"). All loans are set at an interest rate between the rates charged on overnight repurchase agreements and short-term bank loans. All loans are subject to numerous conditions designed to ensure fair and equitable treatment of all participating funds. The program is subject to the oversight and periodic review of the Boards of Directors of the Price Funds. Repurchase Agreements The fund may enter into a repurchase agreement through which an investor (such as the fund) purchases a security (known as the "underlying security") from a well-established securities dealer or a bank that is a member of the Federal Reserve System. Any such dealer or bank will be on T. Rowe Price's approved list. At that time, the bank or securities dealer agrees to repurchase the underlying security at the same price, plus specified interest. Repurchase agreements are generally for a short period of time, often less than a week. Repurchase agreements which do not provide for payment within seven days will be treated as illiquid securities. The fund will only enter into repurchase agreements where (i) (A) Government Reserve Investment, Prime Reserve, Reserve Investment, and U.S. Treasury Money Funds-- the underlying securities are either U.S. government securities or securities that, at the time the repurchase agreement is entered into, are rated in the highest rating category by the requisite number of NRSROs (as required by Rule 2a-7 under the 1940 Act) and otherwise are of the type (excluding maturity limitations) which the fund's investment guidelines would allow it to purchase directly , (B) Corporate Income, GNMA, High Yield, New Income, Personal Strategy, Short-Term Bond, U.S. Treasury Intermediate, and U.S. Treasury Long-Term Funds--the underlying securities are of the type (excluding maturity limitations) which the fund's investment guidelines would allow it to purchase directly ; (ii) the market value of the underlying security, including interest accrued, will be equal to or exceed the value of the repurchase agreement; and (iii) payment for the underlying security is made only upon physical delivery or evidence of book-entry transfer to the account of the custodian or a bank acting as agent. In the event of a bankruptcy or other default of a seller of a repurchase agreement, the fund could experience both delays in liquidating the underlying security and losses, including: (a) possible decline in the value of the underlying security during the period while the fund seeks to enforce its rights thereto; (b) possible subnormal levels of income and lack of access to income during this period; and (c) expenses of enforcing its rights. Reverse Repurchase Agreements Although the fund has no current intention of engaging in reverse repurchase agreements, the fund reserves the right to do so. Reverse repurchase agreements are ordinary repurchase agreements in which a fund is the seller of, rather than the investor in, securities and agrees to repurchase them at an agreed upon time and price. Use of a reverse repurchase agreement may be preferable to a regular sale and later repurchase of the securities because it avoids certain market risks and transaction costs. A reverse repurchase agreement may be viewed as a type of borrowing by the fund, subject to Investment Restriction (1). (See "Investment Restrictions.") 20 All funds except Government Reserve Investment and Reserve Investment Funds Money Market Reserves The fund may invest its cash reserves primarily in one or more money market funds established for the exclusive use of the T. Rowe Price family of mutual funds and other clients of T. Rowe Price. Currently, two such money market funds are in operation: T. Rowe Price Reserve Investment Fund and T. Rowe Price Government Reserve Investment Fund, each a series of the T. Rowe Price Reserve Investment Funds, Inc. . (The Prime Reserve and U.S. Treasury Money Funds will not purchase shares of either fund, and the GNMA, U.S. Treasury Intermediate, and U.S. Treasury Long-Term Funds can only purchase shares of GRF.) Additional series may be created in the future. These funds were created and operate under an Exemptive Order issued by the SEC (Investment Company Act Release No. IC-22770, July 29, 1997). Both funds must comply with the requirements of Rule 2a-7 under the 1940 Act governing money market funds. The RIF invests at least 95% of its total assets in prime money market instruments receiving the highest credit rating. The GRF invests primarily in a portfolio of U.S. government-backed securities, primarily U.S. Treasuries, and repurchase agreements thereon. The RIF and GRF provide a very efficient means of managing the cash reserves of the fund. While neither RIF nor GRF pays an advisory fee to the investment manager, they will incur other expenses. However, the RIF and GRF are expected by T. Rowe Price to operate at very low expense ratios. The fund will only invest in RIF or GRF to the extent it is consistent with its objective and program. Neither fund is insured or guaranteed by the FDIC or any other government agency. Although the funds seek to maintain a stable net asset value of $1.00 per share, it is possible to lose money by investing in them. High Yield and Institutional High Yield Funds Short Sales The fund may make short sales for hedging purposes to protect the fund against companies whose credit is deteriorating. Short sales are transactions in which the fund sells a security it does not own in anticipation of a decline in the market value of that security. The fund's short sales would be limited to situations where the fund owns a debt security of a company and would sell short the common or preferred stock or another debt security at a different level of the capital structure of the same company. No securities will be sold short if, after the effect is given to any such short sale, the total market value of all securities sold short would exceed 2% of the value of the fund's net assets. To complete a short-sale transaction, the fund must borrow the security to make delivery to the buyer. The fund then is obligated to replace the security borrowed by purchasing it at the market price at the time of replacement. The price at such time may be more or less than the price at which the security was sold by the fund. Until the security is replaced, the fund is required to pay to the lender amounts equal to any dividends or interest which accrue during the period of the loan. To borrow the security, the fund also may be required to pay a premium, which would increase the cost of the security sold. The proceeds of the short sale will be retained by the broker, to the extent necessary to meet margin requirements, until the short position is closed out. Until the fund replaces a borrowed security in connection with a short sale, the fund will: (a) maintain daily a segregated account, containing cash, U.S. government securities, or other suitable cover as permitted by the SEC, at such a level that (i) the amount deposited in the account plus the amount deposited with the broker as collateral will equal the current value of the security sold short and (ii) the amount deposited in the segregated account plus the amount deposited with the broker as collateral will not be less than the market value of the security at the time its was sold short; or (b) otherwise cover its short position. The fund will incur a loss as a result of the short sale if the price of the security sold short increases between the date of the short sale and the date on which the fund replaces the borrowed security. The fund will realize a gain if the security sold short declines in price between those dates. This result is the opposite of what one would expect from a cash purchase of a long position in a security. The amount of any gain will be decreased, and the amount of any loss increased, by the amount of any premium, dividends, or interest the fund may be 21 required to pay in connection with a short sale. Any gain or loss on the security sold short would be separate from a gain or loss on the fund security being hedged by the short sale. The Taxpayer Relief Act of 1997 requires a mutual fund to recognize gain upon entering into a constructive sale of stock, a partnership interest, or certain debt positions occurring after June 8, 1997. A constructive sale is deemed to occur if the fund enters into a short sale, an offsetting notional principal contract, or a futures or forward contract which is substantially identical to the appreciated position. Some of the transactions in which the fund is permitted to invest may cause certain appreciated positions in securities held by the fund to qualify as a "constructive sale," in which case it would be treated as sold and the resulting gain subjected to tax or, in the case of a mutual fund, distributed to shareholders. If this were to occur, the fund would be required to distribute such gains even though it would receive no cash until the later sale of the security. Such distributions could reduce the amount of cash available for investment by the fund. Because these rules do not apply to "straight" debt transactions, it is not anticipated that they will have a significant impact on the fund; however, the effect cannot be determined until the issuance of clarifying regulations. All funds except Government Reserve Investment, Prime Reserve, Reserve Investment, and U.S. Treasury Money Funds Options Options are a type of potentially high-risk derivative. Writing Covered Call Options The fund may write (sell) American or European style "covered" call options and purchase options to close out options previously written by the fund. In writing covered call options, the fund expects to generate additional premium income, which should serve to enhance the fund's total return and reduce the effect of any price decline of the security or currency involved in the option. Covered call options will generally be written on securities or currencies which, in T. Rowe Price's opinion, are not expected to have any major price increases or moves in the near future but which, over the long term, are deemed to be attractive investments for the fund. A call option gives the holder (buyer) the right to purchase, and the writer (seller) has the obligation to sell, a security or currency at a specified price (the exercise price) at expiration of the option (European style) or at any time until a certain date (the expiration date) (American style). So long as the obligation of the writer of a call option continues, he may be assigned an exercise notice by the broker-dealer through whom such option was sold, requiring him to deliver the underlying security or currency against payment of the exercise price. This obligation terminates upon the expiration of the call option or such earlier time at which the writer effects a closing purchase transaction by repurchasing an option identical to that previously sold. To secure his obligation to deliver the underlying security or currency in the case of a call option, a writer is required to deposit in escrow the underlying security or currency or other assets in accordance with the rules of a clearing corporation. The fund generally will write only covered call options. This means that the fund will either own the security or currency subject to the option or an option to purchase the same underlying security or currency having an exercise price equal to or less than the exercise price of the "covered" option. From time to time, the fund will write a call option that is not covered as indicated above but where the fund will establish and maintain, with its custodian for the term of the option, an account consisting of cash, U.S. government securities, other liquid high-grade debt obligations, or other suitable cover as permitted by the SEC, having a value equal to the fluctuating market value of the optioned securities or currencies. While such an option would be "covered" with sufficient collateral to satisfy SEC prohibitions on issuing senior securities, this type of strategy would expose the fund to the risks of writing uncovered options. Portfolio securities or currencies on which call options may be written will be purchased solely on the basis of investment considerations consistent with the fund's investment objective. The writing of covered call options is a conservative investment technique believed to involve relatively little risk (in contrast to the writing of naked or uncovered options, which the fund generally will not do) but capable of enhancing the fund's total return. When writing a covered call option, a fund, in return for the premium, gives up the opportunity for profit from a price increase in the underlying security or currency above the exercise price, but conversely 22 retains the risk of loss should the price of the security or currency decline. Unlike one that owns securities or currencies not subject to an option, the fund has no control over when it may be required to sell the underlying securities or currencies, since it may be assigned an exercise notice at any time prior to the expiration of its obligation as a writer. If a call option the fund has written expires, the fund will realize a gain in the amount of the premium; however, such gain may be offset by a decline in the market value of the underlying security or currency during the option period. If the call option is exercised, the fund will realize a gain or loss from the sale of the underlying security or currency. The fund does not consider a security or currency covered by a call to be "pledged" as that term is used in the fund's policy, which limits the pledging or mortgaging of its assets. If the fund writes an uncovered option as described above, it will bear the risk of having to purchase the security subject to the option at a price higher than the exercise price of the option. As the price of a security could appreciate substantially, the fund's loss could be significant. The premium received is the market value of an option. The premium the fund will receive from writing a call option will reflect, among other things, the current market price of the underlying security or currency, the relationship of the exercise price to such market price, the historical price volatility of the underlying security or currency, and the length of the option period. Once the decision to write a call option has been made, T. Rowe Price, in determining whether a particular call option should be written on a particular security or currency, will consider the reasonableness of the anticipated premium and the likelihood that a liquid secondary market will exist for those options. The premium received by the fund for writing covered call options will be recorded as a liability of the fund. This liability will be adjusted daily to the option's current market value, which will be the latest sale price on its primary exchange at the time at which the net asset value per share of the fund is computed (close of the New York Stock Exchange) or, in the absence of such sale, the mean of closing bid and ask prices. The option will be terminated upon expiration of the option, the purchase of an identical option in a closing transaction, or delivery of the underlying security or currency upon the exercise of the option. Closing transactions will be effected in order to realize a profit on an outstanding call option, to prevent an underlying security or currency from being called, or to permit the sale of the underlying security or currency. Furthermore, effecting a closing transaction will permit the fund to write another call option on the underlying security or currency with either a different exercise price or expiration date or both. If the fund desires to sell a particular security or currency from its portfolio on which it has written a call option, or purchased a put option, it will seek to effect a closing transaction prior to, or concurrently with, the sale of the security or currency. There is, of course, no assurance that the fund will be able to effect such closing transactions at favorable prices. If the fund cannot enter into such a transaction, it may be required to hold a security or currency that it might otherwise have sold. When the fund writes a covered call option, it runs the risk of not being able to participate in the appreciation of the underlying securities or currencies above the exercise price, as well as the risk of being required to hold on to securities or currencies that are depreciating in value. This could result in higher transaction costs. The fund will pay transaction costs in connection with the writing of options to close out previously written options. Such transaction costs are normally higher than those applicable to purchases and sales of portfolio securities. Call options written by the fund will normally have expiration dates of less than nine months from the date written. The exercise price of the options may be below, equal to, or above the current market values of the underlying securities or currencies at the time the options are written. From time to time, the fund may purchase an underlying security or currency for delivery in accordance with an exercise notice of a call option assigned to it, rather than delivering such security or currency from its portfolio. In such cases, additional costs may be incurred. The fund will realize a profit or loss from a closing purchase transaction if the cost of the transaction is less or more than the premium received from the writing of the option. Because increases in the market price of a call option will generally reflect increases in the market price of the underlying security or currency, any loss resulting from the repurchase of a call option is likely to be offset in whole or in part by appreciation of the underlying security or currency owned by the fund. The fund will not write a covered call option if, as a result, the aggregate market value of all portfolio securities or currencies covering written call or put options exceeds 25% of the market value of the fund's total assets. In 23 calculating the 25% limit, the fund will offset the value of securities underlying purchased calls and puts on identical securities or currencies with identical maturity dates. Writing Covered Put Options The fund may write American or European style covered put options and purchase options to close out options previously written by the fund. A put option gives the purchaser of the option the right to sell, and the writer (seller) has the obligation to buy, the underlying security or currency at the exercise price during the option period (American style) or at the expiration of the option (European style). So long as the obligation of the writer continues, he may be assigned an exercise notice by the broker-dealer through whom such option was sold, requiring him to make payment to the exercise price against delivery of the underlying security or currency. The operation of put options in other respects, including their related risks and rewards, is substantially identical to that of call options. The fund would write put options only on a covered basis. This means that the fund would maintain, in a segregated account, cash, U.S. government securities, other liquid high-grade debt obligations, or other suitable cover as determined by the SEC, in an amount not less than the exercise price. Alternatively, the fund will own an option to sell the underlying security or currency subject to the option having an exercise price equal to or greater than the exercise price of the "covered" option at all times while the put option is outstanding. (The rules of a clearing corporation currently require that such assets be deposited in escrow to secure payment of the exercise price.) The fund would generally write covered put options in circumstances where T. Rowe Price wishes to purchase the underlying security or currency for the fund's portfolio at a price lower than the current market price of the security or currency. In such event the fund would write a put option at an exercise price which, reduced by the premium received on the option, reflects the lower price it is willing to pay. Since the fund would also receive interest on debt securities or currencies maintained to cover the exercise price of the option, this technique could be used to enhance current return during periods of market uncertainty. The risk in such a transaction would be that the market price of the underlying security or currency would decline below the exercise price, less the premiums received. Such a decline could be substantial and result in a significant loss to the fund. In addition, the fund, because it does not own the specific securities or currencies which it may be required to purchase in exercise of the put, cannot benefit from appreciation, if any, with respect to such specific securities or currencies. The fund will not write a covered put option if, as a result, the aggregate market value of all portfolio securities or currencies covering put or call options exceeds 25% of the market value of the fund's total assets. In calculating the 25% limit, the fund will offset the value of securities underlying purchased puts and calls on identical securities or currencies with identical maturity dates. The premium received by the fund for writing covered put options will be recorded as a liability of the fund. This liability will be adjusted daily to the option's current market value, which will be the latest sale price on its primary exchange at the time at which the net asset value per share of the fund is computed (close of the New York Stock Exchange), or, in the absence of such sale, the mean of the closing bid and ask prices. Purchasing Put Options The fund may purchase American or European style put options. As the holder of a put option, the fund has the right to sell the underlying security or currency at the exercise price at any time during the option period (American style) or at the expiration of the option (European style). The fund may enter into closing sale transactions with respect to such options, exercise them, or permit them to expire. The fund may purchase put options for defensive purposes in order to protect against an anticipated decline in the value of its securities or currencies. An example of such use of put options is provided next. The fund may purchase a put option on an underlying security or currency (a "protective put") owned by the fund as a defensive technique in order to protect against an anticipated decline in the value of the security or currency. Such hedge protection is provided only during the life of the put option when the fund, as the holder of the put option, is able to sell the underlying security or currency at the put exercise price regardless of any decline in the underlying security's market price or currency's exchange value. For example, a put option may be purchased in order to protect unrealized appreciation of a security or currency where T. Rowe 24 Price deems it desirable to continue to hold the security or currency because of tax considerations. The premium paid for the put option and any transaction costs would reduce any capital gain otherwise available for distribution when the security or currency is eventually sold. The fund may also purchase put options at a time when the fund does not own the underlying security or currency. By purchasing put options on a security or currency it does not own, the fund seeks to benefit from a decline in the market price of the underlying security or currency. If the put option is not sold when it has remaining value and if the market price of the underlying security or currency remains equal to or greater than the exercise price during the life of the put option, the fund will lose its entire investment in the put option. In order for the purchase of a put option to be profitable, the market price of the underlying security or currency must decline sufficiently below the exercise price to cover the premium and transaction costs, unless the put option is sold in a closing sale transaction. The fund will not commit more than 5% of its assets to premiums when purchasing put options. The premium paid by the fund when purchasing a put option will be recorded as an asset of the fund in the portfolio of investments. This asset will be adjusted daily to the option's current market value, which will be the latest sale price on its primary exchange at the time at which the net asset value per share of the fund is computed (close of New York Stock Exchange) or, in the absence of such sale, the mean of closing bid and ask prices. This asset will be terminated upon expiration of the option, the selling (writing) of an identical option in a closing transaction, or the delivery of the underlying security or currency upon the exercise of the option. Purchasing Call Options The fund may purchase American or European style call options. As the holder of a call option, the fund has the right to purchase the underlying security or currency at the exercise price at any time during the option period (American style) or at the expiration of the option (European style). The fund may enter into closing sale transactions with respect to such options, exercise them, or permit them to expire. The fund may purchase call options for the purpose of increasing its current return or avoiding tax consequences which could reduce its current return. The fund may also purchase call options in order to acquire the underlying securities or currencies. Examples of such uses of call options are provided next. Call options may be purchased by the fund for the purpose of acquiring the underlying securities or currencies for its portfolio. Utilized in this fashion, the purchase of call options enables the fund to acquire the securities or currencies at the exercise price of the call option plus the premium paid. At times the net cost of acquiring securities or currencies in this manner may be less than the cost of acquiring the securities or currencies directly. This technique may also be useful to the fund in purchasing a large block of securities or currencies that would be more difficult to acquire by direct market purchases. So long as it holds such a call option, rather than the underlying security or currency itself, the fund is partially protected from any unexpected decline in the market price of the underlying security or currency and in such event could allow the call option to expire, incurring a loss only to the extent of the premium paid for the option. The fund may also purchase call options on underlying securities or currencies it owns in order to protect unrealized gains on call options previously written by it. A call option would be purchased for this purpose where tax considerations make it inadvisable to realize such gains through a closing purchase transaction. Call options may also be purchased at times to avoid realizing losses. The fund will not commit more than 5% of its assets to premiums when purchasing call and put options. The premium paid by the fund when purchasing a call option will be recorded as an asset of the fund. This asset will be adjusted daily to the option's current market value, which will be the latest sale price on its primary exchange at the time at which the net asset value per share of the fund is computed (close of New York Stock Exchange), or, in the absence of such sale, the mean of closing bid and ask prices. Dealer (Over-the-Counter) Options The fund may engage in transactions involving dealer options. Certain risks are specific to dealer options. While the fund would look to a clearing corporation to exercise exchange-traded options, if the fund were to purchase a dealer option, it would rely on the dealer from whom it purchased the option to perform if the option were exercised. Failure by the dealer to do so would result in the loss of the premium paid by the fund as well as loss of the expected benefit of the transaction. 25 Exchange-traded options generally have a continuous liquid market, while dealer options have none. Consequently, the fund will generally be able to realize the value of a dealer option it has purchased only by exercising it or reselling it to the dealer who issued it. Similarly, when the fund writes a dealer option, it generally will be able to close out the option prior to its expiration only by entering into a closing purchase transaction with the dealer to which the fund originally wrote the option. While the fund will seek to enter into dealer options only with dealers who will agree to and 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 a dealer option at a favorable price at any time prior to expiration. Until the fund, as a covered dealer call option writer, is able to effect a closing purchase transaction, it will not be able to liquidate securities (or other assets) or currencies used as cover until the option expires or is exercised. In the event of insolvency of the counter-party, the fund may be unable to liquidate a dealer 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. For example, since the fund must maintain a secured position with respect to any call option on a security it writes, the fund may not sell the assets it has segregated to secure the position while it is obligated under the option. This requirement may impair a fund's ability to sell portfolio securities or currencies at a time when such sale might be advantageous. The staff of the SEC has taken the position that purchased dealer options and the assets used to secure the written dealer options are illiquid securities. The fund may treat the cover used for written Over-the-Counter ("OTC") options as liquid if the dealer agrees that the fund may repurchase the OTC option it has written for a maximum price to be calculated by a predetermined formula. In such cases, the OTC option would be considered illiquid only to the extent the maximum repurchase price under the formula exceeds the intrinsic value of the option. High Yield and Institutional High Yield Funds Spread Option Transactions The fund may purchase from and sell to securities dealers covered spread options. Such covered spread options are not presently exchange listed or traded. The purchase of a spread option gives the fund the right to put, or sell, a security that it owns at a fixed dollar spread or fixed yield spread in relationship to another security that the fund does not own, but which is used as a benchmark. The risk to the fund in purchasing covered spread options is the cost of the premium paid for the spread options and any transaction costs. In addition, there is no assurance that closing transactions will be available. The purchase of spread options will be used to protect the fund against adverse changes in prevailing credit quality spreads, i.e., the yield spread between high-quality and lower-quality securities. Such protection is only provided during the life of the spread option. The security covering the spread option will be maintained in a segregated account by the fund's custodian. The fund does not consider a security covered by a spread option to be "pledged" as that term is used in the fund's policy limiting the pledging or mortgaging of its assets. The fund may also buy and sell uncovered spread options. Such options would be used for the same purposes and be subject to similar risks as covered spread options. However, in an uncovered spread option, the fund would not own either of the securities involved in the spread. All funds except Government Reserve Investment, Prime Reserve, Reserve Investment, and U.S. Treasury Money Funds Futures Contracts Futures contracts are a type of potentially high-risk derivative. Transactions in Futures The fund may enter into futures contracts including stock index, interest rate, and currency futures ("futures" or "futures contracts"). Stock index futures contracts may be used to provide a hedge for a portion of the fund's portfolio, as a cash management tool, or as an efficient way for T. Rowe Price to implement either an increase or decrease in portfolio market exposure in response to changing market conditions. The fund may purchase or sell futures contracts with respect to any stock index. Nevertheless, to hedge the fund's portfolio successfully, the fund must sell futures contracts with respect to indices or subindices whose movements will have a significant correlation with movements in the prices of the fund's portfolio securities. 