Montgomery Street Income Securities, Inc.
(Unaudited)
Statement of Assets and Liabilities
June 30, 2013
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Assets
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Investments in securities, at value (cost $188,899,596)
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$
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190,411,975
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Cash
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766,231
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Foreign currency (cost $320,386)
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320,061
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Receivables:
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Investments sold
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29,664,939
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Forward foreign currency contracts
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404,952
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Interest
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1,785,731
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Variation margin on financial derivative instruments
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22,879
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Deposits with brokers
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15,445,951
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Unrealized appreciation on OTC swap agreements
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429,968
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OTC swap premiums paid
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55,639
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Other assets
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50,426
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Total assets
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239,358,752
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Liabilities
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Accrued management and investment advisory fee
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119,599
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Accrued administrative fee
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33,705
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Written options, at value (premiums $231,089)
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523,005
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Payables:
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Investment securities purchased
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9,106,678
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Directors’ fees and expense
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1,784
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Variation margin on financial derivative instruments
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31,688
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Investment forward sales commitments, at value (cost $27,595,781)
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27,694,395
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Forward foreign currency contracts
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395,925
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Deposits from counterparties
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15,409,951
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Unrealized depreciation on OTC swap agreements
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956,865
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OTC swap premiums received
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368,465
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Other liabilities
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77,043
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Total liabilities
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54,719,103
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Net Asset Value
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$
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184,639,649
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Net assets consist of:
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Paid-in capital
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202,450,984
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Undistributed (excess of distributions over) net investment income
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70,957
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Net unrealized appreciation on investments and foreign currency related items
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844,157
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Accumulated net realized loss
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(18,726,449
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)
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Net Asset Value
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$
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184,639,649
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Net Asset Value
per share ($184,639,649/10,366,512 shares of common stock outstanding, $.01 par value, 30,000,000 shares
authorized)
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$
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17.81
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The accompanying notes are an integral part of the financial statements.
Montgomery Street Income Securities, Inc.
(Unaudited)
Statement of Operations
For the period ended June 30, 2013
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Investment Income
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Income:
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Interest
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$
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3,336,667
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Total income
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3,336,667
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Expenses:
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Management and investment advisory fee
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237,678
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Administrative fee
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222,390
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Legal
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55,898
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Directors’ fees and expenses
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53,584
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Stockholder reporting
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24,198
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Audit fees
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26,105
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Insurance
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24,737
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NYSE listing fee
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12,065
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Stockholder services
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12,650
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Interest expense
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877
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Custodian fees
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3,897
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Other
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4,466
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Total expenses
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678,545
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Net investment income
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2,658,122
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Realized and Unrealized Gain (Loss) on Investment Transactions and Foreign Currency Related Items
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Net realized gain from:
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Investment transactions
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1,207,295
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Futures contracts
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6,952
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Swap agreements
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1,322,799
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Written options contracts
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3,115
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Foreign currency related items
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102,782
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Net change in unrealized appreciation (depreciation) on:
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Investments
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(7,634,328
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)
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Futures contracts and centrally cleared swap agreements
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97,735
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OTC swap agreements
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(1,444,713
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)
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Written options contracts
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(317,705
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)
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Foreign currency related items
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187,588
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Net loss on investment transactions and foreign currency related Items
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(6,468,480
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)
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Net decrease in net assets resulting from operations
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$
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(3,810,358
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)
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The accompanying notes are an integral part of the financial statements.
Montgomery Street Income Securities, Inc.
(Unaudited)
Statement of Changes in Net Assets
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Increase (Decrease) in Net Assets
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Six Months Ended
June 30, 2013
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Year Ended
December 31, 2012
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Operations:
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Net investment income
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$
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2,658,122
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$
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6,235,953
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Net realized gain on investment transactions and foreign currency related items
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2,642,943
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6,220,384
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Net change in unrealized appreciation (depreciation) on investment transactions and foreign currency related items
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(9,111,423)
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9,373,924
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Net increase (decrease) in net assets resulting from operations
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(3,810,358)
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21,830,261
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Distributions to stockholders from net investment income
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(1,970,238)
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(8,811,954)
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Fund share transactions:
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Reinvestment of distributions
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83,837
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413,770
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Cost of shares repurchased
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(240,226)
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(343,385)
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Net increase (decrease) in net assets from Fund share transactions
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(156,389)
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70,385
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Net increase (decrease) in net assets
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(5,936,985)
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13,088,692
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Net assets at beginning of period
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190,576,634
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177,487,942
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Net assets at end of period (including undistributed (excess of distributions over) net investment income of $70,957 and $(616,927), respectively)
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$
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184,639,649
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$
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190,576,634
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Other information
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Shares outstanding at beginning of period
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10,375,675
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10,371,852
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Shares issued to stockholders in reinvestment of distributions
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4,837
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24,823
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Shares repurchased
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(14,000)
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(21,000)
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Net increase/(decrease) in fund shares outstanding
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(9,163)
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3,823
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Shares outstanding at end of period
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10,366,512
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10,375,675
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The accompanying notes are an integral part of the financial statements.
Montgomery Street Income Securities, Inc.
(Unaudited)
Financial Highlights
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Years Ended December 31,
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2013
e
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2012
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2011
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2010
c
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2009
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2008
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Selected Per Share Data
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Net asset value, beginning of period
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$18.37
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$17.11
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$17.12
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$16.42
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$15.13
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$18.07
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Income from investment operations:
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Income
a
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0.32
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0.73
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0.86
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0.86
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0.85
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1.07
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Operating expenses
a
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(0.07)
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(0.13)
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(0.12)
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(0.14)
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(0.12)
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(0.12)
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Net investment income
a
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0.25
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0.60
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|
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0.74
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|
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0.72
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0.73
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|
0.95
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Net realized and unrealized gain (loss) on investment transactions
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(0.62)
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1.51
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(0.04)
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0.71
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1.33
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(2.84)
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Total from investment operations
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(0.37)
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2.11
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0.70
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1.43
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2.06
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(1.89)
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Less distributions from:
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Net investment income
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(0.19)
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(0.85)
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(0.71)
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|
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(0.73)
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(0.77)
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(1.05)
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Net asset value, end of period
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$17.81
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$18.37
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$17.11
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$17.12
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$16.42
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$15.13
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Per share market value, end of period
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$16.16
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$16.90
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$15.43
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$15.78
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$14.68
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$13.82
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Closing price range on New York Stock Exchange for each share of Common Stock outstanding:
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High ($)
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17.76
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17.30
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|
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16.03
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|
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16.78
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|
|
|
15.10
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|
17.27
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Low ($)
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15.86
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|
|
15.38
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|
|
15.05
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|
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14.67
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|
|
|
13.19
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|
|
|
11.25
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Total Return
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Based on market value (%)
b
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(3.33)
f
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|
|
15.22
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|
|
|
2.28
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|
|
|
12.50
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|
|
|
12.04
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(7.94)
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Based on net asset value (%)
b
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(1.99)
f
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|
|
12.94
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|
|
|
4.54
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|
|
|
9.12
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|
|
|
14.47
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(10.04)
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Ratio to Average Net Assets and Supplemental Data
|
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|
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|
|
|
|
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|
Net assets, end of year ($ millions)
|
|
|
185
|
|
|
|
191
|
|
|
|
177
|
|
|
|
178
|
|
|
|
170
|
|
|
|
157
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|
|
Ratio of net expenses (%)
|
|
|
0.71
d
|
|
|
|
0.72
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|
|
|
0.71
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|
|
|
0.82
|
|
|
|
0.76
|
|
|
|
0.73
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|
Ratio of net investment income (%)
|
|
|
2.80
d
|
|
|
|
3.35
|
|
|
|
4.24
|
|
|
|
4.28
|
|
|
|
4.64
|
|
|
|
5.57
|
|
|
Portfolio turnover rate (%)
|
|
|
102
f
|
|
|
|
246
|
|
|
|
49
|
|
|
|
132
|
|
|
|
175
|
|
|
|
170
|
|
|
a
|
Based on average shares outstanding during the year.
|
|
b
|
Total return based on net asset value reflects changes in the Fund’s net asset value during the year. Total return based on market value reflects changes in market price. Each figure includes reinvestment of
dividends. These figures will differ depending upon the level of any discount or premium between market price and net asset value.
|
|
c
|
The Fund changed investment adviser effective March 15, 2010.
|
|
e
|
For the six months ended June 30,2013.
|
The accompanying notes are an integral part of the financial statements.
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
A. Significant Accounting Policies
Montgomery Street Income
Securities, Inc. (the “Fund”) is registered under the Investment Company Act of 1940, as amended (the “1940 Act”), as a closed-end, diversified management investment company. Pacific Investment Management Company LLC
(“PIMCO” or “Adviser”) serves as the investment adviser to the Fund.
The Fund’s financial statements are prepared in
accordance with U.S. generally accepted accounting principles (“GAAP”), which requires the use of management estimates. Actual results could differ from those estimates. The policies described below are followed consistently by the Fund in
the preparation of its financial statements.
Security Valuation.
Under the Fund’s valuation policy and procedures, the Fund’s
Board of Directors (the “Board”) has delegated the daily operational oversight of the securities valuation function to Jackson Fund Services (“JFS” or “Administrator”), a division of Jackson National Asset Management,
LLC. The Board has delegated to the Pricing Committee of JFS (“Pricing Committee”), the authority to approve determinations of fair valuations of securities for which market quotations are not readily available as well as to supervise JFS
in the performance of its responsibilities pursuant to the valuation policy and procedures. The Pricing Committee consists of the Fund’s Chief Executive Officer, Chief Financial Officer and Chief Compliance Officer. For those securities fair
valued under procedures adopted by the Board, the Pricing Committee reviews and affirms the reasonableness of the fair valuation determinations after considering all relevant information that is reasonably available. The Pricing Committee’s
fair valuation determinations are subject to review by the Chair of the Fund’s Valuation Committee on a monthly basis and the Board at its next regularly scheduled meeting covering the calendar quarter in which the fair valuation was
determined.
Investments are stated at value determined as of the close of regular trading (generally, 4:00 PM Eastern Time) on the New York Stock
Exchange (“NYSE”) on each day the exchange is open for trading. Debt securities are valued by independent pricing services approved by, or at the direction of, the Board. If the pricing services are unable to provide valuations, debt
securities are valued at the most recent bid quotation or evaluated price, as applicable, obtained from a broker/dealer or widely used quotation system. Fixed income securities with a remaining maturity of sixty days or less, maturing at par, are
valued at amortized cost, unless it is determined that such price does not approximate market value. Forward foreign currency contracts are generally valued at the forward foreign currency exchange rate as of the close of the NYSE. Futures contracts
traded on a liquid exchange are valued at the settlement price. If the settlement price is not available, exchange traded futures are valued at the last sales price as of the close of business on the local exchange. Options traded on an exchange are
valued at the last traded price as of the close of business on the local exchange. If the last trade is determined to not be representative of fair value, exchange traded options are valued at the last bid. Centrally cleared swap agreements, listed
on a multilateral or trade facility platform, such as a registered exchange, are valued by the respective exchange. The exchange determines a daily settlement price via pricing models which use, as appropriate, its members’ actionable levels
across complete term structures along with external third party prices for centrally cleared credit default swaps and underlying rates including overnight index swap rates and forward interest rates for centrally cleared interest rate swaps. Over
the counter (“OTC”) derivatives, including options and swap agreements, are generally valued by approved pricing services. If the pricing services are unable to provide valuations, OTC derivatives are valued at the most recent bid
quotation or evaluated price, as applicable, obtained from a broker/dealer or by pricing models using observable inputs. Pricing services utilized to value debt and derivative securities may use various pricing techniques which take into account
appropriate factors such as yield, credit quality, coupon rate, maturity, type of issue, trading characteristics, call features, credit ratings, broker quotes and other relevant data.
