-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, MGrP7JIuiW3preSC1U9XSnI4TCdVQ1pXh3lXk2LN+czns6gp2pOXLNoGC7Q2JzRv 7UAjbhCtfm2VeEskCU6cRA== 0000950149-02-002246.txt : 20021112 0000950149-02-002246.hdr.sgml : 20021111 20021112125314 ACCESSION NUMBER: 0000950149-02-002246 CONFORMED SUBMISSION TYPE: 485BPOS PUBLIC DOCUMENT COUNT: 18 FILED AS OF DATE: 20021112 EFFECTIVENESS DATE: 20021112 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SCHWAB INVESTMENTS CENTRAL INDEX KEY: 0000869365 STATE OF INCORPORATION: MA FISCAL YEAR END: 0831 FILING VALUES: FORM TYPE: 485BPOS SEC ACT: 1940 Act SEC FILE NUMBER: 811-06200 FILM NUMBER: 02816306 BUSINESS ADDRESS: STREET 1: 101 MONTGOMERY ST CITY: SAN FRANCISCO STATE: CA ZIP: 94104 BUSINESS PHONE: 4156277000 MAIL ADDRESS: STREET 1: 101 MONTGOMERY ST CITY: SAN FRANCISCO STATE: CA ZIP: 94104 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SCHWAB INVESTMENTS CENTRAL INDEX KEY: 0000869365 STATE OF INCORPORATION: MA FISCAL YEAR END: 0831 FILING VALUES: FORM TYPE: 485BPOS SEC ACT: 1933 Act SEC FILE NUMBER: 033-37459 FILM NUMBER: 02816307 BUSINESS ADDRESS: STREET 1: 101 MONTGOMERY ST CITY: SAN FRANCISCO STATE: CA ZIP: 94104 BUSINESS PHONE: 4156277000 MAIL ADDRESS: STREET 1: 101 MONTGOMERY ST CITY: SAN FRANCISCO STATE: CA ZIP: 94104 485BPOS 1 f84662e485bpos.txt POST-EFFECTIVE AMENDMENT #44 TO FORM N-1A File Nos. 33-37459 and 811-6200 As filed with the Securities and Exchange Commission on November 12, 2002 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM N-1A REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 Post-Effective Amendment No. 44 [X] and REGISTRATION STATEMENT UNDER THE INVESTMENT COMPANY ACT OF 1940 Amendment No. 48 [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 Randall W. Merk 101 Montgomery Street, San Francisco, California 94104 (Name and Address of Agent for Service) Copies of communications to: Richard W. Grant Esq. John Loder, Esq. Koji 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 120K-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, 2002, 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, 2002 Schwab Short/Intermediate Tax-Free Bond Fund Schwab Long-Term Tax-Free Bond Fund Schwab California Short/Intermediate Tax-Free Bond Fund Schwab California Long-Term Tax-Free Bond Fund 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. In particular, the California state-specific funds are offered for sale and are available only to residents of California, Arizona, the District of Columbia, Florida, South Carolina, New Jersey and the U.S. Virgin Islands. [CHARLES SCHWAB LOGO] SCHWAB TAX-FREE BOND FUNDS ABOUT THE FUNDS Schwab Short/Intermediate Tax-Free Bond Fund ..................................................... 2 Schwab Long-Term Tax-Free Bond Fund .................................... 6 Schwab California Short/Intermediate Tax-Free Bond Fund ..................................................... 10 Schwab California Long-Term Tax-Free Bond Fund ..................................................... 14 Fund management ........................................................ 18 INVESTING IN THE FUNDS Buying shares .......................................................... 20 Selling/exchanging shares .............................................. 21 Transaction policies ................................................... 22 Distributions and taxes ................................................ 23
ABOUT THE FUNDS The Schwab Tax-Free Bond Funds seek to provide high current income free from federal income tax and, in the case of the California funds, California personal income tax. Each fund has a similar investment goal but uses a different strategy. Because these funds invest primarily in municipal bonds, their dividends are generally free from federal income tax. Dividends from the California funds are generally free from California personal income tax as well. Each fund also seeks to lower risks by investing across different sectors of the municipal bond market. The funds are designed for long-term investors. Their performance will fluctuate over time and, as with all investments, future performance may differ from past performance. SCHWAB TAX-FREE BOND FUNDS TICKER SYMBOL: SWITX 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. STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN INVESTMENT-GRADE MUNICIPAL SECURITIES--THOSE IN THE FOUR HIGHEST CREDIT RATING CATEGORIES (AAA TO BBB-). The fund normally invests at least 80% of its assets in municipal securities the interest from which is free from federal income tax; including federal alternative minimum tax. 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 total assets in municipal securities financing similar projects, 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, 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. In this case, the fund would not be pursuing its goal and, as a result, may not achieve its investment objective. 2 Individuals in higher tax brackets who are seeking tax-free income along with the potential for lower volatility may want to consider this fund. MAIN 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-free status, also could affect performance. 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 federal alternative minimum tax (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. 3 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
BEST QUARTER: 3.00% Q1 1995 WORST QUARTER: (2.33%) Q1 1994 YEAR-TO-DATE PERFORMANCE AS OF 9/30/02: 7.12% AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/01
Since 1 year 5 years inception - -------------------------------------------------------------------------------- FUND Before taxes 4.42 4.29 4.32 1 After tax on distributions 4.42 4.29 4.32 1 After tax on distributions and sale 4.15 4.24 4.26 1 LEHMAN BROTHERS THREE- YEAR MUNICIPAL BOND INDEX 6.59 5.08 4.91 2
1 Inception: 4/21/93. 2 From: 4/21/93. 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* 0.35 ---- Total annual operating expenses** 0.65 ====
* Restated to reflect current expenses. ** Guaranteed by Schwab and the investment adviser not to exceed 0.65% through 11/15/03 (excluding interest, taxes and certain non-routine expenses). 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 11/15/03). 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 $208 $362 $810
Schwab Short/Intermediate Tax-Free Bond Fund 4 FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the past five years. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/01- 9/1/00- 9/1/99- 9/1/98- 9/1/97- 8/31/02 8/31/01 8/31/00 8/31/99 8/31/98 - ------------------------------------------------------------------------------------------------------------------------------------ PER-SHARE DATA ($) - ------------------------------------------------------------------------------------------------------------------------------------ Net asset value at beginning of period 10.42 10.08 10.05 10.26 10.16 --------------------------------------------------------------------------------- Income from investment operations: Net investment income 0.35 0.39 0.41 0.40 0.42 Net realized and unrealized gains or losses 0.20 0.34 0.03 (0.21) 0.10 --------------------------------------------------------------------------------- Total income from investment operations 0.55 0.73 0.44 0.19 0.52 Less distributions: Dividends from net investment income (0.34) (0.39) (0.41) (0.40) (0.42) --------------------------------------------------------------------------------- Net asset value at end of period 10.63 10.42 10.08 10.05 10.26 --------------------------------------------------------------------------------- Total return (%) 5.37 7.42 4.50 1.86 5.17 RATIOS/SUPPLEMENTAL DATA (%) - ------------------------------------------------------------------------------------------------------------------------------------ Ratio of net operating expenses to average net assets 0.49 0.49 0.49 1 0.49 0.49 Expense reductions reflected in above ratio 0.21 0.24 0.25 0.32 0.36 Ratio of net investment income to average net assets 3.29 3.84 4.11 3.87 3.99 Portfolio turnover rate 28 14 11 8 22 Net assets, end of period ($ x 1,000,000) 139 109 76 87 68
1 Would have been 0.50% if non-routine expenses (proxy fees) had been included. 5 SCHWAB LONG-TERM TAX-FREE BOND FUND TICKER SYMBOL: SWNTX 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. 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. STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN INVESTMENT-GRADE MUNICIPAL SECURITIES--THOSE IN THE FOUR HIGHEST CREDIT RATING CATEGORIES (AAA TO BBB-). The fund normally invests at least 80% of its assets in municipal securities the interest from which is free from federal income tax; including federal alternative minimum tax. 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 total assets in municipal securities financing similar projects, 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, 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. In this case, the fund would not be pursuing its goal and, as a result, may not achieve its investment objective. 6 This fund is designed for individuals in higher tax brackets who are interested in high current tax-free income and can accept a higher degree of risk to their investment. MAIN 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-free status, also could affect performance. 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 federal alternative minimum tax (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. 7 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] 93 13.61 94 (7.04) 95 18.14 96 4.18 97 9.83 98 6.14 99 (7.31) 00 15.61 01 3.80
BEST QUARTER: 8.03% Q1 1995 WORST QUARTER: (5.88%) Q1 1994 YEAR-TO-DATE PERFORMANCE AS OF 9/30/02: 10.66% AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/01
Since 1 year 5 years inception - -------------------------------------------------------------------------------- FUND Before taxes 3.80 5.33 5.87 1 After tax on distributions 3.80 5.30 5.82 1 After tax on distributions and sale 4.14 5.25 5.73 1 LEHMAN BROTHERS GENERAL MUNICIPAL BOND INDEX 5.13 5.98 6.29 2
1 Inception: 9/11/92. 2 From: 9/11/92. 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* 0.38 Total annual operating expenses 0.68 Expense reduction (0.03) Net operating expenses** 0.65
* Restated to reflect current expenses. ** Guaranteed by Schwab and the investment adviser through 11/15/03 (excluding interest, taxes and certain non-routine expenses). 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 11/15/03). 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 $215 $376 $844
Schwab Long-Term Tax-Free Bond Fund 8 FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the past five years. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in report the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual (see back cover).
9/1/01- 9/1/00- 9/1/99- 9/1/98- 9/1/97- 8/31/02 8/31/01 8/31/00 8/31/99 8/31/98 - --------------------------------------------------------------------------------------------------------------- PER-SHARE DATA ($) - --------------------------------------------------------------------------------------------------------------- Net asset value at beginning of period 10.87 10.24 10.11 11.01 10.53 ------------------------------------------------------------- Income from investment operations: Net investment income 0.49 0.50 0.50 0.50 0.53 Net realized and unrealized gains or losses 0.17 0.63 0.13 (0.85) 0.48 ------------------------------------------------------------- Total income from investment operations 0.66 1.13 0.63 (0.35) 1.01 Less distributions: Dividends from net investment income (0.48) (0.50) (0.50) (0.50) (0.53) Distributions from net realized gains -- -- -- (0.05) -- ------------------------------------------------------------- Total distributions (0.48) (0.50) (0.50) (0.55) (0.53) ------------------------------------------------------------- Net asset value at end of period 11.05 10.87 10.24 10.11 11.01 ------------------------------------------------------------- Total return (%) 6.24 11.29 6.59 (3.34) 9.81 RATIOS/SUPPLEMENTAL DATA (%) - --------------------------------------------------------------------------------------------------------------- Ratio of net operating expenses to average net assets 0.49 0.49 0.49 1 0.49 0.49 Expense reductions reflected in above ratio 0.25 0.25 0.26 0.32 0.37 Ratio of net investment income to average net assets 4.49 4.73 5.11 4.59 4.76 Portfolio turnover rate 25 35 25 35 39 Net assets, end of period ($ x 1,000,000) 85 88 76 90 70
1 Would have been 0.50% if creation non-routine expenses (proxy fees) had been included. 9 SCHWAB CALIFORNIA SHORT/INTERMEDIATE TAX-FREE BOND FUND 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, 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 STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN INVESTMENT-GRADE MUNICIPAL SECURITIES--THOSE IN THE FOUR HIGHEST CREDIT RATING CATEGORIES (AAA TO BBB-) - --FROM CALIFORNIA ISSUERS. The fund normally invests at least 80% of its assets in municipal securities the interest from which is free from federal and California personal income tax and federal alternative minimum tax. 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 total assets in municipal securities financing similar projects, 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, 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. In this case, the fund would not be pursuing its goal and, as a result, may not achieve its investment objective. 10 California taxpayers who are seeking double tax-free income along with the potential for lower volatility may want to consider this fund. MAIN 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. THIS FUND PRIMARILY INVESTS IN SECURITIES ISSUED BY THE STATE OF CALIFORNIA AND ITS MUNICIPALITIES. The fund's 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-free status, also could affect performance. 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 federal alternative minimum tax (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. 11 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
BEST QUARTER: 3.62% Q1 1995 WORST QUARTER: (2.45%) Q1 1994 YEAR-TO-DATE PERFORMANCE AS OF 9/30/02: 6.20% AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/01
Since 1 year 5 years inception - -------------------------------------------------------------------------------- FUND Before taxes 4.90 4.54 4.49 1 After tax on distributions 4.90 4.54 4.49 1 After tax on distributions and sale 4.44 4.43 4.41 1 LEHMAN BROTHERS THREE- YEAR MUNICIPAL BOND INDEX 6.59 5.08 4.91 2
1 Inception: 4/21/93. 2 From: 4/21/93. 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* 0.32 Total annual operating expenses** 0.62
* Restated to reflect current expenses. ** Guaranteed by Schwab and the investment adviser not to exceed 0.65% through 11/15/03 (excluding interest, taxes and certain non-routine expenses). 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 - -------------------------------------------------------------------------------- $63 $205 $359 $808
Schwab California Short/Intermediate Tax-Free Bond Fund 12 FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the past five years. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/01- 9/1/00- 9/1/99- 9/1/98- 9/1/97- 8/31/02 8/31/01 8/31/00 8/31/99 8/31/98 PER-SHARE DATA ($) - --------------------------------------------------------------------------------------------------------------------------------- Net asset value at beginning of period 10.51 10.22 10.09 10.26 10.16 ------------------------------------------------------------------------ Income from investment operations: Net investment income 0.34 0.40 0.39 0.39 0.41 Net realized and unrealized gains or losses 0.15 0.29 0.13 (0.17) 0.11 ------------------------------------------------------------------------ Total income from investment operations 0.49 0.69 0.52 0.22 0.52 Less distributions: Dividends from net investment income (0.34) (0.40) (0.39) (0.39) (0.42) ------------------------------------------------------------------------ Net asset value at end of period 10.66 10.51 10.22 10.09 10.26 ------------------------------------------------------------------------ Total return (%) 4.66 6.95 5.32 2.16 5.19 RATIOS/SUPPLEMENTAL DATA (%) - --------------------------------------------------------------------------------------------------------------------------------- Ratio of net operating expenses to average net assets 0.49 0.49 0.49 1 0.49 0.49 Expense reductions reflected in above ratio 0.17 0.18 0.21 0.28 0.30 Ratio of net investment income to average net assets 3.29 3.83 3.91 3.81 4.02 Portfolio turnover rate 17 30 42 7 8 Net assets, end of period ($ x 1,000,000) 184 145 124 126 96
1 Would have been 0.50% if non-routine expenses (proxy fees) had been included. 13 Schwab California Long-Term Tax-Free Bond Fund 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. 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 (AAA TO BBB-) - -- FROM CALIFORNIA ISSUERS. The fund normally invests at least 80% of its assets in municipal securities the interest from which is free from federal and California personal income tax and federal alternative minimum tax. 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 total assets in municipal securities financing similar projects, 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, 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. In this case, the fund would not be pursuing its goal and, as a result, may not achieve its investment objective. 14 This fund is designed for California taxpayers who want double tax-free income and can accept higher risk in exchange for potentially higher long-term returns. MAIN 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. THIS FUND PRIMARILY INVESTS IN SECURITIES ISSUED BY THE STATE OF CALIFORNIA AND ITS MUNICIPALITIES. The fund's 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-free status, also could affect performance. 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 federal alternative minimum tax (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. 15 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. [BAR CHART] ANNUAL TOTAL RETURNS (%) as of 12/31 93 12.88 94 (8.75) 95 19.63 96 4.33 97 10.04 98 6.43 99 (6.14) 00 15.22 01 4.92
BEST QUARTER: 8.47% Q1 1995 WORST QUARTER: (6.74%) Q1 1994 YEAR-TO-DATE PERFORMANCE AS OF 9/30/02: 9.29% AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/01
Since 1 year 5 years inception - -------------------------------------------------------------------------------- FUND Before taxes 4.92 5.85 6.72 1 After tax on distributions 4.92 5.85 6.67 1 After tax on distributions and sale 4.88 5.70 6.48 1 LEHMAN BROTHERS GENERAL MUNICIPAL BOND INDEX 5.13 5.98 6.71 2
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* 0.30 ---- Total annual operating expenses 0.60 ====
* Restated to reflect current expenses. 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 - -------------------------------------------------------------------------------- $61 $192 $335 $750
1 Inception: 2/24/92. 2 From: 2/24/92. 16 Schwab California Long-Term Tax-Free Bond Fund FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the past five years. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/01- 9/1/00- 9/1/99- 9/1/98- 9/1/97- 8/31/02 8/31/01 8/31/00 8/31/99 8/31/98 PER-SHARE DATA ($) - ------------------------------------------------------------------------------------------------------------------------------------ Net asset value at beginning of period 11.63 11.06 10.82 11.52 11.10 ---------------------------------------------------------------------------- Income from investment operations: Net investment income 0.53 0.55 0.55 0.54 0.54 Net realized and unrealized gains or losses 0.05 0.57 0.24 (0.70) 0.43 ---------------------------------------------------------------------------- Total income from investment operations 0.58 1.12 0.79 (0.16) 0.97 Less distributions: Dividends from net investment income (0.52) (0.55) (0.55) (0.54) (0.55) ---------------------------------------------------------------------------- Net asset value at end of period 11.69 11.63 11.06 10.82 11.52 ---------------------------------------------------------------------------- Total return (%) 5.14 10.38 7.67 (1.57) 8.96 RATIOS/SUPPLEMENTAL DATA (%) - ------------------------------------------------------------------------------------------------------------------------------------ Ratio of net operating expenses to average net assets 0.49 0.49 0.49 1 0.49 0.49 Expense reductions reflected in above ratio 0.15 0.16 0.19 0.26 0.27 Ratio of net investment income to average net assets 4.58 4.86 5.19 4.69 4.79 Portfolio turnover rate 34 37 36 55 28 Net assets, end of period ($ x 1,000,000) 238 215 179 202 190
1 Would have been 0.50% if non-routine expenses (proxy fees) had been included. 17 FUND MANAGEMENT The funds' investment adviser, Charles Schwab Investment Management, Inc., has more than $143 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 6.8 million accounts. (All figures on this page are as of 8/31/02.) 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 8/31/02, these fees were 0.09%for the Schwab Short/Intermediate Tax-Free Bond Fund, 0.05% for the Schwab Long-Term Tax-Free Bond Fund, 0.13% for the Schwab California Short/Intermediate Tax-Free Bond Fund and 0.15% for the Schwab California Long-Term Tax-Free Bond Fund. 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. JOANNE LARKIN, a vice president 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. 18 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 distribution option for your investment. Helpful information on taxes is included as well. 19 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. STEP 1 CHOOSE A FUND, then decide how much you want to invest.
