The chart that follows shows the allocation of the Funds holdings by asset category as of November 30, 2005.
THE HYPERION STRATEGIC MORTGAGE INCOME FUND, INC.
* | As a percentage of total investments. |
1
We welcome this opportunity to provide you with information about The Hyperion Strategic Mortgage Income Fund, Inc. (the Fund), for the fiscal year ended November 30, 2005. The Fund is a closed-end bond fund whose shares are traded on the New York Stock Exchange (NYSE) under the symbol HSM.
Description of the Fund
The Fund is a diversified closed-end management investment company. The Funds primary investment objective is to provide a high level of current income by investing primarily in mortgage-backed securities that offer an attractive combination of credit quality, yield and maturity. The Funds secondary investment objective is to provide capital appreciation. Under normal market conditions, the Fund will invest at least 80% of its total assets in investment-grade mortgage-backed securities (MBS) including Agency MBS, Non-Agency Residential MBS (RMBS), and Commercial MBS (CMBS), and may invest up to 20% of its total assets in U.S. Government securities, cash or other short-term instruments.
Portfolio Performance
For the fiscal year ending November 30, 2005, shareholders realized a total investment return of -5.20%, which assumes the reinvestment of dividends and is exclusive of brokerage commissions. Based on the NYSE closing price of $12.70 on November 30, 2005, the Funds shares had a current yield of 7.69%.
As of November 30, 2005, the Fund, inclusive of the effect of leverage, was managed with an average duration (a bonds duration is the weighted average number of years until maturity of all its cash flows, including coupon payments and principal) of 3.6 years, as measured on a net asset basis.
Market Outlook and Portfolio Strategy
2005 witnessed the continued resolve of the Federal Reserve to raise interest rates in an attempt to bring monetary policy towards a more neutral stance. Eight interest rate tightenings occurred in 2005 and it had its most dramatic affect on short-term interest rates where the yield on the 2-year Treasury increased by 123 bps over the year. A nominal increase in longer term interest rates of 15 bps was witnessed by the 10-year maturity Treasury. The tepid increase in long-term interest rates, especially when compared to the move of short-term interest rates, can be a result of many factors, but we cite lower than expected core (excluding food and energy) inflation and moderate economic growth as the primary factors.
We believe that 2006 will be a transition period for the U. S. economy and for U.S. bonds. The key for the economy is the consumer they make up over 70% of GDP and as a result, as the consumer goes so does the economy, and as the economy goes, so do interest rates. We believe that rising oil prices, reduced savings, increased consumer debt and an increase in mortgage costs due to resetting interest rates on short-term hybrid mortgages will weigh heavily on the consumer in the second half of 2006. We believe this will lead to a slowdown in the economy. We also believe that the Federal Reserve will react by first halting their tightening of monetary policy by the second quarter, and even begin to lower interest rate targets by the fourth quarter. It would not surprise us to see interest rates dip low enough to cause another dramatic wave of mortgage refinancings. After all, it has been these refinancings that have bailed out the consumer, which have in turn bailed out the economy. It is too early for us to call whether a full fledged recession will occur, but we do see headwinds against the economy forming.
Budget deficits, trade deficits, increased governmental borrowings, and a weak currency are all factors that can push interest rates higher, but we view these as long-term factors that have the potential to have a dramatic effect on interest rates. However, we believe that our dominate position in the world economy would have to dramatically change before these factors come into play. In the mean time, the focus is on the economy, and right now, at 75% of GNP, our focus is on the consumer.
Much has been written about the housing bubble over the last few months, and while the Fund does invest in mortgages backed by residential homes, our view is as follows: There has rarely been (if any) a simultaneous decline in home prices across the nation. Home price declines have typically been localized to specific regions of the country and are triggered by
2
economic conditions that are unique to the specific geographic area. Having said that, we are extremely aware of the risks of certain areas of the country where home prices have dramatically exceeded the affordability characteristics of the borrowers. There are, however, ways for us to manage those risks. For example, we have been reviewing the structures of the securities in which we invest, moving up in credit, reviewing the borrowers, being cognizant of the vintage of securities in which we invest, and insuring that we invest in securities that have a diversified exposure across the country. These are but a few of the ways we can mitigate the risks in the investments that we make for the Fund.
The markets risk aversion away from residential MBS in 2005 caused an underperformance of the sector. This is a situation that we view as an opportunity to take selective positions in specific securities at attractive yield levels. We expect this scenario to continue to play out in 2006 as more stress is brought onto the consumer. As these opportunities present themselves, we expect to capitalize.
From a Fund duration point of view, we have been managing the portfolio to a conservative 3.6 years, a strategy that served us well in 2005. With our outlook for 2006, we intend to bring the duration more in line with its longer term target of between 4.0 and 4.5 years.
The sector allocation of the Fund reflects changes made to take advantage of opportunities in the market. Some below-investment-grade older issued CMBS holdings were sold at investment-grade levels to take advantage of their strong performance. Their performance was due to their higher subordination at issuance in 2000-2002, the overall rise in value of commercial real estate, and favorable lease roll-over rates. These sales had the impact of reducing our below-investment-grade exposures which we offset by buying some selected securities in the RMBS and ABS sectors. Finally, pass-throughs paid down and the proceeds from those paydowns, along with the CMBS sales, have been placed in Treasuries while we wait for other higher-yielding RMBS and ABS opportunities.
3
Conclusion
We remain committed to the Fund and its shareholders. As always, we will continue to actively seek investment opportunities in the market and act on them in a timely fashion in an effort to achieve the Funds objectives. We welcome your questions and comments, and encourage you to contact our Shareholder Services Representatives at 1-800-HYPERION.
We appreciate the opportunity to serve your investment needs.
Sincerely, | |
/s/ CLIFFORD E. LAI | |
CLIFFORD E. LAI President, The Hyperion Strategic Mortgage Income Fund, Inc. President and Chief Executive Officer, Hyperion Capital Management, Inc. |
|
/s/ JOHN H. DOLAN | |
JOHN H. DOLAN | |
Vice President, The Hyperion Strategic Mortgage Income Fund, Inc. Chief Investment Officer, Hyperion Capital Management, Inc. |
4
THE HYPERION STRATEGIC MORTGAGE INCOME FUND, INC. | |||||||||||||||||
Portfolio of Investments | |||||||||||||||||
Principal | |||||||||||||||||
November 30, 2005 | Interest | Amount | Value | ||||||||||||||
Rate | Maturity | (000s) | (Note 2) | ||||||||||||||
U.S. GOVERNMENT & AGENCY OBLIGATIONS 76.7% | |||||||||||||||||
U.S. Government Agency Pass-Through Certificates 57.5% | |||||||||||||||||
Federal Home Loan Mortgage Corporation
|
|||||||||||||||||
Pool A14559
|
6.50 | % | 09/01/33 | $ | 2,370 | $ | 2,424,877 | ||||||||||
Pool C68878
|
7.00 | 06/01/32 | 501 | 522,647 | |||||||||||||
Pool C69047
|
7.00 | 06/01/32 | 1,133 | 1,180,729 | |||||||||||||
Pool G01466
|
9.50 | 12/01/22 | 1,364 | 1,496,679 | |||||||||||||
Pool 555559
|
10.00 | 03/01/21 | 1,448 | 1,611,356 | |||||||||||||
7,236,288 | |||||||||||||||||
Federal National Mortgage Association
|
|||||||||||||||||
Pool 29596
|
5.50 | 12/01/99 | 5,000 | 4,923,440 | |||||||||||||
Pool 694391
|
5.50 | 03/01/33 | 3,833 | 3,784,045 | |||||||||||||
Pool 753914
|
5.50 | 12/01/33 | 8,969 | @ | 8,855,715 | ||||||||||||
Pool 754355
|
6.00 | 12/01/33 | 5,385 | @ | 5,417,945 | ||||||||||||
Pool 761836
|
6.00 | 06/01/33 | 3,173 | 3,194,345 | |||||||||||||
Pool 763643
|
6.00 | 01/01/34 | 7,719 | @ | 7,766,242 | ||||||||||||
Pool 255413
|
6.50 | 10/01/34 | 9,486 | @ | 9,714,424 | ||||||||||||
Pool 323982
|
6.50 | 10/01/06 | 295 | 297,428 | |||||||||||||
Pool 795367
|
6.50 | 09/01/34 | 4,560 | @ | 4,670,302 | ||||||||||||
Pool 809989
|
6.50 | 03/01/35 | 4,295 | @ | 4,398,705 | ||||||||||||
Pool 626299
|
7.00 | 06/01/32 | 530 | 553,624 | |||||||||||||
Pool 635095
|
7.00 | 06/01/32 | 927 | 967,842 | |||||||||||||
Pool 641575
|
7.00 | 04/01/32 | 406 | 424,402 | |||||||||||||
Pool 645399
|
7.00 | 05/01/32 | 2,515 | 2,626,439 | |||||||||||||
Pool 645466
|
7.00 | 05/01/32 | 2,535 | 2,646,982 | |||||||||||||
Pool 650131
|
7.00 | 07/01/32 | 1,529 | 1,597,292 | |||||||||||||
Pool 398800
|
8.00 | 06/01/12 | 695 | 735,531 | |||||||||||||
Pool 827854
|
8.00 | 10/01/29 | 2,926 | 3,122,651 | |||||||||||||
Pool 636449
|
8.50 | 04/01/32 | 2,314 | 2,502,870 | |||||||||||||
Pool 823757
|
8.50 | 10/01/29 | 4,183 | 4,536,641 | |||||||||||||
Pool 458132
|
9.44 | 03/15/31 | 1,868 | 2,049,257 | |||||||||||||
74,786,122 | |||||||||||||||||
Total U.S. Government Agency Pass-Through Certificates | |||||||||||||||||
(Cost $83,376,156)
|
82,022,410 | ||||||||||||||||
U.S. Treasury Obligations 19.2% | |||||||||||||||||
United States Treasury Notes
|
|||||||||||||||||
4.00 | 02/15/15 | 1,173 | 1,125,943 | ||||||||||||||
4.25 | 11/15/14 | 26,800 | @ | 26,240,979 | |||||||||||||
Total U.S. Treasury Obligations | |||||||||||||||||
(Cost $28,019,831)
|
27,366,922 | ||||||||||||||||
Total U.S. Government & Agency Obligations | |||||||||||||||||
(Cost $111,395,987)
|
109,389,332 | ||||||||||||||||
See notes to financial statements.