Market quotations may not be readily available for certain debt and derivative investments. If market quotations are not readily available or if it is
determined that a quotation of an investment does not represent market value, then the investment is valued at a “fair value” as determined in good faith using procedures approved by the Board. Although there can be no assurance, in
general, the fair value of a security is the amount the owner of such security might reasonably expect to receive upon its current sale. Situations that may require a security to be fair valued may include instances where a security is thinly traded
or restricted as to resale. In addition, securities may be fair valued based on the occurrence of a significant event. Significant events may be specific to a particular issuer, such as mergers, restructurings or defaults. Alternatively, significant
events may affect an
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
entire market, such as natural disasters or government actions. Securities are fair valued based on observable and unobservable inputs including the Administrator‘s own assumptions in
determining fair value. Under the procedures approved by the Board, the Administrator may rely on independent pricing services or other sources, including the Fund’s Adviser, to assist in determining the fair value of a security. Factors
considered to determine fair value include the correlation with price movement of similar securities in the same or other markets; the type, cost and investment characteristics of the security; the business and financial condition of the issuer; and
trading or other market data. The value of an investment for purposes of calculating the Fund’s net asset value (“NAV”) can differ depending on the source and method used to determine the value.
Security Transactions, Investment Income and Expenses.
Investment transactions are reported on trade date for financial reporting
purposes. Interest income including level-yield amortization of discounts and premiums is accrued daily. The Fund may place a debt obligation on non-accrual status and reduce related interest income by ceasing accruals and writing off interest
receivable when the collection of all or a portion of interest has become doubtful. A debt obligation is removed from non-accrual status when the issuer resumes interest payments or when collectability of interest is reasonably assured. Dividend
income is recorded on the ex-dividend date. Expenses are recorded on an accrual basis.
Federal Income Taxes.
The Fund intends to
qualify as a “regulated investment company” and to distribute substantially all net investment income and net capital gains, if any, to its stockholders and otherwise comply with Subchapter M of the Internal Revenue Code applicable to
regulated investment companies. Therefore, no federal income tax provision is required.
Distribution of Income and Capital Gains.
The amount and timing of distributions are determined in accordance with federal income tax regulations, which may differ from GAAP. Distributions of net investment income are paid quarterly. Net realized gains from investment
transactions will be distributed to stockholders at least annually to the extent they exceed available capital loss carryforwards. The Fund uses the specific identification method for determining realized gain or loss on investments sold for both
financial and federal income tax reporting purposes.
Contingencies.
In the normal course of business, the Fund may enter into
contracts with service providers that contain general indemnification clauses. The Fund’s maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet been made.
However, based on experience to date, the Fund expects any risk of loss to be remote.
B. Financial Accounting Standards Board (“FASB”) Accounting
Standards Codification (“ASC”) Topic 820, “Fair Value Measurements and Disclosure”
This standard establishes a single
authoritative definition of fair value, sets out a framework for measuring fair value and requires additional disclosures about fair value measurements. Various inputs are used in determining the value of the Fund’s investments under FASB ASC
Topic 820 guidance. The inputs are summarized into three broad categories.
Level 1 includes valuations based on unadjusted quoted prices of
identical securities in active markets, including valuations for securities listed on an exchange.
Level 2 includes valuations determined from
significant direct or indirect observable inputs. Direct observable inputs include broker quotes, third party prices, closing prices of similar securities in active markets, closing prices for identical or similar securities in non-active markets.
Indirect significant observable inputs include factors such as interest rates, yield curves, prepayment speeds or credit ratings. Level 2 includes valuations of vendor evaluated debt instruments, broker quotes in active markets, securities valued at
amortized cost, centrally cleared swap agreements, modeled OTC derivatives contracts and swap agreements valued by pricing services.
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
Level 3 includes valuations determined from significant unobservable inputs including the
Administrator’s own assumptions in determining the fair value of the investment. Inputs used to determine the fair value of Level 3 securities include security specific inputs such as: credit quality, credit rating spreads, issuer news, trading
characteristics, call features or maturity; or industry specific inputs such as trading activity of similar markets or securities, changes in the security’s underlying index or comparable securities’ models. Level 3 valuations include
certain single source quotes received from brokers (either directly or through a vendor), securities restricted to resale due to market events, newly issued or investments for which reliable quotes are not available.
To assess the continuing appropriateness of security valuation, the Administrator regularly compares prior day prices with current day prices,
transaction prices and alternative vendor prices. When the comparison results exceed pre-defined thresholds, the Administrator challenges the prices exceeding tolerance levels with the pricing service or broker. To verify Level 3 unobservable
inputs, the Administrator uses a variety of techniques as appropriate to substantiate these valuation approaches including a regular review of key inputs and assumptions, transaction back-testing or disposition analysis and review of related market
activity.
The inputs or methodology used for valuing securities are not necessarily an indication of the risk associated with investing in those
securities.
The following table summarizes the Fund’s investments in securities and other financial instruments as of June 30, 2013 by
valuation level.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Assets - Investments in Securities
|
|
|
|
|
Level 1
|
|
|
Level 2
|
|
|
Level 3
|
|
|
Total
|
|
|
Corporate Bonds
|
|
$
|
—
|
|
|
$
|
97,908,321
|
|
|
$
|
—
|
|
|
$
|
97,908,321
|
|
|
Non-U.S. Government ABS
|
|
|
—
|
|
|
|
13,755,532
|
|
|
|
14,613
|
|
|
|
13,770,145
|
|
|
Government and Agency Obligations
|
|
|
—
|
|
|
|
61,381,704
|
|
|
|
—
|
|
|
|
61,381,704
|
|
|
Purchased Options
|
|
|
—
|
|
|
|
273,187
|
|
|
|
—
|
|
|
|
273,187
|
|
|
Short Term Investments
|
|
|
—
|
|
|
|
17,078,618
|
|
|
|
—
|
|
|
|
17,078,618
|
|
|
|
|
|
|
|
|
Fund Total
|
|
$
|
—
|
|
|
$
|
190,397,362
|
|
|
$
|
14,613
|
|
|
$
|
190,411,975
|
|
|
|
|
|
|
|
Liabilities - Investments in Securities
|
|
|
|
|
Level 1
|
|
|
Level 2
|
|
|
Level 3
|
|
|
Total
|
|
|
Government and Agency Obligations
|
|
$
|
—
|
|
|
$
|
(27,694,395
|
)
|
|
$
|
—
|
|
|
$
|
(27,694,395
|
)
|
|
|
|
|
|
|
|
Fund Total
|
|
$
|
—
|
|
|
$
|
(27,694,395
|
)
|
|
$
|
—
|
|
|
$
|
(27,694,395
|
)
|
|
|
|
|
|
|
Assets - Investments in Other Financial Instruments*
|
|
|
|
|
Level 1
|
|
|
Level 2
|
|
|
Level 3
|
|
|
Total
|
|
|
Open Futures Contracts
|
|
$
|
822
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
822
|
|
|
Exchange Traded Purchased Options
|
|
|
482
|
|
|
|
—
|
|
|
|
—
|
|
|
|
482
|
|
|
Open Forward Foreign Currency Contracts
|
|
|
—
|
|
|
|
404,952
|
|
|
|
—
|
|
|
|
404,952
|
|
|
OTC Interest Rate Swap Agreements
|
|
|
—
|
|
|
|
178,064
|
|
|
|
—
|
|
|
|
178,064
|
|
|
Centrally Cleared Interest Rate Swap Agreements
|
|
|
—
|
|
|
|
19,499
|
|
|
|
—
|
|
|
|
19,499
|
|
|
OTC Credit Default Swap Agreements
|
|
|
—
|
|
|
|
251,904
|
|
|
|
—
|
|
|
|
251,904
|
|
|
Centrally Cleared Credit Default Swap Agreements
|
|
|
—
|
|
|
|
370,646
|
|
|
|
—
|
|
|
|
370,646
|
|
|
|
|
|
|
|
|
Fund Total
|
|
$
|
1,304
|
|
|
$
|
1,225,065
|
|
|
$
|
—
|
|
|
$
|
1,226,369
|
|
|
|
|
|
|
|
Liabilities - Investments in Other Financial Instruments*
|
|
|
|
|
Level 1
|
|
|
Level 2
|
|
|
Level 3
|
|
|
Total
|
|
|
Written Options
|
|
$
|
—
|
|
|
$
|
(523,005
|
)
|
|
$
|
—
|
|
|
$
|
(523,005
|
)
|
|
Exchange Traded Purchased Options
|
|
|
(1,215
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
(1,215
|
)
|
|
Open Futures Contracts
|
|
|
(153,787
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
(153,787
|
)
|
|
Open Forward Foreign Currency Contracts
|
|
|
—
|
|
|
|
(395,925
|
)
|
|
|
—
|
|
|
|
(395,925
|
)
|
|
OTC Interest Rate Swap Agreements
|
|
|
—
|
|
|
|
(885,967
|
)
|
|
|
—
|
|
|
|
(885,967
|
)
|
|
Centrally Cleared Interest Rate Swap Agreements
|
|
|
—
|
|
|
|
(88,368
|
)
|
|
|
—
|
|
|
|
(88,368
|
)
|
|
OTC Credit Default Swap Agreement
|
|
|
—
|
|
|
|
(70,898
|
)
|
|
|
—
|
|
|
|
(70,898
|
)
|
|
|
|
|
|
|
|
Fund Total
|
|
$
|
(155,002
|
)
|
|
$
|
(1,964,163
|
)
|
|
$
|
—
|
|
|
$
|
(2,119,165
|
)
|
*
Investments in other financial instruments are derivative instruments not reflected in the Investment Portfolio and
include written options, futures contracts, forward foreign currency contracts, and swap agreements. All derivatives are reflected at the unrealized appreciation/(depreciation) on the instrument, except for written options which are reflected at
value.
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
The Fund recognizes transfers between levels as of the beginning of the period. There were no
significant transfers into or out of Level 1, 2 or 3 during the period. There were no significant Level 3 valuations for which significant unobservable valuation inputs were developed at June 30, 2013.
C. Investments
Forward Sales
Commitments.
The Fund may purchase or sell forward sales commitments. A forward sales commitment involves the Fund entering into a contract to purchase or sell securities for a fixed price at a future date beyond the customary
settlement period. The purchase of a forward sales commitment involves the risk of loss if the value of the security to be purchased declines before the settlement date while the sale of a forward sales commitment involves the risk that the value of
the securities to be sold may increase before the settlement date. The Fund may dispose of or renegotiate forward sales commitments after they are entered into, and may close these positions before they are delivered, which may result in a realized
gain or loss.
When-Issued/Delayed-Delivery Securities.
The Fund may purchase securities with delivery or payment to occur at a
date beyond the normal settlement period. At the time the Fund enters into a commitment to purchase a security, the transaction is recorded and the value of the security is reflected in the NAV. The price of such security and the date when the
security will be delivered and paid for are fixed at the time the transaction is negotiated. The value of the security may vary with market fluctuations. No interest accrues to the Fund until settlement of the trade. Certain risks may arise upon
entering into when-issued or delayed-delivery securities from the potential inability of counterparties to meet the terms of their contracts or if the issuer does not issue the securities due to political, economic or other factors. Additionally,
losses may arise due to changes in the value of the underlying securities prior to settlement date, if the counterparty does not perform under the contract’s terms, or if the issuer does not issue the securities due to political, economic or
other factors.