MINIMUM INITIAL MINIMUM ADDITIONAL INVESTMENT INVESTMENTS MINIMUM BALANCE - -------------------------------------------------------------------------------- $2,500 $500 $1,000 ($1,000 for custodial ($100 for Automatic ($500 for custodial accounts) Investment Plan) accounts)
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. Cash/reinvestment mix You receive payment for dividends, while any capital gain distributions are invested in shares of your fund. Cash You receive payment for all dividends and capital gain distributions.
STEP 3 PLACE YOUR ORDER. Use any of the methods described at right. 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. 20 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 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. - - Exchange orders are limited to other SchwabFunds(R) that are not Sweep Investments(TM) as well as variable NAV funds and 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) 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 Visit the nearest Charles Schwab branch office. 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 Schwab- Link 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 become irrevocable at the time you mail them. 21 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 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. TRANSACTION POLICIES THE FUNDS ARE OPEN FOR BUSINESS EACH DAY THAT THE NEW YORK STOCK EXCHANGE (NYSE) IS OPEN. The funds calculate their share prices each business day after 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 the 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 the 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 the fund receives your order from your investment provider. However, some investment providers may arrange with the 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 LEFT. 22 Investing in the funds 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. Schwab Short/Intermediate Tax-Free Bond Fund's and Schwab Long-Term Tax-Free Bond Fund's dividends typically are free from federal income tax and federal alternative minimum tax, but are subject to state and local income taxes. A portion of each of these fund's dividends may be free 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 Schwab California Short/Intermediate Tax-Free Bond Fund and Schwab California Long-Term Tax-Free Bond Fund typically are free from federal and California personal income taxes and federal alternative minimum taxes. Some securities the funds may invest in produce income that is subject to the federal alternative minimum tax (AMT). To the extent that a fund invests in these securities, share-holders who are subject to the AMT may have to pay this tax on some or all dividends received from that 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. For tax purposes an exchange of your shares for shares of another SchwabFund is treated the same as a sale. 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. 23 DISTRIBUTIONS AND TAXES CONTINUED 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. 24 Investing in the funds NOTES SCHWAB TAX-FREE BOND FUNDS PROSPECTUS November 15, 2002 [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. SHAREHOLDER REPORTS, which are mailed to current fund investors, discuss recent performance and portfolio 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. You can obtain free copies of these documents by contacting SchwabFunds(R). You can also review and copy them in person at the SEC's Public Reference Room, access them on line at www.sec.gov or obtain paper copies by sending an electronic request to publicinfo@sec.gov. You will need to pay a duplicating fee before receiving paper copies from the SEC. SEC FILE NUMBER Schwab Tax-Free Bond Funds 811-6200 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549-0102 1-202-942-8090 (Public Reference Section) WWW.SEC.GOV PUBLICINFO@SEC.GOV SCHWABFUNDS P.O. Box 3812 Englewood, CO 80155-3812 1-800-435-4000 WWW.SCHWAB.COM/SCHWABFUNDS REG14272FLT-04 SCHWAB TAXABLE BOND FUNDS PROSPECTUS November 15, 2002 Schwab Short-Term Bond Market Fund Schwab Total Bond Market Fund 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 TAXABLE BOND FUNDS About the funds Schwab Short-Term Bond Market Fund ...................................... 2 Schwab Total Bond Market Fund ........................................... 6 Fund management ......................................................... 10 Investing in the funds Buying shares ........................................................... 12 Selling/exchanging shares ............................................... 13 Transaction policies .................................................... 14 Distributions and taxes ................................................. 15
ABOUT THE FUNDS The funds in this prospectus share the same basic investment strategy: They are designed to track the price and yield performance of a bond index. Each fund tracks a different index. By investing in bonds, the funds seek to provide current income to shareholders. Each fund also seeks to lower risk by diversifying broadly across the various sectors of the bond market. The funds are designed for long-term investing. Their performance will fluctuate over time and, as with all investments, future performance may differ from past performance. SCHWAB SHORT-TERM BOND MARKET FUND TICKER SYMBOL: SWBDX THE FUND SEEKS 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 typically do not react as strongly as longer-term bonds to interest rate changes. 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. 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 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 high yield securities ("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 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 under- lying 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). 2 Investors who are seeking a diversified source of current income and want potentially lower volatility and lower returns, compared to a long-term fund, may want to consider this fund. MAIN 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. 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. 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. 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. 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. Prices of lower-quality bonds tend to be more volatile than those of investment-grade bonds, and may fall based on bad news about an issuer, an industry or the overall economy. 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 uses 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 falls below the agreed repurchase price, or if the counterparty is unable to honor the agreement. Additionally, the fund may have a relatively high portfolio turnover rate, which could increase transaction costs and the likelihood of capital gain distributions. 3 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 goal and former strategy on 11/1/97; performance before that time may have been different had its current goal and strategy been in place. The fund began its current strategy on 5/6/02; performance before that time may have been different had its current strategy been in place. ANNUAL TOTAL RETURNS (%) as of 12/31 [BAR CHART] 92 6.08 93 7.84 94 (2.82) 95 10.90 96 4.00 97 6.88 98 6.96 99 1.54 00 9.12 01 7.31
BEST QUARTER: 4.32% Q3 1992 WORST QUARTER: (2.09%) Q1 1994 YEAR-TO-DATE PERFORMANCE AS OF 9/30/02: 5.38% AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/01 1 year 5 years 10 years - -------------------------------------------------------------------------------- FUND Before taxes 7.31 6.33 5.71 After tax on distributions 5.01 3.99 3.36 After tax on distributions and sale 4.42 3.89 3.39 LEHMAN BROTHERS MUTUAL FUND SHORT (1-5 YEAR) U.S. GOVERNMENT/CREDIT INDEX 9.03 6.93 6.49
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* 0.30 Total annual operating expenses 0.60 Expense reduction (0.15) Net operating expenses** 0.45
* Restated to reflect current expenses. ** Guaranteed by Schwab and the investment adviser through 11/15/03 (excluding interest, taxes and certain non-routine expenses). For the period 11/16/03 through 11/15/04, Schwab and the investment adviser will guarantee that the net operating expenses (excluding interest, taxes and certain non-routine expenses) will not exceed 0.55% of average daily net assets. 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 11/15/03). 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 - -------------------------------------------------------------------------------- $46 $177 $320 $736
Schwab Short-Term Bond Market Fund 4 FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the past five years. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/01 - 9/1/00 - 9/1/99 - 9/1/98 - 9/1/97 - 8/31/02 8/31/01 8/31/00 8/31/99 8/31/98 PER-SHARE DATA ($) - ------------------------------------------------------------------------------------------------------ Net asset value at beginning of period 10.08 9.65 9.66 9.90 9.74 -------------------------------------------------- Income from investment operations: Net investment income 0.50 0.59 0.57 0.50 0.56 Net realized and unrealized gains or losses (0.02) 0.43 (0.01) (0.24) 0.17 -------------------------------------------------- Total income from investment operations 0.48 1.02 0.56 0.26 0.73 Less distributions: Dividends from net investment income (0.49) (0.59) (0.57) (0.50) (0.57) -------------------------------------------------- Net asset value at end of period 10.07 10.08 9.65 9.66 9.90 -------------------------------------------------- Total return (%) 4.88 10.84 5.97 2.66 7.64 RATIOS/SUPPLEMENTAL DATA (%) - ------------------------------------------------------------------------------------------------------ Ratio of net operating expenses to average net assets 0.35 0.35 0.35 1 0.35 0.46 Expense reductions reflected in above ratio 0.28 0.31 0.32 0.42 0.39 Ratio of net investment income to average net assets 4.95 5.90 5.91 5.11 5.58 Portfolio turnover rate 150 248 129 195 128 Net assets, end of period ($ x 1,000,000) 493 369 219 218 157
1 Would have been 0.36% if certain non-routine expenses (proxy fees) had been included. 5 SCHWAB TOTAL BOND MARKET FUND TICKER SYMBOL: SWLBX THE FUND SEEKS CURRENT INCOME BY TRACKING THE PERFOR- MANCE OF THE LEHMAN BROTHERS U.S. AGGREGATE BOND INDEX. THE INDEX 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. By investing in longer-term bonds, the fund seeks to earn higher yields over time than the Schwab Short-Term Bond Market Fund, although with more share price volatility than that fund. 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 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 high yield securities ("junk bonds"). Ifan 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 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 under- lying 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). 6 This fund is designed for investors seeking to fill the fixed income component to their asset allocation plan, and who can accept higher risk in exchange for potentially higher long-term returns compared to a short-term fund. MAIN 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 to 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. When interest rates fall, issuers tend to pay off their bonds, which may force the fund to reinvest in lower-yielding securities. 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. 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 hurt the fund's yield or share price. 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. Prices of lower-quality bonds tend to be more volatile than those of investment-grade bonds, and may fall based on bad news about an issuer, an industry or the overall economy. 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 counter-party 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 falls below the agreed repurchase price, or if the counterparty is unable to honor the agreement. Additionally, the fund may have a relatively high portfolio turnover rate, which could increase transaction costs and the likelihood of capital gain distributions. 7 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 goal and former strategy on 11/1/97; performance before that time may have been different had its current goal and strategy been in place. The fund began its current strategy on 5/6/02; performance before that time may have been different had its 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
BEST QUARTER: 6.79% Q2 1995 WORST QUARTER: (4.83%) Q1 1994 YEAR-TO-DATE PERFORMANCE AS OF 9/30/2002: 7.20% AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/01
Since 1 year 5 years inception - ---------------------------------------------------------------------------------- FUND Before taxes 8.16 7.23 6.72 1 After tax on distributions 5.19 4.55 4.01 1 After tax on distributions and sale 4.93 4.45 4.00 1 LEHMAN BROTHERS U.S. AGGREGATE BOND INDEX 8.44 7.43 6.84 2
1 Inception: 3/5/93. 2 From: 3/5/93. 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* 0.30 Total annual operating expenses 0.56 Expense reduction (0.11) Net operating expenses** 0.45
* Restated to reflect current expenses. ** Guaranteed by Schwab and the investment adviser through 11/15/03 (excluding interest, taxes and certain non-routine expenses). For the period 11/16/03 through 11/15/04, Schwab and the investment adviser will guarantee that the net operating expenses (excluding interest, taxes and certain non-routine expenses) will not exceed 0.55% of average daily net assets. 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 11/15/03). 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 - ------------------------------------------------------------------------- $46 $168 $302 $691
Schwab Total Bond Market Fund 8 FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the past five years. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an investor in the fund would have earned or lost during a given period, assuming all distributions were reinvested. The fund's independent accountants, PricewaterhouseCoopers LLP, audited these figures. Their full report is included in the fund's annual report (see back cover).
9/1/01 - 9/1/00 - 9/1/99 - 9/1/98 - 9/1/97 - 8/31/02 8/31/01 8/31/00 8/31/99 8/31/98 PER-SHARE DATA ($) - --------------------------------------------------------------------------------------------------------- Net asset value at beginning of period 10.24 9.65 9.58 10.18 9.75 ---------------------------------------------------- Income from investment operations: Net investment income 0.47 0.60 0.61 0.55 0.60 Net realized and unrealized gains or losses 0.13 0.59 0.07 (0.53) 0.43 ---------------------------------------------------- Total income from investment operations 0.60 1.19 0.68 0.02 1.03 Less distributions: Dividends from net investment income (0.46) (0.60) (0.61) (0.55) (0.60) Distributions from net realized gains (0.16) -- -- (0.07) -- ---------------------------------------------------- Total distributions (0.62) (0.60) (0.61) (0.62) (0.60) ---------------------------------------------------- Net asset value at end of period 10.22 10.24 9.65 9.58 10.18 ---------------------------------------------------- Total return (%) 6.18 12.68 7.360 0.14 10.83 RATIOS/SUPPLEMENTAL DATA (%) - --------------------------------------------------------------------------------------------------------- Ratio of net operating expenses to average net assets 0.35 0.35 0.35 1 0.35 0.31 Expense reductions reflected in above ratio 0.22 0.23 0.27 0.39 0.51 Ratio of net investment income to average net assets 4.66 6.00 6.42 5.55 5.86 Portfolio turnover rate 74 153 135 174 285 Net assets, end of period ($ x 1,000,000) 1,053 926 647 480 294
1 Would have been 0.36% if non-routine expenses (proxy fees) had been included. 9 FUND MANAGEMENT The funds' investment adviser, Charles Schwab Investment Management, Inc., has more than $143 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 6.8 million accounts. (This figure is as of 8/31/02.) As the investment adviser,the firm oversees the asset management and administration of the Schwab Bond Funds. As compensation for these services, the firm receives a management fee from each fund. For the 12 months ended 8/31/02, these fees were 0.02% for the Schwab Short-Term Bond Market Fund and 0.05% for the Schwab Total Bond Market Fund. 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, is a vice president and portfolio manager of the investment adviser. Since joining the firm in September 1997, he has had overall responsibility for the management of the funds. Prior to joining Schwab, he worked for more than 18 years in research and asset management. 10 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 distribution option for your investment. Helpful information on taxes is included as well. 11 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. STEP 1 CHOOSE A FUND, then decide how much you want to invest.
MINIMUM INITIAL MINIMUM ADDITIONAL INVESTMENT INVESTMENTS MINIMUM BALANCE - -------------------------------------------------------------------------------- $2,500 $500 $1,000 ($1,000 for retirement and ($100 for Automatic ($500 for retirement and custodial accounts) Investment Plan) custodial accounts)
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. Cash/reinvestment mix You receive payment for dividends, while any capital gain distributions are invested in shares of your fund. Cash You receive payment for all dividends and capital gain distributions.