26 Interest rate or currency futures contracts may be used as a hedge against changes in prevailing levels of interest rates or currency exchange rates in order to establish more definitely the effective return on securities or currencies held or intended to be acquired by the fund. In this regard, the fund could sell interest rate or currency futures as an offset against the effect of expected increases in interest rates or currency exchange rates and purchase such futures as an offset against the effect of expected declines in interest rates or currency exchange rates. The fund will enter into futures contracts, which are traded on national or foreign futures exchanges and are standardized as to maturity date and underlying financial instrument. Futures exchanges and trading in the United States are regulated under the Commodity Exchange Act by the CFTC. Although techniques other than the sale and purchase of futures contracts could be used for the above-referenced purposes, futures contracts offer an effective and relatively low-cost means of implementing the fund's objectives in these areas. Regulatory Limitations If the fund purchases or sells futures contracts or related options which do not qualify as bona fide hedging under applicable CFTC rules, the aggregate initial margin deposits and premium required to establish those positions cannot exceed 5% of the liquidation value of the fund after taking into account unrealized profits and unrealized losses on any such contracts it 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 calculating the 5% limitation. For purposes of this policy, options on futures contracts and foreign currency options traded on a commodities exchange will be considered "related options." This policy may be modified by the Board of Directors without a shareholder vote and does not limit the percentage of the fund's assets at risk to 5%. In instances involving the purchase of futures contracts or the writing of call or put options thereon by the fund, an amount of cash, liquid assets, or other suitable cover as permitted by the SEC, equal to the market value of the futures contracts and options thereon (less any related margin deposits), will be identified by the fund to cover the position, or alternative cover (such as owning an offsetting position) will be employed. Assets used as cover or held in an identified account cannot be sold while the position in the corresponding option or future is open, unless they are replaced with similar assets. As a result, the commitment of a large portion of a fund's assets to cover or identified accounts could impede portfolio management or the fund's ability to meet redemption requests or other current obligations. If the CFTC or other regulatory authorities adopt different (including less stringent) or additional restrictions, the fund would comply with such new restrictions. Trading in Futures Contracts A futures contract provides for the future sale by one party and purchase by another party of a specified amount of a specific financial instrument (e.g., units of a debt security) for a specified price, date, time, and place designated at the time the contract is made. Brokerage fees are incurred when a futures contract is bought or sold and margin deposits must be maintained. Entering into a contract to buy is commonly referred to as buying or purchasing a contract or holding a long position. Entering into a contract to sell is commonly referred to as selling a contract or holding a short position. Unlike when the fund purchases or sells a security, no price would be paid or received by the fund upon the purchase or sale of a futures contract. Upon entering into a futures contract, and to maintain the fund's open positions in futures contracts, the fund would be required to deposit with its custodian in a segregated account in the name of the futures broker an amount of cash or liquid assets known as "initial margin." The margin required for a particular futures contract is set by the exchange on which the contract is traded and may be significantly modified from time to time by the exchange during the term of the contract. Futures contracts are customarily purchased and sold on margins that may range upward from less than 5% of the value of the contract being traded. Financial futures are valued daily at closing settlement prices. If the price of an open futures contract changes (by increase in the case of a sale or by decrease in the case of a purchase) so that the loss on the futures contract reaches a point at which the margin on deposit does not satisfy margin requirements, the broker will require a payment by the fund ("variation margin") to restore the margin account to the amount of the initial margin. 27 Subsequent payments ("mark-to-market payments") to and from the futures broker, are made on a daily basis as the price of the underlying assets fluctuate, making the long and short positions in the futures contract more or less valuable. If the value of the open futures position increases in the case of a sale or decreases in the case of a purchase, the fund will pay the amount of the daily change in value to the broker. However, if the value of the open futures position decreases in the case of a sale or increases in the case of a purchase, the broker will pay the amount of the daily change in value to the fund. Although certain futures contracts, by their terms, require actual future delivery of and payment for the underlying instruments, in practice most futures contracts are usually closed out before the delivery date. Closing out an open futures contract purchase or sale is effected by entering into an offsetting futures contract sale or purchase, respectively, for the same aggregate amount of the identical securities and the same delivery date. If the offsetting purchase price is less than the original sale price, the fund realizes a gain; if it is more, the fund realizes a loss. Conversely, if the offsetting sale price is more than the original purchase price, the fund realizes a gain; if it is less, the fund realizes a loss. The transaction costs must also be included in these calculations. There can be no assurance, however, that the fund will be able to enter into an offsetting transaction with respect to a particular futures contract at a particular time. If the fund is not able to enter into an offsetting transaction, the fund will continue to be required to maintain the margin deposits on the futures contract. As an example of an offsetting transaction in which the underlying instrument is not delivered, the contractual obligations arising from the sale of one contract of September Treasury bills on an exchange may be fulfilled at any time before delivery of the contract is required (i.e., on a specified date in September, the "delivery month") by the purchase of one contract of September Treasury bills on the same exchange. In such instance, the difference between the price at which the futures contract was sold and the price paid for the offsetting purchase, after allowance for transaction costs, represents the profit or loss to the fund. For example, the S&P 500 Stock Index is made up of 500 selected common stocks, most of which are listed on the New York Stock Exchange. The S&P 500 Index assigns relative weightings to the common stocks included in the Index, and the Index fluctuates with changes in the market values of those common stocks. In the case of futures contracts on the S&P 500 Index, the contracts are to buy or sell 250 units. Thus, if the value of the S&P 500 Index were $150, one contract would be worth $37,500 (250 units x $150). The stock index futures contract specifies that no delivery of the actual stocks making up the index will take place. Instead, settlement in cash occurs. Over the life of the contract, the gain or loss realized by the fund will equal the difference between the purchase (or sale) price of the contract and the price at which the contract is terminated. For example, if the fund enters into a futures contract to buy 250 units of the S&P 500 Index at a specified future date at a contract price of $150 and the S&P 500 Index is at $154 on that future date, the fund will gain $1,000 (250 units x gain of $4). If the fund enters into a futures contract to sell 250 units of the stock index at a specified future date at a contract price of $150 and the S&P 500 Index is at $152 on that future date, the fund will lose $500 (250 units x loss of $2). Special Risks of Transactions in Futures Contracts . Volatility and Leverage The prices of futures contracts are volatile and are influenced, among other things, by actual and anticipated changes in the market and interest rates, which in turn are affected by fiscal and monetary policies and national and international political and economic events. Most United States futures exchanges limit the amount of fluctuation permitted in futures contract prices during a single trading day. The daily limit establishes the maximum amount that the price of a futures contract may vary either up or down from the previous day's settlement price at the end of a trading session. Once the daily limit has been reached in a particular type of futures contract, no trades may be made on that day at a price beyond that limit. The daily limit governs only price movement during a particular trading day and therefore does not limit potential losses because the limit may prevent the liquidation of unfavorable positions. Futures contract prices have occasionally moved to the daily limit for several consecutive trading days with little or no trading, thereby preventing prompt liquidation of futures positions and subjecting some futures traders to substantial losses. Margin deposits required on futures trading are low. As a result, a relatively small price movement in a futures contract may result in immediate and substantial loss, as well as gain, to the investor. For example, if at the 28 time of purchase, 10% of the value of the futures contract is deposited as margin, a subsequent 10% decrease in the value of the futures contract would result in a total loss of the margin deposit, before any deduction for the transaction costs, if the account were then closed out. A 15% decrease would result in a loss equal to 150% of the original margin deposit, if the contract were closed out. Thus, a purchase or sale of a futures contract may result in losses in excess of the amount invested in the futures contract. . Liquidity The fund may elect to close some or all of its futures positions at any time prior to their expiration. The fund would do so to reduce exposure represented by long futures positions or short futures positions. The fund may close its positions by taking opposite positions, which would operate to terminate the fund's position in the futures contracts. Final determinations of mark-to-market payments would then be made, additional cash would be required to be paid by or released to the fund, and the fund would realize a loss or a gain. Futures contracts may be closed out only on the exchange or board of trade where the contracts were initially traded. Although the fund intends to purchase or sell futures contracts only on exchanges or boards of trade where there appears to be an active market, there is no assurance that a liquid market on an exchange or board of trade will exist for any particular contract at any particular time. In such event, it might not be possible to close a futures contract, and in the event of adverse price movements, the fund would continue to be required to make daily mark-to-market and variation margin payments. However, in the event futures contracts have been used to hedge the underlying instruments, the fund would continue to hold the underlying instruments subject to the hedge until the futures contracts could be terminated. In such circumstances, an increase in the price of underlying instruments, if any, might partially or completely offset losses on the futures contract. However, as described next, there is no guarantee that the price of the underlying instruments will, in fact, correlate with the price movements in the futures contract and thus provide an offset to losses on a futures contract. . Hedging Risk A decision whether, when, and how to hedge involves skill and judgment, and even a well-conceived hedge may be unsuccessful to some degree because of unexpected market or economic events. There are several risks in connection with the use by the fund of futures contracts as a hedging device. One risk arises because of the imperfect correlation between movements in the prices of the futures contracts and movements in the prices of the underlying instruments which are the subject of the hedge. T. Rowe Price will, however, attempt to reduce this risk by entering into futures contracts whose movements, in its judgment, will have a significant correlation with movements in the prices of the fund's underlying instruments sought to be hedged. Successful use of futures contracts by the fund for hedging purposes is also subject to T. Rowe Price's ability to correctly predict movements in the direction of the market. It is possible that, when the fund has sold futures to hedge its portfolio against a decline in the market, the index, indices, or instruments underlying futures might advance, and the value of the underlying instruments held in the fund's portfolio might decline. If this were to occur, the fund would lose money on the futures and also would experience a decline in value in its underlying instruments. However, while this might occur to a certain degree, T. Rowe Price believes that over time the value of the fund's portfolio will tend to move in the same direction as the market indices used to hedge the portfolio. It is also possible that, if the fund were to hedge against the possibility of a decline in the market (adversely affecting the underlying instruments held in its portfolio) and prices instead increased, the fund would lose part or all of the benefit of increased value of those underlying instruments that it had hedged because it would have offsetting losses in its futures positions. In addition, in such situations, if the fund had insufficient cash, it might have to sell underlying instruments to meet daily mark-to-market and variation margin requirements. Such sales of underlying instruments might be, but would not necessarily be, at increased prices (which would reflect the rising market). The fund might have to sell underlying instruments at a time when it would be disadvantageous to do so. In addition to the possibility that there might be an imperfect correlation, or no correlation at all, between price movements in the futures contracts and the portion of the portfolio being hedged, the price movements of futures contracts might not correlate perfectly with price movements in the underlying instruments due to certain market distortions. First, all participants in the futures market are subject to margin deposit and maintenance requirements. Rather than meeting additional margin deposit requirements, investors might close futures contracts through offsetting transactions, which could distort the normal relationship between the 29 underlying instruments and futures markets. Second, the margin requirements in the futures market are less onerous than margin requirements in the securities markets and, as a result, the futures market might attract more speculators than the securities markets. Increased participation by speculators in the futures market might also cause temporary price distortions. Due to the possibility of price distortion in the futures market and also because of imperfect correlation between price movements in the underlying instruments and movements in the prices of futures contracts, even a correct forecast of general market trends by T. Rowe Price might not result in a successful hedging transaction over a very short time period. Options on Futures Contracts The fund may purchase and sell options on the same types of futures in which it may invest. Options (another type of potentially high-risk derivative) on futures are similar to options on underlying instruments except that options on futures give 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), rather than to purchase or sell the futures contract, at a specified exercise price at any time during the period of the option. Upon exercise of the option, the delivery of the futures position by the writer of the option to the holder of the option will be accompanied by the delivery of 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. Purchasers of options who fail to exercise their options prior to the exercise date suffer a loss of the premium paid. Options on futures contracts are valued daily at the last sale price on its primary exchange at the time at which the net asset value per share of the fund is computed (close of New York Stock Exchange), or, in the absence of such sale, the mean of closing bid and ask prices. As an alternative to writing or purchasing call and put options on interest rate futures, the fund may write or purchase call and put options on financial indices. Such options would be used in a manner similar to the use of options on futures contracts. From time to time, a single order to purchase or sell futures contracts (or options thereon) may be made on behalf of the fund and other T. Rowe Price funds. Such aggregated orders would be allocated among the funds and the other T. Rowe Price funds in a fair and nondiscriminatory manner. Special Risks of Transactions in Options on Futures Contracts The risks described under "Special Risks of Transactions in Futures Contracts" are substantially the same as the risks of using options on futures. If the fund were to write an option on a futures contract, it would be required to deposit and maintain initial and variation margin in the same manner as a regular futures contract. In addition, where the fund seeks to close out an option position by writing or buying an offsetting option covering the same index, underlying instrument, or contract and having the same exercise price and expiration date, its ability to establish and close out positions on such options will be subject to the maintenance of a liquid secondary market. Reasons for the absence of a liquid secondary market on an exchange include the following: (1) there may be insufficient trading interest in certain options; (2) restrictions may be imposed by an exchange on opening transactions or closing transactions or both; (3) trading halts, suspensions, or other restrictions may be imposed with respect to particular classes or series of options, or underlying instruments; (4) unusual or unforeseen circumstances may interrupt normal operations on an exchange; (5) the facilities of an exchange or a clearing corporation may not at all times be adequate to handle current trading volume; or (6) one or more exchanges could, for economic or other reasons, decide or be compelled at some future date 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 the class or series of options) would cease to exist, although outstanding options on the exchange that had been issued by a clearing corporation as a result of trades on that exchange would continue to be exercisable in accordance with their terms. There is no assurance that higher-than-anticipated trading activity or other unforeseen events might not, at times, render certain of the facilities of any of the clearing corporations inadequate, and thereby result in the institution by an exchange of special procedures, which may interfere with the timely execution of customers' orders. 30 Additional Futures and Options Contracts Although the fund has no current intention of engaging in futures or options transactions other than those described above, it reserves the right to do so. Such futures and options trading might involve risks which differ from those involved in the futures and options described above. Foreign Futures and Options Participation in foreign futures and foreign options transactions involves the execution and clearing of trades on or subject to the rules of a foreign board of trade. Neither the National Futures Association nor any domestic exchange regulates activities of any foreign boards of trade, including the execution, delivery, and clearing of transactions, or has the power to compel enforcement of the rules of a foreign board of trade or any applicable foreign law. This is true even if the exchange is formally linked to a domestic market so that a position taken on the market may be liquidated by a transaction on another market. Moreover, such laws or regulations will vary depending on the foreign country in which the foreign futures or foreign options transaction occurs. For these reasons, when the fund trades foreign futures or foreign options contracts, it may not be afforded certain of the protective measures provided by the Commodity Exchange Act, the CFTC's regulations, and the rules of the National Futures Association and any domestic exchange, including the right to use reparations proceedings before the CFTC and arbitration proceedings provided by the National Futures Association or any domestic futures exchange. In particular, funds received from the fund for foreign futures or foreign options transactions may not be provided the same protections as funds received for transactions on United States futures exchanges. In addition, the price of any foreign futures or foreign options contract and, therefore, the potential profit and loss thereon may be affected by any variance in the foreign exchange rate between the time the fund's order is placed and the time it is liquidated, offset, or exercised. Corporate Income, High Yield, Institutional High Yield, New Income, Personal Strategy, and Short-Term Bond Funds Swap Agreements The fund may enter into interest rate, index, total return, credit, and, to the extent it may invest in foreign currency-denominated securities, currency rate swap agreements. The fund may also enter into options on swap agreements ("swap options") on the types of swaps listed above. Swap agreements are two party contracts entered into primarily by institutional investors for a specified period of time. In a standard swap transaction, two parties agree to exchange the returns (or differentials in rates of return) earned or realized on a particular predetermined investment, index, or currency. The gross returns to be exchanged or swapped between the parties are generally calculated with respect to a notional amount, i.e., the return on or increase in value of a particular dollar amount invested at a particular interest rate, in a particular foreign currency, or in a basket of securities representing a particular index. A swap option is a contract that gives a counterparty the right (but not the obligation) to enter into a new swap agreement or to shorten, extend, cancel, or otherwise modify an existing swap agreement at some designated future time on specified terms. The fund may write (sell) and purchase put and call swap options. One example of the use of swaps within a fund may be to manage the interest rate sensitivity of the fund. The fund might receive or pay a fixed-rate interest rate of a particular maturity and pay or receive a floating rate in order to increase or decrease the duration of the fund. Or, the fund may buy or sell swap options to effect the same result. The fund may also replicate a security by selling it, placing the proceeds in cash deposits and receiving a fixed rate in the swap market. Another example is the use of credit default swaps to buy or sell credit protection. A default swap is a bilateral contract that enables an investor to buy/sell protection against a defined-issuer credit event. The seller of credit protection against a security or basket of securities receives an up-front or periodic payment to compensate against potential default event(s). The fund may enhance income by selling protection or protect credit risk by buying protection. Market supply and demand factors may cause distortions between the cash securities market and the default swap market. The credit protection market is still relatively new and should be considered illiquid. Most swap agreements entered into by the fund would calculate the obligations of the parties to the agreement on a "net basis." Consequently, the fund's current obligations (or rights) under a swap agreement will generally 31 be equal only to the net amount to be paid or received under the agreement based on the relative values of the positions held by each party to the agreement (the "net amount"). The fund's current obligations under a net swap agreement will be accrued daily (offset against any amounts owed to the fund) and any accrued but unpaid net amounts owed to a swap counterparty will be covered by assets determined to be liquid by T. Rowe Price. The use of swap agreements by the fund entails certain risks. Interest rate and currency swaps could result in losses if interest rate or currency changes are not correctly anticipated by the fund. Total return swaps could result in losses if the reference index, security, or investments do not perform as anticipated by the fund. Credit default swaps could result in losses if the fund does not correctly evaluate the creditworthiness of the company on which the credit default swap is based. The fund will generally incur a greater degree of risk when it writes a swap option than when it purchases a swap option. When the fund purchases a swap option it risks losing only the amount of the premium it has paid should it decide to let the option expire unexercised. However, when the fund writes a swap option it will become obligated, upon exercise of the option, according to the terms of the underlying agreement. Because swaps are two party contracts and because they may have terms of greater than seven days, swap agreements may be considered to be illiquid. Moreover, the fund bears the risk of loss of the amount expected to be received under a swap agreement in the event of the default or bankruptcy of a swap agreement counterparty. The fund will enter into swap agreements only with counterparties that meet certain standards of creditworthiness. The swaps market is a relatively new market and is largely unregulated. It is possible that developments in the swaps market, including potential government regulation, could adversely affect the fund's ability to terminate existing swap agreements or to realize amounts to be received under such agreements. U.S. Treasury Intermediate and U.S. Treasury Long-Term Funds Limitations on Futures and Options for Intermediate and Long-Term Funds The funds will not purchase a futures contract or option thereon if, with respect to positions in futures or options on futures which do not represent bona fide hedging, the aggregate initial margin and premiums on such positions would exceed 5% of the fund's net asset value. In addition, neither of the funds will enter into a futures transaction if it would be obligated to purchase or deliver amounts that would exceed 15% of the fund's total assets outstanding open futures contracts. A fund will not write a covered call option if, as a result, the aggregate market value of all portfolio securities covering call options or subject to delivery under put options exceeds 15% of the market value of the fund's total assets. A fund will not write a covered put option if, as a result, the aggregate market value of all portfolio securities subject to such put options or covering call options exceeds 15% of the market value of the fund's total assets. The funds have no current intention of investing in options on securities. However, they reserve the right to do so in the future and could be subject to the following limitations: a fund may invest up to 15% of its total assets in premiums on put options and 15% of its total assets in premiums on call options. The total amount of a fund's total assets invested in futures and options will not exceed 15% of the fund's total assets. Corporate Income, High Yield, Institutional High Yield, New Income, Personal Strategy, and Short-Term Bond Funds Foreign Currency Transactions A forward foreign currency exchange contract involves an obligation to purchase or sell a specific currency at a future date, which may be any fixed number of days from the date of the contract agreed upon by the parties, at a price set at the time of the contract. These contracts are principally traded in the interbank market conducted directly between currency traders (usually large, commercial banks) and their customers. A forward contract generally has no deposit requirement, and no commissions are charged at any stage for trades. The fund may enter into forward contracts for a variety of purposes in connection with the management of the foreign securities portion of its portfolio . The fund's use of such contracts would include, but not be limited to, the following: 32 First, when the fund enters into a contract for the purchase or sale of a security denominated in a foreign currency, it may desire to "lock in" the U.S. dollar price of the security. By entering into a forward contract for the purchase or sale, for a fixed amount of dollars, of the amount of foreign currency involved in the underlying security transactions, the fund will be able to protect itself against a possible loss resulting from an adverse change in the relationship between the U.S. dollar and the subject foreign currency during the period between the date the security is purchased or sold and the date on which payment is made or received. Second, when T. Rowe Price believes that one currency may experience a substantial movement against another currency, including the U.S. dollar, it may enter into a forward contract to sell or buy the amount of the former foreign currency, approximating the value of some or all of the fund's portfolio securities denominated in such foreign currency. Alternatively, where appropriate, the fund may hedge all or part of its foreign currency exposure through the use of a basket of currencies or a proxy currency where such currency or currencies act as an effective proxy for other currencies. In such a case, the fund may enter into a forward contract where the amount of the foreign currency to be sold exceeds the value of the securities denominated in such currency. The use of this basket hedging technique may be more efficient and economical than entering into separate forward contracts for each currency held in the fund. The precise matching of the forward contract amounts and the value of the securities involved will not generally be possible since the future value of such securities in foreign currencies will change as a consequence of market movements in the value of those securities between the date the forward contract is entered into and the date it matures. The projection of short-term currency market movement is extremely difficult, and the successful execution of a short-term hedging strategy is highly uncertain. Under normal circumstances, consideration of the prospect for relative currency values will be incorporated into the longer-term investment decisions made with regard to overall diversification strategies. However, T. Rowe Price believes that it is important to have the flexibility to enter into such forward contracts when it determines that the best interest of the fund will be served. Third, the fund may use forward contracts when the fund wishes to hedge out of the dollar into a foreign currency in order to create a synthetic bond or money market instrument-the security would be issued in U.S. dollars but the dollar component would be transformed into a foreign currency through a forward contract. The fund may enter into forward contacts for any other purpose consistent with the fund's investment objective and program. However, the fund will not enter into a forward contract, or maintain exposure to any such contract(s), if the amount of foreign currency required to be delivered thereunder would exceed the fund's holdings of liquid, high-grade debt securities, currency available for cover of the forward contract(s), or other suitable cover as permitted by the SEC. In determining the amount to be delivered under a contract, the fund may net offsetting positions. At the maturity of a forward contract, the fund may sell the portfolio security and make delivery of the foreign currency, or it may retain the security and either extend the maturity of the forward contract (by "rolling" that contract forward) or may initiate a new forward contract. If the fund retains the portfolio security and engages in an offsetting transaction, the fund will incur a gain or a loss (as described below) to the extent that there has been movement in forward contract prices. If the fund engages in an offsetting transaction, it may subsequently enter into a new forward contract to sell the foreign currency. Should forward prices decline during the period between the fund's entering into a forward contract for the sale of a foreign currency and the date it enters into an offsetting contract for the purchase of the foreign currency, the fund will realize a gain to the extent the price of the currency it has agreed to sell exceeds the price of the currency it has agreed to purchase. Should forward prices increase, the fund will suffer a loss to the extent the price of the currency it has agreed to purchase exceeds the price of the currency it has agreed to sell. The fund's dealing in forward foreign currency exchange contracts will generally be limited to the transactions described above. However, the fund reserves the right to enter into forward foreign currency contracts for different purposes and under different circumstances. Of course, the fund is not required to enter into forward contracts with regard to its foreign currency-denominated securities and will not do so unless deemed appropriate by T. Rowe Price. It also should be realized that this method of hedging against a decline in the value of a currency does not eliminate fluctuations in the underlying prices of the securities. It simply establishes a rate of exchange at a future date. Additionally, although such contracts tend to minimize the risk 33 of loss due to a decline in the value of the hedged currency, at the same time, they tend to limit any potential gain which might result from an increase in the value of that currency. Although the fund values its assets daily in terms of U.S. dollars, it does not intend to convert its holdings of foreign currencies into U.S. dollars on a daily basis. It will do so from time to time, and there are costs associated with currency conversion. Although foreign exchange dealers do not charge a fee for conversion, they do realize a profit based on the difference (the "spread") between the prices at which they are buying and selling various currencies. Thus, a dealer may offer to sell a foreign currency to the fund at one rate, while offering a lesser rate of exchange should the fund desire to resell that currency to the dealer. Federal Tax Treatment of Options, Futures Contracts, and Forward Foreign Exchange Contracts The fund may enter into certain options, futures, forward foreign exchange contracts, and swaps, including options and futures on currencies, which will be treated as Section 1256 contracts or straddles. These transactions will be considered to have been closed at the end of the fund's fiscal year and any gains or losses will be recognized for tax purposes at that time. Such gains or losses from the normal closing or settlement of such transactions will be characterized as 60% long-term capital gain (taxable at a maximum rate of 20%) or loss and 40% short-term capital gain or loss regardless of the holding period of the instrument (ordinary income or loss for foreign exchange contracts). The fund will be required to distribute net gains on such transactions to shareholders even though it may not have closed the transaction and received cash to pay such distributions. Options, futures, forward foreign exchange contracts, and swaps, including options and futures on currencies, which offset a foreign dollar-denominated bond or currency position, may be considered straddles for tax purposes, in which case a loss on any position in a straddle will be subject to deferral to the extent of unrealized gain in an offsetting position. The holding period of the securities or currencies comprising the straddle will be deemed not to begin until the straddle is terminated. The holding period of the security offsetting an "in-the-money qualified covered call" option on an equity security will not include the period of time the option is outstanding. Losses on written covered calls and purchased puts on securities, excluding certain "qualified covered call" options on equity securities, may be long-term capital losses, if the security covering the option was held for more than 12 months prior to the writing of the option. In order for