N-30D 1 nif40416.txt T. ROWE PRICE NEW INCOME FUND Annual Report NEW INCOME FUND MAY 31, 2001 T. ROWE PRICE Report Highlights New Income Fund o Aggressive easing by the Federal Reserve buoyed bond prices and the performance of the New Income Fund. o Your fund's six- and 12-month returns were in line with the performance of the Lehman Brothers U.S. Aggregate Index and the Lipper peer group average. o We added to the corporate bond portion of the portfolio and trimmed the mortgage sector. o With the economy likely to be weak for several more months, we expect the Fed to continue its easy money policy. UPDATES AVAILABLE For updates on T. Rowe Price funds following the end of each calendar quarter, please see our Web site at www.troweprice.com. FELLOW SHAREHOLDERS The past 12 months were favorable for investment-grade bonds and your fund. The Federal Reserve lowered its target for the key federal funds rate five times in the first five months of this year. Efforts by many corporate borrowers to reduce excess debt and strengthen their balance sheets added support to the already attractive corporate bond markets. This combination helped the New Income Fund post a double-digit total return in the 12 months ended May 31. MARKET ENVIRONMENT A glance in the rear view mirror shows that rising interest rates characterized the bond market from June 1999 through May 2000. In response to inflation pressure and an overheating economy, the Federal Reserve ratcheted the fed funds rate up six times from 4.75% to 6.5%. We adopted a defensive strategy during this difficult period, trimming interest rate sensitivity and improving the quality. The following table was depicted as a line graph in the printed material. 30-Year Treasury Bond 5-Year Treasury Note 1-Year Treasury Bill --------------------- -------------------- -------------------- 5/31/00 6.14 6.65 6.28 5.94 6.25 6.13 5.8 6.16 6.06 8/31/00 5.71 6.02 6.23 5.89 5.9 6.08 5.72 5.73 6.01 11/30/00 5.66 5.52 6 5.44 4.98 5.34 5.5 4.77 4.58 2/28/01 5.31 4.65 4.46 5.44 4.56 4.11 5.79 4.88 3.92 5/31/01 5.75 4.91 3.56 Interest rates peaked in mid-summer, shortly after the Fed's last tightening on May 16, 2000. By that time, the tech-stock bubble had already begun to deflate, leading to a severe decline in capital expenditures and bulging inventories. Spiking fuel and energy prices added to the economic problems. Real (inflation-adjusted) gross domestic product slowed to 2.2% in the third quarter of 2000 and to 1% the following quarter. As the bond market sensed this deceleration, bond prices rallied, yields drifted lower, and fixed-income investors enjoyed profitable third and fourth quarters. The yield on the 30-year Treasury bond declined to 5.44% at year-end from 6.14% in May. The Fed, which had kept its hands off the policy lever during the second half of the election year, surprised the markets with a 50 basis points rate cut (100 basis points equal one percent) on January 3, 2001. It subsequently lowered rates in four more half-point increments from January to May. Bottom line: In less than two years, the central bank raised rates 175 basis points (six hikes in 12 months), then lowered rates 250 basis points. The following table was depicted as a line graph in the printed material. 6-Month Return 12-Month Return -------------- --------------- Treasury 3.36 11.09 Mortgage 5.18 13.38 AAA 5.84 14.15 BBB 8.08 15.21 BBB/BB 12.53 20.22 Most bond market sectors made the most of the recent rally and achieved impressive results in 2001. However, the most noteworthy turnaround occurred in corporate bonds. Last year, stock buybacks, the threat of bankruptcy, and increasingly leveraged balance sheets contributed to push corporate bond yields up, well above Treasury yields. This "yield spread" stood at recession-like levels. Despite heavy net issuance so far during 2001, the corporate bond market has been the best performing investment-grade fixed-income sector. Lower-quality bonds have performed even better. Foreign buyers seeking conservative dollar-based investments have also added to renewed interest in U.S. corporate bonds. Mortgages, asset-backed securities, and agency bonds also delivered strong returns. A wave of homeowner refinancing earlier in the year, triggered by a dip in 30-year mortgage rates, did not dampen the outstanding performance achieved in mortgages over the last 12 months. Government-sponsored enterprises, such as Fannie Mae, survived several scares, mainly from regulatory sources. These agency issuers emerged relatively unscathed, and their debt continues to perform well. Commercial mortgage-backed securities also generated above-average yields and performed extremely well as they gained broader market acceptance during the past year. PERFORMANCE REVIEW PERFORMANCE COMPARISON Periods Ended 5/31/01 6 Months 12 Months ------------------------------------------------------------------ New Income Fund 5.16% 12.54% Lehman Brothers U.S. Aggregate Index 5.14 13.12 Lipper Average of Corporate Bond Funds A-Rated 5.02 12.09 New Income generated a strong 5.16% six-month gain ($0.17 of per share appreciation and $0.26 of income), and an outstanding 12.54% 12-month total return. The six-month gain was in line with the Lehman Brothers U.S. Aggregate Index and modestly better than the Lipper average of A-rated corporate bond funds. Your fund's 12-month total return was slightly better than the average competing fund and a similar amount below the Lehman Brothers index. The banner performance raises New Income's five-year average annual return to 6.54% and its 10-year average gain to 6.95%. STRATEGY The following table was depicted as a pie chart in the printed material. Corporate Bonds and Convertibles 43 Mortgage-Backed Securities 