STEP 3 PLACE YOUR ORDER. Use any of the methods described at right. 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 12 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 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. - - Exchange orders are limited to other SchwabFunds(R) that are not Sweep Investments(TM) as well as variable NAV funds and 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 SCHWAB BY PHONE(TM) 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 Visit the nearest Charles Schwab branch office. 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. 13 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 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. TRANSACTION POLICIES THE FUNDS ARE OPEN FOR BUSINESS EACH DAY THAT THE NEW YORK STOCK EXCHANGE (NYSE) IS OPEN. The funds calculate their share prices each business day after 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 that are received in good order (generally 4 p.m.Eastern time) are executed at the next NAV to be calculated. 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. 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. 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 a fund's portfolio may change on days when it is not possible to buy or sell shares of the funds. THE FUNDS RESERVE CERTAIN RIGHTS REGARDING TRANSACTION POLICIES, AS DETAILED AT LEFT. Investing in the funds 14 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. 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 FREE 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.For tax purposes, an exchange of your shares for shares of another SchwabFund is treated the same as a sale. 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. 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 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. 15 NOTES NOTES SCHWAB TAXABLE BOND FUNDS PROSPECTUS November 15, 2002 [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. SHAREHOLDER REPORTS, which are mailed to current fund investors, discuss recent performance and portfolio 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. You can obtain free copies of these documents by contacting SchwabFunds(R). You can also review and copy them in person at the SEC's Public Reference Room, access them online at www.sec.gov or obtain paper copies by sending an electronic request to publicinfo@sec.gov. You will need to pay a duplicating fee before receiving paper copies from the SEC. SEC FILE NUMBER Schwab Taxable Bond Funds 811-6200 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549-0102 1-202-942-8090 (Public Reference Room) www.sec.gov publicinfo@sec.gov SCHWABFUNDS P.O. Box 3812 Englewood, CO 80155-3812 1-800-435-4000 WWW.SCHWAB.COM/SCHWABFUNDS REG14271FLT-05 SCHWAB YIELDPLUS FUND(R) PROSPECTUS November 15, 2002 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] [INSIDE COVER] SCHWAB YIELDPLUS FUND(R) ABOUT THE FUND Strategy ................................................. 2 Main risks ............................................... 3 Performance .............................................. 4 Fees and expenses ........................................ 4 Financial highlights ..................................... 5 Fund management .......................................... 6 INVESTING IN THE FUND Buying shares ............................................ 8 Schwab accounts .......................................... 8 Selling/exchanging shares ................................ 9 Transaction policies ..................................... 10 Distributions and taxes .................................. 11
SCHWAB YIELDPLUS FUND(R) TICKER SYMBOL 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. Certain types of derivatives (investments whose value is based on one or more securities, rates or indices) can be effective risk management tools. For example, the fund may buy and sell futures contracts to manage the effects of interest rate changes. By doing this, the fund has the potential to reduce the share price volatility that tends to be a characteristic of bond funds. STRATEGY TO PURSUE ITS GOAL, THE FUND PRIMARILY INVESTS IN INVESTMENT-GRADE (HIGH AND CERTAIN MEDIUM QUALITY, AAA TO BBB--) 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. For any bonds with interest payments occurring before principal is repaid, duration is ordinarily less than the maturity. 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 as low as BB or are the unrated equivalent. 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 downgraded below B, 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. 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. MAIN 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. SOME INVESTMENTS CARRY ADDITIONAL RISKS. To the extent that the manager decides to invest in foreign or lower quality bonds, 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. Prices of lower-quality bonds tend to be more volatile than those of investment-grade bonds, and may fall based on bad news about an issuer, an industry or the overall economy. 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. 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. OTHER RISK FACTORS While the fund may use techniques to 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, 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 fund could lose money if the prices of securities sold short increase. 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 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 8. ANNUAL TOTAL RETURNS (%) as of 12/31 INVESTOR SHARES [BAR CHART] 00 5.75 01 5.85
BEST QUARTER: 2.25% Q1 2001 WORST QUARTER: (0.13)% Q4 2001 YEAR-TO-DATE PERFORMANCE AS OF 9/30/02: 1.53% AVERAGE ANNUAL TOTAL RETURNS (%) as of 12/31/01
Since 1 year inception - -------------------------------------------------------------------------------- FUND Investor Shares Before taxes 5.85 5.82 1 After tax on distributions 3.61 3.27 1 After tax on distributions and sale 3.54 3.38 1 Select Shares(R) Before taxes 6.00 5.98 1 LEHMAN US SHORT TREASURY: 9-12 months 6.56 6.31 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 0.32 0.32 Distribution (12b-1) fees None None Other expenses* 0.29 0.14 Total annual operating expenses 0.61 0.46
* Restated to reflect current expenses. 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 $ 62 $ 195 $ 340 $ 762 Select Shares $ 47 $ 148 $ 258 $ 579
Schwab YieldPlus Fund(R) 4 FINANCIAL HIGHLIGHTS This section provides further details about the fund's financial history for the period of operations. Certain information reflects financial results for a single fund share. "Total return" shows the percentage that an figures. 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 Their full report is included in the fund's annual report (see back cover).
9/1/01 - 9/1/00 - 10/1/99 1 - INVESTOR SHARES 8/31/02 8/31/01 8/31/00 - ------------------------------------------------------------------------------------------------------------------------------------ PER-SHARE DATA ($) - ------------------------------------------------------------------------------------------------------------------------------------ Net asset value at beginning of period 10.00 9.92 10.00 ------------------------------------------------------------------------ Income from investment operations: Net investment income 0.42 0.62 0.61 Net realized and unrealized gains or losses (0.23) 0.08 (0.08) ------------------------------------------------------------------------ Total income from investment operations 0.19 0.70 0.53 Less distributions: Dividends from net investment income (0.44) (0.62) (0.61) ------------------------------------------------------------------------ Net asset value at end of period 9.75 10.00 9.92 ------------------------------------------------------------------------ Total return (%) 1.89 7.33 5.44 2 RATIOS/SUPPLEMENTAL DATA (%) - ------------------------------------------------------------------------------------------------------------------------------------ Ratio of net operating expenses to average net assets 0.55 0.55 0.55 3,4 Expense reductions reflected in above ratio 0.07 0.16 0.24 3 Ratio of net investment income to average net assets 4.36 6.03 6.72 3 Portfolio turnover rate 42 106 81 Net assets, end of period ($ x 1,000,000) 392 185 53
9/1/01 - 9/1/00 - 10/1/99 1 - SELECT SHARES(R) 8/31/02 8/31/01 8/31/00 - ------------------------------------------------------------------------------------------------------------------------------------ PER-SHARE DATA ($) - ------------------------------------------------------------------------------------------------------------------------------------ Net asset value at beginning of period 10.00 9.92 10.00 ------------------------------------------------------------------------ Income from investment operations: Net investment income 0.44 0.64 0.62 Net realized and unrealized gains or losses (0.24) 0.08 (0.08) ------------------------------------------------------------------------ Total income from investment operations 0.20 0.72 0.54 Less distributions: Dividends from net investment income (0.45) (0.64) (0.62) ------------------------------------------------------------------------ Net asset value at end of period 9.75 10.00 9.92 ------------------------------------------------------------------------ Total return (%) 2.04 7.50 5.58 2 RATIOS/SUPPLEMENTAL DATA (%) - ------------------------------------------------------------------------------------------------------------------------------------ Ratio of net operating expenses to average net assets 0.40 0.40 0.40 3,5 Expense reductions reflected in above ratio 0.07 0.16 0.24 3 Ratio of net investment income to average net assets 4.52 6.18 6.88 3 Portfolio turnover rate 42 106 81 Net assets, end of period ($ x 1,000,000) 1,443 772 219
1 Commencement of operations. 2 Not annualized. 3 Annualized. 4 Would have been 0.56% if non-routine expenses (proxy fees) had been included. 5 Would have been 0.41% if non-routine expenses (proxy fees) had been included. 5 FUND MANAGEMENT The fund's investment adviser, Charles Schwab Investment Management, Inc., has more than $143 billion under management. The investment adviser for the fund 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 6.8 million accounts. (All figures on this page are as of 8/31/02.) As the investment adviser, the firm oversees the asset management and administration of the Schwab YieldPlus Fund(R). As compensation for these services, the firm receives a management fee from the fund. For the 12 months ended 8/31/02 these fees were 0.24% for the fund. This figure, which is expressed as a percentage of the fund's average daily net assets, represents the actual amount paid, including the effect of reductions. KIMON DAIFOTIS, CFA, is a vice president and portfolio manager of the investment adviser. Since joining the firm in September 1997,he has had overall responsibility for the management of the fund. Prior to joining Schwab, he worked for more than 18 years in research and asset management. 6 INVESTING IN THE FUND 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. 7 SCHWAB ACCOUNTS Some Schwab account features can work in tandem with features offered by the fund. For example, when you sell shares in the 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 fund 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 fund's policies, to buy, sell and exchange shares of the fund. 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 SHARE CLASS. Your choice may depend on the amount of your investment. The minimums shown below are for each share class.
MINIMUM INITIAL MINIMUM ADDITIONAL SHARE CLASS INVESTMENT INVESTMENTS MINIMUM BALANCE - ----------------------------------------------------------------------------------- Investor Shares $2,500 ($1,000 for $500 ($100 for $1,000 ($500 for retirement and Automatic Investment retirement and custodial accounts) Plan) custodial accounts) Select Shares(R) $50,000 $1,000 $40,000
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 share class. Cash/reinvestment mix You receive payment for dividends, while any capital gain distributions are invested in shares of your share class. Cash You receive payment for all dividends and capital gain distributions.
Step 3 PLACE YOUR ORDER. Use any of the methods described at right. 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 fund 8 SELLING/EXCHANGING SHARES USE ANY OF THE METHODS DESCRIBED BELOW TO SELL SHARES OF THE FUND. When selling or exchanging shares, please be aware of the following policies: - - The 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 fund reserves the right to honor redemptions in portfolio securities instead of cash when your redemptions over a 90-day period exceed $250,000 or 1% of the fund's assets, whichever is less. - - Exchange orders are limited to other SchwabFunds(R) that are not Sweep Investments(TM) and 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) 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 Visit the nearest Charles Schwab branch office. 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 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 become irrevocable at the time you mail them. 9 THE FUND 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 share class as a result of selling or exchanging your shares. - - To 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 impact the fund's operations and orders that appear to be associated with short-term trading activities. - - To change or waive the fund's investment minimums. - - To suspend the right to sell shares back to the 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 FUND IS OPEN FOR BUSINESS EACH DAY THAT THE NEW YORK STOCK EXCHANGE (NYSE) IS OPEN. The fund calculates its share price each business day, for each share class, after the close of the NYSE (generally 4 p.m. Eastern time). The 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 the 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 the 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 the fund receives your order from your investment provider. However, some investment providers may arrange with the 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 its securities, the fund uses market quotes if they are readily available. In cases where quotes are not readily available, or the adviser deems them to be unreliable, the fund may value securities based on fair values developed using methods approved by the fund's Board of Trustees. Because foreign markets are often open on weekends and other days when the fund is closed, the value of the fund's portfolio may change on days when it is not possible to buy or sell shares of the fund. THE FUND RESERVES CERTAIN RIGHTS REGARDING TRANSACTION POLICIES, AS DETAILED AT LEFT. Investing in the fund 10 DISTRIBUTIONS AND TAXES ANY INVESTMENT IN THE 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 the 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 THE FUND EARNS. The fund distributes to its shareholders substantially all of its net investment income and net capital gains, if any. The fund declares a dividend every business day, based on its determination of its net investment income. The fund pays its dividends on the last business day of every month. The fund expects 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. The 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 the fund. Distributions generally are taxable in the tax year in which they are declared, whether you reinvest them or take them in cash. 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 FUNDS IS DIFFERENT FROM AN EXCHANGE BETWEEN CLASSES. An exchange between funds is considered a sale. An exchange between classes within the fund is not reported as a taxable sale. AT THE BEGINNING OF EVERY YEAR, THE FUND PROVIDES SHAREHOLDERS WITH INFORMATION DETAILING THE TAX STATUS OF ANY DISTRIBUTIONS the fund declared during the previous calendar year. 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. 11 NOTES NOTES SCHWAB YIELDPLUS FUND(R) PROSPECTUS November 15, 2002 [CHARLES SCHWAB LOGO] TO LEARN MORE This prospectus contains important information on the fund and should be read and kept for reference. You also can obtain more information from the following sources. SHAREHOLDER REPORTS, which are mailed to current fund investors, discuss recent performance and portfolio 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. You can obtain free copies of these documents by contacting SchwabFunds(R). You can also review and copy them in person at the SEC's Public Reference Room, access them online at www.sec.gov or obtain paper copies by sending an electronic request to publicinfo@sec.gov. You will need to pay a duplicating fee before receiving paper copies from the SEC. SEC FILE NUMBER Schwab YieldPlus Fund(R) 811-6200 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549-0102 1-202-942-8090 (Public Reference Section) WWW.SEC.GOV PUBLICINFO@SEC.GOV SCHWABFUNDS P.O. Box 3812 Englewood, CO 80155-3812 1-800-435-4000 WWW.SCHWAB.COM/SCHWABFUNDS REG14087FLT-04 STATEMENT OF ADDITIONAL INFORMATION SCHWAB INVESTMENTS SCHWAB SHORT-TERM BOND MARKET FUND SCHWAB TOTAL BOND MARKET FUND SCHWAB SHORT/INTERMEDIATE TAX-FREE BOND FUND SCHWAB LONG-TERM TAX-FREE BOND FUND SCHWAB CALIFORNIA SHORT/INTERMEDIATE TAX-FREE BOND FUND SCHWAB CALIFORNIA LONG-TERM TAX-FREE BOND FUND SCHWAB YIELDPLUS FUND(R) November 15, 2002 The Statement of Additional Information (SAI) is not a prospectus. It should be read in conjunction with the funds' prospectuses dated November 15, 2002 (as amended from time to time). To obtain a 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 3815, Englewood, CO 80155-3815. 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 funds' most recent annual reports are separate documents supplied with the SAI and include the funds' audited financial statements, which are incorporated by reference into this SAI. Prior to May 6, 2002, Schwab Short-Term Bond Market Fund was named Schwab Short-Term Bond Market Index Fund, and Schwab Total Bond Market Fund was named Schwab Total Bond Market Index Fund. Prior to November 1, 1997, Schwab Short-Term Bond Market Index Fund was named Schwab Short/Intermediate Government Bond Fund, and Schwab Total Bond Market Index Fund was named Schwab Long-Term Government Bond Fund. TABLE OF CONTENTS
Page ---- INVESTMENT OBJECTIVES, STRATEGIES, SECURITIES, RISKS AND LIMITATIONS........................................................................ 2 MANAGEMENT OF THE FUNDS............................................................ 44 CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES................................ 57 INVESTMENT ADVISORY AND OTHER SERVICES............................................. 57 BROKERAGE ALLOCATION AND OTHER PRACTICES........................................... 59 DESCRIPTION OF THE TRUST........................................................... 62 PURCHASE, REDEMPTION, DELIVERY OF SHAREHOLDER DOCUMENTS AND PRICING OF SHARES.............................................................. 63 TAXATION........................................................................... 65 CALCULATION OF PERFORMANCE DATA.................................................... 68 APPENDIX - RATINGS OF INVESTMENT SECURITIES........................................ 74