the fund to continue to qualify for federal income tax treatment as a regulated investment company, at least 90% of its gross income for a taxable year must be derived from qualifying income, i.e., dividends, interest, income derived from loans of securities, and gains from the sale of securities or currencies. Tax regulations could be issued limiting the extent that net gain realized from options, futures, or foreign forward exchange contracts on currencies is qualifying income for purposes of the 90% requirement. Entering into certain options, futures contracts, swaps, or foreign forward contracts may result in the "constructive sale" of offsetting stocks or debt securities of the fund. See "Portfolio Management Practices--Short Sales" for further discussion. The Internal Revenue Service has issued a notice proposing alternative methods for the inclusion or deduction of certain payments made under swap contracts. Although not anticipated, it is possible that final rules could result in changes to the amounts recorded by the fund, potentially impacting the tax results of the fund. INVESTMENT RESTRICTIONS ------------------------------------------------------------------------------- Fundamental policies may not be changed without the approval of the lesser of (1) 67% of the fund's shares present at a meeting of shareholders if the holders of more than 50% of the outstanding shares are present in person or by proxy or (2) more than 50% of a fund's outstanding shares. Other restrictions in the form of operating policies are subject to change by the fund's Board of Directors without shareholder approval. Any investment restriction which involves a maximum percentage of securities or assets shall not be considered to be violated unless an excess over the percentage occurs immediately after, and is caused by, an acquisition of securities or assets of, or borrowings by, the fund. Calculation of the fund's total assets for compliance with 34 any of the following fundamental or operating policies or any other investment restrictions set forth in the fund's prospectus or Statement of Additional Information will not include cash collateral held in connection with securities lending activities. Fundamental Policies As a matter of fundamental policy, the fund may not: (1) Borrowing Borrow money except that the fund may (i) borrow for non-leveraging, temporary, or emergency purposes; and (ii) engage in reverse repurchase agreements and make other investments or engage in other transactions, which may involve a borrowing, in a manner consistent with the fund's investment objective and program, provided that the combination of (i) and (ii) shall not exceed 33/1//\\/3/\\% of the value of the fund's total assets (including the amount borrowed) less liabilities (other than borrowings) or such other percentage permitted by law. Any borrowings which come to exceed this amount will be reduced in accordance with applicable law. The fund may borrow from banks, other Price Funds, or other persons to the extent permitted by applicable law; (2) Commodities Purchase or sell physical commodities, except that the fund (other than the Government Reserve Investment, Prime Reserve, Reserve Investment, U.S. Treasury Money Funds) may enter into futures contracts and options thereon; (3) (a) Industry Concentration (All funds except High Yield, New Income, Prime Reserve, Reserve Investment, and Short-Term Bond Funds) Purchase the securities of any issuer if, as a result, more than 25% of the value of the fund's total assets would be invested in the securities of issuers having their principal business activities in the same industry; (b) Industry Concentration (High Yield Fund) Purchase the securities of any issuer if, as a result, more than 25% of the value of the fund's total assets would be invested in the securities of issuers having their principal business activities in the same industry, provided, however, that the fund will normally concentrate 25% or more of its assets in securities of the banking industry when the fund's position in issues maturing in one year or less equals 35% or more of the fund's total assets; (c) Industry Concentration (New Income Fund) Purchase the securities of any issuer if, as a result, more than 25% of the value of the fund's total assets would be invested in the securities of issuers having their principal business activities in the same industry, provided, however, that the fund will invest more than 25% of its total assets, but not more than 50%, in any one of the gas utility, gas transmission utility, electric utility, telephone utility, and petroleum industries under certain circumstances, and further provided that this limitation does not apply to securities of the banking industry including, but not limited to, certificates of deposit and banker's acceptances; (d) Industry Concentration (Prime Reserve and Reserve Investment Funds) Purchase the securities of any issuer if, as a result, more than 25% of the value of the fund's total assets would be invested in the securities of issuers having their principal business activities in the same industry; provided, however, that this limitation does not apply to securities of the banking industry including, but not limited to, certificates of deposit and banker's acceptances; and (e) Industry Concentration (Short-Term Bond Fund) Purchase the securities of any issuer if, as a result, more than 25% of the value of the fund's total assets would be invested in the securities of issuers having their principal business activities in the same industry, provided, however, that the fund will normally invest more than 25% of its total assets in the securities of the banking industry including, but not limited to, bank certificates of deposit and banker's acceptances when the fund's position in issues maturing in one year or less equals 35% or more of the fund's total assets; provided, further, that the fund will invest more than 25% of its total assets, but not more than 50%, in any one of the gas utility, gas transmission utility, electric utility, telephone utility, and petroleum industries under certain circumstances; (4) Loans Make loans, although the fund may (i) lend portfolio securities and participate in an interfund lending program with other Price Funds provided that no such loan may be made if, as a result, the aggregate of such loans would exceed 33/1//\\/3/\\% of the value of the fund's total assets; (ii) purchase money 35 market securities and enter into repurchase agreements; and (iii) acquire publicly distributed or privately placed debt securities and purchase debt; (5) Percent Limit on Assets Invested in Any One Issuer Purchase a security if, as a result, with respect to 75% of the value of its total assets, more than 5% of the value of the fund's total assets would be invested in the securities of a single issuer, except securities issued or guaranteed by the U.S. government, its agencies, or instrumentalities; (6) Percent Limit on Share Ownership of Any One Issuer Purchase a security if, as a result, with respect to 75% of the value of its total assets, more than 10% of the outstanding voting securities of any issuer would be held by the fund (other than obligations issued or guaranteed by the U.S. government, its agencies, or instrumentalities); (7) Real Estate Purchase or sell real estate, including limited partnership interests therein, unless acquired as a result of ownership of securities or other instruments (but this shall not prevent the fund from investing in securities or other instruments backed by real estate or securities of companies engaged in the real estate business); (8) Senior Securities Issue senior securities except in compliance with the 1940 Act; or (9) Underwriting Underwrite securities issued by other persons, except to the extent that the fund may be deemed to be an underwriter within the meaning of the 1933 Act in connection with the purchase and sale of its portfolio securities in the ordinary course of pursuing its investment program. NOTES The following Notes should be read in connection with the above-described fundamental policies. The Notes are not fundamental policies. With respect to investment restriction (1), the Government Reserve Investment, Prime Reserve, Reserve Investment, and U.S. Treasury Money Funds have no current intention of engaging in any borrowing transactions. With respect to investment restriction (2), the fund does not consider currency contracts or hybrid investments to be commodities. For purposes of investment restriction (3): . U.S., state, or local governments, or related agencies or instrumentalities, are not considered an industry. . Industries are determined by reference to the classifications of industries set forth in the fund's semiannual and annual reports. . It is the position of the staff of the SEC that foreign governments are industries for purposes of this restriction. . The High Yield, New Income, and Short-Term Bond Funds have no current intention of concentrating their investments. For purposes of investment restriction (4), the fund will consider the acquisition of a debt security to include the execution of a note or other evidence of an extension of credit with a term of more than nine months. For purposes of investment restriction (5), the fund will consider a repurchase agreement fully collateralized with U.S. government securities to be U.S. government securities. Operating Policies As a matter of operating policy, the fund may not: (1) Borrowing Purchase additional securities when money borrowed exceeds 5% of its total assets; (2) Control of Portfolio Companies Invest in companies for the purpose of exercising management or control; 36 (3) (a) Equity Securities (All funds, except High Yield and New Income Funds) Purchase any equity security or security convertible into an equity security except as set forth in its prospectus and operating policy on investment companies; (b) Equity Securities (High Yield Fund) Invest more than 20% of the fund's total assets in equity securities (including up to 10% in warrants); (c) Equity Securities (New Income Fund) Invest more than 25% of the fund's total assets in equity securities; (4) Futures Contracts Purchase a futures contract or an option thereon if, with respect to positions in futures or options on futures which do not represent bona fide hedging, the aggregate initial margin and premiums on such options would exceed 5% of the fund's net asset value; (5) Illiquid Securities Purchase illiquid securities if, as a result, more than 15% of its net assets would be invested in such securities; (6) Investment Companies Purchase securities of open-end or closed-end investment companies except (i) in compliance with the 1940 Act; (ii) securities of the Reserve Investment or Government Reserve Investment Funds; or (iii) in the case of the Government Reserve Investment, Prime Reserve, Reserve Investment, and U.S. Treasury Money Funds, only securities of other money market funds; (7) Margin Purchase securities on margin, except (i) for use of short-term credit necessary for clearance of purchases of portfolio securities and (ii) it may make margin deposits in connection with futures contracts or other permissible investments; (8) Mortgaging Mortgage, pledge, hypothecate, or, in any manner, transfer any security owned by the fund as security for indebtedness, except as may be necessary in connection with permissible borrowings or investments, and then such mortgaging, pledging, or hypothecating may not exceed 33/1//\\/3/\\% of the fund's total assets at the time of borrowing or investment; (9) Oil and Gas Programs Purchase participations or other direct interests in or enter into leases with respect to oil, gas, or other mineral exploration or development programs if, as a result thereof, more than 5% of the value of the total assets of the fund would be invested in such programs; (10) Options, etc. Invest in puts, calls, straddles, spreads, or any combination thereof, except to the extent permitted by the prospectus and Statement of Additional Information; (11) (a) Short Sales (All funds except High Yield Fund) Effect short sales of securities; (b) Short Sales (High Yield Fund) Effect short sales of securities, other than as set forth in its prospectus and Statement of Additional Information; or (12) Warrants Invest in warrants if, as a result thereof, more than 10% of the value of the net assets of the fund would be invested in warrants. Institutional High Yield and Personal Strategy Funds Notwithstanding anything in the above fundamental and operating restrictions to the contrary, the fund may invest all of its assets in a single investment company or a series thereof in connection with a "master-feeder" arrangement. Such an investment would be made where the fund (a "Feeder"), and one or more other funds with the same investment objective and program as the fund, sought to accomplish its investment objective and program by investing all of its assets in the shares of another investment company (the "Master"). The Master would, in turn, have the same investment objective and program as the fund. The fund would invest in this manner in an effort to achieve the economies of scale associated with having a Master fund make investments in portfolio companies on behalf of a number of Feeder funds. 37 MANAGEMENT OF THE FUND ------------------------------------------------------------------------------- The officers and directors of the fund are listed below. Unless otherwise noted, the address of each is 100 East Pratt Street, Baltimore, Maryland 21202. Except as indicated, each has been an employee of T. Rowe Price for more than five years. The fund is governed by a Board of Directors that meets regularly to review fund investments, performance, expenses, and other business affairs. The Board elects the fund's officers. The Board also is responsible for performing various duties imposed on them by the 1940 Act and by the laws of Maryland or Massachusetts. The majority of Board members are independent of T. Rowe Price and T. Rowe Price International. The directors who are also employees or officers of T. Rowe Price are referred to as inside or interested directors. Each Board currently has three committees, described in the following paragraphs. The Committee of Independent Directors, which consists of all of the independent directors of the funds, is responsible for selecting candidates for election as independent directors to fill vacancies on each fund's Board. F. Pierce Linaweaver is chairman of the committee. The committee will consider written recommendations from shareholders for possible nominees. Shareholders should submit their recommendations to the secretary of the funds. The committee held no formal meetings during the last fiscal year. The Joint Audit Committee is comprised of David K. Fagin, Hanne M. Merriman, John G. Schreiber, and Paul M. Wythes, all independent directors. The Audit Committee holds two regular meetings during each fiscal year, at which time it meets with the independent accountants of the T. Rowe Price funds to review: (1) the services provided; (2) the findings of the most recent audit; (3) management's response to the findings of the most recent audit; (4) the scope of the audit to be performed; (5) the accountants' fees; and (6) any accounting or other questions relating to particular areas of the T. Rowe Price funds' operations or the operations of parties dealing with the T. Rowe Price funds, as circumstances indicate. The Audit Committee for the funds met three times in 2002. All members of the committee participated in the meetings. Independent Directors
Name, Date of Birth, and Term of Office(a) Number of Portfolios in Fund and Length of Time Principal Occupation(s) Other Directorships of Complex Overseen by Director Served During Past 5 Years Public Companies ------------------------------------------------------------------------------------------------------------------------ Calvin W. Burnett, Ph.D. Since later of 1993 President, Coppin State College Provident Bank of 3/16/32 or year of Maryland 98 portfolios incorporation(b) ------------------------------------------------------------------------------------------------------------------------ Anthony W. Deering Since later of 1979 Director, Chairman of the Board, The Rouse Company 1/28/45 or year of President, and Chief Executive 98 portfolios corporation(b) Officer, The Rouse Company, real estate developers ------------------------------------------------------------------------------------------------------------------------ Donald W. Dick, Jr. Since later of 2001 Principal, EuroCapital Advisors, None 1/27/43 or year of LLC, an acquisition and management 98 portfolios incorporation(b) advisory firm ------------------------------------------------------------------------------------------------------------------------ David K. Fagin Since later of 2001 Director, Dayton Mining Corporation Dayton Mining 4/9/38 or year of (6/98 to present), Golden Star Corporation, Golden Star 98 portfolios incorporation(b) Resources Ltd., and Canyon Resources Ltd., and Resources, Corp. (5/00 to present); Canyon Resources, Corp. Chairman and President, Nye Corporation ------------------------------------------------------------------------------------------------------------------------ F. Pierce Linaweaver Since later of 1980 President, F. Pierce Linaweaver & None 8/22/34 or year of Associates, Inc., consulting 98 portfolios incorporation(b) environmental & civil engineers ------------------------------------------------------------------------------------------------------------------------ Hanne M. Merriman Since later of 2001 Retail Business Consultant Ann Taylor Stores 11/16/41 or year of Corporation, Ameren 98 portfolios incorporation(b) Corp., Finlay Enterprises, Inc., The Rouse Company, and US Airways Group, Inc. ------------------------------------------------------------------------------------------------------------------------ John G. Schreiber Since later of 1992 Owner/President, Centaur Capital AMLI Residential 10/21/46 or year of Partners, Inc., a real estate Properties Trust, Host 98 portfolios incorporation(b) investment company; Senior Advisor Marriott Corporation, and and Partner, Blackstone Real Estate The Rouse Company, real Advisors, L.P. estate developers ------------------------------------------------------------------------------------------------------------------------ Hubert D. Vos Since later of 2001 Owner/President, Stonington Capital None 8/2/33 or year of Corporation, a private investment 98 portfolios incorportion(b) company ------------------------------------------------------------------------------------------------------------------------ Paul M. Wythes Since later of 2001 Founding Partner of Sutter Hill Teltone Corporation 6/23/33 or year of Ventures, a venture capital limited 98 portfolios incorporation(b) partnership, providing equity capital to young high technology companies throughout the United States ------------------------------------------------------------------------------------------------------------------------
38 (a) Each director serves until election of a successor. (b) See years of incorporation in the following table.
Incorporation Years Corporation Year of Incorporation ----------- --------------------- Corporate Income Fund 1995 GNMA Fund 1985 High Yield Fund 1984 Institutional Income Funds 2000 New Income Fund 1973 Personal Strategy Funds 1994 Prime Reserve Fund 1975 Short-Term Bond Fund 1983 U.S. Treasury Funds 1989
39 Inside Directors
Name, Date of Birth, Term of Of and Number of fice(a) Portfolios in Fund and Length of Principal Occupation(s) Other Directorships Complex Overseen by Time Served During Past 5 Years of Public Companies Director ------------------------------------------------------------------------------------------
James A.C. Kennedy Since later of 1997 Director None 8/15/53 or year of and Vice President 32 portfolios incorporation(b) , T. Rowe Price and T. Rowe Price Group, Inc. Director, Personal Strategy Funds --------------------------------------------------------------------------------------------------
William T. Reynolds Prime Reserve Director and None 5/26/48 Fund, 1995, all Vice President 37 portfolios other corporations, , since later of 1997 T. Rowe Price and T. Rowe Price or year of Group, Inc. incorporation(b) ; Director, T. Rowe Price Global Asset Management Limited Director, all funds except Personal Strategy Funds; Chairman of the Board, Corporate Income, High Yield, Institutional Income, Prime Reserve, Reserve Investment, and Short-Term Bond Funds; President, New Income and U.S. Treasury Funds; V ice President, Personal Strategy Funds -----------------------------------------------------------------------------------------------------
James S. Riepe Prime Reserve Vice Chairman of the Board, None 6/25/43 Fund, 1994, all Director 98 portfolios other corporations, , since later of 1983 and or year of Vice Presiden incorporation(b) t, T. Rowe Price and T. Rowe Price Group, Inc.; Chairman of the Board and Director, T. Rowe Price Investment Services, Inc., T. Rowe Price Retirement Plan Services, Inc., and T. Rowe Price Services, Inc.; Chairman of the Board, Director, President, and Trust Officer, T. Rowe Price Trust Company; Director, T. Rowe Price International , T. Rowe Price Global Asset Management Limited, and T. Rowe Price Global Investment Services Limited Director and Vice President, all funds ----------------------------------------------------------------------------------------------------
40
M. David Testa Since later of 1997 Vice Chairman of the Board, Chief None 4/22/44 or year of Investment Officer, Director, and 98 portfolios incorporation(b) Vice President , T. Rowe Price Group, Inc.; Chief Investment Officer, Director, and Vice Presiden t, T. Rowe Price ; Chairman, T. Rowe Price Global Asset Management Limited; Vice President and Director, T. Rowe Price Trust Company; Director, T. Rowe Price Global Investment Services Limited and T. Rowe Price International Director, all funds; Chairman of the Board, Personal Strategy Funds ----------------------------------------------------------------------------------------------------
(a) Each director serves until election of a successor. (b) See years of incorporation in the table above. Officers
Name, Date of Birth, Address, and Position(s) Held With Principal Occupations Fund(s) ------------------------------------------------------------------------------
Connice A. Bavely, 3/5/51 President, GNMA Fund; Vice Vice President, T. Rowe Price and T. Rowe President, New Price Group, Inc. Income and Short-Term Bond Funds -------------------------------------------------------------------------------
Stephen W. Boesel, 12/28/44 Executive Vice President, Vice President, T. Rowe Price, T. Rowe Price Personal Strategy Group, Inc., and T. Rowe Price Trust Company Funds -------------------------------------------------------------------------------
Brian J. Brennan, 7/14/64 Vice President, New Vice President, T. Rowe Price and T. Rowe Price Income Fund Group, Inc. -------------------------------------------------------------------------------
Andrew M. Brooks, 2/16/56 Vice President, High Yield and Vice President, T. Rowe Price and T. Rowe Institutional Price Group, Inc. Income Funds -------------------------------------------------------------------------------
Steven G. Brooks, 8/5/54 Vice President, Corporate Income, Prime Vice President, T. Rowe Reserve, Reserve Investment, Short-Term Bond, Price and T. Rowe Price and U.S. Treasury Funds Group, Inc.; Chartered Financial Analyst -------------------------------------------------------------------------------
Brian E. Burns, 10/6/60 Vice President, Prime Reserve, Reserve Assistant Vice President, T. Rowe Investment, and U.S. Treasury Funds Price -------------------------------------------------------------------------------
41
Name, Date of Birth, Address, and Position(s) Held With Principal Occupations Fund (s) ------------------------------------------------------------------------------
Jennifer A. Callaghan, Assistant Vice President, Corporate Income, New 5/6/69 Income, and Short-Term Bond Funds Assistant Vice President, T. Rowe Price -------------------------------------------------------------------------------
Joseph A. Carrier, 12/30/60 Treasurer, all funds Vice President, T. Rowe Price, T. Rowe Price Group, Inc., and T. Rowe Price Investment Services, Inc. -------------------------------------------------------------------------------
Patrick S. Cassidy, 8/27/64 Vice President, Corporate Income, New Income, Vice President, T. Rowe Prime Reserve, Reserve Investment, and Short- Price and T. Rowe Price Term Bond Funds Group, Inc. -------------------------------------------------------------------------------
Jerome A. Clark, 1/2/61 Vice President, U.S. Vice President, T. Rowe Price, T. Rowe Price Treasury Funds Group, Inc., T. Rowe Price Investment Services, and T. Rowe Price Trust Company -------------------------------------------------------------------------------
Mark S. Finn, 1/14/63 Vice President, Corporate Income and Vice President, T. Rowe Price Prime Reserve Funds -------------------------------------------------------------------------------
Alisa Fiumara, 2/7/74 Vice President, Prime Reserve Fund Employee, T. Rowe Price --------------------------------------------------------------------------------
Robert N. Gensler, 10/18/57 Vice President, High Yield and Vice President, T. Rowe Price and T. Rowe Institutional Price Group, Inc. Income Funds -------------------------------------------------------------------------------
Charles B. Hill, 9/22/61 Vice President, Short-Term Bond and U.S. Vice President, T. Rowe Price Treasury Funds and T. Rowe Price Group, Inc. -------------------------------------------------------------------------------
Henry H. Hopkins, 12/23/42 Vice President Director and Vice President, T. Rowe , all funds Price Group, Inc.; Vice President, T. Rowe Price, T. Rowe Price International, Inc., and T. Rowe Price Retirement Plan Services, Inc.; Vice President and Director, T. Rowe Price Investment Services, Inc., T. Rowe Price Services, Inc., and T. Rowe Price Trust Company -------------------------------------------------------------------------------
42
Name, Date of Birth, Address, and Position(s) Held With Principal Occupations Fund (s) ------------------------------------------------------------------------------
Paul A. Karpers, 11/14/67 Vice President, High Yield and Vice President, T. Rowe Price and T. Rowe Institutional Price Group, Inc. Income Funds -------------------------------------------------------------------------------
J. Jeffrey Lang, 1/10/62 Vice President, Personal Vice President, T. Rowe Price and T. Rowe Strategy Funds Price Trust Company -------------------------------------------------------------------------------
John H. Laporte, 7/26/45 Vice President, Personal Strategy Funds Managing Director, T. Rowe Price; Managing Director and Director, T. Rowe Price Group, Inc. -------------------------------------------------------------------------------
Alan D. Levenson, 7/17/58 Vice President, GNMA, New Income, Prime Vice President, T. Rowe Reserve, Reserve Investment, and U.S. Treasury Price and T. Rowe Price Funds Group, Inc.; formerly Senior Vice President and Director of Research at Aubrey G. Lanston & Co., Inc. -------------------------------------------------------------------------------
Nathaniel S. Levy, 7/13/62 Vice President, High Yield and Vice President, T. Rowe Price and T. Rowe Institutional Price Group, Inc. Income Funds -------------------------------------------------------------------------------
Patricia B. Lippert, 1/12/53 Secretary, all funds Assistant Vice President, T. Rowe Price and T. Rowe Price Investment Services, Inc. -------------------------------------------------------------------------------
Kevin P. Loome, 10/19/67 Vice President, High Yield and Vice President, T. Rowe Price, T. Rowe Price Institutional Group, Inc., and T. Rowe Price International, Income Funds Inc. -------------------------------------------------------------------------------
Joseph K. Lynagh, 6/9/58 Vice President, Prime Reserve, Reserve Vice President, T. Rowe Price and Investment, and U.S. Treasury Funds T. Rowe Price Group, Inc.; formerly Corporate Banking Officer with NationsBank; Chartered Financial Analyst -------------------------------------------------------------------------------
James M. McDonald, 9/29/49 Executive Vice President, Prime Reserve and Vice President, T. Rowe Reserve Investment Funds; Vice President, U.S. Price, T. Rowe Price Treasury Funds Group, Inc., and T. Rowe Price Trust Company -------------------------------------------------------------------------------
43
Name, Date of Birth, Address, and Position(s) Held With Principal Occupations Fund (s) ------------------------------------------------------------------------------
Michael J. McGonigle, Vice President, High Yield and Institutional 10/14/66 Income Funds Vice President, T. Rowe Price and T. Rowe Price Group, Inc. -------------------------------------------------------------------------------
Cheryl A. Mickel, 1/11/67 Vice President, Short-Term Bond and U.S. Vice President, T. Rowe Price Treasury Funds and T. Rowe Price Group, Inc. -------------------------------------------------------------------------------
David S. Middleton, 1/18/56 Controller, all funds Vice President, T. Rowe Price, T. Rowe Price Group, Inc., and T. Rowe Price Trust Company -------------------------------------------------------------------------------
Mary J. Miller, 7/19/55 Vice President, Prime Vice President, T. Rowe Price and T. Rowe Reserve, Reserve Price Group, Inc. Investment, and U.S. Treasury Funds -------------------------------------------------------------------------------
M. Christine Munoz, 12/2/62 Vice President, Personal Strategy Vice President, T. Rowe Price Funds -------------------------------------------------------------------------------
Edmund M. Notzon III, 10/1/45 President, Personal Strategy Funds; Vice Vice President, T. Rowe Price, President, GNMA and New Income Funds T. Rowe Price Group, Inc., T. Rowe Price Investment Services, Inc., and T. Rowe Price Trust Company -------------------------------------------------------------------------------
Joan R. Potee, 11/23/47 Vice President, Prime Reserve, Reserve Vice President, T. Rowe Price and Investment, and U.S. Treasury Funds T. Rowe Price Group, Inc. -------------------------------------------------------------------------------
Larry J. Puglia, 8/25/60 Executive Vice President, Personal Strategy Vice President, T. Rowe Price Funds and T. Rowe Price Group, Inc. -------------------------------------------------------------------------------
Vernon A. Reid, Jr., 5/14/54 Vice President, Corporate Vice President, T. Rowe Price and, T. Rowe Income, New Income, Price Group, Inc. and U.S. Treasury Funds -------------------------------------------------------------------------------
Brian C. Rogers, 6/27/55 Vice President, Personal Strategy Funds Director and Vice President, T. Rowe Price Group, Inc.; Vice President, T. Rowe Price, T. Rowe Price International, and T. Rowe Price Trust Company -------------------------------------------------------------------------------
44
Name, Date of Birth, Address, and Position(s) Held With Principal Occupations Fund (s) ------------------------------------------------------------------------------
Robert M. Rubino, 8/2/53 President, Corporate Income Fund; Vice Vice President, T. Rowe Price President, New Income and Short-Term Bond and T. Rowe Price Group, Inc. Funds -------------------------------------------------------------------------------
Daniel O. Shackelford, 3/11/58 Vice President, New Income and Vice President, T. Rowe Price and T. Rowe U.S. Treasury Price Group, Inc. Funds -------------------------------------------------------------------------------
Walter P. Stuart III, 3/27/60 Vice President, High Yield and Assistant Vice President, T. Rowe Institutional Price Income Funds -------------------------------------------------------------------------------
Thomas E. Tewksbury, 8/1/61 Vice President, High Vice President, T. Rowe Price and T. Rowe Price Yield Fund Group, Inc. -------------------------------------------------------------------------------
Susan G. Troll, 8/27/66 Vice President, Prime Vice President, T. Rowe Price and T. Rowe Price Reserve Fund Group, Inc. -------------------------------------------------------------------------------
Mark J. Vaselkiv, 7/22/58 President, High Yield and Institutional Income Vice President, T. Rowe Funds; Executive Vice President, Corporate Price and T. Rowe Price Income Fund; Vice President, Personal Strategy Group, Inc. Funds -------------------------------------------------------------------------------
Lea C. Ward, 6/5/68 Vice President, Prime Reserve Fund Assistant Vice President, T. Rowe Price --------------------------------------------------------------------------------
John D. Wells, 8/17/70 Vice President, GNMA Fund Vice President, T. Rowe Price and T. Rowe Price Group, Inc. -------------------------------------------------------------------------------
Richard T. Whitney, 5/7/58 Vice President, Personal Strategy Funds Vice President, T. Rowe Price, T. Rowe Price Group, Inc., T. Rowe Price Trust Company, and T. Rowe Price International -------------------------------------------------------------------------------
45
Name, Date of Birth, Address, and Position(s) Held With Principal Occupations Fund (s) ------------------------------------------------------------------------------
Edward A. Wiese, 4/12/59 President, Prime Reserve, Vice President, T. Rowe Price, T. Rowe Price Reserve Investment, Group, Inc., and T. Rowe Price Trust and Short-Term Bond Funds; Company; Director, Chief Investment Officer, Executive Vice and Vice President, T. Rowe Price Savings President, U.S. Treasury Funds Bank; Chartered Financial Analyst -------------------------------------------------------------------------------
Thea N. Williams, 12/20/61 Vice President, Corporate Vice President, T. Rowe Price and T. Rowe Income, High Yield, Price Group, Inc. and Institutional Income Funds -------------------------------------------------------------------------------
(a) Unless otherwise indicated, the officers have been employees of T. Rowe Price or T. Rowe Price International for at least five years. Director Compensation Table The fund does not pay pension or retirement benefits to its officers or directors. Also, any director of the fund who is an officer or employee of T. Rowe Price or T. Rowe Price International does not receive any remuneration from the fund.
