485BPOS 1 f01713e485bpos.txt SCHWAB INVESTMENTS FORM N-1A File Nos. 33-37459 and 811-6200 As filed with the Securities and Exchange Commission on November 12, 2004 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM N-1A REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 Post-Effective Amendment No. 53 [X] and REGISTRATION STATEMENT UNDER THE INVESTMENT COMPANY ACT OF 1940 Amendment No. 57 [X] SCHWAB INVESTMENTS (Exact Name of Registrant as Specified in Charter) 101 Montgomery Street, San Francisco, California 94104 (Address of Principal Executive Offices) (zip code) Registrant's Telephone Number, including Area Code: (415) 627-7000 Evelyn Dilsaver 101 Montgomery Street, San Francisco, California 94104 (Name and Address of Agent for Service) Copies of communications to: Richard W. Grant Esq. John M. Loder, Esq. Koji E. Felton, Esq. Morgan Lewis & Bockius LLP Ropes & Gray Charles Schwab Investment Management, Inc. 1701 Market Street One International Place 101 Montgomery Street Philadelphia, PA 19103 Boston, MA 02110-2624 120KNY-14-109 San Francisco, CA 94104
It is proposed that this filing will become effective (check appropriate box): / / Immediately upon filing pursuant to paragraph (b) /X/ On November 15, 2004, pursuant to paragraph (b) / / 60 days after filing pursuant to paragraph (a)(i) / / On (date), pursuant to paragraph (a)(1) / / 75 days after filing pursuant to paragraph (a)(ii) / / On (date), pursuant to paragraph (a)(ii) of Rule 485 if appropriate, check appropriate box: / / This post-effective amendment designates a new effective date for a previously filed post-effective amendment Part C SCHWAB TAX-FREE BOND FUNDS PROSPECTUS November 15, 2004 Schwab Tax-Free YieldPlus Fund TM Schwab Short/Intermediate Tax-Free Bond Fund TM Schwab Long-Term Tax-Free Bond Fund TM Schwab California Tax-Free YieldPlus Fund TM Schwab California Short/Intermediate Tax-Free Bond Fund TM Schwab California Long-Term Tax-Free Bond Fund TM As with all mutual funds, the Securities and Exchange Commission (SEC) has not approved these securities or passed on whether the information in this prospectus is adequate and accurate. Anyone who indicates otherwise is committing a federal crime. This prospectus does not offer for sale and is not a solicitation of offers to purchase shares of certain funds described herein in those states and jurisdictions where the funds are not registered and/or qualified for sale. [CHARLES SCHWAB LOGO] SCHWAB TAX-FREE BOND FUNDS ABOUT THE FUNDS Schwab Tax-Free YieldPlus Fund TM ................................. 2 Schwab Short/Intermediate Tax-Free Bond Fund TM ................... 7 Schwab Long-Term Tax-Free Bond Fund TM ............................ 11 Schwab California Tax-Free YieldPlus Fund TM ...................... 15 Schwab California Short/Intermediate Tax-Free Bond Fund TM ........ 20 Schwab California Long-Term Tax-Free Bond Fund TM ................. 24 Fund management ................................................... 28 INVESTING IN THE FUNDS Buying shares ..................................................... 30 Selling/exchanging shares ......................................... 32 Transaction policies .............................................. 33 Distributions and taxes ........................................... 34 ABOUT THE FUNDS The Schwab Tax-Free Bond Funds seek to provide high current income exempt from federal income tax and, in the case of the California funds, California personal income tax. Because these funds invest primarily in municipal bonds, their dividends are generally exempt from federal income tax. Dividends from the California funds are generally exempt from California personal income tax as well. The fund's performance will fluctuate over time and, as with all investments, future performance may differ from past performance. SCHWAB TAX-FREE YIELDPLUS FUND TM TICKER SYMBOLS Investor Shares: SWYIX Select Shares (R): SWYTX -------------------------------------------------------------------------------- THE FUND SEEKS HIGH CURRENT INCOME THAT IS EXEMPT FROM FEDERAL INCOME TAX CONSISTENT WITH MINIMAL CHANGES IN SHARE PRICE. RISK MANAGEMENT The fund's manager may use a variety of techniques to help manage risk, including investments in derivatives. Derivatives generally are investments whose value is based on one or more securities, rates or indices and can be effective risk management tools. For example, the fund may buy and sell financial futures and swaps to help manage the effects of interest rate changes. A financial future is a contract to buy or sell a specific financial instrument at a specified price at a specific future time. Such financial instruments include treasury securities, and other debt obligations, the prices of which fluctuate with changes in interest rates. A swap is a contract between the fund and another party to exchange a set of payments that the fund owns for a set of payments owned by the other party. Two kinds of swaps are index swaps and interest-rate swaps. -------------------------------------------------------------------------------- STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN INVESTMENT-GRADE (HIGH AND CERTAIN MEDIUM QUALITY, RATED AAA TO BBB- OR THE UNRATED EQUIVALENT AS DETERMINED BY THE INVESTMENT ADVISER) MUNICIPAL SECURITIES. The fund normally invests at least 80% of its net assets in municipal securities the interest from which is exempt from federal income tax, including the federal alternative minimum tax (AMT). The fund does not currently intend to invest in municipal securities whose interest is subject to the AMT. The fund may invest in fixed-, variable- or floating-rate securities from municipal issuers around the country and in U.S. territories and possessions. These may include general obligation issues, which typically are backed by the issuer's ability to levy taxes, and revenue issues, which typically are backed by a stream of revenue from a given source, such as an electric utility or a public water system. The fund may invest more than 25% of its total assets in municipal securities financing similar projects, such as those relating to education, health care, transportation, and utilities. Many of the fund's securities carry credit enhancements (such as bond insurance) or liquidity enhancements (such as a letter of credit), which are designed to provide incremental levels of creditworthiness or liquidity. In choosing securities, the fund's manager seeks to maximize current income within the limits of the fund's credit and maturity policies. To help maintain a high degree of share price stability, the fund seeks to keep the average duration of its portfolio at one year or less. Duration is a tool to measure interest rate risk. The fund may invest in bonds with effective or final maturities of any length and may invest up to 15% of its assets in lower quality bonds (sometimes called junk bonds) that are rated at least B or are the unrated equivalent as determined by the investment adviser. The investment adviser's credit research department analyzes and monitors the securities that the fund owns or is considering buying. The manager may adjust the fund's holdings or its average duration based on actual or anticipated changes in interest rates or credit quality. The manager also 2 Schwab Tax-Free YieldPlus Fund TM may use investment techniques, such as short sales, futures contracts, swap agreements and other derivatives, in seeking to increase income, reduce share price volatility and otherwise manage the fund's exposure to investment risks. The fund's investment strategy is designed to offer the potential for somewhat higher yields than a municipal money market fund, although unlike a money market fund, its share price will fluctuate. In exchange for seeking minimal fluctuation in share price, the fund may offer lower long-term performance than stock investments or certain other bond investments. The fund may buy and sell portfolio securities actively. If it does, its portfolio turnover rate and transaction costs will rise, which may lower fund performance and increase the likelihood of capital gain distributions. During unusual market conditions, the fund may invest in taxable securities, including securities subject to AMT, as a temporary defensive measure. When the fund engages in such activities, the fund would not be pursuing its goal and, as a result, may not achieve its investment objective. Schwab Tax-Free YieldPlus Fund TM 3 Individuals in higher tax brackets with investment horizons of one year or more who are seeking tax-exempt income, including income exempt from AMT, may want to consider this fund as an alternative to a municipal money fund. RISKS INTEREST RATES RISE AND FALL OVER TIME. As with any investment whose yield reflects current interest rates, the fund's yield will change over time. During periods when interest rates are low, the fund's yield (and total return) also may be low. Changes in interest rates also may affect the fund's share price: a sharp rise in interest rates could cause the fund's share price to fall. Assuming a one year duration for the fund, a 2% increase in interest rates would result in approximately a 2% decrease in the fund's share price. This risk is greater when the fund holds bonds with longer maturities. THE FUND IS NOT A MONEY MARKET FUND OR A BANK DEPOSIT. Its shares are not insured or guaranteed. Because the fund's share price may move up and down, the value of your investment in the fund will fluctuate, which means you could lose money. In exchange for seeking minimal fluctuation in share price, the fund may offer lower long-term performance than stock investments or certain other bond investments. STATE AND REGIONAL FACTORS COULD AFFECT THE FUND'S PERFORMANCE. To the extent that the fund invests in securities from a given state or geographic region, its share price and performance could be affected by local, state and regional factors, including erosion of the tax base and changes in the economic climate. National governmental actions, such as the elimination of tax-exempt status, also could affect performance. In addition, the fund may be more sensitive to adverse economic, business or political developments if it invests a substantial portion of its assets in municipal securities financing similar projects. A change that affects one project, such as proposed legislation on the financing of the project, a shortage of the materials needed for the project, or a declining need for the project, would likely affect all similar projects and the overall municipal securities market. Because the fund is non-diversified, it may divide its assets among fewer issuers than a diversified fund. This means that the fund could increase its exposure to the risks of a given issuer. A DECLINE IN THE CREDIT QUALITY OF A PORTFOLIO INVESTMENT COULD CAUSE THE FUND'S SHARE PRICE TO FALL. Although the fund invests primarily in investment-grade securities, the fund could lose money if the issuer or guarantor of a portfolio investment fails to make timely principal or interest payments or otherwise honor its obligations. Lower quality bonds are considered speculative with respect to the issuer's ability to make principal and interest payments. In addition, prices of lower-quality bonds tend to be more volatile than those of investment-grade bonds, and may fall based on bad news about the issuer, and industry or the overall economy. THE MANAGER'S MATURITY AND DURATION DECISIONS ALSO WILL AFFECT THE FUND'S PERFORMANCE. To the extent that the manager anticipates interest rate trends imprecisely, the fund could miss yield opportunities or its share price could fall. 4 Schwab Tax-Free YieldPlus Fund TM IF CERTAIN TYPES OF INVESTMENTS THE FUND BUYS AS TAX-EXEMPT ARE LATER RULED TO BE TAXABLE, A PORTION OF THE FUND'S INCOME COULD BE TAXABLE. Any defensive investments in taxable securities could generate taxable income. Also, some types of municipal securities produce income that is subject to the AMT. WHILE THE FUND MAY USE A VARIETY OF TECHNIQUES TO HELP MANAGE RISK, THEY COULD HURT THE FUND'S PERFORMANCE IF THEY DON'T PERFORM AS EXPECTED. For example, if the fund uses a technique involving a derivative, such as a futures contract or swap agreement, for the purpose of offsetting price changes in the fund's portfolio, but the technique does not precisely offset the price changes, the fund's share price could fall. The fund's performance also could be hurt if the counterparty to a derivative does not honor its contractual obligations to the fund. THE COST OF DERIVATIVES MAY HAVE THE EFFECT OF INCREASING FUND EXPENSES. While the decision to use or not use a given risk management technique depends on market conditions, these costs could at times outweigh the benefits the fund realizes from these techniques. THE FUND COULD LOSE MONEY IF THE PRICES OF SECURITIES SOLD SHORT INCREASE. When the fund sells a security short, it sells a security it does not own and must borrow the security to deliver to the buyer. The fund is obligated to replace the borrowed security by purchasing it at the then current market price, which may be more or less than the price at which the security was sold by the fund. Schwab Tax-Free YieldPlus Fund TM 5 PERFORMANCE Because this is a new fund, no performance figures are given. This information will appear in a future version of the fund's prospectus. FUND FEES AND EXPENSES The following table describes what you could expect to pay as a fund investor. "Shareholder fees" are charged to you directly by the fund. "Annual operating expenses" are paid out of fund assets, so their effect is included in the total return for each share class. FEE TABLE (%)
INVESTOR SELECT SHAREHOLDER FEES SHARES SHARES(R) --------------------------------------------------------------------------------- None None ANNUAL OPERATING EXPENSES (% of average net assets) --------------------------------------------------------------------------------- Management fees 0.35 0.35 Distribution (12b-1) fees None None Other expenses* 0.47 0.32 ------------------ Total annual operating expenses 0.82 0.67 Less expense reduction (0.18) (0.18) ------------------ NET OPERATING EXPENSES** 0.64 0.49 ==================
* Based on estimated expenses for the current fiscal year. ** Schwab and the investment adviser have guaranteed that the "net operating expenses" (excluding interest, taxes, and certain non-routine expenses) of the Investor Shares and the Select Shares will equal 0.00% through 5/01/05. For the period 5/2/05 through 11/15/05, Schwab and the investment adviser have guaranteed that "net operating expenses" (excluding interest, taxes, and certain non-routine expenses) of the Investor Shares and Select Shares will not exceed 0.64% and 0.49%, respectively. Designed to help you compare expenses, the example below uses the same assumptions as other mutual fund prospectuses: a $10,000 investment, a 5% return each year and that the fund's operating expenses remain the same. The one-year figure is based on net operating expenses (after application of the expense reduction guarantee through 11/15/05). The expenses would be the same whether you stayed in the fund or sold your shares at the end of each period. Your actual costs may be higher or lower. EXPENSES ON A $10,000 INVESTMENT
1 year 3 years ------------------------------------------------------- INVESTOR SHARES $43 $222 SELECT SHARES $33 $179
6 Schwab Tax-Free YieldPlus Fund TM SCHWAB SHORT/INTERMEDIATE TAX-FREE BOND FUND TM TICKER SYMBOL: SWITX STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN INVESTMENT-GRADE MUNICIPAL SECURITIES--THOSE IN THE FOUR HIGHEST CREDIT RATING CATEGORIES (RATED AAA TO BBB- OR THE UNRATED EQUIVALENT AS DETERMINED BY THE INVESTMENT ADVISER). The fund normally invests at least 80% of its net assets in municipal securities the interest from which is exempt from federal income tax, including the federal alternative minimum tax (AMT). To help preserve investors' capital, the fund seeks to keep the average maturity of its portfolio between two and five years. The fund may invest in fixed-, variable- or floating-rate securities from municipal issuers around the country and in U.S. territories and possessions. These may include general obligation issues, which typically are backed by the issuer's ability to levy taxes, and revenue issues, which typically are backed by a stream of revenue from a given source, such as an electric utility or a public water system. The fund may invest more than 25% of its total assets in municipal securities financing similar projects, such as those relating to education, health care, transportation, and utilities and may also invest in municipal notes. Many of the fund's securities carry credit enhancements (such as bond insurance) or liquidity enhancements (such as a letter of credit), which are designed to provide incremental levels of creditworthiness or liquidity. In choosing securities, the fund's manager seeks to maximize current income within the limits of the fund's credit and average maturity standards. The investment adviser's credit research department analyzes and monitors the securities that the fund owns or is considering buying. If a portfolio security falls below investment-grade or the unrated equivalent, the fund may continue to hold it if the investment adviser believes it would benefit the fund. The manager may adjust the fund's holdings or its average maturity based on actual or anticipated changes in interest rates or credit quality. During unusual market conditions, the fund may invest in taxable securities as a temporary defensive measure. When the fund engages in such activities, the fund would not be pursuing its goal and, as a result, it may not achieve its investment objective. -------------------------------------------------------------------------------- THE FUND SEEKS HIGH CURRENT INCOME THAT IS EXEMPT FROM FEDERAL INCOME TAX, CONSISTENT WITH CAPITAL PRESERVATION. SHORTER MATURITIES As a bond approaches maturity, its market value typically moves closer to its par value (the amount of the bond's principal value, which a bondholder receives when the bond matures). Investing in short- and intermediate-term bonds is a common strategy for reducing price volatility and other risks. In exchange for these lower risks, short-and intermediate-term bonds typically (though not always) offer lower yields than longer term bonds. -------------------------------------------------------------------------------- Schwab Short/Intermediate Tax-Free Bond Fund TM 7 Individuals in higher tax brackets who are seeking tax-exempt income along with the potential for lower volatility may want to consider this fund. RISKS BOND MARKETS RISE AND FALL DAILY. As with any investment whose performance is tied to these markets, the value of your investment in the fund will fluctuate, which means that you could lose money. WHEN INTEREST RATES RISE, BOND PRICES USUALLY FALL, AND WITH THEM THE FUND'S SHARE PRICE. The fund's short-to-intermediate maturity is designed to reduce this risk, but will not eliminate it. A fall in interest rates could hurt the fund as well, by lowering its yield. This is because issuers tend to pay off their bonds when interest rates fall, often forcing the fund to reinvest in lower-yielding securities. STATE AND REGIONAL FACTORS COULD AFFECT THE FUND'S PERFORMANCE. To the extent that the fund invests in securities from a given state or geographic region, its share price and performance could be affected by local, state and regional factors, including erosion of the tax base and changes in the economic climate. National governmental actions, such as the elimination of tax-exempt status, also could affect performance. In addition, the fund may be more sensitive to adverse economic, business or political developments if it invests a substantial portion of its assets in municipal securities financing similar projects. A change that affects one project, such as proposed legislation on the financing of the project, a shortage of the materials needed for the project, or a declining need for the project, would likely affect all similar projects and the overall municipal securities market. Because the fund is non-diversified, it may divide its assets among fewer issuers than a diversified fund. This means that the fund could increase its exposure to the risks of a given issuer. A DECLINE IN THE CREDIT QUALITY OF A PORTFOLIO INVESTMENT COULD CAUSE THE FUND'S SHARE PRICE TO FALL. Although the fund invests primarily in investment-grade municipal securities, the fund could lose money if the issuer or guarantor of a portfolio investment fails to make timely principal or interest payments or otherwise honor its obligations. The fund's emphasis on quality and preservation of capital also could cause it to underperform certain other types of bond investments, particularly those that take greater maturity and credit risks. At the same time, some of the fund's investments may have greater risks than securities in taxable bond funds. THE MANAGER'S MATURITY DECISIONS ALSO WILL AFFECT THE FUND'S PERFORMANCE. To the extent that the manager anticipates interest rate trends imprecisely, the fund could miss yield opportunities or its share price could fall. IF CERTAIN TYPES OF INVESTMENTS THE FUND BUYS AS TAX-EXEMPT ARE LATER RULED TO BE TAXABLE, A PORTION OF THE FUND'S INCOME COULD BE TAXABLE. Any defensive investments in taxable securities could generate taxable income. Also, some types of municipal securities produce income that is subject to the AMT. THE FUND IS NOT DESIGNED TO OFFER SUBSTANTIAL CAPITAL APPRECIATION. In exchange for its goal of capital preservation, the fund may offer lower long-term performance than stock investments or certain other types of bond investments. 8 Schwab Short/Intermediate Tax-Free Bond Fund TM PERFORMANCE The information below shows fund returns before and after taxes, and compares fund performance (which varies over time) to that of an index. The index is unmanaged and does not include expenses or taxes. All figures assume distributions were reinvested. The after-tax figures: - reflect the highest individual federal marginal income tax rate that applied during the period, but assume no state or local taxes - may not reflect your actual after-tax performance - may not be relevant to shares in an IRA, 401(k) or other tax-advantaged retirement account Keep in mind that future performance (both before and after taxes) may differ from past performance. ANNUAL TOTAL RETURNS (%) as of 12/31 [BAR CHART] 94 (1.12) 95 9.28 96 3.54 97 5.17 98 4.78 99 0.51 00 6.68 01 4.42 02 7.61 03 3.44 BEST QUARTER: 3.16% Q2 2002 WORST QUARTER: (2.33%) Q1 1994 YEAR-TO-DATE PERFORMANCE AS OF 9/30/04: 1.24%
AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/03
1 year 5 years 10 years -------------------------------------------------------------------------------- FUND Before taxes 3.44 4.50 4.39 After tax on distributions 3.44 4.50 4.39 After tax on distributions and sale 3.24 4.37 4.31 LEHMAN BROTHERS THREE-YEAR MUNICIPAL BOND INDEX 2.68 4.81 4.86
FUND FEES AND EXPENSES The following table describes what you could expect to pay as a fund investor. "Shareholder fees" are charged to you directly by the fund. "Annual operating expenses" are paid out of fund assets, so their effect is included in the fund's total return. FEE TABLE (%)
SHAREHOLDER FEES --------------------------------------------------------------------- None ANNUAL OPERATING EXPENSES (% of average net assets) --------------------------------------------------------------------- Management fees 0.30 Distribution (12b-1) fees None Other expenses 0.33 ------ Total annual operating expenses* 0.63 ======
* Schwab and the investment adviser have guaranteed that the "annual operating expenses" (excluding interest, taxes, and certain non-routine expenses) will not exceed 0.65% through 11/15/05. Designed to help you compare expenses, the example below uses the same assumptions as other mutual fund prospectuses: a $10,000 investment, a 5% return each year and that the fund's operating expenses remain the same. The expenses would be the same whether you stayed in the fund or sold your shares at the end of each period. Your actual costs may be higher or lower. EXPENSES ON A $10,000 INVESTMENT
1 year 3 years 5 years 10 years -------------------------------------------------------------------------------- $64 $202 $351 $786
Schwab Short/Intermediate Tax-Free Bond Fund TM 9 FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the past five years. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/03- 9/1/02- 9/1/01- 9/1/00- 9/1/99- 8/31/04 8/31/03 8/31/02 8/31/01 8/31/00 ------------------------------------------------------------------------------------------------------------------------------------ PER-SHARE DATA ($) ------------------------------------------------------------------------------------------------------------------------------------ Net asset value at beginning of period 10.59 10.63 10.42 10.08 10.05 -------------------------------------------------------------------------- Income from investment operations: Net investment income 0.29 0.30 0.35 0.39 0.41 Net realized and unrealized gains or losses 0.10 (0.04) 0.20 0.34 0.03 -------------------------------------------------------------------------- Total income from investment operations 0.39 0.26 0.55 0.73 0.44 Less distributions: Dividends from net investment income (0.29) (0.30) (0.34) (0.39) (0.41) -------------------------------------------------------------------------- Net asset value at end of period 10.69 10.59 10.63 10.42 10.08 -------------------------------------------------------------------------- Total return (%) 3.74 2.50 5.37 7.42 4.50 RATIOS/SUPPLEMENTAL DATA (%) ------------------------------------------------------------------------------------------------------------------------------------ Ratios to average net assets: Net operating expenses 0.63 0.60 0.49 0.49 0.50 1 Gross operating expenses 0.63 0.63 0.70 0.73 0.75 Net investment income 2.73 2.83 3.29 3.84 4.11 Portfolio turnover rate 19 11 28 14 11 Net assets, end of period ($ x 1,000,000) 161 159 139 109 76
1 The ratio of net operating expenses would have been 0.49% if certain non-routine expenses (proxy fees) had not been included. 10 Schwab Short/Intermediate Tax-Free Bond Fund TM SCHWAB LONG-TERM TAX-FREE BOND FUND TM TICKER SYMBOL: SWNTX STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN INVESTMENT-GRADE MUNICIPAL SECURITIES--THOSE IN THE FOUR HIGHEST CREDIT RATING CATEGORIES (RATED AAA TO BBB- OR THE UNRATED EQUIVALENT AS DETERMINED BY THE INVESTMENT ADVISER). The fund normally invests at least 80% of its net assets in municipal securities the interest from which is exempt from federal income tax, including the federal alternative minimum tax (AMT). The fund seeks to maintain an average maturity in its portfolio of at least ten years. The fund may invest in fixed-, variable- or floating-rate securities from municipal issuers around the country and in U.S. territories and possessions. These may include general obligation issues, which typically are backed by the issuer's ability to levy taxes, and revenue issues, which typically are backed by a stream of revenue from a given source, such as an electric utility or a public water system. The fund may invest more than 25% of its total assets in municipal securities financing similar projects, such as those relating to education, health care, transportation, and utilities and may also invest in municipal notes. Many of the fund's securities carry credit enhancements (such as bond insurance) or liquidity enhancements (such as a letter of credit), which are designed to provide incremental levels of creditworthiness or liquidity. In choosing securities, the fund's manager seeks to maximize current income within the limits of the fund's credit and average maturity standards. The investment adviser's credit research department analyzes and monitors the securities that the fund owns or is considering buying. If a portfolio security falls below investment-grade or the unrated equivalent, the fund may continue to hold it if the investment adviser believes it would benefit the fund. The manager may adjust the fund's holdings or its average maturity based on actual or anticipated changes in interest rates or credit quality. During unusual market conditions, the fund may invest in taxable securities as a temporary defensive measure. When the fund engages in such activities, the fund would not be pursuing its goal and, as a result, it may not achieve its investment objective. -------------------------------------------------------------------------------- THE FUND SEEKS HIGH CURRENT INCOME THAT IS EXEMPT FROM FEDERAL INCOME TAX, CONSISTENT WITH CAPITAL PRESERVATION. MATURITY AND YIELD Bond yields typically are higher the longer the bond's maturity. By investing in longer term bonds, the fund seeks to earn higher yields over time than the Schwab Short/Intermediate Tax-Free Bond Fund TM. Maintaining a longer average maturity does carry certain risks, and investors should expect this fund's share price to fluctuate more than that of the Schwab Short/Intermediate Tax-Free Bond Fund. -------------------------------------------------------------------------------- Schwab Long-Term Tax-Free Bond Fund TM 11 This fund is designed for individuals in higher tax brackets who are interested in high current tax-exempt income and can accept a higher degree of risk to their investment. RISKS BOND MARKETS RISE AND FALL DAILY. As with any investment whose performance is tied to these markets, the value of your investment in the fund will fluctuate, which means that you could lose money. WHEN INTEREST RATES RISE, BOND PRICES USUALLY FALL, AND WITH THEM THE FUND'S SHARE PRICE. The fund's comparatively long maturity will tend to make it more sensitive to this risk than funds with shorter average maturities. STATE AND REGIONAL FACTORS COULD AFFECT THE FUND'S PERFORMANCE. To the extent that the fund invests in securities from a given state or geographic region, its share price and performance could be affected by local, state and regional factors, including erosion of the tax base and changes in the economic climate. National governmental actions, such as the elimination of tax-exempt status, also could affect performance. In addition, the fund may be more sensitive to adverse economic, business or political developments if it invests a substantial portion of its assets in municipal securities financing similar projects. A change that affects one project, such as proposed legislation on the financing of the project, a shortage of the materials needed for the project, or a declining need for the project, would likely affect all similar projects and the overall municipal securities market. Because the fund is non-diversified, it may divide its assets among fewer issuers than a diversified fund. This means that the fund could increase its exposure to the risks of a given issuer. A DECLINE IN THE CREDIT QUALITY OF A PORTFOLIO INVESTMENT COULD CAUSE THE FUND'S SHARE PRICE TO FALL. Although the fund invests primarily in investment-grade municipal securities, the fund could lose money if the issuer or guarantor of a portfolio investment fails to make timely principal or interest payments or otherwise honor its obligations. The fund's emphasis on quality and preservation of capital also could cause it to underperform certain other types of bond investments, particularly those that take greater maturity and credit risks. At the same time, some of the fund's investments may have greater risks than securities in taxable bond funds. THE MANAGER'S MATURITY DECISIONS ALSO WILL AFFECT THE FUND'S PERFORMANCE. To the extent that the manager anticipates interest rate trends imprecisely, the fund could miss yield opportunities or its share price could fall. IF CERTAIN TYPES OF INVESTMENTS THE FUND BUYS AS TAX-EXEMPT ARE LATER RULED TO BE TAXABLE, A PORTION OF THE FUND'S INCOME COULD BE TAXABLE. Any defensive investments in taxable securities could generate taxable income. Also, some types of municipal securities produce income that is subject to the AMT. THE FUND IS NOT DESIGNED TO OFFER SUBSTANTIAL CAPITAL APPRECIATION. In exchange for its goal of capital preservation, the fund may offer lower long-term performance than stock investments or certain other types of bond investments. 12 Schwab Long-Term Tax-Free Bond Fund TM PERFORMANCE The information below shows fund returns before and after taxes, and compares fund performance (which varies over time) to that of an index. The index is unmanaged and does not include expenses or taxes. All figures assume distributions were reinvested. The after-tax figures: - reflect the highest individual federal marginal income tax rate that applied during the period, but assume no state or local taxes - may not reflect your actual after-tax performance - may not be relevant to shares in an IRA, 401(k) or other tax-advantaged retirement account Keep in mind that future performance (both before and after taxes) may differ from past performance. ANNUAL TOTAL RETURNS (%) as of 12/31 [BAR CHART] 94 (7.04) 95 18.14 96 4.18 97 9.83 98 6.14 99 (7.31) 00 15.61 01 3.80 02 10.90 03 5.47 BEST QUARTER: 8.03% Q1 1995 WORST QUARTER: (5.88%) Q1 1994 YEAR-TO-DATE PERFORMANCE AS OF 9/30/04: 2.97%
AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/03
1 year 5 years 10 years -------------------------------------------------------------------------------- FUND Before taxes 5.47 5.40 5.67 After tax on distributions 5.47 5.40 5.65 After tax on distributions and sale 4.99 5.27 5.54 LEHMAN BROTHERS GENERAL MUNICIPAL BOND INDEX 5.31 5.82 6.02
FUND FEES AND EXPENSES The following table describes what you could expect to pay as a fund investor. "Shareholder fees" are charged to you directly by the fund. "Annual operating expenses" are paid out of fund assets, so their effect is included in the fund's total return. FEE TABLE (%)
SHAREHOLDER FEES --------------------------------------------------------------------- None ANNUAL OPERATING EXPENSES (% of average net assets) --------------------------------------------------------------------- Management fees 0.30 Distribution (12b-1) fees None Other expenses 0.36 -------- Total annual operating expenses 0.66 Expense reduction (0.01) -------- NET OPERATING EXPENSES* 0.65 ========
* Schwab and the investment adviser have guaranteed that the "annual operating expenses" (excluding interest, taxes, and certain non-routine expenses) will not exceed 0.65% through 11/15/05. Designed to help you compare expenses, the example below uses the same assumptions as other mutual fund prospectuses: a $10,000 investment, a 5% return each year and that the fund's operating expenses remain the same. The one-year figure is based on net operating expenses (after application of the expense reduction guarantee through 11/15/05). The expenses would be the same whether you stayed in the fund or sold your shares at the end of each period. Your actual costs may be higher or lower. EXPENSES ON A $10,000 INVESTMENT
1 year 3 years 5 years 10 years -------------------------------------------------------------------------------- $66 $210 $367 $822
Schwab Long-Term Tax-Free Bond Fund TM 13 FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the past five years. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/03- 9/1/02- 9/1/01- 9/1/00- 9/1/99- 8/31/04 8/31/03 8/31/02 8/31/01 8/31/00 ------------------------------------------------------------------------------------------------------------------------------------ PER-SHARE DATA ($) ------------------------------------------------------------------------------------------------------------------------------------ Net asset value at beginning of period 11.04 11.05 10.87 10.24 10.11 -------------------------------------------------------------------------- Income from investment operations: Net investment income 0.45 0.45 0.49 0.50 0.50 Net realized and unrealized gains or losses 0.29 (0.01) 0.17 0.63 0.13 -------------------------------------------------------------------------- Total income from investment operations 0.74 0.44 0.66 1.13 0.63 Less distributions: Dividends from net investment income (0.45) (0.45) (0.48) (0.50) (0.50) -------------------------------------------------------------------------- Net asset value at end of period 11.33 11.04 11.05 10.87 10.24 -------------------------------------------------------------------------- Total return (%) 6.77 4.01 6.24 11.29 6.59 RATIOS/SUPPLEMENTAL DATA (%) ------------------------------------------------------------------------------------------------------------------------------------ Ratios to average net assets: Net operating expenses 0.65 0.62 0.49 0.49 0.50 1 Gross operating expenses 0.66 0.65 0.74 0.74 0.76 Net investment income 4.00 4.06 4.49 4.73 5.11 Portfolio turnover rate 10 22 25 35 25 Net assets, end of period ($ x 1,000,000) 83 81 85 88 76
1 The ratio of net operating expenses would have been 0.49% if certain non-routine expenses (proxy fees) had not been included. 14 Schwab Long-Term Tax-Free Bond Fund TM SCHWAB CALIFORNIA TAX-FREE YIELDPLUS FUND TM TICKER SYMBOLS Investor Shares: SWYKX Select Shares (R): SWYCX STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN INVESTMENT-GRADE (HIGH AND CERTAIN MEDIUM QUALITY, RATED AAA TO BBB- OR THE UNRATED EQUIVALENT AS DETERMINED BY THE INVESTMENT ADVISER) MUNICIPAL SECURITIES FROM CALIFORNIA ISSUERS. The fund normally invests at least 80% of its net assets in municipal securities the interest from which is exempt from federal and California personal income tax and the federal alternative minimum tax (AMT). The fund does not currently intend to invest in municipal securities whose interest is subject to the AMT. The fund may invest in fixed-, variable- or floating-rate securities from municipal issuers in California and in U.S. territories and possessions. These may include general obligation issues, which typically are backed by the issuer's ability to levy taxes, and revenue issues, which typically are backed by a stream of revenue from a given source, such as an electric utility or a public water system. The fund may invest more than 25% of its total assets in municipal securities financing similar projects, such as those relating to education, health care, transportation, and utilities. Many of the fund's securities carry credit enhancements (such as bond insurance) or liquidity enhancements (such as a letter of credit), which are designed to provide incremental levels of creditworthiness or liquidity. In choosing securities, the fund's manager seeks to maximize current income within the limits of the fund's credit and maturity policies. To help maintain a high degree of share price stability, the fund seeks to keep the average duration of its portfolio at one year or less. Duration is a tool to measure interest rate risk. The fund may invest in bonds with effective or final maturities of any length and may invest up to 15% of its assets in lower quality bonds (sometimes called junk bonds) that are rated at least B or are the unrated equivalent as determined by the investment adviser. -------------------------------------------------------------------------------- THE FUND SEEKS HIGH CURRENT INCOME THAT IS EXEMPT FROM FEDERAL AND CALIFORNIA PERSONAL INCOME TAX CONSISTENT WITH MINIMAL CHANGES IN SHARE PRICE. RISK MANAGEMENT The fund's manager may use a variety of techniques to help manage risk, including investments in derivatives. Derivatives generally are investments whose value is based on one or more securities, rates or indices and can be effective risk management tools. For example, the fund may buy and sell financial futures and swaps to help manage the effects of interest rate changes. A financial future is a contract to buy or sell a specific financial instrument at a specified price at a specific future time. Such financial instruments include treasury securities, and other debt obligations, the prices of which fluctuate with changes in interest rates. A swap is a contract between the fund and another party to exchange a set of payments that the fund owns for a set of payments owned by the other party. Two kinds of swaps are index swaps and interest-rate swaps. -------------------------------------------------------------------------------- Schwab California Tax-Free YieldPlus Fund TM 15 The investment adviser's credit research department analyzes and monitors the securities that the fund owns or is considering buying. The manager may adjust the fund's holdings or its average duration based on actual or anticipated changes in interest rates or credit quality. The manager also may use investment techniques, such as short sales, futures contracts, swap agreements and other derivatives, in seeking to increase income, reduce share price volatility and otherwise manage the fund's exposure to investment risks. The fund's investment strategy is designed to offer the potential for somewhat higher yields than a municipal money market fund, although unlike a money market fund, its share price will fluctuate. In exchange for seeking minimal fluctuation in share price, the fund may offer lower long-term performance than stock investments or certain other bond investments. The fund may buy and sell portfolio securities actively. If it does, its portfolio turnover rate and transaction costs will rise, which may lower fund performance and increase the likelihood of capital gains distributions. During unusual market conditions, the fund may invest in taxable securities, including securities subject to AMT, as a temporary defensive measure. When the fund engages in such activities, the fund would not be pursuing its goal and, as a result, may not achieve its investment objective. 16 Schwab California Tax-Free YieldPlus Fund TM California taxpayers in higher tax brackets with investment horizons of one year or more who are seeking double tax-exempt income, including income exempt from AMT, may want to consider this fund as an alternative to a municipal money fund. RISKS INTEREST RATES RISE AND FALL OVER TIME. As with any investment whose yield reflects current interest rates, the fund's yield will change over time. During periods when interest rates are low, the fund's yield (and total return) also may be low. Changes in interest rates also may affect the fund's share price: a sharp rise in interest rates could cause the fund's share price to fall. Assuming a one year duration for the fund, a 2% increase in interest rates would result in approximately a 2% decrease in the fund's share price. This risk is greater when the fund holds bonds with longer maturities. THE FUND IS NOT A MONEY MARKET FUND OR A BANK DEPOSIT. Its shares are not insured or guaranteed. Because the fund's share price may move up and down, the value of your investment in the fund will fluctuate, which means you could lose money. In exchange for seeking minimal fluctuation in share price, the fund may offer lower long-term performance than stock investments or certain other bond investments. BECAUSE THE FUND PRIMARILY INVESTS IN A PORTFOLIO OF CALIFORNIA MUNICIPAL SECURITIES, the fund is more susceptible to political, economic, regulatory or other factors affecting issuers of California municipal securities. California has a diverse economic base that supports it creditworthiness but also makes the state vulnerable to challenges stemming from many sources including economic trends, legislative and legal actions as well as shifts in political views. The possibility exists that a natural disaster, including an earthquake, could create a major dislocation of the California economy and significantly affect the ability of state and local governments to raise money to pay principal and interest on their municipal securities. National governmental actions, such as the elimination of tax-exempt status, also could affect performance. In addition, the fund may be more sensitive to adverse economic, business or political developments if it invests a substantial portion of its assets in municipal securities financing similar projects. A change that affects one project, such as proposed legislation on the financing of the project, a shortage of the materials needed for the project, or a declining need for the project, would likely affect all similar projects and the overall municipal securities market. Because the fund is non-diversified, it may divide its assets among fewer issuers than a diversified fund. This means that the fund could increase its exposure to the risks of a given issuer. A DECLINE IN THE CREDIT QUALITY OF A PORTFOLIO INVESTMENT COULD CAUSE THE FUND'S SHARE PRICE TO FALL. Although the fund invests primarily in investment-grade securities, the fund could lose money if the issuer or guarantor of a portfolio investment fails to make timely principal or interest payments or otherwise honor its obligations. Lower quality bonds are considered speculative with respect to the issuer's ability to make principal and interest payments. In addition, prices of lower-quality bonds tend to be more volatile than those of investment-grade bonds, and may fall based on bad news about the issuer, and industry or the overall economy. Schwab California Tax-Free YieldPlus Fund TM 17 THE MANAGER'S MATURITY AND DURATION DECISIONS ALSO WILL AFFECT THE FUND'S PERFORMANCE. To the extent that the manager anticipates interest rate trends imprecisely, the fund could miss yield opportunities or its share price could fall. IF CERTAIN TYPES OF INVESTMENTS THE FUND BUYS AS TAX-EXEMPT ARE LATER RULED TO BE TAXABLE, A PORTION OF THE FUND'S INCOME COULD BE TAXABLE. Any defensive investments in taxable securities could generate taxable income. Also, some types of municipal securities produce income that is subject to the AMT. WHILE THE FUND MAY USE A VARIETY OF TECHNIQUES TO HELP MANAGE RISK, THEY COULD HURT THE FUND'S PERFORMANCE IF THEY DON'T PERFORM AS EXPECTED. For example, if the fund uses a technique involving a derivative, such as a futures contract or swap agreement, for the purpose of offsetting price changes in the fund's portfolio, but the technique does not precisely offset the price changes, the fund's share price could fall. The fund's performance also could be hurt if the counterparty to a derivative does not honor its contractual obligations to the fund. THE COST OF DERIVATIVES MAY HAVE THE EFFECT OF INCREASING FUND EXPENSES. While the decision to use or not use a given risk management technique depends on market conditions, these costs could at times outweigh the benefits the fund realizes from these techniques. THE FUND COULD LOSE MONEY IF THE PRICES OF SECURITIES SOLD SHORT INCREASE. When the fund sells a security short, it sells a security it does not own and must borrow the security to deliver to the buyer. The fund is obligated to replace the borrowed security by purchasing it at the then current market price, which may be more or less than the price at which the security was sold by the fund. 18 Schwab California Tax-Free YieldPlus Fund TM PERFORMANCE Because this is a new fund, no performance figures are given. This information will appear in a future version of the fund's prospectus. FUND FEES AND EXPENSES The following table describes what you could expect to pay as a fund investor. "Shareholder fees" are charged to you directly by the fund. "Annual operating expenses" are paid out of fund assets, so their effect is included in the total return for each share class. FEE TABLE (%)
INVESTOR SELECT SHAREHOLDER FEES SHARES SHARES(R) -------------------------------------------------------------------------------- None None ANNUAL OPERATING EXPENSES (% of average net assets) -------------------------------------------------------------------------------- Management fees 0.35 0.35 Distribution (12b-1) fees None None Other expenses* 0.47 0.32 ------------------ Total annual operating expenses 0.82 0.67 Less expense reduction (0.18) (0.18) ------------------ NET OPERATING EXPENSES** 0.64 0.49 ==================
* Based on estimated expenses for the current fiscal year. ** Schwab and the investment adviser have guaranteed that the "net operating expenses" (excluding interest, taxes, and certain non-routine expenses) of the Investor Shares and the Select Shares will equal 0.00% through 5/01/05. For the period 5/02/05 through 11/15/05, Schwab and the investment adviser have guaranteed that "net operating expenses" (excluding interest, taxes, and certain non-routine expenses) of the Investor Shares and Select Shares will not exceed 0.64% and 0.49%, respectively. Designed to help you compare expenses, the example below uses the same assumptions as other mutual fund prospectuses: a $10,000 investment, a 5% return each year and that the fund's operating expenses remain the same. The one-year figure is based on net operating expenses (after application of the expense reduction guarantee through 11/15/05). The expenses would be the same whether you stayed in the fund or sold your shares at the end of each period. Your actual costs may be higher or lower. EXPENSES ON A $10,000 INVESTMENT