Mortgage-Backed Dollar and Treasury Roll Transactions.
The Fund may sell mortgage-backed or treasury securities
and simultaneously contract to repurchase securities at a future date at an agreed upon price. The Fund may only enter into covered rolls. A “covered roll” is a type of dollar roll for which the Fund maintains offsetting positions in cash,
U.S. Government securities, or other liquid assets which mature on or before the forward repurchase settlement date of the dollar roll transaction. During the period between the sale and repurchase, the Fund forgoes interest and principal paid on
the mortgage-backed securities. The Fund is compensated by the interest earned on the cash proceeds of the initial sale and from negotiated fees paid by brokers offered as an inducement to the Fund to “roll over” its purchase commitments.
The Fund may dispose of “covered roll” securities after they are entered into and close these positions before their maturity, which may result in a realized gain or loss.
In a mortgage-backed or treasury securities roll transaction, if the repurchased security is determined to be similar, but not substantially the same,
the transaction is accounted for as a purchase and sale. Any gains, losses and any income or fees earned are recorded to realized gain or loss. If the repurchased security is determined to be substantially the same, the transaction is accounted for
as a secured borrowing, rather than as a purchase and sales transaction. Any income or fees earned are recorded to investment income and financing costs associated with the transaction are recorded to interest expense.
For the period ended June 30, 2013, income, fees and financing costs relating to treasury transactions characterized as secured borrowing
transactions were not significant, and as a result, reclassifications were not made on the Statement of Operations for these transactions.
Dollar
roll transactions involve the risk that the market value of the securities sold by the Fund may decline below the repurchase price of those securities which the Fund is obligated to purchase or that the return earned by the Fund with the proceeds of
a dollar roll may not exceed transaction costs.
Illiquid Investments and Restricted Securities.
Illiquid securities and other
investments are those that may not be sold or disposed of in the ordinary course of business within seven days, at approximately the price used to determine the Fund’s NAV per share. The Fund may not be able to sell illiquid investments when
the Adviser considers it desirable to do so or may have to sell such investments at a price that is lower than the price that
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
could be obtained if the investments were liquid. A sale of illiquid investments may require more time and may result in higher dealer discounts and other selling expenses than would the sale of
those that are liquid. Illiquid investments also may be more difficult to value, due to the unavailability of reliable market quotations for such investments, and investment in them may have an adverse impact on NAV. The Fund may also purchase
certain restricted securities, commonly known as Rule 144A and Section 4(2) paper securities, which may be determined to be liquid pursuant to policies and guidelines established by the Board.
Repurchase Agreements.
The Fund may invest in repurchase agreements. In a repurchase agreement, the Fund takes possession of an
underlying debt obligation (collateral) subject to an obligation of the seller to repurchase, and the Fund to resell, the obligation at an agreed upon price and date. Earnings on collateral and compensation to the seller are based on agreed upon
rates between the seller and the Fund. The market value of the collateral must be equal to or exceed at all times the total amount of the repurchase obligations, including interest. Interest earned on repurchase agreements is recorded as a component
of interest income on the Statement of Operations. In periods of increased demand for collateral, the Fund may pay a fee for receipt of the collateral, which may result in interest expense to the Fund. The underlying securities used as collateral
for repurchase agreements may be held in safekeeping by the Fund’s Custodian or designated sub custodians under triparty repurchase agreements or delivered to the counterparty. Securities purchased under repurchase agreements are reflected as
an asset on the Statement of Assets and Liabilities. The value of repurchase agreements and collateral pledged or received by a counterparty are disclosed in the Investment Portfolio. The Fund’s net exposure to the counterparty is determined by
the amount of any excess or shortfall in collateral compared to the value of the repurchase agreement. In the event of a default by the counterparty, realization of the collateral proceeds could be delayed, during which time the value of such
collateral may decline.
Reverse Repurchase Agreements.
The Fund may enter into reverse repurchase agreements. In a reverse
repurchase agreement, a Fund delivers a security to a counterparty in exchange for cash, with a simultaneous agreement to repurchase the same or substantially the same security at an agreed upon price and date. The Fund receives principal and
interest payments, if any, made on the security delivered to the counterparty during the term of the agreement. In periods of increased demand of the security, the Fund may receive a fee for use of the security by the counterparty, which may result
in interest income to the Fund. Cash received in exchange for securities delivered plus accrued interest payments to be made by the Fund are reflected as a liability on the Statement of Assets and Liabilities. Interest payments made to the
counterparty are recorded as a component of interest expense on the Statement of Operations. A reverse repurchase agreement involves the risk that the value of the security delivered by the Fund may decline below the repurchase price of the
security. The Fund will segregate assets determined to be liquid at the Custodian or otherwise cover its obligations under reverse repurchase agreements. The Fund’s net exposure to the counterparty is determined by the amount of any excess or
shortfall in collateral compared to the value of the reverse repurchase agreement.
For the 67 days reverse repurchase agreements were outstanding,
the average daily balance and the weighted average interest rate for reverse repurchase agreements during the period ended June 30, 2013 were $2,865,431 and 0.17%, respectively. The Fund did not hold any reverse repurchase agreements at
June 30, 2013.
U.S. Government Agencies or Government Sponsored Enterprises.
The Fund may invest in U.S. government agencies
or government sponsored enterprises. U.S. government securities are obligations of, and in certain cases, guaranteed by, the U.S. government, its agencies or instrumentalities. Some U.S. government securities, such as Treasury bills, notes and
bonds, and securities guaranteed by the Government National Mortgage Association, are supported by the full faith and credit of the U.S. government; others, such as those of the Federal Home Loan Bank, are supported by the right of the issuer to
borrow from the U.S. Department of the Treasury (“U.S. Treasury”); others, such as those of the Federal National Mortgage Association (“FNMA”) are supported by the discretionary authority of the U.S. government to purchase the
agency’s obligations. U.S. government securities may include zero coupon securities, which do not distribute interest on a current basis and tend to be subject to greater risk than interest-paying securities of similar maturities.
Government-related guarantors (i.e., guarantors that are not backed by the full faith and credit of the U.S. government) include FNMA and the Federal
Home Loan Mortgage Corporation (“FHLMC”). FNMA purchases conventional (i.e., not insured or guaranteed by any government agency) residential mortgages from a list of
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
approved seller/servicers, which include state and federally chartered savings and loan associations, mutual savings banks, commercial banks and credit unions and mortgage bankers. Pass-through
securities issued by FNMA are guaranteed as to timely payment of principal and interest by FNMA, but are not backed by the full faith and credit of the U.S. government. FHLMC issues Participation Certificates (“PCs”), which are
pass-through securities, each representing an undivided interest in a pool of residential mortgages. FHLMC guarantees the timely payment of interest and ultimate collection of principal, but PCs are not backed by the full faith and credit of the
U.S. government.
FNMA and FHMLC were placed into conservatorship by the Federal Housing Finance Agency (“FHFA”). As the conservator, FHFA
succeeded to all rights, titles, powers and privileges of FNMA and FHLMC and of any stockholder, officer or director of FNMA and FHLMC with respect to FNMA and FHLMC and each enterprise’s assets. In connection with the conservatorship, the U.S.
Treasury entered into a Senior Preferred Stock Purchase Agreement with FNMA and FHLMC. This agreement contains various covenants that severely limit each enterprise’s operations. In exchange for entering into these agreements, the U.S. Treasury
received senior preferred stock in each enterprise and warrants to purchase each enterprise’s common stock. The U.S. Treasury announced the creation of a new secured lending facility, which is available to FNMA and FHLMC as a liquidity backstop
and the creation of a temporary program to purchase mortgage-backed securities issued by FNMA and FHLMC. FNMA and FHLMC are continuing to operate as going concerns while in conservatorship and each remains liable for all of its obligations,
including its guaranty obligations, associated with its mortgage-backed securities.
D. Risks
Interest Rate Risk.
Interest rate risk is the risk that fixed income securities will decline in value because of changes in interest
rates. As nominal interest rates rise, the value of certain fixed income securities held by the Fund is likely to decrease. A nominal interest rate can be described as the sum of a real interest rate and an expected inflation rate. Fixed income
securities with longer durations tend to be more sensitive to changes in interest rates, usually making them more volatile than securities with shorter durations.
Inflation-indexed bonds, including Treasury Inflation-Protected Securities, decline in value when real interest rates rise. In certain interest rate
environments, such as when real interest rates are rising faster than nominal interest rates, inflation-indexed bonds may experience greater losses than other fixed income securities with similar durations.
Variable and floating rate securities generally are less sensitive to interest rate changes but may decline in value if their interest rates do not rise
as much, or as quickly, as interest rates in general. Conversely, variable and floating rate securities will not generally increase in value if interest rates decline. Inverse floating rate securities may decrease in value if interest rates
increase. Inverse floating rate securities may also exhibit greater price volatility than a fixed rate obligation with similar credit quality. When the Fund holds variable or floating rate securities, a decrease (or, in the case of inverse floating
rate securities, an increase) in market interest rates will adversely affect the income received from such securities and the net asset value of the Fund’s shares.
Credit Risk.
The Fund could lose money if the issuer or guarantor of a fixed income security, or the counterparty to a derivatives
contract or repurchase agreement, is unable or unwilling to make timely principal and/or interest payments, or to otherwise honor its obligations. Securities are subject to varying degrees of credit risk, which are often reflected in credit ratings.
Municipal bonds are subject to specific risks that litigation, legislation or other political events, local business or economic conditions, or the bankruptcy of the issuer could have a significant effect on an issuer’s ability to make payments
of principal and/or interest.
High Yield Risk.
Investments in high yield securities and unrated securities of similar credit
quality (commonly known as “junk bonds”) may be subject to greater levels of credit and liquidity risk than investments in higher rated securities. These securities are considered predominately speculative with respect to the issuer’s
continuing ability to make principal and interest payments. An economic downturn or period of rising interest rates could adversely affect the market for these securities and reduce the Fund’s ability to sell these securities (liquidity risk).
If the issuer of a security is in default with respect to interest or principal payments, the Fund may lose its entire investment.
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
Market Risk.
The market price of securities owned by the Fund may go up or down,
sometimes rapidly or unpredictably. The value of a security may decline due to general market conditions that are not specifically related to a particular company, such as real or perceived adverse economic conditions, changes in the general outlook
for corporate earnings, changes in interest or currency rates or adverse investor sentiment generally. It may also decline due to factors which affect a particular industry or industries, such as labor shortages or increased production costs and
competitive conditions within an industry. During a general downturn in the securities markets, multiple asset classes may decline in value simultaneously. Equity securities, like common stocks and preferred stocks, generally have greater price
volatility than fixed income securities.
Issuer Risk.
The value of a security may decline for a number of reasons that directly
relate to the issuer, such as management performance, financial leverage and reduced demand for the issuer’s goods or services.
Liquidity
Risk.
Liquidity risk exists when particular investments are difficult to purchase or sell. The Fund’s investments in illiquid securities may reduce the returns of the Fund because it may be unable to sell the illiquid securities
at an advantageous time or price. Additionally, the markets for certain investments may become illiquid under adverse market or economic conditions independent of any specific adverse changes in the condition of a particular issuer. In such cases,
the Fund, due to the difficulty in purchasing and selling illiquid securities and limitations on the Fund’s investments in such securities, may be unable to achieve its desired level of exposure to a certain sector. Foreign (non-U.S.)
securities, certain derivatives and securities with substantial market and/or credit risk will tend to have greater exposure to liquidity risk.
Derivatives Risk.