Name of Person Aggregate Compensation From Total Compensation From Fund and -------------------------------------- Fund(a) Fund Complex Paid to Directors(b) -------------------------------------------- --------------------------------- Corporate Income Fund $ Calvin W. Burnett, Ph.D. 843 $110,000 Anthony W. Deering 903 110,000 Donald W. Dick, Jr.(c) 349 110,000 David K. Fagin(c) 350 112,000 F. Pierce Linaweaver 968 113,000 Hanne M. Merriman(c) 349 110,000 John G. Schreiber 968 113,000 Hubert D. Vos(c) 350 111,000 Paul M. Wythes 351 113,000 ------------------------------------------------------------------------------------------------------------------------- GNMA Fund $ Calvin W. Burnett, Ph.D. 2,832 $110,000 Anthony W. Deering 1,784 110,000 Donald W. Dick, Jr.(c) 703 110,000 David K. Fagin(c) 726 112,000 F. Pierce Linaweaver 2,865 113,000 Hanne M. Merriman(c) 703 110,000 2, John G. Schreiber 865 113,000 Hubert D. Vos(c) 714 111,000 Paul M. Wythes 736 113,000 ------------------------------------------------------------------------------------------------------------------------- High Yield Fund $ Calvin W. Burnett, Ph.D. 3,702 $110,000 Anthony W. Deering 2,198 110,000 Donald W. Dick, Jr.(c) 877 110,000 David K. Fagin(c) 907 112,000 F. Pierce Linaweaver 3,747 113,000 Hanne M. Merriman(c) 877 110,000 John G. Schreiber 3,747 113,000 Hubert D. Vos(c) 892 111,000 Paul M. Wythes 922 113,000 ------------------------------------------------------------------------------------------------------------------------- Institutional High Yield Fund(d) $ Calvin W. Burnett, Ph.D. 564 $110,000 Anthony W. Deering 564 110,000 Donald W. Dick, Jr. 564 110,000 11 0 David K. Fagin 564 ,000 11 0 F. Pierce Linaweaver 564 ,000 Hanne M. Merriman 564 110,000 11 0 John G. Schreiber 564 ,000 11 0 Hubert D. Vos 564 ,000 11 Paul M. Wythes 564 0 ,000 ------------------------------------------------------------------------------------------------------------------------- New Income Fund $ Calvin W. Burnett, Ph.D. 4,034 $110,000 Anthony W. Deering 2,342 110,000 Donald W. Dick, Jr.(c) 918 110,000 David K. Fagin(c) 953 112,000 F. Pierce Linaweaver 4,087 113,000 Hanne M. Merriman(c) 918 110,000 John G. Schreiber 4,087 113,000 Hubert D. Vos(c) 935 111,000 Paul M. Wythes 970 113,000 ------------------------------------------------------------------------------------------------------------------------- Personal Strategy Balanced Fund $ Calvin W. Burnett, Ph.D. 544 $110,000 Anthony W. Deering 544 110,000 Donald W. Dick, Jr.(c) 1,090 110,000 David K. Fagin(c) 1,233 112,000 F. Pierce Linaweaver 563 113,000 Hanne M. Merriman(c) 1,220 110,000 John G. Schreiber 563 113,000 Hubert D. Vos(c) 1,226 111,000 Paul M. Wythes 1,108 113,000 ------------------------------------------------------------------------------------------------------------------------- Personal Strategy Growth Fund $ Calvin W. Burnett, Ph.D. 432 $110,000 Anthony W. Deering 432 110,000 Donald W. Dick, Jr.(c) 907 110,000 David K. Fagin(c) 972 112,000 F. Pierce Linaweaver 441 113,000 Hanne M. Merriman(c) 966 110,000 John G. Schreiber 441 113,000 Hubert D. Vos(c) 969 111,000 Paul M. Wythes 915 113,000 ------------------------------------------------------------------------------------------------------------------------- Personal Strategy Income Fund $ Calvin W. Burnett, Ph.D. 408 $110,000 Anthony W. Deering 408 110,000 Donald W. Dick, Jr.(c) 873 110,000 David K. Fagin(c) 927 112,000 F. Pierce Linaweaver 416 113,000 Hanne M. Merriman(c) 922 110,000 John G. Schreiber 416 113,000 Hubert D. Vos(c) 924 111,000 Paul M. Wythes 880 113,000 ------------------------------------------------------------------------------------------------------------------------- Prime Reserve Fund $ Calvin W. Burnett, Ph.D. 6,916 $110,000 Anthony W. Deering 5,824 110,000 Donald W. Dick, Jr.(c) 2,226 110,000 David K. Fagin(c) 2,342 112,000 F. Pierce Linaweaver 7,089 113,000 Hanne M. Merriman(c) 2,226 110,000 John G. Schreiber 7,089 113,000 Hubert D. Vos(c) 2,283 111,000 Paul M. Wythes 2,399 113,000 ------------------------------------------------------------------------------------------------------------------------- Short-Term Bond Fund $ Calvin W. Burnett, Ph.D. 1,790 $110,000 Anthony W. Deering 1,307 110,000 Donald W. Dick, Jr.(c) 528 110,000 David K. Fagin(c) 539 112,000 F. Pierce Linaweaver 1,806 113,000 Hanne M. Merriman(c) 528 110,000 John G. Schreiber 1,806 113,000 Hubert D. Vos(c) 533 111,000 Paul M. Wythes 544 113,000 ------------------------------------------------------------------------------------------------------------------------- U.S. Treasury Intermediate Fund $ Calvin W. Burnett, Ph.D. 1,317 $110,000 1, Anthony W. Deering 069 110,000 Donald W. Dick, Jr.(c) 416 110,000 David K. Fagin(c) 421 112,000 F. Pierce Linaweaver 1,325 113,000 Hanne M. Merriman(c) 416 110,000 John G. Schreiber 1,325 113,000 Hubert D. Vos(c) 419 111,000 Paul M. Wythes 424 113,000 ------------------------------------------------------------------------------------------------------------------------- U.S. Treasury Long-Term Fund $ Calvin W. Burnett, Ph.D. 1,420 $110,000 Anthony W. Deering 1,110 110,000 Donald W. Dick, Jr.(c) 425 110,000 David K. Fagin(c) 431 112,000 F. Pierce Linaweaver 1,429 113,000 Hanne M. Merriman(c) 425 110,000 1 John G. Schreiber ,429 113,000 Hubert D. Vos(c) 428 111,000 Paul M. Wythes 434 113,000 ------------------------------------------------------------------------------------------------------------------------- U.S. Treasury Money Fund $ Calvin W. Burnett, Ph.D. 2,633 $110,000 Anthony W. Deering 1,684 110,000 Donald W. Dick, Jr.(c) 656 110,000 David K. Fagin(c) 676 112,000 F. Pierce Linaweaver 2,663 113,000 Hanne M. Merriman(c) 656 110,000 John G. Schreiber 2,663 113,000 Hubert D. Vos(c) 666 111,000 Paul M. Wythes 685 113,000 -------------------------------------------------------------------------------------------------------------------------
46 47 48 (a) Amounts in this column are based on accrued compensation for fiscal year 2002. (b) Amounts in this column are based on compensation received for fiscal year 2002. The T. Rowe Price complex included 97 funds as of December 31, 2001. (c) Newly elected to fund Board as of October 24, 2001. (d) Expenses estimated for the period June 1, 2002 through May 30, 2003. Note: GRF and RIF will not incur director's fees. Directors' Holdings in the T. Rowe Price Funds The following table sets forth the T. Rowe Price fund holdings of the independent and inside directors, as of December 31, 2001. 49
Burnett Deering Dick Fagin Linaweaver Merriman Schreiber Vos Wythes ----------------------------------------------------------- ---------- Aggregate Holdings, ------------------- $1- over over over over over over over over All Funds $10,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 --------- -------------------------------------------------------------------------------------------------------------------------- Balanced Fund None None None None $50,001-$100,000 None None None None -------------------------------------------------------------------------------------------------------------------------- Blue Chip Growth Fund None None $1-$10,0$10,001-$50,000 None over None None None $100,000 ------------------------------------------------------------------------------------------------------------------------------ Blue Chip Growth None None None None None None None None None Fund-Advisor Class ----------------------------------------------------------------------------------------------------------------------------------- Blue Chip Growth Portfolio None None None None None None None None None ----------------------------------------------------------------------------------------------------------------------------------- California Tax-Free Bond None None None None None None None None None Fund ----------------------------------------------------------------------------------------------------------------------------------- California Tax-Free Money None None None None None None None None None Fund ----------------------------------------------------------------------------------------------------------------------------------- Capital Appreciation Fund None None over None None $10,001-$50,000 None None None $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Capital Opportunity Fund None None None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Corporate Income Fund None None None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Developing Technologies None None None None None None None None None Fund ------------------------------------------------------------------------------------------------------------------------------------ Diversified Small-Cap None None None None None None None None None Growth Fund ------------------------------------------------------------------------------------------------------------------------------------ Dividend Growth Fund None None None $10,001-$50,000 None $10,001-$50,000 None None None ------------------------------------------------------------------------------------------------------------------------------------ Emerging Europe & None None None None None None None None None Mediterranean Fund ------------------------------------------------------------------------------------------------------------------------------------ Emerging Markets Bond Fund None None None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Emerging Markets Stock Fund None None None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Equity Income Fund None None$50,001-$100,$50,001-$100,000 None $50,001-$100,000 None $10,001-$50,00None ------------------------------------------------------------------------------------------------------------------------------------ Equity Income Fund-Advisor None None None None None None None None Class ------------------------------------------------------------------------------------------------------------------------------------ Equity Income Portfolio None None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Equity Index 500 Fund None None None None None over $100,000 None None ------------------------------------------------------------------------------------------------------------------------------------ Equity Index 500 Portfolio None None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ European Stock Fund None over $10,001-$50,000 $10,001-$50,000 None None None None $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Extended Equity Market None None None None None None None None Index Fund ------------------------------------------------------------------------------------------------------------------------------------ Financial Services Fund None None $10,001-$50,000 None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Florida Intermediate None None None None None None None None Tax-Free Fund ------------------------------------------------------------------------------------------------------------------------------------ Georgia Tax-Free Bond Fund None None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Global Stock Fund None None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Global Technology Fund None None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ GNMA Fund None None None None None None over None $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Government Reserve None None None None None None None None Investment Fund ------------------------------------------------------------------------------------------------------------------------------------ Growth & Income Fund None None $1-$10,000 None None None over No$10, $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Growth Stock Fund None None $10,001-$50,000 None $10,001-$50,000 None None None ------------------------------------------------------------------------------------------------------------------------------------ Growth Stock Fund-Advisor None None None None None None None None Class ------------------------------------------------------------------------------------------------------------------------------------ Health Sciences Fund None None $10,001-$50,000 None None None None $50,001-$100 ------------------------------------------------------------------------------------------------------------------------------------ Health Sciences Portfolio None None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ High Yield Fund $1-$10,000 None $10,001-$50,000 None None None over None $100,000 ------------------------------------------------------------------------------------------------------------------------------------ High Yield Fund-Advisor None None None None None None None None Class ------------------------------------------------------------------------------------------------------------------------------------ Institutional Foreign None None None None None None None None Equity Fund ------------------------------------------------------------------------------------------------------------------------------------ Institutional Large-Cap None None None None None None None None Growth Fund ------------------------------------------------------------------------------------------------------------------------------------ Institutional Large-Cap None None None None None None None None Value Fund ------------------------------------------------------------------------------------------------------------------------------------ Institutional Mid-Cap None None None None None None None None Equity Growth Fund ------------------------------------------------------------------------------------------------------------------------------------ Institutional Small-Cap None None None None None None None None Stock Fund ------------------------------------------------------------------------------------------------------------------------------------ International Bond Fund None None $50,001-$100,000 None None None None None ------------------------------------------------------------------------------------------------------------------------------------ International Bond None None None None None None None None Fund-Advisor Class ------------------------------------------------------------------------------------------------------------------------------------ International Discovery None$50,001-$100,0$10,001-$50,000 None over $100,000 None None None Fund ------------------------------------------------------------------------------------------------------------------------------------ International Equity Index None None None None None None None No Fund ------------------------------------------------------------------------------------------------------------------------------------ International Growth & None None None None None None None No Income Fund ------------------------------------------------------------------------------------------------------------------------------------ International Stock Fund $1-$10,000 over $100,000 None over $100,000 None None None No ------------------------------------------------------------------------------------------------------------------------------------ International Stock None None None None None None None No Fund-Advisor Class ------------------------------------------------------------------------------------------------------------------------------------ International Stock None None None None None None None No Portfolio ------------------------------------------------------------------------------------------------------------------------------------ Japan Fund None None None None None None None No ------------------------------------------------------------------------------------------------------------------------------------ Latin America Fund None None None None None None None No ------------------------------------------------------------------------------------------------------------------------------------ Limited-Term Bond Portfolio None None None None None None None No ------------------------------------------------------------------------------------------------------------------------------------ Maryland Short-Term None None None None None None None No Tax-Free Bond Fund ------------------------------------------------------------------------------------------------------------------------------------ Maryland Tax-Free Bond Fund None None None None None None None No ------------------------------------------------------------------------------------------------------------------------------------ Maryland Tax-Free Money None None None None None None None No Fund ------------------------------------------------------------------------------------------------------------------------------------ Media & Telecommunications None $10,001-$50,000 None None None None None No Fund ------------------------------------------------------------------------------------------------------------------------------------ Mid-Cap Growth Fund None None $1-$10,000 $10,001-$50,000 None None No$10,001- ------------------------------------------------------------------------------------------------------------------------------------ Mid-Cap Growth Fund-Advisor None None None None None None None No Class ------------------------------------------------------------------------------------------------------------------------------------ Mid-Cap Growth Portfolio None None None None None None None No ------------------------------------------------------------------------------------------------------------------------------------ Mid-Cap Value Fund None None None None None None None No ------------------------------------------------------------------------------------------------------------------------------------ New America Growth Fund None None None None over $100,000 $10,001-$50,000 None No ------------------------------------------------------------------------------------------------------------------------------------ New America Growth None None None None None None None No Portfolio ------------------------------------------------------------------------------------------------------------------------------------ New Asia Fund None None None $10,001-$50,000 None None None No ------------------------------------------------------------------------------------------------------------------------------------ New Era Fund None None None None None None No$10,001- ------------------------------------------------------------------------------------------------------------------------------------ New Horizons Fund $1-$10,000 None $10,001-$50,000 $1-$10,000 over $100,000 $10,001-$50,000 No$10,001- ------------------------------------------------------------------------------------------------------------------------------------ New Income Fund None None $50,001-$100,000 None None None over No $100,000 ------------------------------------------------------------------------------------------------------------------------------------ New Jersey Tax-Free Bond None None None None None None None No Fund ------------------------------------------------------------------------------------------------------------------------------------ New York Tax-Free Bond Fund None None None None None None None No ------------------------------------------------------------------------------------------------------------------------------------ New York Tax-Free Money None None None None None None None No Fund ------------------------------------------------------------------------------------------------------------------------------------ Personal Strategy Balanced None None None None None None None No Fund ------------------------------------------------------------------------------------------------------------------------------------ Personal Strategy Balanced None None None None None None None No Portfolio ------------------------------------------------------------------------------------------------------------------------------------ Personal Strategy Growth None None None None None None None No Fund ------------------------------------------------------------------------------------------------------------------------------------ Personal Strategy Income None None None None None None None No Fund ------------------------------------------------------------------------------------------------------------------------------------ Prime Reserve Fund $1-$10,000 None over $100,000 None $1-$10,000 $50,001-$100,0$10,001-$50,0No ------------------------------------------------------------------------------------------------------------------------------------ Prime Reserve Fund-PLUS None None None None None None None Class ------------------------------------------------------------------------------------------------------------------------------------ Prime Reserve Portfolio None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Real Estate Fund None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Reserve Investment Fund None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Science & Technology Fund None over $100,000 None None None $10,001-$50,000 No$10,00 ------------------------------------------------------------------------------------------------------------------------------------ Science & Technology None None None None None None None Fund-Advisor Class ------------------------------------------------------------------------------------------------------------------------------------ Short-Term Bond Fund None None None $50,001-$100,000 None None over $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Small-Cap Stock Fund None None $1-$10,000 $10,001-$50,000 None None No$10,00 ------------------------------------------------------------------------------------------------------------------------------------ Small-Cap Stock None None None None None None None Fund-Advisor Class ------------------------------------------------------------------------------------------------------------------------------------ Small-Cap Value Fund None None None None None None No$10,00 ------------------------------------------------------------------------------------------------------------------------------------ Small-Cap Value None None None None None None None Fund-Advisor Class ------------------------------------------------------------------------------------------------------------------------------------ Spectrum Growth Fund None None None None None over $100,000 None ------------------------------------------------------------------------------------------------------------------------------------ Spectrum Income Fund None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Spectrum International Fund None None None None None $10,001-$50,000 None ------------------------------------------------------------------------------------------------------------------------------------ Summit Cash Reserves Fund None None None over $100,000 None None over $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Summit GNMA Fund None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Summit Municipal Income None None None None None None over Fund $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Summit Municipal None None None None None None over Intermediate Fund $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Summit Municipal Money None None None None None $50,001-$100,000 None Market Fund ------------------------------------------------------------------------------------------------------------------------------------ Tax-Efficient Balanced Fund None None None $50,001-$100,000 None None None ------------------------------------------------------------------------------------------------------------------------------------ Tax-Efficient Growth Fund None None None $10,001-$50,000 None None None ------------------------------------------------------------------------------------------------------------------------------------ Tax-Efficient Multi-Cap None None None None None None None Growth Fund ------------------------------------------------------------------------------------------------------------------------------------ Tax-Exempt Money Fund None None None None None None over $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Tax-Exempt Money Fund-PLUS None None None None None None None Class ------------------------------------------------------------------------------------------------------------------------------------ Tax-Free High Yield Fund None None None None None None over $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Tax-Free Income Fund None None None None None None over $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Tax-Free Intermediate Bond None None None None None None None Fund ------------------------------------------------------------------------------------------------------------------------------------ Tax-Free Short-Intermediate None None None None None None None Fund ------------------------------------------------------------------------------------------------------------------------------------ Total Equity Market Index None None None None None None None Fund ------------------------------------------------------------------------------------------------------------------------------------ U.S. Bond Index Fund None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ U.S. Treasury Intermediate None None over $100,000 None None None over Fund $100,000 ------------------------------------------------------------------------------------------------------------------------------------ U.S. Treasury Long-Term None None None None None None over Fund $100,000 ------------------------------------------------------------------------------------------------------------------------------------ U.S. Treasury Money Fund None None None None None None over $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Value Fund None None $10,001-$50,000 None None $50,001-$100,000 over $100,000 ------------------------------------------------------------------------------------------------------------------------------------ Value Fund-Advisor Class None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------ Virginia Tax-Free Bond Fund None None None None None None None ------------------------------------------------------------------------------------------------------------------------------------
50 51 52 53