1 year 3 years --------------------------------------------------------------------------- INVESTOR SHARES $43 $222 SELECT SHARES $33 $179
Schwab California Tax-Free YieldPlus Fund TM 19 SCHWAB CALIFORNIA SHORT/INTERMEDIATE TAX-FREE BOND FUND TM TICKER SYMBOL: SWCSX -------------------------------------------------------------------------------- THE FUND SEEKS HIGH CURRENT INCOME EXEMPT FROM FEDERAL AND CALIFORNIA PERSONAL INCOME TAX THAT IS CONSISTENT WITH CAPITAL PRESERVATION. SHORTER MATURITIES As a bond approaches maturity, its market value typically moves closer to its par value (the amount of the bond's principal value, which a bondholder receives when the bond matures). Investing in short- and intermediate-term bonds is a common strategy for reducing price volatility and other risks. In exchange for these lower risks, short-and intermediate-term bonds typically (though not always) offer lower yields than longer term bonds. -------------------------------------------------------------------------------- STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN INVESTMENT-GRADE MUNICIPAL SECURITIES--THOSE IN THE FOUR HIGHEST CREDIT RATING CATEGORIES (RATED AAA TO BBB- OR THE UNRATED EQUIVALENT AS DETERMINED BY THE INVESTMENT ADVISER) FROM CALIFORNIA ISSUERS. The fund normally invests at least 80% of its net assets in municipal securities the interest from which is exempt from federal and California personal income tax and federal alternative minimum tax (AMT). To help preserve investors' capital, the fund seeks to keep the average maturity of its portfolio between two and five years. The fund may invest in securities from municipal issuers in California and in U.S. territories and possessions. These may include general obligation issues, which typically are backed by the issuer's ability to levy taxes, and revenue issues, which typically are backed by a stream of revenue from a given source, such as an electric utility or a public water system. The fund may invest more than 25% of its total assets in municipal securities financing similar projects, such as those relating to education, health care, transportation, and utilities and may also invest in municipal notes. Many of the fund's securities carry credit enhancements (such as bond insurance) or liquidity enhancements (such as a letter of credit), which are designed to provide incremental levels of credit-worthiness or liquidity. In choosing securities, the fund's manager seeks to maximize current income within the limits of the fund's credit and average maturity standards. The investment adviser's credit research department analyzes and monitors the securities that the fund owns or is considering buying. If a portfolio security falls below investment-grade or the unrated equivalent, the fund may continue to hold it if the investment adviser believes it would benefit the fund. The manager may adjust the fund's holdings or its average maturity based on actual or anticipated changes in interest rates or credit quality. During unusual market conditions, the fund may invest in taxable securities as a temporary defensive measure. When the fund engages in such activities, the fund would not be pursuing its goal and, as a result, it may not achieve its investment objective. 20 Schwab California Short/Intermediate Tax-Free Bond Fund TM California taxpayers who are seeking double tax-exempt income along with the potential for lower volatility may want to consider this fund. RISKS BOND MARKETS RISE AND FALL DAILY. As with any investment whose performance is tied to these markets, the value of your investment in the fund will fluctuate, which means that you could lose money. WHEN INTEREST RATES RISE, BOND PRICES USUALLY FALL, AND WITH THEM THE FUND'S SHARE PRICE. The fund's short-to-intermediate maturity is designed to reduce this risk, but will not eliminate it. A fall in interest rates could hurt the fund as well, by lowering its yield. This is because issuers tend to pay off their bonds when interest rates fall, often forcing the fund to reinvest in lower-yielding securities. BECAUSE THE FUND PRIMARILY INVESTS IN A PORTFOLIO OF CALIFORNIA MUNICIPAL SECURITIES, the fund is more susceptible to political, economic, regulatory or other factors affecting issuers of California municipal securities. California has a diverse economic base that supports its creditworthiness but also makes the state vulnerable to challenges stemming from many sources including economic trends, legislative and legal actions as well as shifts in political views. The possibility exists that a natural disaster, including an earthquake, could create a major dislocation of the California economy and significantly affect the ability of state and local governments to raise money to pay principal and interest on their municipal securities. National governmental actions, such as the elimination of tax-exempt status, also could affect performance. In addition, the fund may be more sensitive to adverse economic, business or political developments if it invests a substantial portion of its assets in municipal securities financing similar projects. A change that affects one project, such as proposed legislation on the financing of the project, a shortage of the materials needed for the project, or a declining need for the project, would likely affect all similar projects and the overall municipal securities market. Because the fund is non-diversified, it may divide its assets among fewer issuers than a diversified fund. This means that the fund could increase its exposure to the risks of a given issuer. A DECLINE IN THE CREDIT QUALITY OF A PORTFOLIO INVESTMENT COULD CAUSE THE FUND'S SHARE PRICE TO FALL. Although the fund invests primarily in investment-grade municipal securities, the fund could lose money if the issuer or guarantor of a portfolio investment fails to make timely principal or interest payments or otherwise honor its obligations. The fund's emphasis on quality and preservation of capital also could cause it to underperform certain other types of bond investments, particularly those that take greater maturity and credit risks. At the same time, some of the fund's investments may have greater risks than securities in taxable bond funds. THE MANAGER'S MATURITY DECISIONS ALSO WILL AFFECT THE FUND'S PERFORMANCE. To the extent that the manager anticipates interest rate trends imprecisely, the fund could miss yield opportunities or its share price could fall. IF CERTAIN TYPES OF INVESTMENTS THE FUND BUYS AS TAX-EXEMPT ARE LATER RULED TO BE TAXABLE, A PORTION OF THE FUND'S INCOME COULD BE TAXABLE. Any defensive investments in taxable securities could generate taxable income. Also, some types of municipal securities produce income that is subject to the AMT. THE FUND IS NOT DESIGNED TO OFFER SUBSTANTIAL CAPITAL APPRECIATION. In exchange for its goal of capital preservation, the fund may offer lower long-term performance than stock investments or certain other types of bond investments. Schwab California Short/Intermediate Tax-Free Bond Fund TM 21 PERFORMANCE The information below shows fund returns before and after taxes, and compares fund performance (which varies over time) to that of an index. The index is unmanaged and does not include expenses or taxes. All figures assume distributions were reinvested. The after-tax figures: - reflect the highest individual federal marginal income tax rate that applied during the period, but assume no state or local taxes - may not reflect your actual after-tax performance - may not be relevant to shares in an IRA, 401(k) or other tax-advantaged retirement account Keep in mind that future performance (both before and after taxes) may differ from past performance. ANNUAL TOTAL RETURNS (%) as of 12/31 [BAR CHART] 94 (2.08) 95 10.46 96 3.90 97 5.19 98 4.83 99 0.66 00 7.25 01 4.90 02 6.12 03 3.01 BEST QUARTER: 3.62% Q1 1995 WORST QUARTER: (2.45%) Q1 1994 YEAR-TO-DATE PERFORMANCE AS OF 9/30/04: 1.46%
AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/03
1 year 5 years 10 years -------------------------------------------------------------------------------- FUND Before taxes 3.01 4.36 4.37 After tax on distributions 3.01 4.36 4.37 After tax on distributions and sale 3.01 4.25 4.30 LEHMAN BROTHERS THREE-YEAR MUNICIPAL BOND INDEX 2.68 4.81 4.86
FUND FEES AND EXPENSES The following table describes what you could expect to pay as a fund investor. "Shareholder fees" are charged to you directly by the fund. "Annual operating expenses" are paid out of fund assets, so their effect is included in the fund's total return. FEE TABLE (%)
SHAREHOLDER FEES -------------------------------------------------------------------------- None ANNUAL OPERATING EXPENSES (% of average net assets) -------------------------------------------------------------------------- Management fees 0.30 Distribution (12b-1) fees None Other expenses 0.31 ------ Total annual operating expenses* 0.61 ======
* Schwab and the investment adviser have guaranteed that the "annual operating expenses" (excluding interest, taxes, and certain non-routine expenses) will not exceed 0.65% through 11/15/05. Designed to help you compare expenses, the example below uses the same assumptions as other mutual fund prospectuses: a $10,000 investment, a 5% return each year and that the fund's operating expenses remain the same. The expenses would be the same whether you stayed in the fund or sold your shares at the end of each period. Your actual costs may be higher or lower. EXPENSES ON A $10,000 INVESTMENT
1 year 3 years 5 years 10 years -------------------------------------------------------------------------------- $62 $195 $340 $762
22 Schwab California Short/Intermediate Tax-Free Bond Fund TM FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the past five years. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/03- 9/1/02- 9/1/01- 9/1/00- 9/1/99- 8/31/04 8/31/03 8/31/02 8/31/01 8/31/00 ------------------------------------------------------------------------------------------------------------------------------------ PER-SHARE DATA ($) ------------------------------------------------------------------------------------------------------------------------------------ Net asset value at beginning of period 10.57 10.66 10.51 10.22 10.09 -------------------------------------------------------------------------- Income from investment operations: Net investment income 0.31 0.32 0.34 0.40 0.39 Net realized and unrealized gains or losses 0.06 (0.09) 0.15 0.29 0.13 -------------------------------------------------------------------------- Total income from investment operations 0.37 0.23 0.49 0.69 0.52 Less distributions: Dividends from net investment income (0.31) (0.32) (0.34) (0.40) (0.39) -------------------------------------------------------------------------- Net asset value at end of period 10.63 10.57 10.66 10.51 10.22 -------------------------------------------------------------------------- Total return (%) 3.59 2.15 4.66 6.95 5.32 RATIOS/SUPPLEMENTAL DATA (%) ------------------------------------------------------------------------------------------------------------------------------------ Ratios to average net assets: Net operating expenses 0.61 0.58 0.49 0.49 0.50 1 Gross operating expenses 0.61 0.60 0.66 0.67 0.71 Net investment income 2.97 2.96 3.29 3.83 3.91 Portfolio turnover rate 17 11 17 30 42 Net assets, end of period ($ x 1,000,000) 164 174 184 145 124
1 The ratio of net operating expenses would have been 0.49% if certain non-routine expenses (proxy fees) had not been included. Schwab California Short/Intermediate Tax-Free Bond Fund TM 23 SCHWAB CALIFORNIA LONG-TERM TAX-FREE BOND FUND TM TICKER SYMBOL: SWCAX -------------------------------------------------------------------------------- THE FUND SEEKS HIGH CURRENT INCOME EXEMPT FROM FEDERAL AND CALIFORNIA PERSONAL INCOME TAX THAT IS CONSISTENT WITH CAPITAL PRESERVATION. MATURITY AND YIELD Bond yields typically are higher the longer the bond's maturity. By investing in longer term bonds, the fund seeks to earn higher yields over time than the Schwab California Short/Intermediate Tax-Free Bond Fund TM. Maintaining a longer average maturity does carry certain risks, and investors should expect this fund's share price to fluctuate more than that of the Schwab California Short/Intermediate Tax-Free Bond Fund. -------------------------------------------------------------------------------- STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN INVESTMENT-GRADE MUNICIPAL SECURITIES--THOSE IN THE FOUR HIGHEST CREDIT RATING CATEGORIES (RATED AAA TO BBB- OR THE UNRATED EQUIVALENT AS DETERMINED BY THE INVESTMENT ADVISER) FROM CALIFORNIA ISSUERS. The fund normally invests at least 80% of its net assets in municipal securities the interest from which is exempt from federal and California personal income tax and federal alternative minimum tax (AMT). The fund seeks to maintain an average maturity in its portfolio of at least ten years. The fund may invest in securities from municipal issuers in California and in U.S. territories and possessions. These may include general obligation issues, which typically are backed by the issuer's ability to levy taxes, and revenue issues, which typically are backed by a stream of revenue from a given source, such as an electric utility or a public water system. The fund may invest more than 25% of its total assets in municipal securities financing similar projects, such as those relating to education, health care, transportation, and utilities and may also invest in municipal notes. Many of the fund's securities carry credit enhancements (such as bond insurance) or liquidity enhancements (such as a letter of credit), which are designed to provide incremental levels of creditworthiness or liquidity. In choosing securities, the fund's manager seeks to maximize current income within the limits of the fund's credit and average maturity standards. The investment adviser's credit research department analyzes and monitors the securities that the fund owns or is considering buying. If a portfolio security falls below investment-grade or the unrated equivalent, the fund may continue to hold it if the investment adviser believes it would benefit the fund. The manager may adjust the fund's holdings or its average maturity based on actual or anticipated changes in interest rates or credit quality. During unusual market conditions, the fund may invest in taxable securities as a temporary defensive measure. When the fund engages in such activities, the fund would not be pursuing its goal and, as a result, it may not achieve its investment objective. 24 Schwab California Long-Term Tax-Free Bond Fund TM This fund is designed for California taxpayers who want double tax-exempt income and can accept higher risk in exchange for potentially higher long-term returns. RISKS BOND MARKETS RISE AND FALL DAILY. As with any investment whose performance is tied to these markets, the value of your investment in the fund will fluctuate, which means that you could lose money. WHEN INTEREST RATES RISE, BOND PRICES USUALLY FALL, AND WITH THEM THE FUND'S SHARE PRICE. The fund's comparatively long average maturity will tend to make it more sensitive to this risk than funds with shorter average maturities. BECAUSE THE FUND PRIMARILY INVESTS IN A PORTFOLIO OF CALIFORNIA MUNICIPAL SECURITIES, the fund is more susceptible to political, economic, regulatory or other factors affecting issuers of California municipal securities. California has a diverse economic base that supports it creditworthiness but also makes the state vulnerable to challenges stemming from many sources including economic trends, legislative and legal actions as well as shifts in political views. The possibility exists that a natural disaster, including an earthquake, could create a major dislocation of the California economy and significantly affect the ability of state and local governments to raise money to pay principal and interest on their municipal securities. National governmental actions, such as the elimination of tax-exempt status, also could affect performance. In addition, the fund may be more sensitive to adverse economic, business or political developments if it invests a substantial portion of its assets in municipal securities financing similar projects. A change that affects one project, such as proposed legislation on the financing of the project, a shortage of the materials needed for the project, or a declining need for the project, would likely affect all similar projects and the overall municipal securities market. Because the fund is non-diversified, it may divide its assets among fewer issuers than a diversified fund. This means that the fund could increase its exposure to the risks of a given issuer. A DECLINE IN THE CREDIT QUALITY OF A PORTFOLIO INVESTMENT COULD CAUSE THE FUND'S SHARE PRICE TO FALL. Although the fund invests primarily in investment-grade municipal securities, the fund could lose money if the issuer or guarantor of a portfolio investment fails to make timely principal or interest payments or otherwise honor its obligations. The fund's emphasis on quality and preservation of capital also could cause it to underperform certain other types of bond investments, particularly those that take greater maturity and credit risks. At the same time, some of the fund's investments may have greater risks than securities in taxable bond funds. THE MANAGER'S MATURITY DECISIONS ALSO WILL AFFECT THE FUND'S PERFORMANCE. To the extent that the manager anticipates interest rate trends imprecisely, the fund could miss yield opportunities or its share price could fall. IF CERTAIN TYPES OF INVESTMENTS THE FUND BUYS AS TAX-EXEMPT ARE LATER RULED TO BE TAXABLE, A PORTION OF THE FUND'S INCOME COULD BE TAXABLE. Any defensive investments in taxable securities could generate taxable income. Also, some types of municipal securities produce income that is subject to the AMT. THE FUND IS NOT DESIGNED TO OFFER SUBSTANTIAL CAPITAL APPRECIATION. In exchange for its goal of capital preservation, the fund may offer lower long-term performance than stock investments or certain other types of bond investments. Schwab California Long-Term Tax-Free Bond Fund TM 25 PERFORMANCE The information below shows fund returns before and after taxes, and compares fund performance (which varies over time) to that of an index. The index is unmanaged and does not include expenses or taxes. All figures assume distributions were reinvested. The after-tax figures: - reflect the highest individual federal marginal income tax rate that applied during the period, but assume no state or local taxes - may not reflect your actual after-tax performance - may not be relevant to shares in an IRA, 401(k) or other tax-advantaged retirement account Keep in mind that future performance (both before and after taxes) may differ from past performance. ANNUAL TOTAL RETURNS (%) as of 12/31 [BAR CHART] 94 (8.75) 95 19.63 96 4.33 97 10.04 98 6.43 99 (6.14) 00 15.22 01 4.92 02 8.17 03 4.64 BEST QUARTER: 8.47% Q1 1995 WORST QUARTER: (6.74%) Q1 1994 YEAR-TO-DATE PERFORMANCE AS OF 9/30/04: 3.76%
AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/03
1 year 5 years 10 years ----------------------------------------------------------------------- FUND Before taxes 4.64 5.13 5.53 After tax on distributions 4.64 5.13 5.53 After tax on distributions and sale 4.51 5.06 5.45 LEHMAN BROTHERS GENERAL MUNICIPAL BOND INDEX 5.31 5.82 6.02
FUND FEES AND EXPENSES The following table describes what you could expect to pay as a fund investor. "Shareholder fees" are charged to you directly by the fund. "Annual operating expenses" are paid out of fund assets, so their effect is included in the fund's total return. FEE TABLE (%)
SHAREHOLDER FEES --------------------------------------------------------------------- None ANNUAL OPERATING EXPENSES (% of average net assets) --------------------------------------------------------------------- Management fees 0.30 Distribution (12b-1) fees None Other expenses 0.31 ------ Total annual operating expenses 0.61 ======
Designed to help you compare expenses, the example below uses the same assumptions as other mutual fund prospectuses: a $10,000 investment, a 5% return each year and that the fund's operating expenses remain the same. The expenses would be the same whether you stayed in the fund or sold your shares at the end of each period. Your actual costs may be higher or lower. EXPENSES ON A $10,000 INVESTMENT
1 year 3 years 5 years 10 years ----------------------------------------------------------------------- $62 $195 $340 $762
26 Schwab California Long-Term Tax-Free Bond Fund TM FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the past five years. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/03- 9/1/02- 9/1/01- 9/1/00- 9/1/99- 8/31/04 8/31/03 8/31/02 8/31/01 8/31/00 ------------------------------------------------------------------------------------------------------------------------------------ PER-SHARE DATA ($) ------------------------------------------------------------------------------------------------------------------------------------ Net asset value at beginning of period 11.45 11.69 11.63 11.06 10.82 -------------------------------------------------------------------------- Income from investment operations: Net investment income 0.50 0.49 0.53 0.55 0.55 Net realized and unrealized gains or losses 0.33 (0.24) 0.05 0.57 0.24 -------------------------------------------------------------------------- Total income from investment operations 0.83 0.25 0.58 1.12 0.79 Less distributions: Dividends from net investment income (0.50) (0.49) (0.52) (0.55) (0.55) -------------------------------------------------------------------------- Net asset value at end of period 11.78 11.45 11.69 11.63 11.06 -------------------------------------------------------------------------- Total return (%) 7.36 2.14 5.14 10.38 7.67 RATIOS/SUPPLEMENTAL DATA (%) ------------------------------------------------------------------------------------------------------------------------------------ Ratios to average net assets: Net operating expenses 0.61 0.58 0.49 0.49 0.50 1 Gross operating expenses 0.61 0.60 0.64 0.65 0.69 Net investment income 4.30 4.16 4.58 4.86 5.19 Portfolio turnover rate 15 29 34 37 36 Net assets, end of period ($ x 1,000,000) 180 194 238 215 179
1 The ratio of net operating expenses would have been 0.49% if certain non-routine expenses (proxy fees) had not been included. Schwab California Long-Term Tax-Free Bond Fund TM 27 FUND MANAGEMENT The funds' investment adviser, Charles Schwab Investment Management, Inc., has more than $137 billion under management. The investment adviser for the funds is Charles Schwab Investment Management, Inc., 101 Montgomery Street, San Francisco, CA 94104. Founded in 1989, the firm today serves as investment adviser for all of the SchwabFunds R. The firm manages assets for more than 5 million accounts. (All figures on this page are as of 8/31/04.) As the investment adviser, the firm oversees the asset management and administration of the funds. As compensation for these services, the firm receives a management fee from each fund. For the 12 months ended 8/31/04, these fees were 0.30% for the Schwab Short/Intermediate Tax-Free Bond Fund TM, 0.29% for the Schwab Long-Term Tax-Free Bond Fund TM, 0.30% for the Schwab California Short/Intermediate Tax-Free Bond Fund TM and 0.30% for the Schwab California Long-Term Tax-Free Bond Fund TM. These figures, which are expressed as a percentage of each fund's average daily net assets, represent the actual amounts paid, including the effects of reductions. In addition, the firm is entitled to receive an annual management fee from the Schwab Tax-Free YieldPlus Fund TM and the Schwab California Tax-Free YieldPlus Fund TM of 0.35% of each fund's average daily net assets not in excess of $500 million and 0.30% of such assets over $500 million. JOANNE LARKIN, a vice president and senior portfolio manager of the investment adviser, has had overall responsibility for the management of each fund since inception. Prior to joining the firm in February 1992, she worked for more than eight years in research and asset management at another firm. KIMON DAIFOTIS, CFA, a senior vice president and chief investment officer of fixed income of the investment adviser, co-manages the Schwab Tax-Free YieldPlus Fund TM and Schwab California Tax-Free YieldPlus Fund TM. He joined the firm in September 1997 and has worked in fixed-income asset management and research since 1982. 28 Fund management INVESTING IN THE FUNDS As a SchwabFunds R investor, you have a number of ways to do business with us. On the following pages, you will find information on buying, selling and exchanging shares using the method that is most convenient for you. You also will see how to choose a share class and a distribution option for your investment. Helpful information on taxes is included as well. Investing in the funds 29 -------------------------------------------------------------------------------- The funds are generally not appropriate investments for IRAs and other tax- deferred accounts. Please consult with your tax advisor about your situation. SCHWAB ACCOUNTS Some Schwab account features can work in tandem with features offered by the funds. For example, when you sell shares in a fund, the proceeds automatically are paid to your Schwab account. From your account, you can use features such as MoneyLink R, which lets you move money between your brokerage accounts and bank accounts, and Automatic Investment Plan (AIP), which lets you set up periodic investments. For more information on Schwab accounts, call 1-800-435-4000 or visit the Schwab web site at www.schwab.com. -------------------------------------------------------------------------------- BUYING SHARES Shares of the funds may be purchased through a Schwab account or through certain third-party investment providers, such as other financial institutions, investment professionals and workplace retirement plans. The information on these pages outlines how Schwab investors can place "good orders," which are orders made in accordance with the funds' policies, to buy, sell and exchange shares of the funds. If you are investing through a third-party investment provider, some of the instructions, minimums and policies may be different. Some investment providers may charge transaction or other fees. Contact your investment provider for more information. Schwab intends to seek investors for the Schwab Tax-Free YieldPlus Fund TM and the Schwab California Tax-Free YieldPlus Fund TM during an initial offering period. As of the date of the printing of this prospectus, Schwab anticipates that this period will begin on 11/15/04 and end on 12/15/04, although the period may be extended or otherwise changed. Payment for shares of the funds will not be accepted until the completion of the initial offering period. Orders received after the initial offering period will be executed at the next share price calculated for each of the funds. The fee payable to Schwab for orders placed in person or through a telephone representative will be waived by Schwab during the initial offering period. 30 Investing in the funds STEP 1 CHOOSE A FUND AND SHARE CLASS (IF APPLICABLE), then decide how much you want to invest. Your choice may depend on the amount of your investment. The minimums shown below are for each fund and share class.
MINIMUM MINIMUM INITIAL ADDITIONAL MINIMUM FUND AND SHARE CLASS INVESTMENT INVESTMENTS BALANCE -------------------------------------------------------------------------- SCHWAB TAX-FREE $2,500 ($1,000 $500 ($100 for $1,000 ($500 YIELDPLUS FUND for custodial Automatic for custodial INVESTOR SHARES accounts) Investment accounts) Plan) SELECT SHARES(R) $50,000 $1,000 $40,000 SCHWAB SHORT/INTERMEDIATE $2,500 ($1,000 $500 ($100 for $1,000 ($500 TAX-FREE BOND FUND for custodial Automatic for custodial accounts) Investment accounts) Plan) SCHWAB LONG-TERM $2,500 ($1,000 $500 ($100 for $1,000 ($500 TAX-FREE BOND FUND for custodial Automatic for custodial accounts) Investment accounts) Plan) SCHWAB CALIFORNIA $2,500 ($1,000 $500 ($100 for $1,000 ($500 TAX-FREE YIELDPLUS FUND for custodial Automatic for custodial INVESTOR SHARES accounts) Investment accounts) Plan) SELECT SHARES(R) $50,000 $1,000 $40,000 SCHWAB CALIFORNIA SHORT/ $2,500 ($1,000 $500 ($100 for $1,000 ($500 INTERMEDIATE TAX-FREE for custodial Automatic for custodial BOND FUND accounts) Investment accounts) Plan) SCHWAB CALIFORNIA $2,500 ($1,000 $500 ($100 for $1,000 ($500 LONG-TERM TAX-FREE for custodial Automatic for custodial BOND FUND accounts) Investment accounts) Plan)
STEP 2 CHOOSE AN OPTION FOR FUND DISTRIBUTIONS. The three options are described below. If you don't indicate a choice, you will receive the first option.
OPTION FEATURES ------------------------------------------------------------------------- REINVESTMENT All dividends and capital gain distributions are invested automatically in shares of your fund or share class, as applicable. CASH/REINVESTMENT MIX You receive payment for dividends, while any capital gain distributions are invested in shares of your fund or share class, as applicable. CASH You receive payment for all dividends and capital gain distributions.
STEP 3 PLACE YOUR ORDER. Use any of the methods described on the next page. Make checks payable to Charles Schwab and Co., Inc. Orders placed in person or through a telephone representative are subject to a service fee, payable to Schwab. Investing in the funds 31 -------------------------------------------------------------------------------- WHEN PLACING ORDERS With every order to buy, sell or exchange shares, you will need to include the following information: - Your name or, for Internet orders, your account number/"Login ID." - Your account number (for SchwabLink transactions, include the master account and subaccount numbers) or, for Internet orders, your password. - The name and share class (if applicable) of the fund whose shares you want to buy or sell. - The dollar amount or number of shares you would like to buy, sell or exchange. - When selling or exchanging shares, be sure to include the signature of at least one of the persons whose name is on the account. - For exchanges, the name and share class (if applicable) of the fund into which you want to exchange and the distribution option you prefer. - When selling shares, how you would like to receive the proceeds. Please note that orders to buy, sell or exchange shares become irrevocable at the time you mail them. -------------------------------------------------------------------------------- SELLING/EXCHANGING SHARES USE ANY OF THE METHODS DESCRIBED BELOW TO SELL SHARES OF A FUND. When selling or exchanging shares, please be aware of the following policies: - A fund may take up to seven days to pay sale proceeds. - If you are selling shares that were recently purchased by check, the proceeds may be delayed until the check for purchase clears; this may take up to 15 days from the date of purchase. - The funds reserve the right to honor redemptions in liquid portfolio securities instead of cash when your redemptions over a 90-day period exceed $250,000 or 1% of a fund's assets, whichever is less. A shareholder may incur transaction expenses in converting these securities to cash. - Exchange orders are limited to other SchwabFunds R that are not Sweep Investments TM. Exchange orders must meet the minimum investment and other requirements for the fund and share class into which you are exchanging. - You must obtain and read the prospectus for the fund into which you are exchanging prior to placing your order. METHODS FOR PLACING DIRECT ORDERS INTERNET www.schwab.com SCHWAB BY PHONE TM 1 Automated voice service or speak with a representative at 1-800-435-4000 (for TDD service, call 1-800-345-2550). SCHWABLINK(R) Investment professionals should follow the transaction instructions in the SchwabLink manual; for technical assistance, call 1-800-647-5465. MAIL Write to SchwabFunds at: P.O. Box 3812 Englewood, CO 80155-3812 IN PERSON 1 Visit the nearest Charles Schwab branch office. You are automatically entitled to initiate transactions by the Internet or telephone. The funds and Schwab employ procedures to confirm the authenticity of Internet and telephone instructions. If the funds and Schwab follow these procedures, they will not be responsible for any losses or costs incurred by following Internet or telephone instructions that they reasonably believe to be genuine. 1 Orders placed in person or through a telephone representative are subject to a service fee, payable to Schwab. 32 Investing in the funds TRANSACTION POLICIES THE FUNDS ARE OPEN FOR BUSINESS EACH DAY THAT THE NEW YORK STOCK EXCHANGE (NYSE) IS OPEN. A fund calculates its share price or the share price for each of its share classes, as applicable, each business day as of the close of the NYSE (generally 4 p.m. Eastern time). A fund's share price is its net asset value per share, or NAV, which is the fund's net assets divided by the number of its shares outstanding. Orders to buy, sell or exchange shares that are received in good order prior to the close of a fund (generally 4 p.m. Eastern time) will be executed at the next share price calculated that day. Orders to buy shares that are accepted prior to the close of a fund generally will receive the next day's dividend. Orders to sell or exchange shares that are accepted and executed prior to the close of a fund on a given day generally will receive that day's dividend. If you place an order through a third-party investment provider, please consult with that investment provider to determine when your order will be executed. Generally, you will receive the share price next calculated after a fund receives your order from your investment provider. However, some investment providers may arrange with a fund for you to receive the share price next calculated after your investment provider has received your order. Some investment providers may require that they receive orders prior to a specified cut-off time. In valuing their securities, the funds use market quotes if they are readily available. In cases where quotes are not readily available, or the adviser deems them to be unreliable, a fund may value securities based on fair values developed using methods approved by the fund's Board of Trustees. THE FUNDS RESERVE CERTAIN RIGHTS REGARDING TRANSACTION POLICIES, AS DETAILED AT RIGHT. -------------------------------------------------------------------------------- THE FUNDS AND SCHWAB RESERVE CERTAIN RIGHTS, INCLUDING THE FOLLOWING: - To automatically redeem your shares if the account they are held in is closed for any reason or your balance falls below the minimum as a result of selling or exchanging your shares. - To materially modify or terminate the exchange privilege upon 60 days' written notice to shareholders. - To refuse any purchase or exchange order, including large purchase orders that may negatively affect a fund's operations or orders that appear to be associated with short-term trading activities. - To change or waive a fund's investment minimums. - To suspend the right to sell shares back to a fund, and delay sending proceeds, during times when trading on the NYSE is restricted or halted, or otherwise as permitted by the SEC. - To withdraw or suspend any part of the offering made by this prospectus. -------------------------------------------------------------------------------- Investing in the funds 33 DISTRIBUTIONS AND TAXES ANY INVESTMENT IN THE FUNDS TYPICALLY INVOLVES SEVERAL TAX CONSIDERATIONS. The information below is meant as a general summary for U.S. citizens and residents. Because each person's tax situation is different, you should consult your tax advisor about the tax implications of your investment in a fund. You also can visit the Internal Revenue Service (IRS) web site at www.irs.gov. AS A SHAREHOLDER, YOU ARE ENTITLED TO YOUR SHARE OF THE DIVIDENDS AND GAINS YOUR FUND EARNS. Each fund distributes to its shareholders substantially all of its net investment income and net capital gains, if any. Each fund declares a dividend every business day, based on its determination of its net investment income. Each fund pays its dividends on the last business day of every month. The funds expect to pay any capital gain distributions every year, typically in December, to all shareholders of record. THE FUNDS' DISTRIBUTIONS MAY HAVE TAX CONSEQUENCES. Typically, dividends of the Schwab Tax-Free YieldPlus Fund TM, Schwab Short/Intermediate Tax-Free Bond Fund TM and Schwab Long-Term Tax-Free Bond Fund TM are exempt from federal income tax, but are subject to state and local income taxes. A portion of each of these funds' dividends may be exempt from state or local income taxes, depending on the extent to which a fund invests in bonds that are tax-exempt in your state. Dividends from the Schwab California Tax-Free YieldPlus Fund TM, Schwab California Short/Intermediate Tax-Free Bond Fund TM and Schwab California Long-Term Tax-Free Bond Fund TM typically are exempt from federal and California personal income taxes. To the extent the funds invest in securities subject to the AMT, shareholders who are subject to the AMT may have to pay this tax on some or all dividends received from a fund. Each fund's capital gain distributions, if any, generally are taxable in the tax year in which they are declared, whether you reinvest them or take them in cash. Each fund may invest a portion of its assets in securities that generate income that is not exempt from federal or state income tax. GENERALLY, ANY SALE OR EXCHANGE OF YOUR SHARES IS A TAXABLE EVENT. A sale may result in a capital gain or loss for you. The gain or loss generally will be treated as short-term if you held the shares for 12 months or less, long-term if you held the shares longer. FOR TAX PURPOSES, AN EXCHANGE BETWEEN SCHWAB FUNDS IS DIFFERENT FROM AN EXCHANGE BETWEEN SHARE CLASSES. An exchange between is considered a sale. An exchange between classes within a fund is not reported as a taxable sale. AT THE BEGINNING OF EVERY YEAR, THE FUNDS PROVIDE SHAREHOLDERS WITH INFORMATION DETAILING THE TAX STATUS OF ANY DISTRIBUTIONS a fund paid during the previous calendar year, including a breakdown of the fund's income from each state. Schwab customers also receive information on distributions and transactions in their monthly account statements. SCHWAB CUSTOMERS WHO SELL FUND SHARES typically will receive a report that calculates their gain or loss using the "average cost" single-category method. This information is not reported to the IRS, and you still have the option of calculating gains or losses using any other methods permitted by the IRS. 34 Investing in the funds NOTES SCHWAB TAX-FREE BOND FUNDS PROSPECTUS November 15, 2004 [CHARLES SCHWAB LOGO] TO LEARN MORE This prospectus contains important information on the funds and should be read and kept for reference. You also can obtain more information from the following sources. ANNUAL AND SEMI-ANNUAL REPORTS, which are mailed to current fund investors, discuss recent performance and fund holdings. THE STATEMENT OF ADDITIONAL INFORMATION (SAI) includes a more detailed discussion of investment policies and the risks associated with various investments. The SAI is incorporated by reference into the prospectus, making it legally part of the prospectus. For a free copy of any of these documents or to request other information or ask questions about the funds, call SchwabFunds at 1-800-435-4000. In addition, you may visit SchwabFunds' web site at www.schwab.com/schwabfunds to obtain a free copy of a prospectus or an annual or semi-annual report. The SAI, as well as the funds' annual and semi-annual reports, and other related materials are available from the EDGAR Database on the SEC's web site (http://www.sec.gov). You can obtain copies of this information, after paying a duplicating fee, by sending a request by e-mail to publicinfo@sec.gov or by writing the Public Reference Section of the SEC, Washington, D.C. 20549-0102. You can also review and copy information about the funds, including the funds' SAI, at the SEC's Public Reference Room in Washington, D.C. Call 1-202-942-8090 for information on the operation of the SEC's Public Reference Room. SEC FILE NUMBER Schwab Tax-Free Bond Funds 811-6200 REG14272FLT-06 SCHWAB BOND FUNDS PROSPECTUS November 15, 2004 Schwab YieldPlus Fund(R) Schwab Short-Term Bond Market Fund TM Schwab Total Bond Market Fund TM Schwab GNMA Fund TM As with all mutual funds, the Securities and Exchange Commission (SEC) has not approved these securities or passed on whether the information in this prospectus is adequate and accurate. Anyone who indicates otherwise is committing a federal crime. [CHARLES SCHWAB LOGO] SCHWAB BOND FUNDS ABOUT THE FUNDS Schwab YieldPlus Fund(R) .......................................... 2 Schwab Short-Term Bond Market Fund TM.............................. 7 Schwab Total Bond Market Fund TM .................................. 12 Schwab GNMA Fund TM ............................................... 17 Fund management ................................................... 21 INVESTING IN THE FUNDS Buying shares ..................................................... 23 Selling/exchanging shares ......................................... 25 Transaction policies .............................................. 26 Distributions and taxes ........................................... 27 ABOUT THE FUNDS THE SCHWAB YIELDPLUS FUND(R) is an ultra short-term bond fund, designed to offer high current income with minimal changes in share price. The fund invests primarily in investment-grade bonds. The fund offers the potential for higher yields than a money market fund. However, unlike a money market fund, its share price will fluctuate. The fund seeks to keep the average duration of its portfolio at one year or less. THE SCHWAB SHORT-TERM BOND MARKET FUND TM is a short-term bond fund designed to offer high current income by tracking the performance of the Lehman Brothers Mutual Fund Short (1-5 year) U.S. Government/Credit Index. The fund invests primarily in a diversified portfolio of investment-grade debt instruments. The fund seeks to maintain an average weighted maturity of less than three years. THE SCHWAB TOTAL BOND MARKET FUND TM is designed to offer high current income by tracking the performance of the Lehman Brothers U.S. Aggregate Bond Index. The fund invests primarily in a diversified portfolio of investment-grade debt instruments. The fund is intended for investors seeking to fill the fixed income component of their asset allocation plan. THE SCHWAB GNMA FUND TM is a bond fund designed to offer current income by investing primarily in Government National Mortgage Association (GNMA) securities. GNMA guarantees payment of principal and interest on these securities, a guarantee backed by the full faith and credit of the U.S. government. The performance of the funds will fluctuate over time and, as with all investments, future performance may differ from past performance. SCHWAB YIELDPLUS FUND(R) TICKER SYMBOLS Investor Shares: SWYPX Select Shares(R): SWYSX -------------------------------------------------------------------------------- THE FUND SEEKS HIGH CURRENT INCOME WITH MINIMAL CHANGES IN SHARE PRICE. RISK MANAGEMENT The manager may use a variety of techniques to help manage risk, including investments in derivatives. Derivatives generally are investments whose value is based on one or more securities, rates or indices and can be effective risk management tools. For example, the fund may buy and sell financial futures and swaps to help manage the effects of interest rate changes. A financial future is a contract to buy or sell a specific financial instrument at a specified price at a specific future time. Such financial instruments include treasury securities, and other debt obligations, the prices of which fluctuate with changes in interest rates. A swap is a contract between the fund and another party to exchange a set of payments that the fund owns for a set of payments owned by the other party. Two kinds of swaps are index swaps and interest-rate swaps. -------------------------------------------------------------------------------- STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN INVESTMENT-GRADE (HIGH AND CERTAIN MEDIUM QUALITY, AAA TO BBB- OR THE UNRATED EQUIVALENT AS DETERMINED BY THE INVESTMENT ADVISER) BONDS. These may include fixed-, variable- or floating-rate corporate, mortgage-backed and asset-backed debt securities, collateralized mortgage obligations and convertible and preferred securities from U.S. and foreign issuers. In choosing securities, the fund's manager seeks to maximize current income within the limits of the fund's credit and maturity policies. To help maintain a high degree of share price stability and preserve investors' capital, the fund seeks to keep the average duration of its portfolio at one year or less. Duration is a tool to measure interest rate risk. Historically, the fund's average maturity measurement and average duration have closely followed each other. The fund may invest in bonds with effective or final maturities of any length and may invest up to 25% of its assets in lower quality bonds (sometimes called junk bonds) that are rated at least B by at least one nationally recognized statistical rating organization (NRSRO) or are the unrated equivalent as determined by the investment adviser. The investment adviser's credit research department analyzes and monitors the securities that the fund owns or is considering buying. The manager may adjust the fund's holdings or its average duration based on actual or anticipated changes in interest rates or credit quality. In the event a portfolio security is no longer rated at least B by at least one NRSRO or the unrated equivalent as determined by the investment advisor, the manager will promptly sell the security. The manager also may use investment techniques, such as short sales, futures contracts, swap agreements and other derivatives, in seeking to increase income, reduce share price volatility and otherwise manage the fund's exposure to investment risks. The fund's investment strategy is designed to offer the potential for somewhat higher yields than a money market fund, although unlike a money market fund, its share price will fluctuate. In exchange for seeking minimal fluctuation in share price, the fund may offer lower long-term performance than stock investments or certain other bond investments. The fund may buy and sell portfolio securities actively. If it does, its portfolio turnover rate and transaction costs will rise, which may lower fund performance and increase the likelihood of capital gain distributions. 2 Investors with investment horizons of one year or more who are seeking an alternative to a money fund or other fixed-income fund may want to consider this fund. RISKS INTEREST RATES RISE AND FALL OVER TIME. As with any investment whose yield reflects current interest rates, the fund's yield will change over time. During periods when interest rates are low, the fund's yield (and total return) also may be low. Changes in interest rates also may affect the fund's share price: a sharp rise in interest rates could cause the fund's share price to fall. Assuming a one year duration for the fund, a 2% increase in interest rates would result in approximately a 2% decrease in the fund's share price. This risk is greater when the fund holds bonds with longer maturities. THE FUND IS NOT A MONEY MARKET FUND OR A BANK DEPOSIT. Its shares are not insured or guaranteed. Because the fund's share price may move up and down, the value of your investment in the fund will fluctuate, which means you could lose money. A DECLINE IN THE CREDIT QUALITY OF A PORTFOLIO INVESTMENT COULD CAUSE THE FUND'S SHARE PRICE TO FALL. Although the fund invests primarily in investment-grade securities, the fund could lose money if the issuer or guarantor of a portfolio investment fails to make timely principal or interest payments or otherwise honor its obligations. Lower quality bonds are considered speculative with respect to the issuer's ability to make principal and interest payments. In addition, prices of lower-quality bonds tend to be more volatile than those of investment-grade bonds, and may fall based on bad news about the issuer, an industry or the overall economy. SOME INVESTMENTS CARRY ADDITIONAL RISKS. To the extent that the manager decides to invest in foreign or mortgage- and asset-backed debt securities, the fund takes on a greater exposure to certain risks. Prices of foreign bonds may be more volatile than those of comparable bonds from U.S. issuers, for reasons ranging from limited issuer information to the risk of political upheaval. With certain mortgage- and asset-backed bonds, a primary risk is the possibility that the bonds may be paid off earlier or later than expected. Either situation could cause the fund to hold securities paying lower than the market rate of interest, which could hurt the fund's -------------------------------------------------------------------------------- OTHER RISK FACTORS While the fund may use a variety of techniques to help manage risk, they could hurt the fund's performance if they don't perform as expected. For example, if the fund uses a technique involving a derivative, such as a futures contract or swap agreement, for the purpose of offsetting price changes in the fund's portfolio, but the technique does not precisely offset the price changes, the fund's share price could fall. The fund's performance also could be hurt if the counterparty to a derivative does not honor its contractual obligations to the fund. The cost of derivatives may have the effect of increasing fund expenses. While the decision to use or not use a given risk management technique depends on market conditions, these costs could at times outweigh the benefits the fund realizes from these techniques. -------------------------------------------------------------------------------- 3 yield or share price. A fund that purchases mortgage-related securities is subject to certain additional risks. Rising interest rates tend to extend the duration of mortgage-related securities, making them more sensitive to changes in interest rates. As a result, in a period of rising interest rates, a fund that holds mortgage-related securities may exhibit additional volatility. This is known as extension risk. In addition, 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 a fund because the fund will have to reinvest that money at the lower prevailing interest rates. THE MANAGER'S MATURITY AND DURATION DECISIONS ALSO WILL AFFECT THE FUND'S PERFORMANCE. To the extent that the manager anticipates interest rate trends imprecisely, the fund could miss yield opportunities or its share price could fall. THE FUND COULD LOSE MONEY IF THE PRICES OF SECURITIES SOLD SHORT INCREASE. When the Fund sells a security short, it sells a security it does not own and must borrow the security to deliver to the buyer. The Fund is obligated to replace the borrowed security by purchasing it at the then current market price, which may be more or less than the price at which the security was sold by the Fund. 4 Schwab YieldPlus Fund(R) PERFORMANCE The information below shows fund returns before and after taxes, and compares fund performance (which varies over time) to that of an index. The index is unmanaged and does not include expenses or taxes. All figures assume distributions were reinvested. The after-tax figures: - reflect the highest individual federal marginal income tax rate that applied during the period, but assume no state or local taxes - are shown for one class only, and would be different for the other share class - may not reflect your actual after-tax performance - may not be relevant to shares in an IRA, 401(k) or other tax-advantaged retirement account. Keep in mind that future performance (both before and after taxes) may differ from past performance. The fund has two share classes, which have different minimum investments and different costs. For information on choosing a class, see page 23. [BAR CHART] ANNUAL TOTAL RETURNS (%) as of 12/31