Derivatives are financial contracts whose value depends on, or is derived from, the value of an underlying asset,
reference rate or index. When investing in a derivative instrument, the Fund could lose more than the principal amount invested The Fund typically uses derivatives as a substitute for taking a position in the underlying asset or as part of a
strategy designed to reduce exposure to other risks, such as interest rate or currency risk. The Fund may also use derivatives for leverage, in which case their use would involve leveraging risk. For example, a small investment in a derivative
instrument may have a significant impact on the Fund’s exposure to interest rates, currency exchange rates or other investments. As a result a relatively small price movement in a derivative instrument may cause an immediate and substantial
loss or gain. The Fund may engage in such transactions regardless of whether the Fund owns the asset, instrument or components of the index underlying the derivative instrument. The Fund may invest a portion of its assets in these types of
instruments, which could cause the Fund’s investment exposure to exceed the value of its portfolio securities and its investment performance could be affected by securities it does not own. The Fund’s use of derivative instruments involves
risks different from, or possibly greater than, the risks associated with investing directly in securities and other traditional investments. Derivatives are subject to a number of risks described elsewhere in this section, such as liquidity risk,
interest rate risk, market risk, credit risk and management risk. They also involve the risk of mispricing or improper valuation and the risk that changes in the value of the derivative may not correlate perfectly with the underlying asset, rate or
index. The Fund’s Adviser must choose the correct derivatives exposure versus the underlying assets to be hedged or the income to be generated, in order to realize the desired results from the investment. The Fund’s Adviser must correctly
predict price, credit or other applicable movements, during the life of a derivative, with respect to the underlying asset in order to realize the desired results from the investment. The Fund could experience losses if its derivatives were poorly
correlated with its other investments, or if the Fund were unable to liquidate its position because of an illiquid secondary market. The market for many derivatives is, or suddenly can become, illiquid. Changes in liquidity may result in
significant, rapid and unpredictable changes in the prices for derivatives. The value of derivatives may fluctuate more rapidly than other investments, which may increase the volatility of the Fund, depending on the nature and extent of the
derivatives in the Fund’s portfolio. If the Fund’s Adviser uses derivatives in attempting to manage or “hedge” the overall risk of the portfolio, the strategy might not be successful. To the extent that the Fund is unable to
close out a position because of market illiquidity or counterparty default, the Fund may not be able to prevent further losses of value in its derivatives holdings and the Fund’s liquidity may be impaired to the extent that it has a substantial
portion of its otherwise liquid assets marked as segregated to cover its obligations under such derivative instruments. The Fund may also be required to take or make delivery of an underlying instrument
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
that the manager would otherwise have attempted to avoid. Also, suitable derivative transactions may not be available in all circumstances, and there can be no assurance that the Fund will engage
in these transactions to reduce exposure to other risks when that would be beneficial. The use of derivative strategies may also have a tax impact on the Fund. The timing and character of income, gains or losses from these strategies could impair
the ability of the investment manager to utilize derivatives when it wishes to do so.
Mortgage-Related and Other Asset-Backed Securities
Risk.
Mortgage-related and other asset-backed securities are subject to certain additional risks. Generally, rising interest rates tend to extend the duration of fixed rate mortgage-related securities, making them more sensitive to
changes in interest rates. This is known as extension risk. In addition, adjustable and fixed rate mortgage-related securities are subject to prepayment risk. When interest rates decline, borrowers may pay off their mortgages sooner than expected.
This can reduce the returns of the Fund because the Fund may have to reinvest that money at the lower prevailing interest rates. The Fund’s investments in other asset-backed securities are subject to risks similar to those associated with
mortgage-related securities, as well as additional risks associated with the nature and servicing of those assets.
Foreign (Non-U.S.) Investment
Risk.
Investments in foreign (non-U.S.) securities may experience more rapid and extreme changes in value than investments in securities of U.S. companies. The securities markets of many foreign countries are relatively small, with a
limited number of companies representing a small number of industries. Additionally, issuers of foreign securities are usually not subject to the same degree of regulation as U.S. issuers. Reporting, accounting and auditing standards of foreign
countries differ, in some cases significantly, from U.S. standards. Also, nationalization, expropriation or confiscatory taxation, currency blockage, political changes or diplomatic developments could adversely affect the Fund’s investments in
a foreign country. In the event of nationalization, expropriation or other confiscatory taxation, the Fund could lose its entire investment in foreign securities. Adverse conditions in a certain region can adversely affect securities of other
countries whose economies appear to be unrelated. If the Fund invests a significant portion of its assets in a specific geographic region, the Fund will generally have more exposure to regional economic risks associated with foreign investments in
that region.
Emerging Markets Risk.
Foreign investment risk may be particularly high to the extent that the Fund invests in
emerging market securities that are economically tied to countries with developing economies. These securities may present market, credit, currency, liquidity, legal, political and other risks different from, or greater than, the risks of investing
in developed foreign countries.
Currency Risk.
To the extent that the Fund invests directly in foreign (non-U.S.) currencies, in
securities that are denominated in foreign currencies, or in derivatives that provide exposure to foreign currencies, it will be subject to the risk that those currencies will decline in value relative to the U.S. dollar, or, in the case of hedging
positions, that the U.S. dollar will decline in value relative to the currency being hedged.
Currency rates in foreign countries may fluctuate
significantly over short periods of time for a number of reasons, including changes in interest rates, intervention (or the failure to intervene) by U.S. or foreign governments, central banks or supranational entities such as the International
Monetary Fund, or the imposition of currency controls or other political developments in the United States or abroad. As a result, the Fund’s investments in foreign currencies or instruments with exposure to foreign currencies may reduce the
returns of the Fund.
Leveraging Risk.
Certain transactions may give rise to a form of leverage. Such transactions include, among
others, reverse repurchase agreements and when-issued, delayed delivery or forward commitment transactions. The use of derivatives may also create leveraging risk. To mitigate leveraging risk, the Investment Adviser will segregate or
“earmark” liquid assets or otherwise cover the transactions that may give rise to such risk. The Fund also may be exposed to leveraging risk by borrowing money for investment purposes. Leveraging may cause the Fund to liquidate portfolio
positions to satisfy its obligations or to meet segregation requirements when it may not be advantageous to do so. Leveraging, including borrowing, may cause the Fund to be more volatile than if the Fund had not been leveraged. This is because
leveraging tends to exaggerate the effect of any increase or decrease in the value of the Fund’s portfolio securities.
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
Smaller Company Risk.
The general risks associated with fixed income securities are
particularly pronounced for securities issued by companies with smaller market capitalizations. These companies may have limited product lines, markets or financial resources or they may depend on a few key employees. As a result, they may be
subject to greater levels of credit, market and issuer risk. Securities of smaller companies may trade less frequently and in lesser volumes than more widely held securities and their values may fluctuate more sharply than other securities.
Companies with medium-sized market capitalizations may have risks similar to those of smaller companies.
Management Risk.
The
Fund is subject to management risk because it is an actively managed investment portfolio. The Investment Adviser will apply investment techniques and risk analyses in making investment decisions for the Fund, but there can be no guarantee that
these decisions will produce the desired results. Additionally, legislative, regulatory, or tax developments may affect the investment techniques available to the Investment Adviser and may also adversely affect the ability of the Fund to achieve
its investment objectives.
Municipal Project-Specific Risk.
The Fund may be more sensitive to adverse economic, business or
political developments if it invests a substantial portion of its assets in the municipal bonds of similar projects (such as those relating to education, health care, housing, transportation, and utilities), in industrial development bonds, or in
bonds from issuers in a single state.
Short Sale Risk.
The Fund’s short sales, if any, are subject to special risks. A short
sale involves the sale by the Fund of a security that it does not own with the hope of purchasing the same security at a later date at a lower price. The Fund may also enter into a short position through a forward commitment or a short derivative
position through a futures contract or swap agreement. If the price of the security or derivative has increased during this time, then the Fund will incur a loss equal to the increase in price from the time that the short sale was entered into plus
any premiums and interest paid to the third party. Therefore, short sales involve the risk that losses may be exaggerated, potentially losing more money than the actual cost of the investment. Also, there is the risk that the third party to the
short sale may fail to honor its contract terms, causing a loss to the Fund.
Government, Legislative and Regulatory
Risk.
Instability in the financial markets can lead to a number of unprecedented actions that may support certain financial institutions and segments of the financial markets under extreme volatility, and in some cases a lack of
liquidity. Federal, state, and other governments, their regulatory agencies, or self regulatory organizations may take actions that affect the regulation of the instruments in which the Fund invests, or the issuers of such instruments, in ways that
are unforeseeable. Legislation or regulation may also change the way in which the Funds themselves are regulated. Such legislation or regulation could limit or preclude the Fund’s ability to achieve its investment objectives. Governments or
their agencies may also acquire distressed assets from financial institutions and acquire ownership interests in those institutions. The implications of government ownership and disposition of these assets are unclear, and such a program may have
positive or negative effects on the liquidity, valuation and performance of the Fund’s portfolio holdings.
E. Collateral and Master Netting Agreements
Under various agreements, certain investment transactions require collateral to be exchanged by the Fund and a counterparty or segregated at
the custodian. U.S. Treasury Bills and U.S. dollar cash are generally the preferred forms of collateral, although other forms of high quality or sovereign securities may be used. Securities held by the Fund that are used as collateral are identified
as such within the Investment Portfolio. Collateral for OTC financial derivative transactions paid to or received from counterparties is included in receivable from/payable for deposits with/from counterparties in the Statement of Assets and
Liabilities.
Master Netting Agreements (“Master Agreements”).
The Fund is subject to various Master Agreements, which
govern the terms of certain transactions and mitigate the counterparty risk associated with relevant transactions by specifying credit protection mechanisms and providing standardization that improves legal certainty. Since different types of
financial transactions have different mechanics and are sometimes traded out of different legal entities of a particular counterparty organization, each type of transaction may be covered by a different Master Agreement, resulting in the need for
multiple agreements with a single counterparty. The Fund may net exposure and collateralize multiple transaction types governed by the same Master Agreement with the
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
same counterparty and may close out and net its total exposure to a counterparty in the event of a default and/or termination event with respect to all the transactions governed under a single
agreement with a counterparty. Each Master Agreement defines whether the Fund is contractually able to net settle daily payments. Additionally, certain circumstances, such as laws of a particular jurisdiction or settlement of amounts due in
different currencies, may prohibit or restrict the right of offset as defined in the Master Agreements.
Master Agreements also help limit credit
and counterparty risk by specifying collateral posting arrangements at pre-arranged exposure levels. Under the Master Agreements, collateral is routinely transferred if the total net exposure to certain transactions (net of existing collateral)
governed under the relevant master agreement with a counterparty in a given account exceeds a specified threshold depending on the counterparty and the type of Master Agreement. The Fund’s overall exposure to counterparty risk can change
substantially within a short period, as it is affected by each transaction subject to the relevant Master Agreement. To the extent amounts due to the Fund from its counterparties are not fully collateralized, contractually or otherwise, the Fund
bears the risk of loss from counterparty non-performance. The Fund’s investment adviser attempts to limit counterparty risk by only entering into Master Agreements with counterparties which are believed to have the financial resources to honor
their obligations and by monitoring the financial stability of those counterparties. For swap agreements executed with a Derivatives Clearing Organization (“DCO”) in a multilateral or other trade facility platform (“centrally cleared
swaps”), counterparty risk is reduced by shifting exposure from the counterparty to the DCO. Additionally the DCO has broad powers to provide an orderly liquidation in the event of a default.
Master Repurchase Agreements and Global Master Repurchase Agreements (individually and collectively “Master Repo
Agreements”).