Reynolds Riepe Testa ------------------------------------------------------------------------------- Aggregate Holdings, ------------------- All Funds over $100,000 over $100,000 over $100,000 --------- ------------------------------------------------------------------------------- Balanced Fund None over $100,000 None ------------------------------------------------------------------------------- Blue Chip Growth Fund None None None ------------------------------------------------------------------------------- Blue Chip Growth None None None Fund-Advisor Class ------------------------------------------------------------------------------- Blue Chip Growth Portfolio None None None ------------------------------------------------------------------------------- California Tax-Free Bond None None None Fund ------------------------------------------------------------------------------- California Tax-Free Money None None None Fund ------------------------------------------------------------------------------- Capital Appreciation Fund None over $100,000 None ------------------------------------------------------------------------------- Capital Opportunity Fund None None None ------------------------------------------------------------------------------- Corporate Income Fund None None None ------------------------------------------------------------------------------- Developing Technologies None None None Fund ------------------------------------------------------------------------------- Diversified Small-Cap None None None Growth Fund ------------------------------------------------------------------------------- Dividend Growth Fund None None None ------------------------------------------------------------------------------- Emerging Europe & None None None Mediterranean Fund ------------------------------------------------------------------------------- Emerging Markets Bond Fund None None None ------------------------------------------------------------------------------- Emerging Markets Stock None None over $100,000 Fund ------------------------------------------------------------------------------- Equity Income Fund $50,001-$100,000 over $100,000 None ------------------------------------------------------------------------------- Equity Income Fund-Advisor None None None Class ------------------------------------------------------------------------------- Equity Income Portfolio None None None ------------------------------------------------------------------------------- Equity Index 500 Fund None None None ------------------------------------------------------------------------------- Equity Index 500 Portfolio None None None ------------------------------------------------------------------------------- European Stock Fund None None None ------------------------------------------------------------------------------- Extended Equity Market None None None Index Fund ------------------------------------------------------------------------------- Financial Services Fund None None None ------------------------------------------------------------------------------- Florida Intermediate None None None Tax-Free Fund ------------------------------------------------------------------------------- Georgia Tax-Free Bond Fund None None None ------------------------------------------------------------------------------- Global Stock Fund None None None ------------------------------------------------------------------------------- Global Technology Fund None None None ------------------------------------------------------------------------------- GNMA Fund over $100,000 None None ------------------------------------------------------------------------------- Government Reserve None None None Investment Fund ------------------------------------------------------------------------------- Growth & Income Fund None over $100,000 None ------------------------------------------------------------------------------- Growth Stock Fund None None None ------------------------------------------------------------------------------- Growth Stock Fund-Advisor None None None Class ------------------------------------------------------------------------------- Health Sciences Fund over $100,000 None over $100,000 ------------------------------------------------------------------------------- Health Sciences Portfolio None None None ------------------------------------------------------------------------------- High Yield Fund None over $100,000 None ------------------------------------------------------------------------------- High Yield Fund-Advisor None None None Class ------------------------------------------------------------------------------- Institutional Foreign None None None Equity Fund ------------------------------------------------------------------------------- Institutional Large-Cap None None None Growth Fund ------------------------------------------------------------------------------- Institutional Large-Cap None None None Value Fund ------------------------------------------------------------------------------- Institutional Mid-Cap None None None Equity Growth Fund ------------------------------------------------------------------------------- Institutional Small-Cap None None None Stock Fund ------------------------------------------------------------------------------- International Bond Fund $1-$10,000 None None ------------------------------------------------------------------------------- International Bond None None None Fund-Advisor Class ------------------------------------------------------------------------------- International Discovery None $1-$10,000 over $100,000 Fund ------------------------------------------------------------------------------- International Equity Index None None None Fund ------------------------------------------------------------------------------- International Growth & None None None Income Fund ------------------------------------------------------------------------------- International Stock Fund None over $100,000 over $100,000 ------------------------------------------------------------------------------- International Stock None None None Fund-Advisor Class ------------------------------------------------------------------------------- International Stock None None None Portfolio ------------------------------------------------------------------------------- Japan Fund None over $100,000 None ------------------------------------------------------------------------------- Latin America Fund None None None ------------------------------------------------------------------------------- Limited-Term Bond None None None Portfolio ------------------------------------------------------------------------------- Maryland Short-Term $50,001-$100,000 None None Tax-Free Bond Fund ------------------------------------------------------------------------------- Maryland Tax-Free Bond $10,001-$50,000 None None Fund ------------------------------------------------------------------------------- Maryland Tax-Free Money None None None Fund ------------------------------------------------------------------------------- Media & Telecommunications None None None Fund ------------------------------------------------------------------------------- Mid-Cap Growth Fund None None over $100,000 ------------------------------------------------------------------------------- Mid-Cap Growth None None None Fund-Advisor Class ------------------------------------------------------------------------------- Mid-Cap Growth Portfolio None None None ------------------------------------------------------------------------------- Mid-Cap Value Fund None None None ------------------------------------------------------------------------------- New America Growth Fund None None None ------------------------------------------------------------------------------- New America Growth None None None Portfolio ------------------------------------------------------------------------------- New Asia Fund None $1-$10,000 None ------------------------------------------------------------------------------- New Era Fund None None None ------------------------------------------------------------------------------- New Horizons Fund $50,001-$100,000 None over $100,000 ------------------------------------------------------------------------------- New Income Fund None None None ------------------------------------------------------------------------------- New Jersey Tax-Free Bond None None None Fund ------------------------------------------------------------------------------- New York Tax-Free Bond None None None Fund ------------------------------------------------------------------------------- New York Tax-Free Money None None None Fund ------------------------------------------------------------------------------- Personal Strategy Balanced None None None Fund ------------------------------------------------------------------------------- Personal Strategy Balanced None None None Portfolio ------------------------------------------------------------------------------- Personal Strategy Growth None None None Fund ------------------------------------------------------------------------------- Personal Strategy Income None None None Fund ------------------------------------------------------------------------------- Prime Reserve Fund $1-$10,000 over $100,000 $10,001-$50,000 ------------------------------------------------------------------------------- Prime Reserve Fund-PLUS None None None Class ------------------------------------------------------------------------------- Prime Reserve Portfolio None None None ------------------------------------------------------------------------------- Real Estate Fund None None None ------------------------------------------------------------------------------- Reserve Investment Fund None None None ------------------------------------------------------------------------------- Science & Technology Fund over $100,000 over $100,000 None ------------------------------------------------------------------------------- Science & Technology None None None Fund-Advisor Class ------------------------------------------------------------------------------- Short-Term Bond Fund $50,001-$100,000 over $100,000 None ------------------------------------------------------------------------------- Small-Cap Stock Fund None None None ------------------------------------------------------------------------------- Small-Cap Stock None None None Fund-Advisor Class ------------------------------------------------------------------------------- Small-Cap Value Fund $10,001-$50,000 over $100,000 over $100,000 ------------------------------------------------------------------------------- Small-Cap Value None None None Fund-Advisor Class ------------------------------------------------------------------------------- Spectrum Growth Fund None None None ------------------------------------------------------------------------------- Spectrum Income Fund None None None ------------------------------------------------------------------------------- Spectrum International None None None Fund ------------------------------------------------------------------------------- Summit Cash Reserves Fund None over $100,000 over $100,000 ------------------------------------------------------------------------------- Summit GNMA Fund None None None ------------------------------------------------------------------------------- Summit Municipal Income None None None Fund ------------------------------------------------------------------------------- Summit Municipal None None over $100,000 Intermediate Fund ------------------------------------------------------------------------------- Summit Municipal Money over $100,000 over $100,000 None Market Fund ------------------------------------------------------------------------------- Tax-Efficient Balanced None None None Fund ------------------------------------------------------------------------------- Tax-Efficient Growth Fund None None None ------------------------------------------------------------------------------- Tax-Efficient Multi-Cap None None None Growth Fund ------------------------------------------------------------------------------- Tax-Exempt Money Fund over $100,000 None None ------------------------------------------------------------------------------- Tax-Exempt Money Fund-PLUS None None None Class ------------------------------------------------------------------------------- Tax-Free High Yield Fund None None None ------------------------------------------------------------------------------- Tax-Free Income Fund None None $10,001-$50,000 ------------------------------------------------------------------------------- Tax-Free Intermediate Bond None None None Fund ------------------------------------------------------------------------------- Tax-Free $1-$10,000 over $100,000 None Short-Intermediate Fund ------------------------------------------------------------------------------- Total Equity Market Index None over $100,000 None Fund ------------------------------------------------------------------------------- U.S. Bond Index Fund None None None ------------------------------------------------------------------------------- U.S. Treasury Intermediate over $100,000 None None Fund ------------------------------------------------------------------------------- U.S. Treasury Long-Term None None None Fund ------------------------------------------------------------------------------- U.S. Treasury Money Fund None None None ------------------------------------------------------------------------------- Value Fund $10,001-$50,000 over $100,000 over $100,000 ------------------------------------------------------------------------------- Value Fund-Advisor Class None None None ------------------------------------------------------------------------------- Virginia Tax-Free Bond None None None Fund -------------------------------------------------------------------------------
54 55 PRINCIPAL HOLDERS OF SECURITIES ------------------------------------------------------------------------------- As of July 31, 2002, the officers and directors of the fund, as a group, owned less than 1% of the outstanding shares of the fund. As of July 31, 2002, the following shareholders of record owned more than 5% of the outstanding shares of any share class of the fund: Corporate Income Fund (9.31%): T. Rowe Price RPS Inc., OMNIPLAN Account, Corporate Income Fund, Fund #02/112, P.O. Box 17215, Baltimore, Maryland 21297-1215. GNMA: Yachtcrew & Co./a/, T. Rowe Price Associates, Inc., Attn.: Fund Accounting Department, 100 East Pratt Street, Baltimore, Maryland 21202-1009; T. Rowe Price Trust Company, Inc. (6.25%), Attn.: RPS Control Department, 10090 Red Run Boulevard, Owings Mills, Maryland 21117-4842. 56 /a/ Yachtcrew & Co owns 26.39% of the outstanding shares of the fund through the Spectrum Fund. Shares of the fund held by the Spectrum Fund are echo-voted by Spectrum Fund in the same proportion as the shares of the fund are voted by its non-Spectrum Fund shareholders. High Yield Fund: Yachtcrew & Co./b/, T. Rowe Price Associates, Inc., Attn.: Fund Accounting Department, 100 East Pratt Street, Baltimore, Maryland 21202-1009. /b/ Yachtcrew & Co owns 32.40% of the outstanding shares of the fund through the Spectrum Fund. Shares of the fund held by the Spectrum Fund are echo-voted by Spectrum Fund in the same proportion as the shares of the fund are voted by its non-Spectrum Fund shareholders. New Income Fund: Yachtcrew & Co./c/, T. Rowe Price Associates, Inc., Attn.: Fund Accounting Department, 100 East Pratt Street, Baltimore, Maryland 21202-1009; T. Rowe Price Trust Company, Inc. (16.83%), Attn.: TRPS Inst. Control Department, P.O. Box 17215, Baltimore, Maryland 21297-1215. /c/ Yachtcrew & Co owns 35.85% of the outstanding shares of the fund through the Spectrum Fund. Shares of the fund held by the Spectrum Fund are echo-voted by Spectrum Fund in the same proportion as the shares of the fund are voted by its non-Spectrum Fund shareholders. Personal Strategy Balanced Fund: T. Rowe Price Trust Company Tr. Balanced/d/, Attn.: Asset Reconciliation, P.O. Box 17215, Baltimore, Maryland 21297-1215. /d/ T. Rowe Price Trust Company is a wholly owned subsidiary of T. Rowe Price Associates, Inc., which is a wholly owned subsidiary of T. Rowe Price Group, Inc., each a Maryland corporation. T. Rowe Price Trust Company owns 76.03% of the outstanding shares of the fund. T. Rowe Price Trust Company is not the beneficial owner of these shares. Such shares are held of record by T. Rowe Price Trust Company and are voted by various retirement plans and retirement participants. Personal Strategy Growth Fund: T. Rowe Price Trust Company Tr./e/, Attn.: Growth Asset, P.O. Box 17215, Baltimore, Maryland 21297-1215; Hartford Life Insurance Co. (6.33%), Separate Account TK, Attn: David Ten Broeck, P.O. Box 2999, Hartford, Connecticut 06104-2999. /e/ T. Rowe Price Trust Company is a wholly owned subsidiary of T. Rowe Price Associates, Inc., which is a wholly owned subsidiary of T. Rowe Price Group, Inc., each a Maryland corporation. T. Rowe Price Trust Company owns 62.12% of the outstanding shares of the fund. T. Rowe Price Trust Company is not the beneficial owner of these shares. Such shares are held of record by T. Rowe Price Trust Company and are voted by various retirement plans and retirement participants. Personal Strategy Income Fund: T. Rowe Price Trust Company Tr. Income/f/, Attn.: Asset Reconciliation, P.O. Box 17215, Baltimore, Maryland 21297-1215. /f/ T. Rowe Price Trust Company is a wholly owned subsidiary of T. Rowe Price Associates, Inc., which is a wholly owned subsidiary of T. Rowe Price Group, Inc., each a Maryland corporation. T. Rowe Price Trust Company owns 70.94% of the outstanding shares of the fund. T. Rowe Price Trust Company is not the beneficial owner of these shares. Such shares are held of record by T. Rowe Price Trust Company and are voted by various retirement plans and retirement participants. Prime Reserve Fund (17.57%): T. Rowe Price Trust Company, Inc., Attn.: TRPS Inst. Control Department, P.O. Box 17215, Baltimore, Maryland 21297-1215. Prime Reserve Fund-PLUS Class (99.94%): Pershing Div. of DLJ Secs. Corp. For Exclusive Benefit of TRP Money Fund Customer Accounts, 1 Pershing Plaza, Jersey City, New Jersey, 07399-0002. Short-Term Bond Fund (10.71%): T. Rowe Price Trust Company, Inc., Attn.: TRPS Inst. Control Department, P.O. Box 17215, Baltimore, Maryland 21297-1215. U.S. Treasury Intermediate Bond Fund (20.52%): T. Rowe Price Trust Company, Inc., Attn.: TRPS Inst. Control Department, P.O. Box 17215, Baltimore, Maryland 21297-1215. 57 U.S. Treasury Long-Term Bond Fund: Yachtcrew & Co./g/, T. Rowe Price Associates, Inc., Attn.: Fund Accounting Department, 100 East Pratt Street, Baltimore, Maryland 21202-1009; T. Rowe Price Trust Company, Inc. (6.13%), Attn.: TRPS Inst. Control Department, P.O. Box 17215, Baltimore, Maryland 21297-1215. /g/ Yachtcrew & Co owns 56.07% of the outstanding shares of the fund through the Spectrum Fund. Shares of the fund held by the Spectrum Fund are echo-voted by Spectrum Fund in the same proportion as the shares of the fund are voted by its non-Spectrum Fund shareholders. U.S. Treasury Money Fund: T. Rowe Price Trust Company, Inc. (16.87%), Attn.: TRPS Inst. Control Department, P.O. Box 17215, Baltimore, Maryland 21297-1215; T. Rowe Price Retirement Plan Service, Inc. (6.80%), Attn.: RPS Cash, 10090 Red Run Boulevard, Owings Mills, Maryland 21117-4842. INVESTMENT MANAGEMENT SERVICES ------------------------------------------------------------------------------- Services Under the Management Agreement, T. Rowe Price provides the fund with discretionary investment services. Specifically, T. Rowe Price is responsible for supervising and directing the investments of the fund in accordance with the fund's investment objectives, program, and restrictions as provided in its prospectus and this Statement of Additional Information. T. Rowe Price is also responsible for effecting all security transactions on behalf of the fund, including the negotiation of commissions and the allocation of principal business and portfolio brokerage. . In addition to these services, T. Rowe Price provides the fund with certain corporate administrative services, including: maintaining the fund's corporate existence and corporate records; registering and qualifying fund shares under federal laws; monitoring the financial, accounting, and administrative functions of the fund; maintaining liaison with the agents employed by the fund such as the fund's custodian and transfer agent; assisting the fund in the coordination of such agent's activities; and permitting T. Rowe Price's employees to serve as officers, directors, and committee members of the fund without cost to the fund. The Management Agreement also provides that T. Rowe Price, its directors, officers, employees, and certain other persons performing specific functions for the fund will be liable to the fund only for losses resulting from willful misfeasance, bad faith, gross negligence, or reckless disregard of duty. Approval of Management Agreements The Management Agreements of the funds are reviewed each year by the funds' Boards of Directors to determine whether the agreements should be renewed for a one-year period or not. Renewal of the agreements requires the majority vote of the Board of Directors, including a majority of the independent directors. Each fund Board consists of a majority of independent directors. In approving the continuation of the investment management agreements for each fund for the current year, the Board reviewed reports prepared by T. Rowe Price, materials provided by fund counsel and counsel to the independent directors, as well as other information. The Board considered the nature and quality of the investment management services provided to the fund by T. Rowe Price under the investment management agreements and the personnel who provide these services, including the historical performance of the fund compared to its benchmark index and its peer group of similar investment companies. In addition, the Board considered other services provided to the fund by T. Rowe Price and its affiliates, such as administrative services, shareholder services, fund accounting, assistance in meeting legal and regulatory requirements, and other services necessary for the fund's operation. All funds except Government Reserve Investment and Reserve Investment Funds Management Fee The fund pays T. Rowe Price a fee ("Fee") which consists of two components: a Group Management Fee ("Group Fee") (other than the Equity Index 500 Fund) and an Individual Fund Fee ("Fund Fee"). The Fee is paid monthly to T. Rowe Price on the first business day of the next succeeding calendar month and is calculated as described next. 58 The monthly Group Fee ("Monthly Group Fee") is the sum of the daily Group Fee accruals ("Daily Group Fee Accruals") for each month. The Daily Group Fee Accrual for any particular day is computed by multiplying the Price Funds' group fee accrual as determined below ("Daily Price Funds' Group Fee Accrual") by the ratio of the Price Funds' net assets for that day to the sum of the aggregate net assets of the Price Funds for that day. The Daily Price Funds' Group Fee Accrual for any particular day is calculated by multiplying the fraction of one (1) over the number of calendar days in the year by the annualized Daily Price Funds' Group Fee Accrual for that day as determined in accordance with the following schedule:
0.480% First $1 billion 0.360% Next $2 billion 0.310% Next $16 billion ------------------------------------------------------------------------------ 0.450% Next $1 billion 0.350% Next $2 billion 0.305% Next $30 billion ------------------------------------------------------------------------------ 0.420% Next $1 billion 0.340% Next $5 billion 0.300% Next $40 billion ------------------------------------------------------------------------------ 0.390% Next $1 billion 0.330% Next $10 billion 0.295% Thereafter ------------------------------------------------------------------------------ 0.370% Next $1 billion 0.320% Next $10 billion
For the purpose of calculating the Group Fee, the Price Funds include all the mutual funds distributed by Investment Services (excluding the T. Rowe Price Spectrum Funds and any institutional, index, or private label mutual funds). For the purpose of calculating the Daily Price Funds' Group Fee Accrual for any particular day, the net assets of each Price Fund are determined in accordance with the fund's prospectus as of the close of business on the previous business day on which the fund was open for business. The monthly Fund Fee ("Monthly Fund Fee") is the sum of the daily Fund Fee accruals ("Daily Fund Fee Accruals") for each month. The Daily Fund Fee Accrual for any particular day is computed by multiplying the fraction of one (1) over the number of calendar days in the year by the individual Fund Fee Rate and multiplying this product by the net assets of the fund for that day, as determined in accordance with the fund's prospectus as of the close of business on the previous business day on which the fund was open for business. The individual fund fees are listed in the following table:
Corporate Income Fund 0.15% GNMA Fund 0.15 High Yield Fund 0.30 New Income Fund 0.15 Personal Strategy Balanced Fund 0.25 Personal Strategy Growth Fund 0.30 Personal Strategy Income Fund 0.15 Prime Reserve Fund 0.05 Prime Reserve Fund-PLUS Class 0.05 Short-Term Bond Fund 0.10 U.S. Treasury Intermediate Fund 0.05 U.S. Treasury Long-Term Fund 0.05 U.S. Treasury Money Fund 0.00
The following table sets forth the total management fees, if any, paid to T. Rowe Price by each fund, during the last three years:
Fund 2002 2001 2000 ---- ---- ---- ---- Corporate Income $ 232,000 $ 124,000 $ 112,000 GNMA 5,287,000 5,005,000 5,086,000 High Yield* 10,173,000 9,413,000 10,209,000 New Income 8,361,000 7,887,000 8,438,000 Personal Strategy Balanced 3,775,000 3,604,000 3,341,000 Personal Strategy Growth 1,908,000 1,696,000 1,493,000 Personal Strategy Income 1,092,000 914,000 1,044,000 Prime Reserve* 21,485,000 21,004,000 19,755,000 Short-Term Bond 1,881,000 1,219,000 1,276,000 U.S. Treasury Intermediate 1,001,000 869,000 901,000 U.S. Treasury Long-Term 1,147,000 1,128,000 1,200,000 U.S. Treasury Money 3,163,000 2,945,000 2,922,000 -----------------------------------------------------
59 * The fund has two classes of shares. The management fee is allocated to each class based on relative net assets. Limitation on Fund Expenses The Management Agreement between the fund and T. Rowe Price provides that the fund will bear all expenses of its operations not specifically assumed by T. Rowe Price. Expense Limitations and Reimbursements The following chart sets forth expense ratio limitations and the periods for which they are effective. For each, T. Rowe Price has agreed to bear any fund expenses (other than interest, taxes, brokerage, and other expenditures that are capitalized in accordance with generally accepted accounting principles and extraordinary expenses) which would cause the fund's ratio of expenses to average net assets to exceed the indicated percentage limitation. (The expense limitations for the Advisor and R Classes relate to operating expenses other than management fees and certain other portfolio level expenses such as fees for custody, outside directors, and auditors.) The expenses borne by T. Rowe Price are subject to reimbursement by the fund through the indicated reimbursement date, provided no reimbursement will be made if it would result in the fund's expense ratio exceeding its applicable limitation.