INVESTOR SHARES 00 5.75 01 5.85 02 2.64 03 2.91 BEST QUARTER: 2.25% Q1 2001 WORST QUARTER: (0.13%) Q4 2001 YEAR-TO-DATE PERFORMANCE AS OF 9/30/04: 1.74%
AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/03
Since 1 year inception -------------------------------------------------------------------------------- FUND INVESTOR SHARES Before taxes 2.91 4.38 1 After tax on distributions 1.84 2.40 1 After tax on distributions and sale 1.88 2.50 1 SELECT SHARES(R) Before taxes 3.06 4.53 1 LEHMAN US SHORT TREASURY: 9-12 months 1.43 4.36 2
1 Inception: 10/1/99. 2 From: 10/1/99. FUND FEES AND EXPENSES The following table describes what you could expect to pay as a fund investor. "Shareholder fees" are charged to you directly by the fund. "Annual operating expenses" are paid out of fund assets, so their effect is included in the total return for each share class. FEE TABLE (%)
INVESTOR SELECT SHAREHOLDER FEES SHARES SHARES(R) -------------------------------------------------------------------------------- None None ANNUAL OPERATING EXPENSES (% of average net assets) ------------------------------------------------------------------------------- Management fees 0.31 0.31 Distribution (12b-1) fees None None Other expenses 0.29 0.14 ---------------- Total annual operating expenses 0.60 0.45 ================
Designed to help you compare expenses, the example below uses the same assumptions as other mutual fund prospectuses: a $10,000 investment, a 5% return each year and that the fund's operating expenses remain the same. The expenses would be the same whether you stayed in the fund or sold your shares at the end of each period. Your actual costs may be higher or lower. EXPENSES ON A $10,000 INVESTMENT
1 year 3 years 5 years 10 years -------------------------------------------------------------------------------- INVESTOR SHARES $61 $192 $335 $750 SELECT SHARES $46 $144 $252 $567
5 FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for its period of operations. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/03- 9/1/02- 9/1/01- 9/1/00- 10/1/99 1- INVESTOR SHARES 8/31/04 8/31/03 8/31/02 8/31/01 8/31/00 -------------------------------------------------------------------------------------------------------------------------------- PER-SHARE DATA ($) -------------------------------------------------------------------------------------------------------------------------------- Net asset value at beginning of period 9.70 9.75 10.00 9.92 10.00 ------------------------------------------------------------------------ Income from investment operations: Net investment income 0.24 0.30 0.42 0.62 0.61 Net realized and unrealized gains or losses 0.01 (0.02) (0.23) 0.08 (0.08) ------------------------------------------------------------------------ Total income from investment operations 0.25 0.28 0.19 0.70 0.53 Less distributions: Dividends from net investment income (0.24) (0.33) (0.44) (0.62) (0.61) ------------------------------------------------------------------------ Net asset value at end of period 9.71 9.70 9.75 10.00 9.92 ------------------------------------------------------------------------ Total return (%) 2.63 2.95 1.89 7.33 5.44 2 RATIOS/SUPPLEMENTAL DATA (%) -------------------------------------------------------------------------------------------------------------------------------- Ratios to average net assets: Net operating expenses 0.60 0.59 0.55 0.55 0.56 3,4 Gross operating expenses 0.60 0.59 0.62 0.71 0.80 3 Net investment income 2.43 3.08 4.36 6.03 6.72 3 Portfolio turnover rate 89 109 42 106 81 2 Net assets, end of period ($ X 1,000,000) 639 410 392 185 53
9/1/03- 9/1/02- 9/1/01- 9/1/00- 10/1/99 1- SELECT SHARES(R) 8/31/04 8/31/03 8/31/02 8/31/01 8/31/00 ------------------------------------------------------------------------------------------------------------------------------- PER-SHARE DATA ($) ------------------------------------------------------------------------------------------------------------------------------- Net asset value at beginning of period 9.70 9.75 10.00 9.92 10.00 ----------------------------------------------------------------------- Income from investment operations: Net investment income 0.25 0.32 0.44 0.64 0.62 Net realized and unrealized gains or losses 0.01 (0.02) (0.24) 0.08 (0.08) ----------------------------------------------------------------------- Total income from investment operations 0.26 0.30 0.20 0.72 0.54 Less distributions: Dividends from net investment income (0.26) (0.35) (0.45) (0.64) (0.62) ----------------------------------------------------------------------- Net asset value at end of period 9.70 9.70 9.75 10.00 9.92 ----------------------------------------------------------------------- Total return (%) 2.67 3.10 2.04 7.50 5.58 2 RATIOS/SUPPLEMENTAL DATA (%) -------------------------------------------- ----------------------------------------------------------------------- Ratios to average net assets: Net operating expenses 0.45 0.44 0.40 0.40 0.41 3,5 Gross operating expenses 0.45 0.44 0.47 0.56 0.65 3 Net investment income 2.57 3.23 4.52 6.18 6.88 3 Portfolio turnover rate 89 109 42 106 81 2 Net assets, end of period ($ X 1,000,000) 3,030 1,476 1,443 772 219
1 Commencement of operations. 2 Not annualized. 3 Annualized. 4 The ratio of net operating expenses would have been 0.55% if certain non-routine expenses (proxy fees) had not been included. 5 The ratio of net operating expenses would have been 0.40% if certain non-routine expenses (proxy fees) had not been included. 6 Schwab YieldPlus Fund(R) SCHWAB SHORT-TERM BOND MARKET FUND TM TICKER SYMBOL: SWBDX STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN A DIVERSIFIED PORTFOLIO OF DEBT INSTRUMENTS THAT IS DESIGNED TO TRACK THE PERFORMANCE OF THE LEHMAN BROTHERS MUTUAL FUND SHORT (1-5 YEAR) U.S. GOVERNMENT/CREDIT INDEX. The fund uses the index as a guide in structuring the fund's portfolio and selecting its investments. However, the fund is not required to invest any percentage of its assets in the securities represented in the index. Under normal circumstances, the dollar-weighted average maturity of the fund's portfolio is not expected to exceed three years. The fund normally invests at least 80% of its net assets in debt instruments of varying maturities. The fund will notify its shareholders at least 60 days before changing this policy. The fund invests primarily in investment-grade instruments and, under normal circumstances, will not invest more than 5% of its assets in lower quality bonds ("junk bonds"). If an instrument falls below investment-grade, the fund may continue to hold it if the investment adviser believes that it would benefit the fund. The fund may invest in fixed-, variable- or floating-rate debt instruments. The fund may invest in debt instruments of domestic and foreign issuers, including convertible, preferred, mortgage-backed or asset-backed securities and collateralized mortgage obligations. The fund also may invest in derivative instruments, such as swap agreements, options or futures contracts. 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. The fund may lend its securities to certain financial institutions to earn additional income. The fund also may seek to obtain market exposure to the instruments in which it invests by entering into a series of purchase and sale contracts or by using other investment techniques (such as mortgage dollar rolls). The fund may buy and sell portfolio securities actively. If it does, its portfolio turnover rate and transaction costs will rise, which may lower fund performance and increase the likelihood of capital gain distributions. -------------------------------------------------------------------------------- THE FUND SEEKS HIGH CURRENT INCOME BY TRACKING THE PERFORMANCE OF THE LEHMAN BROTHERS MUTUAL FUND SHORT (1-5 YEAR) U.S. GOVERNMENT/CREDIT INDEX. SHORT-TERM BONDS As a bond approaches maturity, its market value typically approaches its par value (the amount a bond-holder receives when the bond matures). Because of this, short-term bond prices are not as sensitive to interest rate changes as longer-term bond prices. In exchange for this lower volatility, short-term bonds typically (though not always) offer lower yields than longer-term bonds. The Lehman Brothers Mutual Fund Short (1-5 Year) U.S. Government/Credit Index includes investment-grade government and corporate bonds that are denominated in U.S. dollars and have maturities of one to five years. Investment-grade securities are rated in the four highest credit rating categories (AAA to BBB-). Bonds are represented in the index in proportion to their market value. -------------------------------------------------------------------------------- 7 Schwab Short-Term Bond Market Fund TM Investors seeking a diversified source of current income who want potentially lower volatility compared to a long-term fund may want to consider this fund. -------------------------------------------------------------------------------- OTHER RISK FACTORS The fund's other investment strategies also involve risks. For example, the fund's investment in securities that are not included in the index may increase the gap between the performance of the fund and that of the index. Futures contracts, which the fund may use to gain market exposure or to enhance total return, also could cause the fund to track the index less closely if they don't perform as expected. The fund also may lend a portion of its securities to certain financial institutions. The fund's loans are fully collateralized. However, if the institution defaults, the fund's performance could be reduced. The fund also could lose money if a swap agreement doesn't perform as expected or if the counterparty to a swap agreement fails to honor the agreement. The fund's mortgage dollar rolls could lose money if the price of the mortgage-backed securities sold fall below the agreed upon repurchase price, or if the counterparty is unable to honor the agreement. -------------------------------------------------------------------------------- RISKS BOND MARKETS RISE AND FALL DAILY. As with any investment whose performance is tied to these markets, the value of your investment in the fund will fluctuate, which means that you could lose money. YOUR INVESTMENT FOLLOWS THE SHORT-TERM BOND MARKET, AS MEASURED BY THE INDEX. The fund is designed to follow the performance of the index during upturns as well as downturns. As a result, the fund may not take steps to reduce market exposure or to lessen the effects of a declining market. WHEN INTEREST RATES RISE, BOND PRICES USUALLY FALL, AND WITH THEM THE FUND'S SHARE PRICE. The fund's short average maturity is designed to reduce this risk, but will not eliminate it. In periods of falling interest rates, the fund may be forced to reinvest the income proceeds in lower yielding securities, which may adversely affect the fund's yield. This is known as reinvestment risk. A DECLINE IN THE CREDIT QUALITY OF A PORTFOLIO INVESTMENT COULD CAUSE THE FUND'S SHARE PRICE TO FALL. Although the fund invests primarily in investment-grade securities, the fund could lose money if the issuer or guarantor of a portfolio investment fails to make timely principal or interest payments or otherwise honor its obligations. Lower-quality bonds are considered speculative with respect to the issuer's ability to make principal and interest payments. In addition, prices of lower-quality bonds tend to be more volatile than those of investment-grade bonds, and may fall based on bad news about the issuer, an industry or the overall economy. DIFFERENT TYPES OF BONDS CARRY DIFFERENT TYPES OF RISKS. To the extent that the fund is exposed to a given sector of the bond market, it takes on the risks of that sector. With certain mortgage- and asset-backed bonds, a primary risk is the possibility that the bonds may be paid off earlier or later than expected. Either situation could cause the fund to hold securities paying lower than market rates of interest, which could hurt the fund's yield or share price. A fund that purchases mortgage-related securities is 8 subject to certain additional risks. Rising interest rates tend to extend the duration of mortgage-related securities, making them more sensitive to changes in interest rates. As a result, in a period of rising interest rates, a fund that holds mortgage-related securities may exhibit additional volatility. This is known as extension risk. When interest rates decline, borrowers may pay off their mortgages sooner than expected. This can reduce the returns of a fund because the fund will have to reinvest that money at the lower prevailing interest rates. This is known as prepayment risk. Prices of foreign bonds may be more volatile than those of comparable bonds from U.S. issuers, for reasons ranging from limited issuer information to the risk of political upheaval. 9 PERFORMANCE The information below shows fund returns before and after taxes, and compares fund performance (which varies over time) to that of an index. The index is unmanaged and does not include expenses or taxes. All figures assume distributions were reinvested. The after-tax figures: - reflect the highest individual federal marginal income tax rate that applied during the period, but assume no state or local taxes - may not reflect your actual after-tax performance - may not be relevant to shares held in an IRA, 401(k) or other tax-advantaged retirement account. Keep in mind that future performance (both before and after taxes) may differ from past performance. The fund adopted its current goal and former strategy on 11/1/97; performance before that time may have been different had its current strategy been in place. [BAR CHART] ANNUAL TOTAL RETURNS (%) as of 12/31 94 (2.82) 95 10.90 96 4.00 97 6.88 98 6.96 99 1.54 00 9.12 01 7.31 02 6.58 03 3.46 BEST QUARTER: 3.87% Q3 2001 WORST QUARTER: (2.09%) Q1 1994 YEAR-TO-DATE PERFORMANCE AS OF 9/30/04: 1.75%
AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/03
1 year 5 years 10 years -------------------------------------------------------------------------------- FUND Before taxes 3.46 5.57 5.33 After tax on distributions 2.34 3.58 3.14 After tax on distributions and sale 2.24 3.50 3.14 LEHMAN BROTHERS MUTUAL FUND SHORT (1-5 YEAR) U.S. GOVERNMENT/CREDIT INDEX 3.35 6.26 6.24
FUND FEES AND EXPENSES The following table describes what you could expect to pay as a fund investor. "Shareholder fees" are charged to you directly by the fund. "Annual operating expenses" are paid out of fund assets, so their effect is included in the fund's total return. FEE TABLE (%)
SHAREHOLDER FEES -------------------------------------------------------------------------------- None ANNUAL OPERATING EXPENSES (% of average net assets) -------------------------------------------------------------------------------- Management fees 0.28 Distribution (12b-1) fees None Other expenses 0.29 -------- Total annual operating expenses 0.57 Expense reduction (0.02) -------- NET OPERATING EXPENSES* 0.55 ========
* Schwab and the investment adviser have guaranteed that the "net operating expenses" (excluding interest, taxes and certain non-routine expenses) will not exceed 0.55% through 11/15/05. Designed to help you compare expenses, the example below uses the same assumptions as other mutual fund prospectuses: a $10,000 investment, a 5% return each year and that the fund's operating expenses remain the same. The one-year figure is based on net operating expenses (after application of the expense reduction guarantee through 11/15/05). The expenses would be the same whether you stayed in the fund or sold your shares at the end of each period. Your actual costs may be higher or lower. EXPENSES ON A $10,000 INVESTMENT
1 year 3 years 5 years 10 years -------------------------------------------------------------------------------- $56 $181 $316 $712
10 Schwab Short-Term Bond Market Fund TM FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the past five years. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/03- 9/1/02- 9/1/01- 9/1/00- 9/1/99- 8/31/04 8/31/03 8/31/02 8/31/01 8/31/00 ---------------------------------------------------------------------------------------------------------------------------- PER-SHARE DATA ($) ---------------------------------------------------------------------------------------------------------------------------- Net asset value at beginning of period 10.14 10.07 10.08 9.65 9.66 -------------------------------------------------------------------- Income from investment operations: Net investment income 0.28 0.34 0.50 0.59 0.57 Net realized and unrealized gains or losses 0.07 0.07 (0.02) 0.43 (0.01) -------------------------------------------------------------------- Total income from investment operations 0.35 0.41 0.48 1.02 0.56 Less distributions: Dividends from net investment income (0.28) (0.34) (0.49) (0.59) (0.57) -------------------------------------------------------------------- Net asset value at end of period 10.21 10.14 10.07 10.08 9.65 -------------------------------------------------------------------- Total return (%) 3.46 4.16 4.88 10.84 5.97 RATIOS/SUPPLEMENTAL DATA (%) ---------------------------------------------------------------------------------------------------------------------------- Ratios to average net assets: Net operating expenses 0.53 0.43 0.35 0.35 0.36 1 Gross operating expenses 0.57 0.58 0.63 0.66 0.68 Net investment income 2.69 3.34 4.95 5.90 5.91 Portfolio turnover rate 114 124 150 248 129 Net assets, end of period ($ X 1,000,000) 728 648 493 369 219
1 The ratio of net operating expenses would have been 0.35% if certain non-routine expenses (proxy fees) had not been included. 11 SCHWAB TOTAL BOND MARKET FUND TM TICKER SYMBOL: SWLBX -------------------------------------------------------------------------------- THE FUND SEEKS HIGH CURRENT INCOME BY TRACKING THE PERFORMANCE OF THE LEHMAN BROTHERS U.S. AGGREGATE BOND INDEX. THE INDEX The Lehman Brothers U.S. Aggregate Bond Index includes investment-grade government, corporate, mortgage-, commercial mortgage- and asset-backed bonds that are denominated in U.S. dollars and have maturities longer than one year. Investment-grade securities are rated in the four highest rating categories (AAA to BBB-). Bonds are represented in the index in proportion to their market value. -------------------------------------------------------------------------------- STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN A DIVERSIFIED PORTFOLIO OF DEBT INSTRUMENTS THAT IS DESIGNED TO TRACK THE PERFORMANCE OF THE LEHMAN BROTHERS U.S. AGGREGATE BOND INDEX. The fund uses the index as a guide in structuring the fund's portfolio and selecting its investments. However, the fund is not required to invest any percentage of its assets in the securities represented in the index. The fund normally invests at least 80% of its net assets in debt instruments of varying maturities. The fund will notify its shareholders at least 60 days before changing this policy. The fund invests primarily in investment-grade instruments and, under normal circumstances, will not invest more than 5% of its assets in lower quality bonds ("junk bonds"). If an instrument falls below investment-grade, the fund may continue to hold it if the investment adviser believes that it would benefit the fund. The fund may invest in fixed-, variable- or floating-rate debt instruments. The fund may invest in debt instruments of domestic and foreign issuers, including convertible, preferred, mortgage-backed or asset-backed securities and collateralized mortgage obligations. The fund also may invest in derivative instruments, such as swap agreements, options or futures contracts. 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. The fund may lend its securities to certain financial institutions to earn additional income. The fund also may seek to obtain market exposure to the instruments in which it invests by entering into a series of purchase and sale contracts or by using other investment techniques (such as mortgage dollar rolls). The fund may buy and sell portfolio securities actively. If it does, its portfolio turnover rate and transaction costs will rise, which may lower fund performance and increase the likelihood of capital gain distributions. 12 This fund is designed for investors seeking to fill the fixed income component of their asset allocation plan, who can accept higher risk in exchange for potentially higher long-term returns compared to a short-term fund. RISKS BOND MARKETS RISE AND FALL DAILY. As with any investment whose performance is tied to these markets, the value of your investment in the fund will fluctuate, which means that you could lose money. YOUR INVESTMENT FOLLOWS THE BOND MARKET, AS MEASURED BY THE INDEX. The fund is designed to follow the performance of the index during upturns as well as downturns. As a result, the fund may not take steps to reduce market exposure or to lessen the effects of a declining market. WHEN INTEREST RATES RISE, BOND PRICES USUALLY FALL, AND WITH THEM THE FUND'S SHARE PRICE. The longer the fund's dollar-weighted average maturity, the more sensitive to interest rate movements its share price is likely to be. In periods of falling interest rates, the fund may be forced to reinvest the income proceeds in lower yielding securities, which may adversely affect the fund's yield. This is known as reinvestment risk. A DECLINE IN THE CREDIT QUALITY OF A PORTFOLIO INVESTMENT COULD CAUSE THE FUND'S SHARE PRICE TO FALL. Although the fund invests primarily in investment-grade securities, the fund could lose money if the issuer or guarantor of a portfolio investment fails to make timely principal or interest payments or otherwise honor its obligations. Lower-quality bonds are considered speculative with respect to the issuer's ability to make principal and interest payments. In addition, prices of lower-quality bonds tend to be more volatile than those of investment-grade bonds, and may fall based on bad news about the issuer, an industry or the overall economy. DIFFERENT TYPES OF BONDS CARRY DIFFERENT TYPES OF RISKS. To the extent that the fund is exposed to a given sector of the bond market, it takes on the risks of that sector. With certain mortgage- and asset-backed bonds, a primary risk is the possibility that the bonds may be paid off earlier or later than expected. Either situation could cause the fund to hold securities paying lower than market rates of interest, which could hurt the fund's yield or share price. A fund that purchases mortgage-related securities is subject to certain additional risks. Rising interest rates tend to extend the -------------------------------------------------------------------------------- OTHER RISK FACTORS The fund's other investment strategies also involve risks. For example, the fund's investment in securities that are not included in the index may increase the gap between the performance of the fund and that of the index. Futures contracts, which the fund may use to gain market exposure or to enhance total return, also could cause the fund to track the index less closely if they don't perform as expected. The fund also may lend a portion of its securities to certain financial institutions. The fund's loans are fully collateralized. However, if the institution defaults, the fund's performance could be reduced. The fund also could lose money if a swap agreement doesn't perform as expected or if the counterparty to a swap agreement fails to honor the agreement. The fund's mortgage dollar rolls could lose money if the price of the mortgage-backed securities sold fall below the agreed upon repurchase price, or if the counterparty is unable to honor the agreement. -------------------------------------------------------------------------------- 13 duration of mortgage-related securities, making them more sensitive to changes in interest rates. As a result, in a period of rising interest rates, a fund that holds mortgage-related securities may exhibit additional volatility. This is known as extension risk. When interest rates decline, borrowers may pay off their mortgages sooner than expected. This can reduce the returns of a fund because the fund will have to reinvest that money at the lower prevailing interest rates. This is known as prepayment risk. Prices of foreign bonds may be more volatile than those of comparable bonds from U.S. issuers, for reasons ranging from limited issuer information to the risk of political upheaval. 14 Schwab Total Bond Market Fund TM PERFORMANCE The information below shows fund returns before and after taxes, and compares fund performance (which varies over time) to that of an index. The index is unmanaged and does not include expenses or taxes. All figures assume distributions were reinvested. The after-tax figures: - reflect the highest individual federal marginal income tax rate that applied during the period, but assume no state or local taxes - may not reflect your actual after-tax performance - may not be relevant to shares held in an IRA, 401(k) or other tax-advantaged retirement account Keep in mind that future performance (both before and after taxes) may differ from past performance. The fund adopted its current goal and former strategy on 11/1/97; performance before that time may have been different had its current strategy been in place. ANNUAL TOTAL RETURNS (%) as of 12/31 [BAR CHART] 94 (5.74) 95 22.47 96 1.06 97 9.98 98 8.41 99 (1.04) 00 11.09 01 8.16 02 8.77 03 4.28 BEST QUARTER: 6.79% Q2 1995 WORST QUARTER: (4.83%) Q1 1994 YEAR-TO-DATE PERFORMANCE AS OF 9/30/04: 3.53%
AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/03
1 year 5 years 10 years -------------------------------------------------------------------------------- FUND Before taxes 4.28 6.17 6.50 After tax on distributions 2.15 3.73 3.89 After tax on distributions and sale 3.09 3.77 3.90 LEHMAN BROTHERS U.S. AGGREGATE BOND INDEX 4.10 6.62 6.94
FUND FEES AND EXPENSES The following table describes what you could expect to pay as a fund investor. "Shareholder fees" are charged to you directly by the fund. "Annual operating expenses" are paid out of fund assets, so their effect is included in the fund's total return. FEE TABLE (%)
SHAREHOLDER FEES -------------------------------------------------------------------------------- None ANNUAL OPERATING EXPENSES (% of average net assets) -------------------------------------------------------------------------------- Management fees 0.26 Distribution (12b-1) fees None Other expenses 0.28 ------- Total annual operating expenses* 0.54 =======
* Schwab and the investment adviser have guaranteed that the "net annual operating expenses" (excluding interest, taxes and certain non-routine expenses) will not exceed 0.55% through 11/15/05. Designed to help you compare expenses, the example below uses the same assumptions as other mutual fund prospectuses: a $10,000 investment, a 5% return each year and that the fund's operating expenses remain the same. The expenses would be the same whether you stayed in the fund or sold your shares at the end of each period. Your actual costs may be higher or lower. EXPENSES ON A $10,000 INVESTMENT
1 year 3 years 5 years 10 years -------------------------------------------------------------------------------- $55 $173 $302 $677
15 FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the past five years. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/03- 9/1/02- 9/1/01- 9/1/00- 9/1/99- 8/31/04 8/31/03 8/31/02 8/31/01 8/31/00 --------------------------------------------------------------------------------------------------------------------------- PER-SHARE DATA ($) --------------------------------------------------------------------------------------------------------------------------- Net asset value at beginning of period 10.20 10.22 10.24 9.65 9.58 -------------------------------------------------------------------------- Income from investment operations: Net investment income 0.31 0.34 0.47 0.60 0.61 Net realized and unrealized gains 0.32 0.10 0.13 0.59 0.07 -------------------------------------------------------------------------- Total income from investment operations 0.63 0.44 0.60 1.19 0.68 Less distributions: Dividends from net investment income (0.33) (0.37) (0.46) (0.60) (0.61) Distributions from net realized gains (0.35) (0.09) (0.16) -- -- -------------------------------------------------------------------------- Total distributions (0.68) (0.46) (0.62) (0.60) (0.61) -------------------------------------------------------------------------- Net asset value at end of period 10.15 10.20 10.22 10.24 9.65 -------------------------------------------------------------------------- Total return (%) 6.37 4.37 6.18 12.68 7.36 RATIOS/SUPPLEMENTAL DATA (%) --------------------------------------------------------------------------------------------------------------------------- Ratios to average net assets: Net operating expenses 0.52 0.43 0.35 0.35 0.36 1 Gross operating expenses 0.54 0.54 0.57 0.58 0.63 Net investment income 3.08 3.36 4.66 6.00 6.42 Portfolio turnover rate 223 121 74 153 135 Net assets, end of period ($ X 1,000,000) 1,042 1,025 1,053 926 647
1 The ratio of net operating expenses would have been 0.35% if certain non-routine expenses (proxy fees) had not been included. 16 Schwab Total Bond Market Fund TM SCHWAB GNMA FUND TM TICKER SYMBOLS Investor Shares: SWGIX Select Shares(R): SWGSX STRATEGY TO PURSUE ITS GOAL, THE FUND NORMALLY INVESTS AT LEAST 80% OF ITS NET ASSETS IN GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA) SECURITIES. The fund will notify its shareholders at least 60 days before changing this policy. In addition to GNMA securities, the fund may invest in securities issued by the U.S. government or its other agencies and instrumentalities such as the Federal National Mortgage Association ("Fannie Mae"), Federal Home Loan Mortgage Corporation ("Freddie Mac") and Federal Home Loan Banks ("FHLBs"). The fund may also invest in mortgage-backed and asset-backed securities, collateralized mortgage obligations, repurchase agreements, corporate bonds, commercial paper and derivatives (financial contracts whose value is based on, or derived from, an underlying asset, rate or index), such as swap agreements, structured notes, options and futures contracts. The fund is not subject to any maturity or duration restrictions. In addition, the fund may invest in other financial instruments or use other investment techniques (such as reverse repurchase agreements or mortgage dollar rolls). To earn additional income, the fund may lend portfolio securities to certain financial institutions. For temporary defensive purposes during unusual market conditions, the fund may invest up to 100% of its assets in cash, cash equivalents or other high quality short-term investments. When the fund engages in such activities, the fund would not be pursuing its goal and as a result, it may not achieve its investment goal. The fund may buy and sell portfolio securities actively. If it does, its portfolio turnover rate and transaction costs will rise, which may lower fund performance and increase the likelihood of capital gain distributions. -------------------------------------------------------------------------------- THE FUND SEEKS HIGH CURRENT INCOME CONSISTENT WITH PRESERVATION OF CAPITAL. GNMA SECURITIES GNMA is a government-owned corporation and a federal agency. GNMA-guaranteed securities represent interests in pools of residential mortgage loans. GNMA guarantees payment of principal and interest on these securities, a guarantee backed by the full faith and credit of the U.S. government. -------------------------------------------------------------------------------- 17 The fund is designed for investors seeking current income consistent with the high credit quality of GNMA securities. RISKS BOND MARKETS RISE AND FALL DAILY. As with any investment whose performance is tied to these markets, the value of your investment in the fund will fluctuate, which means that you could lose money. WHEN INTEREST RATES RISE, PRICES OF GNMA SECURITIES AND OTHER BONDS USUALLY FALL, AND WITH THEM THE FUND'S SHARE PRICE. The longer the fund's dollar-weighted average maturity, the more sensitive to interest rate movements its share price is likely to be. GNMA, MORTGAGE- AND ASSET-BACKED SECURITIES MAY BE PAID OFF EARLIER OR LATER THAN EXPECTED, POTENTIALLY AFFECTING FUND PERFORMANCE. Prices and yields of these securities reflect market expectations of future interest rate behavior. If interest rates do not behave as anticipated, yields and prices of these securities could be affected. A fund that purchases mortgage-related securities is subject to certain additional risks. Rising interest rates tend to extend the duration of mortgage-related securities, making them more sensitive to changes in interest rates. As a result, in a period of rising interest rates, a fund that holds mortgage-related securities may exhibit additional volatility. This is known as extension risk. In addition, 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 a fund because the fund will have to reinvest that money at the lower prevailing interest rates. DERIVATIVES MAY INVOLVE DIFFERENT OR GREATER RISKS THAN THOSE ASSOCIATED WITH INVESTING DIRECTLY IN BONDS OR OTHER TRADITIONAL INVESTMENTS. In addition to the risks described above, derivatives involve the risks that the counterparty to a transaction may not fulfill its contractual obligations and that changes in the value of the derivative may not correlate with the underlying asset, rate or index. If the fund invests in a derivative, it could lose more than the principal amount invested. SOME TRANSACTIONS, SUCH AS REVERSE REPURCHASE AGREEMENTS OR MORTGAGE DOLLAR ROLLS, MAY GIVE RISE TO A FORM OF LEVERAGE AND MAY EXPOSE THE FUND TO GREATER RISK. Leverage tends to magnify the effect of any decrease or increase in the value of the fund's portfolio securities. THE MANAGER'S MATURITY AND DURATION DECISIONS ALSO WILL AFFECT THE FUND'S PERFORMANCE. To the extent that the manager anticipates interest rate trends imprecisely, the fund could miss yield opportunities or its share price could fall. -------------------------------------------------------------------------------- OTHER RISK FACTORS A decline in the credit quality of a portfolio investment could cause the fund's share price to fall. Although the fund invests primarily in GNMA securities, which are guaranteed by the full faith and credit of the U.S. government, the fund may also invest in securities that are not guaranteed or insured by the U.S. government; including, for example, securities issued by Freddie Mac, Fannie Mae and FHLBs. The fund could lose money if an issuer or guarantor of these other investments fails to make timely principal or interest payments or otherwise honor its obligations. The fund also may lend a portion of its securities to certain financial institutions. The fund's loans are fully collateralized. However, if the institution defaults, the fund's performance could be reduced. -------------------------------------------------------------------------------- 18 Schwab GNMA Fund TM PERFORMANCE Because this is a new fund, tables reflecting the fund's annual total returns and average annual total return are not included. This information will appear in a future version of the fund's prospectus. FUND FEES AND EXPENSES The following table describes what you could expect to pay as a fund investor. "Shareholder fees" are charged to you directly by the fund. "Annual operating expenses" are paid out of fund assets, so their effect is included in the total return for each share class. FEE TABLE (%) INVESTOR SELECT SHAREHOLDER FEES SHARES SHARES(R) -------------------------------------------------------------------------------- None None ANNUAL OPERATING EXPENSES (% of average net assets) -------------------------------------------------------------------------------- Management fees 0.45 0.45 Distribution (12b-1) fees None None Other expenses 0.66 0.51 ------------------- Total annual operating expenses 1.11 0.96 Expense reduction (0.37) (0.41) ------------------- NET OPERATING EXPENSES* 0.74 0.55 ===================
* Schwab and the investment adviser have guaranteed that the "net operating expenses" (excluding interest, taxes and certain non-routine expenses) of the Investor Shares and Select Shares will not exceed 0.74% and 0.55%, respectively, through 11/15/05. Designed to help you compare expenses, the example below uses the same assumptions as other mutual fund prospectuses: a $10,000 investment, a 5% return each year and that the fund's operating expenses remain the same. The one-year figure is based on net operating expenses (after application of the expense reduction guarantee through 11/15/05). The expenses would be the same whether you stayed in the fund or sold your shares at the end of each period. Your actual costs may be higher or lower. EXPENSES ON A $10,000 INVESTMENT
1 year 3 years 5 years 10 years -------------------------------------------------------------------------------- INVESTOR SHARES $76 $316 $576 $1,319 SELECT SHARES $56 $265 $491 $1,141
19 FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for its period of operations. Certain information reflects financial results for a single fund share. "Total Return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/03- 3/3/03 1- INVESTOR SHARES 8/31/04 8/31/03 ------------------------------------------------------------------------------------------------------------- PER-SHARE DATA ($) ------------------------------------------------------------------------------------------------------------- Net asset value at beginning of period 9.69 10.00 ---------------------------------------------------- Income from investment operations: Net investment income 0.16 0.06 Net realized and unrealized gains or losses 0.26 (0.17) ---------------------------------------------------- Total income or loss from investment operations 0.42 (0.11) Less distributions: Dividends from net investment income (0.33) (0.20) ---------------------------------------------------- Net asset value at end of period 9.78 9.69 ---------------------------------------------------- Total return (%) 4.39 (1.11) 2 RATIOS/SUPPLEMENTAL DATA (%) ------------------------------------------------------------------------------------------------------------- Ratios to average net assets: Net operating expenses 0.51 -- Gross operating expenses 1.11 0.99 3 Net investment income 1.89 1.37 3 Portfolio turnover rate 199 105 2 Net assets, end of period ($ X 1,000,000) 18 21
9/1/03- 3/3/03 1- SELECT SHARES(R) 8/31/04 8/31/03 ------------------------------------------------------------------------------------------------------------- PER-SHARE DATA ($) ------------------------------------------------------------------------------------------------------------- Net asset value at beginning of period 9.69 10.00 ---------------------------------------------------- Income from investment operations: Net investment income 0.17 0.06 Net realized and unrealized gains or losses 0.26 (0.17) ---------------------------------------------------- Total income or loss from investment operations 0.43 (0.11) Less distributions: Dividends from net investment income (0.34) (0.20) ---------------------------------------------------- Net asset value at end of period 9.78 9.69 ---------------------------------------------------- Total return (%) 4.53 (1.11) 2 RATIOS/SUPPLEMENTAL DATA (%) ------------------------------------------------------------------------------------------------------------- Ratios to average net assets: Net operating expenses 0.37 -- Gross operating expenses 0.96 0.83 3 Net investment income 2.03 1.37 3 Portfolio turnover rate 199 105 2 Net assets, end of period ($ X 1,000,000) 19 28
1 Commencement of operations. 2 Not annualized. 3 Annualized. 20 Schwab GNMA Fund TM FUND MANAGEMENT The funds' investment adviser, Charles Schwab Investment Management, Inc., has more than $137 billion under management. The investment adviser for the funds is Charles Schwab Investment Management, Inc., 101 Montgomery Street, San Francisco, CA 94104. Founded in 1989, the firm today serves as investment adviser for all of the SchwabFunds(R). The firm manages assets for more than 5 million accounts. (All figures on this page are as of 8/31/04.) As the investment adviser, the firm oversees the asset management and administration of the funds. As compensation for these services, the firm receives a management fee from each fund. For the 12 months ended 8/31/04, these fees were 0.31% for the Schwab YieldPlus Fund(R), 0.24% for the Schwab Short-Term Bond Market Fund TM, 0.24% for the Schwab Total Bond Market Fund TM and 0.06% for the Schwab GNMA Fund TM. These figures, which are expressed as a percentage of each fund's average daily net assets, represent the actual amounts paid, including the effects of reductions. KIMON DAIFOTIS, CFA, a senior vice president and chief investment officer of fixed income portfolio management of the investment adviser, has overall responsibility for management of the funds. He joined the firm in September 1997 and has worked in fixed-income asset management and research since 1982. MICHAEL SHEARER, PH.D., is a vice president and senior portfolio manager of the investment adviser. He joined the firm in February 2003 and has day-to-day responsibility for the management of the funds. Prior to joining Schwab, he worked for 16 years in portfolio management and quantitative research. MATTHEW HASTINGS, CFA, a director and portfolio manager of the investment adviser, has day-to-day co-responsibility for the management of the funds. He joined the firm in 1999 and has worked in fixed-income and asset management since 1996. 21 INVESTING IN THE FUNDS As a SchwabFunds(R) investor, you have a number of ways to do business with us. On the following pages, you will find information on buying, selling and exchanging shares using the method that is most convenient for you. You also will see how to choose a class share and a distribution option for your investment. Helpful information on taxes is included as well. 22 BUYING SHARES Shares of the funds may be purchased through a Schwab account or through certain third-party investment providers, such as other financial institutions, investment professionals and workplace retirement plans. The information on these pages outlines how Schwab investors can place "good orders," which are orders made in accordance with the funds' policies, to buy, sell and exchange shares of the funds. If you are investing through a third-party investment provider, some of the instructions, minimums and policies may be different. Some investment providers may charge transaction or other fees. Contact your investment provider for more information. STEP 1 CHOOSE A FUND AND SHARE CLASS (IF APPLICABLE), then decide how much you want to invest. Your choice may depend on the amount of your investment. The minimums shown below are for each fund and share class.
MINIMUM MINIMUM SHARE INITIAL ADDITIONAL MINIMUM FUND CLASS INVESTMENT INVESTMENT BALANCE --------------------------------------------------------------------------------- SCHWAB YIELDPLUS INVESTOR $2,500 $500 ($100 $1,000 ($500 FUND(R) SHARES ($1,000 for for Automatic for retirement Investment retirement and custodial Plan) and custodial accounts) accounts) SELECT $50,000 $1,000 $40,000 SHARES(R) SCHWAB SHORT-TERM $2,500 $500 ($100 $1,000 ($500 BOND MARKET FUND TM ($1,000 for for Automatic for retirement Investment retirement and custodial Plan) and custodial accounts) accounts) SCHWAB TOTAL BOND $2,500 $500 ($100 $1,000 ($500 MARKET FUND TM ($1,000 for for Automatic for retirement Investment retirement and custodial Plan) and custodial accounts) accounts) SCHWAB GNMA FUND TM INVESTOR $2,500 $500 ($100 $1,000 ($500 SHARES ($1,000 for for custodial for retirement accounts and retirement and custodial Automatic and custodial accounts) Investment accounts) Plan) SELECT SHARES $50,000 $1,000 $40,000
-------------------------------------------------------------------------------- SCHWAB ACCOUNTS Some Schwab account features can work in tandem with features offered by the funds. For example, when you sell shares in a fund, the proceeds automatically are paid to your Schwab account. From your account, you can use features such as MoneyLink(R), which lets you move money between your brokerage accounts and bank accounts, and Automatic Investment Plan (AIP), which lets you set up periodic investments. For more information on Schwab accounts, call 1-800-435-4000 or visit the Schwab web site at www.schwab.com. -------------------------------------------------------------------------------- 23 STEP 2 CHOOSE AN OPTION FOR FUND DISTRIBUTIONS. The three options are described below. If you don't indicate a choice, you will receive the first option.
OPTION FEATURES ----------------------------------------------------------------------- REINVESTMENT All dividends and capital gain distributions are invested automatically in shares of your fund or share class, as applicable. CASH/REINVESTMENT MIX You receive payment for dividends, while any capital gain distributions are invested in shares of your fund or share class, as applicable. CASH You receive payment for all dividends and capital gain distributions.