5
THE HYPERION STRATEGIC MORTGAGE INCOME FUND, INC. | ||||||||||||||||
Portfolio of Investments | ||||||||||||||||
Principal | ||||||||||||||||
November 30, 2005 | Interest | Amount | Value | |||||||||||||
Rate | Maturity | (000s) | (Note 2) | |||||||||||||
ASSET-BACKED SECURITIES 26.2% | ||||||||||||||||
Housing Related Asset-Backed Securities 24.4% | ||||||||||||||||
Asset Backed Funding Certificates
|
||||||||||||||||
Series 2005-AQ1, Class B1*(b)
|
5.75/6.25 | % | 06/25/35 | $ | 993 | $ | 849,274 | |||||||||
Series 2005-AQ1, Class B2*(b)
|
5.75/6.25 | 06/25/35 | 1,050 | 866,490 | ||||||||||||
1,715,764 | ||||||||||||||||
Bank of America Funding Corp.
|
||||||||||||||||
Series 2005-2, Class B4
|
5.66 | | 04/25/35 | 874 | 759,282 | |||||||||||
Series 2005-2, Class B5
|
5.66 | | 04/25/35 | 700 | 461,147 | |||||||||||
Series 2005-2, Class B6
|
5.66 | | 04/25/35 | 526 | 175,316 | |||||||||||
1,395,745 | ||||||||||||||||
First Franklin Mortgage Loan Asset
Backed Certificates
|
||||||||||||||||
Series 2003-FFH1, Class M4(a)
|
7.69 | | 09/25/33 | 4,740 | 4,832,032 | |||||||||||
Series 2004-FFH1, Class B*(a)
|
7.69 | | 03/25/34 | 1,550 | 1,447,982 | |||||||||||
Series 2004-FF2, Class B*(a)
|
7.69 | | 03/25/34 | 900 | 849,064 | |||||||||||
Series 2004-FFH2C, Class B1*(a)
|
7.69 | | 06/25/34 | 1,250 | 1,142,905 | |||||||||||
Series 2004-FF8, Class B4*(a)
|
7.69 | | 10/25/34 | 1,250 | 1,141,230 | |||||||||||
9,413,213 | ||||||||||||||||
Green Tree Financial Corp.
|
||||||||||||||||
Series 1997-3, Class M1
|
7.53 | 03/15/28 | 2,000 | 1,220,000 | ||||||||||||
Series 1995-6, Class M1
|
8.10 | 09/15/26 | 4,325 | 4,488,052 | ||||||||||||
5,708,052 | ||||||||||||||||
Harborview Mortgage Loan Trust
|
||||||||||||||||
Series 2005-1, Class B4*(a)
|
5.91 | | 03/19/35 | 629 | 524,585 | |||||||||||
Series 2005-1, Class B5*(a)
|
5.91 | | 03/19/35 | 914 | 610,927 | |||||||||||
Series 2005-1, Class B6*(a)
|
5.91 | | 03/19/35 | 1,144 | 257,333 | |||||||||||
Series 2005-2, Class B4*(a)
|
5.91 | | 05/19/35 | 1,488 | 1,217,541 | |||||||||||
2,610,386 | ||||||||||||||||
Long Beach Mortgage Loan Trust
|
||||||||||||||||
Series 2002-5, Class M3(a)
|
7.44 | | 11/25/32 | 2,500 | 2,509,758 | |||||||||||
Mid-State Trust
|
||||||||||||||||
Series 2004-1, Class M2
|
8.11 | 08/15/37 | 1,565 | 1,631,214 | ||||||||||||
Structured Asset Investment Loan Trust
|
||||||||||||||||
Series 2004-4, Class B*(b)
|
5.00/5.50 | 04/25/34 | 1,500 | 1,323,068 | ||||||||||||
Series 2004-11, Class M9(b)
|
5.00/5.50 | 01/25/35 | 1,900 | 1,800,335 | ||||||||||||
Series 2004-7, Class B(a)
|
6.69 | | 08/25/34 | 2,161 | 1,941,576 | |||||||||||
Series 2004-8, Class B1(a)
|
6.69 | | 09/25/34 | 1,000 | 958,017 | |||||||||||
Series 2004-10, Class M7(a)
|
6.69 | | 11/25/34 | 2,000 | 2,016,072 | |||||||||||
Series 2004-2, Class B*(a)
|
7.19 | | 03/25/34 | 1,074 | 989,525 | |||||||||||
9,028,593 | ||||||||||||||||
See notes to financial statements.
6
THE HYPERION STRATEGIC MORTGAGE INCOME FUND, INC. | |||||||||||||||||
Portfolio
of Investments
November 30, 2005 |
|||||||||||||||||
Principal | |||||||||||||||||
Interest | Amount | Value | |||||||||||||||
Rate | Maturity | (000s) | (Note 2) | ||||||||||||||
ASSET-BACKED SECURITIES (continued) | |||||||||||||||||
Structured Asset Securities Corporation
|
|||||||||||||||||
Series 2005-6, Class B5
|
5.34 | % | 05/25/35 | $ | 496 | $ | 410,039 | ||||||||||
Series 2005-6, Class B6
|
5.34 | | 05/25/35 | 496 | 315,723 | ||||||||||||
Series 2005-6, Class B7
|
5.34 | | 05/25/35 | 347 | 107,719 | ||||||||||||
833,481 | |||||||||||||||||
Total Housing Related Asset-Backed Securities | |||||||||||||||||
(Cost $35,195,433)
|
34,846,206 | ||||||||||||||||
Non-Housing Related Asset-Backed Securities 1.8% | |||||||||||||||||
Airplanes Pass Through Trust
|
|||||||||||||||||
Series 1R, Class A8
|
|||||||||||||||||
(Cost $2,299,543)
|
4.49 | | 03/15/19 | 2,668 | 2,494,573 | ||||||||||||
Total Asset-Backed Securities | |||||||||||||||||
(Cost $37,494,976)
|
37,340,779 | ||||||||||||||||
COMMERCIAL MORTGAGE BACKED SECURITIES 16.6% | |||||||||||||||||
Bear Stearns Commercial Mortgage Securities
|
|||||||||||||||||
Series 1999-C1, Class D
|
6.53 | 02/14/31 | 2,500 | 2,652,750 | |||||||||||||
Series 2000-WF1, Class E
|
7.90 | | 02/15/32 | 2,000 | 2,190,560 | ||||||||||||
4,843,310 | |||||||||||||||||
Chase Commercial Mortgage Securities Corp.
|
|||||||||||||||||
Series 2000-2, Class I*
|
6.65 | 07/15/32 | 1,000 | 624,192 | |||||||||||||
GE Capital Commercial Mortgage Corp.
|
|||||||||||||||||
Series 2002-2A, Class G*
|
6.04 | 08/11/36 | 3,000 | 3,101,898 | |||||||||||||
Series 2000-1, Class G*
|
6.13 | 01/15/33 | 1,000 | 452,200 | |||||||||||||
Series 2002-2A, Class H*
|
6.31 | 08/11/36 | 2,000 | 2,098,858 | |||||||||||||
5,652,956 | |||||||||||||||||
JP Morgan Chase Commercial
Mortgage Securities
|
|||||||||||||||||
Series 2003-LN1, Class G*
|
5.48 | | 10/15/37 | 1,600 | 1,565,354 | ||||||||||||
Morgan Stanley Capital I
|
|||||||||||||||||
Series 1999-FNV1, Class E
|
7.46 | | 03/15/31 | 2,000 | 2,119,540 | ||||||||||||
Nationslink Funding Corp.
|
|||||||||||||||||
Series 1998-2, Class E
|
7.11 | 08/20/30 | 4,000 | 4,221,852 | |||||||||||||
UBS 400 Atlantic Street Mortgage Trust
|
|||||||||||||||||
Series 2002-C1A, Class B3*
|
7.19 | 01/11/22 | 2,000 | 2,128,840 | |||||||||||||
Wachovia Bank Commercial Mortgage Trust
|
|||||||||||||||||
Series 2004-WL4A, Class H*
|
4.97 | | 10/15/15 | 700 | 698,178 | ||||||||||||
Series 2005-C16, Class H*
|
5.30 | | 10/15/41 | 2,000 | 1,834,944 | ||||||||||||
2,533,122 | |||||||||||||||||
Total Commercial Mortgage Backed Securities | |||||||||||||||||
(Cost $23,972,941)
|
23,689,166 | ||||||||||||||||
See notes to financial statements.