25 U.S. Treasuries 17 Asset-Backed Securities 9 U.S. Agency Obligations 4 Cash and Other 2 Our investment strategy focuses on fundamental analysis of companies, sectors, and security structures in which we invest. We analyze government, mortgage, asset-backed, and corporate bonds, and the credit market trends in the U.S. and selected foreign markets in search of investment-grade (BBB rated and higher) securities that offer high yield and sta-ble or improving credit quality. The themes discussed in the Market Environment section guided our investment decisions over the last six months. The most pivotal shift in the period was raising our allocation to corporate bonds from 35% to 43%. Much of the shift occurred in the last six months when it became clear that the Fed's actions would aggressively ease borrowing costs. Our credit analysts were also impressed that many companies were planning to improve their balance sheets by reducing debt. Our major source of funding for new corporate bond purchases was from sales of mortgage-backed securities. While we remain constructive on the mortgage market, we reduced our position in the sector to 25% of assets from 34% six months ago. Reducing our mortgage exposure improved the fund's cash flow stability and did not materially affect its overall credit rating, which remains AA. Our strategic focus remained on sector and security selection, rather than the overall direction of interest rates. However, we elected to extend the portfolio's duration (sensitivity to interest rate changes) relative to its benchmark last year. While the decision proved beneficial in 2000 and the first quarter of 2001, it has hurt performance recently. Nonetheless, we believe it is the right posture to maintain going forward. Recognizing that higher energy prices would keep the headline consumer price index (CPI) somewhat elevated, we supplemented the portfolio with Treasury Inflation Protected Securities (TIPS). These securities capture the benefit of higher inflation, as measured by the CPI, and provide an attractive real rate of return. TIPS performed extremely well during the last 6- and 12-month periods and at the end of May represented 2% of the portfolio. Our small allocation to nondollar bonds (those denominated in a foreign currency) provided mixed results. We initiated several positions because of the attractive relative valuations of the euro and Canadian dollar. While both currencies added value during the fourth quarter last year, a stronger U.S. dollar in 2001 caused these positions to underperform domestic issues. OUTLOOK It is too early to be sure, but recent efforts by the Federal Reserve appear to have slowed the economy's downward momentum. Residential construction and home sales continue to hold up, auto sales are steady at relatively high levels, and consumer confidence has rebounded from its lows. A tax cut this year and the prospect of lower energy prices add to the view that the worst may be behind us. The recent upturn in long-term rates suggests that the bond market has embraced this economic optimism. Although short-term rates continued to fall, longer-term interest rates touched their lowest point in this cycle near the end of 2001's first quarter. The yield on the 10-year Treasury note and 30-year Treasury bond reached levels of 4.75% and 5.25%, respectively, near the end of March. The reluctance of market participants to push longer-term Treasury yields much below 5% may reflect a few other concerns. In spite of dramatic economic weakness, inflation has remained above 3%. While it is unlikely that the U.S. economy will experience a contraction, in all likelihood it will undergo the functional equivalent of a recession. Economic data released in late May and early June suggest that GDP will average less than 1% through this year's third quarter. Additional concerns include rising unemployment, declining consumer spending, and persistent weakness in business investment. The Federal Reserve appears to be providing both timely and adequate response to the aforementioned concerns, and the potential for further rate cuts enhances the appeal of bonds on a total return basis. As a result, we will continue to maintain a long duration in the portfolio. We still view corporate, mortgage, and asset-backed securities as attractive investments because, even though their rates have come down, they still offer a yield advantage over Treasuries. Adding to corporate bond holdings during a period of economic uncertainty may be counterintuitive, but we believe the climate for this asset class will remain positive as long as the Fed remains accommodative, corporations continue to rebuild their balance sheets, and growth stays positive. We remain confident in our investment strategy and in the ability of our analysts to identify and recommend companies and investments with stable and improving prospects. Respectfully submitted, /s/ William T. Reynolds President of the fund and chairman of its Investment Advisory Committee June 18, 2001 The committee chairman has day-to-day responsibility for managing the portfolio and works with committee members in developing and executing the fund's investment program. T. ROWE PRICE NEW INCOME FUND -------------------------------------------------------------------------------- PORTFOLIO HIGHLIGHTS KEY STATISTICS 11/30/00 5/31/01 Price Per Share $ 8.36 $ 8.53 Dividends Per Share For 6 months 0.27 0.26 For 12 months 0.53 0.53 30-Day Dividend Yield * 6.50% 5.94% 30-Day Standardized Yield to Maturity 6.82 5.90 Weighted Average Maturity (years) 9.3 8.2 Weighted Average Effective Duration (years) 5.0 5.0 Weighted Average Quality ** AA AA * Dividends earned for the last 30 days of each period indicated