Expense Reimbursement Fund Limitation Period Ratio Date ---- ----------------- Limitation ---- ---------- June 1, 2001-May 31, May 31, 200 Corporate Income(a) 2003 0.80% 5 High Yield January 1, 2002-May Fund-Advisor Class(b) 31, 2003 1.05% May 31, 2005 September 30, New Income 2002-September 30, September Fund-Advisor Class 2004 0.90% 30, 2006 September 30, New Income Fund-R 2002-September 30, September Class 2004 1.15% 30, 2006 Personal Strategy June 1, 2002-May 31, May 31, 200 Income (c) 2004 0.90% 6 Personal Strategy June 1, 2002-May 31, Growth (d) 2004 1.10% May 31, 2006 Short-Term Bond(e) June 1, 2002-May 31, 0.55% May 31 2004 , 2006 --------------------------------------------------------------------------------
(a) The Corporate Income Fund previously operated under a 0.80% limitation that expired May 31, 2001. The reimbursement period for this limitation extends through May 31, 2003. (b) The High Yield Fund-Advisor Class previously operated under a 1.05% limitation that expired December 31, 2001. The reimbursement period for this limitation extends through December 31, 2003. (c) The Personal Strategy Income Fund previously operated under a 0.90% limitation that expired May 31, 2002. The reimbursement period for this limitation extends through May 31, 2004. (d) The Personal Strategy Growth Fund previously operated under a 1.10% limitation that expired May 31, 2002. The reimbursement period for this limitation extends through May 31, 2004. (e) The Short-Term Bond Fund previously operated under a 0.55% limitation that expired May 31, 2002. The reimbursement period for this limitation extends through May 31, 2004. Each of the above-referenced fund's Management Agreement also provides that one or more additional expense limitation periods (of the same or different time periods) may be implemented after the expiration of the current expense limitation, and that with respect to any such additional limitation period, the fund may 60 reimburse T. Rowe Price, provided the reimbursement does not result in the fund's aggregate expenses exceeding the additional expense limitation. Corporate Income Fund Pursuant to the current expense limitation, $104,000 of management fees were not accrued by the fund for the year ended May 31, 2002. At May 31, 2002, unaccrued fees in the amount of $239,000 remain subject to reimbursement by the fund through May 31, 2003, and $104,000 through May 31, 2005. Personal Strategy Growth Fund Pursuant to the current expense limitation, $60,000 of management fees were not accrued by the fund for the year ended May 31, 2002. At May 31, 2002, unaccrued fees in the amount of $118,000 remain subject to reimbursement by the fund through May 31, 2004. Personal Strategy Income Fund Pursuant to the current expense limitation, $96,000 of management fees were not accrued by the fund for the year ended May 31, 2002. At May 31, 2002, unaccrued fees in the amount of $225,000 remain subject to reimbursement by the fund through May 31, 2004. Short-Term Bond Fund Pursuant to the current expense limitation, $535,000 of management fees were not accrued by the fund for the year ended May 31, 2002. At May 31, 2002, unaccrued fees in the amount of $961,000 remain subject to reimbursement by the fund through May 31, 2004. GNMA, High Yield, New Income, Short-Term Bond, and U.S. Treasury Long-Term Funds T. Rowe Price Spectrum Fund, Inc. The funds listed above are a party to a Special Servicing Agreement ("Agreement") between and among T. Rowe Price Spectrum Fund, Inc. ("Spectrum Fund"), T. Rowe Price, and various other T. Rowe Price funds which, along with such fund, are funds in which Spectrum Fund invests (collectively all such funds "Underlying Price Funds"). The Agreement provides that, if the Board of Directors of any underlying Price fund determines that such underlying fund's share of the aggregate expenses of Spectrum Fund is less than the estimated savings to the underlying Price fund from the operation of Spectrum Fund, the underlying Price fund will bear those expenses in proportion to the average daily value of its shares owned by Spectrum Fund, provided further that no underlying Price fund will bear such expenses in excess of the estimated savings to it. Such savings are expected to result primarily from the elimination of numerous separate shareholder accounts which are or would have been invested directly in the underlying Price funds and the resulting reduction in shareholder servicing costs. Although such cost savings are not certain, the estimated savings to the underlying Price funds generated by the operation of Spectrum Fund are expected to be sufficient to offset most, if not all, of the expenses incurred by Spectrum Fund. Management Fee Government Reserve Investment and Reserve Investment Funds Neither fund pays T. Rowe Price an investment management fee. Institutional High Yield Fund The fund pays T. Rowe Price an annual investment management fee in monthly installments of 0.50% of the average daily net asset value of the fund. Management Related Services As noted above, the Management Agreement spells out the expenses to be paid by the fund. In addition to the Management Fee, the fund pays for the following: shareholder service expenses; custodial, accounting, legal, and audit fees; costs of preparing and printing prospectuses and reports sent to shareholders; registration fees and expenses; proxy and annual meeting expenses (if any); and director fees and expenses. 61 T. Rowe Price Services, Inc., a wholly owned subsidiary of T. Rowe Price, acts as the fund's transfer and dividend disbursing agent and provides shareholder and administrative services. Services for certain types of retirement plans are provided by T. Rowe Price Retirement Plan Services, Inc., also a wholly owned subsidiary. The address for each is 100 East Pratt Street, Baltimore, MD 21202. Additionally, T. Rowe Price, under a separate agreement with the fund, provides accounting services to the fund. The funds paid the expenses shown in the following table for the fiscal year ended May 31, 2002, to T. Rowe Price and its affiliates.
Transfer Agent and Retirement Fund Shareholder Services Subaccounting Accounting Services ---- -------------------- Services ------------------- -------- Corporate Income $ 65,000 $ 28,000 $ 84,000 GNMA 1,383,000 282,000 104,000 Government Reserve Investment -- -- 64,000 High Yield 2,172,000 217,000 136,000 High Yield Fund-Advisor Class 2,000 -- 3,000 New Income 2,189,000 1,359,000 109,000 Personal Strategy Balanced 173,000 2,044,000 85,000 Personal Strategy Growth 180,000 844,000 84,000 Personal Strategy Income 72,000 682,000 85,000 Prime Reserve 5,013,000 3,811,000 98,000 Prime Reserve Fund-PLUS Class 78,000 -- 1,000 Reserve Investment -- -- 64,000 Short-Term Bond 436,000 276,000 84,000 U.S. Treasury Intermediate 196,000 225,000 64,000 U.S. Treasury Long-Term 567,000 73,000 64,000 U.S. Treasury Money 624,000 347,000 64,000 ------------------------
SERVICES BY OUTSIDE PARTIES ------------------------------------------------------------------------------- The shares of some fund shareholders are held in omnibus accounts maintained by various third parties, including retirement plan sponsors, insurance companies, banks, and broker-dealers. The fund has adopted an administrative fee payment ("AFP") program that authorizes the fund to make payments to these third parties. The payments are made for transfer agent, recordkeeping, and other administrative services provided by, or on behalf of, the third parties with respect to such shareholders and the omnibus accounts. Under the AFP program, the funds paid the amounts set forth below to various third parties in calendar year 2001.
GNMA Fund $ 7,603 High Yield Fund 31,471 New Income Fund 16,138 Personal Strategy Balanced Fund 29,543 Personal Strategy Growth Fund 24,963 Personal Strategy Income Fund 12,560 Prime Reserve Fund 16,270 U.S. Treasury Money Fund 16,894
The Advisor Class has adopted an Advisor Class administrative fee payment program ("Advisor Class AFP") under which various intermediaries, including intermediaries receiving 12b-1 payments, may receive 62 payments from the Advisor Class in addition to 12b-1 fees for providing various recordkeeping and transfer agent type services to the Advisor Classes and/or shareholders thereof. These services include, but are not limited to: transmission of net purchase and redemption orders; maintenance of separate records for shareholders reflecting purchases, redemptions, and share balances; mailing of shareholder confirmations and periodic statements; and telephone services in connection with the above. Under the Advisor Class AFP program, the funds paid the amounts set forth below to various third parties in calendar year 2001.
High Yield Fund-Advisor Class $54,240
Control of Investment Advisor T. Rowe Price Group, Inc., ("Group") owns 100% of the stock of T. Rowe Price Associates, Inc. . Group was formed in 2000 as a holding company for the T. Rowe Price-affiliated companies. All funds except Government Reserve Investment and Reserve Investment Funds DISTRIBUTOR FOR THE FUND ------------------------------------------------------------------------------- Investment Services, a Maryland corporation formed in 1980 as a wholly owned subsidiary of T. Rowe Price, serves as the fund's distributor for all T. Rowe Price mutual funds on a continuous basis. Investment Services is registered as a broker-dealer under the Securities Exchange Act of 1934 and is a member of the National Association of Securities Dealers, Inc. Investment Services is located at the same address as the fund and T. Rowe Price-100 East Pratt Street, Baltimore, Maryland 21202. Investment Services serves as distributor to the funds, pursuant to an Underwriting Agreement ("Underwriting Agreement"), which provides that the fund will pay all fees and expenses in connection with: necessary state filings; preparing, setting in type, printing, and mailing of prospectuses and reports to shareholders; and issuing shares, including expenses of confirming purchase orders. The Underwriting Agreement also provides that Investment Services will pay all fees and expenses in connection with: printing and distributing prospectuses and reports for use in offering and selling fund shares; preparing, setting in type, printing, and mailing all sales literature and advertising; Investment Services' federal and state registrations as a broker-dealer; and offering and selling shares for each fund, except for those fees and expenses specifically assumed by the fund. Investment Services' expenses are paid by T. Rowe Price. Investment Services acts as the agent of the fund, in connection with the sale of fund shares in the various states in which Investment Services is qualified as a broker-dealer. Under the Underwriting Agreement, Investment Services accepts orders for fund shares at net asset value. No sales charges are paid by investors or the fund. No compensation is paid to Investment Services. High Yield Fund-Advisor Class, New Income Fund-Advisor Class, and New Income Fund-R Class Distribution and Shareholder Services Plan The fund Directors adopted a Plan pursuant to Rule 12b-1 with respect to each Advisor Class and each R Class (collectively "Class"). Each Plan provides that the Class may compensate Investment Services or such other persons as the fund or Investment Services designates, to finance any or all of the distribution, shareholder servicing, maintenance of shareholder accounts, and/or other administrative services with respect to Class shares. It is expected that most, if not all, payments under the Plan will be made (either directly, or indirectly through Investment Services) to brokers, dealers, banks, insurance companies, and intermediaries other than Investment Services. Under the Plan, each Advisor Class pays a fee at the annual rate of up to 0.25% of that class's average daily net assets and each R Class pays a fee at the annual rate of up to 0.50% of that class's average daily net assets. Normally, the full amount of the fee is paid to the intermediary on shares sold through that intermediary. However, a lesser amount may be paid based on the level of services provided. Intermediaries may use the payments for, among other purposes, compensating employees engaged in sales and/or shareholder servicing of the Class, as well as for a wide variety of other purposes associated with 63 supporting, distributing, and servicing Class shares. The amount of fees paid by a Class during any year may be more or less than the cost of distribution and other services provided to the Class and its investors. NASD rules limit the amount of annual distribution and service fees that may be paid by a mutual fund and impose a ceiling on the cumulative distribution fees paid. The Plan complies with these rules. The Plan requires that Investment Services provide, or cause to be provided, a quarterly written report identifying the amounts expended by each Class and the purposes for which such expenditures were made to the fund Directors for their review. Prior to approving the Plan, the fund considered various factors relating to the implementation of the Plan and determined that there is a reasonable likelihood that the Plan will benefit each fund, its Class, and the Class's shareholders. The fund Directors noted that to the extent the Plan allows a fund to sell Class shares in markets to which it would not otherwise have access, the Plan may result in additional sales of fund shares. This may enable a fund to achieve economies of scale that could reduce expenses. In addition, certain ongoing shareholder services may be provided more effectively by intermediaries with which shareholders have an existing relationship. The Plan is renewable from year to year with respect to each fund, so long as its continuance is approved at least annually (1) by the vote of a majority of the fund Directors and (2) by a vote of the majority of the funds' independent directors ("Rule 12b-1 Directors"), cast in person at a meeting called for the purpose of voting on such approval. The Plan may not be amended to increase materially the amount of fees paid by any Class thereunder unless such amendment is approved by a majority vote of the outstanding shares of such Class and by the fund Directors in the manner prescribed by Rule 12b-1 under the 1940 Act. The Plan is terminable with respect to a Class at any time by a vote of a majority of the Rule 12b-1 Directors or by a majority vote of the outstanding shares in the Class. The following payments for the period ended December 31, 2002 were made to third-party intermediaries, including broker-dealers and insurance companies, for the distribution, shareholder servicing, maintenance of shareholder accounts, and/or other administration services under the Advisor Class 12b-1 Plans.
High Yield Fund-Advisor Class $133,000
CUSTODIAN ------------------------------------------------------------------------------- State Street Bank and Trust Company is the custodian for the fund's U.S. securities and cash, but it does not participate in the fund's investment decisions. Portfolio securities purchased in the U.S. are maintained in the custody of the Bank and may be entered into the Federal Reserve Book Entry System, or the security depository system of the Depository Trust Corporation. State Street Bank's main office is at 225 Franklin Street, Boston, Massachusetts 02110. The fund (other than GNMA, Government Reserve Investment, Prime Reserve, Reserve Investment, U.S. Treasury Intermediate, U.S. Treasury Long-Term, and U.S. Treasury Money Funds) The fund has entered into a Custodian Agreement with JPMorgan Chase Bank, London, pursuant to which portfolio securities which are purchased outside the United States are maintained in the custody of various foreign branches of JPMorgan Chase Bank and such other custodians, including foreign banks and foreign securities depositories as are approved in accordance with regulations under the 1940 Act. The address for JPMorgan Chase Bank, London is Woolgate House, Coleman Street, London, EC2P 2HD, England. CODE OF ETHICS ------------------------------------------------------------------------------- The fund, its investment adviser (T. Rowe Price), and its principal underwriter (T. Rowe Price Investment Services), have a written Code of Ethics which requires persons with access to investment information ("Access Persons") to obtain prior clearance before engaging in personal securities transactions. In addition, 64 all Access Persons must report their personal securities transactions within 10 days of their execution. Access Persons will not be permitted to effect transactions in a security if: there are pending client orders in the security; the security has been purchased or sold by a client within seven calendar days; the security is being considered for purchase for a client; ; or the security is subject to internal trading restrictions. In addition, Access Persons are prohibited from profiting from short-term trading (e.g., purchases and sales involving the same security within 60 days). Any person becoming an Access Person must file a statement of personal securities holdings within 10 days of this date. All Access Persons are required to file an annual statement with respect to their personal securities holdings. Any material violation of the Code of Ethics is reported to the Board of the fund. The Board also reviews the administration of the Code of Ethics on an annual basis. PORTFOLIO TRANSACTIONS ------------------------------------------------------------------------------- Investment or Brokerage Discretion Decisions with respect to the purchase and sale of portfolio securities on behalf of the fund are made by T. Rowe Price. T. Rowe Price is also responsible for implementing these decisions, including the negotiation of commissions and the allocation of portfolio brokerage and principal business and the use of affiliates to assist in routing orders for execution. The fund's purchases and sales of fixed-income portfolio securities are normally done on a principal basis and do not involve the payment of a commission although they may involve the designation of selling concessions. That part of the discussion below relating solely to brokerage commissions would not normally apply to the fund (except to the extent it purchases equity securities (High Yield, New Income, and Personal Strategy Funds only). However, it is included because T. Rowe Price does manage a significant number of common stock portfolios which do engage in agency transactions and pay commissions and because some research and services resulting from the payment of such commissions may benefit the fund. How Brokers and Dealers Are Selected Equity Securities In purchasing and selling equity securities, it is T. Rowe Price's policy to obtain quality execution at favorable security prices, through responsible brokers and dealers, and in the case of agency transactions, at competitive commission rates. However, under certain conditions, higher brokerage commissions may be paid in return for brokerage and research services. As a general practice, over-the-counter orders are executed with market-makers or on an agency basis through an electronic communications network. In selecting among market-makers, T. Rowe Price generally seeks to select those it believes to be actively and effectively trading the security being purchased or sold. In selecting broker and dealers to execute the fund's portfolio transactions, consideration is given to such factors as the price of the security, the rate of the commission, the size and difficulty of the order, the reliability, integrity, financial condition, general execution, and operational capabilities of competing brokers and dealers, their expertise in particular markets, and brokerage and research services provided by them. It is not the policy of T. Rowe Price to seek the lowest available commission rate where it is believed that a broker or dealer charging a higher commission rate would offer greater reliability or provide better price or execution. Fixed-Income Securities Fixed-income securities are generally purchased from the issuer or a primary market-maker acting as principal for the securities on a net basis, with no brokerage commission being paid by the client, although the price usually includes an undisclosed compensation. Transactions placed through dealers serving as primary market-makers reflect the spread between the bid and ask prices. Securities may also be purchased from underwriters at prices which include underwriting fees. Equity and Fixed-Income Securities With respect to equity and fixed-income securities, T. Rowe Price may effect principal transactions on behalf of the fund with a broker or dealer who furnishes brokerage and/or research services; designate any such broker or dealer to receive selling concessions, discounts, or other allowances; or otherwise deal with any such 65 broker or dealer in connection with the acquisition of securities in underwritings. T. Rowe Price may receive research services in connection with brokerage transactions, including designations in fixed-price offerings. How Evaluations Are Made of the Overall Reasonableness of Brokerage Commissions Paid On a continuing basis, T. Rowe Price seeks to determine what levels of commission rates are reasonable in the marketplace for transactions executed on behalf of clients. In evaluating the reasonableness of commission rates, T. Rowe Price considers: (a) historical commission rates; (b) rates which other institutional investors are paying, based on available public information; (c) rates quoted by brokers and dealers; (d) the size of a particular transaction in terms of the number of shares and dollar amount; (e) the complexity of a particular transaction in terms of both execution and settlement; (f) the level and type of business done with a particular firm over a period of time; and (g) the extent to which the broker or dealer has capital at risk in the transaction. Descriptions of Research Services Received From Brokers and Dealers T. Rowe Price receives a wide range of research services from brokers and dealers. These services include information on the economy, industries, groups of securities, individual companies, statistical information, accounting and tax law interpretations, political developments, legal developments affecting portfolio securities, technical market action, pricing and appraisal services, credit analysis, risk measurement analysis, performance analysis, and analysis of corporate responsibility issues. These services provide both domestic and international perspective. Research services are received primarily in the form of written reports, computer-generated services, telephone contacts, and personal meetings with security analysts. Such services may be provided in the form of meetings arranged with corporate and industry spokespersons, economists, academicians, and government representatives. In some cases, research services are generated by third parties but are provided to T. Rowe Price by or through broker-dealers. In addition, such services may include computers and related hardware. Research services received from brokers and dealers are supplemental to T. Rowe Price's own research effort and, when utilized, are subject to internal analysis before being incorporated by T. Rowe Price into its investment process. As a practical matter, it would not be possible for T. Rowe Price's Equity Research Division to generate all of the information presently provided by brokers and dealers. T. Rowe Price pays cash for certain research services received from external sources. T. Rowe Price also allocates brokerage for research services which are available for cash. While receipt of research services from brokerage firms has not reduced T. Rowe Price's normal research activities, the expenses of T. Rowe Price could be materially increased if it attempted to generate such additional information through its own staff. To the extent that research services of value are provided by brokers or dealers, T. Rowe Price is relieved of expenses which it might otherwise bear. Subject to its policy on directed brokerage (see below), T. Rowe Price has a policy of not allocating brokerage business in return for products or services other than brokerage or research services. In accordance with the provisions of Section 28(e) of the Securities Exchange Act of 1934, T. Rowe Price may from time to time receive services and products which serve both research and non-research functions. In such event, T. Rowe Price makes a good faith determination of the anticipated research and non-research use of the product or service and allocates brokerage only with respect to the research component. Directed Brokerage In 2002, the T. Rowe Price Funds that invest in domestic equity securities adopted a commission recapture program. Under the program, a percentage of commissions generated by the portfolio transactions of those funds is rebated to the funds by the brokers and used to pay for certain fund operating expenses. Commissions to Brokers Who Furnish Research Services Certain brokers and dealers who provide quality brokerage and execution services also furnish research services to T. Rowe Price. With regard to the payment of brokerage commissions, T. Rowe Price has adopted a brokerage allocation policy embodying the concepts of Section 28(e) of the Securities Exchange Act of 1934, which permits an investment adviser to cause an account to pay commission rates in excess of those another broker or dealer would have charged for effecting the same transaction if the adviser determines in good faith that the commission paid is reasonable in relation to the value of the brokerage and research services provided. The determination may be viewed in terms of either the particular transaction involved or the 66 overall responsibilities of the adviser with respect to the accounts over which it exercises investment discretion. Therefore, research may not necessarily benefit all accounts paying commissions to such brokers. Accordingly, while T. Rowe Price cannot readily determine the extent to which commission rates charged by broker-dealers reflect the value of their research services, T. Rowe Price would expect to assess the reasonableness of commissions in light of the total brokerage and research services provided by each particular broker. T. Rowe Price may receive research, as defined in Section 28(e), in connection with selling concessions and designations in fixed-price offerings in which the fund participates. Such research is used to benefit the accounts that purchase in the offering. Internal Allocation Procedures T. Rowe Price has a policy of not precommitting a specific amount of business to any broker or dealer over any specific time period. Historically, the majority of brokerage placement has been determined by the needs of a specific transaction such as market-making, availability of a buyer or seller of a particular security, or specialized execution skills. However, T. Rowe Price does have an internal brokerage allocation procedure for that portion of its discretionary client brokerage business where special needs do not exist, or where the business may be allocated among several brokers or dealers, which are able to meet the needs of the transaction. Each year, T. Rowe Price assesses the contribution of the brokerage and research services provided by brokers and dealers and attempts to allocate a portion of its brokerage business in response to these assessments. Research analysts, counselors, various investment committees, and the Trading Department each seek to evaluate the brokerage execution and research services they receive from brokers and dealers and make judgments as to the level of business which would recognize such services. In addition, brokers and dealers sometimes suggest a level of business they would like to receive in return for the various brokerage and research services they provide. Actual business received by any firm may be less than the suggested allocations but can, and often does, exceed the suggestions because the total business is allocated on the basis of all the considerations described above. In no case is a broker or dealer excluded from receiving business from T. Rowe Price because it has not been identified as providing research services. Miscellaneous T. Rowe Price's brokerage allocation policy is generally applied to all its fully discretionary accounts, which represent a substantial majority of all assets under management. Research services furnished by brokers or dealers through which T. Rowe Price effects securities transactions may be used in servicing all accounts (including non-fund accounts) managed by T. Rowe Price. Conversely, research services received from brokers or dealers which execute transactions for the fund are not necessarily used by T. Rowe Price exclusively in connection with the management of the fund. From time to time, orders for clients may be placed through a computerized transaction network. The fund does not allocate business to any broker-dealer on the basis of its sales of the fund's shares. However, this does not mean that broker-dealers who purchase fund shares for their clients will not receive business from the fund. Some of T. Rowe Price's other clients have investment objectives and programs similar to those of the fund. T. Rowe Price may make recommendations which result in clients purchasing or selling securities simultaneously with the fund. As a result, the demand for securities being purchased or the supply of securities being sold may increase, and this could have an adverse effect on the price of those securities. It is T. Rowe Price's policy not to favor one client over another in making recommendations or in placing orders. T. Rowe Price frequently follows the practice of grouping orders of various clients for execution, which generally results in lower commission rates being attained. In certain cases, where the aggregate order is executed in a series of transactions at various prices on a given day, each participating client's proportionate share of such order reflects the average price paid or received with respect to the total order. Price Associates has developed written trade allocation guidelines for its Equity, Municipal, and Taxable Fixed Income Trading Desks. Generally, when the amount of securities available in a public offering or the secondary markets is insufficient to satisfy the volume or price requirements for the participating client portfolios, the guidelines require a pro rata allocation based upon the relative sizes of the participating client 67 portfolios or the relative sizes of the participating client orders depending upon the market involved. In allocating trades made on a combined basis, the trading desks seek to achieve the same net unit price of the securities for each participating client. Because a pro rata allocation may not always adequately accommodate all facts and circumstances, the guidelines provide for exceptions to allocate trades on an adjusted, pro rata basis. For example, adjustments may be made: (i) to recognize the efforts of a portfolio manager in negotiating a transaction or a private placement; (ii) to eliminate de minimus positions; (iii) to give priority to accounts with specialized investment policies and objectives; and (iv) to reallocate in light of a participating portfolio's characteristics (e.g., available cash, industry or issuer concentration, duration, credit exposure). Also, with respect to private placement transactions, conditions imposed by the issuer may limit availability of allocations to client accounts. T. Rowe Price has established a general investment policy that it will ordinarily not make additional purchases of a common stock of a company for its clients (including the T. Rowe Price funds) if, as a result of such purchases, 10% or more of the outstanding common stock of such company would be held by its clients in the aggregate. Price Associates may give advice and take action for clients, including investment companies, which differs from advice given or the timing or nature of action taken for other clients. Price Associates is not obligated to initiate transactions for clients in any security which its principals, affiliates, or employees may purchase or sell for their own accounts or for other clients. Purchase and sale transactions may be effected directly between non-ERISA client accounts (including mutual funds), provided no commission is paid to any broker, the security traded has readily available market quotations, and the transaction is effected at the independent current market price. Price Associates has Brokerage Control Committees which are responsible for developing brokerage policy, monitoring its implementation, and resolving questions which arise in that connection. At the present time, T. Rowe Price does not recapture commissions or underwriting discounts or selling group concessions in connection with taxable securities acquired in underwritten offerings. T. Rowe Price does, however, attempt to negotiate elimination of all or a portion of the selling group concession or underwriting discount when purchasing tax-exempt municipal securities on behalf of its clients in underwritten offerings. Other For the last three fiscal years the fund's engaged in portfolio transactions involving broker-dealers in the following amounts:
Fund 2002 2001 2000 ---- ---- ---- ---- Corporate Income $ 113,035,000 $ 113,035,000 $ 87,158,000 GNMA 3,180,275,000 1,478,634,000 1,340,767,000 Government Reserve Investment 227,711,000,000 168,448,618,000 208,368,283,000 High Yield 2,679,515,000 2,151,430,000 2,228,594,000 New Income 7,748,028,000 3,606,669,000 2,787,051,000 Personal Strategy Balanced 1,271,606,000 784,704,000 572,235,000 Personal Strategy Growth 501,020,000 330,295,000 232,667,000 Personal Strategy Income 536,916,000 339,026,000 169,938,000 Prime Reserve 36,649,105,000 38,321,006,000 44,694,574,000 Reserve Investment 93,148,376,000 79,731,548,000 85,643,368,000 Short-Term Bond 547,984,000 547,984,000 267,997,000 U.S. Treasury Intermediate 583,662,000 508,503,000 253,839,000 U.S. Treasury Long-Term 317,124,000 191,764,000 155,975,000 U.S. Treasury Money 5,506,199,000 4,879,524,000 5,655,456,000 -------------------------
With respect to the GNMA, Government Reserve, Prime Reserve, Reserve Investment, U.S. Treasury Intermediate, U.S. Treasury Long-Term, and U.S. Treasury Money Funds, the entire amount for each of these 68 years represented principal transactions as to which the funds have no knowledge of the profits or losses realized by the respective broker-dealers for the last three fiscal years. With respect to the Corporate Income, High Yield, New Income, Personal Strategy Balanced, Personal Strategy Growth, Personal Strategy Income, and Short-Term Bond Funds, the following amounts consisted of principal transactions as to which the funds have no knowledge of the profits or losses realized by the respective broker-dealers for the last three fiscal years.