7
THE HYPERION STRATEGIC MORTGAGE INCOME FUND, INC. | ||||||||||||||||
Portfolio of Investments | ||||||||||||||||
Principal | ||||||||||||||||
November 30, 2005 | Interest | Amount | Value | |||||||||||||
Rate | Maturity | (000s) | (Note 2) | |||||||||||||
NON-AGENCY RESIDENTIAL MORTGAGE BACKED SECURITIES 25.5% | ||||||||||||||||
Subordinated Collateralized Mortgage Obligations 25.5% | ||||||||||||||||
Bank of America Alternative Loan Trust
|
||||||||||||||||
Series 2004-3, Class 30B4*
|
5.50 | % | 04/25/34 | $ | 995 | $ | 820,277 | |||||||||
Series 2004-3, Class 30B5
|
5.50 | 04/25/34 | 697 | 430,634 | ||||||||||||
1,250,911 | ||||||||||||||||
Bank of America Mortgage Securities, Inc.
|
||||||||||||||||
Series 2004-A, Class B4
|
3.91 | | 02/25/34 | 2,042 | 1,880,881 | |||||||||||
Series 2003-10, Class 1B4
|
5.50 | 01/25/34 | 558 | 506,744 | ||||||||||||
Series 2002-10, Class 1B3
|
6.00 | 11/25/32 | 1,442 | 1,436,081 | ||||||||||||
3,823,706 | ||||||||||||||||
Cendant Mortgage Corp.
|
||||||||||||||||
Series 2002-4, Class B1
|
6.50 | 07/25/32 | 2,585 | 2,578,018 | ||||||||||||
Series 2002-4, Class B2
|
6.50 | 07/25/32 | 1,034 | 1,031,008 | ||||||||||||
Series 2002-4, Class B3
|
6.50 | 07/25/32 | 603 | 586,482 | ||||||||||||
Series 2002-4, Class B4
|
6.50 | 07/25/32 | 345 | 324,128 | ||||||||||||
Series 2002-4, Class B5
|
6.50 | 07/25/32 | 258 | 242,838 | ||||||||||||
Series 2002-4, Class B6*
|
6.50 | 07/25/32 | 345 | 284,307 | ||||||||||||
5,046,781 | ||||||||||||||||
First Horizon Alternative Mortgage Securities
|
||||||||||||||||
Series 2005-AA6, Class B4
|
5.48 | | 08/25/35 | 849 | 720,937 | |||||||||||
Series 2005-AA6, Class B5
|
5.48 | | 08/25/35 | 799 | 553,907 | |||||||||||
Series 2005-AA6, Class B6
|
5.48 | | 08/25/35 | 500 | 142,392 | |||||||||||
1,417,236 | ||||||||||||||||
First Horizon Mortgage Pass-Through Trust
|
||||||||||||||||
Series 2005-4, Class B4*
|
5.45 | | 07/25/35 | 426 | 350,994 | |||||||||||
Series 2005-5, Class B4*
|
5.46 | | 10/25/35 | 728 | 597,994 | |||||||||||
Series 2005-5, Class B5*
|
5.46 | | 10/25/35 | 546 | 341,849 | |||||||||||
Series 2005-5, Class B6*
|
5.46 | | 10/25/35 | 547 | 164,208 | |||||||||||
Series 2005-3, Class B4
|
5.50 | 06/25/35 | 457 | 376,353 | ||||||||||||
1,831,398 | ||||||||||||||||
G3 Mortgage Reinsurance Ltd.
|
||||||||||||||||
Series 1, Class E*
|
24.00 | | 05/25/08 | 4,213 | 4,671,049 | |||||||||||
JP Morgan Mortgage Trust
|
||||||||||||||||
Series 2003-A1, Class B4
|
4.49 | | 10/25/33 | 535 | 464,353 | |||||||||||
Residential Finance Limited Partnership
|
||||||||||||||||
Series 2002-A, Class B7
|
9.80 | | 10/10/34 | 1,921 | 1,961,815 | |||||||||||
Residential Funding Mortgage Securities
I, Inc.
|
||||||||||||||||
Series 2004-S1, Class B2
|
5.25 | 02/25/34 | 451 | 295,578 | ||||||||||||
Series 2003-S7, Class B3
|
5.50 | 05/25/33 | 319 | 227,139 | ||||||||||||
Series 2003-S7, Class B2
|
5.50 | 05/25/33 | 527 | 200,991 | ||||||||||||
723,708 | ||||||||||||||||
Resix Finance Limited Credit-Linked Note
|
||||||||||||||||
Series 2005-C, Class B7*
|
7.20 | | 09/10/37 | 1,996 | 1,995,565 | |||||||||||
Series 2004-C, Class B7*
|
7.60 | | 09/10/36 | 984 | 1,005,066 | |||||||||||
Series 2004-B, Class B8*
|
8.85 | | 02/10/36 | 798 | 821,811 | |||||||||||
Series 2003-CB1, Class B8*
|
10.90 | | 06/10/35 | 962 | 1,005,068 |
See notes to financial statements.
8
THE HYPERION STRATEGIC MORTGAGE INCOME FUND, INC. | |||||||||||||||||
Portfolio of Investments | |||||||||||||||||
Principal | |||||||||||||||||
November 30, 2005 | Interest | Amount | Value | ||||||||||||||
Rate | Maturity | (000s) | (Note 2) | ||||||||||||||
NON-AGENCY RESIDENTIAL MORTGAGE BACKED SECURITIES (continued) | |||||||||||||||||
Series 2004-B, Class B9*
|
12.40 | % | 02/10/36 | $ | 1,222 | $ | 1,271,124 | ||||||||||
Series 2004-A, Class B10*
|
15.60 | | 02/10/36 | 488 | 507,643 | ||||||||||||
6,606,277 | |||||||||||||||||
Structured Asset Mortgage Investments, Inc.
|
|||||||||||||||||
Series 2002-AR1, Class B4
|
5.53 | | 03/25/32 | 641 | 632,129 | ||||||||||||
Washington Mutual Mortgage Securities Corp.
|
|||||||||||||||||
Series 2002-AR12, Class B4
|
4.67 | | 10/25/32 | 929 | 896,616 | ||||||||||||
Series 2002-AR12, Class B5
|
4.67 | | 10/25/32 | 697 | 659,100 | ||||||||||||
Series 2002-AR12, Class B6
|
4.67 | | 10/25/32 | 1,162 | 860,145 | ||||||||||||
Series 2002-AR10, Class B4*
|
4.95 | | 10/25/32 | 945 | 915,704 | ||||||||||||
Series 2002-AR10, Class B5*
|
4.95 | | 10/25/32 | 708 | 668,439 | ||||||||||||
Series 2002-AR10, Class B6*
|
4.95 | | 10/25/32 | 1,182 | 874,705 | ||||||||||||
Series 2005-AR2, Class B10(a)
|
5.03 | | 01/25/45 | 1,792 | 1,452,131 | ||||||||||||
Series 2002-AR11, Class B5
|
5.14 | | 10/25/32 | 603 | 593,606 | ||||||||||||
Series 2002-AR11, Class B6
|
5.14 | | 10/25/32 | 809 | 621,615 | ||||||||||||
7,542,061 | |||||||||||||||||
Wells Fargo Mortgage Backed Securities Trust
|
|||||||||||||||||
Series 2002, Class B5
|
6.00 | 06/25/32 | 359 | 352,586 | |||||||||||||
Total Subordinated Collateralized Mortgage Obligations | |||||||||||||||||
(Cost $35,147,987)
|
36,324,010 | ||||||||||||||||
Total Non-Agency Residential Mortgage Backed Securities | |||||||||||||||||
(Cost $35,147,987)
|
36,324,010 | ||||||||||||||||
SHORT TERM INVESTMENTS 0.1% | |||||||||||||||||
United States Treasury Bills
|
|||||||||||||||||
(Cost $99,333)
|
4.11 | 12/15/05 | 100 | 99,848 | |||||||||||||
Total Investments 145.1% | |||||||||||||||||
(Cost $208,111,224)
|
206,843,135 | ||||||||||||||||
Liabilities in Excess of Other
Assets (45.1)%
|
(64,312,542 | ) | |||||||||||||||
NET ASSETS 100.0%
|
$ | 142,530,593 | |||||||||||||||
@
|
| Portion or entire principal amount delivered as collateral for reverse repurchase agreements (Note 5). | ||
|
| Variable Rate Security: Interest rate is the rate in effect November 30, 2005. | ||
*
|
| Security exempt from registration under Rule 144A of the Securities Act of 1933. These securities may only be resold in transactions exempt from registration, normally to qualified institutional buyers. | ||
(a)
|
| Security is a step up bond where coupon increases or steps up at a predetermined date. At that date these coupons increase to LIBOR plus a predetermined margin. | ||
(b)
|
| Security is a step up bond where coupon increases or steps up at a predetermined date. Rates shown are current coupon and next coupon rate when security steps up. |
See notes to financial statements.