Master Repo Agreements govern repurchase and reverse repurchase transactions between the Fund and select counterparties. The Master Repo Agreements maintain provisions for, among other things, initiation and
confirmation, income payments and transfer, events of default, termination, and maintenance of collateral. In the event of default, the total value exposure will be offset against collateral exchanged to date, which would result in a net
receivable/(payable) that would be due from/to the counterparty.
Master Securities Forward Transaction Agreements (“Master Forward
Agreements”).
Master Forward Agreements govern the considerations and factors surrounding the settlement of certain forward-settling transactions, such as delayed-delivery transactions, TBA securities and U.S. treasury roll
transactions between the Fund and select counterparties. The Master Forward Agreements maintain provisions for, among other things, initiation and confirmation, payment and transfer, events of default, termination, and maintenance of collateral.
Losses may arise due to changes in the value of the underlying securities prior to settlement date, if the counterparty does not perform under the contract’s terms, or if the issuer does not issue the securities due to political, economic or
other factors. In the event of default, the unrealized gain or loss will be offset against collateral exchanged to date, which would result in a net receivable/(payable) that would be due from/to the counterparty. In the ordinary course of business,
settlements of transactions, are not typically subject to net settlement, except for TBA pools.
International Swaps and Derivatives Association
Inc. Master Agreements and Credit Support Annexes (“ISDA Master Agreements”).
ISDA Master Agreements govern OTC financial derivative transactions entered into by the Fund’s investment adviser and select counterparties.
The ISDA Master Agreements maintain provisions for general obligations, representations, agreements, events of default, termination and maintenance of collateral. Termination includes conditions that may entitle counterparties to elect to terminate
early and cause settlement of all outstanding transactions under the applicable ISDA Master Agreement. Any election to early termination could be material to the financial statements. In the event of default, the total financial derivative value
exposure will be offset against collateral exchanged to date, which would result in a net receivable/(payable) that would be due from/to the counterparty. The amount of collateral exchanged is based on provisions within the ISDA Master Agreements
and is determined by the net exposure with the counterparty and is not identified for a specific OTC derivative instrument.
Customer Account
Agreements.
Customer Account Agreements and related addendums govern cleared derivative transactions such as futures, options on futures and centrally cleared derivatives. If a Fund transacts in centrally cleared derivatives, the
investment adviser is a party to agreements with (1) a Futures Commissions Merchant (“FCM”) in which the FCM acts as agent in the execution of the centrally cleared derivative with the
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
DCO and (2) with an executing broker/swap dealer to agree to the terms of the swap and resolution process in the event the centrally cleared swap is not accepted for clearing by the
designated DCO. Cleared derivatives transactions require posting an amount of cash or cash equivalents equal to a certain percentage of the contract amount known as the “initial margin” as determined by each relevant clearing agency and is
segregated at an FCM which is registered with the Commodity Futures Trading Commission (“CFTC”) or the applicable regulator. The Fund receives from or pays to the counterparty an amount of cash equal to the daily fluctuation in the value
of the contracts. Such receipts or payments are known as the “variation margin”. Variation margin received may not be netted between futures and centrally cleared derivatives. In the event of default, counterparty risk is significantly
reduced as creditors to the FCM do not have claim to a Fund’s assets in the segregated account. Additionally, portability of exposure in the event of default further reduces risk.
F. Financial Derivative Instruments
FASB ASC Topic 815,
“Derivatives and Hedging”.
This standard includes the requirement for enhanced qualitative disclosures about objectives and strategies for using derivative instruments and disclosures regarding credit-related contingent
features in derivative instruments, as well as quantitative disclosures in the semi-annual and annual financial statements about fair value, gains and losses and volume of activity for derivative instruments. Information about these instruments is
disclosed in the context of each instrument’s primary underlying risk exposure which is categorized as credit, equity price, interest rate and foreign currency exchange rate risk. The objectives, strategies and underlying risks for each
instrument held by the Fund are discussed in the following paragraphs.
Futures Contracts.
The Fund may be subject to interest
rate risk in the normal course of pursuing its investment objective. The Fund entered into futures contracts to manage exposure to or hedge changes in interest rates, as a substitute for investment in physical securities and as an efficient means of
adjusting overall exposure to certain markets as part of its overall investment strategy. A futures contract is a standardized contract obligating two parties to exchange a specified asset at an agreed upon price and date. Variation margin is
recorded by the Fund until the contracts are terminated at which time realized gains and losses are recognized. Futures contracts involve, to varying degrees, risk of loss in excess of the variation margin recorded by the Fund. The primary risks
associated with the use of futures contracts are the imperfect correlation between the change in value of the securities held by the Fund and the prices of the futures contracts and the possibility the Fund may not be able to enter into a closing
transaction because of an illiquid market. With futures, counterparty risk to the Fund is reduced since futures contracts are exchange traded and the exchange’s clearinghouse, acting as counterparty to all exchange traded futures, guarantees
the futures contracts against default.
Options Contracts.
The Fund may be subject to interest rate risk, equity price, and
foreign currency exchange rate in the normal course of pursuing its investment objective. During the period, the Fund purchased and sold (“wrote”) option contracts to manage exposure to or hedge changes in interest rates and to manage
exposure to or hedge changes in inflation.
An option is a contract that gives the purchaser of the option, in return for a premium paid, the right
to buy a specified underlying instrument from the writer of the option (in the case of a call option), or to sell a specified underlying instrument to the writer of the option (in the case of a put option) at a designated price during the term of
the option. When the Fund purchases an option, the premium paid by the Fund is recorded as an asset and is subsequently marked-to-market to reflect the current value of the option. Premiums paid for purchasing options which expire are treated as
realized losses. Premiums paid for purchasing options which are exercised or closed are added to the cost basis of the underlying investment or offset against the proceeds of the underlying investment transaction to determine realized gain or loss.
Purchasing call options tends to increase the Fund’s exposure to the underlying instrument. Purchasing put options tends to decrease the Fund’s exposure to the underlying instrument. The risks associated with purchasing options are limited
to premiums paid and the failure of the counterparty to honor its obligation under the contract. When the Fund writes a call or put option, the premium received by the Fund is recorded as a liability and is subsequently marked-to-market to reflect
the current value of the option. Premiums received from writing options which expire are treated as realized gains. Premiums received from writing options which are exercised or closed are added to the proceeds of the underlying investment
transaction or reduce the cost basis of the underlying investment to determine the realized
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
gain or loss. Writing call options tends to decrease the Fund’s exposure to the underlying instrument. Writing put options tends to increase the Fund’s exposure to the underlying
instrument. The risk associated with writing an option that is exercised is that an unfavorable change in the price of the security underlying the option could result in the Fund buying the underlying security at a price higher than the current
value or selling the underlying security at a price lower than the current market value. There is also the risk the Fund may not be able to enter into a closing transaction if the market is illiquid. Options written by the Fund do not give rise to
counterparty credit risk, as they obligate the Fund, not the counterparty, to perform.
The Fund may also buy and sell (“write”) call and
put options on futures, currencies and swaps agreements (“swaptions”). Swaptions are similar to options on securities except that instead of purchasing the right to buy or sell a security, the writer or purchaser of the swaption is
granting or buying the right to enter into a previously agreed upon interest rate swap agreement at any time before the expiration of the option. Swaptions are illiquid investments.
Options contracts involve, to varying degrees, risk of loss in excess of the premium paid or received recorded by the Fund. The primary risks associated
with the use of option contracts on futures contracts involve similar risks to trading in the underlying futures contracts, including the imperfect correlation between the change in value of the securities held by the Fund and the prices of the
underlying futures contracts and the possibility the Fund may not be able to enter into a closing transaction because of an illiquid market. Option contracts entered into by the Fund during the period were traded on public markets that are regulated
by the U.S. Commodity Futures Trading Commission (“CFTC”). Similar to futures contracts, counterparty risk to the Fund is reduced since the options on futures contracts traded by the Fund were exchange traded and the exchange’s
clearing house, as counterparty to all exchange traded options, guarantees the options contracts against default.
Forward Foreign Currency
Contracts.
The Fund may be subject to foreign currency exchange rate risk in the normal course of pursuing its investment objective. The Fund entered into forward foreign currency contracts to minimize foreign currency risk on
portfolio securities denominated in foreign currencies. A forward foreign currency contract is an agreement between two parties to buy and sell a currency at a set price on a future date. The use of forward foreign currency contracts does not
eliminate fluctuations in the underlying prices of the Fund’s portfolio securities, but it does establish a fixed rate of currency exchange that can be achieved in the future. The value of a forward foreign currency contract fluctuates with
changes in foreign currency exchange rates. Forward foreign currency contracts are marked-to-market daily and the change in value is recorded by the Fund as an unrealized gain or loss and as a receivable or payable from forward foreign currency
contracts. Upon settlement, or delivery or receipt of the currency, a realized gain or loss is recorded, which is equal to the difference between the value of the contract at the time it was opened and the value at the time it was closed. Forward
foreign currency contracts involve market risk in excess of the receivable or payable related to forward foreign currency contracts recorded by the Fund. Although contracts limit the risk of loss due to a decline in the value of the hedged currency,
they also limit any potential gain that might result should the value of the currency increase. Additionally, the Fund could be exposed to the risk of a previously hedged position becoming unhedged if the counterparty to a contract is unable to meet
the terms of the contract or if the value of the currency changes unfavorably to the offsetting currency.
Swap Agreements.
Swap
agreements are bilaterally negotiated agreements between the Fund and a counterparty to exchange or swap investment cash flows, assets, foreign currencies or market-linked returns at specified, future intervals. Swap agreements are privately
negotiated in the OTC market or may be executed and centrally cleared with a DCO. OTC swaps are typically illiquid investments.
Swap agreements are
marked-to-market daily and change in value is recorded by the Fund as an unrealized gain or loss. For OTC swaps, premiums paid or received at the beginning of the measurement period are recorded as an asset or liability by the Fund and represent
payments made or received upon entering into the OTC swap to compensate for differences between the stated terms of the OTC swap and prevailing market conditions relating to credit spreads, interest rates, currency exchange rates and other relevant
factors as appropriate. These upfront payments are recorded as a realized gain or loss upon termination or maturity of the OTC swap. For centrally cleared swaps, daily changes in the valuation are recorded as a receivable or payable, as appropriate,
and received from or paid to the DCO on a daily basis until the contracts are terminated at which time a realized
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
gain or loss is recorded. The use of centrally cleared swaps may require the Fund to commit more initial and variation margin than the Fund would otherwise commit under an OTC swap. A liquidation
payment received or made at the termination of the swap agreement is recorded as a realized gain or loss. Net periodic payments received or paid by the Fund are included as part of realized gain or loss.
Entering into swap agreements involves, to varying degrees, elements of interest, credit, market and documentation risk in excess of the unrealized gain
or loss recorded by the Fund. Such risks include that there is no liquid market for OTC swaps, that the counterparty to the agreements may default on its obligation to perform or disagree as to the meaning of contractual terms in the agreement and
that there may be unfavorable changes in interest rates or value of underlying securities. Centrally cleared swaps involve to varying degrees, risk of loss in excess of the variation margin recorded by the Fund.
Interest Rate Swap Agreements.
The Fund may be subject to interest rate risk in the normal course of pursuing its investment
objective. The Fund entered into interest rate swap agreements to manage duration, to manage interest rate and yield curve exposure and as a substitute for investment in physical securities. Interest rate swap agreements involve the exchange by the
Fund with another party of their respective commitments to pay or receive interest with respect to the notional amount of principal. Interest rate swap agreements that the Fund entered into include: fixed-for-floating rate swaps, under which a party
agrees to pay a fixed rate in exchange for receiving a floating rate tied to a benchmark and floating-for-fixed rate swaps, under which a party agrees to pay a floating rate in exchange for receiving a fixed rate.