are annualized and divided by the fund's net asset value per share at the end of the period. ** Based on T. Rowe Price research. T. ROWE PRICE NEW INCOME FUND -------------------------------------------------------------------------------- PORTFOLIO HIGHLIGHTS SECTOR DIVERSIFICATION Percent of Percent of Net Assets Net Assets 11/30/00 5/31/01 Mortgage-Backed Securities 34% 25% U.S. Treasury Obligations 16 17 Asset-Backed Securities 6 9 Banking 5 5 Telephones 4 5 U.S. Agency Obligations 5 4 Investment Dealers 1 3 Electric Utilities 2 3 Energy 2 2 Entertainment and Leisure 1 2 Money Market Funds * 3 3 All Other 20 23 Other Assets Less Liabilities 1 -1 Total 100% 100% * See note at end of the financial statements. T. ROWE PRICE NEW INCOME FUND -------------------------------------------------------------------------------- PERFORMANCE COMPARISON This chart shows the value of a hypothetical $10,000 investment in the fund over the past 10 fiscal year periods or since inception (for funds lacking 10-year records). The result is compared with benchmarks, which may include a broad-based market index and a peer group average or index. Market indexes do not include expenses, which are deducted from fund returns as well as mutual fund averages and indexes. AVERAGE ANNUAL COMPOUND TOTAL RETURN This table shows how the fund would have performed each year if its actual (or cumulative) returns for the periods shown had been earned at a constant rate. Periods Ended 5/31/01 1 Year 3 Years 5 Years 10 Years -------------------------------------------------------------------------------- New Income Fund 12.54% 4.76% 6.54% 6.95% Investment return and principal value represent past performance and will vary. Shares may be worth more or less at redemption than at original purchase. Returns do not reflect taxes that the shareholder may pay on fund distributions or the redemption of fund shares. T. ROWE PRICE NEW INCOME FUND -------------------------------------------------------------------------------- For a share outstanding throughout each period FINANCIAL HIGHLIGHTS Year Ended 5/31/01 5/31/00 5/31/99 5/31/98 5/31/97 NET ASSET VALUE Beginning of period $ 8.07 $ 8.50 $ 9.09 $ 8.77 $ 8.70 Investment activities Net investment income (loss) 0.53 0.52 0.54 0.57 0.58 Net realized and unrealized gain (loss) 0.46 (0.43) (0.45) 0.36 0.07 Total from investment activities 0.99 0.09 0.09 0.93 0.65 Distributions Net investment income (0.53) (0.52) (0.54) (0.57) (0.58) Net realized gain - - (0.14) (0.04) - Total distributions (0.53) (0.52) (0.68) (0.61) (0.58) NET ASSET VALUE End of period $ 8.53 $ 8.07 $ 8.50 $ 9.09 $ 8.77 RATIOS/SUPPLEMENTAL DATA Total returnu 12.54% 1.13% 1.02% 10.84% 7.70% Ratio of total expenses to average net assets 0.73% 0.73% 0.72% 0.71% 0.74% Ratio of net investment income (loss) to average net assets 6.30% 6.32% 6.16% 6.31% 6.65% Portfolio turnover rate 112.1% 83.6% 94.3% 147.3% 87.1% Net assets, end of period (in millions) $ 1,684 $ 1,633 $ 1,942 $ 2,076 $ 1,711 ** Total return reflects the rate that an investor would have earned on an investment in the fund during each period, assuming reinvestment of all distributions. The accompanying notes are an integral part of these financial statements. T. ROWE PRICE NEW INCOME FUND -------------------------------------------------------------------------------- May 31, 2001 PORTFOLIO OF INVESTMENTS Par/Shares Value In thousands CORPORATE BONDS AND NOTES 40.3% Aerospace & Defense 0.5% Raytheon, Sr. Notes, 6.15%, 11/1/08 $ 8,600 $ 8,095 8,095 Automotive 0.6% Ford Motor, Sr. Notes, 7.375%, 10/28/09 10,000 10,233 10,233 Banking 5.5% Banco Generale, Sr. Notes, (144a), 7.70%, 8/1/02 + 10,000 10,018 Banco Santiago, Sr. Sub. Notes, 7.00%, 7/18/07 10,800 10,291 Bank of America, Sr. Sub. Notes, 7.40%, 1/15/11ss. 11,350 11,773 BankUnited, MTN, Sr. Sub. Notes, 8.00%, 3/15/09 5,000 5,240 Capital One Financial, Sr. Notes, 8.25%, 6/15/05 10,000 10,366 Citigroup Sr. Notes, 6.75%, 12/1/05ss. 17,000 17,573 Sr. Sub. Notes, 7.25%, 10/1/10ss. 10,000 10,416 First Union, MTN, Sr. Sub. Notes, 7.55%, 8/18/05ss. 7,500 7,941 MBNA, Sr. Sub. Notes, 7.75%, 9/15/05ss. 8,500 8,754 92,372 Beverages 0.3% Panamerican Beverages, Sr. Notes, 7.25%, 7/1/09 5,550 5,010 5,010 Broadcasting 0.5% Hearst-Argyle Television, Sr. Notes, 7.50%, 11/15/27 10,000 9,043 9,043 Cable Operators 0.6% Comcast, Sr. Notes, 6.75%, 1/30/11 10,500 10,322 10,322 Conglomerates 0.4% Hutchison Whampoa, Sr. Notes, (144a), 7.00%, 2/16/11 + 6,465 6,436 6,436 Electric Utilities 2.8% AEP Resources, Sr. Notes, (144a), 6.50%, 12/1/03 + 15,000 15,271 DTE Energy, Sr. Notes, 6.45%, 6/1/06 10,500 10,497 Korea Electric Power, Sr. Notes, 7.00%, 10/1/02ss. 5,500 5,566 PSEG Power, Sr. Notes, (144a), 6.875%, 4/15/06 + 4,550 4,548 Sempra Energy, Sr. Notes, 6.95%, 12/1/05 3,800 3,766 South Carolina Electric & Gas, 1st Mtg. Bonds 6.125%, 3/1/09 8,000 7,631 47,279 Electronic Components 0.4% Arrow Electronics, Sr. Notes, 8.20%, 10/1/03 $ 6,200 $ 6,297 6,297 Energy 1.9% PDVSA Finance Sr. Notes 6.80%, 11/15/08ss. 8,000 7,055 9.75%, 2/15/10ss. 7,750 7,920 YPF Sociedad Anonima, Sr. Notes 7.25%, 3/15/03ss. 10,000 9,959 10.00%, 11/2/28 6,720 7,027 31,961 Entertainment and Leisure 1.5% International Speedway, Sr. Notes, 7.875%, 10/15/04 10,000 10,152 Royal Caribbean Cruises, Sr. Notes, 8.75%, 2/2/11 4,740 4,610 Viacom, Sr. Notes, 7.875%, 7/30/30ss. 10,000 10,617 25,379 Finance and Credit 1.4% CIT Group, Sr. Notes, 5.50%, 2/15/04 6,000 5,945 General Electric Capital, MTN, 7.375%, 1/19/10 10,000 10,711 PHH, Sr. Notes, 8.125%, 2/3/03 7,000 7,135 23,791 Food Processing 0.4% McCormick, Sr. Notes, 6.40%, 2/1/06 7,300 7,315 7,315 Foreign Government and Municipalities 2.8% Banco Latinoamericano, Sr. Notes, 6.55%, 4/15/03 