9
Assets:
|
||||||
Investments in securities, at market (cost
$208,111,224) (Note 2)
|
$ | 206,843,135 | ||||
Cash
|
671,319 | |||||
Interest receivable
|
955,031 | |||||
Principal paydowns receivable
|
1,743,497 | |||||
Unrealized appreciation on swap contracts
(Note 7)
|
385,848 | |||||
Prepaid expenses and other assets
|
14,427 | |||||
Total assets
|
210,613,257 | |||||
Liabilities:
|
||||||
Reverse repurchase agreements (Note 5)
|
62,805,000 | |||||
Interest payable for reverse repurchase
agreements (Note 5)
|
72,271 | |||||
Payable for investments purchased
|
4,956,628 | |||||
Investment advisory fee payable (Note 3)
|
76,189 | |||||
Administration fee payable (Note 3)
|
18,783 | |||||
Directors fees payable
|
24,812 | |||||
Accrued expenses and other liabilities
|
128,981 | |||||
Total liabilities
|
68,082,664 | |||||
Net Assets
(equivalent to $14.05 per share based
on 10,144,002 shares issued and outstanding)
|
$ | 142,530,593 | ||||
Composition of Net Assets:
|
||||||
Capital stock, at par value ($.01) (Note 6)
|
$ | 101,440 | ||||
Additional paid-in capital (Note 6)
|
144,148,737 | |||||
Accumulated undistributed net
investment income
|
1,739,109 | |||||
Accumulated net realized loss
|
(2,576,452 | ) | ||||
Net unrealized depreciation
|
(882,241 | ) | ||||
Net assets applicable to capital
stock outstanding
|
$ | 142,530,593 | ||||
See notes to financial statements.
10
Investment Income
(Note 2):
|
|||||||
Interest
|
$ | 15,680,410 | |||||
Expenses:
|
|||||||
Investment advisory fee (Note 3)
|
948,388 | ||||||
Administration fee (Note 3)
|
287,152 | ||||||
Insurance
|
151,139 | ||||||
Custodian
|
76,225 | ||||||
Accounting and tax services
|
102,383 | ||||||
Reports to shareholders
|
80,717 | ||||||
Transfer agency
|
30,032 | ||||||
Directors fees
|
80,847 | ||||||
Legal
|
19,833 | ||||||
Registration fees
|
23,750 | ||||||
Miscellaneous
|
10,066 | ||||||
Total operating expenses
|
1,810,532 | ||||||
Interest expense on reverse repurchase agreements
(Note 5)
|
2,121,336 | ||||||
Total expenses
|
3,931,868 | ||||||
Net investment income
|
11,748,542 | ||||||
Realized and Unrealized Gain (Loss) on
Investments (Notes 2 and 7):
|
|||||||
Net realized gain (loss) on:
|
|||||||
Investment transactions
|
(215,525 | ) | |||||
Futures transactions
|
(168,844 | ) | |||||
Swap contracts
|
94,348 | ||||||
Net realized loss on investment
transactions, futures transactions and swap contracts
|
(290,021 | ) | |||||
Net change in unrealized
appreciation/depreciation on:
|
|||||||
Investments
|
(4,681,463 | ) | |||||
Futures
|
323 | ||||||
Swap contracts
|
321,395 | ||||||
Net change in unrealized
appreciation/depreciation on investments, futures and
swap contracts
|
(4,359,745 | ) | |||||
Net realized and unrealized loss on investments,
futures and swap contracts
|
(4,649,766 | ) | |||||
Net increase in net assets resulting
from operations
|
$ | 7,098,776 | |||||
See notes to financial statements.
11
For the Year | For the Year | |||||||||
Ended | Ended | |||||||||
November 30, 2005 | November 30, 2004 | |||||||||
Increase (Decrease) in Net Assets Resulting
from Operations:
|
||||||||||
Net investment income
|
$ | 11,748,542 | $ | 12,144,805 | ||||||
Net realized gain (loss) on investment
transactions, futures transactions and swap contracts
|
(290,021 | ) | 2,397,402 | |||||||
Net change in unrealized
appreciation/depreciation on investments, futures and
swap contracts
|
(4,359,745 | ) | 46,772 | |||||||
Net increase in net assets resulting
from operations
|
7,098,776 | 14,588,979 | ||||||||
Dividends to Shareholders
(Note 2):
|
||||||||||
Net investment income
|
(12,233,207 | ) | (13,144,369 | ) | ||||||
Capital Stock Transactions
(Note 6):
|
||||||||||
Net asset value of shares issued through dividend
reinvestment (1,366 and 1,416 shares, respectively)
|
19,808 | 20,761 | ||||||||
Net increase from capital stock transactions
|
19,808 | 20,761 | ||||||||
Total increase (decrease) in net assets
|
(5,114,623 | ) | 1,465,371 | |||||||
Net Assets:
|
||||||||||
Beginning of year
|
147,645,216 | 146,179,845 | ||||||||
End of year (including undistributed net
investment income of $1,739,109
and $1,107,938, respectively)
|
$ | 142,530,593 | $ | 147,645,216 | ||||||
See notes to financial statements.
12
Increase (Decrease) in Cash:
|
||||||
Cash flows provided by (used for) operating
activities:
|
||||||
Net increase in net assets resulting
from operations
|
$ | 7,098,776 | ||||
Adjustments to reconcile net increase in net
assets from operations to net cash provided by operating
activities:
|
||||||
Purchases of long-term portfolio investments
|
(97,830,021 | ) | ||||
Proceeds from disposition of long-term portfolio
investments, principal paydowns, net of losses
|
105,940,558 | |||||
Purchases of short-term portfolio
investments, net
|
1,500,000 | |||||
Decrease in interest receivable
|
45,283 | |||||
Decrease in receivable for investments sold
|
610,709 | |||||
Increase in prepaid expenses and other assets
|
(276 | ) | ||||
Decrease in variation margin payable
|
(100,972 | ) | ||||
Increase in interest payable for reverse
repurchase agreements
|
30,316 | |||||
Increase in payable for investments purchased
|
2,282,454 | |||||
Decrease in investment advisory fee payable
|
(1,822 | ) | ||||
Decrease in administration fee payable
|
(9,881 | ) | ||||
Increase in accrued expenses and
other liabilities
|
10,524 | |||||
Net accretion on investments
|
(1,943,451 | ) | ||||
Unrealized depreciation on investments
|
4,681,463 | |||||
Unrealized appreciation on swaps
|
(321,395 | ) | ||||
Net realized loss on investment transactions
|
215,525 | |||||
Net cash provided by operating activities
|
22,207,790 | |||||
Cash flows used for financing activities:
|
||||||
Net cash provided by reverse
repurchase agreements
|
(9,696,750 | ) | ||||
Dividends paid to shareholders, net
of reinvestments
|
(12,213,399 | ) | ||||
Net cash used for financing activities
|
(21,910,149 | ) | ||||
Net increase in cash
|
297,641 | |||||
Cash at beginning of year
|
373,678 | |||||
Cash at end of year
|
$ | 671,319 | ||||
Interest payments for the year ended November 30, 2005, totaled $2,091,020.
See notes to financial statements.
13
For the Year | For the Year | For the Year | For the Period | ||||||||||||||
Ended | Ended | Ended | Ended | ||||||||||||||
November 30, | November 30, | November 30, | November 30, | ||||||||||||||
2005 | 2004 | 2003 | 2002@ | ||||||||||||||
Per Share Operating Performance:
|
|||||||||||||||||
Net asset value, beginning of period
|
$ | 14.56 | $ | 14.41 | $ | 14.10 | $ | 14.25 | * | ||||||||
Net investment income
|
1.16 | 1.20 | 1.22 | 0.37 | |||||||||||||
Net realized and unrealized gain (loss) on
investments, short sales, futures transactions and
swap contracts
|
(0.46 | ) | 0.25 | 0.39 | (0.17 | ) | |||||||||||
Net increase in net asset value resulting from
operations
|
0.70 | 1.45 | 1.61 | 0.20 | |||||||||||||
Dividends from net investment income
|
(1.21 | ) | (1.30 | ) | (1.30 | ) | (0.32 | ) | |||||||||
Offering costs charged to additional
paid-in-capital
|
| | | (0.03 | ) | ||||||||||||
Net asset value, end of period
|
$ | 14.05 | $ | 14.56 | $ | 14.41 | $ | 14.10 | |||||||||
Market price, end of period
|
$ | 12.7000 | $ | 14.6100 | $ | 14.6700 | $ | 13.6800 | |||||||||
Total Investment Return+
|
(5.20% | ) | 9.10% | 17.55% | (6.66% | )(1) | |||||||||||
Ratios to Average Net Assets/ Supplementary
Data:
|
|||||||||||||||||
Net assets, end of period (000s)
|
$ | 142,531 | $ | 147,645 | $ | 146,180 | $ | 142,921 | |||||||||
Operating expenses
|
1.24% | 1.25% | 1.28% | 1.23% | (2) | ||||||||||||
Interest expense
|
1.45% | 0.58% | 0.51% | 0.99% | (2) | ||||||||||||
Total expenses
|
2.69% | 1.83% | 1.79% | 2.22% | (2) | ||||||||||||
Net expenses
|
2.69% | 1.83% | 1.79% | 2.19% | (2) | ||||||||||||
Net investment income
|
8.05% | 8.23% | 8.54% | 7.48% | (2) | ||||||||||||
Portfolio turnover rate
|
46% | 65% | 78% | 70% | (1) |
+ | Total investment return is calculated assuming a purchase of common stock at the current market price on the first day and a sale at the current market price on the last day of the period reported. For the period ended November 30, 2002, total investment return is based on a beginning period price of $15.00 (initial offering price). Total investment return for subsequent periods is computed based upon the New York Stock Exchange market price of the Funds shares. Dividends and distributions, if any, are assumed for purposes of this calculation, to be reinvested at the prices obtained under the Funds dividend reinvestment plan. Total investment return does not reflect brokerage commissions and is not annualized. |
(1) | Not Annualized |
(2) | Annualized |
@ | Commenced operations on July 26, 2002 |
* | Initial public offering of $15.00 per share less underwriting discount of $0.75 per share. |
See notes to financial statements.