1 INVESTMENT OBJECTIVES, STRATEGIES, SECURITIES, RISKS AND LIMITATIONS INVESTMENT OBJECTIVE SCHWAB SHORT-TERM BOND MARKET FUND SCHWAB TOTAL BOND MARKET FUND 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 indexes 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. The securities in each index also are required to be publicly issued and have a par amount outstanding of at least $150 million and a fixed interest rate. SCHWAB SHORT/INTERMEDIATE TAX-FREE BOND FUND SCHWAB LONG-TERM TAX-FREE BOND FUND SCHWAB CALIFORNIA SHORT/INTERMEDIATE TAX-FREE BOND FUND SCHWAB CALIFORNIA LONG-TERM TAX-FREE BOND FUND 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. There is no guarantee a fund will achieve its investment objective. 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. There is no guarantee a fund will achieve its investment objective. 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. SCHWAB YIELDPLUS FUND(R) The fund's investment objective is to seek high current income with minimal changes in share price. 2 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 Schwab Short-Term Bond Market Fund, Schwab Total Bond Market Fund (collectively "the Bond Funds") will each, under normal circumstances, invest at least 80% of its 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, assets mean net assets plus the amount of any borrowings for investment purposes. The Schwab Short/Intermediate Tax-Free Bond Fund, Schwab Long-Term Tax-Free Bond Fund, Schwab California Short/Intermediate Tax-Free Bond Fund, Schwab California Long-Term Tax-Free Bond Fund (collectively "the Tax-Free Bond Funds") will each normally invest at least 80% of its total assets in municipal securities the interest of which is free from federal income tax including federal alternative minimum tax. In addition, the Schwab California Short/Intermediate Tax Free Bond Fund and the Schwab California Long-Term Tax-Free Bond Fund will each normally invest at least 80% of its assets in municipal securities the interest of which is free from California personal income tax. These policies may be changed only by shareholders. For purposes of these policies, assets mean net assets plus the amount of any borrowings for investment purposes. Each fund may invest more than 25% in municipal securities financing similar projects. 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. Also, policies and 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 a fund's acquisition of such security or asset unless otherwise noted. Any subsequent change in values, net assets or other circumstances will not be considered when determining whether the investment complies with a fund's investment policies and limitations. 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. 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. 3 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 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 and Schwab California Long-Term Tax-Free Bond 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 of their assets in such securities. The economy of the State of California (sometimes referred to herein as the "State") is the largest among the 50 states and one of the largest in the world. This diversified economy has major components in high technology, trade, entertainment, agriculture, tourism, construction and services. Certain of the State's significant industries are sensitive to trade disruptions in their export markets and the State's rate of economic growth, therefore, could be adversely affected by any such disruption. A significant downturn in U.S. stock market prices could adversely affect California's economy by reducing household spending and business investment, particularly in the important high technology sector. Moreover, a large and increasing share of the State's General Fund revenue in the form of income and capital gains taxes is directly related to, and would be adversely affected by, a significant downturn in the performance of the stock markets. 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 governmental budgets. 4 Following a severe recession beginning in 1990, the State's financial condition improved markedly during the fiscal years starting in 1995-96, due to a combination of better than expected revenues, a slowdown in growth of social welfare programs, and continued spending restraint based on actions taken in earlier years. The State's cash position also improved, and the State's General Fund took in substantially greater tax revenue than was initially planned when the budgets were enacted for the fiscal years ended in 1996, 1997, 1998, 1999 and 2000 ($2.2 billion, $1.6 billion, $2.4 billion, 1.7 billion and $8.2 billion, respectively). The Fiscal Year 2001 Budget Act was signed by the Governor on July 26, 2001. The spending plan for 2001-02 included General Fund expenditures of $78.8 billion, a reduction of $1.3 billion from the prior year. This could be accomplished without serious program cuts because such a large part of the 2000 Budget Act comprised one-time expenditures. The spending plan utilizes more than half of the budget surplus as of June 30, 2001, but still left a projected balance in the Special Fund for Economic Uncertainties (the "SFEU") at June 30, 2002, of $2.6 billion, the largest appropriated reserve in State history. The 2001 Budget Act assumed that, during the course of the fiscal year, the $6.2 billion advanced by the General Fund to the Department of Water Resources ("DWR") for power purchases would be repaid with interest. An updated estimate of fiscal year 2001-02 revenues and expenditures was included in the 2002-03 May Revision, released May 14, 2002. Revenues continued to fall below projections, and the DWR power revenue bonds were not issued before June 30, 2002, resulting in a substantial budgetary deficit and cash flow difficulties. The Administration estimates that, on a budgetary basis, the General Fund had a $1.4 billion deficit at June 30, 2002. The 2002-03 Budget, released January 10, 2002, projected a fall-off in General Fund revenues due to the national economic recession combined with the stock market decline, which began in mid-2000. Personal income tax receipts, including stock option and capital gain realizations, have been particularly impacted. As a result, the Administration projected a combined budget gap for 2001-02 and 2002-03 of approximately $12.5 billion. The May Revision to the Governor's Budget projected further deterioration in revenues of $9.5 billion and additional costs of $1.6 billion over the 2001-02 and 2002-03 fiscal years. As a result, the combined budget gap rose from the $12.5 billion estimated in January to $23.6 billion. The May Revision projected total General Fund revenues and transfers of $78.6 billion for 2002-03. The Administration proposed to close the $23.6 billion budget gap through a combination of spending reductions and revenue proposals, as well as the maximum fiscally responsible level of fund shifts, loans, accelerations, transfers and deferrals. On September 5, 2002, the Governor signed the budget bill for fiscal year 2002-03. The budget forecast $79.2 billion in General Fund revenues and transfers and $76.7 billion in expenditures. The budget projected total revenues and transfers in 2001-02 to be $73.9 billion, including repayment of the DWR revenue bonds described below. Because the Legislative Analyst estimated the structural deficit for the 2003-04 fiscal year to be at least $10 billion, with similar deficits for several further years absent corrective action, and because many of the one-time techniques used in the 2002-03 Budget cannot be replicated, the Governor directed State agencies to propose plans to permanently reduce expenditures by 20% in fiscal year 2003-04. In June 2002, the State Controller issued $7.5 billion of revenue anticipation warrants. The State expects to issue up to $12.5 billion in revenue anticipation warrants to fund cash flow requirements in 2002-03, including repayment of the warrants. If State revenues fall 5 significantly below projections, or the DWR power revenue bonds or tobacco securitization bonds are not sold during the current fiscal year, the State may have to issue additional warrants to meet its cash obligations. A series of reports after the start of the 2001-02 Fiscal Year have indicated that both the national and the State economics have been in a recession starting in 2001. In California, the impact has been particularly felt in the high technology section centered in the Bay Area/Silicon Valley, in the construction sector and in exports. The tragic events of September 11, 2001 exacerbated the impact of the weakened economy, especially on tourism related industries and locations. Both the national and the State economies began to recover in later 2001 and early 2002. The Administration recently predicted the State economy will grow slowly until mid to late 2002, and then accelerate going into 2003. The slowdown in the California economy, combined with weakness in the stock market, has resulted in a dramatic decline in General Fund revenues compared to previous estimates, as discussed in the previous section on the Fiscal Year 2002-03 Budget. 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. In January 2001, the Governor proclaimed a state of emergency to exist in California under the California Emergency Services Act on the basis that the electricity available from California's investor-owned utilities ("IOUs") was insufficient to prevent widespread and prolonged disruption of electric service in California. The Governor directed the State Department of Water Resources ("DWR") to enter into contracts and arrangements for the purchase and sale of electric power as necessary to assist in mitigating the effects of the emergency. The DWR began selling electricity to 10 million retail electric customers in California in January 2001. The DWR purchases power from wholesale suppliers under long-term contracts and in short-term and spot market transactions. DWR's power supply program is designed to cover the electricity shortfall until at least December 31, 2002. The Administration and the California Public Utilities Commission (the "CPUC") are developing plans to have the IOUs purchase the residential net short after DWR is no longer authorized to do so. Alternatively, it is possible that the power supply program will be extended by legislation or that another State agency will be authorized to develop a successor program. The rate agreement executed by DWR and the CPUC dated March 8, 2002 anticipates the imposition of charges upon electric power supplied to the retail end use customers of the IOUs and potentially other electric service providers, with the result that DWR would not be required to continue to sell electricity to pay its bonds. However, DWR will continue to sell the power it purchases under its long term contracts unless the IOUs assume such contracts. The power supply program has been financed by unsecured interest-bearing loans from the General Fund of the State aggregating $6.2 billion, secured loans from banks and other financial institutions aggregating $4.1 billion and DWR revenues from power sales to customers aggregating $5.2 billion through May 31, 2002. DWR plans to issue approximately $12 billion in revenue bonds in several series and use the net proceeds of the revenue bonds to repay outstanding loans from banks and commercial lenders in the amount of approximately $3.5 billion and then to repay the General Fund. Completion of the DWR bond sales has been delayed by a number of factors, including potential legal challenges. 6 The sale of the DWR revenue bonds is currently anticipated to occur no later than the end of November 2002. The primary source of money to pay debt service on the DWR revenue bonds will be revenues from customers of the IOUs resulting from charges set by the CPUC. The DWR revenue bonds will not be a debt or liability of the State or directly or indirectly or contingently obligate the State to levy or to pledge any form of taxation whatever therefore or to make any appropriation for their payment. A rate agreement was executed by the CPUC and DWR as of March 8, 2002, which provides for the CPUC to impose bond charges and department power charges in response to DWR's submittal of its revenue requirement for its purchases of electricity and its debt service. The CPUC has adopted a decision suspending as of September 20, 2001 the right of additional customers to elect to purchase electricity from suppliers other than DWR and the IOUs until DWR is no longer a supplier of electricity. A number of lawsuits have been filed concerning various aspects of the energy situation. These include disputes over rates set by the California Public Utilities Commission; responsibility for electricity and natural gas purchases made by the IOUs and the California Independent System Operator; continuing contractual obligations of certain small independent power generators; and antitrust and fraud claims against various parties. These actions do not seek a judgment against the State's General Fund, and in some cases, neither the State nor the DWR is even a party to these actions. However, adverse rulings in certain of these matters may affect power costs home by the DWR power supply program described above and may cause a delay in the issuance of the DWR revenue bonds described above. As of October 24, 2002, the State's general obligation bonds were rated Al by Moody's, A+ by Standard & Poor's, and AA by Fitch Ratings. Standard & Poor's lowered its rating of the State's general obligation bonds from AA to A+ in April 2001, citing the mounting and uncertain cost to the State of the current electrical power crisis, as well as its likely long-term detrimental effect on the State's economy. During that same month Fitch Ratings placed the State's general obligation bonds on a negative rating watch. Moody's lowered its rating of the State's general obligation bonds from Aa2 to Aa3 in May 2001 because of the financial risks associated with the energy crisis and trends in the broader U.S. and California economies, and to A1 in November 2001, citing the expectation that the State's General Fund budget and liquidity position will weaken substantially over the next eighteen months, in light of weakness in the technology sector of the State's economy, greatly reduced State revenue projections and the likelihood that the State will have great difficulty reaching consensus on the necessary fiscal adjustments during its upcoming budget session. On June 28, 2001, Standard & Poor's removed California's debt ratings from credit watch and affirmed the State's general obligation bonds ratings. 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. As of September 1, 2002, the State had approximately $25.2 billion aggregate amount of its general obligation bonds outstanding. General obligation bond authorizations in an aggregate amount of approximately $11.4 billion remained unissued as of that date. Pursuant to the terms of the bank credit agreement presently in effect supporting the general obligation commercial paper program, not more than $1.5 billion of general obligation commercial paper notes may be outstanding at any time; this amount may be increased or 7 decreased in the future. As of September 1, 2002, the Finance Committees had authorized the issuance of up to approximately $4.9 billion of commercial paper notes; as of that date approximately $0.8 billion aggregate principal amount of general obligation commercial paper notes was outstanding. In addition to general obligation bonds, the State builds and acquires capital facilities through the use of lease-purchase borrowing. As of September 1, 2002, the State had approximately $6.3 billion of outstanding lease purchase debt. Certain State agencies and authorities issue revenue obligations for which the General Fund has no liability. Revenue bonds represent obligations payable from State revenue-producing enterprises and projects, which are not payable for the General Fund, and conduit obligations payable only from revenues paid by private users of facilities financed by the revenue bonds. There are 17 agencies and authorities authorized to issue revenue obligations (excluding lease-purchase debt). State agencies and authorities had $30.5 billion aggregate principal amount of revenue bonds and notes which are non-recourse to the General Fund outstanding as of June 30, 2002. As part of its cash management program, the State has regularly issued short-term obligations to meet cash flow needs. The State did not issue any revenue anticipation notes for the 2000-01 fiscal year. The State issued $5.7 billion of 2001-02 Revenue Anticipation Notes on October 4, 2001 that matured on June 28, 2002. To provide additional cash resources necessary to pay the State's obligations at the end of June 2002 and into the first few months of the 2002-03 fiscal year, on June 24, 2002, the State issued $7.5 billion of 2001-02 Revenue Anticipation Warrants as follows: $1.5 billion that matured on October 25, 2002; $3.0 billion to mature on November 27, 2002; and $3.0 Billion to mature on January 30, 2003. The State expects to issue up to $12.5 billion of 2002-03 Revenue Anticipation Notes in October and November 2002 that would mature in June 2003, to partially fund its cash flow needs in the 2002-03 fiscal year, including repayment of the 2001-02 Revenue Anticipation Warrants. The primary units of local government in California are the counties, ranging in population from 1,200 (Alpine) to over 9,800,000 (Los Angeles). Counties are responsible for the provision of many basic services, including indigent healthcare, welfare, courts, jails and public safety in unincorporated areas. There are also about 475 incorporated cities and thousands of other special districts formed for education, utility and other services. The fiscal condition of local governments has been constrained since the enactment of "Proposition 13" in 1978 and later 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. 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. On November 5, 1996, voters approved Proposition 218, entitled the "Right to Vote on Taxes Act," which incorporates new Articles XIII C and XIII D into the California Constitution. These new provisions enact limitations on the ability of local government agencies to impose or raise various taxes, fees, charges and assessments without voter approval. 8 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. "Appropriations subject to limitation," with respect to the State, are authorizations to spend "proceeds of taxes," which consist of tax revenues, and certain other funds, including proceeds from regulatory licenses, user charges or other fees to the extent that such proceeds exceed "the cost reasonably borne by that entity in providing the regulation, product or service," but "proceeds of taxes" exclude most state subventions to local governments, tax refunds and some benefit payments such as unemployment insurance. No limit is imposed on appropriations of funds which are not "proceeds of taxes," such as reasonable user charges or fees and certain other non-tax funds. There are various types of appropriations excluded from the Appropriations Limit. The State's Appropriations Limit in each year is based on the Limit for the prior year, adjusted annually for changes in state per capita personal income and changes in population, and adjusted, when applicable, for any transfer of financial responsibility of providing services to or from another unit of government or any transfer of the financial source for the provisions of services from tax proceeds to non-tax proceeds. The Legislature has enacted legislation to implement Article XIII B which defines certain terms used in Article XIII B and sets forth the methods for determining the Appropriations Limit. California Government code Section 7912 requires an estimate of the Appropriations Limit to be included in the Governor's Budget, and thereafter to be subject to the budget process and established in the Budget Act. On November 8, 1988, voters of the State approved Proposition 98, a combined initiative constitutional amendment and statute called the "Classroom Instructional Improvement and Accountability Act." Proposition 98 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 permits the Legislature by two-thirds vote of both houses, with the Governor's concurrence, to suspend the K-14 schools' minimum funding formula for a one-year period. Proposition 98 also contains provisions transferring certain State tax revenues in excess of the Article XIII B limit to K-14 schools. Substantially increased General Fund revenues in the fiscal years 1994-95 through 2002-03 have resulted in significant increases in the level of Proposition 98 appropriations budgeted for those years. 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 Sponsor cannot predict the impact of this or related legislation on the Bonds in the California Trust portfolio. 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, 9 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. Articles XIII A, XIII B, XIII C and XIII D were each adopted as measures that qualified for the ballot pursuant to the State's initiative process. From time to time, other initiative measures could be adopted that could effect revenues of the State or public agencies within the State. Pending Litigation 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 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 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. 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 10 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 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 it 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. 11 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." 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 12 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 Depository 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. 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 Taxable Bond Funds and the YieldPlus 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 13 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. The YieldPlus Fund seeks to keep the average duration of its overall portfolio at one year or less. There may be times when the YieldPlus Fund 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 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. Each fund may invest up to 5% of its net assets in "event-linked bonds," which 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. A fund may engage in these transactions 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 14 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. 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 invest 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: 15 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 a 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. 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 16 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. 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 17 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 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, 18 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 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. 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 19 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. 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 invest in Index Participations. INDEXING STRATEGIES involve tracking the performance of an index. Each of the Bond Funds uses its index as a guide in structuring the fund and selecting its investments. However each Bond Fund is not required to invest any percentage of its assets in the securities of the index. Each Bond Fund will seek a correlation between its performance and that of its index of 0.90 or better. A perfect correlation of 1.0 is unlikely as the funds incur operating and trading expenses unlike their indices. Each Bond Fund may rebalance its holdings in order to track its index more closely. In the event its intended correlation is not achieved, the Board of Trustees will consider alternative arrangements for a Bond Fund. The Tax-Free Bond Funds do not utilize Indexing Strategies. 