7,900 7,918 Canada Government, 6.00%, 9/1/05 (CAD) 23,400 15,408 Federal Republic of Germany, Sr. Notes 6.00%, 2/16/06 (EUR) 20,275 18,027 Petroleos Mexicanos, Sr. Notes, 9.25%, 3/30/18ss. 5,000 5,042 46,395 Gas & Gas Transmission 0.4% PG&E National Energy Group Sr. Notes, (144a), 10.375%, 5/16/11 + 7,590 7,543 7,543 Insurance 1.2% AIG Sunamerica Global Financing, Sr. Notes, (144a) 7.60%, 6/15/05 + 7,000 7,466 Jefferson Pilot Capital Trust,(144a),8.14%, 1/15/46+ 3,000 2,944 Sun Life Canada U.S. Capital Trust, (144a) 8.526%, 5/29/49 + $ 7,000 $ 6,537 Trenwick Capital Trust I, 8.82%, 2/1/37 5,500 4,115 21,062 Investment Dealers 2.8% Goldman Sachs Group, Sr. Notes, 6.875%, 1/15/11ss. 15,000 14,939 Lehman Brothers, Sr. Notes, 7.875%, 8/15/10ss. 12,000 12,616 Morgan Stanley Dean Witter Sr. Notes 6.10%, 4/15/06 10,000 9,993 6.75%, 4/15/11 10,000 9,934 47,482 Long Distance 1.0% AT&T Sr. Notes 6.00%, 3/15/09 8,000 7,488 6.50%, 3/15/29 4,000 3,433 Sprint, Sr. Notes, 6.125%, 11/15/08 6,000 5,535 16,456 Manufacturing 0.7% Mallinckrodt Group, Sr. Notes, 6.75%, 9/15/05 5,000 5,094 Tyco International, Sr. Notes, 6.75%, 2/15/11 6,500 6,453 11,547 Media and Communications 0.5% AOL Time Warner, Sr. Notes, 7.625%, 4/15/31 8,000 8,035 Metals 0.2% Alcoa, Sr. Notes, 7.375%, 8/1/10ss. 3,320 3,513 3,513 Metals and Mining 0.5% Phelps Dodge, Sr. Notes, 8.75%, 6/1/11ss. 8,000 8,062 8,062 Paper and Paper Products 1.1% Celulosa Arauco Y Constitucion, Sr. Notes 8.625%, 8/15/10 7,500 7,628 Georgia-Pacific, Sr. Notes, 7.50%, 5/15/06ss. 4,710 4,751 International Paper, Sr. Notes, 8.00%, 7/8/03 5,350 5,600 17,979 Petroleum 1.2% Union Texas Petroleum, Sr. Notes, 7.00%, 4/15/08 20,000 20,531 20,531 Railroads 0.4% Union Pacific, Sr. Notes, 6.65%, 1/15/11ss. $ 7,000 $ 6,896 6,896 Real Estate 0.7% Simon Debartolo Group, Sr. Notes, 6.875%, 11/15/06 4,440 4,363 Simon Property Group, Sr. Notes, (144a) 7.375%, 1/20/06 + 7,190 7,211 11,574 Retail 1.0% Federated Department Stores Sr. Notes 6.625%, 4/1/11 4,000 3,864 7.00%, 2/15/28 5,075 4,658 Sears Roebuck Acceptance, Sr. Notes, 7.00%, 2/1/11 8,685 8,539 17,061 Savings and Loan 0.7% Dime Bancorp, Sr. Notes, 7.00%, 7/25/01 5,750 5,754 Greenpoint Bank, Sr. Sub. Notes, 9.25%, 10/1/10 5,550 5,794 11,548 Service 0.5% Waste Management, Sr. Notes, 7.70%, 10/1/02 8,579 8,777 8,777 Specialty Chemicals 0.3% Union Carbide, Sr. Notes, 6.70%, 4/1/09 5,000 5,026 5,026 Supermarkets 0.8% Delhaize America, Sr. Notes,(144a),8.125%,4/15/11ss.+ 13,750 14,241 14,241 Telephones 4.8% Ameritech Capital Funding, Sr. Notes, 6.25%, 5/18/09 10,000 9,675 British Telecommunications, Sr. Notes, 8.125%,12/15/10 10,835 11,456 CenturyTel, Sr. Notes, 8.375%, 10/15/10 7,000 7,285 KPN, Sr. Notes, 8.00%, 10/1/10 8,500 8,281 Qwest Communications International Capital Funding Sr. Notes, 7.90%, 8/15/10 11,580 12,077 U.S. West Capital Funding, Sr. Notes, 6.875%, 8/15/01 15,000 15,045 Verizon Communications Global Funding Sr. Notes, (144a) 6.75%, 12/1/05 + 8,235 8,438 7.75%, 12/1/30 + 8,000 8,288 80,545 Transportation Services 0.5% Erac USA Finance, Sr. Notes, (144a), 8.00%, 1/15/11 + $ 8,145 $ 8,235 8,235 Wireline Communications 1.4% Worldcom, Sr. Notes, 8.25%, 5/15/31 23,450 23,490 23,490 Total Corporate Bonds and Notes (Cost $676,936) 679,531 ASSET-BACKED SECURITIES 8.9% Airlines 1.2% Atlas Air, 7.63%, 1/2/15 9,506 9,222 Continental Airlines, 8.312%, 4/2/11 10,000 10,429 19,651 Auto-Backed 1.5% DaimlerChrysler Auto Trust, 6.66%, 1/8/05 9,800 10,078 Nissan Auto Receivables, 5.75%, 6/15/06 10,097 10,213 Provident Auto Lease, 7.73%, 10/14/07 5,386 5,525 25,816 Credit Card-Backed 3.8% Citibank Credit Card Issuance Trust 6.90%, 10/15/07ss. 15,900 16,558 7.45%, 9/15/07 11,075 11,453 MBNA Credit Card Trust, 5.75%, 10/15/08 16,950 16,908 MBNA Master Credit Card Trust II 4.923%, 12/15/06 5,250 5,221 (144a), 7.10%, 9/15/13 + 5,000 4,772 World Financial Network Credit Card Master Trust 6.981%, 7/15/06 8,500 8,505 63,417 Equipment Lease Heavy Duty 0.3% Case Equipment Loan Trust, 5.77%, 8/15/05 6,000 6,056 6,056 Recreational Vehicles 1.5% Chase Manhattan Owner Trust, 6.54%, 8/15/17 11,795 11,836 CIT RV Trust, 6.35%, 4/15/11 13,375 13,501 25,337 Transportation (excluding Railroad) 0.6% Federal Express, ETC, 8.25%, 1/15/19 $ 9,674 $ 9,792 9,792 Total Asset-Backed Securities (Cost $149,177) 150,069 EQUITY AND CONVERTIBLE SECURITIES 1.6% Banking 0.0% Silicon Valley Bancshares, Pfd., 8.25% + 30 683 683 Building and Real Estate 0.6% Reckson Associates Realty, REIT, Cv. Pfd. (Series A), 7.625% 429 9,619 9,619 Electronic Components 0.1% Analog Devices, 4.75%, 10/1/05 2,000 1,826 1,826 Media and Communications 0.2% Mediaone Group, Cv. Pfd., 7.00% 105 3,071 3,071 Paper and Paper Products 0.1% International Paper, Cv. Pfd., 5.25%ss. 52 2,325 2,325 Railroads 0.2% Union Pacific Capital Trust, Cv. Pfd., 6.25% 50 2,466 2,466 Telephones 0.2% Liberty Media/Sprint PCS, 4.00%, 11/15/29 4,995 3,638 3,638 Telecom Equipment 0.2% Corning, Zero Coupon, 11/8/15 5,806 3,412 3,412 Total Equity and Convertible Securities (Cost $27,351) 27,040 NON-U.S. GOVERNMENT MORTGAGE-BACKED SECURITIES 10.1% Commercial Mortgage-Backed 3.5% COMM 2000, CMO, 7.494%, 4/15/10 8,400 8,805 GE Capital Commercial Mortgage, CMO, 6.531%, 5/15/33 5,225 5,193 JP Morgan Commercial Mortgage Finance, CMO 7.679%, 8/15/32 $ 8,500 $ 8,912 LB Commercial Conduit Mortgage Trust, CMO, 6.78%, 4/15/09 8,800 8,981 Prudential Securities Secured Financing, CMO 6.074%, 1/15/08 11,792 11,604 Salomon Brothers Mortgage Securities VII, CMO 7.455%, 4/18/10 8,125 8,316 7.52%, 12/18/09 7,464 7,902 59,713 Home Equity Loans-Backed 3.8% Bankboston Home Equity Loan Trust, 6.35%, 2/25/13 7,125 7,127 Chase Funding Mortgage Loan, 6.59%, 5/25/28 5,053 4,980 GE Capital Mortgage