The Fund’s maximum risk of loss from counterparty credit risk for an interest rate swap agreement is the discounted net value of the cash flows to
be received from the counterparty over the contract’s remaining life, to the extent this amount is positive.
Credit Default Swap
Agreements.
The Fund may be subject to credit risk in the normal course of pursuing its investment objective. The Fund used credit default swap agreements on corporate issues, sovereign issues and indices to manage credit exposure.
Credit default swap agreements involve one party making a stream of payments (referred to as the buyer of protection) to another party (the seller of protection) in exchange for the right to receive a specified return if a credit event occurs for
the referenced entity, obligation or index.
As a seller of protection, the Fund will generally receive from the buyer of protection a premium in
return for such protection and/or a fixed rate of income throughout the term of the swap if there is no credit event. A credit event is defined under the terms of each swap agreement and may include, but is not limited to, underlying entity default,
bankruptcy, restructuring, write-down, principal shortfall or interest shortfall. As a seller, the Fund adds leverage to its portfolio because, in addition to its total net assets, the Fund is subject to investment exposure on the notional amount of
the swap. If the Fund is a seller of protection and a credit event occurs, as defined under the terms of that particular swap agreement, the Fund will either pay to the buyer of protection an amount equal to the notional amount of the credit default
swap and take delivery of the referenced obligation, other deliverable obligations or underlying securities comprising the referenced index or pay a net settlement amount in the form of cash or securities equal to the notional amount of the credit
default swap less the recovery value of the referenced obligation or underlying securities comprising the referenced index. If the Fund is a buyer of protection and a credit event occurs, as defined under the terms of that particular credit default
swap agreement, the Fund will either receive from the seller of protection an amount equal to the notional amount of the credit default swap and deliver the referenced obligation, other deliverable obligations or underlying securities comprising the
referenced index or receive a net settlement amount in the form of cash or securities equal to the notional amount of the credit default swap less the recovery value of the referenced obligation or underlying securities comprising the referenced
index. Until a credit event occurs, recovery values are determined by market makers considering either industry standard recovery rates or entity specific factors and considerations. When a credit event occurs, the recovery value is determined by a
facilitated auction, administered by ISDA, whereby a minimum number of allowable broker bids, together with a specified valuation method, are used to calculate the settlement value.
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
The Fund may use credit default swap agreements on corporate or sovereign issues to provide a measure
of protection against defaults of an issuer (i.e., to reduce risk where the Fund owns or has exposure to the referenced obligation) or to take an active long or short position with respect to the likelihood of a particular issuer’s default. If
a credit event occurs and cash settlement is not elected, a variety of other deliverable obligations may be delivered in lieu of the specific referenced obligation. The ability to deliver other obligations may result in a cheapest-to-deliver option
(the buyer of protection’s right to choose the deliverable obligation with the lowest value following a credit event).
The Fund may use credit
default swap agreements on credit indices to hedge a portfolio of credit default swap agreements or bonds, to protect investors owning bonds against default and to speculate on changes in credit quality. A credit index is a basket of credit
instruments or exposures designed to represent a portion of the credit market. These indices consist of reference credits that are considered to be the liquid entities in the credit default swap market based on the index sector. Components of the
indices may include, but are not limited to, investment grade securities, high yield securities, asset-backed securities and emerging market securities. These components can be determined based upon various credit ratings within each sector. Credit
indices are traded using credit default swaps with standardized terms including a fixed spread and standard maturity dates. An index credit default swap references all the issuers in the index, and if there is a credit event, the credit event is
settled based on that issuer’s weight in the index. The composition of the indices changes periodically, usually every six months, and for most indices, each issuer has an equal weight in the index.
Either as a seller of protection or a buyer of protection of a credit default swap agreement, the Fund’s maximum risk of loss from counterparty
risk is the fair value of the agreement. The maximum potential amount of future payments (undiscounted) that the Fund as a seller of protection could be required to make under a credit default swap agreement would be an amount equal to the notional
amount of the agreement. Notional amounts of all credit default swap agreements outstanding, as of June 30, 2013, for which the Fund is a seller of protection, are disclosed in the Notes to the Investment Portfolio. These potential amounts
would be partially offset by any recovery values of the respective referenced obligations, upfront payments received upon entering into the agreement or net amounts received from the settlement of buy protection credit default swap agreements
entered into by the Fund for the same referenced entity or entities.
Derivative Instruments Categorized by Risk Exposure and Financial
Instruments Eligible for Offset.
The following tables include (1) a summary of the fair valuations of the Fund’s derivative instruments categorized by risk exposure, which references the location on the Statement of Assets
and Liabilities and the realized and unrealized gain or loss on the Statement of Operations for each derivative instrument as of June 30, 2013 and (2) a summary of derivative instruments and certain investments of the Fund, which are
subject to master netting agreements or a similar agreement and are eligible for offset in the Statement of Assets and Liabilities as of June 30, 2013.
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|
|
|
|
|
Credit Contracts
|
|
|
Foreign Exchange
Contracts
|
|
|
Interest Rate
Contracts
|
|
|
Total
|
|
|
|
|
|
|
|
|
Fair values of derivative instruments on the Statement of Assets and Liabilities as of June 30, 2013:
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Assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investments in securities, at value
1
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
273,187
|
|
|
$
|
273,187
|
|
|
Forward foreign currency contracts
|
|
|
—
|
|
|
|
404,952
|
|
|
|
—
|
|
|
|
404,952
|
|
|
Variation margin on financial derivative instruments
|
|
|
—
|
|
|
|
—
|
|
|
|
22,879
|
|
|
|
22,879
|
|
|
Unrealized appreciation on OTC swap agreements
|
|
|
251,904
|
|
|
|
—
|
|
|
|
178,064
|
|
|
|
429,968
|
|
|
OTC swap premiums paid
|
|
|
33,795
|
|
|
|
—
|
|
|
|
21,845
|
|
|
|
55,640
|
|
|
|
|
|
|
|
|
|
|
$
|
285,699
|
|
|
$
|
404,952
|
|
|
$
|
495,975
|
|
|
$
|
1,186,626
|
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Written options, at value
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
523,005
|
|
|
$
|
523,005
|
|
|
Forward foreign currency contracts
|
|
|
—
|
|
|
|
395,925
|
|
|
|
—
|
|
|
|
395,925
|
|
|
Variation margin on financial derivative instruments
|
|
|
29,332
|
|
|
|
—
|
|
|
|
2,356
|
|
|
|
31,688
|
|
|
Unrealized depreciation on OTC swap agreements
|
|
|
70,898
|
|
|
|
—
|
|
|
|
885,967
|
|
|
|
956,865
|
|
|
OTC swap premiums received
|
|
|
335,863
|
|
|
|
—
|
|
|
|
32,602
|
|
|
|
368,465
|
|
|
|
|
|
|
|
|
|
|
$
|
436,093
|
|
|
$
|
395,925
|
|
|
$
|
1,443,930
|
|
|
$
|
2,275,948
|
|
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Credit Contracts
|
|
|
Foreign Exchange
Contracts
|
|
|
Interest Rate
Contracts
|
|
|
Total
|
|
|
|
|
|
|
|
|
The effect of derivative instruments on the Statement of Operations for the period ended June 30, 2013:
|
|
|
Net realized gain (loss) on:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investment transactions
1
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
Futures contracts and exchange traded option contracts
|
|
|
—
|
|
|
|
—
|
|
|
|
6,952
|
|
|
|
6,952
|
|
|
Swap agreements
|
|
|
1,055,109
|
|
|
|
—
|
|
|
|
267,690
|
|
|
|
1,322,799
|
|
|
Written option contracts
|
|
|
—
|
|
|
|
—
|
|
|
|
3,115
|
|
|
|
3,115
|
|
|
Forward foreign currency contracts
|
|
|
—
|
|
|
|
100,945
|
|
|
|
—
|
|
|
|
100,945
|
|
|
|
|
|
|
|
|
|
|
$
|
1,055,109
|
|
|
$
|
100,945
|
|
|
$
|
277,757
|
|
|
$
|
1,433,811
|
|
|
Net change in unrealized appreciation (depreciation) on :
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investments
1
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
112,203
|
|
|
$
|
112,203
|
|
|
Futures contracts and financial derivative instruments
|
|
|
343,274
|
|
|
|
—
|
|
|
|
(246,272)
|
|
|
|
97,002
|
|
|
OTC swap agreements
|
|
|
(417,513)
|
|
|
|
—
|
|
|
|
(1,027,200)
|
|
|
|
(1,444,713)
|
|
|
Written options contracts
|
|
|
—
|
|
|
|
—
|
|
|
|
(317,705)
|
|
|
|
(317,705)
|
|
|
Forward foreign currency contracts
|
|
|
—
|
|
|
|
187,426
|
|
|
|
—
|
|
|
|
187,426
|
|
|
|
|
|
|
|
|
|
|
$
|
(74,239)
|
|
|
$
|
187,426
|
|
|
$
|
(1,478,974)
|
|
|
$
|
(1,365,787)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross Amount
Presented in
the Statements
of Assets and
|
|
|
Financial
Instruments
3
|
|
|
Collateral
4
|
|
|
Net Amount
5
|
|
|
Collateral
6
|
|
|
|
|
Liabilities
2
|
|
|
|
|
|
Cash
|
|
|
Security
|
|
|
|
|
|
|
|
|
|
|
|
|
Derivative Assets by Counterparty
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
BOA
|
|
$
|
22,588
|
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
22,588
|
|
|
$
|
-
|
|
|
$
|
-
|
|
|
BBP
|
|
|
373,206
|
|
|
|
(81,979)
|
|
|
|
-
|
|
|
|
291,227
|
|
|
|
-
|
|
|
|
-
|
|
|
BCL
|
|
|
313,120
|
|
|
|
(311,875)
|
|
|
|
-
|
|
|
|
1,245
|
|
|
|
-
|
|
|
|
-
|
|
|
Exchange cleared derivatives
8
|
|
|
22,880
|
|
|
|
-
|
|
|
|
-
|
|
|
|
22,880
|
|
|
|
-
|
|
|
|
-
|
|
|
GSC
|
|
|
242,356
|
|
|
|
(234,574)
|
|
|
|
-
|
|
|
|
7,782
|
|
|
|
-
|
|
|
|
-
|
|
|
GSI
|
|
|
212,476
|
|
|
|
(56,671)
|
|
|
|
-
|
|
|
|
155,805
|
|
|
|
-
|
|
|
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$
|
1,186,626
|
|
|
$
|
(685,099)
|
|
|
$
|
-
|
|
|
$
|
501,527
|
|
|
$
|
-
|
|
|
$
|
-
|
|
|
Derivative Liabilities by Counterparty
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
BBP
|
|
$
|
104,034
|
|
|
$
|
(81,979)
|
|
|
$
|
(22,055)
|
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
129,009
|
|
|
BCL
|
|
|
671,050
|
|
|
|
(311,875)
|
|
|
|
-
|
|
|
|
359,175
|
|
|
|
-
|
|
|
|
-
|
|
|
Exchange cleared derivatives
8
|
|
|
31,688
|
|
|
|
-
|
|
|
|
(31,688)
|
|
|
|
-
|
|
|
|
36,000
|
|
|
|
1,134,296
|
|
|
GSC
|
|
|
1,145,434
|
|
|
|
(234,574)
|
|
|
|
(910,860)
|
|
|
|
-
|
|
|
|
-
|
|
|
|
1,216,793
|
|
|
GSI
|
|
|
323,742
|
|
|
|
(56,671)
|
|
|
|
-
|
|
|
|
267,071
|
|
|
|
-
|
|
|
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$
|
2,275,948
|
|
|
$
|
(685,099)
|
|
|
$
|
(964,603)
|
|
|
$
|
626,246
|
|
|
$
|
36,000
|
|
|
$
|
2,480,098
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross Amount of
Investment Liabilities
Presented in
the
Statement of Assets and
Liabilities
7
|
|
|
Gross Amount of
Investment Assets
Presented in the
Statement of
Assets and
Liabilities
7
|
|
|
Collateral
Requirement
|
|
|
Collateral
4
|
|
|
Net
Liability
5
|
|
|
|
|
|
|
|
|
Master Forward Agreement Transactions by Counterparty
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
GSC
|
|
$
|
27,694,395
|
|
|
$
|
27,595,781
|
|
|
$
|
(98,614
|
)
|
|
$
|
-
|
|
|
$
|
98,614
|
|
|
|
|
|
|
|
|
|
|
$
|
27,694,395
|
|
|
$
|
27,595,781
|
|
|
$
|
(98,614
|
)
|
|
$
|
-
|
|
|
$
|
98,614
|
|
1
Purchased options market value is reflected in Investments, at
value. Realized gain (loss) and change in unrealized appreciation (depreciation) on purchased options are reflected in realized gain (loss) on investments and change in unrealized appreciation (depreciation) on investments, respectively, in the
Statement of Operations.