STEP 3 PLACE YOUR ORDER. Use any of the methods described on the next page. Make checks payable to Charles Schwab and Co., Inc. Orders placed in person or through a telephone representative are subject to a service fee, payable to Schwab. 24 Investing in the funds SELLING/EXCHANGING SHARES USE ANY OF THE METHODS DESCRIBED BELOW TO SELL SHARES OF A FUND. When selling or exchanging shares, please be aware of the following policies: - A fund may take up to seven days to pay sale proceeds. - If you are selling shares that were recently purchased by check, the proceeds may be delayed until the check for purchase clears; this may take up to 15 days from the date of purchase. - The funds reserve the right to honor redemptions in liquid portfolio securities instead of cash when your redemptions over a 90-day period exceed $250,000 or 1% of a fund's assets, whichever is less. A shareholder may incur transaction expenses in converting these securities to cash. - Exchange orders are limited to other SchwabFunds(R) that are not Sweep Investments TM. Exchange orders must meet the minimum investment and other requirements for the fund and share class into which you are exchanging. - You must obtain and read the prospectus for the fund into which you are exchanging prior to placing your order. METHODS FOR PLACING DIRECT ORDERS INTERNET www.schwab.com SCHWAB BY PHONE TM 1 Automated voice service or speak with a representative at 1-800-435-4000 (for TDD service, call 1-800-345-2550). SCHWABLINK(R) Investment professionals should follow the transaction instructions in the SchwabLink manual; for technical assistance, call 1-800-647-5465. MAIL Write to SchwabFunds at: P.O. Box 3812 Englewood, CO 80155-3812 IN PERSON 1 Visit the nearest Charles Schwab branch office. You are automatically entitled to initiate transactions by the Internet or telephone. The funds and Schwab employ procedures to confirm the authenticity of Internet and telephone instructions. If the funds and Schwab follow these procedures, they will not be responsible for any losses or costs incurred by following Internet or telephone instructions that they reasonably believe to be genuine. 1 Orders placed in person or through a telephone representative are subject to a service fee, payable to Schwab. -------------------------------------------------------------------------------- WHEN PLACING ORDERS With every order to buy, sell or exchange shares, you will need to include the following information: - Your name or, for Internet orders, your account number/"Login ID." - Your account number (for SchwabLink transactions, include the master account and subaccount numbers) or, for Internet orders, your password. - The name and share class (if applicable) of the fund whose shares you want to buy or sell. - The dollar amount or number of shares you would like to buy, sell or exchange. - When selling or exchanging shares, be sure to include the signature of at least one of the persons whose name is on the account. - For exchanges, the name and share class (if applicable) of the fund into which you want to exchange and the distribution option you prefer. - When selling shares, how you would like to receive the proceeds. Please note that orders to buy, sell or exchange shares become irrevocable at the time you mail them. -------------------------------------------------------------------------------- 25 -------------------------------------------------------------------------------- THE FUNDS RESERVE CERTAIN RIGHTS REGARDING TRANSACTION POLICIES, AS DETAILED AT RIGHT. THE FUNDS AND SCHWAB RESERVE CERTAIN RIGHTS, INCLUDING THE FOLLOWING: - To automatically redeem your shares if the account they are held in is closed for any reason or your balance falls below the minimum for your fund or share class, as applicable, as a result of selling or exchanging your shares. - To materially modify or terminate the exchange privilege upon 60 days' written notice to shareholders. - To refuse any purchase or exchange order, including large purchase orders that may negatively affect a fund's operations and orders that appear to be associated with short-term trading activities. - To change or waive a fund's or share class' investment minimums. - To suspend the right to sell shares back to a fund, and delay sending proceeds, during times when trading on the NYSE is restricted or halted, or otherwise as permitted by the SEC. - To withdraw or suspend any part of the offering made by this prospectus. -------------------------------------------------------------------------------- TRANSACTION POLICIES THE FUNDS ARE OPEN FOR BUSINESS EACH DAY THAT THE NEW YORK STOCK EXCHANGE (NYSE) IS OPEN. A fund calculates its share price or the share price for each of its share classes, as applicable, each business day as of the close of the NYSE (generally 4 p.m. Eastern time). A fund's share price is its net asset value per share, or NAV, which is the fund's net assets divided by the number of its shares outstanding. Orders to buy, sell or exchange shares that are received in good order on or prior to the close of a fund (generally 4 p.m. Eastern time) will be executed at the next share price calculated that day. Orders to buy shares that are accepted prior to the close of a fund generally will receive the next day's dividend. Orders to sell or exchange shares that are accepted and executed prior to the close of a fund on a given day generally will receive that day's dividend. If you place an order through a third-party investment provider, please consult with that investment provider to determine when your order will be executed. Generally, you will receive the share price next calculated after a fund receives your order from your investment provider. However, some investment providers may arrange with a fund for you to receive the share price next calculated after your investment provider has received your order. Some investment providers may require that they receive orders prior to a specified cut-off time. In valuing their securities, the funds use market quotes if they are readily available. In cases where quotes are not readily available, or the adviser deems them to be unreliable, the funds may value securities based on fair values developed using methods approved by the funds' Board of Trustees. 26 Investing in the funds DISTRIBUTIONS AND TAXES ANY INVESTMENT IN A FUND TYPICALLY INVOLVES SEVERAL TAX CONSIDERATIONS. The information below is meant as a general summary for U.S. citizens and residents. Because each person's tax situation is different, you should consult your tax advisor about the tax implications of your investment in a fund. You also can visit the Internal Revenue Service (IRS) web site at www.irs.gov. AS A SHAREHOLDER, YOU ARE ENTITLED TO YOUR SHARE OF THE DIVIDENDS AND GAINS YOUR FUND EARNS. Each fund distributes to its shareholders substantially all of its net investment income and net capital gains, if any. Each fund declares a dividend every business day, based on its determination of its net investment income. Each fund pays its dividends on the last business day of every month. The funds expect to pay any capital gain distributions every year, typically in December, to all shareholders of record. UNLESS YOU ARE INVESTING THROUGH A TAX-DEFERRED OR ROTH RETIREMENT ACCOUNT, YOUR FUND DISTRIBUTIONS GENERALLY HAVE TAX CONSEQUENCES. Each fund's net investment income and short-term capital gains are distributed as dividends and are taxable as ordinary income. Other capital gain distributions are taxable as long-term capital gains, regardless of how long you have held your shares in a fund. Distributions generally are taxable in the tax year in which they are declared, whether you reinvest them or take them in cash. DIVIDENDS DERIVED FROM U.S. GOVERNMENT SECURITIES ARE GENERALLY EXEMPT FROM STATE AND LOCAL INCOME TAXES. However, some states may limit this benefit, and some agency-backed securities may not qualify for tax-exempt status. GENERALLY, ANY SALE OR EXCHANGE OF YOUR SHARES IS A TAXABLE EVENT. A sale may result in a capital gain or loss for you. The gain or loss generally will be treated as short-term if you held the shares for 12 months or less and long-term if you held the shares longer. FOR TAX PURPOSES, AN EXCHANGE BETWEEN SCHWABFUNDS IS DIFFERENT FROM AN EXCHANGE BETWEEN SHARE CLASSES. An exchange between funds is considered a sale. An exchange between classes within a fund is not reported as a taxable sale. AT THE BEGINNING OF EVERY YEAR, THE FUNDS PROVIDE SHAREHOLDERS WITH INFORMATION DETAILING THE TAX STATUS OF ANY DISTRIBUTIONS a fund declared during the previous calendar year including the percentage of dividends paid that may qualify for tax-exempt status. Schwab customers also receive information on distributions and transactions in their monthly account statements. SCHWAB CUSTOMERS WHO SELL FUND SHARES typically will receive a report that calculates their gain or loss using the "average cost" single-category method. This information is not reported to the IRS, and you still have the option of calculating gains or losses using any other methods permitted by the IRS. 27 NOTES SCHWAB YIELDPLUS FUND(R) Schwab Short-Term Bond Market Fund TM Schwab Total Bond Market Fund TM Schwab GNMA Fund TM PROSPECTUS November 15, 2004 [CHARLES SCHWAB LOGO] TO LEARN MORE This prospectus contains important information on the funds and should be read and kept for reference. You also can obtain more information from the following sources. ANNUAL AND SEMI-ANNUAL REPORTS, which are mailed to current fund investors, discuss recent performance and fund holdings. THE STATEMENT OF ADDITIONAL INFORMATION (SAI) includes a more detailed discussion of investment policies and the risks associated with various investments. The SAI is incorporated by reference into the prospectus, making it legally part of the prospectus. For a free copy of any of these documents or to request other information or ask questions about the funds, call SchwabFunds at 1-800-435-4000. In addition, you may visit SchwabFunds' web site at www.schwab.com/schwabfunds for a free copy of a prospectus or an annual or semi-annual report. The SAI, the funds' annual and semi-annual reports and other related materials are available from the EDGAR Database on the SEC's web site (http://www.sec.gov). You can obtain copies of this information, after paying a duplicating fee, by sending a request by e-mail to publicinfo@sec.gov or by writing the Public Reference Section of the SEC, Washington, D.C. 20549-0102. You can also review and copy information about the funds, including the funds' SAI, at the SEC's Public Reference Room in Washington, D.C. Call 1-202-942-8090 for information on the operation of the SEC's Public Reference Room. SEC FILE NUMBER Schwab YieldPlus Fund(R) 811-6200 Schwab Short-Term Bond Market Fund TM 811-6200 Schwab Total Bond Market Fund TM 811-6200 Schwab GNMA Fund TM 811-6200 REG14271FLT-07 STATEMENT OF ADDITIONAL INFORMATION SCHWAB INVESTMENTS SCHWAB SHORT-TERM BOND MARKET FUND(TM) SCHWAB TOTAL BOND MARKET FUND(TM) SCHWAB SHORT/INTERMEDIATE TAX-FREE BOND FUND(TM) SCHWAB LONG-TERM TAX-FREE BOND FUND(TM) SCHWAB CALIFORNIA SHORT/INTERMEDIATE TAX-FREE BOND FUND(TM) SCHWAB CALIFORNIA LONG-TERM TAX-FREE BOND FUND(TM) SCHWAB YIELDPLUS FUND(R) SCHWAB GNMA FUND(TM) SCHWAB TAX-FREE YIELDPLUS FUND(TM) SCHWAB CALIFORNIA TAX-FREE YIELDPLUS FUND(TM) NOVEMBER 15, 2004 The Statement of Additional Information (SAI) is not a prospectus. It should be read in conjunction with the funds' prospectuses dated November 15, 2004 (as amended from time to time). To obtain a free copy of the prospectuses, please contact SchwabFunds(R) at 1-800-435-4000, day or night, or write to the funds at P.O. Box 3812, Englewood, CO 80155-3812. For TDD service call 1-800-345-2550, day or night. The prospectuses also may be available on the Internet at: http://www.schwab.com/schwabfunds. Each fund is a series of Schwab Investments (the Trust). The Trust, The Charles Schwab Family of Funds, Schwab Capital Trust and Schwab Annuity Portfolios are collectively referred to as the "SchwabFunds". The funds' audited financial statements from the funds' most recent annual shareholder reports are incorporated by reference into this SAI. A fund's most recent annual shareholder report is supplied with the SAI. For each fund that includes a summary portfolio schedule in its shareholder reports, the fund's most recent annual full portfolio schedule from Form N-CSR is a separate document supplied with the SAI and is incorporated by reference into this SAI. The information in this Statement of Additional Information (SAI) is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This SAI is not an offer to sell these securities and is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. 1 TABLE OF CONTENTS Page INVESTMENT OBJECTIVES, STRATEGIES, SECURITIES, RISKS AND LIMITATIONS..................................................................3 MANAGEMENT OF THE FUNDS.....................................................44 DESCRIPTION OF PROXY VOTING POLICY AND PROCEDURES...........................56 CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES.........................62 INVESTMENT ADVISORY AND OTHER SERVICES......................................62 BROKERAGE ALLOCATION AND OTHER PRACTICES....................................66 DESCRIPTION OF THE TRUST....................................................69 PURCHASE, REDEMPTION, DELIVERY OF SHAREHOLDER DOCUMENTS AND PRICING OF SHARES.......................................................71 TAXATION....................................................................73 APPENDIX - RATINGS OF INVESTMENT SECURITIES.................................77 2 INVESTMENT OBJECTIVES, STRATEGIES, SECURITIES, RISKS AND LIMITATIONS INVESTMENT OBJECTIVES SCHWAB SHORT-TERM BOND MARKET FUND(TM) SCHWAB TOTAL BOND MARKET FUND(TM) Each fund's investment objective is to attempt to provide a high level of current income consistent with preservation of capital by seeking to track the investment results of a particular bond index through the use of an indexing strategy. The indices are the Lehman Brothers Mutual Fund Short (1-5 Year) U.S. Government/Credit Index for the Schwab Short-Term Bond Market Fund (the Short-Term Index), and the Lehman Brothers U.S. Aggregate Bond Index for the Schwab Total Bond Market Fund (the U.S. Aggregate Bond Index). The Short-Term Index is a market-capitalization weighted index of investment-grade debt securities with maturities between one and five years. The U.S. Aggregate Bond Index is a market-capitalization weighted index of investment-grade debt securities with maturities of greater than one year. SCHWAB SHORT/INTERMEDIATE TAX-FREE BOND FUND(TM) SCHWAB LONG-TERM TAX-FREE BOND FUND(TM) SCHWAB CALIFORNIA SHORT/INTERMEDIATE TAX-FREE BOND FUND(TM) SCHWAB CALIFORNIA LONG-TERM TAX-FREE BOND FUND(TM) SCHWAB TAX-FREE YIELDPLUS FUND(TM) SCHWAB CALIFORNIA TAX-FREE YIELDPLUS FUND(TM) Schwab Short/Intermediate Tax-Free Bond Fund and Schwab Long-Term Tax-Free Bond Fund's investment objective is to seek a high level of current income that is exempt from federal income tax, consistent with preservation of capital. Schwab California Short/Intermediate Tax-Free Bond Fund and Schwab California Long-Term Tax-Free Bond Fund's investment objective is to seek a high level of current income that is exempt from federal income and State of California personal income taxes, consistent with preservation of capital. Schwab Tax-Free YieldPlus Fund(TM)'s investment objective is to seek high current income that is exempt from federal income tax consistent with minimal changes in share price. Schwab California Tax-Free YieldPlus Fund(TM)'s investment objective is to seek high current income that is exempt from federal and California personal income tax consistent with minimal changes in share price. These funds are not suitable for investors who would not benefit from the tax-exempt character of each fund's investments, such as holders of IRAs, qualified retirement plans or other tax-exempt entities. 3 SCHWAB YIELDPLUS FUND(R) The fund's investment objective is to seek high current income with minimal changes in share price. SCHWAB GNMA FUND(TM) The fund's investment objective is to seek high current income consistent with preservation of capital. CHANGE OF INVESTMENT OBJECTIVE Each fund's investment objective may be changed by vote of a majority of its outstanding voting shares. A majority vote of outstanding securities of a fund means the vote, at an annual or a special meeting of shareholders of a fund where (a) of 67% or more of the voting securities present at the meeting, if the shareholders of more than 50% of the outstanding securities of a fund are present or represented by proxy, or (b) of more than 50% of the outstanding voting securities of a fund, whichever is less. There is no guarantee that a fund will achieve its investment objective. CHANGE TO 80% INVESTMENT POLICY OF CERTAIN FUNDS The Schwab Short-Term Bond Market Fund(TM), Schwab Total Bond Market Fund(TM) (collectively "the Bond Funds") will each, under normal circumstances, invest at least 80% of its net assets in debt instruments of varying maturities. Each fund will notify its shareholders at least 60 days before changing this policy. For purposes of this policy, net assets mean net assets plus the amount of any borrowings for investment purposes. The Schwab Short/Intermediate Tax-Free Bond Fund(TM), Schwab Long-Term Tax-Free Bond Fund(TM), Schwab California Short/Intermediate Tax-Free Bond Fund(TM), Schwab California Long-Term Tax-Free Bond Fund(TM), Schwab Tax-Free YieldPlus Fund(TM), and Schwab California Tax-Free YieldPlus Fund(TM) (collectively "the Tax-Free Bond Funds") will each normally invest at least 80% of their total net assets in municipal securities the interest of which is exempt from federal income tax including the federal alternative minimum tax. In addition, the Schwab California Short/Intermediate Tax Free Bond Fund, Schwab California Long-Term Tax-Free Bond Fund, and the Schwab California Tax-Free YieldPlus Fund(TM) will each normally invest at least 80% of its net assets in municipal securities the interest of which is exempt from California personal income tax. These policies may be changed only by shareholders. For purposes of these policies, net assets mean net assets plus the amount of any borrowings for investment purposes. Each fund may invest more than 25% of its total assets in municipal securities financing similar projects. Schwab GNMA Fund will, under normal circumstances, invest at least 80% of its net assets in securities issued by GNMA. The fund will notify its shareholders at least 60 days before changing this policy. For purposes of this policy, net assets mean net assets plus the amount of any borrowings for investment purposes. 4 INVESTMENTS, RISKS AND LIMITATIONS The following descriptions of investment securities, risks and limitations supplement those set forth in the prospectus and may be changed without shareholder approval unless otherwise noted. Not all investment securities or techniques discussed below are eligible investments for each fund. Each fund will invest in securities or engage in techniques that are intended to help achieve its investment objective. AUCTION-RATE SECURITIES ("ARS") are long-term variable rate bonds whose interest rates reset at specific shorter frequencies through a Dutch auction process. A Dutch auction is a competitive bidding process used to determine rates on each auction date. Bids are submitted to the auction agent. The winning bid rate is the rate at which the auction "clears", meaning the lowest possible interest rate that equals the cumulative total of securities demanded (buyers) to the amount auctioned (sellers). New buyers wishing to purchase ARS may submit a bid at a specified rate on the day of the auction. Holders of the bonds will be notified of the indicative market rate. All accepted bids receive the same interest rate. Owners of ARS have the option to (i) hold: elect to hold an existing position regardless of what the new rate might be; (ii) Bid: submit a bid to hold an existing position at a specified rate; or (iii) Sell: request to sell an existing position regardless of the rate set at the auction. Interest rates are generally reset every 7 or 28 days for taxable issues and every 35 days for tax-exempt issues. Most ARS pay interest on the business day following the auction; however, some may have quarterly or semi-annual coupons and trade with accrued interest. ARS settle on the business day following the auction. ARS holders do not have the right to "put" their securities back to the issuer, but rather rely on the liquidity generated by the Dutch auction. Due to this lack of a dedicated liquidity facility, ARS are very credit sensitive. BANKERS' ACCEPTANCES or notes are credit instruments evidencing a bank's obligation to pay a draft drawn on it by a customer. These instruments reflect the obligation both of the bank and of the drawer to pay the full amount of the instrument upon maturity. A fund will invest only in bankers' acceptances of banks that have capital, surplus and undivided profits in excess of $100 million. BOND SUBSTITUTION is a strategy whereby a fund may, from time to time, substitute one type of investment-grade bond for another. This means that, as an example, a fund may have a higher weighting in corporate bonds and a lower weighting in U.S. Treasury securities than its index in order to increase income. This particular substitution -- a corporate bond substitution - may increase a fund's credit risk, although this may be mitigated through increased diversification in the corporate sector of the bond market. The Tax-Free Bond Funds do not utilize the strategy of bond substitution. BORROWING may subject a fund to interest costs, which may exceed the interest received on the securities purchased with the borrowed funds. A fund normally may borrow at times to meet redemption requests rather than sell portfolio securities to raise the necessary cash. Borrowing can involve leveraging when securities are purchased with the borrowed money. To avoid this, a fund will earmark or segregate assets to cover such borrowings in accordance with positions of the Securities and Exchange Commission (the SEC). Each fund may borrow money from banks and make other investments or engage in other transactions permissible under the Investment 5 Company Act of 1940, (the 1940 Act) which may be considered a borrowing (such as mortgage dollar rolls and reverse repurchase agreements). Each fund may establish lines-of-credit (lines) with certain banks by which it may borrow funds for temporary or emergency purposes. A borrowing is presumed to be for temporary or emergency purposes if it is repaid by a fund within 60 days and is not extended or renewed. Each fund intends to use the lines to meet large or unexpected redemptions that would otherwise force a fund to liquidate securities under circumstances which are unfavorable to the fund's remaining shareholders. Each fund will pay a fee to the bank for using the lines. CALIFORNIA MUNICIPAL SECURITIES are municipal securities issued by or on behalf of, the State of California, or its counties, municipalities, authorities or other subdivisions. The Schwab California Short/Intermediate Tax-Free Bond Fund(TM), Schwab California Long-Term Tax-Free Bond Fund(TM) and Schwab California YieldPlus Tax-Free Fund are state-specific municipal funds that invest substantially all of their assets in California Municipal Securities. The other funds also may invest a portion of their assets in California Municipal Securities but will not invest substantially all of their assets in such securities. By many measures the State of California (sometimes referred to herein as the "State") is both sizable and diverse. California is the largest state in the union and among the largest economies in the world. The State's geography and position on the edge of the Pacific Rim lends itself to a vast array of economic activity. Major components of the State's economy include high technology, trade, entertainment, agriculture, tourism, construction and services. While this diverse economic base is a fundamental strength for the State and supports its creditworthiness, it also makes the State vulnerable to challenges stemming from many sources including economic trends, legislative and legal actions as well as shifts in political views. Within the State's borders are areas of geological instability that have in the past experienced major earthquakes resulting in significant economic damage. It is impossible to predict the time, magnitude or location of a major earthquake or its effect on the California economy. In January 1994, a major earthquake struck the Los Angeles area, causing significant damage in a four county area. The possibility exists that another such earthquake could create a major dislocation of the California economy and significantly affect State and local government budgets. Since early 2001, the State has faced severe financial challenges, which may continue for several years. The recession in 2001 and sluggish economic growth in 2002 and 2003 (with greatest impacts in the high technology, internet, and telecommunications sectors, especially in Northern California, and the attendant adverse impact on stock market valuations) led to a substantial decline in General Fund revenues that was not adequately addressed by either a proportionate cut in State spending or increase in taxes or other revenues. At a special election held in October 2003, the Governor of the State, Gray Davis, was recalled and replaced by Arnold Schwarzenegger, who took office in November. Governor Schwarzenegger sponsored the California Economic Recovery Bond Act ("Proposition 57"), which was approved by voters statewide in March 2004. Proposition 57 authorized the issuance of up to $15 billion in economic recovery bonds to finance the negative General Fund reserve balance as of June 30, 2004, and other General Fund obligations undertaken prior to June 30, 2004. Repayment of the economic recovery bonds is secured by a pledge of revenues from a one-quarter cent increase in the State's sales and use tax starting July 1, 2004. Fifty percent, or up to $5 billion of future deposits in a deficit recovery fund created by the balanced budget proposition also approved by voters, may be used to repay the economic recovery bonds. In addition, as 6 voter-approved general obligation bonds, the economic recovery bonds will be secured by the State's full faith and credit in the event the dedicated revenue is insufficient to repay the bonds. In May and June 2004, the State issued $10.9 billion of economic recovery bonds, which resulted (due to the sale of bonds at a premium) in the deposit of net proceeds in the General Fund of approximately $11.3 billion. The State may issue the remainder of authorized economic recovery bonds in future fiscal years. According to the 2004 Budget Act passed in July 2004, revenues and transfers for 2003-04 were estimated to be $74.6 billion with $75.6 billion in expenditures. As a result of the sale of the economic recovery bonds and the use of the deficit recovery fund, California ended fiscal year 2003-04 with a positive General Fund balance of $3.1 billion. The 2004 Budget Act forecasts $77.3 billion in General Fund revenues and transfers and $80.7 billion in expenditures in fiscal year 2004-05. The Act projects that by utilizing $1.4 billion of the prior year's General Fund balance and an additional $2.0 billion from the Deficit Recovery Fund the General Fund will end the year with a positive balance of $1.7 billion. In connection with the 2004 Budget Act, local governments reached an agreement with the Governor and legislative leaders to place an initiative on the November 2004 ballot to permanently limit the State's ability to reallocate property and sales tax revenue away from local governments to the State. In exchange, local governments have agreed to transfer $1.3 billion in local funds to the State in each of fiscal years 2004-05 and 2005-06. It cannot be predicted what actions will be taken in the future by the State Legislature and the Governor to deal with changing State revenues and expenditures. The State budget will be affected by national and State economic conditions and other factors. As of August 24, 2004, the State's general obligation bonds were rated A3 by Moody's, A by Standard & Poor's, and BBB by Fitch Ratings. In August 2004, Standard & Poor's raised its rating to A from BBB citing the easing of immediate liquidity pressure on the State following the sale of the economic recovery bonds and the State's recent economic improvement. Standard & Poor's factored into the rating, however, the continued structural deficit between ongoing revenues and expenditures, coupled with future fiscal pressure due to promises made to substantially increase funding for local governments, schools, and state higher education institutions in fiscal 2007. In May 2004, Moody's upgraded its rating from BAA1 to A3 and stated that the upgrade reflected a now established trend of recovery in the State's economy and tax revenues, as well as an improved state budgetary and liquidity outlook. In December 2003, Fitch Ratings lowered the State's general obligation bond rating to BBB from A citing the State's heavy reliance on the completion of an increased deficit financing, the tremendous amount of measures needed to close a widening budget gap, and the decision to submit the deficit bonds and the balanced budget proposal for the March 2004 election, which would inject another element of uncertainty. It is not presently possible to determine whether, or the extent to which, Moody's, S&P or Fitch Ratings will change such ratings in the future. It should be noted that the creditworthiness of obligations issued by local California issuers may be unrelated to the creditworthiness of obligations issued by the State, and there is no obligation on the part of the State to make payment on such local obligations in the event of default. The primary units of local government in California are the counties, ranging in population from 1,200 (Alpine) to approximately 10,000,000 (Los Angeles). The fiscal condition of local governments has been constrained since the enactment of "Proposition 13" in 1978 and later 7 constitutional amendments, which reduced and limited the future growth of property taxes and limited the ability of local governments to impose "special taxes" (those devoted to a specific purpose) without two-thirds voter approval. Proposition 218, another initiative constitutional amendment enacted in 1996, further limited the ability of local governments to impose or raise various taxes, fees, charges and assessments without voter approval. Counties, in particular, have had fewer options to raise revenues than many other local government entities, and have been required to maintain many services. Some local governments in California have experienced notable financial difficulties, including Los Angeles County and Orange County, and there is no assurance that any California issuer will make full or timely payments of principal or interest or remain solvent. The State is subject to an annual appropriations limit imposed by Article XIII B of the State Constitution (the "Appropriations Limit"). The Appropriations Limit does not restrict appropriations to pay debt service on voter-authorized bonds. Article XIII B prohibits the State from spending "appropriations subject to limitation" in excess of the Appropriations Limit. On November 8, 1988, voters of the State approved Proposition 98, a combined initiative constitutional amendment that changed State funding of public education below the university level and the operation of the State appropriations funding, primarily by guaranteeing K-14 schools a minimum share of General Fund revenues. Proposition 98 also contains provisions transferring certain State tax revenues in excess of the Article XIII B limit to K-14 schools. Because of the complexities of Article XIII B, the ambiguities and possible inconsistencies in its terms, the applicability of its exceptions and exemptions and the impossibility of predicting future appropriations, the impact of this or related legislation cannot be predicted. Other Constitutional amendments affecting State and local taxes and appropriations have been proposed from time to time. If any such initiatives are adopted, the State could be pressured to provide additional financial assistance to local Governments or appropriate revenues as mandated by such initiatives. Propositions such as Proposition 98 and others that may be adopted in the future, may place increasing pressure on the State's budget over future years, potentially reducing resources available for other State programs, especially to the extent the Article XIII B spending limit would restrain the State's ability to fund such other programs by raising taxes. The State of California is a party to numerous legal proceedings, many of which normally occur in governmental operations. In addition, the State is involved in certain other legal proceedings that, if decided against the State might require the State to make significant future expenditures or impair future revenue sources. Because of the prospective nature of these proceedings, it is not presently possible to predict the outcome of such litigation or estimate the potential impact on the ability of the State to pay debt service costs on its obligations. CAPITAL SECURITIES are certain subordinated bank securities. They are bank obligations that fall below senior unsecured debt and deposits in liquidation. A bank's capital comprises share capital reserves and a series of hybrid instruments also know as capital securities. These securities are used to augment equity Tier 1 and are usually in the form of subordinated debt. A capital security has to adhere to supervisory guidelines concerning its characteristics such as amount, maturity, subordination and deferral language in order to count as capital. Regulators across the world tend to look toward the Bank for International Settlements ("BIS") for guidance in setting the capital adequacy framework for banks. Regulators use these guidelines to place limits on the proportions and type of capital (including capital securities) allowed to make up the capital base. Capital adequacy requires not just a certain quantity of capital but certain types in relationship to the nature of a bank's assets. Capital securities may be denominated in U.S. or local currency. The 8 Tax-Free Bond Funds do not invest in Capital Securities. CERTIFICATES OF DEPOSIT or time deposits are issued against funds deposited in a banking institution for a specified period of time at a specified interest rate. A fund will invest only in certificates of deposit of banks that have capital, surplus and undivided profits in excess of $100 million. COMMERCIAL PAPER consists of short-term, promissory notes issued by banks, corporations and other institutions to finance short-term credit needs. These securities generally are discounted but sometimes may be interest bearing. Commercial paper, which also may be unsecured, is subject to credit risk. CONCENTRATION means that substantial amounts of assets are invested in a particular industry or group of industries. Concentration increases investment exposure. Based on the characteristics of mortgage-backed securities, each fund has identified mortgage-backed securities issued by private lenders and not guaranteed by U.S. government agencies or instrumentalities as a separate industry for purposes of a fund's concentration policy. Each of the Tax-Free Bond Funds may invest more than 25% of its total assets in municipal securities financing similar projects, such as those relating to education, health care, transportation, and utilities, which may make them more sensitive to certain adverse economic, business or political developments affecting issuers of such securities. CONVERTIBLE SECURITIES are typically preferred stock or bonds that are exchangeable for a specific number of another form of security (usually the issuer's common stock) at a specified price or ratio. A corporation may issue a convertible security that is subject to redemption after a specified date and usually under certain circumstances. A holder of a convertible security that is called for redemption would be required to tender it for redemption to the issuer, convert it to the underlying common stock or sell it to a third party. Convertible bonds typically pay a lower interest rate than nonconvertible bonds of the same quality and maturity, because of the convertible feature. This structure allows the holder of the convertible bond to participate in share price movements in the company's common stock. The actual return on a convertible bond may exceed its stated yield if the company's common stock appreciates in value and the option to convert to common shares becomes more valuable. Convertible securities typically trade at prices above their conversion value, which is the current market value of the common stock received upon conversion, because of their higher yield potential than the underlying common stock. The difference between the conversion value and the price of a convertible security will vary depending on the value of the underlying common stock and interest rates. When the underlying value of the common stocks decline, the price of the issuer's convertible securities will tend not to fall as much because the convertible security's income potential will act as a price support. While the value of a convertible security also tends to rise when the underlying common stock value rises, it will not rise as much because their conversion value is more narrow. The value of convertible securities also is affected by changes in interest rates. For example, when interest rates fall, the value of convertible securities may rise because of their fixed income component. The Tax-Free Bond Funds do not invest in convertible securities. CREDIT DEFAULT SWAPS may be entered into for investment purposes. As the seller in a credit default swap contract, a fund would be required to pay the par (or other agreed-upon) value of a referenced debt obligation to the counterparty in the event of a default by a third party, such as a U.S. or foreign corporate issuer, on the debt obligation. In return, a fund would receive from the 9 counterparty a periodic stream of payments over the term of the contract provided that no event of default has occurred. If no default occurs, a fund would keep the stream of payments and would have no payment obligations. As the seller, a fund would be subject to investment exposure on the notional amount of the swap. A fund may also purchase credit default swap contracts in order to hedge against the risk of default of debt securities held in its portfolio, in which case a fund would function as the counterparty referenced in the preceding paragraph. This would involve the risk that the investment may expire worthless and would only generate income in the event of an actual default by the issuer of the underlying obligation (as opposed to a credit downgrade or other indication of financial instability). It would also involve credit risk -- that the seller may fail to satisfy its payment obligations to a fund in the event of a default. The Tax-Free Bond Funds do not invest in credit default swaps. CREDIT AND LIQUIDITY SUPPORTS may be employed by issuers or a fund to reduce the credit risk of their securities. Credit supports include letters of credit, insurance, total return and credit swap agreements and guarantees provided by foreign and domestic entities. Liquidity supports include puts, demand features, and lines of credit. Most of these arrangements move the credit risk of an investment from the issuer of the security to the support provider. Changes in the credit quality of a support provider could cause losses to a fund. DEBT SECURITIES are obligations issued by domestic and foreign entities, including governments and corporations, in order to raise money. They are basically "IOUs," but are commonly referred to as bonds or money market securities. These securities normally require the issuer to pay a fixed, variable or floating rate of interest on the amount of money borrowed (the "principal") until it is paid back upon maturity. Debt securities experience price changes when interest rates change. For example, when interest rates fall, the prices of debt securities generally rise. Also, issuers tend to pre-pay their outstanding debts and issue new ones paying lower interest rates. This is especially true for bonds with sinking fund provisions, which commit the issuer to set aside a certain amount of money to cover timely repayment of principal and typically allow the issuer to annually repurchase certain of its outstanding bonds from the open market or at a pre-set call price. Conversely, in a rising interest rate environment, prepayment on outstanding debt securities generally will not occur. This is known as extension risk and may cause the value of debt securities to depreciate as a result of the higher market interest rates. Typically, longer-maturity securities react to interest rate changes more severely than shorter-term securities (all things being equal), but generally offer greater rates of interest. Debt securities also are subject to the risk that the issuers will not make timely interest and/or principal payments or fail to make them at all. This is called credit risk. Corporate debt securities (bonds) tend to have higher credit risk generally than U.S. government debt securities. Debt securities also may be subject to price volatility due to market perception of future interest rates, the creditworthiness of the issuer and general market liquidity (market risk). Investment-grade debt securities are considered medium- or/and high-quality securities, although some still possess varying degrees of speculative characteristics and risks. Debt securities rated below investment-grade are riskier, but may offer higher yields. These securities are sometimes referred to as high yield securities or "junk bonds." 10 Corporate bonds are debt securities issued by corporations. Although a higher return is expected from corporate bonds, these securities, while subject to the same general risks as U.S. government securities, are subject to greater credit risk than U.S. government securities. Their prices may be affected by the perceived credit quality of their issuer. See the Appendix for a full description of the various ratings assigned to debt securities by various nationally recognized statistical rating organizations (NRSROs). DELAYED-DELIVERY TRANSACTIONS include purchasing and selling securities on a delayed-delivery or when-issued basis. These transactions involve a commitment to buy or sell specific securities at a predetermined price or yield, with payment and delivery taking place after the customary settlement period for that type of security. When purchasing securities on a delayed-delivery basis, a fund assumes the rights and risks of ownership, including the risk of price and yield fluctuations. Typically, no interest will accrue to a fund until the security is delivered. Each fund will earmark or segregate appropriate liquid assets to cover its delayed-delivery purchase obligations. When a fund sells a security on a delayed-delivery basis, the fund does not participate in further gains or losses with respect to that security. If the other party to a delayed-delivery transaction fails to deliver or pay for the securities, a fund could suffer losses. DEMAND FEATURES, which may include guarantees, are used to shorten a security's effective maturity and/or enhance its creditworthiness. If a demand feature provider were to refuse to permit the feature's exercise or otherwise terminate its obligations with respect to such feature, however, the security's effective maturity may be lengthened substantially, and/or its credit quality may be adversely impacted. In either event, a fund may experience an increase in share price volatility. This also could lengthen a fund's overall average effective maturity. DEPOSITARY RECEIPTS include American or European Depositary Receipts (ADRs or EDRs), Global Depositary Receipts or Shares (GDRs or GDSs) or other similar global instruments that are receipts representing ownership of shares of a foreign-based issuer held in trust by a bank or similar financial institution. These securities are designed for U.S. and European securities markets as alternatives to purchasing underlying securities in their corresponding national markets and currencies. Depositary receipts can be sponsored or unsponsored. Sponsored depositary receipts are certificates in which a bank or financial institution participates with a custodian. Issuers of unsponsored depositary receipts are not contractually obligated to disclose material information in the United States. Therefore, there may not be a correlation between such information and the market value of an unsponsored depositary receipt. The Tax-Free Bond Funds do not invest in depositary receipts. DERIVATIVE INSTRUMENTS are commonly defined to include securities or contracts whose values depend on (or "derive" from) the value of one or more other assets such as securities, currencies, or commodities. These "other assets" are commonly referred to as "underlying assets." A derivative instrument generally consists of, is based upon, or exhibits characteristics similar to options or forward contracts. Options and forward contracts are considered to be the basic "building blocks" of derivatives. For example, forward-based derivatives include forward contracts, as well as exchange-traded futures. Option-based derivatives include privately negotiated, over-the-counter (OTC) options (including caps, floors, collars, and options on forward and swap contracts) and exchange-traded options on futures. Diverse types of derivatives may be created by combining options or forward contracts in different ways, and applying these structures to a wide range of underlying assets. 11 Risk management strategies include investment techniques designed to facilitate the sale of portfolio securities, manage the average duration of the portfolio or create or alter exposure to certain asset classes, such as equity, other debt or foreign securities. In addition to the derivative instruments and strategies described in this SAI, the investment adviser expects to discover additional derivative instruments and other hedging or risk management techniques. The investment adviser may utilize these new derivative instruments and techniques to the extent that they are consistent with a fund's investment objective and permitted by a fund's investment limitations, operating policies, and applicable regulatory authorities. DIVERSIFICATION involves investing in a wide range of securities and thereby spreading and reducing the risks of investment. Each fund is a series of an open-end investment management company. The Bond Funds, the YieldPlus Fund and the GNMA Fund are diversified mutual funds. The Tax-Free Bond Funds are non-diversified mutual funds, which means that each of the funds may invest in the securities of a limited number of issuers. As a result, the performance of a particular investment or small group of investments may affect a Tax-Free Bond Fund's performance more than if the fund were diversified. DURATION was developed as a more precise alternative to the concept of "maturity." Traditionally, a debt obligation's maturity has been used as a proxy for the sensitivity of the security's price to changes in interest rates (which is the "interest rate risk" or "volatility" of the security). However, maturity measures only the time until a debt obligation provides its final payment, taking no account of the pattern of the security's payments prior to maturity. In contrast, duration incorporates a bond's yield, coupon interest payments, final maturity, call and put features and prepayment exposure into one measure. Duration is the magnitude of the change in the price of a bond relative to a given change in market interest rates. Duration management is one of the fundamental tools used by the investment adviser. With respect to the Schwab YieldPlus Fund, Schwab Tax-Free YieldPlus Fund and Schwab California Tax-Free YieldPlus Fund(TM), each seeks to keep the average duration of its overall portfolio at one year or less. For each of these funds, there may be times when the portfolio's average duration is more than one year. Duration is a measure of the expected life of a debt obligation on a present value basis. Duration takes the length of the time intervals between the present time and the time that the interest and principal payments are scheduled or, in the case of a callable bond, the time the principal payments are expected to be received, and weights them by the present values of the cash to be received at each future point in time. For debt obligations with interest payments occurring prior to the payment of principal, duration will usually be less than maturity. In general, all else being equal, the lower the stated or coupon rate of the interest of a fixed income security, the longer the duration of the security; conversely, the higher the stated or coupon rate of a fixed income security, the shorter the duration of the security. Holding long futures or call option positions will lengthen the duration of a fund's portfolio. Holding short futures or put options will shorten the duration of a fund's portfolio. A swap agreement on an asset or group of assets may affect the duration of the portfolio depending on the attributes of the swap. For example, if the swap agreement provides a fund 12 with a floating rate of return in exchange for a fixed rate of return, the duration of the fund would be modified to reflect the duration attributes of a similar security that the fund is permitted to buy. There are some situations where even the standard duration calculation does not properly reflect the interest rate exposure of a security. For example, floating- and variable-rate securities often have final maturities of ten or more years; however, their interest rate exposure corresponds to the frequency of the coupon reset. Another example where the interest rate exposure is not properly captured by maturity is mortgage pass-through securities. The stated final maturity of such securities is generally 30 years, but current prepayment rates are more critical in determining the securities' interest rate exposure. Finally, the duration of the debt obligation may vary over time in response to changes in interest rates and other market factors. Event-Linked Bonds are fixed income securities for which the return of principal and payment of interest is contingent on the non-occurrence of a specific "trigger" event, such as a hurricane, earthquake, or other physical or weather-related phenomenon. Some event-linked bonds are commonly referred to as "catastrophe bonds." If a trigger event occurs, a fund may lose a portion or all of its principal invested in the bond. Event-linked bonds often provide for an extension of maturity to process and audit loss claims where a trigger event has, or possibly has, occurred. An extension of maturity may increase volatility. Event-linked bonds may also expose a fund to certain unanticipated risks including credit risk, adverse regulatory or jurisdictional interpretations, and adverse tax consequences. Event-linked bonds may also be subject to liquidity risk. The Tax-Free Bond Funds do not invest in event-linked bonds. FOREIGN CURRENCY TRANSACTIONS may occur in order to protect against uncertainty in the level of future foreign exchange rates in the purchase and sale of securities. All funds that may invest in foreign currency-denominated securities also may purchase and sell foreign currency options and foreign currency futures contracts and related options and may engage in foreign currency transactions either on a spot (cash) basis at the rate prevailing in the currency exchange market at the time or through forward currency contracts ("forwards") with terms generally of less than one year. A fund may also use foreign currency options and foreign currency forward contracts to increase exposure to a foreign currency or to shift exposure to foreign currency fluctuations from one country to another. The fund will earmark or segregate assets for any open positions in forwards used for non-hedging purposes and mark to market daily as may be required under the federal securities laws. A forward involves an obligation to purchase or sell a specific currency at a future date, which may be any fixed number of days from the date of the contract agreed upon by the parties, at a price set at the time of the contract. These contracts may be bought or sold to protect a fund against a possible loss resulting from an adverse change in the relationship between foreign currencies and the U.S. dollar or to increase exposure to a particular foreign currency. Many foreign securities markets do not settle trades within a time frame that would be considered customary in the U.S. stock market. Therefore, a fund may engage in forward foreign currency exchange contracts in order to secure exchange rates for fund securities purchased or sold, but awaiting settlement. These transactions do not seek to eliminate any fluctuations in the underlying prices of the securities involved. Instead, the transactions simply establish a rate of exchange that can be expected when a fund settles its securities transactions in the future. Forwards involve certain risks. For example, if the counterparties to the contracts are unable to meet the terms of the contracts or if the value of the foreign currency changes unfavorably, a fund could sustain a loss. 13 Certain funds also may engage in forward foreign currency exchange contracts to protect the value of specific portfolio positions, which is called "position hedging." When engaging in position hedging, a fund may enter into forward foreign currency exchange transactions to protect against a decline in the values of the foreign currencies in which portfolio securities are denominated (or against an increase in the value of currency for securities a fund expects to purchase). Buying and selling foreign currency exchange contracts involves costs and may result in losses. The ability of a fund to engage in these transactions may be limited by tax considerations. Although these techniques tend to minimize the risk of loss due to declines in the value of the hedged currency, they tend to limit any potential gain that might result from an increase in the value of such currency. Transactions in these contracts involve certain other risks. Unanticipated fluctuations in currency prices may result in a poorer overall performance for the funds than if it had not engaged in any such transactions. Moreover, there may be imperfect correlation between the fund's holdings of securities denominated in a particular currency and forward contracts into which the fund enters. Such imperfect correlation may cause a fund to sustain losses, which will prevent it from achieving a complete hedge or expose it to risk of foreign exchange loss. Suitable hedging transactions may not be available in all circumstances and there can be no assurance that a fund will engage in such transactions at any given time or from time to time. Also, such transactions may not be successful and may eliminate any chance for a fund to benefit from favorable fluctuations in relevant foreign currencies. The Tax-Free Bond Funds do not engage in foreign currency transactions. Forwards will be used primarily to adjust the foreign exchange exposure of a fund with a view to protecting the outlook, and a fund might be expected to enter into such contracts under the following circumstances: LOCK IN: When the investment adviser desires to lock in the U.S. dollar price on the purchase or sale of a security denominated in a foreign currency. CROSS HEDGE: If a particular currency is expected to decrease against another currency. A fund may sell the currency expected to decrease and purchase a currency which is expected to increase against the currency sold in an amount approximately equal to some or all of the fund's portfolio holdings denominated in the currency sold. DIRECT HEDGE: If the investment adviser wants to eliminate substantially all of the risk of owning a particular currency, and/or if the investment adviser thinks that a fund can benefit from price appreciation in a given country's bonds but does not want to hold the currency, it may employ a direct hedge back into the U.S. dollar. In either case, a fund would enter into a forward contract to sell the currency in which a portfolio security is denominated and purchase U.S. dollars at an exchange rate established at the time it initiated the contract. The cost of the direct hedge transaction may offset most, if not all, of the yield advantage offered by the foreign security, but a fund would benefit from an increase in value of the bond. 14 PROXY HEDGE: The investment adviser might choose to use a proxy hedge, which may be less costly than a direct hedge. In this case, a fund, having purchased a security, will sell a currency whose value is believed to be closely linked to the currency in which the security is denominated. Interest rates prevailing in the country whose currency was sold would be expected to be closer to those in the U.S. and lower than those of securities denominated in the currency of the original holding. This type of hedging entails greater risk than a direct hedge because it is dependent on a stable relationship between the two currencies paired as proxies and the relationships can be very unstable at times. COSTS OF HEDGING: When a fund purchases a foreign bond with a higher interest rate than is available on U.S. bonds of a similar maturity. The additional yield on the foreign bond could be substantially reduced or lost if the fund were to enter into a direct hedge by selling the foreign currency and purchasing the U.S. dollar. This is what is known as the "cost" of hedging. Proxy hedging attempts to reduce this cost through an indirect hedge back to the U.S. dollar. It is important to note that hedging costs are treated as capital transactions and are not, therefore, deducted from a fund's dividend distribution and are not reflected in its yield. Instead such costs will, over time, be reflected in a fund's net asset value per share. Tax consequences of hedging under applicable tax law, may require a fund to limit its gain from hedging in foreign currency forwards, futures, and options. Although each fund is expected to comply with such limits, the extent to which these limits apply is subject to tax regulations as yet unissued. Hedging may also result in the application of the mark-to-market and straddle provisions of the Internal Revenue Code. Those provisions could result in an increase (or decrease) in the amount of taxable dividends paid by a fund and could affect whether dividends paid by a fund is classified as capital gains or ordinary income. FOREIGN SECURITIES involve additional risks, including foreign currency exchange rate risks, because they are issued by foreign entities, including foreign governments, banks, corporations or because they are traded principally overseas. Foreign securities in which a fund may invest include foreign entities that are not subject to uniform accounting, auditing and financial reporting standards, practices and requirements comparable to those applicable to U.S. corporations. In addition, there may be less publicly available information about foreign entities. Foreign economic, political and legal developments, as well as fluctuating foreign currency exchange rates and withholding taxes, could have more dramatic effects on the value of foreign securities. For example, conditions within and around foreign countries, such as the possibility of expropriation or confiscatory taxation, political or social instability, diplomatic developments, change of government or war could affect the value of foreign investments. Moreover, individual foreign economies may differ favorably or unfavorably from the U.S. economy in such respects as growth of gross national product, rate of inflation, capital reinvestment, resource self-sufficiency and balance of payments position. Foreign securities typically have less volume and are generally less liquid and more volatile than securities of U.S. companies. Fixed commissions on foreign securities exchanges are generally higher than negotiated commissions on U.S. exchanges, although a fund will endeavor to achieve the most favorable overall results on portfolio transactions. There is generally less government supervision and regulation of foreign securities exchanges, brokers, dealers and listed companies than in the United States, thus increasing the risk of delayed settlements of portfolio transactions or loss of certificates for portfolio securities. There may be difficulties in obtaining or enforcing judgments against foreign issuers as well. These factors and others may increase the risks with respect to the liquidity of a fund, and its ability to meet a large number of shareholder redemption requests. 