14
The Hyperion Strategic Mortgage Income Fund, Inc. (the Fund), which was incorporated under the laws of the State of Maryland on May 17, 2002, is registered under the Investment Company Act of 1940 (the 1940 Act) as a diversified, closed-end management investment company. The Fund commenced operations on July 26, 2002. Prior to July 26, 2002, the Fund had no operations other than the sale of 7,018 shares for $100,000 to Hyperion Capital Management, Inc. (the Advisor).
The Funds investment objective is to provide a high level of current income by investing primarily in mortgage-backed securities. No assurance can be given that the Funds investment objective will be achieved.
2. Significant Accounting Policies
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Valuation of Investments: Where market quotations are readily available, securities held by the Fund are valued based upon the current bid price, except preferred stocks, which are valued based upon the closing price. Securities may be valued by independent pricing services that have been approved by the Board of Directors. The prices provided by a pricing service take into account broker dealer market price quotations for institutional size trading in similar groups of securities, security quality, maturity, coupon and other security characteristics as well as any developments related to the specific securities. The Fund values mortgage-backed securities (MBS) and other debt securities for which market quotations are not readily available (approximately 17% of the investments in securities held by the Fund at November 30, 2005) at their fair value as determined in good faith, utilizing procedures approved by the Board of Directors, on the basis of information provided by dealers in such securities. Some of the general factors which may be considered in determining fair value include the fundamental analytic data relating to the investment and an evaluation of the forces which influence the market in which these securities are purchased and sold. Determination of fair value involves subjective judgment, as the actual market value of a particular security can be established only by negotiations between the parties in a sales transaction. Debt securities having a remaining maturity of sixty days or less when purchased and debt securities originally purchased with maturities in excess of sixty days but which currently have maturities of sixty days or less are valued at amortized cost.
The ability of issuers of debt securities held by the Fund to meet their obligations may be affected by economic developments in a specific industry or region. The values of MBS can be significantly affected by changes in interest rates or in the financial condition of an issuer or market.
Options Written or Purchased: The Fund may write or purchase options as a method of hedging potential declines in similar underlying securities. When the Fund writes or purchases an option, an amount equal to the premium received or paid by the Fund is recorded as a liability or an asset and is subsequently adjusted to the current market value of the option written or purchased. Premiums received or paid from writing or purchasing options which expire unexercised are treated by the Fund on the expiration date as realized gains or losses. The difference between the premium and the amount paid or received on effecting a closing purchase or sale transaction, including brokerage commissions, also is treated as a realized gain or loss. If an option is exercised, the premium paid or received is added to the proceeds from the sale or cost of the purchase in determining whether the Fund has realized a gain or a loss on the investment transaction.
The Fund, as writer of an option, may have no control over whether the underlying securities may be sold (call) or purchased (put) and as a result bears the market risk of an unfavorable change in the price of the security underlying the written option.
The Fund purchases or writes options to hedge against adverse market movements or fluctuations in value caused by changes in interest rates. The Fund bears the risk in purchasing an option, to the extent of the premium paid, that it will expire without being exercised. If this occurs, the option expires worthless and the premium paid for the option is recognized as a realized loss. The risk associated with writing call options is that the Fund may forego the opportunity for a profit if the market value of the underlying position increases and the option is exercised. The Fund will only write call options on positions held in its portfolio. The risk in writing a put option is that the Fund may incur a loss if the market value of the
15
underlying position decreases and the option is exercised. In addition, the Fund bears the risk of not being able to enter into a closing transaction for written options as a result of an illiquid market.
Short Sales: The Fund may make short sales of securities as a method of hedging potential declines in similar securities owned. The Fund may have to pay a fee to borrow the particular securities and may be obligated to pay to the lender an amount equal to any payments received on such borrowed securities. A gain, limited to the amount at which the Fund sold the security short, or a loss, unlimited as to dollar amount, will be realized upon the termination of a short sale if the market price is less or greater than the proceeds originally received.
Financial Futures Contracts: A futures contract is an agreement between two parties to buy and sell a financial instrument for a set price on a future date. Initial margin deposits are made upon entering into futures contracts and can be either cash or securities. During the period the futures contract is open, changes in the value of the contract are recognized as unrealized gains or losses by marking-to-market on a daily basis to reflect the market value of the contract at the end of each days trading. Variation margin payments are made or received, depending upon whether unrealized gains or losses are incurred. When the contract is closed, the Fund records a realized gain or loss equal to the difference between the proceeds from (or cost of) the closing transaction and the Funds basis in the contract.
The Fund invests in financial futures contracts to hedge against fluctuations in the value of portfolio securities caused by changes in prevailing market interest rates. Should interest rates move unexpectedly, the Fund may not achieve the anticipated benefits of the financial futures contracts and may realize a loss. The use of futures transactions involves the risk of imperfect correlation in movements in the price of futures contracts, interest rates and the underlying hedged assets. The Fund is at risk that it may not be able to close out a transaction because of an illiquid market.
Swap agreements: The Fund may enter into interest rate swap agreements to manage its exposure to interest rates. Interest rate swap agreements involve the exchange by the Fund with another party of their respective commitments to pay or receive interest, e.g., an exchange of floating rate payments for fixed rate payments with respect to a notional amount of principal. The Fund will usually enter into interest rate swaps on a net basis, i.e., the two payment streams are netted out, with the Fund receiving or paying, as the case may be, only the net amount of the two payments. Swaps are marked to market based upon quotations from market makers and the change, if any, along with an accrual for periodic payments due or owed is recorded as unrealized gain or loss in the Statement of Operations. Net payments of interest on interest rate swap agreements are included as part of realized gain/loss in the Statement of Operations. Entering into these agreements involves, to varying degrees, elements of credit and market risk in excess of the amounts recognized on the Statement of Assets and Liabilities. Such risks involve the possibility that there will be no liquid market for these agreements, that the counterparty to the agreements may default on its obligation to perform or that there may be unfavorable changes in the fluctuation of interest rates. See Note 7 for a summary of all open swap agreements as of November 30, 2005.
When-Issued Purchases and Forward Commitments: The Fund may purchase securities on a when-issued basis and may purchase or sell securities on a forward commitment basis in order to hedge against anticipated changes in interest rates and prices and secure a favorable rate of return. When such transactions are negotiated, the price, which is generally expressed in yield terms, is fixed at the time the commitment is made, but delivery and payment for the securities take place at a later date, which can be a month or more after the date of the transaction. At the time the Fund makes the commitment to purchase securities on a when-issued or forward commitment basis it will record the transaction and thereafter reflect the value of such securities in determining its net asset value. At the time the Fund enters into a transaction on a when-issued or forward commitment basis, the Advisor will identify collateral consisting of cash or liquid securities equal to the value of the when-issued or forward commitment securities and will monitor the adequacy of such collateral on a daily basis. On the delivery date, the Fund will meet its obligations from securities that are then maturing or sales of the securities identified as collateral by the Advisor and/or from then available cash flow. When-issued securities and forward commitments may be sold prior to the settlement date. If the Fund disposes of the right to acquire a when-issued security prior to its acquisition or disposes of its right to deliver or receive against a forward commitment, it can incur a gain or loss due to market fluctuation. There is always a risk that the securities may not be delivered and that the Fund may incur a loss. Settlements in the ordinary course are not treated by the Fund as when-issued or forward commitment transactions and, accordingly, are not subject to the foregoing limitations even though some of the risks described above may be present in such transactions.
16
Securities Transactions and Investment Income: Securities transactions are recorded on the trade date. Realized gains and losses from securities transactions are calculated on the identified cost basis. Interest income is recorded on the accrual basis. Discounts and premiums on securities are accreted and amortized, respectively, using the effective yield to maturity method.
Taxes: It is the Funds intention to continue to meet the requirements of the Internal Revenue Code applicable to regulated investment companies and to distribute substantially all of its taxable income to its shareholders. Therefore, no federal income or excise tax provision is required.
Dividends and Distributions: The Fund declares and pays dividends monthly from net investment income. Distributions of realized capital gains in excess of capital loss carryforwards are distributed at least annually. Dividends and distributions are recorded on the ex-dividend date. Dividends from net investment income and distributions from realized gains from investment transactions have been determined in accordance with Federal income tax regulations and may differ from net investment income and realized gains recorded by the Fund for financial reporting purposes. These differences, which could be temporary or permanent in nature, may result in reclassification of distributions; however, net investment income, net realized gains and net assets are not affected.