|
2
|
Amounts eligible for offset are presented gross in the Statement of Assets and Liabilities.
|
|
3
|
Financial instruments eligible for offset but not offset in the Statement of Assets and Liabilities.
|
4
Cash and security collateral not offset in the Statement of Assets and Liabilities. Amounts do not reflect over-collateralization.
5
For assets, net amount represents the amount payable by the counterparty to the Fund in the
event of default. For liabilities, net amount represents the amount payable by the Fund to the counterparty in the event of default.
6
Cash and security collateral pledged or segregated for investments. For assets, amount reflects collateral received from or segregated by the counterparty. For liabilities, amount reflects collateral
pledged or segregated by the Fund.
7
Investment liabilities and assets include delayed
delivery securities and secured borrowings which are reflected at value. Investment liabilities represent amounts payable to the counterparty for unsettled investments. Investment assets represent settled investments. Investments are marked to
market daily and the net unrealized gain or loss constitutes the amount which is subject to margin or collateral requirements as required under the Master Forward Agreement.
|
8
|
Exchange cleared derivatives are recognized on the Statement of Assets and Liabilities at the daily variation margin.
|
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
The derivative instruments outstanding as of June 30, 2013, as disclosed in the Notes to the
Investment Portfolio and the amounts of realized and changes in unrealized gains and losses on derivative instruments during the period ended June 30, 2013, as disclosed in the Statement of Operations, serve as indicators of the volume of
derivative activity for the Fund. For the period ended June 30, 2013, the average monthly volume for derivatives is as follows:
|
|
|
|
|
|
|
Options Purchased and Written
|
|
|
|
|
|
Premiums Paid
(1)
|
|
$
|
174,446
|
|
|
Premiums Received
(1)
|
|
|
203,175
|
|
|
Futures Contracts
|
|
|
|
|
|
Long
(2)
|
|
|
24,958,577
|
|
|
Short
(2)
|
|
|
-
|
|
|
Forward Foreign Currency Contracts
|
|
|
|
|
|
Purchased
(1)
|
|
|
10,915,520
|
|
|
Sold
(1)
|
|
|
24,867,846
|
|
|
Interest Rate Swap Agreements
|
|
|
|
|
|
Paying Floating Rate
(3)
|
|
|
37,987,958
|
|
|
Receiving Floating Rate
(3)
|
|
|
-
|
|
|
Credit Default Swap Agreements
|
|
|
|
|
|
Purchase Protection
(3)
|
|
|
-
|
|
|
Sell Protection
(3)
|
|
|
90,171,593
|
|
|
2
|
Notional value at purchase in USD
|
G. Regulatory Matters
On February 8, 2012, the CFTC adopted amendments to its existing part 4 regulations, effective January 1, 2013. Previously, investment
companies were excluded from the definition of a “commodity pool operator” (“CPO”) under Rule 4.5 and did not have to register with the CFTC and the National Futures Association. The amendments added certain conditions to Rule
4.5 that narrowed the exclusion from registration. The Fund is not currently considered a CPO and is not required to register as such. However, if, in the future, the Fund fails to meet the conditions of the exclusion, the Fund may determine either
to restrict its activities so that it will meet those conditions or to incur the additional regulatory burden and expense associated with registration as a CPO.
H. Purchases and Sales of Securities
During the period
ended June 30, 2013, purchases and sales of investment securities, excluding U.S. government obligations and short-term investments, aggregated $9,954,075 and $32,577,214, respectively. During the period ended June 30, 2013, purchases and
sales of long-term U.S. government obligations aggregated $18,087,689 and $12,376,982 respectively.
Subject to compliance with Rule 17a-7 under the
1940 Act, the Adviser is permitted to cause the Fund to purchase securities from or sell securities to another account, including another investment company, advised by the Adviser.
There are occasions when portfolio transactions for the Fund are executed as part of concurrent authorizations to purchase or sell the same security for
the Fund and for other accounts served by the Adviser or an affiliated company. They are effected only when the Adviser believes that to do so is in the best interest of the Fund and the other accounts participating. When such concurrent
authorizations occur, the executions will be allocated in an equitable manner.
I. Fees and Agreements
Investment Advisory Agreement.
Pursuant to an Investment Advisory Agreement, the Fund pays PIMCO a quarterly fee at the annual rate of
0.25% of the average daily net assets of the Fund.
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
Fund Accounting and Administration Services Agreement.
Pursuant to a Fund
Accounting and Administration Services Agreement, the Fund pays JFS an annual fee, payable monthly, equal to 0.25% of the average daily value of the net assets of the Fund up to $100 million; 0.20% of the average daily value of the net assets of the
Fund from $100 million to $200 million; and 0.15% of the average daily value of the net assets of the Fund over $200 million. JFS makes individuals available to the Fund to serve as its officers. Officers are not directly compensated by the Fund.
Directors’ Fees and Expenses.
The Fund pays each Director of the Board a specified retainer fee plus specified
amounts for each Board and Committee meeting attended.
J. Income Tax Matters
The following information is presented on an income tax basis. The timing and characterization of certain income and capital gains are determined in
accordance with federal tax regulations, which may differ from GAAP. These differences primarily relate to timing differences in recognizing certain gains and losses on investment transactions and accounting treatment for notional principal
contracts. To the extent that differences arise that are permanent in nature, such amounts are reclassified within the components of net assets on the Statement of Assets and Liabilities based on their federal income tax treatment; timing
differences do not require reclassification. Permanent differences may include but are not limited to the following: expired capital loss carryforwards, foreign currency reclassifications, paydown reclassifications, net operating losses, accounting
treatment of notional principal contracts and distribution adjustments. Timing and permanent differences do not impact the NAV of the Fund.
At
June 30, 2013, the cost of investments and the components of net unrealized appreciation/(depreciation) were as follows:
|
|
|
|
|
|
|
|
|
Cost of
Investments
|
|
Gross Unrealized
Depreciation
|
|
Gross Unrealized
Appreciation
|
|
Net Unrealized
Depreciation
|
|
$189,063,393
|
|
$(3,884,625)
|
|
$5,233,207
|
|
$1,348,582
|
The distributions paid of $8,811,954 for the year ended December 31, 2012, were from net ordinary income.
The Regulated Investment Company Modernization Act of 2010 (“Act”) was enacted on December 22, 2010. Under the Act, the Fund is permitted
to carry forward capital losses for an unlimited period. However, any losses incurred during those future taxable years are required to be utilized prior to the losses incurred in pre-enactment taxable years. As a result of this ordering rule,
pre-enactment capital loss carry forwards may be more likely to expire unused. Additionally, post-enactment capital losses that are carried forward will retain their character as either short-term or long-term capital losses, and will not be
considered exclusively short-term as under previous law.
At December 31, 2012, the Fund’s last fiscal year end, the Fund had unused
pre-enactment capital loss carryforwards available for federal income tax purposes which may be applied against any future realized net taxable capital gains or until the respective expiration dates occur as noted below.
|
|
|
|
|
Years of
Expiration
|
|
Amount
|
|
2016
|
|
$9,694,440
|
|
2017
|
|
11,494,100
|
|
Total
|
|
$21,188,540
|
The Fund had $126,612 of currency losses realized from November 1, 2012, through December 31, 2012, which were
deferred for tax purposes to January 1, 2013, the first day of the current fiscal year.
FASB ASC Topic 740, “Income Taxes”, provides
guidance for how uncertain tax positions should be recognized, measured, presented and disclosed in the financial statements. FASB ASC Topic 740 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the
Fund’s tax returns to determine whether
Montgomery Street Income Securities, Inc.
(Unaudited)
Notes to Financial Statements
June 30, 2013
the tax positions are “more-likely-than-not” of being sustained by the applicable tax authority. Tax positions not deemed to meet the “more-likely-than-not” threshold would
result in the Fund recording a tax expense in the current year. FASB ASC Topic 740 requires that management evaluate the tax positions taken in returns for 2009 through 2012 which remain subject to examination, by the Internal Revenue Service and
certain other jurisdictions. Management completed an evaluation of the Fund’s tax positions and based on that evaluation, determined that no provision for federal income tax was required in the Fund’s financial statements during the period
ended June 30, 2013.
K. Share Repurchases
Under
the Fund’s limited repurchase program, the Fund is authorized to effect repurchases of its shares in the open market from time to time when the Fund’s shares trade at a discount to their NAV. During the period ended June 30, 2013, the
Fund purchased 14,000 shares of common stock on the open market at a total cost of $240,226. The weighted average discount of these purchases, comparing the purchase price to the NAV at the time of purchase, was 7.92%. During the year ended
December 31, 2012, the Fund purchased 21,000 shares of common stock on the open market at a total cost of $343,385. The weighted average discount of these purchases, comparing the purchase price to the NAV at the time of purchase, was 8.88%.
L. Subsequent Events
Management has evaluated
subsequent events for the Fund through the date the financial statements are issued, and has concluded there are no events that require financial statement disclosure and/or adjustments to the financial statements.
Montgomery Street Income Securities, Inc.
(Unaudited)
Dividend Reinvestment and Cash Purchase Plan (the “Plan”)
June 30, 2013
All registered stockholders of the Fund’s
Common Stock are offered the opportunity of participating in the Plan. Registered stockholders, on request or on becoming registered stockholders, are mailed information regarding the Plan, including a form by which they may elect to participate in
the Plan and thereby cause their future net investment income dividends and capital gains distributions to be invested in shares of the Fund’s common stock. The Custodian is the agent (the “Plan Agent”) for stockholders who elect to
participate in the Plan.