15 Foreign markets also have different clearance and settlement procedures and, in certain markets, there have been times when settlements have been unable to keep pace with the volume of securities transactions, making it difficult to conduct such transactions. Such delays in settlement could result in temporary periods when a portion of the assets of a fund is uninvested and no return is earned thereon. The inability to make intended security purchases due to settlement problems could cause a fund to miss attractive investment opportunities. Losses to a fund arising out of the inability to fulfill a contract to sell such securities also could result in potential liability for a fund. Investments in the securities of foreign issuers may be made and held in foreign currencies. In addition, a fund may hold cash in foreign currencies. These investments may be affected favorably or unfavorably by changes in currency rates and in exchange control regulations, and may cause a fund to incur costs in connection with conversions between various currencies. The rate of exchange between the U.S. dollar and other currencies is determined by the forces of supply and demand in the foreign exchange market as well as by political and economic factors. Changes in the foreign currency exchange rates also may affect the value of dividends and interest earned, gains and losses realized on the sale of securities, and net investment income and gains, if any, to be distributed to shareholders by a fund. The Tax-Free Bond Funds do not invest in Foreign Securities. FORWARD CONTRACTS are sales contracts between a buyer (holding the "long" position and the seller (holding the "short" position) for an asset with delivery deferred to a future date. The buyer agrees to pay a fixed price at the agreed future date and the seller agrees to deliver the asset. The seller hopes that the market price on the delivery date is less than the agreed upon price, while the buyer hopes for the contrary. The change in value of a forward-based derivative generally is roughly proportional to the change in value of the underlying asset. FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS involve the purchase or sale of foreign currency at an established exchange rate, but with payment and delivery at a specified future time. Many foreign securities markets do not settle trades within a time frame that would be considered customary in the U.S. stock market. Therefore, a fund may engage in forward foreign currency exchange contracts in order to secure exchange rates for portfolio securities purchased or sold, but awaiting settlement. These transactions do not seek to eliminate any fluctuations in the underlying prices of the securities involved. Instead, the transactions simply establish a rate of exchange that can be expected when a fund settles its securities transactions in the future. A fund also may engage in forward foreign currency exchange contracts to protect the value of specific portfolio positions, which is called "position hedging." When engaging in position hedging, a fund may enter into forward foreign currency exchange transactions to protect against a decline in the values of the foreign currencies in which portfolio securities are denominated (or against an increase in the value of currency for securities that a fund expects to purchase). Buying and selling foreign currency exchange contracts involve costs and may result in losses. The ability of a fund to engage in these transactions may be limited by tax considerations. Although these techniques tend to minimize the risk of loss due to decline in the value of the hedged currency, they tend to limit any potential gain that might result from an increase in the value of such currency. Transactions in these contracts involve certain other risks. Unanticipated fluctuations in currency prices may result in a poorer overall performance for a fund than if it had not engaged in any such transactions. Moreover, there may be imperfect correlation between a fund's holdings of securities denominated in a particular currency and forward contracts into 16 which a fund enters. Such imperfect correlation may cause a fund to sustain losses, which will prevent it from achieving a complete hedge or expose it to risk of foreign exchange loss. Losses to a fund will affect its performance. The Tax-Free Bond Funds do not invest in Forward Foreign Currency Exchange Contracts. FUTURES CONTRACTS are securities that represent an agreement between two parties that obligates one party to buy and the other party to sell specific securities at an agreed-upon price on a stipulated future date. In the case of futures contracts relating to an index or otherwise not calling for physical delivery at the close of the transaction, the parties usually agree to deliver the final cash settlement price of the contract. Each fund may purchase and sell futures contracts based on securities, securities indices and foreign currencies, interest rates or any other futures contracts traded on U.S. exchanges or boards of trade that the Commodities Future Trading Commission (the "CFTC") licenses and regulates on foreign exchanges. Each fund must maintain a small portion of its assets in cash to process shareholder transactions in and out of it to pay its expenses. In order to reduce the effect this otherwise uninvested cash would have on its performance a fund may purchase futures contracts. Such transactions allow a fund's cash balance to produce a return similar to that of the underlying security or index on which the futures contract is based. Also, each fund may purchase or sell futures contracts on a specified foreign currency to "fix" the price in U.S. dollars of the foreign security it has acquired or sold or expects to acquire or sell. Each fund may enter into futures contracts for these or other reasons. When buying or selling futures contracts, each fund must place a deposit with its broker equal to a fraction of the contract amount. This amount is known as "initial margin" and must be in the form of liquid debt instruments, including cash, cash-equivalents and U.S. government securities. Subsequent payments to and from the broker, known as "variation margin" may be made daily, if necessary, as the value of the futures contracts fluctuate. This process is known as "marking-to-market." The margin amount will be returned to a fund upon termination of the futures contracts assuming all contractual obligations are satisfied. Each fund's aggregate initial and variation margin payments required to establish its futures positions may not exceed 5% of its net assets. Because margin requirements are normally only a fraction of the amount of the futures contracts in a given transaction, futures trading can involve a great deal of leverage. In order to avoid this, a fund will earmark or segregate assets for any outstanding futures contracts as may be required by the federal securities laws. While each fund may purchase and sell futures contracts in order to simulate full investment, there are risks associated with these transactions. Adverse market movements could cause a fund to experience substantial losses when buying and selling futures contracts. Of course, barring significant market distortions, similar results would have been expected if a fund had instead transacted in the underlying securities directly. There also is the risk of losing any margin payments held by a broker in the event of its bankruptcy. Additionally, a fund incurs transaction costs (i.e. brokerage fees) when engaging in futures trading. When interest rates are rising or securities prices are falling, a fund may seek, through the sale of futures contracts, to offset a decline in the value of its current portfolio securities. When rates are falling or prices are rising, a fund, through the purchase of futures contracts, may attempt to secure better rates or prices than might later be available in the market when they effect anticipated purchases. Similarly, a fund may sell futures contracts on a specified currency to protect against a decline in the value of that currency and its portfolio securities that are denominated in that currency. Each fund may purchase futures contracts on a foreign currency to 17 fix the price in U.S. dollars of a security denominated in that currency that a fund has acquired or expects to acquire. Futures contracts normally require actual delivery or acquisition of an underlying security or cash value of an index on the expiration date of the contract. In most cases, however, the contractual obligation is fulfilled before the date of the contract by buying or selling, as the case may be, identical futures contracts. Such offsetting transactions terminate the original contracts and cancel the obligation to take or make delivery of the underlying securities or cash. There may not always be a liquid secondary market at the time a fund seeks to close out a futures position. If a fund is unable to close out its position and prices move adversely, a fund would have to continue to make daily cash payments to maintain its margin requirements. If a fund had insufficient cash to meet these requirements it may have to sell portfolio securities at a disadvantageous time or incur extra costs by borrowing the cash. Also, a fund may be required to make or take delivery and incur extra transaction costs buying or selling the underlying securities. Each fund would seek to reduce the risks associated with futures transactions by buying and selling futures contracts that are traded on national exchanges or for which there appears to be a liquid secondary market. Except for the Schwab Tax-Free YieldPlus Fund(TM) and Schwab California Tax-Free YieldPlus Fund(TM), the Tax-Free Bond Funds do not invest in futures contracts. HIGH YIELD SECURITIES, also called lower quality bonds ("junk bonds"), are frequently issued by companies without long track records of sales and earnings, or by those of questionable credit strength, and are more speculative and volatile (though typically higher yielding) than investment grade bonds. Adverse economic developments could disrupt the market for high yield securities, and severely affect the ability of issuers, especially highly-leveraged issuers, to service their debt obligations or to repay their obligations upon maturity. Also, the secondary market for high yield securities at times may not be as liquid as the secondary market for higher-quality debt securities. As a result, the investment adviser could find it difficult to sell these securities or experience difficulty in valuing certain high yield securities at certain times. Prices realized upon the sale of such lower rated securities, under these circumstances, may be less than the prices at which a fund purchased them. Thus, high yield securities are more likely to react to developments affecting interest rates and market and credit risk than are more highly rated securities, which primarily react to movements in the general level of interest rates. When economic conditions appear to be deteriorating, medium- to lower-quality debt securities may decline in value more than higher-quality debt securities due to heightened concern over credit quality, regardless of prevailing interest rates. Prices for high yield securities also could be affected by legislative and regulatory developments. These laws could adversely affect a fund's net asset value and investment practices, the secondary market value for high yield securities, the financial condition of issuers of these securities and the value of outstanding high yield securities. INFLATION-INDEXED BONDS are fixed income securities whose value is periodically adjusted according to the rate of inflation. Two structures are common. The U.S. Treasury and some other issuers utilize a structure that accrues inflation into the principal value of the bond. Most other issuers pay out the Consumer Price Index ("CPI") accruals as part of a semiannual coupon. Inflation-indexed securities issued by the U.S. Treasury have maturities of approximately five, ten or thirty years, although it is possible that securities with other maturities will be issued in the future. The U.S. Treasury securities pay interest on a semi-annual basis equal to a fixed percentage of the inflation-adjusted principal amount. 18 If the periodic adjustment rate measuring inflation falls, the principal value of inflation-indexed bonds will be adjusted downward, and consequently the interest payable on these securities (calculated with respect to a smaller principal amount) will be reduced. Repayment of the original bond principal upon maturity (as adjusted for inflation) is guaranteed in the case of U.S. Treasury inflation-indexed bonds, even during a period of deflation. However, the current market value of the bonds is not guaranteed and will fluctuate. A fund may also invest in other inflation-related bonds which may or may not provide a similar guarantee. If a guarantee of principal is not provided, the adjusted principal value of the bond repaid at maturity may be less than the original principal amount. The value of inflation-indexed bonds is expected to change in response to changes in real interest rates. Real interest rates in turn are tied to the relationship between nominal interest rates and the rate of inflation. Therefore, if the rate of inflation rises at a faster rate than nominal interest rates, real interest rates might decline, leading to an increase in value of inflation-indexed bonds. In contrast, if nominal interest rates increase at a faster rate than inflation, real interest rates might rise, leading to a decrease in value of inflation-indexed bonds. While these securities are expected to be protected from long-term inflationary trends, short-term increases in inflation may lead to a decline in value. If interest rates rise due to reasons other than inflation (for example, due to changes in currency exchange rates), investors in these securities may not be protected to the extent that the increase is not reflected in the bond's inflation measure. The periodic adjustment of U.S. inflation-indexed bonds is tied to the Consumer Price Index for Urban Consumers ("CPI-U"), which is calculated monthly by the U.S. Bureau of Labor Statistics. The CPI-U is a measurement of changes in the cost of living, made up of components such as housing, food, transportation and energy. Inflation-indexed bonds issued by a foreign government are generally adjusted to reflect a comparable inflation index calculated by that government. There can be no assurance that the CPI-U or any foreign inflation index will accurately measure the real rate of inflation in the prices of goods and services. Moreover, there can be no assurance that the rate of inflation in a foreign country will be correlated to the rate of inflation in the United States. Any increase in the principal amount of an inflation-indexed bond will be considered taxable ordinary income, even though investors do not receive their principal until maturity. ILLIQUID SECURITIES generally are any securities that cannot be disposed of promptly and in the ordinary course of business at approximately the amount at which a fund has valued the instruments. The liquidity of a fund's investments is monitored under the supervision and direction of the Board of Trustees. Investments currently not considered liquid include repurchase agreements not maturing within seven days and certain restricted securities. INDEX PARTICIPATIONS and index participation contracts provide the equivalent of a position in the securities comprising an index, with each security's representation equaling its index weighting. Moreover, their holders are entitled to payments equal to the dividends paid by the underlying index securities. Generally, the value of an index participation or index participation contract will rise and fall along with the value of the related index. A fund will invest in index participation contracts only if a liquid market for them appears to exist. The Tax-Free Bond Funds do not engage in index participations. 19 INTERFUND BORROWING AND LENDING transactions may be entered into by all funds and portfolios in the Schwab complex ("SchwabFunds(R)"). All loans are for temporary or emergency purposes and the interest rates to be charged will be the average of the overnight repurchase agreement rate and the short-term bank loan rate. All loans are subject to numerous conditions designed to ensure fair and equitable treatment of all participating funds/portfolios. The interfund lending facility is subject to the oversight and periodic review of the Board of Trustees of the SchwabFunds. INTERNATIONAL BONDS are certain obligations or securities of foreign issuers, including Eurodollar Bonds, which are U.S. dollar-denominated bonds issued by foreign issuers payable in Eurodollars (U.S. dollars held in banks located outside the United States, primarily Europe), Yankee Bonds, which are U.S. dollar-denominated bonds issued in the U.S. by foreign banks and corporations, and EuroBonds, which are bonds denominated in U.S. dollars and usually issued by large underwriting groups composed of banks and issuing houses from many countries. Investments in securities issued by foreign issuers, including American Depositary Receipts and securities purchased on foreign securities exchanges, may subject a fund to additional investment risks, such as adverse political and economic developments, possible seizure, nationalization or expropriation of foreign investments, less stringent disclosure requirements, non-U.S. withholding taxes and the adoption of other foreign governmental restrictions. Additional risks include less publicly available information, the risk that companies may not be subject to the accounting, auditing and financial reporting standards and requirements of U.S. companies, the risk that foreign securities markets may have less volume and therefore may be less liquid and their prices more volatile than U.S. securities, and the risk that custodian and transaction costs may be higher. Foreign issuers of securities or obligations are often subject to accounting requirements and engage in business practices different from those respecting domestic issuers of similar securities or obligations. Foreign branches of U.S. banks and foreign banks may be subject to less stringent reserve requirements than those applicable to domestic branches of U.S. banks. The Tax-Free Bond Funds do not invest in international bonds. LOAN INTERESTS, and other direct debt instruments or interests therein, may be acquired by a fund. A loan interest is typically originated, negotiated, and structured by a U.S. or foreign commercial bank, insurance company, finance company, or other financial institution ("Agent") for a lending syndicate of financial institutions. The Agent typically administers and enforces the loan on behalf of the other lenders in the syndicate. In addition, an institution typically but not always the Agent ("Collateral Bank"), holds collateral (if any) on behalf of the lenders. When a Collateral Bank holds collateral, such collateral typically consists of one or more of the following asset types: inventory, accounts receivable, property, plant and equipment, intangibles, common stock of subsidiaries or other investments. These loan interests may take the form of participation interests in, assignments of or novations of a loan during its second distribution, or direct interests during a primary distribution. Such loan interests may be acquired from U.S. or foreign banks, insurance companies, finance companies, or other financial institutions who have made loans or are members of a lending syndicate or from other holders of loan interests. A fund may also acquire loan interests under which a fund derives its rights directly from the borrower. Such loan interests are separately enforceable by a fund against the borrower and all payments of interest and principal are typically made directly to a fund from the borrower. In the event that a fund and other lenders become entitled to take possession of shared collateral, it is anticipated that such collateral would be held in the custody of the Collateral Bank for their mutual benefit. A fund may not act as an Agent, a Collateral Bank, a guarantor or sole negotiator or structurer with respect to a loan. 20 The investment adviser will analyze and evaluate the financial condition of the borrower in connection with the acquisition of any Loan Interest. Credit ratings are typically assigned to Loan Interests in the same manner as with other fixed income debt securities, and the investment adviser analyzes and evaluates these ratings, if any, in deciding whether to purchase a Loan Interest. The investment adviser also analyzes and evaluates the financial condition of the Agent and, in the case of Loan Interests in which a fund does not have privity with the borrower, those institutions from or through whom a fund derives its rights in a loan ("Intermediate Participants"). In a typical loan, the Agent administers the terms of the loan agreement. In such cases, the Agent is normally responsible for the collection of principal and interest payments from the borrower and the apportionment of these payments to the credit of all the institutions which are parties to the loan agreement. A fund will generally rely upon the Agent or Intermediate Participant to receive and forward to a fund its portion of the principal and interest payments on the loan. Furthermore, unless under the terms of a participation agreement a fund has direct recourse against the borrower, a fund will rely on the Agent and the other members of the lending syndicate to use appropriate credit remedies against the borrower. The Agent is typically responsible for monitoring compliance with covenants contained in the loan agreement based upon reports prepared by the borrower. The seller of the Loan Interest usually does, but is often not obligated to, notify holders of Loan Interests of any failures of compliance. The Agent may monitor the value of the collateral and, if the value of the collateral declines, may accelerate the loan, may give the borrower an opportunity to provide additional collateral or may seek other protection for the benefit of the participants in the loan. The Agent is compensated by the borrower for providing these services under a loan agreement, and such compensation may include special fees paid upon structuring and funding the loan and other fees paid on a continuing basis. With respect to Loan Interests for which the Agent does not perform such administrative and enforcement functions, a fund will perform such tasks on its own behalf, although a Collateral Bank will typically hold any collateral on behalf of a fund and the other holders pursuant to the applicable loan agreement. A financial institution's appointment as Agent may usually be terminated in the event that it fails to observe the requisite standard of care or becomes insolvent, enters Federal Deposit Insurance Corporation ("FDIC") receivership, or, if not FDIC insured, enters into bankruptcy proceedings. A successor agent generally would be appointed to replace the terminated Agent, and assets held by the Agent under the loan agreement should remain available to holders of Loan Interests. However, if assets held by the Agent for the benefit of a fund were determined to be subject to the claims of the Agent's general creditors, a fund might incur certain costs and delays in realizing payment on a Loan Interest, or suffer a loss of principal and/or interest. In situations involving Intermediate Participants, similar risks may arise. Purchasers of Loan Interests depend primarily upon the creditworthiness of the borrower for payment of principal and interest. If a fund does not receive a scheduled interest or principal payment on such indebtedness, a fund's share price and yield could be adversely affected. Loans that are fully secured offer a fund more protections than an unsecured loan in the event of non-payment of scheduled interest or principal. However, there is no assurance that the liquidation of collateral from a secured loan would satisfy the borrower's obligation, or that the collateral can be liquidated. Indebtedness of borrowers whose creditworthiness is poor involves substantially greater risks, and may be highly speculative. Borrowers that are in bankruptcy or restructuring may never pay off their indebtedness, or may pay only a small fraction of the amount owed. Direct indebtedness of developing countries also will involve a risk that the governmental entities responsible for the repayment of the debt may be unable, or unwilling, to pay interest and repay principal when due. 21 The Loan Interests market is in a developing phase with increased participation among several investor types. The dealer community has become increasingly involved in this secondary market. If, however, a particular Loan Interest is deemed to be illiquid, it would be valued using procedures adopted by the Board of Trustees. In such a situation, there is no guarantee that a fund will be able to sell such Loan Interests, which could lead to a decline in the value of the Loan Interests and the value of a fund's shares. The Tax-Free Bond Funds do not invest in Loan Interests. MATURITY OF INVESTMENTS will generally be determined using the portfolio securities' final maturity dates. However for certain securities, maturity will be determined using the security's effective maturity date. The effective maturity date for a security subject to a put or demand feature is the demand date, unless the security is a variable- or floating-rate security. If it is a variable-rate security, its effective maturity date is the earlier of its demand date or next interest rate change date. For variable-rate securities not subject to a put or demand feature and floating-rate securities, the effective maturity date is the next interest rate change date. The effective maturity of mortgage-backed and certain other asset-backed securities is determined on an "expected life" basis by the investment adviser. For the Schwab YieldPlus Fund, Schwab Tax-Free YieldPlus Fund(TM), and Schwab California Tax-Free YieldPlus Fund(TM), the effective maturity of mortgage-backed and certain other asset-backed securities is determined on an "expected life" basis by the investment adviser using a duration measurement. For an interest rate swap agreement, its effective maturity would be equal to the difference in the effective maturity of the interest rates "swapped." Securities being hedged with futures contracts may be deemed to have a longer maturity, in the case of purchases of future contracts, and a shorter maturity, in the case of sales of futures contracts, than they would otherwise be deemed to have. In addition, a security that is subject to redemption at the option of the issuer on a particular date ("call date"), which is prior to, or in lieu of, the security's stated maturity, may be deemed to mature on the call date rather than on its stated maturity date. The call date of a security will be used to calculate average portfolio maturity when the investment adviser reasonably anticipates, based upon information available to it, that the issuer will exercise its right to redeem the security. The average portfolio maturity of a fund is dollar-weighted based upon the market value of a fund's securities at the time of the calculation. A fund may invest in securities with final or effective maturities of any length. There may be times when the Schwab YieldPlus Fund, Schwab Tax-Free YieldPlus Fund(TM), and Schwab California Tax-Free YieldPlus Fund(TM) portfolios' overall average effective maturity, or duration, or overall average weighted maturity is more than one year. The GNMA Fund is not subject to maturity or duration restrictions. MONEY MARKET SECURITIES are high-quality, short-term debt securities that may be issued by entities such as the U.S. government, corporations and financial institutions (like banks). Money market securities include commercial paper, certificates of deposit, banker's acceptances, notes and time deposits. Money market securities pay fixed, variable or floating rates of interest and are generally subject to credit and interest rate risks. The maturity date or price of and financial assets collateralizing a security may be structured in order to make it qualify as or act like a money market security. These securities may be subject to greater credit and interest rate risks than other money market securities because of their structure. Money market securities may be issued with puts or these can be sold separately. MORTGAGE-BACKED SECURITIES ("MBS") and other ASSET-BACKED SECURITIES may be purchased by a fund. MBS represent participations in mortgage loans, and include pass-through securities, collateralized mortgage obligations and stripped mortgage-backed securities. MBS may be issued 22 or guaranteed by U.S. government agencies or instrumentalities, such as the Government National Mortgage Association (GNMA or Ginnie Mae) and the Federal National Mortgage Association (FNMA or Fannie Mae) or the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). The National Housing Act authorized GNMA to guarantee the timely payment of principal and interest on securities backed by a pool of mortgages insured by the Federal Housing Administration ("FHA") or guaranteed by the Veterans Administration ("VA"). The GNMA guarantee is backed by the full faith and credit of the U.S. Government. The GNMA is also empowered to borrow without limitation from the U.S. Treasury if necessary to make any payments required under its guarantee. GNMA are mortgage securities which evidence an undivided interest in a pool or pools of mortgages. GNMA Certificates that a fund may purchase are the "modified pass-through" type, which entitle the holder to receive timely payment of all interest and principal payments due on the mortgage pool, net of fees paid to the "issuer" and GNMA, regardless of whether or not the mortgagor actually makes the payment. The average life of a GNMA Certificate is likely to be substantially shorter than the original maturity of the mortgages underlying the securities. Prepayments of principal by mortgagors and mortgage foreclosures will usually result in the return of the greater part of principal investment long before the maturity of the mortgages in the pool. Foreclosures impose no risk to principal investment because of the GNMA guarantee, except to the extent that a Fund has purchased the certificates above par in the secondary market. FHLMC was created in 1970 to promote development of a nationwide secondary market in conventional residential mortgages. The FHLMC issues two types of mortgage pass-through securities ("FHLMC Certificates"): mortgage participation certificates ("PCs") and guaranteed mortgage certificates ("GMCs"). PCs resemble GNMA Certificates in that each PC represents a pro rata share of all interest and principal payments made and owed on the underlying pool. The FHLMC guarantees timely monthly payment of interest on PCs and the ultimate payment of principal, but its issues are not backed by the full faith and credit of the U.S. Government. GMCs also represent a pro rata interest in a pool of mortgages. However, these instruments pay interest semi-annually and return principal once a year in guaranteed minimum payments. The expected average life of these securities is approximately 10 years. The FHLMC guarantee is not backed by the full faith and credit of the U.S. Government. FNMA was established in 1938 to create a secondary market in mortgages the FHA insures. FNMA issues guaranteed mortgage pass-through certificates ("FNMA Certificates"). FNMA Certificates resemble GNMA Certificates in that each FNMA Certificate represents a pro rata share of all interest and principal payments made and owed on the underlying pool. FNMA guarantees timely payment of interest and principal on FNMA Certificates. The FNMA guarantee is not backed by the full faith and credit of the U.S. Government. MBS may also be issued by private issuers, generally originators and investors in mortgage loans, including savings associations, mortgage banks, commercial banks, and special purpose entities (collectively, "private lenders"). MBS are based on different types of mortgages including those on commercial real estate and residential property. MBS issued by private lenders may be supported by pools of mortgage loans or other MBS that are guaranteed, directly or indirectly, by the U.S. government or one of its agencies or instrumentalities, or they may be issued without any 23 governmental guarantee of the underlying mortgage assets but with some form of credit enhancement. Asset-backed Securities ("ABS") have structural characteristics similar to MBS. ABS represent direct or indirect participation in assets such as automobile loans, credit card receivables, trade receivables, home equity loans (which sometimes are categorized as MBS) or other financial assets. Therefore, repayment depends largely on the cash flows generated by the assets backing the securities. The credit quality of most ABS depends primarily on the credit quality of the assets underlying such securities, how well the entity issuing the security is insulated from the credit risk of the originator or any other affiliated entities, and the amount and quality of any credit enhancement of the securities. Payments or distributions of principal and interest on ABS may be supported by credit enhancements including letters of credit, an insurance guarantee, reserve funds and overcollateralization. Commercial Mortgage-Backed Securities include securities that reflect an interest in, and are secured by, mortgage loans on commercial real property. The market for commercial mortgage-backed securities developed more recently and in terms of total outstanding principal amount of issues is relatively small compared to the market for residential single-family MBS. Many of the risks of investing in commercial MBS reflect the risks of investing in the real estate securing the underlying mortgage loans. These risks reflect the effects of local and other economic conditions on real estate markets, the ability of tenants to make loan payments, and the ability of a property to attract and retain tenants. Commercial MBS may be less liquid and exhibit greater price volatility than other types of mortgage- or asset-backed securities. Collateralized Mortgage Obligations ("CMO") are a hybrid between mortgage-backed bonds and mortgage pass-through securities. Similar to a bond, interest and prepaid principal is paid, in most cases, on a monthly basis. CMOs may be collateralized by whole mortgage loans, but are more typically collateralized by portfolios of mortgage pass-through securities guaranteed by Ginnie Mae, Freddie Mac, Fannie Mae, and their income streams. CMOs are structured into multiple classes, each bearing a different stated maturity. Actual maturity and average life will depend upon the prepayment experience of the collateral. CMOs provide for a modified form of call protection through a de facto breakdown of the underlying pool of mortgages according to how quickly the loans are repaid. Monthly payment of principal received from the pool of underlying mortgages, including prepayments, is first returned to investors holding the shortest maturity class. Investors holding the longer maturity classes receive principal only after the first class has been retired. An investor is partially guarded against a sooner than desired return of principal because of the sequential payments. In a typical CMO transaction, a corporation ("issuer") issues multiple series (e.g., A, B, C, Z) of CMO bonds ("Bonds"). Proceeds of the Bond offering are used to purchase mortgages or mortgage pass-through certificates ("Collateral"). The Collateral is pledged to a third party trustee as security for the Bonds. Principal and interest payments from the Collateral are used to pay principal on the Bonds in the order A, B, C, Z. The Series A, B, and C Bonds all bear current interest. Interest on the Series Z Bond is accrued and added to principal and a like amount is paid as principal on the Series A, B, or C Bond currently being paid off. When the Series A, B, and C Bonds are paid in full, interest and principal on the Series Z Bond begins to be paid currently. With some CMOs, the issuer serves as a conduit to allow loan originators (primarily builders or savings and loan associations) to borrow against their loan portfolios. The rate of principal payment on MBS and ABS generally depends on the rate of principal 24 payments received on the underlying assets which in turn may be affected by a variety of economic and other factors. As a result, the price and yield on any MBS or ABS is difficult to predict with precision and price and yield to maturity may be more or less than the anticipated yield to maturity. If a fund purchases these securities at a premium, a prepayment rate that is faster than expected will reduce yield to maturity, while a prepayment rate that is slower than expected will have the opposite effect of increasing the yield to maturity. Conversely, if a fund purchases these securities at a discount, a prepayment rate that is faster than expected will increase yield to maturity, while a prepayment rate that is slower than expected will reduce yield to maturity. Amounts available for reinvestment by a fund are likely to be greater during a period of declining interest rates and, as a result, are likely to be reinvested at lower interest rates than during a period of rising interest rates. While many MBS and ABS are issued with only one class of security, many are issued in more than one class, each with different payment terms. Multiple class MBS and ABS are issued as a method of providing credit support, typically through creation of one or more classes whose right to payments on the security is made subordinate to the right to such payments of the remaining class or classes. In addition, multiple classes may permit the issuance of securities with payment terms, interest rates, or other characteristics differing both from those of each other and from those of the underlying assets. Examples include stripped securities, which are MBS and ABS entitling the holder to disproportionate interest or principal compared with the assets backing the security, and securities with classes having characteristics different from the assets backing the securities, such as a security with floating interest rates with assets backing the securities having fixed interest rates. The market value of such securities and CMO's generally is more or less sensitive to changes in prepayment and interest rates than is the case with traditional MBS and ABS, and in some cases such market value may be extremely volatile. CMO Residuals are mortgage securities issued by agencies or instrumentalities of the U.S. Government or by private originators of, or investors in, mortgage loans, including savings and loan associations, homebuilders, mortgage banks, commercial banks, investment banks and special purpose entities of the foregoing. The cash flow generated by the mortgage assets underlying a series of CMOs is applied first to make required payments of principal and interest on the CMOs and second to pay the related administrative expenses of the issuer. The residual in a CMO structure generally represents the interest in any excess cash flow remaining after making the foregoing payments. Each payment of such excess cash flow to a holder of the related CMO residual represents income and/or a return of capital. The amount of residual cash flow resulting from a CMO will depend on, among other things, the characteristics of the mortgage assets, the coupon rate of each class of CMO, prevailing interest rates, the amount of administrative expenses and the prepayment experience on the mortgage assets. In particular, the yield to maturity on CMO residuals is extremely sensitive to prepayments on the related underlying mortgage assets, in the same manner as an interest-only ("IO") class of stripped mortgage-backed securities. See "Stripped Mortgage-Backed Securities." In addition, if a series of a CMO includes a class that bears interest at an adjustable rate, the yield to maturity on the related CMO residual will also be extremely sensitive to changes in the level of the index upon which interest rate adjustments are based. As described below with respect to stripped mortgage-backed securities, in certain circumstances a fund may fail to recoup fully its initial investment in a CMO residual. CMO residuals are generally purchased and sold by institutional investors through several investment banking firms acting as brokers or dealers. The CMO residual market has only very recently developed and CMO residuals currently may not have the liquidity of other more 25 established securities trading in other markets. Transactions in CMO residuals are generally completed only after careful review of the characteristics of the securities in question. In addition, CMO residuals may, or pursuant to an exemption therefrom, may not have been registered under the Securities Act of 1933, as amended (the "1933 Act"). CMO residuals, whether or not registered under the 1933 Act, may be subject to certain restrictions on transferability, and may be deemed "illiquid" and subject to a Fund's limitations on investment in illiquid securities. Stripped Mortgage-Backed Securities "SMBS" are derivative multi-class mortgage securities. SMBS may be issued by agencies or instrumentalities of the U.S. Government, or by private originators of, or investors in, mortgage loans, including savings and loan associations, mortgage banks, commercial banks, investment banks and special purpose entities of the foregoing. SMBS are usually structured with two classes that receive different proportions of the interest and principal distributions on a pool of mortgage assets. A common type of SMBS will have one class receiving some of the interest and most of the principal from the mortgage assets, while the other class will receive most of the interest and the remainder of the principal. In the most extreme case, one class will receive all of the interest (the "IO" class), while the other class will receive all of the principal (the principal-only or "PO" class). The yield to maturity on an IO class is extremely sensitive to the rate of principal payments (including prepayments) on the related underlying mortgage assets, and a rapid rate of principal payments may have a material adverse effect on a fund's yield to maturity from these securities. If the underlying mortgage assets experience greater than anticipated prepayments of principal, a fund may fail to recoup some or all of its initial investment in these securities even if the security is in one of the highest rating categories. Under certain circumstances these securities may be deemed "illiquid" and subject to a fund's limitations on investment in illiquid securities. MUNICIPAL LEASES are obligations issued to finance the construction or acquisition of equipment or facilities. These obligations may take the form of a lease, an installment purchase contract, a conditional sales contract or a participation interest in any of these obligations. Municipal leases may be considered illiquid investments. Additionally, municipal leases are subject to "nonappropriation risk," which is the risk that the municipality may terminate the lease because funds have not been allocated to make the necessary lease payments. The lessor would then be entitled to repossess the property, but the value of the property may be less to private sector entities than it would be to the municipality. MUNICIPAL SECURITIES are debt securities issued by municipal issuers. Municipal issuers include states, counties, municipalities, authorities and other subdivisions, or the territories and possessions of the United States and the District of Columbia, including their subdivisions, agencies and instrumentalities and corporations. These securities may be issued to obtain money for various public purposes, including the construction of a wide range of public facilities such as airports, bridges, highways, housing, hospitals, mass transportation, public utilities, schools, streets, and water and sewer works. Other public purposes include refunding outstanding obligations, obtaining funds for general operating expenses and obtaining funds to loan to other public institutions and facilities. Municipal securities also may be issued to finance various private activities, including certain types of private activity bonds ("industrial development bonds" under prior law). These securities may be issued by or on behalf of public authorities to obtain funds to provide certain privately 26 owned or operated facilities. The Tax-Free Bond Funds may not be desirable investments for "substantial users" of facilities financed by private activity bonds or industrial development bonds or for "related persons" of substantial users because distributions from these funds attributable to interest on such bonds may not be tax exempt. The Tax-Free Bond Funds intend to limit investments in these securities to 20% of their net assets. Shareholders should consult their own tax advisors regarding the potential effect on them (if any) of any investments in these funds. Municipal securities may be owned directly or through participation interests, and include general obligation or revenue securities, tax-exempt commercial paper, notes and leases. Municipal securities generally are classified as "general obligation" or "revenue" and may be purchased directly or through participation interests. General obligation securities typically are secured by the issuer's pledge of its full faith and credit and most often its taxing power for the payment of principal and interest. Revenue securities typically are payable only from the revenues derived from a particular facility or class of facilities or, in some cases, from the proceeds of a special tax or other specific revenue source. Private activity bonds and industrial development bonds are, in most cases, revenue bonds and generally do not constitute the pledge of the credit of the issuer of such bonds. The credit quality of private activity bonds is frequently related to the credit standing of private corporations or other entities. In addition to bonds, municipalities issue short-term securities such as tax anticipation notes, bond anticipation notes, revenue anticipation notes, construction loan notes and tax-free commercial paper. Tax anticipation notes typically are sold to finance working capital needs of municipalities in anticipation of the receipt of property taxes on a future date. Bond anticipation notes are sold on an interim basis in anticipation of a municipality's issuance of a longer-term bond in the future. Revenue anticipation notes are issued in expectation of the receipt of other types of revenue, such as that available under the Federal Revenue Sharing Program. Construction loan notes are instruments insured by the Federal Housing Administration with permanent financing by Fannie Mae or Ginnie Mae at the end of the project construction period. Tax-free commercial paper is an unsecured promissory obligation issued or guaranteed by a municipal issuer. A fund may purchase other municipal securities similar to the foregoing that are or may become available, including securities issued to pre-refund other outstanding obligations of municipal issuers. A fund also may invest in moral obligation securities, which are normally issued by special purpose public authorities. If the issuer of a moral obligation security is unable to meet its obligation from current revenues, it may draw on a reserve fund. The state or municipality that created the entity has only a moral commitment, not a legal obligation, to restore the reserve fund. The value of municipal securities may be affected by uncertainties with respect to the rights of holders of municipal securities in the event of bankruptcy or the taxation of municipal securities as a result of legislation or litigation. For example, under federal law, certain issuers of municipal securities may be authorized in certain circumstances to initiate bankruptcy proceedings without prior notice to or the consent of creditors. Such action could result in material adverse changes in the rights of holders of the securities. In addition, litigation challenging the validity under the state constitutions of present systems of financing public education has been initiated or adjudicated in a number of states, and legislation has been introduced to effect changes in public school finances in some states. In other instances, there has been litigation challenging the issuance of pollution control revenue bonds or the validity of their issuance under state or federal law, which ultimately could affect the validity of those municipal securities or the tax-free nature of the interest thereon. 27 Municipal securities pay fixed, variable or floating rates of interest, which may be exempt from federal income tax and, typically, personal income tax of a state or locality. The investment adviser relies on the opinion of the issuer's counsel, which is rendered at the time the security is issued, to determine whether the security is fit, with respect to its validity and tax status, to be purchased by a fund. NON-PUBLICLY TRADED SECURITIES AND PRIVATE PLACEMENTS are securities that are neither listed on a stock exchange nor traded over-the-counter, including privately placed securities. Such unlisted securities may involve a higher degree of business and financial risk that can result in substantial losses. As a result of the absence of a public trading market for these securities, they may be less liquid than publicly traded securities. Although these securities may be resold in privately negotiated transactions, the prices realized from these sales could be less than those originally paid by a fund or less than what may be considered the fair value of such securities. Furthermore, companies whose securities are not publicly traded may not be subject to the disclosure and other investor protection requirements which might be applicable if their securities were publicly traded. If such securities are required to be registered under the securities laws of one or more jurisdictions before being sold, a fund may be required to bear the expenses of registration. OPTIONS CONTRACTS generally provide the right to buy or sell a security, commodity, futures contract or foreign currency in exchange for an agreed upon price. If the right is not exercised after a specified period, the option expires and the option buyer forfeits the money paid to the option seller. A call option gives the buyer the right to buy a specified number of shares of a security at a fixed price on or before a specified date in the future. For this right, the call option buyer pays the call option seller, commonly called the call option writer, a fee called a premium. Call option buyers are usually anticipating that the price of the underlying security will rise above the price fixed with the call writer, thereby allowing them to profit. If the price of the underlying security does not rise, the call option buyer's losses are limited to the premium paid to the call option writer. For call option writers, a rise in the price of the underlying security will be offset by the premium received from the call option buyer. If the call option writer does not own the underlying security, however, the losses that may ensue if the price rises could be potentially unlimited. If the call option writer owns the underlying security or commodity, this is called writing a covered call. All call option written by a fund will be covered, which means that a fund will own the underlying security or own a call option on the same underlying security with the same or lower strike price. A put option is the opposite of a call option. It gives the buyer the right to sell a specified number of shares of a security at a fixed price on or before a specified date in the future. Put option buyers are usually anticipating a decline in the price of the underlying security, and wish to offset those losses when selling the security at a later date. All put options a fund writes will be covered, which means that a fund will deposit with its custodian cash, U.S. government securities or other high-grade debt securities (i.e., securities rated in one of the top three categories by Moody's Investor Service ("Moody's") or Standard & Poor's ("S&P") or Fitch, Inc. or, if unrated, determined by the investment adviser to be of comparable credit quality) with a value at least equal to the exercise price of the put option, or will hold a put option on the same underlying security with the same or higher strike price. The purpose of writing such options is to generate additional income for a fund. However, in return for the option premium, a fund accepts the risk that it may be required to purchase the underlying securities at a price in excess of the securities' market value at the time of purchase. 