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. 20 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. 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 21 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. 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. LOAN PARTICIPATIONS are ownership of interests in commercial loans. Such indebtedness may be secured or unsecured. Loan participations typically represent direct participation in a loan to a corporate borrower, and generally are offered by banks or other financial institutions or lending syndicates. Certain funds may participate in such syndications, or can buy part of a loan, becoming a part lender. When purchasing loan participations, a fund assumes the credit risk associated with the corporate borrower and may assume the credit risk associated with an interposed bank or other financial intermediary. The participation interests in which a fund intends to invest may not be rated by any nationally recognized rating service. 22 A loan is often administered by an agent bank acting as agent for all holders. The agent bank administers the terms of the loan, as specified in the loan agreement. In addition, the agent bank is normally responsible for the collection of principal and interest payments from the corporate borrower and the apportionment of these payments to the credit of all institutions which are parties to the loan agreement. Unless, under the terms of the loan or other indebtedness, a fund has direct recourse against the corporate borrower, the fund may have to rely on the agent bank or other financial intermediary to apply appropriate credit remedies against a corporate borrower. A financial institution's employment as agent bank might be terminated in the event that it fails to observe a requisite standard of care or becomes insolvent. A successor agent bank would generally be appointed to replace the terminated agent bank, and assets held by the agent bank under the loan agreement should remain available to holders of such indebtedness. However, if assets held by the agent bank for the benefit of a fund were determined to be subject to the claims of the agent bank's general creditors, the fund might incur certain costs and delays in realizing payment on a loan or loan participation and could suffer a loss of principal and/or interest. In situations involving other interposed financial institutions (e.g., an insurance company or governmental agency) similar risks may arise. Purchasers of loans and other forms of direct indebtedness depend primarily upon the creditworthiness of the corporate borrower for payment of principal and interest. If a fund does not receive scheduled interest or principal payments on such indebtedness, the fund's share price and yield could be adversely affected. Loans that are fully secured offer a fund more protection 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 corporate borrower's obligation, or that the collateral can be liquidated. A fund may invest in loan participations with credit quality comparable to that of issuers of its securities investments. Indebtedness of companies whose creditworthiness is poor involves substantially greater risks, and may be highly speculative. Some companies may never pay off their indebtedness, or may pay only a small fraction of the amount owed. Consequently, when investing in indebtedness of companies with poor credit, a fund bears a substantial risk of losing the entire amount invested. A fund limits the amount of its total assets that it will invest in any one issuer or in issuers within the same industry. For purposes of these limits, a fund generally will treat the corporate borrower as the "issuer" of indebtedness held by the funds. In the case of loan participations where a bank or other lending institution serves as a financial intermediary between a fund and the corporate borrower, if the participation does not shift to the funds the direct debtor-creditor relationship with the corporate borrower, SEC interpretations require the fund to treat both the lending bank or other lending institution and the corporate borrower as "issuers" for the purposes of determining whether the fund has invested more than 5% of its assets in a single issuer. Treating a financial intermediary as an issuer of indebtedness may restrict a fund's ability to invest in indebtedness related to a single financial intermediary, or a group of intermediaries engaged in the same industry, even if the underlying borrowers represent many different companies and industries. Loans and other types of direct indebtedness may not be readily marketable and may be subject to restrictions on resale. In some cases, negotiations involved in disposing of indebtedness may require weeks to complete. Consequently, some indebtedness may be difficult or impossible to dispose of readily at what the investment adviser believes to be a fair price. In addition, valuation of illiquid indebtedness involves a greater degree of judgment in determining a fund's net asset value than if that value were based on available market quotations, and could result in 23 significant variations in the fund's daily share price. At the same time, some loan interests are traded among certain financial institutions and accordingly may be deemed liquid. As the market for different types of indebtedness develops, the liquidity of these instruments is expected to improve. In addition, each fund currently intends to treat indebtedness for which there is no readily available market as illiquid for purposes of the fund's limitation on illiquid investments. Investments in loan participations are considered to be debt obligations for purposes of the Trust's investment restriction relating to the lending of funds or assets by a fund. Investments in loans through a direct assignment of the financial institution's interests with respect to the loan may involve additional risks to a fund. For example, if a loan is foreclosed, a fund could become part owner of any collateral, and would bear the costs and liabilities associated with owning and disposing of the collateral. In addition, it is conceivable that under emerging legal theories of lender liability, a fund could be held liable as co-lender. It is unclear whether loans and other forms of direct indebtedness offer securities law protections against fraud and misrepresentation. In the absence of definitive regulatory guidance, a fund relies on the investment adviser's research in an attempt to avoid situations where fraud or misrepresentation could adversely affect the funds. The Tax-Free Bond Funds do not invest in Loan Participations. 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 YieldPlus Fund, 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 YieldPlus Fund's portfolio's overall average effective maturity, or duration, or overall average weighted maturity is more than one year. 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 24 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 or guaranteed by U.S. government agencies or instrumentalities, such as the Government National Mortgage Association (GNMA or Ginnie Mae) and Fannie Mae or Freddie Mac, or 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 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 25 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 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 26 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 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 27 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 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. 28 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. 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, 29 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. 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. 30 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 a 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 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. 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 31 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 down-graded to a below investment-grade quality rating. 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. If a Bond Fund's or the YieldPlus Fund's lower-quality securities were down-graded to below the sixth rating category, the investment adviser would promptly sell the security on behalf of a fund. 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 and only in circumstances where the investment adviser believes that the credit quality of the security (or issuer thereof) is reasonably likely to be upgraded to investment-grade in the foreseeable future. If such an upgrade were to occur under these circumstances, the value of the security would likely increase, thereby raising the potential for the investing Bond Fund to realize a gain on its investment and/or track the performance of its index. There is no guarantee that any such upgrade will occur, however, and all such high-yield securities are subject to the risks associated with non-investment grade instruments. In order to limit a fund's exposure in this regard, the investment adviser will not purchase high-yield securities for a Bond Fund that is rated (at the time of purchase) below B or the equivalent by Moody's, S&P or Fitch, Inc. In addition, if a high-yield security that is held by a Bond Fund is downgraded to below B or the equivalent by Moody's, S&P or Fitch, Inc. the investment adviser will promptly dispose of the security. Each Tax-Free Bond Fund will invest at least 80% of its total assets in investment-grade securities. Each Tax-Free Bond Fund 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. In the event a portfolio security is downgraded below B, the manager will promptly sell the security. 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 (sometimes called junk bonds) that are rated as low as BB or are the unrated equivalent. 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). The Tax-Free Bond Funds do not invest in Real Estate Investment Trusts. REPURCHASE AGREEMENTS involve a fund buying securities (usually U.S. government securities) from a seller and simultaneously agreeing to sell them back at an agreed-upon price (usually higher) and time. There are risks that losses will result if the seller does not perform as agreed. Under certain circumstances, repurchase agreements that are fully collateralized by U.S. government securities may be deemed to be investments in U.S. government securities. 32 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 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 AND MORTGAGE DOLLAR ROLLS 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. The Tax-Free Bond Funds do not invest in Reverse Repurchase Agreements and Mortgage Dollar Rolls. RISK MANAGEMENT TECHNIQUES used by a fund may include buying and selling futures and options contracts, entering into total return, asset and credit swaps, credit-linked notes and wrap agreements and investing in various types of derivative instruments. A fund may use risk management techniques, including derivative instruments, for any lawful purpose consistent with its investment objective, such as hedging or managing risk. 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." 33 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. 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. 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-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 34 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 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 35 to profit on such securities if the price rises. 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. 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 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. 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 36 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 appropriate 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. TEMPORARY DEFENSIVE STRATEGIES. 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 federal alternative minimum tax. In addition, under normal conditions, the Schwab California Short/Intermediate Tax-Free Bond Fund and the Schwab California Long-Term Tax-Free Bond Fund do not intent 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 the Tax-Free Bond Funds may make temporary investments in securities, the interest on which is subject to federal income and the Schwab California short/Intermediate Tax-Free Bond fund and the Schwab California Long-Term Tax-Free Bond Fund may make temporary investments in securities that pay interest subject to California personal income tax. 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. 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 37 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. 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. 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 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. 38 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. EACH TAXABLE BOND FUND MAY: 1) Lend or borrow money to the extent permitted by the Investment Company Act of 1940 or rule or regulations thereunder, as such statute, rules or regulations may be amended from time to time. 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. EACH TAX-FREE BOND FUND 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, 39 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 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 YIELDPLUS FUND 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, 40 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 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. 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. EACH TAXABLE BOND FUND 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 41 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. EACH TAX-FREE BOND FUND 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) 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. 42 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 YIELDPLUS FUND 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 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 43 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 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. The information below is provided as of 8/31/02. Each of the below-referenced officers and/or trustees also serves in the same capacity as described for the trust, for Schwab Capital Trust, for The Charles Schwab Family of Funds and Schwab Annuity Portfolios (the "fund complex") which as of 8/31/02 included 45 funds. 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 and affiliations, if any, with The Charles Schwab Corporation, Schwab and CSIM are as follows:
NAME AND POSITION(S) TERM OF OFFICE PRINCIPAL OTHER DIRECTORSHIPS DATE OF BIRTH WITH THE TRUST AND LENGTH OF OCCUPATIONS DURING TIME SERVED (1) THE PAST FIVE YEARS INDEPENDENT TRUSTEES DONALD F. DORWARD Trustee Trustee of Chief Executive September 23, 1931 Schwab Officer, Dorward & Investments Associates since 1991. (corporate
- -------------- 1 Each trustee is elected or appointed to office until resignation. 44 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 May 15, 1931 Schwab Executive Officer Investments and Director, since 1991. Semloh Financial, Inc. (international financial services and investment advisory firm). DONALD R. STEPHENS Trustee Trustee of Managing Partner, June 28, 1938 Schwab D.R. Stephens & Investments Company since 1991. (investments). Prior to 1996, Chairman and Chief Executive Officer of North American Trust (real estate investment trust). MICHAEL W. WILSEY Trustee Trustee of Chairman and Chief August 18, 1943 Schwab Executive Officer, Investments Wilsey Bennett, since 1991. Inc. (truck and air transportation, real estate investment and management, and investments). MARIANN BYERWALTER Trustee Trustee of Chairman of JDN Ms. Byerwalter also is August 13, 1960 Schwab Corporate Advisory on the Board of Investments LLC. Stanford University,
45 From 1996 to since 2000. 2001, Ms. America First Byerwalter was the Companies, Omaha, NE Vice President for (venture capital/fund Business Affairs management), Redwood and Chief Trust, Inc. (mortgage Financial Officer finance), Stanford of Stanford Hospitals and Clinics, University and, in SRI International 2001, Special (research), LookSmart, Advisor to the Ltd. (an Internet President of infrastructure Stanford company), PMI Group, University. Inc. (mortgage insurance) and Lucile Packard Children's Hospital. WILLIAM A. HASLER Trustee Trustee of Co-Chief Executive Mr. Hasler also is on November 22, 1941 Schwab Officer, Aphton the Board of Directors Investments Corporation of Solectron since 2000. (bio-pharmaceuticals) Corporation Prior to August (manufacturing), 1998, Mr. Hasler Tenera, Inc. (services was Dean of the and software), Haas School of Airlease Ltd. Business at the (aircraft leasing), University of Mission West California, Properties (commercial Berkeley (higher real estate) and education). Digital Microwave Corporation (a network equipment corporation). GERALD B. SMITH Trustee Trustee of Since 1990, Mr. Smith is also on September 28, 1950 Schwab Chairman and Chief the Board of Directors Investments Executive Officer of Pennzoil-Quaker since 2000. and founder of State Company (oil and Smith Graham & Co. gas), Rorento N.V. (investment (investments - advisors). Netherlands) and Cooper Industries (electrical products,
46 tools and hardware), and is a member of the audit committee of Northern Border Partners, L.P. (energy). INTERESTED TRUSTEES CHARLES R. SCHWAB (2) Chairman and Chairman and Chairman, Co-Chief Director, U.S. Trust July 29, 1937 Trustee Trustee of Executive Officer Corporation, United Schwab and Director, The States Trust Company Investments Charles Schwab of New York; The Gap, since 1991. Corporation; Chief Inc. (a clothing Executive Officer retailer), Audiobase, and Director, Inc. (full-service Schwab Holdings, audio solutions for Inc.; Chairman and the Internet), Director, Charles Vodaphone AirTouch PLC Schwab & Co., (a telecommunications Inc., Charles company), Siebel Schwab Investment Systems (a software Management, Inc.; company) and Xign, Chairman, Charles Inc. (a developer of Schwab Holdings electronic payment (UK); Chairman and systems); Director Chief Executive until January 1999, Officer, Schwab Schwab Retirement Plan (SIS) Holdings, Services, Inc., Mayer Inc. I, Schwab & Schweitzer, Inc. (a International securities brokerage Holdings, Inc. subsidiary of The Charles Schwab Corporation), Performance Technologies, Inc. (technology company), TrustMark, Inc.; Director until July 2001, The Charles Schwab Trust Company.
- ---------------- 2 In addition to their positions with the investment adviser and the distributor, Messrs. Schwab, Coghlan and Lyons, and certain of Mr. Lyons's immediate family members, also own stock of The Charles Schwab Corporation. 47 JOHN Philip COGHLAN (2) Trustee Trustee of Vice Chairman and Director, Performance May 6, 1951 Schwab Executive Vice Technologies, Inc., Investments President, The (technology company); since 2000. Charles Schwab Director, Charles Corporation; Vice Schwab Asset Chairman and Management (Ireland) President - Ltd. and Charles Retail, Charles Schwab Worldwide Funds Schwab & Co., PLC until March 2002. Inc.; Director, Charles Schwab Investment Management, Inc.; President, Chief Executive Officer and Director, The Charles Schwab Trust Company; Chairman and Director, Schwab Retirement Plan Services, Inc., Schwab Retirement Technologies, Inc. (formerly TrustMark, Inc.). Prior to July 2002, Mr. Coghlan was Vice Chairman and Enterprise President, Retirement Plan Services and Services for Investment Managers, Charles Schwab & Co., Inc. JEFFREY M. Trustee Trustee of Executive Vice
- ---------------- 2 In addition to their positions with the investment adviser and the distributor, Messrs. Schwab, Coghlan and Lyons, and certain of Mr. Lyons's immediate family members, also own stock of The Charles Schwab Corporation. 48 LYONS (2) February 22, 1955 Schwab President, Asset Investments Management since 2002. Products & Services since September 2001, Charles Schwab & Co., Inc. Prior to September 2001, Mr. Lyons was Executive Vice President, Mutual Funds, Charles Schwab & Co., Inc. OFFICERS RANDALL W. MERK President Officer of President and July 25, 1954 and Chief Schwab Chief Executive Executive Investments Officer, Charles Officer since 2002. Schwab Investment Management, Inc. and Executive Vice President, Charles Schwab & Co., Inc. 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
- ----------------- 2 In addition to their positions with the investment adviser and the distributor, Messrs. Schwab, Coghlan and Lyons, and certain of Mr. Lyons's immediate family members, also own stock of The Charles Schwab Corporation. 49 Century Companies, Inc. (January 1997 June 2001). TAI-CHIN TUNG Treasurer Officer of Senior Vice Director, Charles March 7, 1951 and Schwab President and Schwab Asset Principal Chief Financial Management (Ireland) Financial Officer, Charles Limited and Charles Officer. Schwab Investment Schwab Worldwide Funds Management, Inc.; PLC. Vice President, The Charles Schwab Trust Company. STEPHEN B. WARD Senior Vice Officer of Director, Senior April 5, 1955 President Schwab Vice President and and Chief Investments Chief Investment Investment since 1991. Officer, Charles Officer. Schwab Investment Management, Inc.; Chief Investment Officer, The Charles Schwab Trust Company. KOJI E. FELTON Secretary Officer of Senior Vice March 13, 1961 Schwab President, Chief Investments Counsel and since 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.