Services, REMIC, 6.465%, 6/25/28 13,879 13,885 Mellon Residential Funding Corp., 5.945%, 2/25/11 17,750 17,750 Money Store Home Equity Trust 6.985%, 10/15/16 6,000 6,084 7.91%, 5/15/24 13,159 13,606 63,432 Whole Loans-Backed 2.8% Countrywide Mortgage Backed Securities, CMO 6.75%, 11/25/23 5,361 5,293 GE Capital Mortgage Services, REMIC, 6.75%, 8/25/28 13,962 13,862 Norwest Asset Securities, CMO, 6.75%, 10/25/28 11,662 11,138 Residential Accredited Loans, CMO 6.75%, 7/25/28 7,500 7,566 7.25%, 11/25/27 10,226 9,990 47,849 Total Non-U.S. Government Mortgage- Backed Securities (Cost $171,145) 170,994 U.S. GOVERNMENT MORTGAGE-BACKED SECURITIES 15.1% U.S. Government Agency Obligations 5.9% Federal Home Loan Mortgage 6.50%, 11/1/04 - 6/1/24 6,526 6,496 7.00%, 2/1/24 - 6/1/25 2,978 3,023 7.50%, 5/1 - 6/1/24 2,805 2,890 8.00%, 6/1/08 21 21 10.50%, 7/1/11 - 8/1/20 $ 215 $ 230 11.00%, 1/1/16 - 7/1/20 149 162 CMO 5.50%, 10/15/20 791 795 6.35%, 3/15/31 9,864 9,918 6.50%, 7/15/11 - 3/15/23 34,162 34,134 7.00%, 11/15/22 7,606 7,782 Principal only, 8/1/28 6,524 4,796 Federal National Mortgage Assn. 6.00%, 4/1/14 - 1/1/29 5,053 4,962 8.75%, 3/1/10 4 4 CMO, 5.50%, 9/25/11 6,088 6,137 TBA, 6.50%, 4/1/29 17,400 17,133 98,483 U.S. Government Guaranteed Obligations 9.2% Government National Mortgage Assn. I 6.50%, 8/15/25 - 5/15/29 36,960 36,708 7.00%, 1/15/24 - 4/15/28 36,002 36,652 7.50%, 8/15/16 - 8/15/28 8,576 8,870 8.00%, 7/15/16 - 10/15/27 26,095 27,351 8.50%, 9/15/16 - 7/15/23 5,561 5,904 9.00%, 1/15/09 - 11/15/19 674 727 9.50%, 6/15/09 - 3/15/25 235 248 11.00%, 12/15/09 - 1/15/21 5,586 6,189 11.50%, 3/15/10 - 10/15/15 779 872 GPM, I, 10.25%, 4/15/16 - 11/15/20 841 906 II 7.00%, 12/20/23 - 11/20/28 6,324 6,400 8.50%, 9/20/26 25 27 9.00%, 6/20/16 - 2/20/18 415 444 CMO, Principal Only, 3/16/28 7,351 5,567 TBA, II 6.00%, 1/1/31 8,746 8,464 6.50%, 6/20/31 9,946 9,822 155,151 Total U.S. Government Mortgage-Backed Securities (Cost $247,519) 253,634 U.S. GOVERNMENT OBLIGATIONS/AGENCIES 21.8% U.S. Government Agency Obligations 3.4% Federal Home Loan Mortgage 6.875%, 1/15/05 $ 4,750 $ 5,001 7.00%, 3/15/10 4,350 4,621 Federal National Mortgage Assn. 5.50%, 2/15/06ss. 13,710 13,725 6.00%, 5/15/08ss. 7,500 7,567 7.125%, 1/15/30 10,500 11,232 Tennessee Valley Authority, Sr. Notes, 6.235%, 7/15/45 14,934 14,933 57,079 U.S. Treasury Obligations 18.4% Federal Home Loan Mortgage 5.25%, 1/15/06 (EUR) 19,500 16,652 U.S. Treasury Bonds 5.50%, 8/15/28ss. 11,500 10,855 6.50%, 11/15/26ss. 41,300 44,296 7.50%, 11/15/16ss. 29,000 33,795 U.S. Treasury Inflation-Indexed Notes 3.375%, 1/15/07ss. 49,263 50,295 U.S. Treasury Notes 4.25%, 3/31/03 850 850 4.25%, 11/15/03ss. 51,800 51,568 5.75%, 11/15/05ss. 40,010 41,262 6.00%, 9/30/02ss. 30,175 30,951 6.50%, 8/15/05ss. 2,500 2,650 6.75%, 5/15/05ss. 25,000 26,671 309,845 Total U.S. Government Obligations/Agencies (Cost $367,848) 366,924 Options Written (0.0)% Eurodollar Future Put, 6/8/01 @ $0.885 175 (873) Total Options (Cost $(223)) (873) Money Market Funds 3.5% T. Rowe Price Reserve Investment Fund, 4.61% # 58,624 58,624 Total Money Market Funds (Cost $58,624) 58,624 Total Investments in Securities 101.3% of Net Assets (Cost $1,698,377) $1,705,943 Forward Currency Exchange Contracts In thousands Unrealized Counterparty Settlement Receive Deliver Gain (Loss) ------------- ---------- ----------- ------------ ----------- Morgan Stanley 6/8/01 USD 15,562 CAD 24,000 $ 35 Net unrealized gain (loss) on open forward currency exchange contracts 35 FUTURES CONTRACTS In thousands ----------------- ------------ Contract Unrealized Expiration Value Gain (Loss) ---------- --------- ----------- Long, 35 U.S. Treasury Bond contracts, $81,000 of U.S. Treasury Bonds pledged as initial margin 6/01 $ 3,507 $ (16) Long, 390 U.S. Treasury 5 year contracts $315,000 of Federal Home Loan Mortgage pledged as initial margin 6/01 40,572 (668) Net payments (receipts) of variation margin to date 930 Variation margin receivable (payable) on open futures contracts 246 Other Assets Less Liabilities (21,929) NET ASSETS $1,684,295 # Seven-day yield + Private Placement CAD Canadian Dollar CMO Collateralized Mortgage Obligation ETC Equipment Trust Certficate EUR Euro GPM Graduated Payment Mortgage MTN Medium Term Note REIT Real Estate Investment Trust REMIC Real Estate Mortgage Investment Conduit TBA To be announced security was purchased on a forward commitment basis USD U.S. Dollar ss. All or a portion of this security is on loan at May 31, 2001 - See Note 2. 144a Security was purchased pursuant to Rule 144a under the Securities Act of 1933 and may not be resold subject to that rule except to qualified institutional buyers -- total of such securities at period-end amounts to 6.1% of net assets. The accompanying notes are an integral part of these financial statements. T. ROWE PRICE NEW INCOME FUND -------------------------------------------------------------------------------- May 31, 2001 STATEMENT OF ASSETS AND LIABILITIES In thousands Assets Investments in securities, at value (cost $1,698,377) $ 1,705,943 Securities lending collateral 341,966 Other assets 48,390 Total assets 2,096,299 Liabilities Obligation to return securities lending collateral 341,966 Other liabilities 70,038 Total liabilities 412,004 NET ASSETS $ 1,684,295 Net Assets Consist of: Accumulated net investment income - net of distributions $ 2,863 Accumulated net realized gain/loss - net of distributions (82,108) Net unrealized gain (loss) 6,878 Paid-in-capital applicable to 197,524,284 shares of $1.00 par value capital stock outstanding; 300,000,000 shares authorized 1,756,662 NET ASSETS $ 1,684,295 NET ASSET VALUE PER SHARE $ 8.53 The accompanying notes are an integral part of these financial statements. T. ROWE PRICE NEW