Fund 2002 2001 2000 ---- ---- ---- ---- Corporate Income $ 96,190,000 $ 96,190,000 $ 81,635,000 High Yield 2,211,118,000 1,841,819,000 1,950,820,000 New Income 7,341,623,000 3,186,861,000 2,589,971,000 Personal Strategy Balanced 888,905,000 478,739,000 241,804,000 Personal Strategy Growth 256,052,000 157,439,000 69,314,000 Personal Strategy Income 435,915,000 254,071,000 89,593,000 Short-Term Bond 454,590,000 454,590,000 216,139,000 ----------------------------
The following amounts involved trades with brokers acting as agents or underwriters for the last three fiscal years.
Fund 2002 2001 2000 ---- ---- ---- ---- Corporate Income $ 16,845,000 $ 16,845,000 $ 5,523,000 High Yield 468,397,000 309,611,000 277,774,000 New Income 406,405,000 419,808,000 197,080,000 Personal Strategy Balanced 382,701,000 305,965,000 330,431,000 Personal Strategy Growth 244,968,000 172,856,000 163,353,000 Personal Strategy Income 101,001,000 84,955,000 80,344,000 Short-Term Bond 93,393,000 93,393,000 51,858,000 ----------------------------
The amounts shown below involved trades with brokers acting as agents or underwriters, in which such brokers received total commissions, including discounts received in connection with underwritings for the last three fiscal years.
Fund 2002 2001 2000 ---- ---- ---- ---- Corporate Income $ 103,000 $ 103,000 $ 35,000 High Yield 9,189,000 7,746,000 7,250,000 New Income 1,734,000 1,387,000 700,000 Personal Strategy Balanced 843,000 564,000 448,000 Personal Strategy Growth 374,000 218,000 208,000 Personal Strategy Income 332,000 215,000 112,000 Short-Term Bond 217,000 217,000 105,000 ----------------------------
The percentage of total portfolio transactions, placed with firms which provided research, statistical, or other services to T. Rowe Price in connection with the management of the funds, or in some cases, to the funds for the last three fiscal years, are shown below:
Fund 2002 2001 2000 ---- ---- ---- ---- Corporate Income 95% 98% 93% GNMA 100 71 94 Government Reserve Investment -- -- 98 High Yield 82 87 86 New Income 98 112 92 Personal Strategy Balanced 14 11 25 Personal Strategy Growth 19 17 30 Personal Strategy Income 9 7 25 Prime Reserve -- -- 94 Reserve Investment -- -- 93 Short-Term Bond 95 78 90 U.S. Treasury Intermediate 99 108 95 U.S. Treasury Long-Term 99 31 71 U.S. Treasury Money -- -- 98 -------------------------------
69 The portfolio turnover rates for the following funds for the last three fiscal years, are as follows:
Fund 2002 2001 2000 ---- ---- ---- ---- Corporate Income 91.1% 98.1% 90.9% GNMA 145.2 71.2 63.8 High Yield 71.3 80.1 75.9 New Income 222.0 112.1 83.6 Personal Strategy Balanced 97.2 61.5 48.2 Personal Strategy Growth 68.4 54.8 42.6 Personal Strategy Income 115.9 79.8 45.4 Short-Term Bond 49.9 77.6 50.7 U.S. Treasury Intermediate 104.4 108.0 48.5 U.S. Treasury Long-Term 48.5 31.3 21.7 ----------------------------
Government Reserve Investment, Prime Reserve, Reserve Investment, and U.S. Treasury Money Funds The fund, in pursuing its objectives, may engage in short-term trading to take advantage of market variations. The fund will seek to protect principal, improve liquidity of its securities, or enhance yield by purchasing and selling securities based upon existing or anticipated market discrepancies. GNMA and New Income Funds The fund has been rolling mortgages, i.e., selling the current month and buying the forward month, to enhance total return. PRICING OF SECURITIES ------------------------------------------------------------------------------- Personal Strategy Funds :Equity securities listed or regularly traded on a securities exchange or in the over-the-counter market are valued at the last quoted sale price, or official closing price for certain markets, at the time the valuations are made. A security that is listed or traded on more than one exchange is valued at the quotation on the exchange determined to be the primary market for such security. Listed securities not traded on a particular day are valued at the mean of the latest bid and ask prices for domestic securities and the last quoted sale price for international securities. Other equity securities are valued at a price within the limits of the latest bid and ask prices deemed by the Board of Directors, or by persons delegated by the Board, best to reflect fair value. 70 Debt securities are generally traded in the over-the-counter market. Securities with original maturities of one year or more are valued using prices furnished by dealers who make markets in such securities or by an independent pricing service, which considers yield or price of bonds of comparable quality, coupon, maturity, and type, as well as prices quoted by dealers who make markets in such securities. Securities with original maturities less than one year are valued at amortized cost in local currency, which approximates fair value when combined with accrued interest. Corporate Income, GNMA, High Yield, Institutional High Yield, New Income, Short-Term Bond, U.S. Treasury Intermediate, and U.S. Treasury Long-Term Funds Debt securities are generally traded in the over-the-counter market. Securities with original maturities of one year or more are valued at prices furnished by dealers who make markets in such securities or by an independent pricing service, which considers yield or price of bonds of comparable quality, coupon, maturity, and type, as well as prices quoted by dealers who make markets in such securities. Securities with original maturities less than one year are stated at fair value, which is determined by using a matrix system that establishes a value for each security based on bid-side money market yields. Corporate Income, High Yield, Institutional High Yield, and New Income Funds Equity securities listed or regularly traded on a securities exchange or in the over-the-counter market are valued at the last quoted sale price, or official closing price for certain markets, at the time the valuations are made. A security that is listed or traded on more than one exchange is valued at the quotation on the exchange determined to be the primary market for such security. Listed securities not traded on a particular day are valued at the mean of the latest bid and ask prices for domestic securities and the last quoted sale price for international securities. Other equity securities are valued at a price within the limits of the latest bid and ask prices deemed by the Board of Directors, or by persons delegated by the Board, best to reflect fair value. Corporate Income, GNMA, High Yield, Institutional High Yield, New Income, Personal Strategy, Short-Term Bond, U.S. Treasury Intermediate, and U.S. Treasury Long-Term Funds Investments in mutual funds are valued at the closing net asset value per share of the mutual fund on the day of valuation. In the absence of a last sale price, purchased and written options (including options on futures contracts) are valued at the mean of the closing bid and ask prices. Financial futures contracts are valued at closing settlement prices. Corporate Income, High Yield, Institutional High Yield, New Income, Personal Strategy, and Short-Term Bond Funds Assets and liabilities denominated in foreign currencies are translated into U.S. dollar values each day at the prevailing exchange rate, using the mean of the bid and ask prices of such currencies against U.S. dollars quoted by a major bank. Purchases and sales of securities, income, and expenses are translated into U.S. dollars at the prevailing exchange rate on the dates of such transactions. The effect of changes in foreign exchange rates on realized and unrealized security gains and losses is reflected as a component of such gains and losses. Government Reserve Investment, Prime Reserve, Reserve Investment, and U.S. Treasury Money Funds Securities are valued at amortized cost. Assets and liabilities for which such valuation procedures are deemed not to reflect fair value are stated at fair value as determined in good faith by or under the supervision of the officers of the fund, as authorized by the Board of Directors. All funds Assets and liabilities for which the above valuation procedures are inappropriate or are deemed not to reflect fair value are stated at fair value as determined in good faith by or under the supervision of the officers of the fund, as authorized by the Board of Directors. 71 Government Reserve Investment, Prime Reserve, Reserve Investment, and U.S. Treasury Money Funds Maintenance of Money Fund's Net Asset Value per Share at $1.00 It is the policy of the fund to attempt to maintain a net asset value of $1.00 per share by using the amortized cost method of valuation permitted by Rule 2a-7 under the 1940 Act. Under this method, securities are valued by reference to the fund's acquisition cost as adjusted for amortization of premium or accumulation of discount, rather than by reference to their market value. Under Rule 2a-7: (a) The Board of Directors must establish written procedures reasonably designed, taking into account current market conditions and the fund's investment objectives, to stabilize the fund's net asset value per share, as computed for the purpose of distribution, redemption, and repurchase, at a single value; (b) The fund must (i) maintain a dollar-weighted average portfolio maturity appropriate to its objective of maintaining a stable price per share, (ii) not purchase any instrument with a remaining maturity greater than 397 days, and (iii) maintain a dollar-weighted average portfolio maturity of 90 days or less; (c) The fund must limit its purchase of portfolio instruments, including repurchase agreements, to those U.S. dollar-denominated instruments which the fund's Board of Directors determines present minimal credit risks and which are eligible securities as defined by Rule 2a-7; and (d) The Board of Directors must determine that (i) it is in the best interest of the fund and its shareholders to maintain a stable net asset value per share under the amortized cost method; and (ii) the fund will continue to use the amortized cost method only so long as the Board of Directors believes that it fairly reflects the market-based net asset value per share. Although the fund believes that it will be able to maintain its net asset value at $1.00 per share under most conditions, there can be no absolute assurance that it will be able to do so on a continuous basis. If the fund's net asset value per share declined, or was expected to decline, below $1.00 (rounded to the nearest one cent), the Board of Directors of the fund might temporarily reduce or suspend dividend payments in an effort to maintain the net asset value at $1.00 per share. As a result of such reduction or suspension of dividends, an investor would receive less income during a given period than if such a reduction or suspension had not taken place. Such action could result in an investor receiving no dividend for the period during which he holds his shares and in his receiving, upon redemption, a price per share lower than that which he paid. On the other hand, if the fund's net asset value per share were to increase, or were anticipated to increase, above $1.00 (rounded to the nearest one cent), the Board of Directors of the fund might supplement dividends in an effort to maintain the net asset value at $1.00 per share. Prime Reserve and Reserve Investment Funds Prime Money Market Securities Defined Prime money market securities are those which are described as First Tier Securities under Rule 2a-7 of the 1940 Act. These include any security with a remaining maturity of 397 days or less that is rated (or that has been issued by an issuer that is rated with respect to a class of short-term debt obligations, or any security within that class that is comparable in priority and security with the security) by any two nationally recognized statistical rating organizations (NRSROs) (or if only one NRSRO has issued a rating, that NRSRO) in the highest rating category for short-term debt obligations (within which there may be sub-categories). First Tier Securities also include unrated securities comparable in quality to rated securities, as determined by T. Rowe Price under the supervision of the fund's Board of Directors. All funds NET ASSET VALUE PER SHARE ------------------------------------------------------------------------------- The purchase and redemption price of the fund's shares is equal to the fund's net asset value per share or share price. The fund determines its net asset value per share by subtracting its liabilities (including accrued 72 expenses and dividends payable) from its total assets (the market value of the securities the fund holds plus cash and other assets, including income accrued but not yet received) and dividing the result by the total number of shares outstanding. The net asset value per share of the fund is normally calculated as of the close of trading on the New York Stock Exchange ("NYSE") every day the NYSE is open for trading. The NYSE is closed on the following days: New Year's Day, Dr. Martin Luther King, Jr. Holiday, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day, and Christmas Day. Determination of net asset value (and the offering, sale, redemption, and repurchase of shares) for the fund may be suspended at times (a) during which the NYSE is closed, other than customary weekend and holiday closings, , (b) during which trading on the NYSE is restricted, (c) during which 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 which a governmental body having jurisdiction over the fund may by order permit such a suspension for the protection of the fund's shareholders, provided that applicable rules and regulations of the SEC (or any succeeding governmental authority) shall govern as to whether the conditions prescribed in (b), (c), or (d) exist. DIVIDENDS AND DISTRIBUTIONS ------------------------------------------------------------------------------- Unless you elect otherwise, the fund's annual capital gain distribution, if any, will be reinvested on the reinvestment date using the NAV per share of that date. The reinvestment date normally precedes the payment date by one day, although the exact timing is subject to change and can be as great as 10 days. TAX STATUS ------------------------------------------------------------------------------- The fund intends to qualify as a "regulated investment company" under Subchapter M of the Code. A portion of the dividends paid by the fund may be eligible for the dividends-received deduction applicable to corporate shareholders. . Long-term capital gain distributions paid from the funds are never eligible for the dividend-received deduction. For tax purposes, it does not make any difference whether dividends and capital gain distributions are paid in cash or in additional shares. Each fund must declare dividends by December 31 of each year equal to at least 98% of ordinary income (as of December 31) and capital gains (as of October 31) in order to avoid a federal excise tax and distribute within 12 months 100% of ordinary income and capital gains (as of its tax year-end), to avoid a federal income tax. At the time of your purchase, the fund's net asset value may reflect undistributed income , capital gains, or net unrealized appreciation of securities held by the fund. A subsequent distribution to you of such amounts, although constituting a return of your investment, would be taxable as either dividend or capital gain distributions. For federal income tax purposes, the fund is permitted to carry forward its net realized capital losses, if any, for eight years and realize net capital gains up to the amount of such losses without being required to pay taxes on, or distribute, such gains. If, in any taxable year, the fund should not qualify as a regulated investment company under the Code: (1) the fund would be taxed at normal corporate rates on the entire amount of its taxable income, if any, without a deduction for dividends or other distributions to shareholders; and (2) the fund's distributions, to the extent made out of the fund's current or accumulated earnings and profits, would be taxable to shareholders as ordinary dividends (regardless of whether they would otherwise have been considered capital gain dividends), Taxation of Foreign Shareholders The code provides that dividends from net income will be subject to U.S. tax. For shareholders who are not engaged in a business in the U.S., this tax would be imposed at the rate of 30% upon the gross amount of the dividends in the absence of a Tax Treaty providing for a reduced rate or exemption from U.S. taxation. Distributions of net long-term capital gains realized by the fund are not subject to tax unless the foreign shareholder is engaged in a business in the U.S. and the gains are connected with that business, or the 73 shareholder is a nonresident alien individual who was physically present in the U.S. during the tax year for more than 182 days. To the extent the fund invests in foreign securities, the following would apply: Passive Foreign Investment Companies The fund may purchase the securities of certain foreign investment funds or trusts, called passive foreign investment companies, for U.S. tax purposes. Such foreign investment funds or trusts have been the only or primary way to invest in certain countries. In addition to bearing their proportionate share of the fund's expenses (management fees and operating expenses), shareholders will also indirectly bear similar expenses of such foreign investment funds or trusts. Capital gains on the sale of such holdings are considered ordinary income regardless of how long the fund held its investment. In addition, the fund may be subject to corporate income tax and an interest charge on certain dividends and capital gains earned from these investments, regardless of whether such income and gains are distributed to shareholders. To avoid such tax and interest, the fund intends to treat these securities as sold on the last day of its fiscal year and recognize any gains for tax purposes at that time; deductions for losses are allowable only to the extent of any gains resulting from these deemed sales for prior taxable years. Such gains and losses will be treated as ordinary income. The fund will be required to distribute any resulting income, even though it has not sold the security and received cash to pay such distributions. Foreign Currency Gains and Losses Foreign currency gains and losses, including the portion of gain or loss on the sale of debt securities attributable to foreign exchange rate fluctuations, are taxable as ordinary income. If the net effect of these transactions is a gain, the ordinary income dividend paid by the fund will be increased. If the result is a loss, the income dividend paid by the fund will be decreased, or, to the extent such dividend has already been paid, it may be classified as a return of capital. Adjustments to reflect these gains and losses will be made at the end of the fund's taxable year. YIELD INFORMATION ------------------------------------------------------------------------------- GNMA Fund In conformity with regulations of the SEC, an income factor is calculated for each security in the portfolio based upon the security's coupon rate. The income factors are then adjusted for any gains or losses which have resulted from prepayments of principal during the period. The income factors are then totaled for all securities in the portfolio. Next, expenses of the fund for the period, net of expected reimbursements, are deducted from the income to arrive at net income, which is then converted to a per share amount by dividing net income by the average number of shares outstanding during the period. The net income per share is divided by the net asset value on the last day of the period to produce a monthly yield which is then annualized. Quoted yield factors are for comparison purposes only, and are not intended to indicate future performance or forecast the dividend per share of the fund. The yield of the GNMA Fund calculated under the above-described method for the month ended May 31, 2002, was 4.81%. Corporate Income, High Yield, New Income, Short-Term Bond, U.S. Treasury Intermediate, and U.S. Treasury Long-Term Funds An income factor is calculated for each security in the portfolio based upon the security's market value at the beginning of the period and yield as determined in conformity with regulations of the SEC. The income factors are then totaled for all securities in the portfolio. Next, expenses of the fund for the period, net of expected reimbursements, are deducted from the income to arrive at net income, which is then converted to a per share amount by dividing net income by the average number of shares outstanding during the period. The net income per share is divided by the net asset value on the last day of the period to produce a monthly yield, which is then annualized. If applicable, a taxable-equivalent yield is calculated by dividing this yield by one 74 minus the effective federal, state, and/or city or local income tax rates. Quoted yield factors are for comparison purposes only and are not intended to indicate future performance or forecast the dividend per share of the fund. The yields of the Corporate Income, High Yield, High Yield Fund-Advisor Class, New Income, Short-Term Bond, U.S. Treasury Intermediate, and U.S. Treasury Long-Term Funds calculated under the above-described method for the month ended May 31, 2002, were 6.76%, 9.04%, 8.90%, 5.08%, 4.47%, 4.33%, and 5.32%, respectively. Government Reserve Investment, Prime Reserve, Reserve Investment, and U.S. Treasury Money Funds The fund's current and historical yield for a period is calculated by dividing the net change in value of an account (including all dividends accrued and dividends reinvested in additional shares) by the account value at the beginning of the period to obtain the base period return. This base period return is divided by the number of days in the period, then multiplied by 365 to arrive at the annualized yield for that period. The fund's annualized compound yield for such period is compounded by dividing the base period return by the number of days in the period, and compounding that figure over 365 days. The seven-day yields ending May 31, 2002, for the Prime Reserve, Prime Reserve Fund-PLUS Class, and U.S. Treasury Money Funds were 1.45%, 1.39%, and 1.41%, respectively, and the funds' compound yield for the same period were 1.47%, 1.40%, and 1.42%, respectively. All funds INVESTMENT PERFORMANCE ------------------------------------------------------------------------------- Total Return Performance The fund's calculation of total return performance includes the reinvestment of all capital gain distributions and income dividends for the period or periods indicated, without regard to tax consequences to a shareholder in the fund. Total return is calculated as the percentage change between the beginning value of a static account in the fund and the ending value of that account measured by the then current net asset value, including all shares acquired through reinvestment of income and capital gain dividends. The results shown are historical and should not be considered indicative of the future performance of the fund. Each average annual compound rate of return is derived from the cumulative performance of the fund over the time period specified. The annual compound rate of return for the fund over any period of time will vary from the average.