28 A fund may purchase and write put and call options on any securities in which it may invest or any securities index based on securities in which it may invest. A fund may purchase and write such options on securities that are listed on domestic or foreign securities exchanges or traded in the over-the-counter market. Like futures contracts, option contracts are rarely exercised. Option buyers usually sell the option before it expires. Option writers may terminate their obligations under a written call or put option by purchasing an option identical to the one it has written. Such purchases are referred to as "closing purchase transactions." A fund may enter into closing sale transactions in order to realize gains or minimize losses on options it has purchased or written. An exchange-traded currency option position may be closed out only on an options exchange that provides a secondary market for an option of the same series. Although a fund generally will purchase or write only those options for which there appears to be an active secondary market, there is no assurance that a liquid secondary market will exist for any particular option or at any particular time. If a fund is unable to effect a closing purchase transaction with respect to options it has written, it will not be able to sell the underlying securities or dispose of assets earmarked or held in a segregated account until the options expire or are exercised. Similarly, if a fund is unable to effect a closing sale transaction with respect to options it has purchased, it would have to exercise the options in order to realize any profit and will incur transaction costs upon the purchase or sale of underlying securities. Reasons for the absence of a liquid secondary market on an exchange include the following: (1) there may be insufficient trading interest in certain options; (2) an exchange may impose restrictions on opening transactions or closing transactions or both; (3) trading halts, suspensions or other restrictions may be imposed with respect to particular classes or series of options; (4) unusual or unforeseen circumstances may interrupt normal operations on an exchange; (5) the facilities of an exchange or the Options Clearing Corporation (the "OCC") may not at all times be adequate to handle current trading volume; or (6) one or more exchanges could, for economic or other reasons, decide or be compelled at some future date to discontinue the trading of options (or a particular class or series of options), although outstanding options on that exchange that had been issued by the OCC as a result of trades on that exchange would continue to be exercisable in accordance with their terms. The ability to terminate over-the-counter options is more limited than with exchange-traded options and may involve the risk that broker-dealers participating in such transactions will not fulfill their obligations. Until such time as the staff of the SEC changes its position, a fund will treat purchased over-the-counter options and all assets used to cover written over-the-counter options as illiquid securities, except that with respect to options written with primary dealers in U.S. government securities pursuant to an agreement requiring a closing purchase transaction at a formula price, the amount of illiquid securities may be calculated with reference to a formula the staff of the SEC approves. Additional risks are involved with options trading because of the low margin deposits required and the extremely high degree of leverage that may be involved in options trading. There may be imperfect correlation between the change in market value of the securities held by a fund and the prices of the options, possible lack of liquid secondary markets, and the resulting inability to close such positions prior to their maturity dates. A fund may write or purchase an option only when the market value of that option, when aggregated with the market value of all other options transactions made on behalf of a fund, does 29 not exceed 5% of its total assets. PREFERRED STOCKS are nonvoting equity securities that pay a stated fixed or variable rate dividend. Although the preferred shareholders generally have no right to receive discretionary dividends, they must receive the preferred dividend at the stated rate prior to any dividends being paid on the common stock. Since the preferred shareholder receives a fixed dividend payment, the holder's position is much like that of the bondholder. Due to their fixed income features, preferred stocks provide higher income potential than issuers' common stocks, but typically are more sensitive to interest rate changes than an underlying common stock. In the event of liquidation, bondholders have claims on company assets senior to those of shareholders; preferred shareholders have claims senior to those of common shareholders. Preferred stocks are rated like fixed income securities and a fund will only invest in investment-grade preferred stock that has a call feature that the investment adviser expects to be exercised by the issuer on the call date or that has a specified redemption date. Except for the Schwab Tax-Free YieldPlus Fund(TM) and Schwab California Tax-Free YieldPlus Fund(TM), the Tax-Free Bond Funds do not invest in Preferred Stocks. PROMISSORY NOTES are written agreements committing the maker or issuer to pay the payee a specified amount either on demand or at a fixed date in the future, with or without interest. These are sometimes called negotiable notes or instruments and are subject to credit risk. Bank notes are notes used to represent obligations issued by banks in large denominations. PUTS are agreements that allow the buyer to sell a security at a specified price and time to the seller or "put provider." When a fund buys a security with a put feature, losses could occur if the put provider does not perform as agreed. If a put provider fails to honor its commitment upon a fund's attempt to exercise the put, a fund may have to treat the security's final maturity as its effective maturity. If that occurs, the security's price may be negatively impacted, and its sensitivity to interest rate changes may be increased, possibly contributing to increased share price volatility for a fund. This also could lengthen a fund's overall average effective maturity. Standby commitments are types of puts. QUALITY OF INVESTMENTS refers to the quality of the securities purchased by a fund. Investment-grade securities are rated by at least one NRSRO in one of the four highest rating categories (within which there may be sub-categories or gradations indicating relative standing) or have been determined to be of equivalent quality by the investment adviser pursuant to procedures adopted by the Board of Trustees. Sometimes an investment-grade quality security may be downgraded to a below investment-grade quality rating (referred to as lower quality securities, high yield securities or junk bonds). If a security no longer has at least one investment-quality rating from an NRSRO, the investment adviser would reanalyze the security in light of the downgrade and determine whether a fund should continue to hold the security. Each Bond Fund will invest primarily in investment-grade instruments. The investment adviser may also elect to purchase high-yield securities for either Bond Fund, subject to an aggregate limit of 5% of the investing fund's assets. The investment adviser will only purchase a high-yield security for a Bond Fund if such security is rated (at the time of purchase) at least B by at least one NRSRO or the unrated equivalent as determined by the investment adviser. In addition, if a high-yield security that is held by a Bond Fund is no longer rated at least B by at least one NRSRO or the unrated equivalent as determined by the investment adviser, the investment adviser will promptly dispose of the security. The Schwab Short-Term Bond Market Fund(TM), Schwab Total Bond Market Fund(TM), Schwab Short.Intermediate Tax-Free Fund(TM), Schwab Long-Term Tax Free Bond Fund(TM), Schwab California Short/Intermediate Tax-Free Bond Fund(TM), Schwab California Long-Term Tax-Free Bond Fund(TM), Schwab YieldPlus Fund(R) and Schwab GNMA Fund(TM) 30 will invest at least 80% of its total assets in investment-grade securities and will limit its investments in unrated securities to no more than 20% of its net assets. The YieldPlus Fund will invest at least 75% of its total assets in investment-grade securities. The fund may invest in bonds with effective or final maturities of any length and may invest up to 25% of assets in lower quality bonds that are rated at least B by at least one NRSRO or are the unrated equivalent as determined by the investment adviser. In the event a portfolio security is no longer rated at least B by at least one NRSRO or the unrated equivalent as determined by the investment adviser, the manager will promptly sell the security. The GNMA Fund will invest at least 80% of its assets in securities issued by the GNMA. The Schwab Tax-Free YieldPlus Fund(TM) and Schwab California Tax-Free YieldPlus Fund(TM) each will invest at least 85% of its total assets in investment-grade securities. Each fund may invest in bonds with effective or final maturities of any length and may invest up to 15% of its assets in lower quality bonds that are rated at least B by at least one NRSRO or are the unrated equivalent as determined by the investment adviser. REAL ESTATE INVESTMENT TRUSTS (REITS) are pooled investment vehicles, which invest primarily in income producing real estate or real estate related loans or interests and, in some cases, manage real estate. REITs are sometimes referred to as equity REITs, mortgage REITs or hybrid REITs. An equity REIT invests primarily in properties and generates income from rental and lease properties and, in some cases, from the management of real estate. Equity REITs also offer the potential for growth as a result of property appreciation and from the sale of appreciated property. Mortgage REITs invest primarily in real estate mortgages, which may secure construction, development or long-term loans, and derive income for the collection of interest payments. Hybrid REITS may combine the features of equity REITs and mortgage REITs. REITs are generally organized as corporations or business trusts, but are not taxed as a corporation if they meet certain requirements of the Subchapter M of the Internal Revenue Code of 1986, as amended (the Code). Except for the Schwab Tax-Free YieldPlus Fund(TM) and Schwab California Tax-Free YieldPlus Fund(TM), the Tax-Free Bond Funds do not invest in Real Estate Investment Trusts. REPURCHASE AGREEMENTS are instruments under which a buyer acquires ownership of certain securities (usually U.S. government securities) from a seller who agrees to repurchase the securities at a mutually agreed-upon time and price, thereby determining the yield during the buyer's holding period. Any repurchase agreements a fund enters into will involve the fund as the buyer and banks or broker-dealers as sellers. The period of repurchase agreements is usually short - from overnight to one week, although the securities collateralizing a repurchase agreement may have longer maturity dates. Default by the seller might cause a fund to experience a loss or delay in the liquidation of the collateral securing the repurchase agreement. A fund also may incur disposition costs in liquidating the collateral. In the event of a bankruptcy or other default of a repurchase agreement's seller, a fund might incur expenses in enforcing its rights, and could experience losses, including a decline in the value of the underlying securities and loss of income. A fund will make payment under a repurchase agreement only upon physical delivery or evidence of book entry transfer of the collateral to the account of its custodian bank. RESTRICTED SECURITIES are securities that are subject to legal restrictions on their sale. Restricted securities may be considered to be liquid if an institutional or other market exists for these securities. In making this determination, a fund, under the direction and supervision of the Board of Trustees, will take into account the following factors: (1) the frequency of trades and quotes for the security; (2) the number of dealers willing to purchase or sell the security and the number 31 of potential purchasers; (3) dealer undertakings to make a market in the security; and (4) the nature of the security and marketplace trades (e.g., the time needed to dispose of the security, the method of soliciting offers and the mechanics of transfer). To the extent a fund invests in restricted securities that are deemed liquid, the general level of illiquidity in a fund's portfolio may be increased if qualified institutional buyers become uninterested in purchasing these securities. REVERSE REPURCHASE AGREEMENTS, MORTGAGE DOLLAR ROLLS AND SALE-BUYBACKS may be used by a fund. A fund may engage in reverse repurchase agreements to facilitate portfolio liquidity, a practice common in the mutual fund industry, or for arbitrage transactions as discussed below. In a reverse repurchase agreement, a fund would sell a security and enter into an agreement to repurchase the security at a specified future date and price. A fund generally retains the right to interest and principal payments on the security. Because a fund receives cash upon entering into a reverse repurchase agreement, it may be considered a borrowing. When required by guidelines of the SEC, a fund will set aside permissible liquid assets earmarked or in a segregated account to secure its obligations to repurchase the security. A fund also may enter into mortgage dollar rolls, in which a fund would sell MBS for delivery in the current month and simultaneously contract to purchase substantially similar securities on a specified future date. While a fund would forego principal and interest paid on the MBS during the roll period, a fund would be compensated by the difference between the current sales price and the lower price for the future purchase as well as by any interest earned on the proceeds of the initial sale. A fund also could be compensated through the receipt of fee income equivalent to a lower forward price. At the time a fund would enter into a mortgage dollar roll, it would set aside permissible liquid assets earmarked or in a segregated account to secure its obligation for the forward commitment to buy MBS. Mortgage dollar roll transactions may be considered a borrowing by a fund. The mortgage dollar rolls and reverse repurchase agreements entered into by a fund may be used as arbitrage transactions in which a fund will maintain an offsetting position in short duration investment-grade debt obligations. Since a fund will receive interest on the securities or repurchase agreements in which it invests the transaction proceeds, such transactions may involve leverage. However, since such securities or repurchase agreements will be high quality and short duration, the investment adviser believes that such arbitrage transactions present lower risks to a fund than those associated with other types of leverage. There can be no assurance that a fund's use of the cash it receives from a mortgage dollar roll will provide a positive return. Except for the Schwab Tax-Free YieldPlus Fund(TM) and Schwab California Tax-Free YieldPlus Fund(TM), the Tax-Free Bond Funds do not invest in reverse repurchase agreements, mortgage dollar rolls or sale-buy backs. A fund also may effect simultaneous purchase and sale transactions that are known as "sale-buybacks." A sale-buyback is similar to a reverse repurchase agreement, except that in a sale-buyback, the counterparty who purchases the security is entitled to receive any principal or interest payments made on the underlying security pending settlement of the fund's repurchase of the underlying security. A fund's obligations under a sale-buyback typically would be offset by liquid assets equal in value to the amount of the fund's forward commitment to repurchase the subject security. SECURITIES LENDING of portfolio securities is a common practice in the securities industry. A fund may engage in security lending arrangements with the primary objective of increasing its income. For example, a fund may receive cash collateral and it may invest it in short-term, interest- 32 bearing obligations, but will do so only to the extent that it will not lose the tax treatment available to mutual funds. Lending portfolio securities involves risks that the borrower may fail to return the securities or provide additional collateral. Also, voting rights with respect to the loaned securities may pass with the lending of the securities and efforts to call such securities promptly may be unsuccessful, especially for foreign securities. A fund may loan portfolio securities to qualified broker-dealers or other institutional investors provided: (1) the loan is secured continuously by collateral consisting of U.S. government securities, letters of credit, cash or cash-equivalents or other appropriate instruments maintained on a daily marked-to-market basis in an amount at least equal to the current market value of the securities loaned; (2) a fund may at any time call the loan and obtain the return of the securities loaned; (3) a fund will receive any interest or dividends paid on the loaned securities; and (4) an aggregate market value of securities loaned will not at any time exceed one-third of the total assets of a fund, including collateral received from the loan (at market value computed at the time of the loan). Although voting rights with respect to loaned securities pass to the borrower, the lender retains the right to recall a security (or terminate a loan) for the purpose of exercising the security's voting rights. Efforts to recall such securities promptly may be unsuccessful, especially for foreign securities or thinly traded securities such as small-cap stocks. In addition, because recalling a security may involve expenses to a fund, it is expected that a fund will do so only where the items being voted upon are, in the judgment of the investment adviser, either material to the economic value of the security or threaten to materially impact the issuer's corporate governance policies or structure. SECURITIES OF OTHER INVESTMENT COMPANIES may be purchased and sold by a fund and those issued by foreign investment companies. Mutual funds are registered investment companies, which may issue and redeem their shares on a continuous basis (open-end mutual funds) or may offer a fixed number of shares usually listed on an exchange (closed-end mutual funds). Mutual funds generally offer investors the advantages of diversification and professional investment management, by combining shareholders' money and investing it in various types of securities, such as stocks, bonds and money market securities. Mutual funds also make various investments and use certain techniques in order to enhance their performance. These may include entering into delayed-delivery and when-issued securities transactions or swap agreements; buying and selling futures contracts, illiquid and restricted securities and repurchase agreements and borrowing or lending money and/or portfolio securities. The risks of investing in mutual funds generally reflect the risks of the securities in which the mutual funds invest and the investment techniques they may employ. Also, mutual funds charge fees and incur operating expenses. If a fund decides to purchase securities of other investment companies, a fund intends to purchase shares of mutual funds in compliance with the requirements of federal law or any applicable exemptive relief received from the SEC. Mutual fund investments for a fund are currently restricted under federal regulations, and therefore, the extent to which a fund may invest in another mutual fund may be limited. Funds in which a fund also may invest include unregistered or privately-placed funds, such as hedge funds and off-shore funds, and unit investment trusts. Hedge funds and off-shore funds are not registered with the SEC, and therefore are largely exempt from the regulatory requirements that apply to registered investment companies (mutual funds). As a result, these types of funds may have greater ability to make investments or use investment techniques that offer a higher degree of investment return, such as leveraging, which also may subject their fund assets to 33 substantial risk to the investment principal. These funds, while not regulated by the SEC like mutual funds, may be indirectly supervised by the sources of their assets, which tend to be commercial and investment banks and other financial institutions. Investments in these funds also may be more difficult to sell, which could cause losses to a fund. For example, hedge funds typically require investors to keep their investment in a hedge fund for some period of time, such as one month. This means investors would not be able to sell their shares of a hedge fund until such time had past. SHORT SALES may be used by a fund as part of its overall portfolio management strategies or to offset a potential decline in a value of a security. For example, a Bond Fund may use short sales may as a quantitative technique to assemble a portfolio whose performance, average maturity and average duration is expected to track that of its index. This technique may provide a more effective hedge against interest rate risk than other types of hedging transactions, such as selling futures contracts. A fund may sell a security short only if the fund owns the security, or the right to obtain the security or equivalent securities, or covers such short sale with liquid assets as required by the current rules and interpretations of the SEC or its staff. When a fund makes a short sale, it may borrow the security sold short and deliver it to the broker-dealer through which it made the short sale as collateral for its obligation to deliver the security upon conclusion of the sale. A fund also may have to pay a fee to borrow particular securities and is often obligated to pay over any accrued interest and dividends on such borrowed securities. If the price of the security sold short increases between the time of the short sale and the time a fund replaces the borrowed security, a fund will incur a loss; conversely, if the price declines, a fund will realize a gain. Any gain will be decreased, and any loss increased, by the transaction costs described above. Selling securities short against the box involves selling a security that a fund owns or has the right to acquire, for the delivery at a specified date in the future. If a fund sells securities short against the box, it may protect unrealized gains, but will lose the opportunity to profit on such securities if the price rises. A short sale against the box is a taxable transaction to the funds with respect to the securities sold short. The successful use of short selling as a hedging strategy may be adversely affected by imperfect correlation between movements in the price of the security sold short and the securities being hedged. Except for the Schwab Tax-Free YieldPlus Fund(TM) and the Schwab California Tax-Free YieldPlus Fund(TM), the Tax-Free Bond Funds do not engage in short sales. SINKING FUNDS may be established by bond issuers to set aside a certain amount of money to cover timely repayment of bondholders' principal raised through a bond issuance. By creating a sinking fund, the issuer is able to spread repayment of principal to numerous bondholders while reducing reliance on its then current cash flows. A sinking fund also may allow the issuer to annually repurchase certain of its outstanding bonds from the open market or repurchase certain of its bonds at a call price named in a bond's sinking fund provision. This call provision will allow bonds to be prepaid or called prior to a bond's maturity. The likelihood of this occurring is substantial during periods of falling interest rates. SPREAD TRANSACTIONS may be used for hedging or managing risk. A fund may purchase covered spread options from securities dealers. Such covered spread options are not presently exchange-listed or exchange-traded. The purchase of a spread option gives a fund the right to put, or sell, a security that it owns at a fixed dollar spread or fixed yield spread in relation to another security that a fund does not own, but which is used as a benchmark. The risk to a fund in purchasing covered spread options is the cost of the premium paid for the spread option and any transaction costs. In addition, there is no assurance that closing transactions will be available. The purchase of spread options will be used to protect a fund against adverse changes in prevailing credit 34 quality spreads, i.e., the yield spread between high quality and lower quality securities. Such protection is only provided during the life of the spread option. The Tax-Free Bond Funds do not engage in spread transactions. STATE-SPECIFIC MUNICIPAL MUTUAL FUNDS are mutual funds that invest primarily in municipal securities issued by or on behalf of one state or one state's counties, municipalities, authorities or other subdivisions. These funds' securities are subject to the same general risks associated with other municipal funds' securities. In addition, their values will be particularly affected by economic, political, geographic and demographic conditions and developments within the affected state. A fund that invests primarily in securities issued by a single state and its political subdivisions provides a greater level of risk than a fund that is diversified across numerous states and municipal entities. The ability of the state or its municipalities to meet their obligations will depend on the availability of tax and other revenues; economic, political and demographic conditions within the state; and the underlying fiscal condition of the state and its municipalities. The risks of investing in state specific mutual funds generally reflect the risks of the securities in which the mutual funds invest and the investment techniques they may employ. STRIPPED SECURITIES are securities whose income and principal components are detached and sold separately. While risks associated with stripped securities are similar to other fixed income securities, stripped securities are typically subject to greater changes in value. U.S. Treasury securities that have been stripped by the Federal Reserve Bank are obligations of the U.S. Treasury. Except for the Schwab Tax-Free YieldPlus Fund(TM) and Schwab California Tax-Free YieldPlus Fund(TM), the Tax-Free Bond Funds do not invest in Stripped Securities. STRUCTURED NOTES are derivative instruments. An issuing corporation may repay a noteholder based on the movement of an unrelated underlying indicator, such as, an index or a commodity. The noteholder has the opportunity to profit from the changes in the unrelated indicator. SWAP AGREEMENTS can be structured to increase or decrease a fund's exposure to long or short term interest rates, corporate borrowing rates and other conditions, such as changing security prices and inflation rates. They also can be structured to increase or decrease a fund's exposure to specific issuers or specific sectors of the bond market such as mortgage securities. For example, if a fund agreed to pay a longer-term fixed rate in exchange for a shorter-term floating rate while holding longer-term fixed rate bonds, the swap would tend to decrease a fund's exposure to longer-term interest rates. Swap agreements tend to increase or decrease the overall volatility of a fund's investments and its share price and yield. Changes in interest rates, or other factors determining the amount of payments due to and from a fund, can be the most significant factors in the performance of a swap agreement. If a swap agreement calls for payments from a fund, a fund must be prepared to make such payments when they are due. In order to help minimize risks, a fund will earmark or segregate appropriate assets for any accrued but unpaid net amounts owed under the terms of a swap agreement entered into on a net basis. All other swap agreements will require a fund to earmark or segregate assets in the amount of the accrued amounts owed under the swap. A fund could sustain losses if a counterparty does not perform as agreed under the terms of the swap. A fund will enter into swap agreements with counterparties deemed creditworthy by the investment adviser or sub-adviser. Swaps Agreements are privately negotiated over-the-counter derivative products in which two parties agree to exchange payment streams calculated in relation to a rate, index, instrument or certain securities (referred to as the "underlying") and a predetermined amount (referred to as the "notional amount"). The underlying for a swap may be an interest rate (fixed or floating), a currency exchange rate, a commodity 35 price index, a security, group of securities or a securities index, a combination of any of these, or various other rates, assets or indices. Swap agreements generally do not involve the delivery of the underlying or principal, and a party's obligations generally are equal to only the net amount to be paid or received under the agreement based on the relative values of the positions held by each party to the swap agreement. In addition, the funds may invest in swaptions, which are privately-negotiated option-based derivative products. Swaptions give the holder the right to enter into a swap. A fund may use a swaption in addition to or in lieu of a swap involving a similar rate or index. For purposes of applying the fund's investment policies and restrictions (as stated in the prospectuses and this SAI) swap agreements are generally valued by the funds at market value. In the case of a credit default swap sold by a fund (i.e., where the fund is selling credit default protection), however, the fund will generally value the swap at its notional amount. The manner in which certain securities or other instruments are valued by the funds for purposes of applying investment policies and restrictions may differ from the manner in which those investments are valued by other types of investors. TEMPORARY DEFENSIVE STRATEGIES may be engaged by a fund during abnormal economic or market conditions. Under normal conditions, the Tax-Free Bond Funds do not generally intend to invest in securities that pay interest subject to federal income tax, including the federal alternative minimum tax (AMT). In addition, under normal conditions, the Schwab California Short/Intermediate Tax-Free Bond Fund(TM) and the Schwab California Long-Term Tax-Free Bond Fund(TM) do not intend to invest in securities that pay interest subject to California personal income tax. However, from time to time, as a defensive measure or under abnormal market conditions, each of the Tax-Free Bond Funds may make temporary investments in securities, the interest on which is subject to federal income tax and AMT and the Schwab California Short/Intermediate Tax-Free Bond Fund, the Schwab California Long-Term Tax-Free Bond Fund, and the Schwab California Tax-Free YieldPlus Fund(TM) may make temporary investments in securities that pay interest subject to California personal income tax. In addition, as a defensive measure or under abnormal market conditions, the GNMA Fund may invest up to 100% of its assets in cash, cash equivalents or other high quality short-term investments. U.S. GOVERNMENT SECURITIES are issued by the U.S. Treasury or issued or guaranteed by the U.S. government or any of its agencies or instrumentalities. Not all U.S. government securities are backed by the full faith and credit of the United States. Some U.S. government securities, such as those issued by Fannie Mae, Freddie Mac, the Student Loan Marketing Association (SLMA or Sallie Mae), and the Federal Home Loan Banks (FHLB), are supported by a line of credit the issuing entity has with the U.S. Treasury. Others are supported solely by the credit of the issuing agency or instrumentality such as obligations issued by the Federal Farm Credit Banks Funding Corporation (FFCB). There can be no assurance that the U.S. government will provide financial support to U.S. government securities of its agencies and instrumentalities if it is not obligated to do so under law. Of course U.S. government securities, including U.S. Treasury securities, are among the safest securities, however, not unlike other debt securities, they are still sensitive to interest rate changes, which will cause their prices to fluctuate. VARIABLE- AND FLOATING-RATE DEBT SECURITIES pay an interest rate, which is adjusted either periodically or at specific intervals or which floats continuously according to a formula or benchmark. Although these structures generally are intended to minimize the fluctuations in value that occur when interest rates rise and fall, some structures may be linked to a benchmark in such a way as to cause greater volatility to the security's value. 36 Some variable-rate securities may be combined with a put or demand feature (variable-rate demand securities) that entitles the holder to the right to demand repayment in full or to resell at a specific price and/or time. While the demand feature is intended to reduce credit risks, it is not always unconditional, and may make the securities more difficult to sell quickly without losses. There are risks involved with these securities because there may be no active secondary market for a particular variable-rate demand security purchased by a fund. In addition, a fund may exercise its demand rights only at certain times. A fund could also suffer losses in the event that the issuer defaults on its obligation. Synthetic variable or floating rate securities include tender option bond receipts. Tender option bond receipts are derived from fixed-rate municipal bonds that are placed in a trust from which two classes of trust receipts are issued. These receipts represent proportionate interest in the underlying bonds. Interest payments are made on the bonds based upon a predetermined rate. Under certain circumstances, the holder of a trust receipt also may participate in any gain or loss on the sale of such bonds. Tender option bond trust receipts generally are structured as private placements and, accordingly, may be deemed to be restricted securities for purposes of a fund's investment limitations. WARRANTS are a type of security usually issued with bonds and preferred stock that entitles the holder to a proportionate amount of common stock at a specified price for a specific period of time. The prices of warrants do not necessarily move parallel to the prices of the underlying common stock. Warrants have no voting rights, receive no dividends and have no rights with respect to the assets of the issuer. If a warrant is not exercised within the specified time period, it will become worthless and a fund will lose the purchase price it paid for the warrant and the right to purchase the underlying security. Except for the Schwab Tax-Free YieldPlus Fund(TM) and Schwab California Tax-Free YieldPlus Fund(TM), the Tax-Free Bond Funds do not invest in Warrants. WRAP AGREEMENTS may be entered into by a fund with insurance companies, banks or other financial institutions (wrapper providers). A wrap agreement typically obligates the wrapper provider to maintain the value of the assets covered under the agreement (covered assets) up to a specified maximum dollar amount upon the occurrence of certain specified events. The value is pre-determined using the purchase price of the securities plus interest at a specified rate minus an adjustment for any defaulted securities. The specified interest rate may be adjusted periodically under the terms of the agreement. While the rate typically will reflect movements in the market rates of interest, it may at times be less or more than the actual rate of income earned on the covered assets. The rate also can be impacted by defaulted securities and by purchase and redemption levels in a fund. A fund also pays a fee under the agreement, which reduces the rate as well. Wrap agreements may be used as a risk management technique intended to help minimize fluctuations in a fund's NAV. However, a fund's NAV will typically fluctuate at least minimally, and may fluctuate more at times when interest rates are fluctuating. Additionally, wrap agreements do not protect against losses a fund may incur if the issuers of portfolio securities do not make timely payments of interest and/or principal. A wrap agreement provider also could default on its obligations under the agreement. Therefore, a fund will only invest in a wrap provider with an investment-grade credit rating. There is no active trading market for wrap agreements and none is expected to develop. Therefore, wrap agreements are considered illiquid investments. There is no guarantee that a fund will be able to purchase any wrap agreements or replace ones that defaulted. Wrap agreements are valued using procedures adopted by the Board of Trustees. There are risks that the value of a wrap agreement may not be sufficient to minimize 37 the fluctuations in a fund's NAV. All of these factors might result in a decline in the value of a fund's shares. ZERO-COUPON, STEP-COUPON, AND PAY-IN-KIND SECURITIES are debt securities that do not make regular cash interest payments. Zero-coupon and step-coupon securities are sold at a deep discount to their face value. Pay-in-kind securities pay interest through the issuance of additional securities. Because such securities do not pay current cash income, the price of these securities can be volatile when interest rates fluctuate. While these securities do not pay current cash income, federal income tax law requires the holders of zero-coupon, step-coupon, and pay-in-kind securities to include in income each year the portion of the original issue discount (or deemed discount) and other non-cash income on such securities accruing that year. In order to continue to qualify as a "regulated investment company" or "RIC" under the Internal Revenue Code and avoid a certain excise tax, a fund may be required to distribute a portion of such discount and income and may be required to dispose of other portfolio securities, which may occur in periods of adverse market prices, in order to generate cash to meet these distribution requirements. INVESTMENT LIMITATIONS The following investment limitations are fundamental investment polices and restrictions and may be changed only by vote of a majority of a fund's outstanding voting shares. SCHWAB TAX-FREE YIELDPLUS FUND AND SCHWAB CALIFORNIA TAX-FREE YIELDPLUS FUND MAY NOT: 1) Concentrate investments in a particular industry or group of industries, as concentration is defined under the 1940 Act, or the rules or regulations thereunder, as such statute, rules and regulations may be amended from time to time; and 2) (i) Purchase or sell commodities, commodities contracts, futures contracts or real estate, (ii) lend or borrow, (iii) issue senior securities, (iv) underwrite securities or (v) pledge, mortgage or hypothecate any of its assets, except as permitted by the 1940 Act, or the rules or regulations thereunder, as such statute, rules and regulations may be amended from time to time. 3) Normally invest less than 80% of its net assets in municipal securities, the interest from which is exempt from federal income tax, including the federal alternative minimum tax. SCHWAB CALIFORNIA TAX-FREE YIELDPLUS FUND ALSO MAY NOT: 1) Normally invest less than 80% of its net assets in municipal securities, the interest from which is exempt from California personal income tax. SCHWAB SHORT-TERM BOND MARKET FUND(TM) AND SCHWAB TOTAL BOND MARKET FUND(TM) MAY: 1) Lend or borrow money to the extent permitted by the Investment Company Act of 1940 or rules or regulations thereunder, as such statute, rules or regulations may be amended from time to time. 38 2) Pledge, mortgage or hypothecate any of its assets to the extent permitted by the Investment Company Act of 1940 or the rules or regulations thereunder, as such statute, rules or regulations may be amended from time to time. 3) Not concentrate investments in a particular industry or group of industries, or within one state (except to the extent that the index which each fund seeks to track is also so concentrated) as concentration is defined under the Investment Company Act of 1940 or the rules or regulations thereunder, as such statute, rules or regulations may be amended from time to time. 4) Underwrite securities to the extent permitted by the Investment Company Act of 1940 or the rules or regulations thereunder, as such statute, rules or regulations may be amended from time to time. 5) Not purchase securities of an issuer, except as consistent with the maintenance of its status as an open-end diversified company under the 1940 Act, the rules or regulations thereunder or any exemption therefrom, as such statute, rules or regulations may be amended or interpreted from time to time. 6) Not purchase securities of other investment companies, except as permitted by the Investment Company Act of 1940. 7) Issue senior securities to the extent permitted by the Investment Company Act of 1940 or the rules or regulations thereunder, as such statute, rules or regulations may be amended from time to time. 8) Purchase or sell commodities, commodities contracts, futures contracts, or real estate to the extent permitted by the Investment Company Act of 1940 or rules or regulations thereunder, as such statute, rules or regulations may be amended from time to time. SCHWAB SHORT/INTERMEDIATE TAX-FREE BOND FUND(TM), SCHWAB LONG-TERM TAX-FREE BOND FUND(TM), SCHWAB CALIFORNIA SHORT/INTERMEDIATE TAX-FREE BOND FUND(TM) AND SCHWAB CALIFORNIA LONG-TERM TAX-FREE BOND FUND(TM) MAY NOT: 1) Concentrate investments in a particular industry or group of industries, as concentration is defined under the 1940 Act, the rules or regulations thereunder or any exemption therefrom, as such statute, rules or regulations may be amended or interpreted from time to time. 2) Purchase or sell commodities or real estate, except to the extent permitted under the 1940 Act, the rules or regulations thereunder or any exemption therefrom, as such statute, rules or regulations may be amended or interpreted from time to time. 3) Purchase securities of other investment companies, except as permitted by the 1940 Act. 4) Make loans to other persons, except to the extent permitted under the 1940 Act, the rules or regulations thereunder or any exemption therefrom, as such statute, rules or regulations may be amended or interpreted from time to time. 5) Borrow money, except to the extent permitted under the 1940 Act, the rules or regulations thereunder or any exemption therefrom, as such statute, rules or regulations may be 39 amended or interpreted from time to time. 6) Issue senior securities, except to the extent permitted under the 1940 Act, the rules or regulations thereunder or any exemption therefrom, as such statute, rules or regulations may be amended or interpreted from time to time. 7) Underwrite securities issued by other persons, except to the extent permitted under the 1940 Act, the rules or regulations thereunder or any exemption therefrom, as such statute, rules or regulations may be amended or interpreted from time to time. THE SCHWAB YIELDPLUS FUND(R) AND SCHWAB GNMA FUND(TM) MAY NOT: 1) Purchase securities of any issuer, unless consistent with the maintenance of its status as a diversified investment management company under the Investment Company Act of 1940 Act (the 1940 Act), or the rules or regulations thereunder, as such statute, rules or regulations may be amended from time to time; 2) Concentrate investments in a particular industry or group of industries, as concentration is defined under the 1940 Act, or the rules or regulations thereunder, as such statute, rules and regulations may be amended from time to time; and 3) (i) Purchase or sell commodities, commodities contracts, futures contracts or real estate, (ii) lend or borrow, (iii) issue senior securities, (iv) underwrite securities or (v) pledge, mortgage or hypothecate any of its assets, except as permitted by the 1940 Act, or the rules or regulations thereunder, as such statute, rules and regulations may be amended from time to time. THE FOLLOWING DESCRIPTIONS OF THE 1940 ACT MAY ASSIST INVESTORS IN UNDERSTANDING THE ABOVE POLICIES AND RESTRICTIONS. Diversification. Under the 1940 Act, a diversified investment management company, as to 75% of its total assets, may not purchase securities of any issuer (other than U.S. government securities of other investment companies) if, as a result, more than 5% of its total assets would be invested in the securities of such issuer, or more than 10% of the issuer's outstanding voting securities would be held by the fund. Concentration. The SEC has presently defined concentration as investing 25% or more of an investment company's net assets in an industry or group of industries, with certain exceptions. Borrowing. The 1940 Act presently allows a fund to borrow from any bank (including pledging, mortgaging or hypothecating assets) in an amount up to 33 1/3% of its total assets (not including temporary borrowings not in excess of 5% of its total assets). Lending. Under the 1940 Act, a fund may only make loans if expressly permitted by its investment policies. Each fund's non-fundamental investment policy on lending is set forth below. Underwriting. Under the 1940 Act, underwriting securities involves a fund purchasing securities directly from an issuer for the purpose of selling (distributing) them or participating in any such activity either directly or indirectly. Under the 1940 Act, a diversified fund may not make any commitment as underwriter, if immediately thereafter the amount of its outstanding underwriting 40 commitments, plus the value of its investments in securities of issuers (other than investment companies) of which it owns more than 10% of the outstanding voting securities, exceeds 25% of the value of its total assets. The foregoing restriction does not apply to non-diversified funds. Real Estate. The 1940 Act does not directly restrict a fund's ability to invest in real estate, but does require that every fund have a fundamental investment policy governing such investments. The funds have adopted a fundamental policy that would permit direct investment in real estate. However, each fund has a non-fundamental investment limitation that prohibits it from investing directly in real estate. This non-fundamental policy may be changed only by vote of each fund's Board of Trustees. Senior Securities. Senior securities may include any obligation or instrument issued by a fund evidencing indebtedness. The 1940 Act generally prohibits funds from issuing senior securities, although it provides allowances for certain borrowings and certain other investments, such as short sales, reverse repurchase agreements, firm commitment agreements and standby commitments, with appropriate earmarking or segregation of assets to cover such obligation. The following are non-fundamental investment policies and restrictions and may be changed by the Board of Trustees. THE SCHWAB TAX-FREE YIELDPLUS FUND(TM) AND SCHWAB CALIFORNIA TAX-FREE YIELDPLUS FUND(TM) MAY NOT: 1) Sell securities short unless it owns the security or the right to obtain the security or equivalent securities, or unless it covers such short sale as required by current SEC rules and interpretations (transactions in futures contracts, options and other derivative instruments are not considered selling securities short). 2) Purchase securities on margin, except such short-term credits as may be necessary for the clearance of purchases and sales of securities and provided that margin deposits in connection with futures contracts, options on futures or other derivative instruments shall not constitute purchasing securities on margin. 3) Borrow money except that each fund may (i) borrow money from banks or through an interfund lending facility, if any, only for temporary or emergency purposes (and not for leveraging) and (ii) engage in reverse repurchase agreements with any party; provided that (i) and (ii) in combination do not exceed 33 1/3% of its total assets (any borrowings that come to exceed this amount will be reduced to the extent necessary to comply with the limitation within three business days). 4) Lend any security or make any other loan if, as a result, more than 33 1/3% of its total assets would be lent to other parties (this restriction does not apply to purchases of debt securities or repurchase agreements). 5) Invest more than 15% of its net assets in illiquid securities. 6) Purchase securities (other than securities issued or guaranteed by the U.S. government, its agencies or instrumentalities) if, as a result of such purchase, 25% or more of the value of its total assets would be invested in any industry, or group of industries (although securities issued by governments or political subdivisions of governments are not considered to be securities subject to this industry concentration restriction). 41 7) Purchase or sell commodities, commodity contracts or real estate, including interests in real estate limited partnerships, provided that the fund may (i) purchase securities of companies that deal in real estate or interests therein (including REITs), (ii) purchase or sell futures contracts, options contracts, equity index participations and index participation contracts, and (iii) purchase securities of companies that deal in precious metals or interests therein. THE BOND FUNDS MAY NOT: 1) Sell securities short unless it owns the security or the right to obtain the security or equivalent securities, or unless it covers such short sale as required by current SEC rules and interpretations (transactions in futures contracts, options and other derivative instruments are not considered selling securities short). 2) Purchase securities on margin, except such short-term credits as may be necessary for the clearance of purchases and sales of securities and provided that margin deposits in connection with futures contracts, options on futures or other derivative instruments shall not constitute purchasing securities on margin. 3) Lend any security or make any other loan if, as a result, more than 33 1/3% of its total assets would be lent to other parties (this restriction does not apply to purchases of debt securities or repurchase agreements). 4) Borrow money except that each fund may (i) borrow money from banks or through an interfund lending facility, if any, only for temporary or emergency purposes (and not for leveraging) and (ii) engage in reverse repurchase agreements with any party; provided that (i) and (ii) in combination do not exceed 33 1/3% of its total assets (any borrowings that come to exceed this amount will be reduced to the extent necessary to comply with the limitation within three business days). 5) Purchase securities (other than securities issued or guaranteed by the U.S. government, its agencies or instrumentalities) if, as a result of such purchase, 25% or more of the value of its total assets would be invested in any industry or group of industries (except that each fund may purchase securities to the extent that its index is also so concentrated). 6) Invest more than 15% of its net assets in illiquid securities. 7) Purchase or sell commodities, commodity contracts or real estate, including interests in real estate limited partnerships, provided that the fund may (i) purchase securities of companies that deal in real estate or interests therein (including REITs), (ii) purchase or sell futures contracts, options contracts, equity index participations and index participation contracts, and (iii) purchase securities of companies that deal in precious metals or interests therein. THE SCHWAB SHORT/INTERMEDIATE TAX-FREE BOND FUND(TM), SCHWAB LONG-TERM TAX-FREE BOND FUND(TM), SCHWAB CALIFORNIA SHORT/INTERMEDIATE TAX-FREE BOND FUND(TM), AND SCHWAB CALIFORNIA LONG-TERM TAX-FREE BOND FUND(TM) MAY NOT: 1) Sell securities short unless it owns the security or the right to obtain the security or equivalent securities, or unless it covers such short sale as required by current SEC rules 42 and interpretations (transactions in futures contracts, options and other derivative instruments are not considered selling securities short). 2) Purchase securities on margin, except such short-term credits as may be necessary for the clearance of purchases and sales of securities and provided that margin deposits in connection with futures contracts, options on futures or other derivative instruments shall not constitute purchasing securities on margin. 3) Purchase securities the income of which is subject to federal alternative minimum tax if, by reason of such purchase, the total income earned by such securities would exceed 20% of all income earned by a fund. 4) Under normal circumstances, invest less than 65% of its total assets in securities deemed by the investment adviser to be bonds. 5) Borrow money except that each fund may (i) borrow money from banks or through an interfund lending facility, if any, only for temporary or emergency purposes (and not for leveraging) and (ii) engage in reverse repurchase agreements with any party; provided that (i) and (ii) in combination do not exceed 33 1/3% of its total assets (any borrowings that come to exceed this amount will be reduced to the extent necessary to comply with the limitation within three business days). 6) Lend any security or make any other loan if, as a result, more than 33 1/3% of its total assets would be lent to other parties (this restriction does not apply to purchases of debt securities or repurchase agreements). 7) Invest more than 15% of its net assets in illiquid securities. 8) Purchase securities (other than securities issued or guaranteed by the U.S. government, its agencies or instrumentalities) if, as a result of such purchase, 25% or more of the value of its total assets would be invested in any industry, or group of industries (although securities issued by governments or political subdivisions of governments are not considered to be securities subject to this industry concentration restriction). 9) Purchase or sell commodities, commodity contracts or real estate, including interests in real estate limited partnerships, provided that the fund may (i) purchase securities of companies that deal in real estate or interests therein (including REITs), (ii) purchase or sell futures contracts, options contracts, equity index participations and index participation contracts, and (iii) purchase securities of companies that deal in precious metals or interests therein. THE SCHWAB YIELDPLUS FUND AND THE SCHWAB GNMA FUND(TM) MAY NOT: 1) Invest more than 15% of its net assets in illiquid securities. 2) Purchase securities of other investment companies, except as permitted by the 1940 Act, the rules or regulations thereunder or any exemption therefrom, as such statute, rules or regulations may be amended or interpreted from time to time. 3) Sell securities short unless it owns the security or the right to obtain the security or equivalent securities, or unless it covers such short sale as required by current SEC rules 43 and interpretations (transactions in futures contracts, options and other derivative instruments are not considered selling securities short). 4) Purchase securities on margin, except such short-term credits as may be necessary for the clearance of purchases and sales of securities and provided that margin deposits in connection with futures contracts, options on futures or other derivative instruments shall not constitute purchasing securities on margin. 5) Borrow money except that the fund may (i) borrow money from banks or through an interfund lending facility, if any, only for temporary or emergency purposes (and not for leveraging) and (ii) engage in reverse repurchase agreements with any party; provided that (i) and (ii) in combination do not exceed 33 1/3% of its total assets (any borrowings that come to exceed this amount will be reduced to the extent necessary to comply with the limitation within three business days). 6) Purchase securities (other than securities issued or guaranteed by the U.S. government, its agencies or instrumentalities) if, as a result of such purchase, 25% or more of the value of its total assets would be invested in any industry or group of industries. 7) Lend any security or make any other loan if, as a result, more than 33 1/3% of its total assets would be lent to other parties (this restriction does not apply to purchases of debt securities or repurchase agreements). 8) Purchase or sell commodities, commodity contracts or real estate, including interests in real estate limited partnerships, provided that the fund may (i) purchase securities of companies that deal in real estate or interests therein (including REITs), (ii) purchase or sell futures contracts, options contracts, equity index participations and index participation contracts, and (iii) purchase securities of companies that deal in precious metals or interests therein. SUBSEQUENT CHANGES IN NET ASSETS Policies and investment limitations that state a maximum percentage of assets that may be invested in a security or other asset, or that set forth a quality standard shall be measured immediately after and as a result of the fund's acquisition of such security or asset, unless otherwise noted. Except with respect to limitations on borrowing and futures and option contracts, any subsequent change in net assets or other circumstances does not require a fund to sell an investment if it could not then make the same investment. With respect to the limitation on illiquid securities, in the event that a subsequent change in net assets or other circumstances cause a fund to exceed its limitation, the fund will take steps to bring the aggregate amount of illiquid instruments back within the limitations as soon as reasonably practicable. MANAGEMENT OF THE FUNDS Each fund is overseen by a Board of Trustees. The trustees are responsible for protecting shareholder interests. The trustees regularly meet to review the investment activities, contractual arrangements and the investment performance of each fund. The trustees met 7 times during the most recent fiscal year. Certain trustees are "interested persons." A trustee may be considered an interested person of the trust under the 1940 Act if he or she is an officer, director or employee of Charles Schwab 44 Investment Management, Inc. ("CSIM") or Charles Schwab & Co., Inc. ("Schwab"). A trustee also may be considered an interested person of the trust under the 1940 Act if he or she owns stock of The Charles Schwab Corporation, a publicly traded company and the parent company of the funds' investment adviser and distributor. The information below is provided as of August 31, 2004. Each of the below-referenced officers and/or trustees also serves in the same capacity as described for the Trust, for Schwab Capital Trust, The Charles Schwab Family of Funds and Schwab Annuity Portfolios (collectively, referred to herein as the "family of investment companies") which as of August 31, 2004 included 51 funds. On January 30, 2004, CSIM became the investment adviser of the Laudus Trust and the Laudus Variable Insurance Trust (the SchwabFunds, Laudus Trust and Laudus Variable Insurance Trust are collectively referred to herein as the "fund complex"). As of August 31, 2004, the fund complex consisted of 61 funds. Ms. Byerwalter and Mr. Hasler also serve as trustees for the Laudus Trust and the Laudus Variable Insurance Trust, therefore, each of these trustees oversees all 61 funds in the fund complex. The address of each individual listed below is 101 Montgomery Street, San Francisco, California 94104. Each officer's and trustee's principal occupations during the past five years, other directorships and affiliations, if any, with The Charles Schwab Corporation, Schwab and CSIM are as follows:
NAME AND DATE OF BIRTH POSITION(S) WITH TERM OF OFFICE PRINCIPAL OCCUPATIONS OTHER DIRECTORSHIPS THE TRUST AND LENGTH OF DURING THE PAST FIVE YEARS TIME SERVED 1 INDEPENDENT TRUSTEES DONALD F. DORWARD Trustee Trustee of Schwab Chief Executive Officer, September 23, 1931 Investments since Dorward & Associates 1991. (corporate management, marketing and communications consulting firm). From 1996 to 1999, Executive Vice President and Managing Director, Grey Advertising. ROBERT G. HOLMES Trustee Trustee of Chairman, Chief Executive Schwab Officer and
--------------- 1 Trustees remain in office until they resign, retire or are removed by shareholder vote. The SchwabFunds retirement policy requires that independent trustees elected after January 1, 2000 retire at age 72 or after twenty years of service as a trustee, whichever comes first. Independent trustees elected prior to January 1, 2000 will retire on the following schedule: Messrs. Holmes and Dorward will retire on December 31, 2007, and Messrs. Stephens and Wilsey will retire on December 31, 2010. 45 May 15, 1931 Investments since Director, Semloh 1991. Financial, Inc. (international financial services and investment advisory firm). DONALD R. STEPHENS Trustee Trustee of Schwab Managing Partner, D.R. June 28, 1938 Investments since Stephens & Company 1991. (investments). Prior to 1996, Chairman and Chief Executive Officer of North American Trust (real estate investment trust). MICHAEL W. WILSEY Trustee Trustee of Schwab Chairman and Chief August 18, 1943 Investments since Executive Officer, Wilsey 1991. Bennett, Inc. (truck and air transportation, real estate investment and management, and investments). MARIANN BYERWALTER Trustee Trustee of Schwab Chairman of JDN Corporate Ms. Byerwalter is on the August 13, 1960 Investments since Advisory LLC. From 1996 Board of Stanford University, 2000. to 2001, Ms. Byerwalter America First Companies, was the Vice President Omaha, NE (venture for Business Affairs and capital/fund management), Chief Financial Officer Redwood Trust, Inc. (mortgage of Stanford University finance), Stanford Hospitals and, in 2001, Special and Clinics, SRI Advisor to the President International (research), PMI of Stanford University. Group, Inc. (mortgage 4 insurance), Lucile Packard Children's Hospital and in 2004, Laudus Trust and Laudus Variable Insurance Trust; Director until 2002, LookSmart, Ltd. (an Internet infrastructure company).
--------------- 4 Charles R. Schwab, an interested trustee (see below) has served as a Trustee of Standord University since December 1993. From 1996 to 2001, Ms. Byerwalter was Chief Financial Officer of Stanford. 46 WILLIAM A. HASLER Trustee Trustee of Schwab Co-Chief Executive Mr. Hasler is on the Board of November 22, 1941 Investments since Officer, Aphton Airlease Ltd. (aircraft 2000. Corporation leasing), Mission West (bio-pharmaceuticals). Properties (commercial real Prior to August 1998, Mr. estate), Stratex Corp. (a Hasler was Dean of the network equipment Haas School of Business corporation), Solectron at the University of Corporation where he is also California, Berkeley Non-Executive Chairman (higher education). (manufacturing) and in 2004, Laudus Trust and Laudus Variable Insurance Trust. Mr. Hasler is also the Public Governor and member of the Executive Committee for Pacific Stock & Options Exchange. Until 2004, Mr. Hasler was on the Board of Tenera, Inc. (services and software). GERALD B. SMITH Trustee Trustee of Schwab Since 1990, Chairman and Mr. Smith is also on the September 28, 1950 Investments since Chief Executive Officer Board of Rorento N.V. 2000. and founder of Smith (investments - Netherlands) Graham & Co. (investment and Cooper Industries advisors). (electrical products, tools and hardware), and is a member of the audit committee of Northern Border Partners, L.P. (energy); Director until 2002, Pennzoil Quaker State Company (oil and gas). INTERESTED TRUSTEES CHARLES R. SCHWAB 3 Chairman and Chairman and Chairman, Chief Executive Director, Siebel Systems (a July 29, 1937 Trustee Trustee of Schwab Officer and Director, The software company) and Xign, Investments since Charles Schwab Inc. (a developer of 1991. Corporation, Charles electronic payment systems); Schwab & Co., Inc.; Trustee, Stanford University, Chairman and since 1993;
-------------- 3 In addition to his employment with the investment adviser and the distributor, Mr. Schwab also owns stock of The Charles Schwab Corporation. Mr. Schwab is an Interested Trustees because he is an employee of Schwab and/or the adviser. 47 Director,Charles Schwab since 1993; Director, Management, Inc.; Investment TrustMark, Inc.; Director, Chairman, Charles Schwab The Gap, Inc. (clothing Holdings (UK); Chief retailer), until May 2004; Executive Officer and Director, The Charles Schwab Director, Schwab Trust Company, until July Holdings, Inc.; Chairman 2001; Director, Audiobase, and Chief Executive Inc. (full-service audio Officer, Schwab (SIS) solutions for the Internet), Holdings, Inc. I, Schwab until March 2002; Director, International Holdings, Vodaphone AirTouch PLC (a Inc.; Director, U.S. telecommunications company) Trust Corporation, United until May 2002. States Trust Company of New York; Co-Chief Executive Officer until May 2003, The Charles Schwab Corporation. OFFICERS EVELYN DILSAVER President and Officer of Executive Vice President May 4, 1955 Chief Executive Schwab Charles Schwab & Co., Officer Investments since Inc. and President, 2004. Charles Schwab Investment Management, Inc. From June 2003 to July 2004, Ms. Dilsaver was Senior Vice President of the Asset Management Products and Services Enterprise, with responsibility for product development and distribution. Prior to this, Ms. Dilsaver was Executive Vice President of U.S. Trust, a subsidiary of The Charles Schwab Corporation, as their chief financial officer and chief administrative officer.
48 STEPHEN B. WARD Senior Vice Officer of Schwab Director, Senior Vice April 5, 1955 President and Investments since President and Chief Chief Investment 1991. Investment Officer, Officer. Charles Schwab Investment Management, Inc.; Chief Investment Officer, The Charles Schwab Trust Company. GREGORY HAND Acting Treasurer Acting Officer of Director, Fund and Principal Schwab Administration Charles Financial Officer Investments since Schwab Investment 2004 Management. KOJI E. FELTON Secretary Officer of Schwab Senior Vice President, March 13, 1961 Investments since Chief Counsel and 1998. Assistant Corporate Secretary, Charles Schwab Investment Management, Inc. Prior to June 1998, Mr. Felton was a Branch Chief in Enforcement at the U.S. Securities and Exchange Commission in San Francisco.