Cash Flow Information: The Fund invests in securities and distributes dividends and distributions which are paid in cash or are reinvested at the discretion of shareholders. These activities are reported in the Statement of Changes in Net Assets. Additional information on cash receipts and cash payments is presented in the Statement of Cash Flows. Cash, as used in the Statement of Cash Flows, is the amount reported as Cash in the Statement of Assets and Liabilities, and does not include short-term investments.
Accounting practices that do not affect reporting activities on a cash basis include carrying investments at value and accreting discounts and amortizing premiums on debt obligations.
Repurchase Agreements: Through its custodian, the Fund receives delivery of the underlying collateral, the market value of which at the time of purchase is required to be in an amount at least equal to the resale price, including accrued interest. The Advisor is responsible for determining that the value of these underlying securities is sufficient at all times. If the seller defaults and the value of the collateral declines or if bankruptcy proceedings commence with respect to the seller of the security, realization of the collateral by the Fund may be delayed or limited.
3. Investment Advisory Agreements and Affiliated Transactions
Pursuant to a transaction whereby Brascan Financial (U.S.) Corporation purchased all stock ownership of the holding company indirectly owning the advisor as described in the Proxy Statement to Stockholders dated March 18, 2005 (the Transaction) the Fund entered into an Investment Advisory Agreement (the New Investment Advisory Agreement) with the Advisor on April 28, 2005. The Advisor is responsible for the management of the Funds portfolio and provides the necessary personnel, facilities, equipment and certain other services necessary to the operations of the Fund. For such services, the Fund pays a monthly fee at an annual rate of 0.65% of the Funds average weekly net assets. During the year ended November 30, 2005, the Advisor earned $948,388 in investment advisory fees.
The Advisor had entered into a Sub-Advisory Agreement with Hyperion/ GMAC Capital Advisors, LLC (Hyperion/ GMAC). Under the terms of the Sub-Advisory Agreement, Hyperion/ GMAC assisted in managing the Funds investments in CMBS and to provide such investment research and advice regarding CMBS as may be necessary for the operation of the Fund. The fee paid under the Sub-Advisory Agreement was paid by the Advisor, out of its advisory fee. The monthly fee was equal to a percentage of the portion of the Funds average weekly net assets that are invested in CMBS. The fee is determined by the credit rating of the CMBS at the time of purchase, and ranges from 1.00% for unrated CMBS to 0.13% for AAA/ Aaa rated CMBS. On October 31, 2005, the Sub-Advisory Agreement between the Advisor and Hyperion/ GMAC was terminated.
The Fund has entered into an Administration Agreement with Hyperion Capital Management, Inc. (the Administrator). The Administrator entered into a sub-administration agreement with State Street Bank and Trust Company (the Sub-Administrator). The Administrator and Sub-Administrator perform administrative services necessary for the operation of the Fund, including maintaining certain books and records of the Fund and preparing reports and other documents required by federal, state, and other applicable laws and regulations, and providing the Fund with administrative office facilities. For these services, the Fund pays to the Administrator a monthly fee at an annual rate of 0.20% of the Funds average weekly net
17
assets. During the year ended November 30, 2005 the Administrator earned $287,152 in administration fees. The Administrator is responsible for any fees due the Sub-Administrator.
Certain officers and directors of the Fund are officers and/or directors of the Advisor or Administrator.
4. Purchases and Sales of Investments
Purchases and sales of investments, excluding short-term securities, U.S. Government securities and reverse repurchase agreements, for the year ended November 30, 2005, were $25,036,046 and $48,342,605, respectively. Purchases and sales of U.S. Government securities, for the year ended November 30, 2005, were $72,793,975 and $58,104,500, respectively. For purposes of this footnote, U.S. Government securities may include securities issued by the U.S. Treasury, Federal Home Loan Mortgage Corporation, and the Federal National Mortgage Association.
5. Borrowings
The Fund may enter into reverse repurchase agreements with the same parties with whom it may enter into repurchase agreements. Under a reverse repurchase agreement, the Fund sells securities and agrees to repurchase them at a mutually agreed upon date and price. Under the 1940 Act, reverse repurchase agreements will be regarded as a form of borrowing by the Fund unless, at the time it enters into a reverse repurchase agreement, it establishes and maintains a segregated account with its custodian containing securities from its portfolio having a value not less than the repurchase price (including accrued interest). The Fund has established and maintained such an account for each of its reverse repurchase agreements.
Reverse repurchase agreements involve the risk that the market value of the securities retained in lieu of sale by the Fund may decline below the price of the securities the Fund has sold but is obligated to repurchase. In the event the buyer of securities under a reverse repurchase agreement files for bankruptcy or becomes insolvent, such buyer or its trustee or receiver may receive an extension of time to determine whether to enforce the Funds obligation to repurchase the securities, and the Funds use of the proceeds of the reverse repurchase agreement may effectively be restricted pending such decision.
At November 30, 2005, the Fund had the following reverse repurchase agreements outstanding:
Maturity | |||||||||
Face Value | Description | Amount | |||||||
$ | 9,437,000 | Goldman Sachs 4.07%, dated 11/22/05, maturity date 12/06/05 | $ | 9,451,937 | |||||
5,273,000 | Goldman Sachs 4.20%, dated 11/22/05, maturity date 12/27/05 | 5,294,531 | |||||||
23,205,000 | Lehman Brothers 3.95%, dated 11/29/05, maturity date 12/06/05 | 23,222,823 | |||||||
8,533,000 | Lehman Brothers 4.24%, dated 11/10/05, maturity date 01/12/06 | 8,596,315 | |||||||
4,528,000 | Merrill Lynch 4.15%, dated 11/17/05, maturity date 12/15/05 | 4,542,615 | |||||||
7,323,000 | Wachovia Capital Markets 4.23%, dated 11/14/05, maturity date 1/10/06 | 7,372,046 | |||||||
4,506,000 | Wachovia Capital Markets 4.23%, dated 11/14/05, maturity date 1/10/06 | 4,536,179 | |||||||
$ | 62,805,000 | ||||||||
Maturity Amount, Including Interest Payable | $ | 63,016,446 | |||||||
Market Value of Assets Sold Under Agreements | $ | 60,077,805 | |||||||
Weighted Average Interest Rate | 4.10 | % | |||||||
The average daily balance of reverse repurchase agreements outstanding during the year ended November 30, 2005, was approximately $69,691,915 at a weighted average interest rate of 3.04%. The maximum amount of reverse repurchase agreements outstanding at any time during the period was $73,979,250 as of December 3, 2004, which was 33.16% of total assets.
6. Capital Stock
There are 50 million shares of $0.01 par value common stock authorized. Of the 10,144,002 shares outstanding at November 30, 2005, the Advisor owned 7,018 shares.
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In connection with the initial public offering of the Funds Shares, the Advisor made an undertaking to pay any offering costs in excess of $0.03 per common share. The Advisor has advised the Fund that such excess amounted to $482,964.
7. Financial Instruments
The Fund regularly trades in financial instruments with off-balance sheet risk in the normal course of its investing activities to assist in managing exposure to various market risks. These financial instruments include written options, futures contracts and swap agreements and may involve, to a varying degree, elements of risk in excess of the amounts recognized for financial statement purposes. The notional or contractual amounts of these instruments represent the investment the Fund has in particular classes of financial instruments and does not necessarily represent the amounts potentially subject to risk. The measurement of the risks associated with these instruments is meaningful only when all related and offsetting transactions are considered. During the period, the Fund had segregated sufficient cash and/or securities to cover any commitments under these contracts.
There was no written option activity for the year ended November 30, 2005.
As of November 30, 2005, the following swap agreements were outstanding:
Net Unrealized | ||||||||||||
Expiration | Appreciation/ | |||||||||||
Notional Amount | Date | Description | (Depreciation) | |||||||||
$ | 20,000,000 | 10/11/10 | Agreement with Morgan Stanley Capital Services, Inc., dated 10/07/05 to pay semi-annually the notional amount multiplied by 4.716% and to receive quarterly the notional amount multiplied by 3 month USD-LIBOR-BBA. | $ | 153,745 | |||||||
11,000,000 | 12/15/14 | Agreement with Morgan Stanley Capital Services, Inc., dated 12/13/04 to pay semi-annually the notional amount multiplied by 4.555% and to receive quarterly the notional amount multiplied by 3 month USD-LIBOR-BBA. | 232,103 | |||||||||
$ | 385,848 | |||||||||||
8. Federal Income Tax Information
Income and capital gain distributions are determined in accordance with federal income tax regulations, which may differ from generally accepted accounting principles.
During the year ended November 30, 2005 the tax character of the $12,233,207 of distributions paid was entirely from ordinary income.
At November 30, 2005 the components of net assets (excluding paid-in-capital) on a tax basis were as follows:
Undistributed Tax ordinary income
|
$ | 1,584,712 | |||
Accumulated capital loss
|
$ | (2,407,113 | ) | ||
Post October capital loss deferrals
|
(169,339 | ) | |||
Book basis unrealized appreciation/(depreciation)
|
(882,241 | ) | |||
Plus: Cumulative timing differences
|
154,397 | ||||
Unrealized appreciation/(depreciation)
|
$ | (727,844 | ) | ||
The cumulative timing differences under tax basis capital loss carryover are due to post-October losses. The differences between book and tax basis unrealized appreciation/ (depreciation) is primarily attributable to the differing treatment of swap income (expense) for tax purposes.