If a stockholder chooses to participate in the Plan, the stockholder’s dividends and capital gains distributions will
be promptly invested, automatically increasing the stockholder’s holdings in the Fund. If the Fund declares a dividend or capital gains distributions payable either in cash or in stock of the Fund, the stockholder will automatically receive
stock. If the market price per share on the payment date for the dividend (the “Valuation Date”) equals or exceeds the net asset value per share, the Fund will issue new shares to the stockholder at the greater of the following on the
Valuation Date: (a) net asset value per share or (b) 95% of the market price per share. If the market price per share on the Valuation Date is less than the net asset value per share, the Fund will issue new shares to the stockholder at
the market price per share on the Valuation Date. In either case, for federal income tax purposes the stockholder will be deemed to receive a distribution equal to the market value on the Valuation Date of the new shares issued. If dividends or
capital gains distributions are payable only in cash, then the stockholder will receive shares purchased on the New York Stock Exchange or otherwise on the open market. In this event, for federal income tax purposes the amount of the distribution
will equal the cash distribution paid. State and local taxes may also apply. All reinvestments are in full and fractional shares, carried to three decimal places.
Stockholders participating in the Plan can also purchase additional shares quarterly in any amount from $100 to $5,000 (a “Voluntary Cash
Investment”) by sending in a check together with the cash remittance slip, which will be sent with each statement of the stockholder’s account, to Computershare, the Fund’s transfer agent (the “Transfer Agent”). Such
additional shares will be purchased on the open market by the Plan Agent or its delegate. The purchase price of shares purchased on the open market, whether pursuant to a reinvestment of dividends payable only in cash or a Voluntary Cash Investment,
will be the average price (including brokerage commissions) of all shares purchased by the Plan Agent or its delegate on the date such purchases are affected. In addition, stockholders may be charged a service fee in an amount up to 5% of the value
of the Voluntary Cash Investment. Although subject to change, stockholders are currently charged $1 for each Voluntary Cash Investment.
Stockholders may terminate their participation in the Plan at any time and elect to receive dividends and other distributions in cash by notifying the
Transfer Agent in writing. Such notification must be received not less than 10 days prior to the record date of any distribution. There is no charge or other penalty for such termination. The Plan may be terminated by the Fund upon written notice
mailed to the stockholders at least 30 days prior to the record date of any distribution. Upon termination, the Fund will issue certificates for all full shares held under the Plan and cash for any fractional share.
Alternatively, stockholders may request the Transfer Agent to instruct the Plan Agent or its delegate to sell any full shares and remit the proceeds,
less a $2.50 service fee and less brokerage commissions. The sale of shares (including fractional shares) will be a taxable event for federal income tax purposes and may be taxable for state and local tax purposes.
The Plan may be amended by the Fund at any time. Except when required by law, written notice of any amendment will be mailed to stockholders at least 30
days prior to its effective date. The amendment will be deemed accepted unless written notice of termination is received by the Transfer Agent prior to the effective date.
An investor holding shares in its own name can participate directly in the Plan. An investor holding shares in the name of a brokerage firm, bank or
other nominee should contact that nominee, or any successor nominee, to determine whether the nominee can participate in the Plan on the investor’s behalf and to make any necessary arrangements for such participation.
Additional information, including a copy of the Plan and its Terms and Conditions and an enrollment form, can be obtained from the Transfer Agent by
writing Computershare, P.O. Box 43006, Providence, RI 02940-3006, or by calling
(877) 437-3938.
Montgomery Street Income Securities, Inc.
(Unaudited)
June 30, 2013
Stockholder Meeting Results
The Annual Meeting of Stockholders of the Fund was held on July 23, 2013 at 4 Embarcadero Center, 22nd Floor, San Francisco, California. At the
meeting, the following matter was voted upon and approved by the stockholders: To elect four Directors of the Fund to hold office until the next annual meeting or until their respective successors shall have been duly elected and qualified.
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Number of Votes:
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Directors
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For
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Withheld
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Richard J. Bradshaw
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7,722,190
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1,460,321
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Victor L. Hymes
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7,988,280
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1,194,231
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Wendell G. Van Auken
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7,721,558
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1,460,952
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Nancy E. Wallace
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7,966,662
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1,215,849
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Directors and Officers
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DIRECTORS
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OFFICERS
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RICHARD J. BRADSHAW
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MARK D. NERUD
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Chairman
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President and Chief Executive Officer
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VICTOR L. HYMES
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DANIEL W. KOORS
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Treasurer and Chief Financial Officer
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WENDELL G. VAN AUKEN
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DIANA R. GONZALEZ
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Chief Legal Officer
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NANCY E. WALLACE
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JOSEPH B. O’BOYLE
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Chief Compliance Officer
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EMILY J. BENNETT
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Secretary
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DANIELLE A. BERGANDINE
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Assistant Secretary
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Montgomery Street Income Securities, Inc.
(Unaudited)
Investment Advisory Agreement Approval
June 30, 2013
At a meeting held on April 23, 2013, the Board, including the Directors of the Fund who were not parties to the agreement or “interested
persons” of any such party as defined in the Investment Company Act of 1940, as amended (“1940 Act”), (the “Independent Directors”), voted to continue the Investment Advisory Agreement (the “Agreement”) with PIMCO
until July 31, 2014.
In reviewing the advisory agreement, the Board considered, among other information, the written and oral reports provided
by PIMCO, Jackson Fund Services (“JFS”), FactSet Research Systems Inc., and Lipper Inc. In addition, the Board took into account information provided at previous meetings and information provided about PIMCO and other potential advisers
developed in connection with the Board’s search for a new adviser in 2010.
Nature, Extent, and Quality of
Services.
The Board examined the nature, extent, and quality of the advisory services provided and to be provided to the Fund by PIMCO. The Board considered the terms of the advisory agreement, the experience and
qualifications of PIMCO and its personnel in managing fixed-income instruments, PIMCO’s investment strategy for the Fund, and the risk profile of the Fund’s investments. The Board also considered the experience of PIMCO in managing open-
and closed-end funds, the availability and responsiveness of PIMCO’s personnel, the extent and quality of information provided by PIMCO to the Board, PIMCO’s compliance policies and procedures and attention to compliance matters, and the
extent of any regulatory issues relating to PIMCO or its affiliates. Further, the Board considered the stability of the PIMCO organization and turnover in its personnel, the overall commitment of PIMCO to the Fund, and the general financial
condition, resources, and reputation of PIMCO and its parent. The Board was generally satisfied with the nature, extent, and quality of the advisory services provided to the Fund.
Investment Performance.
The Board reviewed the investment performance of PIMCO over various periods compared to the
performance of relevant indices, of a peer group of other similar funds, and of composite fund accounts of PIMCO using similar investment strategies. The Board also reviewed with PIMCO and JFS the ways in which the investment strategies employed by
PIMCO had contributed to its investment performance. The performance data showed, among other things, that the Fund outperformed the Barclays Capital U.S. Aggregate Bond Index, the Barclays Capital U.S. Credit Index, and the average of its peer fund
group for the one-year period ended March 31, 2013 and the period from March 31, 2010 (inception of PIMCO management) to December 31, 2012.
Cost of Services.
The Board examined the cost of the services provided and to be provided to the Fund by PIMCO, including
expense information concerning the peer group of other similar funds and of fund and non-fund accounts of PIMCO employing similar investment strategies. The advisory fee charged by PIMCO was generally comparable to that charged to other PIMCO fund
and non-fund accounts. The advisory fee charged by PIMCO was also comparable to the advisory fee charged by the Fund’s prior investment adviser, as well as to the advisory fees proposed by the other adviser candidates considered by the Board in
connection with its 2010 search. The Board concluded that the advisory fees charged by PIMCO generally were competitive.
Profits
Realized.
The Board considered profits realized and to be realized by PIMCO from its relationship with the Fund and reviewed an estimate prepared by PIMCO. The Board acknowledged the inherent limitations of profitability
analyses, including their reliance on various allocations and assumptions. The Board recognized that PIMCO was entitled to earn a profit for the services it furnishes and concluded that the profit estimated to be earned by PIMCO would not be
excessive.
Economies of Scale.
The Board considered the extent to which economies of scale could be realized as the
Fund grows and whether the advisory fee charged by PIMCO reflects any such economies of scale. It was noted that, as a closed-end fixed income fund making regular dividend distributions, the assets of the Fund were not expected to increase
materially. Accordingly, the Board had negotiated with PIMCO a fixed fee rate taking into account the then-current size of the Fund. In the event the size of the Fund does increase materially in the future, the Board will consider whether the
advisory fee should be adjusted to reflect any economies of scale.
Montgomery Street Income Securities, Inc.
(Unaudited)
Investment Advisory Agreement Approval
June 30, 2013
Other Benefits.
The Board recognized that PIMCO and its affiliates may
derive other benefits from its relationship with the Fund, including the use of the Fund’s performance record in marketing other products, the inclusion of the Fund on its client list, and the aggregation of the Fund’s purchase orders with
other accounts.
In addition to the foregoing factors, among others, the Board considered its ability to terminate the advisory agreement on sixty
days’ notice. In its deliberations, the Board did not identify any particular factor or factors that were all-important or controlling, and each Director assigned different weights to the various factors considered.
Montgomery Street Income Securities, Inc.
(Unaudited)
General Information
June 30, 2013
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Investment
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Pacific Investment Management Company LLC
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Adviser
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840 Newport Center Drive
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Newport Beach, CA 92660
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Administrator
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Jackson Fund Services
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225 West Wacker Drive
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Chicago, IL 60606
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Transfer Agent
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Computershare
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P.O. Box 43006
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Providence, RI 02940-3006
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(Tel) 1/877/437-3938
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Custodian
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The Bank of New York Mellon Corporation
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One Mellon Center
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Pittsburgh, PA 15258
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Legal Counsel
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Pillsbury Winthrop Shaw Pittman LLP
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Four Embarcadero Center
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San Francisco, CA 94111
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Montgomery Street Income Securities, Inc.
(Unaudited)
Privacy Policy Statement
June 30, 2013
The Fund considers the privacy of its stockholders to be of fundamental importance and has established a policy to maintain the privacy of the
information you share with us. In addition, the Fund relies on the privacy and customer information protection policies and procedures of its service providers.
Personal information we collect
We do not sell any
information to any third parties. However, we may collect and retain certain nonpublic personal information about you, including:
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Information we receive from broker-dealers, investment advisers, the Fund’s transfer agent, and the Fund’s dividend reinvestment plan administrator (such as a stockholder’s name, address and tax
identification number);
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An address received from a third party when a stockholder has moved; and
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Account balance and transaction activity.
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Personal information we may disclose
We may occasionally disclose nonpublic personal information about you to affiliates and non-affiliates as permitted by law. Instances when we may share
information include:
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Disclosing information to a third party in order to process account transactions that you request or authorize;
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Disclosing your name and address to companies that mail Fund related materials, such as stockholder reports and proxy materials; and
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Disclosing information in connection with regulatory inquiries and legal proceedings, such as responding to a request for information or subpoena.
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When information is shared with third parties, they are not permitted to use the information for any purpose other than to assist our servicing of your
account(s) or as permitted by law. If you close your account(s) or if we lose contact with you, we will continue to share information in accordance with our current privacy policy and practices. We restrict access to your nonpublic personal
information to authorized agents, including employees of the Fund’s administrator who need to know that information to provide services to the Fund and its stockholders. We maintain physical, electronic and procedural safeguards that comply
with federal standards to guard your nonpublic personal information.
These measures reflect our commitment to maintaining the privacy of your
nonpublic personal information. We appreciate the confidence you have shown by entrusting us with your assets.
If you would like to learn more or
have any questions about our privacy practices, please contact the Fund at the following address:
Montgomery Street Income Securities, Inc.
c/o Jackson Fund Services
225 W. Wacker Drive, Suite
1200
Chicago, IL 60606
Effective: August 31, 2007
Jackson Fund Services
225 West Wacker Drive Suite 1200
Chicago, IL 60606
Presorted Standard
U.S. Postage
PAID
Lancaster, PA
Permit No. 1313
MSIS
(42065 6/13)