The continuation of each fund's investment advisory agreement must be specifically approved at least annually (1) by the vote of the trustees or by a vote of the shareholders of a fund, and (2) by the vote of a majority of the trustees who are not parties to the investment advisory agreement or "interested persons" of any party (the Independent Trustees), cast in person at a meeting called for the purpose of voting on such approval. Each year, the Board of Trustees calls and holds a meeting to decide whether to renew the investment advisory agreement between the Trust and CSIM (the "Agreement"). In preparation for the meeting, the Board requests and reviews a wide variety of materials provided by the funds' investment adviser, as well as extensive data provided by third parties, and the independent trustees receive advice from counsel to the Independent Trustees. At the May 13, 2004 meeting, the Board of Trustees, the trustees, including a majority of Independent Trustees, approved the the Agreement based on its consideration and evaluation of a variety of specific factors such as: (1) the nature and quality of the services provided to the funds under the Agreement; (2) the funds' expenses under the Agreement and how those expenses compared to those of other comparable mutual funds; (3) each fund's investment performance and how it compared to that of other comparable mutual funds; and (4) the profitability of CSIM and its affiliates, including Schwab, with respect to each fund, including both direct and indirect 49 benefits accruing to CSIM and its affiliates. First, with respect to the nature and quality of the services provided by CSIM to the funds, the trustees considered, among other things, CSIM's personnel, experience, track record and compliance program. The trustees also considered how Schwab's extensive branch network, around-the-clock access, Internet access, investment and research tools, telephone services, and array of account features benefit the funds. The trustees also considered Schwab's excellent reputation as a full service firm and its overall financial condition. Second, with respect to the funds' expenses under the Agreement, the trustees considered each fund's net operating expense ratio in comparison to those of other comparable mutual funds, such "peer groups" and comparisons having been selected and calculated by an independent third party. The trustees also considered the existence of any economies of scale and whether those were passed along to a funds' shareholders through a graduated investment advisory fee schedule or other means, including any fee waivers by CSIM and its affiliates. The trustees also considered information about average expense ratios of funds in each fund's respective peer group and the effects of CSIM's and Schwab's voluntary waiver of management and other fees to prevent total fund expenses from exceeding a specified cap. Third, with respect to fund performance, the trustees considered each fund's performance relative to its peer group and appropriate indices/benchmarks, in light of total return and market trends. The trustees considered the composition of the peer group, selection criteria, and the reputation of the third party who prepared the analysis. In evaluating performance, the trustees considered both risk and shareholder risk expectations for a given fund. Fourth, with regard to profitability, the trustees considered all compensation flowing to CSIM and its affiliates, directly or indirectly. In determining profitability of CSIM and its affiliates, the trustees reviewed management's profitability analyses with the assistance of an independent registered public accounting firm. The trustees also considered whether the levels of compensation and profitability under the Agreement and other service agreements were reasonable and justified in light of the quality of all services rendered to the funds by CSIM and its affiliates. In its deliberation, the board did not identify any particular information that was all-important or controlling. Based on the trustees' deliberation and its evaluation of the information described above, the Board, including all of the Independent Trustees, unanimously approved the continuation of the Agreement and concluded that the compensation under the Agreement is fair and reasonable in light of such services and expenses and such other matters as the trustees have considered to be relevant in the exercise of their reasonable judgment. At the August 31-September 1, 2004 meeting, the trustees including all of the Independent Trustees, unanimously approved amending the Agreement to include the Schwab Tax-Free YieldPlus Fund(TM) and the Schwab California Tax-Free YieldPlus Fund(TM) concluding that the compensation under the Agreement is fair and reasonable in light of the services and expenses. The trustees' approval was based on consideration and evaluation of (i) materials received for the May 13, 2004 meeting, which were similar to those outlined above; (ii) updated information requested specifically for the August - September meeting regarding the nature and quality of services to be provided to the fund under the Agreement, the proposed level of each new fund's expenses under the Agreement and how those expenses compared to other comparable mutual funds and the expected profitability of CSIM, and its affiliates, including Schwab, with respect to the fund; and (iii) such other matters as the trustees considered to be relevant in the exercise of 50 their reasonable judgment. In its deliberation, the trustees did not identify any particular information that was all important or controlling. TRUSTEE COMMITTEES The trust has an Audit/Portfolio Compliance Committee that is comprised of all of the Independent Trustees. This Committee reviews financial statements and other audit-related matters for the trust; it does this at least quarterly and, if necessary, more frequently. The Committee met 4 times during the most recent fiscal year. The trust has a Nominating Committee that is comprised of all of the Independent Trustees, which meets as often as deemed appropriate by the Nominating Committee for the primary purpose of nominating persons to serve as a member of the Board of Trustees. This Committee did not meet during the most recent fiscal year. The Committee does not have specific procedures in place to consider nominees recommended by shareholders, but would consider such nominees if submitted in accordance with Rule 14a-8 of the 1934 Act in conjunction with a shareholder meeting to consider the election of trustees. The following tables provide trustee compensation information for the fiscal year ended August 31, 2004. Unless otherwise stated, information is for the fund complex. TAXABLE BOND FUNDS
Pension or ($) Retirement Aggregate Compensation Benefits ($) Total From Each Fund 1 Accrued as Compensation Short-Term Bond Total Bond Part of Fund from Fund Name of Trustee Market Market YieldPlus GNMA Expenses Complex 2 --------------------------------------------------------------------------------------------------------- Charles R. Schwab $0 $0 $0 $0 N/A $0 Mariann Byerwalter $1,606 $1,890 $2,976 $1,053 N/A $180,566 Donald F. Dorward $1,606 $1,890 $2,976 $1,053 N/A $155,010 William A. Hasler $1,606 $1,890 $2,976 $1,053 N/A $180,566 Robert G. Holmes $1,606 $1,890 $2,976 $1,053 N/A $155,010 Gerald B. Smith $1,606 $1,890 $2,976 $1,053 N/A $155,010 Donald R. Stephens $1,544 $1,820 $2,852 $1,013 N/A $148,920
------------ 1 Compensation for the fiscal period ending August 31, 2004. 2 Unless otherwise stated, information is for the fund complex which included 60 funds as of August 31, 2004. 51 Michael W. Wilsey $1,606 $1,890 $2,976 $1,053 N/A $155,010
52 TAX-FREE BOND FUNDS
($) Aggregate Compensation from each Fund 1 Pension or California California Retirement ($) Short/Inter- Short/Inter- Long- Benefits Total mediat Tax- Long-Term mediate Term Tax- Accrued as Compensation Free Bond Tax-Free Tax-Free Free Bond Part of Fund from Fund Name of Trustee Fund Bond Fund Bond Fund Fund Expenses Complex 2 --------------------------------------------------------------------------------------------------------------------- Charles R. Schwab $0 $0 $0 $0 N/A $0 Mariann Byerwalter $1,157 $1,086 $1,159 $1,174 N/A $180,566 Donald F. Dorward $1,157 $1,086 $1,159 $1,174 N/A $155,010 William A. Hasler $1,157 $1,086 $1,159 $1,174 N/A $180,566 Robert G. Holmes $1,157 $1,086 $1,159 $1,174 N/A $155,010 Gerald B $1,157 $1,086 $1,159 $1,174 N/A $155,010 Smith Donald R. Stephens $1,113 $1,044 $1,115 $1,130 N/A $148,920 Michael W. Wilsey $1,157 $1,086 $1,159 $1,174 N/A $155,010
----------- 1 Compensation for the fiscal period ending August 31, 2004. 2 Unless otherwise stated, information is for the fund complex which included 60 funds as of August 31, 2004. 53 TAX-FREE YIELDPLUS AND CALIFORNIA TAX-FREE YIELDPLUS FUNDS
($) ($) Estimated Pension or Estimated Name of Trustee ($) Estimated Aggregate Retirement Benefits Total Estimated Aggregate Compensation from the Accrued as Part Compensation Compensation from the California Tax-Free of Fund from Fund Tax-Free YieldPlus Fund 3 YieldPlus Fund Expenses Complex 4 -------------------------------------------------------------------------------------------------------- Charles R. Schwab 0 0 N/A 0 Mariann Byerwalter $1,000 $1,000 N/A $180,566 Donald F. Dorward $1,000 $1,000 N/A $155,010 William A. Hasler $1,000 $1,000 N/A $180,566 Robert G. Holmes $1,000 $1,000 N/A $155,010 Gerald B. Smith $1,000 $1,000 N/A $155,010 Donald R. Stephens $1,000 $1,000 N/A $155,010 Michael W. Wilsey $1,000 $1,000 N/A $155,010
SECURITIES BENEFICIALLY OWNED BY EACH TRUSTEE The following tables provide information as of December 31, 2003, with respect to a dollar range of securities beneficially owned by each trustee. -------- 3 Estimated compensation for the fiscal period ending August 31, 2004. 4 Unless otherwise stated, information is for the fund complex which included 60 funds as of August 31, 2004. 54 TAXABLE BOND FUNDS
Dollar Range of Trustee Ownership of Equity Securities in the Fund Aggregate Dollar Range of Trustee Ownership In the Family of Investment Name of Trustee Short-Term Bond Total Bond Market YieldPlus Fund GNMA Fund Companies ------------------------------------------------------------------------------------------------------------------------------ Charles R. Schwab Over $100,000 None $50,001 - $100,000 None Over $100,000 Mariann Byerwalter $50,001- $100,000 None None None Over $100,000 Donald F. Dorward None None None None Over $100,000 William A. Hasler None None None None Over $100,000 Robert G. Holmes None None None None Over $100,000 Gerald B. Smith None None None None Over $100,000 Donald R. Stephens None None None None Over $100,000 Michael W. Wilsey None None None None Over $100,000
TAX-FREE BOND FUNDS
Dollar Range of Trustee Ownership of Equity Securities in the Fund California California Aggregate Dollar Range Short/Inter-mediate Long-Term of Trustee Ownership In the Short/Inter-mediate Long-Term Tax-Free Bond Tax-Free Family of Investment Name of Trustee Tax-Free Bond Fund Tax-Free Bond Fund Fund Bond Fund Companies -------------------------------------------------------------------------------------------------------------------------------- Charles R. Schwab None None None None Over $100,000 Mariann Byerwalter None None None None $100,000 Donald F. Dorward None None None $10,001-$50,000 Over $100,000 William A. Hasler None None None None Over $100,000 Robert G. Holmes None None None None Over $100,000 Gerald B. Smith None None None None Over $100,000 Donald R. Stephens None None None None Over $100,000 Michael W. Wilsey None None None None Over $100,000
55 SCHWAB YIELDPLUS FUND AND GNMA FUND
Name of Trustee Dollar Range of Trustee Ownership of Equity Aggregate Dollar Range of Trustee Ownership Securities in the Fund In the Family of Investment Companies YieldPlus Fund GNMA Fund -------------------------------------------------------------------------------------------------------------------- Charles R. Schwab Over $100,000 None Over $100,000 Mariann Byerwalter None None Over $100,000 Donald F. Dorward None None Over $100,000 William A. Hasler None None Over $100,000 Robert G. Holmes None None Over $100,000 Gerald B. Smith None None Over $100,000 Donald R. Stephens None None Over $100,000 Michael W. Wilsey Over $100,000 None Over $100,000
DEFERRED COMPENSATION PLAN Independent Trustees may enter into a fee deferral plan. Under this plan, deferred fees will be credited to an account established by the trust as of the date that such fees would have been paid to the trustee. The value of this account will equal the value that the account would have if the fees credited to the account had been invested in the shares of SchwabFunds(R) selected by the trustee. Currently, none of the Independent Trustees has elected to participate in this plan. CODE OF ETHICS The funds, their investment adviser and Schwab have adopted a Code of Ethics (Code) as required under the 1940 Act. Subject to certain conditions or restrictions, the Code permits the trustees, directors, officers or advisory representatives of the funds or the investment adviser or the directors or officers of Schwab to buy or sell directly or indirectly securities for their own accounts. This includes securities that may be purchased or held by the funds. Securities transactions by some of these individuals may be subject to prior approval of the investment adviser's Chief Compliance Officer or alternate. Most securities transactions are subject to quarterly reporting and review requirements. DESCRIPTION OF PROXY VOTING POLICY AND PROCEDURES Charles Schwab Investment Management ("CSIM"), as an investment adviser, is generally responsible for voting proxies with respect to the securities held in accounts of investment companies for which it provides discretionary investment management services. CSIM 's Proxy Committee exercises and documents CSIM's responsibility with regard to voting of client proxies (the "Proxy Committee"). The Proxy Committee is composed of representatives of CSIM's Compliance, Fund Administration, Legal and Portfolio Management Departments, and chaired by CSIM's Chief Investment Officer. The Chairman of the Committee may appoint the remaining 56 members of the Committee. The Proxy Committee reviews and, as necessary, may amend periodically these Procedures to address new or revised proxy voting policies or procedures. The policies stated in these Proxy Voting Policy and Procedures (the "CSIM Proxy Procedures") pertain to all of CSIM's clients. The Boards of Trustees (the "Trustees") of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust, and Schwab Annuity Portfolios (collectively, the "Funds" or "SchwabFunds") has delegated the responsibility for voting proxies to CSIM through their respective Investment Advisory and Administration Agreements. The Trustees have adopted these Proxy Procedures with respect to proxies voted on behalf of the various SchwabFunds portfolios. CSIM will present amendments to the Trustees for approval. However, there may be circumstances where the Proxy Committee deems it advisable to amend the Proxy Procedures between regular SchwabFunds Board meetings. In such cases, the Trustees will be asked to ratify any changes at the next regular meeting of the Board. To assist CSIM in its responsibility for voting proxies and the overall proxy voting process, CSIM has retained Institutional Shareholder Services ("ISS") as an expert in the proxy voting and corporate governance area. ISS is an independent company that specializes in providing a variety of proxy-related services to institutional investment managers, plan sponsors, custodians, consultants, and other institutional investors. The services provided by ISS include in-depth research, global issuer analysis, and voting recommendations as well as vote execution, reporting and record keeping. PROXY VOTING POLICY For investment companies and other clients for which CSIM exercises its responsibility for voting proxies, it is CSIM's policy to vote proxies in the manner that CSIM and the Proxy Committee determine will maximize the economic benefit to CSIM's clients. In furtherance of this policy, the Proxy Committee has received and reviewed ISS's written proxy voting policies and procedures ("ISS's Proxy Procedures") and has determined that ISS's Proxy Procedures are consistent with the CSIM Proxy Procedures and CSIM's fiduciary duty with respect to its clients. The Proxy Committee will review any material amendments to ISS's Proxy Procedures to determine whether such procedures continue to be consistent with the CSIM Proxy Voting Procedures, and CSIM's fiduciary duty with respect to its clients. Except under the circumstances described below, the Proxy Committee will delegate to ISS responsibility for voting proxies on behalf of CSIM's clients in accordance with ISS's Proxy Procedures. For proxy issues that are not addressed by ISS's Proxy Procedures or are determined by the Proxy Committee or the applicable portfolio manager or other relevant portfolio management staff to raise significant concerns with respect to the accounts of CSIM clients, the Proxy Committee will review the analysis and recommendation of ISS. Examples of factors that could cause a matter to raise significant concerns include, but are not limited to: issues whose outcome has the potential to materially affect the company's industry, or regional or national economy, and matters which involve broad public policy developments which may similarly materially affect the environment in which the company operates. The Proxy Committee also will solicit input from the assigned portfolio manager and other relevant portfolio management staff for the particular portfolio security. After evaluating all such recommendations, the Proxy Committee will decide how to vote the shares and will instruct ISS to vote consistent with its decision. The Proxy Committee has the ultimate responsibility for making the determination of how to vote the shares in order to 57 maximize the value of that particular holding. Conflicts of Interest. For all proxy issues, whether routine or non-routine, that present material conflicts of interest between CSIM, and/or any of its affiliates, and CSIM's clients, CSIM will delegate to ISS responsibility for voting such proxies in accordance with ISS's Proxy Procedures. Voting Foreign Proxies. CSIM has arrangements with ISS for voting proxies. However, voting proxies with respect to shares of foreign securities may involve significantly greater effort and corresponding cost than voting proxies with respect to domestic securities, due to the variety of regulatory schemes and corporate practices in foreign countries with respect to proxy voting. Problems voting foreign proxies may include the following: o proxy statements and ballots written in a foreign language; o untimely and/or inadequate notice of shareholder meetings; o restrictions of foreigner's ability to exercise votes; o requirements to vote proxies in person; o the imposition of restrictions on the sale of securities for a period of time in proximity to the shareholder meeting; o requirements to provide local agents with power of attorney to facilitate CSIM's voting instructions. In consideration of the foregoing issues, ISS uses its best-efforts to vote foreign proxies. As part of its ongoing oversight, the Proxy Committee will monitor the voting of foreign proxies to determine whether all reasonable steps are taken to vote foreign proxies. If the Proxy Committee determines that the cost associated with the attempt to vote outweighs the potential benefits clients may derive from voting, the Proxy Committee may decide not to attempt to vote. Sub-Advisory Relationships. For investment companies or other clients that CSIM has delegated day-to-day investment management responsibilities to an investment adviser, CSIM may delegate its responsibility to vote proxies with respect to such investment companies' or other clients' securities. Each Sub-adviser to whom proxy voting responsibility has been delegated will be required to review all proxy solicitation material and to exercise the voting rights associated with the securities as it has been allocated in the best interest of each investment company and its shareholders, or other client. Prior to delegating the proxy voting responsibility, CSIM will review each sub-adviser's proxy voting policy to ensure that each Sub-adviser's proxy voting policy is generally consistent with the maximization of economic benefits to the investment company or other client. REPORTING AND RECORD RETENTION CSIM will maintain, or cause ISS to maintain, records which identify the manner in which proxies have been voted (or not voted) on behalf of CSIM clients. CSIM will comply with all applicable rules and regulations regarding disclosure of its or its clients proxy voting records and procedures. CSIM will retain all proxy voting materials and supporting documentation as required under the Investment Advisers Act of 1940 and the rules and regulations thereunder. PROXY COMMITTEE QUORUM 58 Attendance by four members (or their respective designates) constitutes a quorum. ISS PROXY VOTING GUIDELINES SUMMARY Following is a concise summary of ISS's current proxy voting policy guidelines. 1. AUDITORS Vote CASE-BY-CASE on shareholder proposals on auditor rotation, taking into account these factors: o Tenure of the audit firm o Establishment and disclosure of a renewal process whereby the auditor is regularly evaluated for both audit quality and competitive price o Length of the rotation period advocated in the proposal o Significant audit-related issues 2. BOARD OF DIRECTORS VOTING ON DIRECTOR NOMINEES IN UNCONTESTED ELECTIONS Generally, vote CASE-BY-CASE. But WITHHOLD votes from: o Insiders and affiliated outsiders on boards that are not at least majority independent o Directors who sit on more than six boards o Compensation Committee members if there is a disconnect between the CEO's pay and performance CLASSIFICATION/DECLASSIFICATION OF THE BOARD Vote AGAINST proposals to classify the board. Vote FOR proposals to repeal classified boards and to elect all directors annually. INDEPENDENT CHAIRMAN (SEPARATE CHAIRMAN/CEO) Vote FOR shareholder proposals asking that the chairman and CEO positions be separated (independent chairman), unless the company has a strong countervailing governance structure, including a lead director, two-thirds independent board, all independent key committees, and established governance guidelines. MAJORITY OF INDEPENDENT DIRECTORS/ESTABLISHMENT OF COMMITTEES Vote FOR shareholder proposals asking that a majority or more of directors be independent unless the board composition already meets the proposed threshold by ISS's definition of independence. OPEN ACCESS (SHAREHOLDER RESOLUTION) Vote CASE-BY-CASE basis, taking into account the ownership threshold proposed in the resolution and the proponent's rationale. 3. SHAREHOLDER RIGHTS SHAREHOLDER ABILITY TO ACT BY WRITTEN CONSENT Vote against proposals to restrict or prohibit shareholder ability to take action by written consent. 59 Vote for proposals to allow or make easier shareholder action by written consent. SHAREHOLDER ABILITY TO CALL SPECIAL MEETINGS Vote against proposals to restrict or prohibit shareholder ability to call special meetings. Vote for proposals that remove restrictions on the right of shareholders to act independently of management. SUPERMAJORITY VOTE REQUIREMENTS Vote AGAINST proposals to require a supermajority shareholder vote. VOTE FOR PROPOSALS TO LOWER SUPERMAJORITY VOTE REQUIREMENTS. CUMULATIVE VOTING Vote against proposals to eliminate cumulative voting. Vote proposals to restore or permit cumulative voting on a case-by-case basis relative to the company's other governance provisions. CONFIDENTIAL VOTING Vote FOR shareholder proposals requesting that corporations adopt confidential voting, use independent vote tabulators and use independent inspectors of election. In proxy contests, support confidential voting proposals only if dissidents agree to the same policy that applies to management. 4. PROXY CONTESTS VOTING FOR DIRECTOR NOMINEES IN CONTESTED ELECTIONS Votes in a contested election of directors must be evaluated on a CASE-BY-CASE basis, considering the factors that include the long-term financial performance, management's track record, qualifications of director nominees (both slates), and an evaluation of what each side is offering shareholders. REIMBURSING PROXY SOLICITATION EXPENSES Vote CASE-BY-CASE. Where ISS recommends in favor of the dissidents, we also recommend voting for reimbursing proxy solicitation expenses. 5. POISON PILLS Vote for shareholder proposals that ask a company to submit its poison pill for shareholder ratification. Review on a case-by-case basis shareholder proposals to redeem a company's poison pill and management proposals to ratify a poison pill. 6. MERGERS AND CORPORATE RESTRUCTURINGS Vote CASE-BY-CASE on mergers and corporate restructurings based on such features as the fairness opinion, pricing, strategic rationale, and the negotiating process. 7. REINCORPORATION PROPOSALS Proposals to change a company's state of incorporation should be evaluated on a CASE-BY-CASE basis, giving consideration to both financial and corporate governance concerns, including the reasons for reincorporating, a comparison of the governance provisions, and a comparison of the jurisdictional laws. Vote FOR reincorporation when the economic factors outweigh any 60 neutral or negative governance changes. 8. CAPITAL STRUCTURE COMMON STOCK AUTHORIZATION Votes on proposals to increase the number of shares of common stock authorized for issuance are determined on a CASE-BY-CASE basis using a model developed by ISS. Vote AGAINST proposals at companies with dual-class capital structures to increase the number of authorized shares of the class of stock that has superior voting rights. Vote FOR proposals to approve increases beyond the allowable increase when a company's shares are in danger of being delisted or if a company's ability to continue to operate as a going concern is uncertain. DUAL-CLASS STOCK Vote AGAINST proposals to create a new class of common stock with superior voting rights. Vote FOR proposals to create a new class of nonvoting or subvoting common stock if: o It is intended for financing purposes with minimal or no dilution to current shareholders o It is not designed to preserve the voting power of an insider or significant shareholder 9. EXECUTIVE AND DIRECTOR COMPENSATION ISS applies a quantitative methodology, but for Russell 3000 companies will also apply a pay-for-performance overlay in assessing equity-based compensation plans. Vote AGAINST a plan if the cost exceeds the allowable cap. Vote FOR a plan if the cost is reasonable (below the cap) unless either of the following conditions apply: o The plan expressly permits repricing without shareholder approval for listed companies; or o There is a disconnect between the CEO's pay and performance (an increase in pay and a decrease in performance), the main source for the pay increase is equity-based, and the CEO participates in the plan being voted on. MANAGEMENT PROPOSALS SEEKING APPROVAL TO REPRICE OPTIONS VOTES ON MANAGEMENT PROPOSALS SEEKING APPROVAL TO REPRICE OPTIONS ARE EVALUATED ON A CASE-BY-CASE BASIS GIVING CONSIDERATION TO THE FOLLOWING: o Historic trading patterns o Rationale for the repricing o Value-for-value exchange o Option vesting o Term of the option o Exercise price o Participation EMPLOYEE STOCK PURCHASE PLANS VOTES ON EMPLOYEE STOCK PURCHASE PLANS SHOULD BE DETERMINED ON A CASE-BY-CASE BASIS. Vote FOR employee stock purchase plans where all of the following apply: o Purchase price is at least 85 percent of fair market value o Offering period is 27 months or less, and 61 o Potential voting power dilution (VPD) is 10 percent or less. VOTE AGAINST EMPLOYEE STOCK PURCHASE PLANS WHERE ANY OF THE OPPOSITE CONDITIONS OBTAIN. SHAREHOLDER PROPOSALS ON COMPENSATION Generally vote CASE-BY-CASE, taking into account company performance, pay level versus peers, pay level versus industry, and long term corporate outlook. But generally vote FOR shareholder proposals that: o Advocate performance-based equity awards (indexed options, premium-priced options, performance-vested awards), unless the proposal is overly restrictive or the company already substantially uses such awards o Call for a shareholder vote on extraordinary benefits contained in Supplemental Executive Retirement Plans (SERPs). 10. SOCIAL AND ENVIRONMENTAL ISSUES These issues cover a wide range of topics, including consumer and public safety, environment and energy, general corporate issues, labor standards and human rights, military business, and workplace diversity. In general, vote CASE-BY-CASE. While a wide variety of factors goes into each analysis, the overall principal guiding all vote recommendations focuses on how the proposal will enhance the economic value of the company. Vote: o FOR proposals for the company to amend its Equal Employment Opportunity (EEO) Statement to include reference to sexual orientation, unless the change would result in excessive costs for the company. o AGAINST resolutions asking for the adopting of voluntary labeling of ingredients or asking for companies to label until a phase out of such ingredients has been completed. The Trust is required to disclose annually the funds' complete proxy voting record on Form N-PX. The funds' proxy voting record for the most recent 12 month period ended June 30th is available by visiting the Schwab website at www.schwab.com/schwabfunds. The funds' Form N-PX will also be available on the SEC's website at www.sec.gov. CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES As of November 1, 2004, the officers and trustees of the funds, as a group owned of record or beneficially less than 1% of the outstanding voting securities of any class of each fund. As of November 1, 2004, the following represents persons or entities that owned, of record or beneficially, more than 5% of the outstanding voting securities of any class of the following funds: Schwab Total Bond Market Fund(TM) Schwab MarketTrack Balanced Portfolio 17.84% Schwab MarketTrack Conservative Portfolio 15.11% Schwab MarketTrack Growth Portfolio 8.61%
62 The Charles Schwab Trust 6.35%
INVESTMENT ADVISORY AND OTHER SERVICES INVESTMENT ADVISER Charles Schwab Investment Management, Inc. (CSIM or the investment adviser), a wholly owned subsidiary of The Charles Schwab Corporation, 101 Montgomery Street, San Francisco CA 94104, serves as each fund's investment adviser and administrator pursuant to an Investment Advisory and Administration Agreement (Advisory Agreement) between it and the trust. Charles Schwab & Co., Inc. (Schwab), 101 Montgomery Street, San Francisco CA 94104, is an affiliate of the investment adviser and is the trust's distributor, shareholder services agent and transfer agent. Charles R. Schwab is the founder, Chairman, Chief Executive Officer and Director of The Charles Schwab Corporation. As a result of his ownership of and interests in The Charles Schwab Corporation, Mr. Schwab may be deemed to be a controlling person of the investment adviser and Schwab. For its advisory and administrative services to each fund, the investment adviser is entitled to receive a graduated annual fee payable monthly based on each fund's average daily net assets as described below. SCHWAB SHORT-TERM BOND MARKET FUND(TM) SCHWAB TOTAL BOND MARKET FUND(TM) First $500 million - 0.30% More than $500 million - 0.22% For the fiscal years ended August 31, 2002, 2003 and 2004 the Schwab Short-Term Bond Market Fund paid net investment advisory fees of $88,000 (gross fees were reduced by $1,174,000), $820,000 (gross fees were reduced by $868,000) and $1,718,000 (gross fees were reduced by $242,000), respectively. For the fiscal years ended August 31, 2002, 2003 and 2004 the Schwab Total Bond Market Fund(TM) paid net investment advisory fees of $447,000 (gross fees were reduced by $2,127,000), $1,533,000 (gross fees were reduced by $1,169,000) and $2,507,000 (gross fees were reduced by $202,000), respectively. Schwab and the investment adviser have guaranteed that, through November 15, 2005, annual operating expenses (excluding interest, taxes and certain non-routine expenses) of the Schwab Short-Term Bond Market Fund and Schwab Total Bond Market Fund will not exceed 0.55%, of each fund's average daily net assets. SCHWAB YIELDPLUS FUND(R) First $500 million - 0.35% More than $500 million - 0.30% For the fiscal years ended August 31, 2002, 2003 and 2004 the fund paid net investment advisory fees of $3,985,000, (gross fees were reduced by $1,185,000), $5,563,000 (gross fees were reduced by $104,000) and $7,584,000, respectively. 63 SCHWAB GNMA FUND(TM) First $500 million - 0.45% More than $500 million to $1 billion - 0.40% More than $1 billion - 0.375% Prior to November 15, 2004 for its advisory and administrative services for the fund, the investment adviser was entitled to receive an annual fee, payable monthly from the fund of 0.45% of its average daily net assets. For the fiscal years ended August 31, 2003 and 2004, the fund paid net investment advisory fees of $121,000 (gross fees were reduced by $121,000) and $24,000 (gross fees were reduced by $166,000), respectively. Schwab and the investment adviser have guaranteed that, through at least November 15, 2005, the annual operating expenses (excluding interest, taxes and certain non-routine expenses) of the Investor Shares and Select Shares(R) of the fund will not exceed 0.74% and 0.55%, respectively, of the share class' average daily net assets. TAX-FREE BOND FUNDS, EXCEPT FOR THE SCHWAB TAX-FREE YIELDPLUS FUND AND THE SCHWAB CALIFORNIA TAX-FREE YIELDPLUS FUND First $500 million - 0.30% More than $500 million - 0.22% For the fiscal years ended August 31, 2002, 2003 and 2004 the Schwab Short/Intermediate Tax-Free Bond Fund(TM) paid net investment advisory fees of $110,000 (gross fees were reduced by $253,000) and $433,000 (gross fees were reduced by $37,000) and $501,000, respectively. For the fiscal years ended August 31, 2002, 2003 and 2004 the Schwab Long-Term Tax-Free Bond Fund(TM) paid net investment advisory fees of $45,000 (gross fees were reduced by $200,000) and $228,000 (gross fees were reduced by $33,000) and $238,000 (gross fees were reduced by $10,000), respectively. For the fiscal years ended August 31, 2002, 2003 and 2004 the Schwab California Short/Intermediate Tax-Free Bond Fund(TM) paid net investment advisory fees of $208,000 (gross fees were reduced by $262,000) and $512,000 (gross fees were reduced by $41,000) and $509,000, respectively. Schwab and the investment adviser have guaranteed that, through November 15, 2005, that annual operating expenses (excluding interest, taxes and certain non-routine expenses) will not exceed 0.65% of the fund's average daily net assets for the Schwab Short/Intermediate Tax-Free Bond Fund, the Schwab Long-Term Tax-Free Bond Fund and the Schwab California Short/Intermediate Tax-Free Bond Fund. For the fiscal years ended August 31, 2002, 2003 and 2004 the Schwab California Long-Term Tax-Free Bond Fund(TM) paid net investment advisory fees of $329,000 (gross fees were reduced by $337,000) and $634,000 (gross fees were reduced by $48,000) and $563,000, respectively. 64 SCHWAB TAX-FREE YIELDPLUS AND SCHWAB CALIFORNIA TAX-FREE YIELDPLUS FUNDS For its advisory and administrative services to the Schwab Tax-Free YieldPlus Fund(TM) and Schwab California Tax-Free YieldPlus Fund(TM), the investment adviser is entitled to receive an annual fee, accrued daily and paid monthly, of 0.35% of each fund's average daily net assets not in excess of $500 million, and 0.30% of such net assets over $500 million. Schwab and the investment adviser have guaranteed that "net operating expenses" (excluding interest, taxes, and certain non-routine expenses) of Investor Shares and Select Shares(R) will equal 0.00% through May 1, 2005. In addition, Schwab and the investment adviser have guaranteed that, from May 2, 2005 through November 15, 2005, that net operating expenses of each fund (excluding interest, taxes and certain non-routine expenses) will not exceed 0.64% of average daily net assets for the Investor Shares and 0.49% of average daily net assets for the Select Shares. DISTRIBUTOR Pursuant to a Distribution Agreement, Schwab is the principal underwriter for shares of a fund and is the trust's agent for the purpose of the continuous offering of a fund's shares. Each fund pays the cost of the prospectuses and shareholder reports to be prepared and delivered to existing shareholders. Schwab pays such costs when the described materials are used in connection with the offering of shares to prospective investors and for supplemental sales literature and advertising. Schwab receives no fee under the Distribution Agreement. SHAREHOLDER SERVICES AND TRANSFER AGENT Schwab provides fund information to shareholders, including share price, reporting shareholder ownership and account activities and distributing a fund's prospectuses, financial reports and other informational literature about the funds. Schwab maintains the office space, equipment and personnel necessary to provide these services. Schwab also distributes and markets SchwabFunds(R) and provides other services. At its own expense, Schwab may engage third party entities, as appropriate, to perform some or all of these services. For the services performed as transfer agent under its contract with a fund, Schwab is entitled to receive an annual fee, payable monthly from each fund, in the amount of 0.05% of a fund's average daily net assets. For the services performed as shareholder services agent under its contract with the Bond Funds and Tax-Free Bond Funds except the Schwab Tax-Free YieldPlus Fund(TM) and Schwab California Tax-Free YieldPlus Fund(TM), Schwab is entitled to receive an annual fee, payable monthly from each class of shares of the funds, in the amount of 0.20% of the Investor Shares' average daily net assets and 0.05% of the Select Shares' average daily net assets. CUSTODIAN AND FUND ACCOUNTANT PFPC Trust company, 8800 Tinicum Blud., Third Floor Suite 200, Philadelphia, PA 19153, serves as custodian for the funds and PFPC, Inc., 400 Bellevue Parkway, Wilmington, DE 19809, serves as fund accountant. The custodian is responsible for the daily safekeeping of securities and cash held or sold by the funds. The accountant maintains the books and records related to each fund's transactions. 65 INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The funds' independent registered public accounting firm, PricewaterhouseCoopers LLP, audits and reports on the annual financial statements of each series of the trust and reviews certain regulatory reports and each fund's federal income tax return. They also perform other professional accounting, auditing, tax and advisory services when the trust engages them to do so. Their address is 333 Market Street, San Francisco, CA 94105. Each fund's audited financial statements for the fiscal year ending August 31, 2004, are included in the fund's annual report that is supplied with the SAI. LEGAL COUNSEL Morgan, Lewis & Bockius LLP serves as counsel to the Trust. BROKERAGE ALLOCATION AND OTHER PRACTICES PORTFOLIO TURNOVER For reporting purposes, a fund's turnover rate is calculated by dividing the value of purchases or sales of portfolio securities for the fiscal year, whichever is less, by the monthly average value of portfolio securities a fund owned during the fiscal year. When making the calculation, all securities whose maturities at the time of acquisition were one year or less ("short-term securities") are excluded. TAX-FREE YIELDPLUS FUND AND CALIFORNIA TAX-FREE YIELDPLUS FUND During the first year of operation, the Schwab Tax-Free YieldPlus Fund(TM) and Schwab California Tax-Free YieldPlus Fund(TM) may have a high portfolio turnover rate, which could increase transaction costs and the likelihood of capital gain distributions. TAXABLE BOND FUNDS The portfolio turnover rates for the Schwab Short-Term Bond Fund(TM) for the fiscal years ended August 31, 2003 and 2004 were 124% and 114%, respectively. The portfolio turnover rates for the Schwab Total Bond Market Fund(TM) for the fiscal years ended August 31, 2003 and 2004 were 121% and 223%, respectively. The fund's increased portfolio turnover rate was largely driven by its increased dollar-roll transactions and increased investments in mortgage pools. YIELDPLUS FUND The portfolio turnover rates for the Schwab YieldPlus Fund(R) for the fiscal years ended August 31, 2003 and 2004 were 109% and 89%, respectively. 66 GNMA FUND The portfolio turnover rates for the Schwab GNMA Fund(TM) for the fiscal years ended August 31, 2003 and 2004 were 105% and 199%. The fund's increased portfolio turnover rate reflects its completion of a full fiscal year of operation over a partial year of operation in 2003. TAX-FREE BOND FUNDS The portfolio turnover rates for the Schwab Short/Intermediate Tax-Free Bond Fund(TM) for the fiscal years ended August 31, 2003 and 2004 were 11% and 19%, respectively. The portfolio turnover rates for the Schwab Long-Term Tax-Free Bond Fund(TM) for the fiscal years ended August 31, 2003 and 2004 were 22% and 10%, respectively. The portfolio turnover rates for the Schwab California Short/Intermediate Tax-Free Bond Fund(TM) for the fiscal years ended August 31, 2003 and 2004 were 11% and 17%, respectively. The portfolio turnover rates for the Schwab California Long-Term Tax-Free Bond Fund(TM) for the fiscal years ended August 31, 2003 and 2004 were 29% and 15%, respectively. PORTFOLIO TRANSACTIONS The Taxable Bond Funds, Tax-Free Bond Funds, YieldPlus Fund and GNMA Fund paid no brokerage commissions in the last 3 fiscal years. The investment adviser makes decisions with respect to the purchase and sale of portfolio securities on behalf of the funds. The investment adviser is responsible for implementing these decisions, including the negotiation of commissions and the allocation of principal business and portfolio brokerage. Purchases and sales of securities on a stock exchange or certain riskless principal transactions placed on NASDAQ are typically effected through brokers who charge a commission for their services. Purchases and sales of fixed income securities may be transacted with the issuer, the issuer's underwriter, or a dealer. The funds do not usually pay brokerage commissions on purchases and sales of fixed income securities, although the price of the securities generally includes compensation, in the form of a spread or a mark-up or mark-down, which is not disclosed separately. The prices the funds pay to underwriters of newly-issued securities usually include a commission paid by the issuer to the underwriter. Transactions placed through dealers who are serving as primary market makers reflect the spread between the bid and asked prices. The money market securities in which certain of the funds invest are traded primarily in the over-the-counter market on a net basis and do not normally involve either brokerage commissions or transfer taxes. It is expected that the cost of executing portfolio securities transactions of the funds will primarily consist of dealer spreads and underwriting commissions. The investment adviser seeks to obtain the best execution in executing portfolio transactions. The investment adviser may take a number of factors into account in selecting brokers or dealers to execute these transactions. Such factors may include, without limitation, the following: execution price; brokerage commission or dealer spread; size or type of the transaction; nature or character of the markets; clearance or settlement capability; reputation; financial strength and stability of the broker or dealer; efficiency of execution and error resolution; block trading capabilities; willingness to execute related or unrelated difficult transactions in the future; order of call; or provision of additional brokerage or research services or products. 67 The investment adviser may cause the fund to pay a higher commission than otherwise obtainable from other brokers or dealers in return for brokerage or research services or products if the investment adviser believes that such commission is reasonable in relation to the services provided. In addition to agency transactions, the investment adviser may receive brokerage and research services or products in connection with certain riskless principal transactions, in accordance with applicable SEC and other regulatory guidelines. In both instances, these services or products may include: economic, industry, or company research reports or investment recommendations; subscriptions to financial publications or research data compilations; compilations of securities prices, earnings, dividends, and similar data; computerized databases; quotation equipment and services; research or analytical computer software and services; products or services that assist in effecting transactions, including services of third-party computer systems developers directly related to research and brokerage activities; and effecting securities transactions and performing functions incidental thereto (such as clearance and settlement). The investment adviser may use research services furnished by brokers or dealers in servicing all client accounts and not all services may necessarily be used in connection with the account that paid commissions to the broker or dealer providing such services. The investment adviser may receive a service from a broker or dealer that has both a "research" and a "non-research" use. When this occurs, the investment adviser will make a good faith allocation, under all the circumstances, between the research and non-research uses of the service. The percentage of the service that is used for research purposes may be paid for with client commissions, while the investment adviser will use its own funds to pay for the percentage of the service that is used for non-research purposes. In making this good faith allocation, the investment adviser faces a potential conflict of interest, but the investment adviser believes that that the costs of such services may be appropriately allocated to their anticipated research and non-research uses. The funds may purchase new issues of securities for clients in a fixed price offering. In these situations, the seller may be a member of the selling group that will, in addition to selling securities, provide the investment adviser with research services, in accordance with applicable rules and regulations permitting these types of arrangements. The investment adviser may place orders with electronic communications networks or other alternative trading systems. Placing orders with electronic communications networks or other alternative trading systems may enable the funds to trade directly with other institutional holders. At times, this may allow the funds to trade larger blocks than would be possible trading through a single market maker. The investment adviser may aggregate securities sales or purchases among two or more clients. The investment adviser will not aggregate transactions unless it believes such aggregation is consistent with its duty to seek best execution for each affected client and is consistent with the terms of the investment advisory agreement for such client. In any single transaction in which purchases and/or sales of securities of any issuer for the account of a fund are aggregated with other accounts managed by the investment adviser, the actual prices applicable to the transaction will be averaged among the accounts for which the transaction is effected, including the account of the fund. In determining when and to what extent to use Schwab or any other affiliated broker-dealer as its broker for executing orders for the funds on securities exchanges, the investment adviser follows procedures, adopted by the Board of Trustees, that are designed to ensure that affiliated brokerage commissions (if relevant) are reasonable and fair in comparison to unaffiliated brokerage commissions for comparable transactions. The Board reviews the procedures annually and 68 approves and reviews transactions involving affiliated brokers quarterly. REGULAR BROKER-DEALERS Each fund's regular broker-dealers during its most recent fiscal year are: (1) the ten broker-dealers that received the greatest dollar amount of brokerage commissions from the fund; (2) the ten broker-dealers that engaged as principal in the largest dollar amount of portfolio transactions; and (3) the ten broker-dealers that sold the largest dollar amount of the fund's shares. As of August 31, 2004, certain of the funds held securities issued by their respective regular broker-dealers, as indicated below. SCHWAB SHORT-TERM BOND MARKET FUND(TM)
Value of Fund's Holdings Regular Broker-Dealer as of August 31, 2004 -------------------------------------------------------------------------------- Morgan Stanley $7,192,000 J.P. Morgan Chase & Co. $6,027,000 Goldman Sachs Group, Inc. $5,014,000 Credit Suisse First Boston International Corp. $3,011,000
SCHWAB TOTAL BOND MARKET FUND(TM)
Value of Fund's Holdings Regular Broker-Dealer as of August 31, 2004 -------------------------------------------------------------------------------- J.P Morgan Chase & Co. $17,065,000 Goldman Sachs & Co. $5,020,000 Morgan Stanley $6,362,000 Credit Suisse First Boston $4,014,000 UBS Warburg $22,999,000
SCHWAB YIELDPLUS FUND(R)
Value of Fund's Holdings Regular Broker-Dealer as of August 31, 2004 -------------------------------------------------------------------------------- Credit Suisse First Boston $38,576,000 Bank of America Mortgage Securities $43,636,000 Deutsche Bank Capital Trust $51,101,000 Lehman Brothers Holdings, Inc. $38,070,000 Morgan Stanley Dean Witter Capital $143,584,000 J.P. Morgan Chase & Co. $60,316,000 Merrill Lynch & Co., Inc. $78,444,000 UBS Warburg $5,999,000
SCHWAB GNMA FUND(TM)
Value of Fund's Holdings Regular Broker-Dealer as of August 31, 2004 -------------------------------------------------------------------------------- Morgan Stanley Dean Witter Capital $333