50 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. 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 22, 2002 meeting the Board of Trustees, the trustees, including a majority of independent trustees, approved the funds' investment advisory and administration agreement with CSIM (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 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, yield 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 independent accountants. 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. 51 In its deliberation, the trustees 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. 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 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 will not consider nominees recommended by shareholders. The following tables provide trustee compensation information for the fiscal year ended August 31, 2002. TAXABLE BOND FUNDS
Name of Trustee ($) Pension or Retirement ($) Aggregate Compensation Benefits Accrued as Total from each Fund 1 Part of Fund Expenses Compensation from Fund Complex 2 Short-Term Bond Total Bond Market - -------------------------------------------------------------------------------------------------------------- Charles R. Schwab 0 0 N/A 0 John Philip Coghlan 0 0 N/A 0 Jeremiah H. Chafkin 3 0 0 N/A 0 Jeffrey M. Lyons 4 0 0 N/A 0 Mariann Byerwalter $1,543 $2,086 N/A $152,025 Donald F. Dorward $1,564 $2,115 N/A $153,025 William A. Hasler $1,564 $2,115 N/A $153,025 Robert G. Holmes $1,564 $2,115 N/A $153,025
- --------------------- 1 Compensation for the fiscal period ending August 31, 2002. 2 Unless otherwise stated, information is for the fund complex which included 45 funds as of August 31, 2002. 3 Mr. Chafkin resigned from the board effective May 22, 2002. 4 Appointed to the board on May 22, 2002. 52
Name of Trustee ($) Pension or Retirement ($) Aggregate Compensation Benefits Accrued as Total from each Fund 1 Part of Fund Expenses Compensation from Fund Complex 2 Short-Term Bond Total Bond Market - -------------------------------------------------------------------------------------------------------------- Gerald B. Smith $1,543 $2,086 N/A $152,025 Donald R. Stephens $1,543 $2,086 N/A $152,025 Michael W. Wilsey $1,564 $2,115 N/A $153,025
TAX-FREE BOND FUNDS
Name of Trustee ($) Pension or ($) Aggregate Compensation Retirement Total from each Fund 1 Benefits Compensation Accrued as from Fund Part of Complex 2 Fund Expenses Short/Inter- Long-Term California California mediate Tax-Free Short/Inter- Long-Term Tax-Free Bond Fund mediate Tax-Free Bond Fund Tax-Free Bond Fund Bond Fund - ----------------------------------------------------------------------------------------------------------------- Charles R. Schwab 0 0 0 0 N/A 0 John Philip Coghlan 0 0 0 0 N/A 0 Jermemiah H.Chafkin 3 0 0 0 0 N/A 0 Jeffrey M. Lyons 4 0 0 0 0 N/A 0 Mariann Byerwalter $1,258 $1,231 $1,292 $1,363 N/A $152,025 Donald F. Dorward $1,275 $1,248 $1,310 $1,382 N/A $153,025 William A. Hasler $1,275 $1,248 $1,310 $1,382 N/A $153,025 Robert G. Holmes $1,275 $1,248 $1,310 $1,382 N/A $153,025
- --------------------- 1 Compensation for the fiscal period ending August 31, 2002. 2 Unless otherwise stated, information is for the fund complex which included 45 funds as of August 31, 2002. 3 Mr. Chafkin resigned from the board effective May 22, 2002. 4 Appointed to the board on May 22, 2002. 53
Name of Trustee ($) Pension or ($) Aggregate Compensation Retirement Total from each Fund 1 Benefits Compensation Accrued as from Fund Part of Complex 2 Fund Expenses Short/Inter- Long-Term California California mediate Tax-Free Short/Inter- Long-Term Tax-Free Bond Fund mediate Tax-Free Bond Fund Tax-Free Bond Fund Bond Fund - ----------------------------------------------------------------------------------------------------------------- Gerald B. Smith $1,258 $1,231 $1,292 $1,363 N/A $152,025 Donald R. Stephens $1,258 $1,231 $1,292 $1,363 N/A $152,025 Michael W. Wilsey $1,275 $1,248 $1,310 $1,382 N/A $153,025
YIELDPLUS FUND
Name of Trustee ($) Pension or ($) Aggregate Retirement Total Compensation Benefits Accrued Total from the Fund 1 as Part of Fund Compensation Expenses from Fund Complex 2 - -------------------------------------------------------------------------------------------- Charles R. Schwab 0 N/A 0 John Philip Coghlan 0 N/A 0 Jeremiah H. Chafkin 3 0 N/A 0 Jeffrey M. Lyons 4 0 N/A 0 Mariann Byerwalter $2,320 N/A $152,025 Donald F. Dorward $2,352 N/A $153,025 William A. Hasler $2,352 N/A $153,025 Robert G. Holmes $2,352 N/A $153,025 Gerald B. Smith $2,320 N/A $153,025 Donald R. Stephens $2,320 N/A $153,025 Michael W. Wilsey $2,352 N/A $153,025
- -------------- 1 Compensation for the fiscal period ending August 31, 2002. 2 Unless otherwise stated, information is for the fund complex which included 45 funds as of August 31, 2002. 3 Mr. Chafkin resigned for the board effective May 22, 2002. 4 Appointed to the board on May 22, 2002. 54 The following tables provide information as of December 31, 2001, with respect to a dollar range of securities beneficially owned by each trustee TAXABLE BOND FUNDS
Name of Trustee Dollar Range of Trustee Aggregate Dollar Range of Trustee Ownership of Equity Securities in Ownership In the Fund Complex the Fund Short-Term Total Bond Bond Market - ------------------------------------------------------------------------------------------------------- Charles R. Schwab Over $100,000 None Over $100,000 John Philip Coghlan None None Over $100,000 Jeremiah H. Chafkin None None Over $100,000 Jeffrey M. Lyons None None None Mariann Byerwalter None None $50,001-$100,000 Donald F. Dorward None None Over $100,000 William A. Hasler None None $50,001-$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 None None Over $100,000
TAX-FREE BOND FUNDS
Name of Trustee Dollar Range of Trustee Ownership of Equity Securities in Aggregate Dollar Range of the Fund Trustee Ownership In the Fund Complex Short/Inter- Long-Term California California mediate Tax- Tax-Free Short/Inter- Long-Term Free Bond Bond Fund mediate Tax-Free Fund Tax-Free Bond Fund Bond Fund - -------------------------------------------------------------------------------------------------------------------- Charles R. Schwab None None None None Over $100,000 John Philip Coghlan None None None None Over $100,000 Jermemiah H.Chafkin None None None Over $100,000 Over $100,000 Jeffrey M. Lyons None None None None None Mariann Byerwalter None None None None $50,001-$100,000 Donald F. Dorward None None None $1-$10,000 Over $100,000 William A. Hasler None None None None $50,001-$100,000 Robert G. Holmes None None None None Over $100,000
55
Name of Trustee Dollar Range of Trustee Ownership of Equity Securities in Aggregate Dollar Range of the Fund Trustee Ownership In the Fund Complex Short/Inter- Long-Term California California mediate Tax- Tax-Free Short/Inter- Long-Term Free Bond Bond Fund mediate Tax-Free Fund Tax-Free Bond Fund Bond Fund - -------------------------------------------------------------------------------------------------------------------- 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
YIELDPLUS FUND
Name of Trustee Dollar Range of Trustee Aggregate Dollar Range of Ownership of Equity Trustee Ownership In the Securities in the Fund Fund Complex - --------------------------------------------------------------------------------------------- Charles R. Schwab Over $100,000 Over $100,000 John Philip Coghlan None Over $100,000 Jeremiah H. Chafkin None Over $100,000 Jeffrey M. Lyons None None Mariann Byerwalter None $50,001-$100,000 Donald F. Dorward None Over $100,000 William A. Hasler None $50,001-$100,000 Robert G. Holmes None Over $100,000 Gerald B. Smith None Over $100,000 Donald R. Stephens None Over $100,000 Michael W. Wilsey Over $100,000 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 securities for their own accounts. This includes securities that may be purchased or held by the funds. Securities transactions by some of these 56 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. CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES As of October 23, 2002, the officers and trustees of the Taxable Bond Funds, Tax-Free Bond Funds and YieldPlus Fund, as a group owned of record or beneficially less than 1% of the outstanding voting securities of any class of each fund. As of October 23, 2002, the following represents entities that owned, of record or beneficially, more than 5% of the outstanding voting securities of any class of the funds:
Schwab Total Bond Market Fund - ----------------------------- Schwab MarketTrack Balanced 16.04% Schwab MarketTrack Conservative 14.31% Schwab MarketTrack Growth 7.42%
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) 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, Co-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. EACH TAXABLE BOND FUND First $500 million - 0.30% More than $500 million - 0.22% For the fiscal years ended August 31, 2000, 2001 and 2002 the investment advisory fees incurred by the Schwab Short-Term Bond Market Fund were $0 (fees were reduced by $705,000), $0 (fees were reduced by $818,000), and $88,000 (fees were reduced by $1,174,000), respectively. For the fiscal years ended August 31, 2000, 2001 and 2002 the investment advisory fees incurred by the Schwab Total Bond Market Fund, were $221,000 (fees were reduced by $1,525,000), and $351,000 (fees were reduced by $1,749,000), and $447,000 (fees were reduced by $2,127,000), respectively. 57 The investment adviser and Schwab have contractually guaranteed that, through November 15, 2003, total 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 0.45%, of each fund's average daily net assets. For the period 11/16/03 through 11/15/04, Schwab and the investment adviser will guarantee that the net operating expenses (excluding interest, taxes and certain non-routine expenses) will not exceed 0.55% of average daily net assets. EACH TAX-FREE BOND FUND First $500 million - 0.30% More than $500 million - 0.22% For the fiscal years ended August 31, 2000, 2001 and 2002 the investment advisory fees incurred by the Schwab Short/Intermediate Tax-Free Bond Fund were $55,000 (fees were reduced by $209,000), $56,000 (fees were reduced by $209,000), and $110,000 (fees were reduced by $253,000), respectively. For the fiscal years ended August 31, 2000, 2001 and 2002, the investment advisory fees incurred by the Schwab Long-Term Tax-Free Bond Fund were $47,000 (fees were reduced by $208,000), and $42,000 (fees were reduced by $200,000), and $45,000 (fees were reduced by $200,000), respectively. For the fiscal years ended August 31, 2000, 2001 and 2002 the investment advisory fees incurred by the Schwab California Short/Intermediate Tax-Free Bond Fund were $128,000 (fees were reduced by $253,000), $168,000 (fees were reduced by $239,000), and $208,000 (fees were reduced by $262,000), respectively. The investment adviser and Schwab have contractually guaranteed that, through November 15, 2003 that total 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, 2000, 2001 and 2002 the investment advisory fees incurred by the Schwab California Long-Term Tax-Free Bond Fund were $232,000 (fees were reduced by $336,000), $264,000 (fees were reduced by $312,000), and $329,000 (fees were reduced by $337,000), respectively. YIELDPLUS FUND First $500 million - 0.35% More than $500 million - 0.30% For the fiscal years ended August 31, 2000, 2001 and 2002 the fund paid investment advisory fees of $194,000, (fees were reduced by $435,000), $795,000, (fees were reduced by $686,000), and $3,985,000, (fees were reduced by $1,185,000), respectively. 58 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 the 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 a fund, Schwab is entitled to receive an annual fee, payable monthly from the funds, in the amount of 0.20% of the average daily net assets of each fund. CUSTODIAN AND FUND ACCOUNTANT PFPC Trust Company, 8800 Tinicum Blvd., 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. INDEPENDENT ACCOUNTANT The funds' independent accountant, PricewaterhouseCooper 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, 2002, are included in the fund's annual report that is supplied with the SAI. 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 59 whose maturities at the time of acquisition were one year or less ("short-term securities") are excluded. TAXABLE BOND FUNDS The portfolio turnover rates for the Schwab Short-Term Bond Fund for the fiscal years ended August 31, 2001 and 2002 were 248% and 150%, respectively. The portfolio turnover rates for the Schwab Total Bond Market Fund for the fiscal years ended August 31, 2001 and 2002 were 153% and 74%, respectively. TAX-FREE BOND FUNDS The portfolio turnover rates for the Schwab Short/Intermediate Tax-Free Bond Fund for the fiscal years ended August 31, 2001 and 2002 were 14% and 28%, respectively. The portfolio turnover rates for the Schwab Long-Term Tax-Free Bond Fund for the fiscal years ended August 31, 2001 and 2002 were 35% and 25%, respectively. The portfolio turnover rates for the Schwab California Short/Intermediate Tax-Free Bond Fund for the fiscal years ended August 31, 2001 and 2002 were 30% and 17%, respectively. The portfolio turnover rates for the Schwab California Long-Term Tax-Free Bond Fund for the fiscal years ended August 31, 2001 and 2002 were 37% and 34%, respectively. YIELDPLUS FUND The portfolio turnover rates for the Schwab YieldPlus Fund(R) for the fiscal years ended August 31, 2001 and 2002 were 106% and 42%, respectively. PORTFOLIO TRANSACTIONS The Taxable Bond Funds, Tax-Free Bond Funds and YieldPlus Fund paid no brokerage commissions during the prior three 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. 60 The investment adviser seeks to obtain the best overall 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. 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 transactions, in accordance with applicable SEC 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 or spreads 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 or spreads, 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. The NASD has adopted rules expressly permitting these types of arrangements under certain circumstances. 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. 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 61 brokerage commissions (if relevant) are reasonable and fair in comparison to unaffiliated brokerage commissions for comparable transactions. The Board reviews the procedures annually and approves and reviews transactions involving affiliated brokers quarterly. 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 may be waived for certain investors, including trustees, officers and employees of Schwab, or changed without prior notice. 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. 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 62 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 2002: New Year's Day, Martin Luther King Jr.'s Birthday (observed), 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 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. 63 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, after 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 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 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. 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. 64 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. FEDERAL INCOME TAX INFORMATION FOR SHAREHOLDERS The discussion of federal income taxation presented below supplements the discussion in the funds' prospectus 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. 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 65 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 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 66 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 and Schwab California Long-Term Tax Free Bond Fund 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 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 67 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. CALCULATION OF PERFORMANCE DATA Average annual total return is a standardized measure of performance calculated using methods prescribed by SEC rules. It is calculated by determining the ending value of a hypothetical initial investment of $1,000 made at the beginning of a specified period. The ending value is then divided by the initial investment, which is annualized and expressed as a percentage. It is reported for periods of one, five and 10 years or since commencement of operations for periods not falling on those intervals. In computing average annual total return, a fund assumes reinvestment of all distributions at net asset value on applicable reinvestment dates. For average "after-tax" total return, the SEC rules mandate several assumptions, including that the highest historical individual federal marginal income tax rates at the time of reinvestment be used, and that the calculations do not reflect the impact of state and local taxes. After-tax returns depend on an investor's tax situation, and may differ from those shown. These returns, for instance, assume that an investor has sufficient capital gains of the same character from other investments to offset any capital losses from the redemption. These returns are not relevant to certain tax-deferred investors. If the sale of shares results in a loss, it is assumed that the shareholder has sufficient capital gains to offset the capital loss. As a result, returns after taxes on distributions and sale of fund shares may exceed returns after taxes on distributions (but before sale of fund shares). TAXABLE BOND FUNDS STANDARDIZED TOTAL RETURN