Cumulative Performance Percentage Change Periods ended 5/31/02 Fund 1 Yr. 5 Yrs. 10 Yrs. Since Inception ---- ----- ------ ------- ----- --------- Inception Date --------- ---- Corporate Income 6.49% % -- 49.83% 10/31/95 GNMA 7.95 41.45 92.37% 11/26/85 High Yield 3.48 25.75 101.27 330.92 12/31/84 High Yield Fund-Advisor Class 3.14 -- -- 6.15 03/31/00 New Income 7.68 37.22 89.01 08/31/73 Personal Strategy Balanced -1.32 40.84 -- 122.71 07/29/94 Personal Strategy Growth -4.33 41.44 -- 140.88 07/29/94 Personal Strategy Income 1.40 39.96 -- 106.32 07/29/94 Prime Reserve 2.47 25.76 53.77 01/26/76 Prime Reserve Fund-PLUS Class 2.39 -- -- 16.47 11/01/98 Short-Term Bond 6.24 35.34 69.35 240.74 03/02/84 U.S. Treasury Intermediate 7.92 40.65 88.86 145.05 09/29/89 U.S. Treasury Long-Term 7.49 48.99 113.35 172.37 09/29/89 U.S. Treasury Money 2.37 23.90 50.29 195.76 06/28/82 -------------------------- -----------
75
Average Annual Compound Rates of Return Periods ended 5/31/02 Fund 1 Yr. 5 Yrs. 10 Yrs. Since Inception ---- ----- ------ ------- ----- --------- Inception Date --------- ---- Corporate Income 6.49% 6.29% -- 6.34% 10/31/95 GNMA 7.95 7.18 6.76% 7.70 11/26/85 High Yield 3.48 4.69 7.25 8.75 12/31/84 High Yield Fund-Advisor Class 3.14 -- -- 2.79 03/31/00 New Income 7.68 6.53 6.57 8.40 08/31/73 Personal Strategy Balanced -1.32 7.09 -- 10.75 07/29/94 Personal Strategy Growth -4.33 7.18 -- 11.87 07/29/94 Personal Strategy Income 1.40 6.96 -- 9.68 07/29/94 Prime Reserve 2.47 4.69 4.40 7.08 01/26/76 Prime Reserve Fund-PLUS Class 2.39 -- -- 4.35 11/01/98 Short-Term Bond 6.24 6.24 5.41 6.95 03/02/84 U.S. Treasury Intermediate 7.92 7.06 6.56 7.33 09/29/89 U.S. Treasury Long-Term 7.49 8.30 7.87 8.23 09/29/89 U.S. Treasury Money 2.37 4.38 4.16 5.59 06/28/82 ------------------------------- -----------
Outside Sources of Information From time to time, in reports and promotional literature: (1) the fund's total return performance, ranking, or any other measure of the fund's performance may be compared to any one or combination of the following: (a) a broad-based index, (b) other groups of mutual funds, including T. Rowe Price funds, tracked by independent research firms, ranking entities, or financial publications, (c) indices of securities comparable to those in which the fund invests; (2) the consumer price index (or any other measure for inflation), or government statistics, such as GNP, may be used to illustrate investment attributes of the fund or the general economic, business, investment, or financial environment in which the fund operates; (3) various financial, economic, and market statistics developed by brokers, dealers, and other persons may be used to illustrate aspects of the fund's performance; (4) the effect of tax-deferred compounding on the fund's investment returns, or on returns in general in both qualified and nonqualified retirement plans or any other tax-advantaged product, may be illustrated by graphs, charts, etc.; (5) the sectors or industries in which the fund invests may be compared to relevant indices or surveys in order to evaluate the fund's historical performance or current or potential value with respect to the particular industry or sector; (6) the fund may disclose the performance of other funds or accounts managed by T. Rowe Price in a manner similar to the fund; and (7) the blended total returns or performance rankings of the funds may be disclosed. Other Publications From time to time, in newsletters and other publications issued by Investment Services, T. Rowe Price mutual fund portfolio managers may discuss economic, financial, and political developments in the U.S. and abroad and how these conditions have affected or may affect securities prices or the fund; individual securities within 76 the fund's portfolio; and their philosophy regarding the selection of individual stocks, including why specific stocks have been added, removed, or excluded from the fund's portfolio. Other Features and Benefits The fund is a member of the T. Rowe Price family of funds and may help investors achieve various long-term investment goals, which include, but are not limited to, investing money for retirement, saving for a down payment on a home, or paying college costs. To explain how the fund could be used to assist investors in planning for these goals and to illustrate basic principles of investing, various worksheets and guides prepared by T. Rowe Price and/or Investment Services may be made available. No-Load Versus Load and 12b-1 Funds Many mutual funds charge sales fees to investors or use fund assets to finance distribution activities. These fees are in addition to the normal advisory fees and expenses charged, by all mutual funds. There are several types of fees charged which vary in magnitude and which may often be used in combination. A sales charge (or "load") can be charged at the time the fund is purchased (front-end load) or at the time of redemption (back-end load). Front-end loads are charged on the total amount invested. Back-end loads are charged either on the amount originally invested or on the amount redeemed. 12b-1 plans allow for the payment of marketing and sales expenses from fund assets. These expenses are usually computed daily as a fixed percentage of assets. The T. Rowe Price funds, including the Advisor Classes, are considered to be "no-load" funds. They impose no front-end or back-end sales loads. However, the Advisor Classes do charge 12b-1 fees. Under applicable National Association of Securities Dealers Regulation, Inc. ("NASDR") regulations, mutual funds that have no front-end or deferred sales charges and whose total asset-based charges for sales-related expenses and/or service fees (as defined by NASDR) do not exceed 0.25% of average net assets per year may be referred to as no-load funds. Redemptions in Kind The fund has filed a notice of election under Rule 18f-1 of the 1940 Act. This permits the fund to effect redemptions in kind and in cash as set forth in its prospectus. In the unlikely event a shareholder were to receive an in-kind redemption of portfolio securities of the fund, it would be the responsibility of the shareholder to dispose of the securities. The shareholder would be at risk that the value of the securities would decline prior to their sale, that it would be difficult to sell the securities, and that brokerage fees could be incurred. Issuance of Fund Shares for Securities Transactions involving issuance of fund shares for securities or assets other than cash will be limited to (1) bona fide reorganizations; (2) statutory mergers; or (3) other acquisitions of portfolio securities that: (a) meet the investment objective and policies of the fund; (b) are acquired for investment and not for resale except in accordance with applicable law; (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 not illiquid. All funds except GNMA Fund CAPITAL STOCK ------------------------------------------------------------------------------- The fund's Charter authorizes the Board of Directors to classify and reclassify any and all shares which are then unissued, including unissued shares of capital stock into any number of classes or series; each class or series consisting of such number of shares and having such designations, such powers, preferences, rights, qualifications, limitations, and restrictions as shall be determined by the Board subject to the 1940 Act and other applicable law. The shares of any such additional classes or series might therefore differ from the shares of the present class and series of capital stock and from each other as to preferences, conversions, or other rights, voting powers, restrictions, limitations as to dividends, qualifications, or terms or conditions of redemption, subject to applicable law, and might thus be superior or inferior to the capital stock or to other classes or series in various characteristics. The Board of Directors may increase or decrease the aggregate 77 number of shares of stock or the number of shares of stock of any class or series that the fund has authorized to issue without shareholder approval. Except to the extent that the fund's Board of Directors might provide that holders of shares of a particular class are entitled to vote as a class on specified matters presented for a vote of the holders of all shares entitled to vote on such matters, there would be no right of class vote unless and to the extent that such a right might be construed to exist under Maryland law. The Directors have provide that as to any matter with respect to which a separate vote of any class is required by the 1940 Act such requirement as to a separate vote by that class shall apply in lieu of any voting requirements established by the Maryland General Corporation Law. Otherwise, holders of each class of capital stock are not entitled to vote as a class on any matter. Accordingly, the preferences, rights, and other characteristics attaching to any class of shares might be altered or eliminated, or the class might be combined with another class or classes, by action approved by the vote of the holders of a majority of all the shares of all classes entitled to be voted on the proposal, without any additional right to vote as a class by the holders of the capital stock or of another affected class or classes. Shareholders are entitled to one vote for each full share held (and fractional votes for fractional shares held) and will vote in the election of or removal of directors (to the extent hereinafter provided) and on other matters submitted to the vote of shareholders. There will normally be no meetings of shareholders for the purpose of electing directors unless and until such time as less than a majority of the directors holding office have been elected by shareholders, at which time the directors then in office will call a shareholders' meeting for the election of directors. Except as set forth above, the directors shall continue to hold office and may appoint successor directors. Voting rights are not cumulative, so that the holders of more than 50% of the shares voting in the election of directors can, if they choose to do so, elect all the directors of the fund, in which event the holders of the remaining shares will be unable to elect any person as a director. As set forth in the By-Laws of the Corporation, a special meeting of shareholders of the Corporation shall be called by the Secretary of the Corporation on the written request of shareholders entitled to cast at least 10% of all the votes of the Corporation entitled to be cast at such meeting. Shareholders requesting such a meeting must pay to the Corporation the reasonably estimated costs of preparing and mailing the notice of the meeting. The Corporation, however, will otherwise assist the shareholders seeking to hold the special meeting in communicating to the other shareholders of the Corporation to the extent required by Section 16(c) of the 1940 Act. GNMA Fund Description of the Fund For tax and business reasons, the fund was organized as a Massachusetts business trust and is registered with the SEC under the 1940 Act as diversified, open-end investment companies, commonly known as "mutual funds." The Declaration of Trust permits the Board of Trustees to issue an unlimited number of full and fractional shares of a single class. The Declaration of Trust also provides that the Board of Trustees may issue additional series or classes of shares. Each share represents an equal proportionate beneficial interest in the fund. In the event of the liquidation of the fund, each share is entitled to a pro-rata share of the net assets of the fund. Shareholders are entitled to one vote for each full share held (and fractional votes for fractional shares held) and will vote in the election of or removal of trustees (to the extent hereinafter provided) and on other matters submitted to the vote of shareholders. There will normally be no meetings of shareholders for the purpose of electing trustees unless and until such time as less than a majority of the trustees holding office have been elected by shareholders, at which time the trustees then in office will call a shareholders' meeting for the election of trustees. Pursuant to Section 16(c) of the 1940 Act, holders of record of not less than two-thirds of the outstanding shares of the fund may remove a trustee by a vote cast in person or by proxy at a meeting called for that purpose. Except as set forth above, the trustees shall continue to hold office and may appoint successor trustees. Voting rights are not cumulative, so that the holders of more than 50% of the shares voting in the election of trustees can, if they choose to do so, elect all the trustees of the Trust, in which event the holders of the remaining shares will be unable to elect any person as a trustee. No amendments may be made to the Declaration of Trust without the affirmative vote of a majority of the outstanding shares of the Trust. 78 Shares have no preemptive or conversion rights; the right of redemption and the privilege of exchange are described in the prospectus. Shares are fully paid and nonassessable, except as set forth below. The Trust may be terminated (i) upon the sale of its assets to another diversified, open-end management investment company, if approved by the vote of the holders of two-thirds of the outstanding shares of the Trust, or (ii) upon liquidation and distribution of the assets of the Trust, if approved by the vote of the holders of a majority of the outstanding shares of the Trust. If not so terminated, the Trust will continue indefinitely. Under Massachusetts law, shareholders could, under certain circumstances, be held personally liable for the obligations of the fund. However, the Declaration of Trust disclaims shareholder liability for acts or obligations of the fund and requires that notice of such disclaimer be given in each agreement, obligation, or instrument entered into or executed by the fund or a Trustee. The Declaration of Trust provides for indemnification from fund property for all losses and expenses of any shareholder held personally liable for the obligations of the fund. Thus, the risk of a shareholder incurring financial loss on account of shareholder liability is limited to circumstances in which the fund itself would be unable to meet its obligations, a possibility which T. Rowe Price believes is remote. Upon payment of any liability incurred by the fund, the shareholders of the fund paying such liability will be entitled to reimbursement from the general assets of the fund. The Trustees intend to conduct the operations of the fund in such a way as to avoid, as far as possible, ultimate liability of the shareholders for liabilities of such fund. FEDERAL REGISTRATION OF SHARES ------------------------------------------------------------------------------- The fund's shares (except for Government Reserve and Reserve Investment Funds) are registered for sale under the 1933 Act. Registration of the fund's shares is not required under any state law, but the fund is required to make certain filings with and pay fees to the states in order to sell its shares in the states. LEGAL COUNSEL ------------------------------------------------------------------------------- Shearman & Sterling, whose address is 599 Lexington Avenue, New York, New York 10022, is legal counsel to the fund. INDEPENDENT ACCOUNTANTS ------------------------------------------------------------------------------- PricewaterhouseCoopers LLP, 250 West Pratt Street, 21st Floor, Baltimore, Maryland 21201, are the independent accountants to the funds. The financial statements of the funds listed below for the period ended May 31, 2002, and the report of independent accountants are included in each fund's Annual Report for the period ended May 31, 2002. A copy of each Annual Report accompanies this Statement of Additional Information. The following financial statements and the report of independent accountants appearing in each Annual Report for the period ended May 31, 2002, are incorporated into this Statement of Additional Information by reference (references are to page numbers in the reports):
ANNUAL REPORT REFERENCES: CORPORATE PRIME PRIME RESERVE INCOME RESERVE FUND-PLUS CLASS ------ ------- ----- Financial Highlights, May 31, 2002 8 7 8 9-1 9-1 Statement of Net Assets, May 31, 2002 9-21 6 6 Statement of Operations, year ended May 31, 2002 22 17 17 Statement of Changes in Net Assets, years ended May 31, 2002, and May 31, May 31, 2001 23 18 18 Notes to Financial Statements, May 31, 2002 24-29 19-21 19-21 2 2 Report of Independent Accountants 30 2 2
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ANNUAL REPORT REFERENCES: GNMA NEW ---- INCOME ------ Financial Highlights, May 31, 2002 6 8 Portfolio of Investments, May 31, 2002 7-10 9-19 Statement of Assets and Liabilities, May 31, 2002 11 20 Statement of Operations, year ended May 31, 2002 12 21 Statement of Changes in Net Assets, years ended May 31, 2002, and May 31, May 31, 2001 13 22 Notes to Financial Statements, May 31, 2002 14-18 23-29 Report of Independent Accountants 19 30
PERSONAL PERSONAL PERSONAL STRATEGY STRATEGY STRATEGY BALANCED GROWTH INCOME -------- ------ ------ Financial Highlights, May 31, 2002 1 1 1 Portfolio of Investments, May 31, 2002 2-38 2-37 2-37 Statement of Assets and Liabilities, May 31, 2002 39 38 38 Statement of Operations, year ended May 31, 2002 40 39 39 Statement of Changes in Net Assets, years ended May 31, 2002, and May 31, May 31, 2001 41 40 40 Notes to Financial Statements, May 31, 2002 42-47 41-46 41-46 Report of Independent Accountants 48 47 47
SHORT-TERM HIGH YIELD HIGH YIELD BOND FUND-ADVISOR ---------- ----- CLASS ----- Financial Highlights, May 31, 2002 9 7 10 Statement of Net Assets, May 31, 2002 11-26 8-16 11-26 Statement of Operations, year ended May 31, 2002 27 17 27 Statement of Changes in Net Assets, years ended May 31, 2002, and May 31, May 31, 2001 28-29 18 28-29 Notes to Financial Statements, May 31, 19-2 2002 30-35 4 30-35 2 Report of Independent Accountants 36 5 36
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U.S. TREASURY U.S. TREASURY U.S. TREASURY INTERMEDIATE LONG-TERM MONEY ------------ --------- ----- Financial Highlights, May 31, 2002 11 12 10 Statement of Net Assets, May 31, 2002 - 19-21 13-14 Portfolio of Investments, May 31, 2002 15-17 - - Statement of Assets and Liabilities, May 31, 2002 18 - - Statement of Operations, year ended May 31, 2002 22 22 22 Statement of Changes in Net Assets, years ended May 31, 2002, and May 31, May 31, 2001 24 25 23 Notes to Financial Statements, May 31, 2002 26-32 26-32 26-32 Report of Independent Accountants 33 33 33
RESERVE GOVERNMENT INVESTMENT RESERVE ---------- INVESTMENT ---------- Financial Highlights, May 31, 2002 4 5 Statement of Net Assets, May 31, 2002 6-10 11 Statement of Operations, May 31, 2002 12 12 Statement of Changes in Net Assets, May 31, 2002 13 14 Notes to Financial Statements, May 31, 2002 15-17 15-17 Report of Independent Accountants 18 18
RATINGS OF COMMERCIAL PAPER ------------------------------------------------------------------------------- Moody's Investors Service, Inc. The rating of Prime-1 is the highest commercial paper rating assigned by Moody's. Among the factors considered by Moody's in assigning ratings are the following: valuation of the management of the issuer; economic evaluation of the issuer's industry or industries and an appraisal of speculative-type risks which may be inherent in certain areas; evaluation of the issuer's products in relation to competition and customer acceptance; liquidity; amount and quality of long-term debt; trend of earnings over a period of 10 years; financial strength of the parent company and the relationships which exist with the issuer; and recognition by the management of obligations which may be present or may arise as a result of public interest questions and preparations to meet such obligations. These factors are all considered in determining whether the commercial paper is rated P1, P2, or P3. Standard & Poor's Corporation Commercial paper rated A (highest quality) by S&P has the following characteristics: liquidity ratios are adequate to meet cash requirements; long-term senior debt is rated "A" or better, although in some cases "BBB" credits may be allowed. The issuer has access to at least two additional channels of borrowing. Basic earnings and cash flow have an upward trend with allowance made for unusual circumstances. Typically, the issuer's industry is well established and the issuer has a strong position within the industry. The reliability and quality of management are unquestioned. The relative strength or weakness of the above factors determines whether the issuer's commercial paper is rated A1, A2, or A3. Fitch IBCA, Inc. Fitch 1-Highest grade Commercial paper assigned this rating is regarded as having the strongest degree of assurance for timely payment. Fitch 2-Very good grade Issues assigned this rating reflect an assurance of timely payment only slightly less in degree than the strongest issues. 82 RATINGS OF CORPORATE DEBT SECURITIES ------------------------------------------------------------------------------- Moody's Investors Service, Inc. Aaa-Bonds rated Aaa are judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as "gilt edge." Aa-Bonds rated Aa are judged to be of high quality by all standards. Together with the Aaa group, they comprise what are generally known as high-grade bonds. A-Bonds rated A possess many favorable investment attributes and are to be considered as upper medium-grade obligations. Baa-Bonds rated Baa are considered as medium-grade obligations, i.e., they are neither highly protected nor poorly secured. Interest payments and principal security appear adequate for the present, but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well. Ba-Bonds rated Ba are judged to have speculative elements: their futures cannot be considered as well assured. Often the protection of interest and principal payments may be very moderate and thereby not well safeguarded during both good and bad times over the future. Uncertainty of position characterizes bonds in this class. B-Bonds rated B generally lack the characteristics of a desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small. Caa-Bonds rated Caa are of poor standing. Such issues may be in default, or there may be present elements of danger with respect to repayment of principal or payment of interest. Ca-Bonds rated Ca represent obligations which are speculative in a high degree. Such issues are often in default or have other marked shortcomings. C-Bonds rated C represent the lowest rated and have extremely poor prospects of attaining investment standing. Standard & Poor's Corporation AAA-This is the highest rating assigned by Standard & Poor's to a debt obligation and indicates an extremely strong capacity to pay principal and interest. AA-Bonds rated AA also qualify as high-quality debt obligations. Capacity to pay principal and interest is very strong. A-Bonds rated A have a strong capacity to pay principal and interest, although they are somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions. BBB-Bonds rated BBB are regarded as having an adequate capacity to pay principal and interest. Whereas they normally exhibit adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay principal and interest for bonds in this category than for bonds in the A category. BB, B, CCC, CC, C-Bonds rated BB, B, CCC, CC, and C are regarded on balance as predominantly speculative with respect to the issuer's capacity to pay interest and repay principal. BB indicates the lowest degree of speculation and C the highest degree of speculation. While such bonds will likely have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions. D-In default. 83 Fitch IBCA, Inc. AAA-High grade, broadly marketable, suitable for investment by trustees and fiduciary institutions, and liable to slight market fluctuation other than through changes in the money rate. The prime feature of a AAA bond is the showing of earnings several times or many times interest requirements for such stability of applicable interest that safety is beyond reasonable question whenever changes occur in conditions. Other features may enter, such as wide margin of protection through collateral, security, or direct lien on specific property. Sinking funds or voluntary reduction of debt by call or purchase are often factors, while guarantee or assumption by parties other than the original debtor may influence the rating. AA-Of safety virtually beyond question and readily salable. Their merits are not greatly unlike those of AAA class, but a bond so rated may be junior, though of strong lien, or the margin of safety is less strikingly broad. The issue may be the obligation of a small company, strongly secured, but influenced as to rating by the lesser financial power of the enterprise and more local type of market. A-Bonds rated A are considered to be investment grade and of high credit quality. The obligor's ability to pay interest and repay principal is considered to be strong but may be more vulnerable to adverse changes in economic conditions and circumstances than bonds with higher ratings. BBB-Bonds rated BBB are considered to be investment grade and of satisfactory credit quality. The obligor's ability to pay interest and repay principal is considered to be adequate. Adverse changes in economic conditions and circumstances, however, are more likely to have adverse impact on these bonds and therefore impair timely payment. The likelihood that the ratings of these bonds will fall below investment grade is higher than for bonds with higher ratings. BB, B, CCC, CC, and C-Bonds rated BB, B, CCC, CC, and C are regarded on balance as predominantly speculative with respect to the issuer's capacity to pay interest and repay principal in accordance with the terms of the obligation for bond issues not in default. BB indicates the lowest degree of speculation and C the highest degree of speculation. The rating takes into consideration special features of the issue, its relationship to other obligations of the issuer, and the current and prospective financial condition and operating performance of the issuer. 84 T. ROWE PRICE INSTITUTIONAL HIGH YIELD FUND APRIL 25, 2002 STATEMENT OF ASSETS AND LIABILITIES Assets Cash $100,000 NET ASSETS $100,000 ======== OFFERING AND REDEMPTION PRICE $ 10.00 - -------- Net Assets Consist of: Paid-in-capital applicable to 10,000 shares of $0.0001 par value capital stock outstanding; 1,000,000,000 shares authorized $100,000 ======== The accompanying note is an integral part of this financial statement. 85 NOTE TO FINANCIAL STATEMENTS T. Rowe Price Institutional Income Funds, Inc. (the corporation) was organized on October 18, 2000, as a Maryland corporation and is registered under the Investment Company Act of 1940. The corporation is a series fund, of which the Institutional High Yield Fund (the fund), a diversified, open-end management company, is the only portfolio currently established. Through April 25, 2002, the fund had no operations other than those matters related to organization and registration as an investment company, the registration of shares for sale under the Securities Act of 1933, and the sale of 10,000 shares of the corporation at $10.00 per share on April 24, 2002 to T. Rowe Price Associates, Inc. via share exchange from a T. Rowe Price money market mutual fund. The exchange was settled in the ordinary course of business on April 25, 2002 with the transfer of $100,000 cash. The fund has entered into an investment management agreement with T. Rowe Price Associates, Inc. (the manager), which provides for an all-inclusive annual fee equal to 0.50% of average net assets. The agreement provides that investment management, shareholder servicing, transfer agency, accounting, and custody services are provided to the fund, and interest, taxes, brokerage commissions, directors' fees and expenses, and extraordinary expenses are paid directly by the fund. Accordingly, all costs related to organization and registration of the fund are borne by the manager. 86 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of T. Rowe Price Institutional Income Funds, Inc. and Shareholder of T. Rowe Price Institutional High Yield Fund In our opinion, the accompanying statement of assets and liabilities presents fairly, in all material respects, the financial position of T. Rowe Price Institutional High Yield Fund (the portfolio comprising T. Rowe Price Institutional Income Funds, Inc., hereafter referred to as the "Fund") at April 25, 2002, in conformity with accounting principles generally accepted in the United States of America. This financial statement is the responsibility of the Fund's management; our responsibility is to express an opinion on this financial statement based on our audit. We conducted our audit of this financial statement in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statement is free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statement, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. /s/PricewaterhouseCoopers LLP PricewaterhouseCoopers LLP Baltimore, Maryland April 26, 2002 87