69 DESCRIPTION OF THE TRUST Each fund is a series of Schwab Investments. Schwab Investments was organized under Massachusetts law on October 26, 1990. The Declaration of Trust provides that shares may be automatically redeemed if held by a shareholder in an amount less than the minimum required by a fund or share class. Each fund's initial and subsequent minimum investment and balance requirements are set forth in the prospectus. These minimums maybe waived, or assets aggregated to meet certain minimums, or certain clients, including clients of Schwab Institutional and Schwab Corporate Services retirement plans. Schwab may receive other compensation for providing services to these clients. These minimums may be waived for certain investors, including trustees, officers and employees of Schwab, or changed without prior notice. In addition, the minimums may also be waived for investment programs such as those programs for retirement savings, college savings, graduation gifts or charitable giving funds. Each fund may hold special shareholder meetings, which may cause the funds to incur non-routine expenses. These meetings may be called for purposes such as electing trustees, changing fundamental policies and amending management contracts. Shareholders are entitled to one vote for each share owned and may vote by proxy or in person. Proxy materials will be mailed to shareholders prior to any meetings, and will include a voting card and information explaining the matters to be voted upon. The bylaws of the trust provides that a majority of shares entitled to vote shall be a quorum for the transaction of business at a shareholders' meeting, except that where any provision of law, or of the Declaration of Trust or of the bylaws permits or requires that (1) holders of any series shall vote as a series, then a majority of the aggregate number of shares of that series entitled to vote shall be necessary to constitute a quorum for the transaction of business by that series, or (2) holders of any class shall vote as a class, then a majority of the aggregate number of shares of that class entitled to vote shall be necessary to constitute a quorum for the transaction of business by that class. Any lesser number shall be sufficient for adjournments. Any adjourned session or sessions may be held, within a reasonable time after the date set for the original meeting, without the necessity of further notice. The Declaration of Trust specifically authorizes the Board of Trustees to terminate the trust (or any of its investment portfolios) by notice to the shareholders without shareholder approval. Under Massachusetts law, shareholders of a Massachusetts business trust could, under certain circumstances, be held personally liable for the trust's obligations. The Declaration of Trust, however, disclaims shareholder liability for the trust's acts or obligations and requires that notice of such disclaimer be given in each agreement, obligation or instrument entered into or executed by the trust or the trustees. In addition, the Declaration of Trust provides for indemnification out of the property of an investment portfolio in which a shareholder owns or owned shares for all losses and expenses of such shareholder or former shareholder if he or she is held personally liable for the obligations of the trust solely by reason of being or having been a shareholder. Moreover, the trust will be covered by insurance which the trustees consider adequate to cover foreseeable tort claims. Thus, the risk of a shareholder incurring financial loss on account of shareholder liability is considered remote, because it is limited to circumstances in which a disclaimer is inoperative and the trust itself is unable to meet its obligations. There is a remote possibility that a fund could become liable for a misstatement in the prospectus or SAI about another fund. 70 As more fully described in the Declaration of Trust, the trustees may each year, or more frequently, distribute to the shareholders of each series accrued income less accrued expenses and any net realized capital gains less accrued expenses. Distributions of each year's income of each series shall be distributed pro rata to shareholders in proportion to the number of shares of each series held by each of them. Distributions will be paid in cash or shares or a combination thereof as determined by the trustees. Distributions paid in shares will be paid at the net asset value as determined in accordance with the bylaws. PURCHASE, REDEMPTION, DELIVERY OF SHAREHOLDER DOCUMENTS AND PRICING OF SHARES PURCHASING AND REDEEMING SHARES OF THE FUNDS The funds are open each day that the New York Stock Exchange (NYSE) is open (business days). The NYSE's trading session is normally conducted from 9:30 a.m. Eastern time until 4:00 p.m. Eastern time, Monday through Friday, although some days, such as in advance of and following holidays, the NYSE's trading session closes early. The following holiday closings are currently scheduled for 2005: New Year's Day, Martin Luther King Jr.'s Birthday, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day. While orders to buy, sell and exchange shares are typically accepted by Schwab at any time, only orders that are received in good order by the funds' transfer agent prior to the close of the NYSE's trading session will be executed that day at the funds' (or classes') share price calculated that day. On any day that the NYSE closes early the funds reserve the right to advance the time by which purchase, redemption and exchanges orders must be received by the funds' transfer agent that day in order to be executed that day at that day's share price. As long as the funds or Schwab follow reasonable procedures to confirm that an investor's telephone or Internet order is genuine, they will not be liable for any losses the investor may experience due to unauthorized or fraudulent instructions. These procedures may include requiring a form of personal identification or other confirmation before acting upon any telephone or Internet order, providing written confirmation of telephone or Internet orders and tape recording all telephone orders. Share certificates will not be issued in order to avoid additional administrative costs, however, share ownership records are maintained by Schwab. The funds have made an election with the SEC to pay in cash all redemptions requested by any shareholder of record limited in amount during any 90-day period to the lesser of $250,000 or 1% of its net assets at the beginning of such period. This election is irrevocable without the SEC's prior approval. Redemption requests in excess of these limits may be paid, in whole or in part, in investment securities or in cash, as the Board of Trustees may deem advisable. Payment will be made wholly in cash unless the Board of Trustees believes that economic or market conditions exist that would make such payment a detriment to the best interests of the fund. If redemption proceeds are paid in investment securities, such securities will be valued as set forth in "Pricing of Shares." A redeeming shareholder would normally incur transaction costs if he or she were to convert the securities to cash. The funds are designed for long-term investing. Because short-term trading activities can disrupt the smooth management of the fund and increase its expenses, the funds reserve the right to refuse any purchase or exchange order, or large purchase or exchange orders, including any purchase or exchange order which appears to be associated with short-term trading activities or 71 "market timing." Because market timing decisions to buy and sell securities typically are based on an individual investor's market outlook, including such factors as the perceived strength of the economy or the anticipated direction of interest rates, it is difficult for the fund to determine in advance what purchase or exchange orders may be deemed to be associated with market timing or short-term trading activities. Shares of the funds may be held only through a Schwab account or certain third-party investment providers that have an arrangement with Schwab. If you close your Schwab account, your fund shares may be redeemed unless you first transfer them to such a third-party investment provider. A fund's share price and principal value change, and when you sell your shares they may be worth less than what you paid for them. EXCHANGING SHARES OF THE FUNDS Shares of any SchwabFund, including any class of shares, may be sold and shares of any other SchwabFund or class purchased, provided the minimum investment and any other requirements of the fund or class purchased are satisfied. Without limiting this privilege, "an exchange order," which is a simultaneous order to sell shares of one fund or class and automatically invest the proceeds in another fund or class, may not be executed between shares of Sweep Investments(TM) and shares of non-Sweep Investments. Shares of Sweep Investments may be bought and sold automatically pursuant to the terms and conditions of your Schwab account agreement or by direct order as long as you meet the minimums for direct investments. In addition, different exchange policies may apply to SchwabFunds(R) that are bought and sold through third-party investment providers and the exchange privilege between SchwabFunds may not be available through third-party investment providers. The funds and Schwab reserve certain rights with regard to exchanging shares of the funds. These rights include the right to: (i) refuse any purchase or exchange order that may negatively impact the fund's operations; (ii) refuse orders that appear to be associated with short-term trading activities; and (iii) modify or terminate the exchange privilege upon 60 days' written notice to shareholders. DELIVERY OF SHAREHOLDER DOCUMENTS Typically once a year, an updated prospectus will be mailed to shareholders describing each fund's investment strategies, risks and shareholder policies. Twice a year, financial reports will be mailed to shareholders describing each fund's performance and investment holdings. In order to eliminate duplicate mailings of shareholder documents, each household may receive one copy of these documents, under certain conditions. This practice is commonly called "householding." If you want to receive multiple copies, you may write or call your fund at the address or telephone number on the front of this SAI. Your instructions will be effective within 30 days of receipt by Schwab. PRICING OF SHARES Each business day, each share class of a fund calculates its share price, or NAV, as of the close of the NYSE (generally 4 p.m. Eastern time). This means that NAVs are calculated using the values of a fund's portfolio securities as of the close of the NYSE. Such values are required to be determined in one of two ways: securities for which market quotations are readily available are required to be valued at current market value; and securities for which market quotations are not 72 readily available or the investment adviser deems them to be unreliable are required to be valued at fair value using procedures approved by the Board of Trustees. Shareholders of the funds should be aware that because foreign markets are often open on weekends and other days when the funds are closed, the value of some of the funds' securities may change on days when it is not possible to buy or sell shares of the funds. The funds use approved pricing services to provide values for their portfolio securities. Current market values are generally determined by the approved pricing services as follows: securities traded on stock exchanges, excluding the NASDAQ National Market System, are valued at the last-quoted sales price on the exchange on which such securities are primarily traded (closing values), or, lacking any sales, at the mean between the bid and ask prices; securities traded in the over-the-counter market are valued at the last reported sales price that day, or, if no sales are reported, at the mean between the bid and ask prices. Securities listed on the NASDAQ National Market System are valued in accordance with the NASDAQ Official Closing Price. In addition, securities that are primarily traded on foreign exchanges are generally valued at the preceding closing values of such securities on their respective exchanges with these values then translated into U.S. dollars at the current exchange rate. Fixed income securities normally are valued based on valuations provided by approved pricing services. Securities may be fair valued pursuant to procedures approved by the funds' Board of Trustees when approved pricing services do not provide a value for a security, a furnished price appears manifestly incorrect or events occur prior to the close of the NYSE that materially affect the furnished price. The Board of Trustees regularly reviews fair value determinations made by the funds pursuant to the procedures. TAXATION FEDERAL TAX INFORMATION FOR THE FUNDS It is each fund's policy to qualify for taxation as a "regulated investment company" (RIC) by meeting the requirements of Subchapter M of the Internal Revenue Code of 1986, as amended (the Code). By qualifying as a RIC, a fund expects to eliminate or reduce to a nominal amount the federal income tax to which it is subject. If a fund does not qualify as a RIC under the Code, it will be subject to federal income tax, at regular corporate rates on its net income, including any net realized capital gains. The Code imposes a non-deductible excise tax on RICs that do not distribute in a calendar year (regardless of whether they otherwise have a non-calendar taxable year) an amount equal to 98% of their "ordinary income" (as defined in the Code) for the calendar year plus 98% of their net capital gain for the one-year period ending on October 31 of such calendar year, plus any undistributed amounts from prior years. The non-deductible excise tax is equal to 4% of the deficiency. For the foregoing purposes, a fund is treated as having distributed any amount on which it is subject to income tax for any taxable year ending in such calendar year. A fund's transactions in futures contracts, options and certain other investment activities may be restricted by the Code and are subject to special tax rules. In a given case, these rules may accelerate income to a fund, defer its losses, cause adjustments in the holding periods of a fund's assets, convert short-term capital losses into long-term capital losses or otherwise affect the character of a fund's income. These rules could therefore affect the amount, timing and character of distributions to shareholders. A fund will endeavor to make any available elections pertaining to these transactions in a manner believed to be in the best interest of a fund and its shareholders. 73 FEDERAL INCOME TAX INFORMATION FOR SHAREHOLDERS The discussion of federal income taxation presented below supplements the discussion in the funds' prospectuses and only summarizes some of the important federal tax considerations generally affecting shareholders of a fund. Accordingly, prospective investors (particularly those not residing or domiciled in the United States) should consult their own tax advisors regarding the consequences of investing in a fund. Any dividends declared by a fund in October, November or December and paid the following January are treated, for tax purposes, as if they were received by shareholders on December 31 of the year in which they were declared. Distributions of net investment income and short-term capital gains are taxed as ordinary income. Long-term capital gains distributions are taxable as long-term capital gains, regardless of how long you have held your shares. However, if you receive a long-term capital gains distribution with respect to fund shares held for six months or less, any loss on the sale or exchange of those shares shall, to the extent of the long-term capital gains distribution, be treated as a long-term capital loss. Because a fund's income is expected to consist of interest rather than dividends, it is anticipated that no portion of its distributions will generally be eligible for the dividends-received deduction or for the lower tax rates applicable to qualified dividend income. Each fund will be required in certain cases to withhold at the applicable withholding rate and remit to the U.S. Treasury, the withheld amount of taxable dividends paid to any shareholder who (1) fails to provide a correct taxpayer identification number certified under penalty of perjury; (2) is subject to withholding by the Internal Revenue Service for failure to properly report all payments of interest or dividends; (3) fails to provide a certified statement that he or she is not subject to "backup withholding;" or (4) fails to provide a certified statement that he or she is a U.S. person (including a U.S. resident alien). Backup withholding is not an additional tax and any amounts withheld may be credited against the shareholder's ultimate U.S. tax liability. Foreign shareholders (i.e., nonresident alien individuals and foreign corporations, partnerships, trusts and estates) are generally subject to U.S. withholding tax at the rate of 30% (or a lower tax treaty rate) on distributions derived from net investment income and short-term capital gains. Distributions to foreign shareholders of long-term capital gains and any gains from the sale or other disposition of shares of the funds generally are not subject to U.S. taxation, unless the recipient is an individual who either (1) meets the Code's definition of "resident alien" or (2) who is physically present in the U.S. for 183 days or more. Different tax consequences may result if the foreign shareholder is engaged in a trade or business within the United States. In addition, the tax consequences to a foreign shareholder entitled to claim the benefits of a tax treaty may be different than those described above. If, at the close of each quarter of its taxable year, at least 50% of the value of a fund's assets consist of obligations the interest on which is excludable from gross income, a fund may pay "exempt-interest dividends" to its shareholders. Those dividends constitute the portion of the aggregate dividends as designated by a fund, equal to the excess of the excludable interest over certain amounts disallowed as deductions. Exempt-interest dividends are excludable from a shareholder's gross income for federal income tax purposes. Exempt-interest dividends may nevertheless be subject to the federal alternative minimum tax (AMT) imposed by Section 55 of the Code and are also taken into account when determining the taxable portion of social security or railroad retirement benefits. The AMT is imposed at rates of 26% and 28%, in the case of non-corporate taxpayers, and at the rate of 20%, in the case of 74 corporate taxpayers, to the extent it exceeds the taxpayer's federal income tax liability. The AMT may be imposed in the following two circumstances. First, exempt-interest dividends derived from certain private activity bonds issued after August 7, 1986, will generally be an item of tax preference (and, therefore, potentially subject to AMT) for both corporate and non-corporate taxpayers. Second, in the case of exempt-interest dividends received by corporate shareholders, all exempt-interest dividends, regardless of when the bonds from which they are derived were issued or whether they are derived from private activity bonds, will be included in the corporation's "adjusted current earnings," as defined in Section 56(g) of the Code, in calculating the corporations' alternative minimum taxable income for purposes of determining the AMT. The funds may realize capital gains or taxable income from the sale of municipal bonds and may make taxable distributions. For federal tax purposes, each fund's distributions of short-term capital gains and gains on the sale of bonds characterized as market discount are taxable to shareholders as ordinary income. Distributions of long-term capital gains are taxable to the shareholder as long-term capital gain, no matter how long the shareholder has held shares in a fund. Current federal law limits the types and volume of bonds qualifying for the federal income tax exemption of interest that may have an effect on the ability of a fund to purchase sufficient amounts of tax-exempt securities to satisfy the Code's requirements for the payment of "exempt-interest dividends." Interest on indebtedness incurred or continued by a shareholder in order to purchase or carry shares of the funds is not deductible for federal income tax purposes. Furthermore, these funds may not be an appropriate investment for persons (including corporations and other business entities) who are "substantial users" (or persons related to "substantial users") of facilities financed by industrial development private activity bonds. Such persons should consult their tax advisors before purchasing shares. A "substantial user" is defined generally to include "certain persons" who regularly use in their trade or business a part of a facility financed from the proceeds of such bonds. GENERAL STATE AND LOCAL TAX INFORMATION Distributions by a fund also may be subject to state, local and foreign taxes, and its treatment under applicable tax laws may differ from the federal income tax treatment. Many states grant tax-free status to dividends paid to you from interest earned on direct obligations of the U.S. government, subject in some states to minimum investment requirements that must be met by a fund. Investment in Ginnie Mae or Fannie Mae securities, banker's acceptances, commercial paper and repurchase agreements collateralized by U.S. government securities do not generally qualify for such tax-free treatment. The rules on exclusion of this income are different for corporate shareholders. Shareholders are urged to consult their tax advisors as to the consequences of these and other state and local tax rules affecting investments in the funds. CALIFORNIA TAX CONSIDERATIONS The Schwab California Short/Intermediate Tax-Free Bond Fund(TM), Schwab California Long-Term Tax Free Bond Fund(TM), and Schwab California Tax-Free YieldPlus Fund(TM) intend to qualify to pay dividends to shareholders that are exempt from California personal income tax ("California exempt-interest dividends"). A fund will qualify to pay California exempt-interest dividends if (1) at the close of each quarter of a fund's taxable year, at least 50% of the value of a fund's total assets consists of obligations the interest on which would be exempt from California 75 personal income tax if the obligations were held by an individual ("California Tax Exempt Obligations") and (2) a fund continues to qualify as a regulated investment company. If a fund qualifies to pay California exempt-interest dividends, dividends distributed to shareholders will be considered California exempt-interest dividends if they meet certain requirements. A fund will notify its shareholders of the amount of exempt-interest dividends each year. Corporations subject to California franchise tax that invest in a fund may not be entitled to exclude California exempt-interest dividends from income. Dividend distributions that do not qualify for treatment as California exempt-interest dividends (including those dividend distributions to shareholders taxable as long-term capital gains for federal income tax purposes) will be taxable to shareholders at ordinary income tax rates for California personal income tax purposes to the extent of a fund's earnings and profits. Interest on indebtedness incurred or continued by a shareholder in connection with the purchase of shares of a fund will not be deductible for California personal income tax purposes if a fund distributes California exempt-interest dividends. If a fund qualifies to pay dividends to shareholders that are California exempt-interest dividends, dividends distributed to shareholders will be considered California exempt-interest dividends if (1) they are designated as exempt-interest dividends by a fund in a written notice to shareholders mailed within 60 days of the close of a fund's taxable year and (2) to the extent the interest received by a fund during the year on California Tax-Exempt Obligations exceeds expenses of a fund that would be disallowed under California personal income tax law as allocable to tax-exempt interest if a fund were an individual. If the aggregate dividends so designated exceed the amount that may be treated as California exempt-interest dividends, only that percentage of each dividend distribution equal to the ratio of aggregate California exempt-interest dividends to aggregate dividends so designated will be treated as a California exempt-interest dividend. 76 APPENDIX - RATINGS OF INVESTMENT SECURITIES From time to time, a fund may report the percentage of its assets that falls into the rating categories set forth below. BONDS MOODY'S INVESTORS SERVICE Aaa Bonds which are rated Aaa are judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as "gilt edged." Interest payments are protected by a large or by an exceptionally stable margin and principal is secure. While the various protective elements are likely to change, such changes as can be visualized are most unlikely to impair the fundamentally strong position of such issues. Aa Bonds which are rated Aa are judged to be of high quality by all standards. Together with the Aaa group they comprise what are generally known as high-grade bonds. They are rated lower than the best bonds because margins of protection may not be as large as in Aaa securities or fluctuation of protective elements may be of greater amplitude or there may be other elements present which make the long-term risk appear somewhat larger than the Aaa securities. A Bonds which are rated A possess many favorable investment attributes and are to be considered as upper-medium grade obligations. Factors giving security to principal and interest are considered adequate, but elements may be present which suggest a susceptibility to impairment some time in the future. Baa Bonds which are rated Baa are considered as medium-grade obligations (i.e., they are neither highly protected nor poorly secured). Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well. Ba Bonds which are rated Ba are judged to have speculative elements; their future cannot be considered as well-assured. Often the protection of interest and principal payments may be very moderate and thereby not well safeguarded during both good and bad times over the future. Uncertainty of position characterizes bonds in this class. B Bonds which are rated B generally lack characteristics of the desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small. STANDARD & POOR'S CORPORATION INVESTMENT GRADE AAA Debt rated 'AAA' has the highest rating assigned by S&P. Capacity to pay interest and repay principal is extremely strong. AA Debt rated 'AA' has a very strong capacity to pay interest and repay principal and differs from the highest rated debt only in small degree. 77 A Debt rated 'A' has a strong capacity to pay interest and repay principal, although it is somewhat more susceptible to adverse effects of changes in circumstances and economic conditions than debt in higher-rated categories. BBB Debt rated 'BBB' is regarded as having an adequate capacity to pay interest and repay principal. Whereas it normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal for debt in this category than in higher rated categories. SPECULATIVE GRADE Debt rated 'BB' and 'B' is regarded as having predominantly speculative characteristics with respect to capacity to pay interest and repay principal. While such debt will likely have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions. BB Debt rated 'BB' has less near-term vulnerability to default than other speculative grade debt. However, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions that could lead to inadequate capacity to meet timely interest and principal payments. The 'BB' rating category is also used for debt subordinated to senior debt that is assigned an actual or implied 'BBB-' rating. B Debt rate 'B' has greater vulnerability to default but presently has the capacity to meet interest payments and principal repayments. Adverse business, financial, or economic conditions would likely impair capacity or willingness to pay interest and repay principal. The 'B' rating category also is used for debt subordinated to senior debt that is assigned an actual or implied 'BB' or 'BB-' rating. FITCH, INC. INVESTMENT GRADE BOND AAA Bonds considered to be investment grade and of the highest credit quality. The obligor has an exceptionally strong ability to pay interest and repay principal, which is unlikely to be affected by reasonably foreseeable events. AA Bonds considered to be investment grade and of very high credit quality. The obligor's ability to pay interest and repay principal is very strong, although not quite as strong as bonds rated 'AAA'. Because bonds rated in the 'AAA' and 'AA' categories are not significantly vulnerable to foreseeable future developments, short-term debt of these issuers is generally rated 'F1+'. A Bonds considered to be investment grade and of high credit quality. The obligor's ability to pay interest and repay principal is considered to be strong, but may be more vulnerable to adverse changes in economic conditions and circumstances than bonds with higher ratings. BBB Bonds considered to be investment grade and of satisfactory credit quality. The obligor's ability to pay interest and repay principal is considered to be adequate. Adverse changes in economic conditions and circumstances, however, are more likely to have adverse impact on these bonds, and therefore impair timely payment. The likelihood that the ratings of these bonds will fall below investment grade is higher than for bonds with higher ratings. 78 SPECULATIVE GRADE BOND BB Bonds are considered speculative. The obligor's ability to pay interest and repay principal may be affected over time by adverse economic changes. However, business and financial alternatives can be identified which could assist the obligor in satisfying its debt service requirements. B Bonds are considered highly speculative. While bonds in this class are currently meeting debt service requirements, the probability of continued timely payment of principal and interest reflects the obligor's limited margin of safety and the need for reasonable business and economic activity throughout the life of the issue. SHORT-TERM NOTES AND VARIABLE RATE DEMAND OBLIGATIONS MOODY'S INVESTORS SERVICE Short-term notes/variable rate demand obligations bearing the designations MIG-1/VMIG-1 are considered to be of the best quality, enjoying strong protection from established cash flows, superior liquidity support or demonstrated broad-based access to the market for refinancing. Obligations rated MIG-2/VMIG-3 are of high quality and enjoy ample margins of protection although not as large as those of the top rated securities. STANDARD & POOR'S CORPORATION An S&P SP-1 rating indicates that the subject securities' issuer has a strong capacity to pay principal and interest. Issues determined to possess very strong safety characteristics are given a plus (+) designation. S&P's determination that an issuer has a satisfactory capacity to pay principal and interest is denoted by an SP-2 rating. FITCH, INC. Obligations supported by the highest capacity for timely repayment are rated F1+. An F1 rating indicates that the obligation is supported by a very strong capacity for timely repayment. Obligations rated F2 are supported by a good capacity for timely repayment, although adverse changes in business, economic, or financial conditions may affect this capacity. COMMERCIAL PAPER MOODY'S INVESTORS SERVICE Prime-1 is the highest commercial paper rating assigned by Moody's. Issuers (or related supporting institutions) of commercial paper with this rating are considered to have a superior ability to repay short-term promissory obligations. Issuers (or related supporting institutions) of securities rated Prime-2 are viewed as having a strong capacity to repay short-term promissory obligations. This capacity will normally be evidenced by many of the characteristics of issuers whose commercial paper is rated Prime-1 but to a lesser degree. 79 STANDARD & POOR'S CORPORATION A Standard & Poor's Corporation ("S&P") A-1 commercial paper rating indicates a strong degree of safety regarding timely payment of principal and interest. Issues determined to possess overwhelming safety characteristics are denoted A-1+. Capacity for timely payment on commercial paper rated A-2 is satisfactory, but the relative degree of safety is not as high as for issues designated A-1. FITCH, INC. F1+ is the highest category, and indicates the strongest degree of assurance for timely payment. Issues rated F1 reflect an assurance of timely payment only slightly less than issues rated F1+. Issues assigned an F2 rating have a satisfactory degree of assurance for timely payment, but the margin of safety is not as great as for issues in the first two rating categories. 80 PART C OTHER INFORMATION SCHWAB INVESTMENTS Item 23. Exhibits. (a) Articles of Agreement and Declaration of Trust, dated Incorporation October 26, 1990, was electronically filed and is incorporated by reference to Exhibit 1, File No. 811-6200, of Post-Effective Amendment No. 22 to Registrant's Registration Statement on Form N-1A, filed on December 30, 1997. (b) By-Laws Amended and Restated By-Laws were electronically filed and are incorporated by reference to Exhibit 2, File No. 811-6200, of Post-Effective Amendment No. 22 to Registrant's Registration Statement on Form N-1A, filed on December 30, 1997. (c) Instruments Defining (i) Article III, Section 5, Article V, Article Rights of Security VI, Article VIII, Section 4 and Article IX, Holders Sections 1, 5 and 7 of the Agreement and Declaration of Trust were filed and are incorporated by reference to Exhibit 1, File No. 811-6200, of Post-Effective Amendment No. 22 to Registrant's Registration Statement on Form N-1A, filed on December 30, 1997. (ii) Article 9, Article 10, Section 6, and Article 11 of the Amended and Restated By-Laws were filed and are incorporated by reference to Exhibit 2, File No. 811-6200, of Post-Effective Amendment No. 22 to Registrant's Registration Statement on Form N-1A filed on December 30, 1997. (d) Investment Advisory (i) Investment Advisory and Administration Contracts Agreement between Registrant and Charles Schwab Investment Management, Inc. (the "Investment Adviser") and Schedules B and C were electronically filed and are incorporated by reference to Exhibit 5(a), File No. 811-6200, of Post-Effective Amendment No. 22 to Registrant's Registration Statement on Form N-1A, filed on December 30, 1997. (ii) Amended Schedules A and D to Investment Advisory and Administration Agreement referred to at Exhibit (d)(i) above are electronically filed as Exhibit (d)(ii), File No. 811-6200. (iii) Letter of Agreement between Registrant and Investment Advisor on behalf of Schwab Investments dated October 30, 2003, incorporated by reference as Exhibit (d)(iii), File No. 811-6200, of Post-Effective Amendment No. 48 to Registrant's Registration Statement on Form N-1A, electronically filed on November 11, 2003. Part C (iv) Letter Agreement between Registrant and Investment Advisor on behalf of Schwab California YieldPlus Fund and the Schwab Municipal YieldPlus Fund is electronically filed as Exhibit (d)(iv), File No. 811-6200. (e) Underwriting (i) Distribution Agreement between Registrant Contracts and Charles Schwab & Co., Inc. ("Schwab") was electronically filed and is incorporated by reference to Exhibit 6, File No. 811-6200, of Post-Effective Amendment No. 22 to Registrant's Registration Statement on Form N-1A, filed on December 30, 1997. (ii) Amended Schedule A to the Distribution Agreement is electronically filed as Exhibit (e)(ii), File No. 811-6200. (f) Bonus or Profit Inapplicable. Sharing Contracts (g) Custodian Agreements (i) Custodian Services Agreement between Registrant and PFPC Trust Company was electronically filed and is incorporated by reference to Exhibit (g)(i), File No. 811-6200, of Post-Effective Amendment No. 44 to the Registrant's Registration Statement on Form N-1A, filed on November 12, 2002. (ii) Amended Custodian Services Fee Agreement dated November 1, 1998, by and between the Registrant and PFPC Trust Company, as assigned by PNC Bank, is incorporated by reference to Exhibit (g)(xii), File No. 811-6200, of Post-Effective Amendment No. 27 to Registrant's Registration Statement on Form N-1A, electronically filed on December 30, 1998. (iii) Schedule A to the Custodian Services Fee Agreement between the registrant and PFPC Trust Company, as assigned by PNC Bank, was electronically filed and is incorporated by reference to Exhibit (g)(xiv), File No. 811-6200, of Post-Effective Amendment No. 29 to Registrant's Registration Statement on Form N-1A, filed on July 21, 1999. (iv) Rule 17f-5 and 17f-7 Services Agreement (Foreign Custody Agreement) between Registrant and PFPC Trust Company dated September 25, 2003, was electronically filed and is incorporated by reference to Exhibit (g)(iv), File No. 811-6200, of Post-Effective Amendment No. 49 to Registrant's Registration Statement on Form N-1A, filed on December 11, 2003. Part C (v) Transfer Agency Agreement between the Registrant and Schwab and Schedule B were electronically filed and are incorporated by reference to Exhibit 8(e), File No. 811-6200, of Post-Effective Amendment No. 22 to Registrant's Registration Statement on Form N-1A, filed on December 30, 1997. (vi) Amended Schedules A and C to the Transfer Agency Agreement referred to at Exhibit (g)(v) above are electronically filed as Exhibit (g)(vi), File No. 811-6200. (vii) Shareholder Service Agreement between the Registrant and Schwab and Schedule B were electronically filed and are incorporated by reference to Exhibit 8(g), File No. 811-6200, of Post-Effective Amendment No. 22 to Registrant's Registration Statement on Form N-1A, filed on December 30, 1997. (viii) Schedules A and C to the Shareholder Service Agreement between the Registrant and Schwab referenced at Exhibit (g)(vii) above are electronically filed as Exhibit (g) (viii), File No. 811-6200. (ix) Accounting Services Agreement between Registrant and PFPC was electronically filed and is incorporated by reference to Exhibit (d)(ix), File No. 811-6200, of Post-Effective Amendment No. 44 to Registrant's Registration Statement on Form N-1A filed on November 12, 2002. (x) Accounting Services Agreement with SEI Fund Resources dated April 1, 1998, was electronically filed and is incorporated herein by reference to Exhibit (g)(xiii), File No. 811-6200, of Post-Effective Amendment No. 27 to Registrant's Registration Statement on Form N-1A, electronically filed on December 30, 1998. (xi) Amended Schedule A of the Accounting Services Agreement between the Registrant and SEI Fund Resources was electronically filed and is incorporated by reference to Exhibit (g)(xvi), File No. 811-6200, of Post-Effective Amendment No. 29 to Registrant's Registration Statement on Form N-1A, filed on July 21, 1999. (xii) Amendment No. 1 to the Accounting Services Agreement dated December 17, 1998, by and between Schwab Capital Trust, Schwab Annuity Portfolios, Schwab Investments and SEI Fund Resources was electronically filed and is incorporated by reference to Exhibit (g)(xvii), File No. 811-6200, of Post-Effective Amendment No. 29 to Registrant's Registration Statement on Form N-1A, filed on July 21, 1999. Part C (h) Other Material Inapplicable. Contracts (i) Legal Opinion Opinion of counsel is filed electronically. (j) Other Opinions Auditors Consent is filed electronically. (k) Omitted Financial Inapplicable. Statements (l) Initial Capital (i) Purchase Agreement relating to shares of the Agreement Schwab 1000 Fund was electronically filed and is incorporated by reference to Exhibit (l)(i), File No. 811-6200, of Post-Effective Amendment No. 29 to Registrant's Registration Statement on Form N-1A, filed on July 21, 1999. (ii) Purchase Agreement relating to shares of the Schwab Short-Term Bond Market Index Fund (formerly Schwab Short/Intermediate Government Bond Fund) was electronically filed and incorporated by reference to Exhibit (l)(ii), File No. 811-6200, of Post-Effective Amendment No. 29 to Registrant's Registration Statement on Form N-1A, filed on July 21, 1999. (iii) Purchase Agreement relating to shares of the Schwab California Long-Term Tax-Free Bond Fund (formerly Schwab California Tax Free Bond Fund) was electronically filed and is incorporated by reference to Exhibit (l)(iii), File No. 811-6200, of Post-Effective Amendment No. 29 to Registrant's Registration Statement on Form N-1A, filed on July 21, 1999. (iv) Purchase Agreement relating to shares of the Schwab Long-Term Tax-Free Bond Fund (formerly Schwab National Tax Free Bond Fund) was electronically filed and is incorporated by reference to Exhibit (l)(iv), File No. 811-6200, of Post-Effective Amendment No. 29 to Registrant's Registration Statement on Form N-1A, filed on July 21, 1999. (v) Purchase Agreement relating to shares of the Schwab Short/Intermediate Tax-Free Bond Fund, Schwab California Short/Intermediate Tax-Free Bond Fund and Schwab Total Bond Market Index Fund (formerly, Schwab Long-Term Government Bond Fund) was electronically filed and is incorporated by reference to Exhibit 13, File No. 811-6200, to Post-Effective Amendment No. 22 to Registrant's Registration Statement on Form N-1A filed on December 30, 1997. Part C (vi) Purchase Agreement relating to shares of the Schwab YieldPlus Fund(R)was electronically filed and is incorporated by reference to Exhibit (l)(vi) of Post-Effective Amendment No. 29, File No. 811-6200, to Registrant's Registration Statement on Form N-1A, filed on July 21, 1999. (vii) Purchase Agreement relating to shares of the Schwab GNMA Fund was electronically filed and is incorporated by reference as Exhibit (l)(vii) of Post-Effective Amendment No. 46, File No. 811-6200 to the Registrant's Registration Statement on Form N-1A, filed on January 27, 2003. (viii) Purchase Agreement relating to the purchase of one share of each class of the Schwab California YieldPlus Fund(TM) and the Schwab Municipal YieldPlus Fund(TM) is electronically filed as Exhibit (l)(viii), File No. 811-6200. (m) Rule 12b-1 Plan Inapplicable. (n) Financial Data Inapplicable. Schedule (o) Rule 18f-3 Plan (i) Registrant's Amended and Restated Multiple Class Plan is incorporated by reference herein as Exhibit (o)(i), File No. 811-6200, of Post-Effective Amendment No. 46 to the Registrant's Registration Statement on Form N-1A, filed on January 27, 2003. (ii) Amended Schedule A to the Multiple Class Plan for Investor and Select Shares share classes of the Schwab California Tax-Free YieldPlus Fund and Schwab Tax-Free YieldPlus Fund is electronically filed as Exhibit (o)(ii), File No. 811-6200. (p) Power of Attorney (i) Power of Attorney executed by Mariann Byerwalter, September 4, 2002, to Post-Effective Amendment No. 44, to Registrant's Statement on Form N-1A, electronically filed on November 12, 2002, is incorporated herein by reference to Exhibit (p)(i), File No. 811-6200. (ii) Power of Attorney executed by William A. Hasler, September 4, 2002, to Post-Effective Amendment No. 44, to Registrant's Statement on Form N-1A, electronically filed on November 12, 2002, is incorporated herein by reference to Exhibit (p)(ii), File No. 811-6200. Part C (iii) Power of Attorney executed by Gerald B. Smith, September 4, 2002, to Post-Effective Amendment No. 44, to Registrant's Statement on Form N-1A, electronically filed on November 12, 2002, is incorporated herein by reference to Exhibit (p)(iii), File No. 811-6200. (iv) Power of Attorney executed by Donald F. Doward, September 4, 2002, to Post-Effective Amendment No. 44, to Registrant's Statement on Form N-1A, electronically filed on November 12, 2002, is incorporated herein by reference to Exhibit (p)(iv), File No. 811-6200. (v) Power of Attorney executed by Robert G. Holmes, September 4, 2002, to Post-Effective Amendment No. 44, to Registrant's Statement on Form N-1A, electronically filed on November 12, 2002, is incorporated herein by reference to Exhibit (p)(v), File No. 811-6200. (vi) Power of Attorney executed by Donald R. Stephens, September 4, 2002, to Post-Effective Amendment No. 44, to Registrant's Statement on Form N-1A, electronically filed on November 12, 2002, is incorporated herein by reference to Exhibit (p)(vi), File No. 811-6200. (vii) Power of Attorney executed by Michael W. Wilsey, September 4, 2002, to Post-Effective Amendment No. 44, to Registrant's Statement on Form N-1A, electronically filed on November 12, 2002, is incorporated herein by reference to Exhibit (p)(vii), File No. 811-6200. (viii) Power of Attorney executed by Charles R. Schwab, September 4, 2002, to Post-Effective Amendment No. 44, to Registrant's Statement on Form N-1A, electronically filed on November 12, 2002, is incorporated herein by reference to Exhibit (p)(viii), File No. 811-6200. (ix) Power of Attorney executed by Evelyn Dilsaver, August 31, 2004, to Post-Effective Amendment No. 51, to Registrant's Registration Statement on Form N-1A, electronically filed on September 1, 2004, is incorporated herein by reference to Exhibit (p)(ix), File No. 811-6200. (x) Power of Attorney executed by Gregory Hand, October 19, 2004, to Post-Effective Amendment No. 52, to Registrant's Registration Statement on Form N-1A, electronically filed on October 25, 2004, is incorporated herein by reference to Exhibit (p)(x), File No. 811-6200. Part C (q) Code of Ethics (i) Code of Ethics adopted by Registrant, Charles Schwab Investment Management Inc. and Charles Schwab & Co., Inc. is incorporated herein by reference to Exhibit (g)(i), File No. 811-6200 of Post-Effective Amendment No. 50 to Registrant's Registration Statement on Form N-1A, electronically filed on February 26, 2004. Item 24. Persons Controlled by or under Common Control with the Registrant. The Charles Schwab Family of Funds (the "Schwab Fund Family"), Schwab Capital Trust and Schwab Annuity Portfolios are each Massachusetts business trusts registered under the Investment Company Act of 1940, as amended (the "1940 Act"). Each is advised by the Investment Manager and employs Schwab as principal underwriter, transfer agent and shareholder services agent. As a result, The Charles Schwab Family of Funds, Schwab Capital Trust and Schwab Annuity Portfolios may each be deemed to be under common control with Registrant. Item 25. Indemnification. Article VIII of Registrant's Agreement and Declaration of Trust (Exhibit (1) hereto, which is incorporated herein by reference) provides in effect that Registrant will indemnify its officers and trustees against all liabilities and expenses, including but not limited to amounts paid in satisfaction of judgments, in compromise, or as fines and penalties, and counsel fees reasonably incurred by any such officer or trustee in connection with the defense or disposition of any action, suit, or other proceeding. However, in accordance with Section 17(h) and 17(i) of the 1940 Act and its own terms, said Agreement and Declaration of Trust does not protect any person against any liability to Registrant or its shareholders to which he or she would otherwise be subject by reason of willful misfeasance, bad faith, gross negligence, or reckless disregard of the duties involved in the conduct of his or her office. In any event, Registrant will comply with 1940 Act Releases No. 7221 and 11330 respecting the permissible boundaries of indemnification by an investment company of its officers and trustees. Insofar as indemnification for liability arising under the Securities Act of 1933, as amended (the "1933 Act"), may be permitted to trustees, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, Registrant has been advised that, in the opinion of the Securities and Exchange Commission, such indemnification is against public policy as expressed in the 1933 Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by Registrant of expenses incurred or paid by a trustee, officer or controlling person of Registrant in the successful defense of any action, suit or proceeding) is asserted by such trustee, officer or controlling person in connection with the securities being registered, Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the 1933 Act and will be governed by the final adjudication of such issue. Item 26. Business and Other Connections of Investment Manager Registrant's investment adviser, Charles Schwab Investment Management, Inc., a Delaware corporation, organized in October 1989 to serve as investment manager to Registrant, also serves as the investment manager to The Charles Schwab Family of Funds, Schwab Capital Trust, and Schwab Annuity Portfolios, Laudus Trust and Laudus Variable Insurance Trust, each an open-end, management investment company. The principal place of business of the investment adviser is 101 Montgomery Street, San Francisco, Part C California 94104. The only business in which the investment adviser engages is that of investment adviser and administrator to Registrant, The Charles Schwab Family of Funds, Schwab Capital Trust, Schwab Annuity Portfolios and any other investment companies that Schwab may sponsor in the future, investment adviser to Laudus Trust and Laudus Variable Trust and an investment adviser to certain non-investment company clients. The business, profession, vocation or employment of a substantial nature in which each director and/or senior or executive officer of the investment adviser (CSIM) is or has been engaged during the past two fiscal years is listed below. The name of any company for which any director and/or senior or executive officer of the investment adviser serves as director, officer, employee, partner or trustee is also listed below. In addition, the name and position of each director and/or senior or executive officer of the Registrant's principal underwriter Charles Schwab & Co. Inc. is listed below.
Name and Position with Registrant Name of Company Capacity ------------------------------------------------------------------------------------------------------ Charles R. Schwab, Charles Schwab & Co., Inc. Chairman Trustee and Chairman The Charles Schwab Bank, N.A. Chairman, Director The Charles Schwab Corporation Chairman, Chief Executive Officer Charles Schwab Investment Management, Inc. Chairman Schwab Holdings, Inc. Chief Executive Officer Schwab International Holdings, Inc. Chairman and Chief Executive Officer Schwab (SIS) Holdings, Inc. I Chairman and Chief Executive Officer Charles Schwab Holdings (UK) Chairman U.S. Trust Corporation Director United States Trust Company of New York Director Siebel Systems Director Stanford University Trustee The Gap, Inc. Director until May 2004 Xign, Inc. Director until June 2003
Part C
Name and Position with Registrant Name of Company Capacity ------------------------------------------------------------------------------------------------------ Audiobase, Inc. Director until March 2002 Vodaphone AirTouch PLC Director until May 2002 Jeffrey M. Lyons Charles Schwab & Co., Inc. Executive Vice President, Active Trustee Trader Enterprise. Prior to July 2004, Mr. Lyons was Executive Vice President, Asset Management Products & Services. Prior to September 2001, Mr. Lyons was Executive Vice President, Mutual Funds. Randall W. Merk Charles Schwab & Co., Inc. Executive Vice President., AMPS President and Chief Enterprise. From September 2002 Executive Officer to July 2004, Mr. Merk was President & CEO of CSIM. Prior to September 2002, Mr. Merk was President and Chief Investment Officer, American Century Investment Management and Director, American Century Companies, Inc. (June 2001 to August 2002); Chief Investment Officer, Fixed Income, American Century Companies, Inc. (January 1997 to June 2001). Evelyn S. Dilsaver Charles Schwab & Co. Inc. Executive Vice President. From President and Chief June 2003 to July 2004, Ms. Executive Officer Dilsaver was Senior Vice President of the Asset Management Products and Services Enterprise, with responsibility for product development and distribution. Prior to this, Ms. Dilsaver was Executive Vice President of U.S. Trust, a subsidiary of The Charles Schwab Corporation, as its chief financial officer and chief administrative officer.
Part C
Name and Position with Registrant Name of Company Capacity ------------------------------------------------------------------------------------------------------ Charles Schwab Investment Management, Inc. President and Chief Executive Office Koji E. Felton, Charles Schwab Investment Management, Inc. Senior Vice President, Chief Secretary Counsel and Assistant Corporate Secretary Charles Schwab & Co., Inc. Senior Vice President, Deputy General Counsel Christopher V. Dodds Charles Schwab & Co., Inc. Executive Vice President and Chief Financial Officer Carrie Dwyer Charles Schwab & Co., Inc. Executive Vice President - Corporate Oversight and Corporate Secretary Lon Gorman Charles Schwab & Co., Inc. Vice Chairman and Enterprise President Schwab Institutional and Asset Management Jan Hier-King Charles Schwab & Co., Inc. Executive Vice President - Human Resources Deborah McWhinney Charles Schwab & Co., Inc. Executive Vice President and President, Schwab Institutional. Prior to January 2001, President, Engage Media Services Group (July 1999 until January 2001). Gideon Sasson Charles Schwab & Co., Inc. Chief Investment Officer Maurisa Sommerfield Charles Schwab & Co., Inc. Executive Vice President - Schwab Operations William Atwell Charles Schwab & Co., Inc. Executive Vice President - Client Sales and Services and Schwab Bank The Charles Schwab Bank, N.A. Director Charles Schwab Asset Management (Ireland) Director Limited
Part C
Name and Position with Registrant Name of Company Capacity ------------------------------------------------------------------------------------------------------ Charles Schwab Worldwide Funds PLC Director Stephen B. Ward, Charles Schwab Investment Management, Inc. Director, Senior Vice President Senior Vice President and Chief Investment Officer and Chief Investment Officer The Charles Schwab Trust Company Chief Investment Officer
Item 27. Principal Underwriters. (a) Schwab acts as principal underwriter and distributor of Registrant's shares. Schwab also acts as principal underwriter for The Charles Schwab Family of Funds, Schwab Capital Trust, Schwab Annuity Portfolios and intends to act as such for any other investment company which Schwab may sponsor in the future. (b) See Item 26(b) for information on each director and/or senior or executive officer of Schwab. The principal business address of Schwab is 101 Montgomery Street, San Francisco, California 94104. (c) Not applicable. Item 28. Location of Accounts and Records. All accounts, books and other documents required to be maintained pursuant to Section 31(a) of the 1940 Act and the Rules thereunder are maintained at the offices of: Registrant; Registrant's investment manager and administrator, Charles Schwab Investment Management, Inc., 101 Montgomery Street, San Francisco, California 94104; Registrant's principal underwriter, Charles Schwab & Co., Inc., 101 Montgomery Street, San Francisco, California 94104; Registrant's Custodian, PFPC Trust Company, 8800 Tinicum Blvd., Third Floor Suite 200, Philadelphia, Pennsylvania 19153; Registrant's fund accountants, PFPC, Inc., 400 Bellevue Parkway, Wilmington, Delaware 19809 or SEI Fund Resources, Oaks, Pennsylvania; or Ropes & Gray, 1301 K Street, N.W., Suite 800 East, Washington, District of Columbia, 20005. Item 29. Management Services. Not applicable. Item 30. Undertakings. Not applicable. Part C SIGNATURES Pursuant to the requirements of the Securities Act of 1933, as amended (the "1933 Act"), and the Investment Company Act of 1940, as amended, Registrant certifies that it meets all of the requirements for the effectiveness of this Post Effective Amendment No. 53 to Registrant's Registration Statement on Form N-1A pursuant to Rule 485(b) under the 1933 Act and has duly caused this Post Effective Amendment No. 53 to be signed on its behalf by the undersigned, thereto duly authorized, in the City of Philadelphia, Commonwealth of Pennsylvania, on the 11th day of November, 2004. SCHWAB INVESTMENTS Registrant Charles R. Schwab* ------------------ Charles R. Schwab, Chairman and Trustee Pursuant to the requirements of the 1933 Act, this Post-Effective Amendment No. 53 to Registrant's Registration Statement on Form N-1A has been signed below by the following persons in the capacities indicated this 11th day of November, 2004. Signature Title --------- ------ Charles R. Schwab* Chairman and Trustee ------------------ Charles R. Schwab Evelyn Dilsaver* President and Chief Executive Officer ---------------- Evelyn Dilsaver Jeff Lyons* Trustee ----------- Jeff Lyons Mariann Byerwalter* Trustee ------------------- Mariann Byerwalter Donald F. Dorward* Trustee ------------------ Donald F. Dorward William A. Hasler* Trustee ------------------ William A. Hasler Robert G. Holmes* Trustee ----------------- Robert G. Holmes Gerald B. Smith* Trustee ---------------- Gerald B. Smith Donald R. Stephens* Trustee ------------------- Donald R. Stephens Michael W. Wilsey* Trustee ------------------ Michael W. Wilsey Gregory Hand* Acting Treasurer and Principal Financial ------------- Officer Gregory Hand *By: /s/ Timothy W. Levin -------------------- Timothy W. Levin, Attorney-in-Fact Pursuant to Power of Attorney EXHIBIT INDEX
EXH. NO. DOCUMENT -------- -------- (d)(ii) Schedules A&D - Investment Advisory Agreement (d)(iv) Letter Agreement (e)(ii) Schedule A - Distribution Agreement (g)(vi) Schedules A&C - Transfer Agency Agreement (g)(viii) Schedules A&C - Shareholder Service Agreement (i) Legal Opinion (j) Auditors' Consent (l)(viii) Purchase Agreement (o)(ii) Schedule A - Multiple Class Plan
Part C