Federal Income Tax Basis: The federal income tax basis of the Funds investments at November 30, 2005 was $208,111,224. Net unrealized depreciation was $1,268,089 (gross unrealized appreciation $2,739,861; gross unrealized
19
depreciation $4,007,950). At November 30, 2005, the Fund had a capital loss carryforward of $2,407,113, which $1,070,268 expires in 2011 and $1,336,845 expires in 2013, available to offset any future gains, to the extent provided by regulations.
Capital Account Reclassification: At November 30, 2005, the Funds undistributed net investment income was increased by $1,115,836 with an offsetting increase in accumulated net realized loss. These adjustments were primarily the result of current period paydown reclassifications and swap interest income (expense) reclassifications.
9. Subsequent Events
Dividend: The Funds Board of Directors declared the following regular monthly dividends:
Dividend | Record | Payable | ||||||||
Per Share | Date | Date | ||||||||
$ | 0.09 | 12/20/05 | 12/29/05 | |||||||
$ | 0.09 | 12/30/05 | 01/27/06 |
10. Contractual Obligations
The Fund enters into contracts that have a variety of indemnification. The Funds maximum exposure under these arrangements is unknown. However, the Fund has not had prior claims or losses pursuant to these contracts and expects the risk of loss to be remote.
11. Change of Independent Registered Public Accounting Firm
In connection with the Transaction, PricewaterhouseCoopers LLP (PwC) was unable to conclude that it continued to be independent with respect to the Fund as a result of this acquisition by the ultimate parent corporation, Brascan Corp. that is now Brookfield Asset Management, Inc. PwC resigned as the Funds Independent Registered Public Accounting Firm, effective December 5, 2005. The Audit Committee of the Fund then submitted a recommendation to the Board of Directors to engage Briggs Bunting & Dougherty, LLP (BBD) as the Funds Independent Registered Public Accounting Firm for the fiscal year ended November 30, 2005. During the fiscal years ended November 30, 2004 and 2003, PwCs audit reports contained no adverse opinion or disclaimer of opinion; nor were their reports qualified as to uncertainty, audit scope or accounting principles. Further, during the fiscal years ended November 30, 2004 and 2003 and through December 5, 2005, there were no disagreements between the Fund and PwC on accounting principles or practices, financial statement disclosure or audit scope, which, if not resolved to the satisfaction of PwC, would have caused them to make reference to the disagreement in their reports.
During the two most recent fiscal years and through December 5, 2005, the date the Board of Directors approved BBD as the Funds auditor, the Fund did not consult BBD regarding either (1) the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Funds financial statements, or (2) any matter that was either the subject of a disagreement or a reportable event, as such terms are defined in Item 304 of Regulation S-K.
The Fund provided PwC with a copy of these disclosures and has requested PwC to furnish the Fund with a letter addressed to the Commission stating whether it agrees with the statements made by the Fund herein and, if not, detailing the particular statements with which it does not agree.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and Board of Directors of
We have audited the accompanying statement of assets and liabilities, including the portfolio of investments, of The Hyperion Strategic Mortgage Income Fund, Inc. as of November 30, 2005, and the related statements of operations and cash flows, changes in net assets and the financial highlights for the year then ended. These financial statements and financial highlights are the responsibility of the Funds management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audit. The statement of changes in net assets for the year ended November 30, 2004 and the financial highlights for each of the years or period in the three-year period then ended, have been audited by other auditors, whose report dated January 26, 2005 expressed an unqualified opinion on such financial statement and financial highlights.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. Our procedures included confirmation of securities owned as of November 30, 2005, by correspondence with the custodian and brokers. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of The Hyperion Strategic Mortgage Income Fund, Inc. as of November 30, 2005, the results of its operations and cash flows, changes in its net assets and its financial highlights for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
Briggs, Bunting & Dougherty, LLP
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TAX INFORMATION (Unaudited)
The Fund is required by subchapter M of the Internal Revenue Code of 1986, as amended, to advise you within 60 days of the Funds fiscal year end (November 30, 2005) as to the federal tax status of distributions received by shareholders during such fiscal year. Accordingly, we are advising you that all distributions paid during the fiscal year were derived from net investment income and are taxable as ordinary income. In addition, 4.56% of the Funds distributions during the fiscal year ended November 30, 2005 were earned from U.S. Treasury obligations. None of the Funds distributions qualify for the dividends received deduction available to corporate shareholders.
Because the Funds fiscal year is not the calendar year, another notification will be sent with respect to calendar 2005. The second notification, which will reflect the amount to be used by calendar year taxpayers on their federal, state and local income tax returns, will be made in conjunction with Form 1099-DIV and will be mailed in January 2006. Shareholders are advised to consult their own tax advisors with respect to the tax consequences of their investment in the Fund.
22
On September 27, 2005, the Board of Directors voted to approve changes to the Funds investment policies to permit the Fund to invest in three new types of investments. First, the Fund may now invest up to 20% of its gross assets in credit default swaps, limited to no more than 5% in any one issuer. Second, the Fund may now invest up to 10% of its gross assets in B-Notes and mezzanine loans, subject to a 5% limit in any one issuer. Third, the Fund may now invest up to 20% of its gross assets in total rate of return swaps, limited to 5% in any one issuer. These investments are described below.
Credit Default Swaps. In a credit default swap, one party agrees to pay another party a premium in exchange for receiving compensation if a third party or its obligation is subject to one or more specified adverse credit events (such as bankruptcy, failure to pay, acceleration of indebtedness, restructuring, or repudiation/moratorium) over a specified period.
B-Notes and Mezzanine Loans. A B-Note represents a subordinated interest in a loan collateralized by a commercial property. A mezzanine loan is an obligation that is secured by the borrowers equity interest in a property that is subject to a first mortgage. B-Notes and mezzanine loans are typically not rated by credit rating agencies.
Total Rate of Return Swaps. A total rate of return swap is a contract in which one party receives interest payments on a specific asset or group of assets plus any capital gains or losses over a specified period, while the other party receives a specified fixed or floating payment.
Credit and Interest Rate Risks. The Funds investments in credit default swaps, B-Notes, mezzanine loans, and total rate of return swaps may subject the Fund to credit risk or interest rate risk. In addition, when the Fund enters into a credit default swap or a total rate of return swap, it is subject to counterparty risk. The Fund seeks to reduce (but cannot eliminate) this risk by entering into swap contracts only with creditworthy counterparties.
23
The following tables provide information concerning the directors and officers of The Hyperion Strategic Mortgage Income Fund, Inc. (the Fund).