INCOME FUND -------------------------------------------------------------------------------- STATEMENT OF OPERATIONS In thousands Year Ended 5/31/01 Investment Income (Loss) Income Interest $ 116,235 Dividend 1,654 Securities lending 746 Total Income 118,635 Expenses Investment management 7,887 Shareholder servicing 4,018 Custody and accounting 236 Prospectus and shareholder reports 106 Registration 24 Legal and audit 17 Directors 14 Miscellaneous 9 Total expenses 12,311 Expenses paid indirectly (54) Net expenses 12,257 Net investment income (loss) 106,378 REALIZED AND UNREALIZED GAIN (LOSS) Net realized gain (loss) Securities 8,611 Futures (3,238) Written options 223 Foreign currency transactions 703 Net realized gain (loss) 6,299 Change in net unrealized gain or loss Securities 87,883 Futures (113) Written options (650) Other assets and liabilities denominated in foreign currencies (3) Change in net unrealized gain or loss 87,117 Net realized and unrealized gain (loss) 93,416 INCREASE (DECREASE) IN NET ASSETS FROM OPERATIONS $ 199,794 The accompanying notes are an integral part of these financial statements. T. ROWE PRICE NEW INCOME FUND -------------------------------------------------------------------------------- STATEMENT OF CHANGES IN NET ASSETS In thousands Year Ended 5/31/01 5/31/00 Increase (Decrease) in Net Assets Operations Net investment income (loss) $ 106,378 $ 113,673 Net realized gain (loss) 6,299 (71,654) Change in net unrealized gain or loss 87,117 (23,998) Increase (decrease) in net assets from operations 199,794 18,021 Distributions to shareholders Net investment income (106,306) (113,579) Capital share transactions * Shares sold 240,495 192,491 Distributions reinvested 99,203 105,794 Shares redeemed (381,670) (511,721) Increase (decrease) in net assets from capital share transactions (41,972) (213,436) Net Assets Increase (decrease) during period 51,516 (308,994) Beginning of period 1,632,779 1,941,773 End of period $1,684,295 $1,632,779 *Share information Shares sold 28,496 23,373 Distributions reinvested 11,807 12,863 Shares redeemed (45,218) (62,339) Increase (decrease) in shares outstanding (4,915) (26,103) The accompanying notes are an integral part of these financial statements. T. ROWE PRICE NEW INCOME FUND -------------------------------------------------------------------------------- May 31, 2001 NOTES TO FINANCIAL STATEMENTS NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES T. Rowe Price New Income Fund, Inc. (the fund) is registered under the Investment Company Act of 1940 as a diversified, open-end management investment company and commenced operations on October 12, 1973. The fund seeks the highest level of income consistent with the preservation of capital over time by investing primarily in marketable debt securities. The accompanying financial statements were prepared in accordance with generally accepted accounting principles, which require the use of estimates made by fund management. Valuation Debt securities are generally traded in the over-the-counter market. Investments in domestic securities and foreign securities are stated at fair value as 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. Equity securities listed or regularly traded on a securities exchange are valued at the last quoted sales price 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 and securities regularly traded in the over-the-counter market are valued at the mean of the latest bid and asked prices. Other equity securities are valued at a price within the limits of the latest bid and asked prices deemed by the Board of Directors, or by persons delegated by the Board, best to reflect fair value. 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, written options are valued at the mean of the latest bid and asked prices. Financial futures contracts are valued at closing settlement prices. 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. Currency Translation 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 offer prices of such currencies against U.S. dollars quoted by a major bank. Purchases and sales of securities and 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. Premiums and Discounts Premiums and discounts on debt securities, other than mortgage-backed securities (MBS), are amortized for both financial reporting and tax purposes. Premiums and discounts on all MBS are recognized upon disposition or principal repayment as gain or loss for financial reporting purposes. For tax purposes, premiums and discounts on MBS acquired on or before June 8, 1997, are recognized upon disposition or principal repayment as ordinary income. For MBS acquired after June 8, 1997, premiums are recognized as gain or loss; discounts are recognized as gain or loss, except to the extent of accrued market discount. In November, 2000, the American Institute of Certified Public Accountants issued a revised Audit and Accounting Guide - Audits of Investment Companies (the guide), which will be adopted by the fund as of June 1, 2001. The guide requires all premiums and discounts on debt securities to be amortized and gain/loss on paydowns of MBS to be accounted for as interest income. Upon adoption, the fund will adjust the cost of its MBS, and corresponding unrealized gain/loss thereon, in the amount of the cumulative amortization that would have been recognized had amortization been in effect from the purchase date of each holding. This adjustment will have no effect on the fund's net assets or results of operations. Other Income and expenses are recorded on the accrual basis. Investment transactions are accounted for on the trade date. Realized gains and losses are reported on the identified cost basis. Dividend income and distributions