Average Annual Total Average Annual Total Average Annual Total Return for 1 year Return for 5 years Return from ended August 31, 2002 ended August 31, 2002 commencement of operations to August 31, 2002* Schwab Short-Term Bond Market Fund 4.88% 6.36% 5.62%** After-tax Returns: On Distribution 2.92% 4.08% 3.27%** On Distribution and Sale 2.95% 3.95% 3.30%** Schwab Total Bond Market Fund 6.18% 7.34% 6.84% After-tax Returns: On Distribution 3.65% 4.79% 4.19% On Distribution and Sale 3.70% 4.60% 4.13%
68 * March 5, 1993 for the Schwab Total Bond Market Fund. ** Average annual total return for 10 years ended August 31, 2002. TAX-FREE BOND FUNDS STANDARDIZED TOTAL RETURN
Average Annual Total Average Annual Total Average Annual Total Return for 1 year Return for 5 years Return from ended ended commencement of August 31, 2002 August 31, 2002 operations* to August 31, 2002 Fund Schwab Short/Intermediate Tax-Free Bond Fund 5.37% 4.85% 4.64% After-tax Returns: On Distribution 5.37% 4.85% 4.64% On Distribution and Sale 4.56% 4.67% 4.51% Schwab Long-Term Tax-Free Bond Fund 6.24% 5.98% 6.28% After-tax Returns: On Distribution 6.24% 5.95% 6.23% On Distribution and Sale 5.55% 5.74% 6.05% Schwab California Short/Intermediate Tax-Free Bond Fund 4.66% 4.84% 4.68% After-tax Returns: On Distribution 4.66% 4.84% 4.68% On Distribution and Sale 4.12% 4.65% 4.55% Schwab California Long-Term Tax-Free Bond Fund 5.14% 6.03% 6.46%** After-tax Returns: On Distribution 5.14% 6.03% 6.42%** On Distribution and Sale 4.90% 5.82% 6.23%**
* April 21, 1993 for the Schwab Short/Intermediate Tax-Free Bond Fund and Schwab California Short/Intermediate Tax-Free Bond Fund; September 11, 1992 for the Schwab Long-Term Tax-Free Bond Fund. ** Average annual total return for 10 years ended August 31, 2002. 69 YIELDPLUS FUND STANDARDIZED TOTAL RETURN
Average Annual Total Return Average Annual Total Return for 1 year ended August 31, from commencement of 2002 operations* to August 31, 2002 Schwab YieldPlus Fund(R) Investor Shares 1.89% 5.00% After-tax Returns: On Distribution 0.17% 2.66% On Distribution and Sale 1.14% 2.84% Select Shares 2.04% 5.16% After-tax Returns: On Distribution 0.26% 2.75% On Distribution and Sale 1.24% 2.93%
* October 1, 1999 for Schwab YieldPlus Fund. An after-tax total return for the fund may be calculated by taking the fund's total return and subtracting applicable federal taxes from the portions of the fund's total return attributable to capital gain and ordinary income distributions. This after-tax total return may be compared to that of other mutual funds with similar investment objectives as reported by independent sources. The fund may advertise the percentage of its total return that would be paid to taxes annually (at the applicable federal personal income and capital gains tax rates) before redemption of fund shares. This proportion may be compared to that of other mutual funds with similar investment objectives as reported by independent sources. TAXABLE BOND FUNDS NONSTANDARDIZED CUMULATIVE TOTAL RETURN
Fund Cumulative Total Return from commencement of operations to August 31, 2002* Schwab Short-Term Bond Market Fund 88.33% Schwab Total Bond Market Fund 87.40%
* November 5, 1991 for Schwab Short-Term Bond Market Fund and March 5, 1993 for the Schwab Total Bond Market Fund. TAX-FREE BOND FUNDS NONSTANDARDIZED CUMULATIVE TOTAL RETURN
Fund Cumulative Total Return from commencement of operations to August 31, 2002* Schwab Short/Intermediate Tax-Free Bond Fund 52.89% Schwab Long-Term Tax-Free Bond Fund 83.56%
70
Fund Cumulative Total Return from commencement of operations to August 31, 2002* Schwab California Short/Intermediate Tax- Free Bond Fund 53.54% Schwab California Long-Term Tax-Free Bond Fund 101.72%
* April 21, 1993 for the Schwab Short/Intermediate Tax-Free Bond Fund and Schwab California Short/Intermediate Tax-Free Bond Fund; September 11, 1992 for the Schwab Long-Term Tax-Free Bond Fund; and February 24, 1992 for the Schwab California Long-Term Tax-Free Bond Fund. YIELDPLUS FUND NONSTANDARDIZED CUMULATIVE TOTAL RETURN
Cumulative Total Return from commencement of operations to August 31, 2002* Schwab YieldPlus Fund(R) Investor Shares 15.31% Select Shares 15.81%
* October 1, 1999 for Schwab YieldPlus Fund. Each fund also may advertise its cumulative total return since inception. This number is calculated using the same formula that is used for average annual total return except that, rather than calculating the total return based on a one-year period, cumulative total return is calculated from commencement of operations to the end of the fiscal year. TAXABLE BOND FUNDS 30-DAY SEC YIELD
Fund 30-day period ended August 31, 2002 Schwab Short-Term Bond Market Fund 4.27% Schwab Total Bond Market Fund 3.85%
TAX FREE-BOND FUNDS 30-DAY SEC YIELD
Fund 30-day period ended August 31, 2002 Schwab Short/Intermediate Tax-Free Bond Fund 2.57% Schwab Long-Term Tax-Free Bond Fund 4.40% Schwab California Short/Intermediate Tax-Free Bond Fund 2.31%
71
Schwab California Long-Term Tax-Free Bond Fund 4.39%
YIELDPLUS FUND 30-DAY SEC YIELD
30-day period ended August 31, 2002 Schwab YieldPlus Fund(R) Investor Shares 4.62% Select Shares 4.77%
A 30-day yield is calculated by dividing the net investment income per share earned during a 30-day period by the maximum offering price per share on the last day of the period, according to the following formula: a-b ----- YIELD=2[(cd+1)(6)-1] Where: a = dividends and interest earned during the period. b = expenses accrued for the period (net of reimbursements). c = the average daily number of shares outstanding during the period that were entitled to receive dividends. d = the maximum offering price per share on the last day of the period. TAX-FREE BOND FUNDS 30-DAY TAX-EQUIVALENT YIELD
Fund 30-day period ended August 31, 2002 Schwab Short/Intermediate Tax-Free Bond Fund 4.19% Schwab Long-Term Tax-Free Bond Fund 7.17% Schwab California Short/Intermediate Tax-Free Bond Fund 4.15% Schwab California Long-Term Tax-Free Bond Fund 7.88%
The tax equivalent yield of the funds is calculated by dividing that portion of the applicable fund's yield (computed as described above) that is tax-exempt by an amount equal to 1 minus the applicable effective tax rate, and adding the result to that portion, if any, of the yield of a fund that is not tax-exempt. For the Schwab Short/Intermediate Tax-Free Bond Fund and Schwab Long-Term Tax-Free Bond Fund, the maximum federal marginal rate of 38.6% is normally used. For the Schwab California Short/Intermediate Tax-Free Bond Fund and Schwab California Long-Term Tax-Free Bond Fund, a maximum combined federal and State of California marginal rate of 44.31% is normally used. Tax equivalent effective yields are computed in the same manner as tax equivalent yields, except that effective yield is substituted for yield in the calculation. 72 COMPARATIVE PERFORMANCE The performance of a fund may be compared with the performance of other mutual funds by comparing the ratings of mutual fund rating services, various indices, U.S. government obligations, bank certificates of deposit, the consumer price index and other investments and measures for which reliable data is available. An index's performance data assumes the reinvestment of dividends but does not reflect deductions for administrative, management and trading expenses. A fund will be subject to these costs and expenses, while an index does not have these expenses. In addition, various factors, such as holding a cash balance, may cause a fund's performance to be higher or lower than that of an index. Each Bond Fund's performance may be compared to various unmanaged bond indexes in addition to the Lehman Brothers Mutual Fund Short (1-5 Year) U.S. Government/Credit Index and the unmanaged Lehman Brothers U.S. Aggregate Bond Index, including but not limited to, Salomon Smith Barney Broad Investment-Grade Bond Index, the Lehman Brothers Government/Credit Bond Index, the Merrill Lynch Domestic Master Index and to Lipper, Inc. averages and Morningstar, Inc. rankings. The following tables illustrate the historical total return of securities comprising the indexes beginning calendar year end December 31, 1989 through calendar year end December 31, 2001. This historical information is not indicative of any future trend of the funds or the particular market sectors that the indexes represent.
DATE U.S. AGGREGATE BOND SHORT (1-5 Year) INDEX GOVERNMENT/CREDIT INDEX Dec. 31, 1989 14.53 11.70 Dec. 31, 1990 8.96 9.69 Dec. 31, 1991 16.00 13.14 Dec. 31, 1992 7.40 6.83 Dec. 31, 1993 9.75 7.10 Dec. 31, 1994 -2.92 -0.72 Dec. 31, 1995 18.47 12.88 Dec. 31, 1996 3.63 4.67 Dec. 31, 1997 9.65 7.13 Dec. 31, 1998 8.67 7.64 Dec. 31, 1999 -0.82 2.09 Dec. 31, 2000 11.63 8.91 Dec. 31, 2001 9.03 8.44
73 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. 74 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 75 ratings of these bonds will fall below investment grade is higher than for bonds with higher ratings. 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. 76 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. 77 PART C OTHER INFORMATION SCHWAB INVESTMENTS Item 23. Exhibits. (a) Articles of Incorporation Agreement and Declaration of Trust, dated 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, Rights of Security Holders Article VI, Article VIII, Section 4 and Article IX, 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 Contracts Administration Agreement between Registrant and Charles Schwab Investment Management, Inc. (the "Investment Manager") 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 was electronically filed and is incorporated by reference to Exhibit (d) (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. Part C (e) Underwriting Contracts (i) Distribution Agreement between Registrant 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 was electronically filed and is incorporated by reference to Exhibit (e) (ii), File No. 811-6200, of Post-Effective Amendment No. 29 to Registrant's Registration Statement on Form N-1A, on July 21, 1999. (f) Bonus or Profit Sharing Inapplicable. Contracts (g) Custodian Agreements (i) Custodian Services Agreement between Registrant and PFPC Trust Company is electronically filed herewith as Exhibit (g)(i), File No. 811-6200. (ii) 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. (iii) Amended Schedules A and C to the Transfer Agency Agreement referred to at Exhibit (g)(vi) above were electronically filed and are incorporated by reference to Exhibit (g)(iii), File No. 811-6200, of Post-Effective Amendment No. 29 to Registrant's Registration Statement on Form N1-1A, filed on July 21, 1999. (iv) 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. (v) Schedules A and C to the Shareholder Service Agreement between the Registrant and Schwab referenced at Exhibit (g)(iv) above were electronically filed and are incorporated by reference to Exhibit (g)(viii), File No. 811-6200, of Post-Effective Amendment No. 29 to Registrant's Registration Statement on Form N-1A, filed on July 21, 1999. (vi) Accounting Services Agreement between Registrant and PFPC is electronically filed herewith as Exhibit (g)(vi), File No. 811-6200. Part C (vii) 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 herein 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. (viii) 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. (ix) 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. (x) 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. (xi) 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. (xii) Custodian Services Agreement pursuant to Rule 17f-5 and Rule 17f-7 between Registrant and PFPC Trust Company dated May 22, 2002, is electronically filed herewith as Exhibit (g)(xii), File No. 811-6200. (h) Other Material Contracts Inapplicable. (i) Legal Opinion Opinion of Counsel is electronically filed herewith as Exhibit (i), File No. 811-6200. Part C (j) Other Opinions Auditors Consent is electronically filed herewith as Exhibit (j), File No. 811-6200. (k) Omitted Financial Inapplicable. Statements (l) Initial Capital Agreement (i) Purchase Agreement relating to shares of the 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. (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. (m) Rule 12b-1 Plan Inapplicable. Part C (n) Financial Data Schedule Inapplicable. (o) Rule 18f-3 Plan Registrant's Amended and Restated Multiple Class Plan for Investor and Select Shares of Schwab 1000 Fund(R) and Schwab YieldPlus Fund(R) was electronically filed and is incorporated by reference to Exhibit (o)(i) of Post-Effective Amendment No. 29 to Registrant's Registration Statement on Form N-1A, filed on July 21, 1999. (p) Power of Attorney (i) Power of Attorney executed by Mariann Byerwalter, dated September 4, 2002, is electronically filed herewith as Exhibit (p)(i), File No. 811-6200. (ii) Power of Attorney executed by William A. Hasler, dated September 4, 2002, is electronically filed herewith as Exhibit (p)(ii), File No. 811-6200. (iii) Power of Attorney executed by Gerald B. Smith, dated September 4, 2002, is electronically filed herewith as Exhibit (p)(iii), File No. 811-6200. (iv) Power of Attorney executed by Charles R. Schwab, dated September 4, 2002, is electronically filed herewith as Exhibit (p)(iv), File No. 811-6200. (v) Power of Attorney executed by John Philip Coghlan, dated September 4, 2002, is electronically filed herewith as Exhibit (p)(v), File No. 811-6200. (vi) Power of Attorney executed by Jeffrey Philip Lyons, dated September 4, 2002, is electronically filed herewith as Exhibit (p)(vi), File No. 811-6200. (vii) Power of Attorney executed by Randall W. Merk, dated September 4, 2002, is electronically filed herewith as Exhibit (p)(vii), File No. 811-6200. (viii) Power of Attorney executed by Donald F. Doward, dated September 4, 2002, is electronically filed herewith as Exhibit (p)(viii), File No. 811-6200. (ix) Power of Attorney executed by Robert G. Holmes, dated September 4, 2002, is electronically filed herewith as Exhibit (p)(ix), File No. 811-6200. Part C (x) Power of Attorney executed by Donald R. Stephens, dated September 4, 2002, is electronically filed herewith as Exhibit (p)(x), File No. 811-6200. (xi) Power of Attorney executed by Michael W. Wilsey, dated September 4, 2002, is electronically filed herewith as Exhibit (p)(xi), File No. 811-6200. (xii) Power of Attorney executed by Tai-Chin Tung, dated September 4, 2002, is electronically filed herewith as Exhibit (p)(xii), File No. 811-6200. (xiii) Certificate of Assistant Secretary executed by Alice L. Schulman, August 20, 2001, to Post-Effective Amendment No. 37 to Registrant's Statement on Form N-1A electronically filed on August 28, 2001, is incorporated herein by reference to Exhibit (p)(xii), File No. 811-6200. (q) Code of Ethics (i) Code of Ethics adopted by Registrant, Charles Schwab Investment Management Inc. and Charles Schwab & Co., Inc. was electronically filed and is incorporated by reference to Exhibit (g)(i), File No. 811-6200, of Post-Effective Amendment No. 41 to Registrant's Registration Statement on Form N-1A, filed on February 26, 2002. 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. Part C 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, each an open-end, management investment company. The principal place of business of the investment adviser is 101 Montgomery Street, San Francisco, 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, 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, Director Chairman, Chief Executive Officer and Trustee The Charles Schwab Corporation Chairman and Co-Chief Executive Officer, Director Charles Schwab Investment Management, Inc. Chairman, Director Schwab Holdings, Inc. Chief Executive Officer, Director
Part C
Name and Position with Registrant Name of Company Capacity - ---------------------------------------------------------------------------------------------------------------------- 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 The Gap, Inc. Director Audiobase, Inc. Director Vodaphone AirTouch PLC Director Siebel Systems Director Xign, Inc. Director The Charles Schwab Trust Company Director until July 2001 David S. Pottruck Charles Schwab & Co., Inc. President and Chief Executive Officer, Director The Charles Schwab Corporation President and Co-Chief Executive Officer, Director U.S. Trust Corporation Director United States Trust Company of New York Director Schwab (SIS) Holdings, Inc. I President and Chief Operating Officer Schwab Holdings, Inc. President and Chief Operating Officer, Director Schwab International Holdings, Inc. President and Chief Operating Officer
Part C
Name and Position with Registrant Name of Company Capacity - ---------------------------------------------------------------------------------------------------------------------- Charles Schwab Investment Management, Inc. Director until October 2001 John Philip Coghlan Charles Schwab & Co., Inc. Vice Chairman and President - Trustee Retail. Prior to July 2002, Mr. Coghlan was Vice Chairman and Enterprise President - Retirement Plan Services and Services for Investment Managers. The Charles Schwab Corporation Vice Chairman and Executive Vice President Charles Schwab Investment Management, Inc. Director The Charles Schwab Trust Company President, Chief Executive Officer and Director Schwab Retirement Technologies, Inc. (formerly Chairman and Director TrustMark, Inc.) Schwab Retirement Plan Services, Inc. Chairman and Director Performance Technologies, Inc. Director Charles Schwab Asset Management (Ireland) Ltd. Director until March 2002 Charles Schwab Worldwide Funds PLC Director until March 2002 Willie C. Bogan The Charles Schwab Corporation Assistant Corporate Secretary Charles Schwab & Co., Inc. Vice President and Assistant Corporate Secretary Charles Schwab Investment Management, Inc. Assistant Corporate Secretary The Charles Schwab Trust Company Assistant Corporate Secretary until February 2000