Position(s) Held with | Number of | |||||||
Fund and Term of | Principal Occupation(s) During Past 5 Years | Portfolios in Fund | ||||||
Name, Address | Office and Length of | and | Complex Overseen | |||||
and Age | Time Served | Other Directorships Held by Director | by Director | |||||
Disinterested Director | ||||||||
Class II Director to serve until 2007 Annual Meeting of Stockholders: | ||||||||
Rodman L. Drake
c/o One Liberty Plaza, 36th floor, New York, New York 10006-1404 Age 62 |
Chairman Elected December 9, 2003 Director since July 1989, Member of the Audit Committee, Chairman of Nominating and Compensation Committee Elected for Three Year Term |
Chairman (since December 2003) and Director of several investment companies advised by the Advisor or by its affiliates (1989-Present); Director of Crystal River Capital, Inc. (Crystal River)(2005-Present); Director of Student Loan Corporation (STU) (2005- Present), General Partner of Resource Capital Fund I, II & III, CIP L.P. (1998-Present); Co- founder, Baringo Capital LLC (2002-Present); Director, Jackson Hewitt Tax Services Inc. (JTX) (2004-Present); Director, Animal Medical Center (2002-Present); Director and/or Lead Director, Parsons Brinckerhoff, Inc. (1995-Present); Trustee of Excelsior Funds (33) (1994-Present). | 5 | |||||
Disinterested Director | ||||||||
Class I Director to serve until 2006 Annual Meeting of Stockholders: | ||||||||
Robert F. Birch
c/o One Liberty Plaza, 36th floor, New York, New York 10006-1404 Age 69 |
Director since December 1998, Member of the Audit
Committee, Member of Nominating and Compensation Committee,
Member of Executive Committee Elected for Three Year Term |
Director of several investment companies advised by the Advisor or by its affiliates (1998- Present); Chairman and President, New America High Income Fund (1992-Present); Director, Brandywine Funds (3) (2001 to Present). | 5 | |||||
Interested Director | ||||||||
Class III Director to serve until 2006 Annual Meeting of Stockholders: | ||||||||
Clifford E. Lai*
c/o One Liberty Plaza, 36th floor, New York, New York 10006-1404 Age 52 |
Director since December 2003 Elected until 2005 Member of Executive Committee Elected for Three Year Term |
President (1998-Present), Managing Partner (April 2005-Present) and Chief Investment Officer (1993-2002) of the Advisor; President and Director of Crystal River (2005-Present); Co-Chairman (2003-Present) and Board of Managers (1995-Present) of Hyperion GMAC Capital Advisors, LLC (Hyperion/GMAC, and formerly Lend Lease Hyperion Capital, LLC); President and Director of several investment companies advised by the Advisor (1993-Present). | 5 |
24
Position(s) Held with | Number of | |||||||
Fund and Term of | Principal Occupation(s) During Past 5 Years | Portfolios in Fund | ||||||
Name, Address | Office and Length of | and | Complex Overseen | |||||
and Age | Time Served | Other Directorships Held by Director | by Director | |||||
Disinterested Director | ||||||||
Class III Director to serve until 2006 Annual Meeting of Stockholders: | ||||||||
Louis P. Salvatore
c/o One Liberty Plaza, 165 Broadway, 36th Floor, New York, New York 10006-1404 Age 59 |
Director since September 2005, Director, Chairman of the Audit Committee, Member of Compensation and Nominating Committee Elected until Next Annual Meeting of Stockholders |
Director of several investment companies advised by the Advisor or by its affiliates (2005- Present); Director of Crystal River (2005- Present); Director of Turner Corp. (2003- Present); Director of Jackson Hewitt Tax Services, Inc. (2004-Present); Employee of Arthur Andersen LLP (2002-Present); Partner of Arthur Andersen LLP (1977-2002). | 2 |
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Officers of the Trust
Position(s) | Term of Office and | Principal Occupation(s) | ||||
Name, Address and Age | Held with Fund | Length of Time Served | During Past 5 Years | |||
Clifford E. Lai*
c/o One Liberty Plaza, 36th floor, New York, New York 10006-1404 Age 52 |
President | Elected Annually Since June 2002 | Please see Information Concerning Nominees/Directors. | |||
John Dolan*
c/o One Liberty Plaza, 36th floor, New York, New York 10006-1404 Age 52 |
Vice President | Elected Annually Since June 2002 | Managing Partner (April 2005-Present), Chief Investment Strategist (1998-Present) and Chief Investment Officer (2002-Present) of the Advisor; Chief Investment Officer of Crystal River (2005-Present). | |||
Daniel S. Kim*
c/o One Liberty Plaza, 36th floor, New York, New York 10006-1404 Age 37 |
Chief Compliance Officer (CCO) & Secretary | Elected Annually CCO Since September 2004 and Secretary Since January 2005 | Director, General Counsel and CCO (September 2004-Present), and Secretary (January 2005- Present) of the Adviser; Secretary (January 2005-Present) and CCO (September 2004- Present) of several investment companies advised by the Advisor; Secretary (January 2005-Present) and CCO (September 2004-Present) of Hyperion/GMAC; Assistant Secretary of Crystal River (2005-Present), Assistant General Counsel (May 2001-August 2004) of Oak Hill Capital Management; Assistant General Counsel (May 2001-August 2004) of Oak Hill Advisors, LP; Lawyer (January 2001-April 2001) Arkin, Kaplan & Cohen. | |||
Thomas F. Doodian*
c/o One Liberty Plaza, 36th floor, New York, New York 10006-1404 Age 46 |
Treasurer | Elected Annually Since June 2002 | Managing Director, Chief Operating Officer (1998-Present) and Director of Finance and Operations of the Advisor (1995-Present); Treasurer of several investment companies advised by the Advisor (1996-Present); Treasurer of Hyperion/GMAC (1996-Present). |
* | Interested person as defined by the Investment Company Act of 1940 (the 1940 Act) because of affiliations with Hyperion Capital Management, Inc., the Funds Advisor. |
The Funds Statement of Additional Information includes additional information about the directors and is available, without charge, upon request by calling 1-800-497-3746.
26
A Dividend Reinvestment Plan (the Plan) is available to shareholders of the Fund pursuant to which they may elect to have all distributions of dividends and capital gains automatically reinvested by American Stock Transfer & Trust Company (the Plan Agent) in additional Fund shares. Shareholders who do not participate in the Plan will receive all distributions in cash paid by check mailed directly to the shareholder of record (or if the shares are held in street or other nominee name, then to the nominee) by the Funds Custodian, as Dividend Disbursing Agent.
The Plan Agent serves as agent for the shareholders in administering the Plan. After the Fund declares a dividend or determines to make a capital gain distribution, payable in cash, if (1) the market price is lower than net asset value, the participants in the Plan will receive the equivalent in Fund shares valued at the market price determined as of the time of purchase (generally, the payment date of the dividend or distribution); or if (2) the market price of the shares on the payment date of the dividend or distribution is equal to or exceeds their net asset value, participants will be issued Fund shares at the higher of net asset value or 95% of the market price. This discount reflects savings in underwriting and other costs that the Fund otherwise will be required to incur to raise additional capital. If net asset value exceeds the market price of the Fund shares on the payment date or the Fund declares a dividend or other distribution payable only in cash (i.e., if the Board of Directors precludes reinvestment in Fund shares for that purpose), the Plan Agent will, as agent for the participants, receive the cash payment and use it to buy Fund shares in the open market, on the New York Stock Exchange or elsewhere, for the participants accounts. If, before the Plan Agent has completed its purchases, the market price exceeds the net asset value of the Funds shares, the average per share purchase price paid by the Plan Agent may exceed the net asset value of the Funds shares, resulting in the acquisition of fewer shares than if the dividend or distribution had been paid in shares issued by the Fund. The Fund will not issue shares under the Plan below net asset value.
Participants in the Plan may withdraw from the Plan upon written notice to the Plan Agent. When a participant withdraws from the Plan or upon termination of the Plan by the Fund, certificates for whole shares credited to his or her account under the Plan will be issued and a cash payment will be made for any fraction of a share credited to such account.
There is no charge to participants for reinvesting dividends or capital gain distributions, except for certain brokerage commissions, as described below. The Plan Agents fees for handling the reinvestment of dividends and distributions are paid by the Fund. There are no brokerage commissions charged with respect to shares issued directly by the Fund. However, each participant will pay a pro rata share of brokerage commissions incurred with respect to the Plan Agents open market purchases in connection with the reinvestment of dividends and distributions.
The automatic reinvestment of dividends and distributions will not relieve participants of any federal income tax that may be payable on such dividends or distributions.
A brochure describing the Plan is available from the Plan Agent, by calling 1-212-936-5100.
If you wish to participate in the Plan and your shares are held in your name, you may simply complete and mail the enrollment form in the brochure. If your shares are held in the name of your brokerage firm, bank or other nominee, you should ask them whether or how you can participate in the Plan. Shareholders whose shares are held in the name of a brokerage firm, bank or other nominee and are participating in the Plan may not be able to continue participating in the Plan if they transfer their shares to a different brokerage firm, bank or other nominee, since such shareholders may participate only if permitted by the brokerage firm, bank or other nominee to which their shares are transferred.
27
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SUB-ADMINISTRATOR
STATE STREET BANK and TRUST COMPANY
225 Franklin Street
Boston, Massachusetts 02116
CUSTODIAN AND FUND ACCOUNTING AGENT
STATE STREET BANK and TRUST COMPANY
225 Franklin Street
Boston, Massachusetts 02116
TRANSFER AGENT
AMERICAN STOCK TRANSFER & TRUST
COMPANY
Investor Relations Department
59 Maiden Lane
New York, NY 10038
For Shareholder Services:
1 (800) 937-5449
INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM
BRIGGS, BUNTING & DOUGHERTY, LLP
Two Penn Center Plaza, Suite 820
Philadelphia, Pennsylvania 19102
LEGAL COUNSEL
SULLIVAN & WORCESTER LLP
1666 K Street, NW
Washington, D.C. 20006
Notice is hereby given in accordance with Section 23(c) of the Investment Company Act of 1940 that periodically the Fund may purchase its shares in the open market at prevailing market prices.
Quarterly Portfolio Schedule: The Fund will file Form N-Q with the Securities and Exchange Commission for the first and third quarters of each fiscal year. The Funds Forms N-Q will be available on the Securities and Exchange Commissions website at http://www.sec.gov. The Funds Forms N-Q may be reviewed and copied at the Securities and Exchange Commissions Public Reference Room in Washington, D.C. and information on the operation of the Public Reference Room may be obtained by calling 1 (800) SEC-0330. Once filed, the most recent Form N-Q will be available without charge, upon request, by calling 1 (800) HYPERION or on the Funds website at http://www.hyperioncapital.com.
Proxy Voting Policies and Procedures
A description of the policies and procedures that the Fund uses to determine how to vote proxies relating to portfolio securities is available without charge, upon request, by calling 1 (800) 497-3746 and on the Securities and Exchange Commissions website at http://www.sec.gov.
Proxy Voting Record
The Fund has filed with the Securities and Exchange Commission its proxy voting record for the 12-month period ending November 30, 2005 on Form N-PX. Once filed, the most recent Form N-PX will be available without charge, upon request, by calling 1 (800) 497-3746 or on the Securities and Exchange Commissions website at http://www.sec.gov.
Rodman L. Drake* Chairman Robert F. Birch* Director Louis P. Salvatore* Director Clifford E. Lai Director and President John Dolan Vice President Thomas F. Doodian Treasurer Daniel Kim CCO and Secretary |
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* Audit Committee Members | ||
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This report is for shareholder information. This is not a prospectus intended for use in the purchase or sale of Fund shares. | ||
The Hyperion Strategic Mortgage | ||
Income Fund, Inc. | ||
One Liberty Plaza | ||
165 Broadway, 36th Floor | ||
New York, NY 10006-1404 |