to shareholders are recorded by the fund on the ex-dividend date. Income and capital gain distributions are determined in accordance with federal income tax regulations and may differ from net investment income and realized gains determined in accordance with generally accepted accounting principles. Expenses paid indirectly reflect credits earned on daily uninvested cash balances at the custodian and are used to reduce the fund's custody charges. Payments ("variation margin") made or received by the fund to settle the daily fluctuations in the value of futures contracts are recorded as unrealized gains or losses until the contracts are closed. Unrealized gains and losses on futures and forward currency exchange contracts are included in Other assets and Other liabilities, respectively, and in Change in net unrealized gain or loss in the accompanying financial statements. NOTE 2 - INVESTMENT TRANSACTIONS Consistent with its investment objective, the fund engages in the following practices to manage exposure to certain risks or enhance performance. The investment objective, policies, program, and risk factors of the fund are described more fully in the fund's prospectus and Statement of Additional Information. Forward Currency Exchange Contracts During the year ended May 31, 2001, the fund was a party to forward currency exchange contracts under which it is obligated to exchange currencies at specified future dates and exchange rates. Risks arise from the possible inability of counterparties to meet the terms of their agreements and from movements in currency values. Futures Contracts During the year ended May 31, 2001, the fund was a party to futures contracts, which provide for the future sale by one party and purchase by another of a specified amount of a specific financial instrument at an agreed upon price, date, time, and place. Risks arise from possible illiquidity of the futures market and from movements in security values and interest rates. Options Call and put options on futures contracts give the holder the right to purchase or sell, respectively, a particular futures contract at a specified price until a certain date. Risks arise from possible illiquidity of the options market and from movements in underlying futures prices. Options are reflected in the accompanying Statement of Net Assets at market value. Transactions in options written and related premiums received during the year ended May 31, 2001 were as follows: Number of Contracts Premiums Outstanding at beginning of period - - Written 175,000 $ 223,000 Exercised - - Expired - - Closed - - ------------------------------------------------------------------------------ Outstanding at end of period 175,000 $ 223,000 Securities Lending The fund lends its securities to approved brokers to earn additional income. It receives as collateral cash and U.S. government securities valued at 102%-105% of the value of the securities on loan. Cash collateral is invested in a money market pooled account by the fund's lending agent. Collateral is maintained over the life of the loan in an amount not less than the value of loaned securities, as determined at the close of fund business each day; any additional collateral required due to changes in security values is delivered to the fund the next business day. Although risk is mitigated by the collateral, the fund could experience a delay in recovering its securities and a possible loss of income or value if the borrower fails to return the securities. At May 31, 2001, the value of loaned securities was $357,578,000; aggregate collateral consisted of $363,331,000 in the securities lending collateral pool. Other Purchases and sales of portfolio securities, other than short-term and U.S. government securities, aggregated $973,482,000 and $778,769,000, respectively, for the year ended May 31, 2001. Purchases and sales of U.S. government securities aggregated $855,916,000 and $1,077,933,000, respectively, for the year ended May 31, 2001. NOTE 3 - FEDERAL INCOME TAXES No provision for federal income taxes is required since the fund intends to continue to qualify as a regulated investment company and distribute all of its taxable income. As of May 31, 2001, the fund has $75,984,000 of capital loss carryforwards, $1,953,000 of which expires in 2007, $36,493,000 in 2008, and $37,538,000 in 2009. The fund intends to retain gains realized in future periods that may be offset by available capital loss carryforwards. At May 31, 2001, the cost of investments for federal income tax purposes was substantially the same as for financial reporting and totaled $1,698,377,000. Net unrealized gain aggregated $7,566,000 at period end, of which $27,317,000 related to appreciated investments and $19,751,000 to depreciated investments. NOTE 4- RELATED PARTY TRANSACTIONS The fund is managed by T. Rowe Price Associates, Inc. (the manager or Price Associates), a wholly owned subsidiary of T. Rowe Price Group. The investment management agreement between the fund and the manager provides for an annual investment management fee, of which $680,000 was payable at May 31, 2001. The fee is computed daily and paid monthly, and consists of an individual fund fee equal to 0.15% of average daily net assets and a group fee. The group fee is based on the combined assets of certain mutual funds sponsored by Price Associates (the group). The group fee rate ranges from 0.48% for the first $1 billion of assets to 0.295% for assets in excess of $120 billion. At May 31, 2001, and for the year then ended, the effective annual group fee rate was 0.32%. The fund pays a pro-rata share of the group fee based on the ratio of its net assets to those of the group. In addition, the fund has entered into agreements with Price Associates and two wholly owned subsidiaries of Price Associates, pursuant to which the fund receives certain other services. Price Associates computes the daily share price and maintains the financial records of the fund. T. Rowe Price Services, Inc. is the fund's transfer and dividend disbursing agent and provides shareholder and administrative services to the fund. T. Rowe Price Retirement Plan Services, Inc. provides subaccounting and recordkeeping services for certain retirement accounts invested in the fund. The fund incurred expenses pursuant to these related party agreements totaling approximately $2,372,000 for the year ended May 31, 2001, of which $211,000 was payable at period-end. Additionally, the fund is one of several mutual funds sponsored by Price Associates (underlying funds) in which the T. Rowe Price Spectrum Funds (Spectrum) may invest. Spectrum does not invest in the underlying funds for the purpose of exercising management or control. Expenses associated with the operation of Spectrum are borne by each underlying fund to the extent of estimated savings to it and in proportion to the average daily value of its shares owned by Spectrum, pursuant to special servicing agreements between and among Spectrum, the underlying funds, Price Associates, and, in the case of T. Rowe Price Spectrum International, T. Rowe Price International. Spectrum Income Fund held approximately 34% of the outstanding shares of the New Income Fund at May 31, 2001. For the year then ended, the fund was allocated $1,431,000 of Spectrum expenses, $167,000 of which was payable at period-end. The fund may invest in the T. Rowe Price Reserve Investment Fund and the T. Rowe Price Government Reserve Investment Fund (collectively, the Reserve Funds), open-end management investment companies managed by Price Associates. The Reserve Funds are offered as cash management options only to mutual funds and other accounts sponsored by Price Associates, and are not available to the public. The Reserve Funds pay no investment management fees. Distributions from the Reserve Funds to the fund for the year ended May 31, 2001, totaled $3,263,000 and are reflected as interest income in the accompanying Statement of Operations. T. ROWE PRICE NEW INCOME FUND -------------------------------------------------------------------------------- REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of T. Rowe Price New Income Fund, Inc. In our opinion, the accompanying statement of assets and liabilities, including the portfolio of investments, and the related statements of operations and of changes in net assets and the financial highlights present fairly, in all material respects, the financial position of T. Rowe Price New Income Fund, Inc. ("the Fund") at May 31, 2001, and the results of its operations, the changes in its net assets and the financial highlights for each of the fiscal periods presented, in conformity with accounting principles generally accepted in the United States of America. These financial statements and financial highlights (hereafter referred to as "financial statements") are the responsibility of the Fund's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial statements in accordance with 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 statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits, which included confirmation of securities at May 31, 2001 by correspondence with custodians and brokers, provide a reasonable basis for our opinion. PricewaterhouseCoopers LLP Baltimore, Maryland June 19, 2001 T. ROWE PRICE NEW INCOME FUND -------------------------------------------------------------------------------- TAX INFORMATION (UNAUDITED) FOR THE TAX YEAR ENDED 5/31/01 We are providing this information as required by the Internal Revenue Code. The amounts shown may differ from those elsewhere in this report because of differences between tax and financial reporting requirements. For corporate shareholders, $656,000 of the fund's distributed income and short-term capital gains qualified for the dividends-received deduction. For fund and account information or to conduct transactions, 24 hours, 7 days a week By touch-tone telephone Tele*Access 1-800-638-2587 By Account Access on the Internet www.troweprice.com/access For assistance with your existing fund account, call: Shareholder Service Center 1-800-225-5132 To open a brokerage account or obtain information, call: 1-800-638-5660 For the hearing impaired, call: 1-800-367-0763 Internet address: www.troweprice.com Plan Account Lines for retirement plan participants: The appropriate 800 number appears on your retirement account statement. T. Rowe Price Associates 100 East Pratt Street Baltimore, Maryland 21202 This report is authorized for distribution only to shareholders and to others who have received a copy of the prospectus appropriate to the fund or funds covered in this report. Investor Centers: For directions, call 1-800-225-5132 or visit our Web site at www.troweprice.com/investorcenters Baltimore Area Downtown 105 East Lombard Street Owings Mills Three Financial Center 4515 Painters Mill Road Boston Area 386 Washington Street Wellesley Chicago Area 1900 Spring Road, Suite 104 Oak Brook Colorado Springs 2260 Briargate Parkway Los Angeles Area Warner Center 21800 Oxnard Street, Suite 270 Woodland Hills New Jersey/New York Area 51 JFK Parkway, 1st Floor Short Hills, New Jersey San Francisco Area 1990 North California Boulevard, Suite 100 Walnut Creek Tampa 4200 West Cypress Street 10th Floor Washington, D.C. Area Downtown 900 17th Street N.W. Farragut Square Tysons Corner 1600 Tysons Boulevard Suite 150 Opening July 2001 T. Rowe Price Investment Services, Inc., Distributor. F43-050 5/31/01