Part C
Name and Position with Registrant Name of Company Capacity - ---------------------------------------------------------------------------------------------------------------------- Jeffrey M. Lyons Charles Schwab & Co., Inc. Executive Vice President, Trustee 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. Prior President and Chief Executive to September 2002, Mr. Merk was Officer 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). Charles Schwab Investment Management, Inc. President and Chief Executive Officer Karen W. Chang Charles Schwab & Co., Inc. Enterprise President - General Investor Services Koji E. Felton, Charles Schwab Investment Management, Inc. Senior Vice President, Chief Secretary Counsel and Assistant Corporate Secretary Christopher V. Dodds Charles Schwab & Co., Inc. Executive Vice President and Chief Financial Officer Carrie Dwyer Charles Schwab & Co., Inc. Executive Vice President - Corporate Oversite and Corporate Secretary Lon Gorman Charles Schwab & Co., Inc. Vice Chairman and Enterprise President - Capital Markets and Trading Daniel O. Leemon Charles Schwab & Co., Inc. Executive Vice President - Business Strategy
Part C
Name and Position with Registrant Name of Company Capacity - ---------------------------------------------------------------------------------------------------------------------- Dawn G. Lepore Charles Schwab & Co., Inc. Vice Chairman - Technology and Administration Frederick E. Matteson Charles Schwab & Co., Inc. Executive Vice President - Smaller Portfolio Investors & Core Initiative Mary McLeod Charles Schwab & Co., Inc. Executive Vice President - Human Resources John P. McGonigle Charles Schwab & Co., Inc. Executive Vice President - Mutual Funds Geoffrey J. Penney Charles Schwab & Co., Inc. Executive Vice President and Chief Information Officer Gideon Sasson Charles Schwab & Co., Inc. Enterprise President - Brokerage Operations Maurisa Sommerfield Charles Schwab & Co., Inc. Executive Vice President - Schwab Operations William Atwell Charles Schwab & Co., Inc. Executive Vice President - Schwab Institutional and International Tai-Chin Tung, Charles Schwab Investment Management, Inc. Senior Vice President and Chief Treasurer and Principal Financial Officer Financial Officer The Charles Schwab Trust Company Vice President Charles Schwab Asset Management (Ireland) Director Limited Charles Schwab Worldwide Funds PLC Director Stephen B. Ward, Charles Schwab Investment Management, Inc. Director, Senior Vice President Senior Vice President and and Chief Investment Officer 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 Part C also acts as principal underwriter for the The Charles Schwab Family of Funds, Schwab Investments, 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. 44 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. 44 to be signed on its behalf by the undersigned, thereto duly authorized, in the City of Philadelphia, Commonwealth of Pennsylvania, on the 6th day of November, 2002. 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. 44 to Registrant's Registration Statement on Form N-1A has been signed below by the following persons in the capacities indicated this 6th day of November, 2002. Signature Title - --------- ------ Charles R. Schwab* Chairman and Trustee - ------------------------ Charles R. Schwab John Philip Coghlan* President, Chief Executive Officer and Trustee - ------------------------ John Philip Coghlan 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 Tai-Chin Tung* Treasurer and Principal Financial Officer - ------------------------ Tai-Chin Tung *By: /s/ Timothy W. Levin -------------------- Timothy W. Levin, Attorney-in-Fact Pursuant to Power of Attorney EXHIBIT INDEX EXH. NO. DOCUMENT - -------- -------- (g)(i) Custodian Services Agreement (g)(vi) Accounting Services Agreement (g)(xii) Custodian Services Agreement Pursuant to Rule 17f-5 and Rule 17f-7 (i) Legal Opinion (j) Other Opinion (p)(i) Power of Attorney (p)(ii) Power of Attorney (p)(iii) Power of Attorney (p)(iv) Power of Attorney (p)(v) Power of Attorney (p)(vi) Power of Attorney (p)(vii) Power of Attorney (p)(viii) Power of Attorney (p)(ix) Power of Attorney (p)(x) Power of Attorney (p)(xi) Power of Attorney (p)(xii) Power of Attorney Part C EX-99.(G)(I) 4 f84662exv99wxgyxiy.txt EXHIBIT 99.(G)(I) Ex-(g)(i) CUSTODIAN SERVICES AGREEMENT TERMS AND CONDITIONS This Agreement is made, as of May 22, 2002, separately by and between each of Schwab Capital Trust, Schwab Investments, The Charles Schwab Family of Funds and Schwab Annuity Portfolios (each a "Fund") and PFPC Trust Company ("PFPC Trust"). Each Fund is registered as an open-end investment company under the Investment Company Act of 1940 (the "1940 Act"), as amended, unless otherwise set forth on the signature page hereof. Each Fund wishes to retain PFPC Trust to provide custody services to its investment portfolios listed on Schedule A, as attached hereto (each a "Portfolio"), and PFPC Trust wishes to furnish such services as more fully described herein. In consideration of the promises and mutual covenants herein contained, each separate Fund and PFPC Trust agree as follows: 1. Definitions. (a) "Authorized Person". The term "Authorized Person" shall mean any person authorized by a Fund to give Oral or Written Instructions with respect to such Fund. Such persons are listed on the Authorized Persons Appendix which is attached hereto as Schedule B (as the same may be revised by a particular Fund with respect to the Authorized Persons applicable to it upon reasonable prior notice to PFPC Trust from time to time). (b) "Book-Entry System". The term "Book-Entry System" means Federal Reserve Treasury book-entry system for United States and federal agency securities, its successor or successors, and its nominee or nominees and any book-entry system or clearing agency registered with the SEC under the 1934 Act. (c) "CFTC". The term "CFTC" shall mean the Commodities Futures Trading Commission. (d) "Governing Board". The term "Governing Board" shall mean a particular Fund's Board of Directors if the Fund is a corporation or a particular Fund's Board of Trustees if the Fund is a trust, or, where duly authorized, a competent committee thereof. If a Fund is a limited partnership, the term "Governing Board" shall mean such Fund's general partner. (e) "Oral Instructions". The term "Oral Instructions" shall mean oral or e-mail instructions received by PFPC Trust from an Authorized Person (or from a person reasonably believed by PFPC Trust to be an Authorized Person listed on the then current Authorized Persons Appendix). For the benefit of PFPC Trust, any e-mail communication sent to PFPC Trust shall be sent to all of the persons listed on Schedule C hereto (as such Schedule C may be changed by PFPC Trust upon notice to the Funds), and PFPC Trust shall not be obligated to consider an e-mail instruction that is not sent to all of such persons to be on Oral Instruction under this Agreement. (f) "SEC". The term "SEC" shall mean the Securities and Exchange Commission. (g) "Securities and Commodities Laws". The terms the -2- "1933 Act" shall mean the Securities Act of 1933, the "1934 Act" shall mean the Securities Exchange Act of 1934, the "1940 Act" shall mean the Investment Company Act of 1940, as amended, and the "CEA" shall mean the Commodities Exchange Act, as amended. The 1933 Act, the 1934 Act, the 1940 Act and CEA shall together be the "Securities and Commodities Laws." (h) "Shares". The term "Shares" shall mean the units of beneficial interest of any Portfolio or class of a Fund. (i) "Property". The term "Property" shall mean: (i) any and all securities and other investment items which a Portfolio may from time to time deposit, or cause to be deposited, with PFPC Trust hereunder or which PFPC Trust may from time to time maintain hereunder with respect to a Portfolio; (ii) all income in respect of any of such securities or other investment items; (iii) all proceeds of the sale of any of such securities or other investment items; and (iv) all proceeds of the sale of securities issued by a Portfolio, which are received by PFPC Trust from time to time, from or on behalf of the Portfolio. (j) "Written Instructions". The term "Written Instructions" shall mean (i) written trade instructions signed by -3- two Authorized Persons (or two persons reasonably believed by PFPC Trust to be Authorized Persons listed on the then current Authorized Persons Appendix) and received by PFPC Trust or (ii) electronic trade instructions transmitted by means of an electronic transaction reporting system which requires the use of a password or other authorized identifier in order to gain access or (iii) written instructions (other then trade instructions) signed by one Authorized Person (or a person reasonably believed by PFPC Trust to be an Authorized Person listed on the then current Authorized Persons Appendix) and received by PFPC Trust. The instructions may be delivered electronically (for clarity, e-mail instructions are governed by Section 1(e) of the Agreement) or by hand, mail or facsimile sending device. 2. Appointment. Each Fund hereby appoints PFPC Trust to provide custodian services to each of its Portfolios listed in Schedule A hereto, and PFPC Trust accepts such appointment and agrees to furnish such services pursuant to and in accordance with the terms hereof. 3. Delivery of Documents. Each Fund has provided or, where applicable, will provide PFPC Trust with the following: (a) if requested by PFPC Trust, certified or authenticated copies of the resolutions of the Fund's Governing Board, approving the appointment of PFPC Trust or its affiliates to provide services; -4- (b) a copy of the Fund's most recent effective registration statement; (c) a copy of the Fund's advisory agreement or agreements; (d) a copy of the Fund's distribution agreement or agreements; (e) a copy of the Fund's administration agreements if PFPC Trust or an affiliate thereof is not providing the Fund with such services; (f) copies of any shareholder servicing agreements made in respect of the Fund; and (g) certified or authenticated copies of any and all amendments or supplements to the foregoing. 4. Compliance with Government Rules and Regulations. With respect to each respective Fund, PFPC Trust undertakes to comply with all applicable requirements of the 1933 Act, the 1934 Act, the 1940 Act, and the CEA and with the requirements of such other laws that are applicable to the duties to be performed by PFPC Trust with respect to such Fund hereunder as are reasonably requested of PFPC by such Fund and as are acceptable to PFPC Trust (such acceptance by PFPC Trust not to be unreasonably withheld). Except as stated herein, PFPC Trust assumes no responsibility for compliance by a Fund or any other entity with respect to any requirements applicable to the Fund or any other entity. 5. Instructions. Unless otherwise provided in this -5- Agreement, PFPC Trust shall act only upon Oral or Written Instructions. PFPC Trust shall be entitled to rely upon any Oral or Written Instructions it receives from an Authorized Persons (or from a person reasonably believed by PFPC Trust to be an Authorized Person listed on the then current Authorized Persons Appendix). PFPC Trust may assume that any Oral or Written Instructions received hereunder are not in any way inconsistent with the provisions of governing documents of a Fund or this Agreement or of any vote, resolution or proceeding relating to a Fund or the assets maintained hereunder. Each Fund agrees to forward to PFPC Trust Written Instructions confirming Oral Instructions so that PFPC Trust receives the Written Instructions by the close of business on the same day that such Oral Instructions are received (provided that Oral Instructions transmitted by means of e-mail do not need to be so confirmed). The fact that such confirming Written Instructions are not received by PFPC Trust or differ from the Oral Instructions shall in no way invalidate the transactions or enforceability of the transactions authorized by the Oral Instructions. PFPC Trust shall promptly notify the Fund providing such confirming Written Instructions of any differences between the Oral Instructions and the confirming Written Instructions. Each Fund further agrees that PFPC Trust shall incur no liability to the Fund for relying upon Oral or Written Instructions provided such instructions reasonably appear to have been received from an Authorized Person listed on -6- the then current Authorized Persons Appendix. 6. Right to Receive Advice. (a) Advice of Counsel. If PFPC Trust shall be in doubt as to any questions of law pertaining to any action it should or should not take, PFPC Trust may (but is not required to) request advice at its own cost from counsel of its own choosing (who may be counsel for any Fund, any Fund's advisor or PFPC Trust, at the option of PFPC Trust). If PFPC Trust requests advice with respect to a Fund from counsel for such Fund, it will inform the Fund of that fact. (b) Protection of PFPC Trust. Without limiting PFPC Trust's other protections under this Agreement, PFPC Trust shall be protected in any action it takes or does not take in good faith reliance upon directions, advice or Oral or Written Instructions it receives from a Fund or from counsel for a Fund and which is in compliance with those directions, advice or Oral or Written Instructions. Nothing in this Agreement shall be construed so as to impose an obligation upon PFPC Trust to act in accordance with directions, advice or Oral or Written Instructions unless, under the terms of other provisions of this Agreement, the same is a condition of PFPC Trust's properly taking or not taking such action. 7. Records. The books and records pertaining to a Fund, which are in the possession of PFPC Trust, shall be the property of -7- such Fund. Such books and records shall be prepared and maintained in a manner reasonably requested by the Fund and acceptable to PFPC Trust; provided that if the Fund is an investment company registered under the 1940 Act, such books and records shall, in addition, be prepared and maintained as required by the 1940 Act and other applicable securities laws, rules and regulations. Each Fund, or the Fund's Authorized Persons, shall have access to the books and records pertaining to the Fund (provided the same are in PFPC Trust's possession) at all times during PFPC Trust's normal business hours. Upon the reasonable request of a Fund, copies of any books and records pertaining to the Fund (provided the same are in PFPC Trust's possession) shall be provided by PFPC Trust to the Fund or to an Authorized Person of the Fund, at the Fund's expense; provided that upon termination of this Agreement with respect to any Fund or Portfolio, the original records of the Fund (or such Portfolio) shall be delivered to the successor custodian, at the Fund's reasonable expense. Following termination of this Agreement with respect to a Fund or Portfolio, PFPC Trust may maintain a copy of the records of such Fund or Portfolio at its own expense. 8. Confidentiality. PFPC Trust shall keep confidential information relating to a Fund which it obtains hereunder, and each Fund shall keep confidential information relating to PFPC Trust which it obtains hereunder. Information to be kept confidential shall include: (a) any data or information that is competitively sensitive material, and not generally known to the public, -8- including, but not limited to, information about product plans, marketing strategies, finances, operations, customer relationships, customer profiles, customer lists, sales estimates, business plans, and internal performance results relating to the past, present or future business activities of a Fund or PFPC Trust; (b) any scientific or technical information, design, process, procedure, formula, or improvement that is commercially valuable and secret in the sense that its confidentiality affords a Fund or PFPC Trust a competitive advantage over its competitors; (c) all confidential or proprietary concepts, documentation, reports, data, specifications, computer software, source code, object code, flow charts, databases, inventions, know-how, and trade secrets, whether or not patentable or copyrightable; and (d) anything designated as confidential. Information shall not be subject to confidentiality obligations under this Agreement if: (a) it is already known to the receiving party at the time it is obtained; (b) it is or becomes publicly known or available through no wrongful act of the receiving party; (c) it is rightfully received from a third party who, to the best of the receiving party's knowledge, is not under a duty of confidentiality; (d) it is released by the protected party to a third party without restriction; (e) it is required to be disclosed by the receiving party pursuant to a requirement of a court order, subpoena, governmental or regulatory agency or law (provided the receiving party will provide the party to which the information relates (i.e., PFPC Trust or a Fund, as applicable) -9- with written notice of such requirement, to the extent such notice is permitted); (f) release of the information is required in connection with the provision of services under this Agreement; (g) it is relevant to the defense of any claim or cause of action asserted against the receiving party; or (h) it has been or is independently developed or obtained by the receiving party. PFPC Trust will not gather, store, or use any Customer Information (as defined below), and will not disclose, distribute, sell, share, rent or otherwise transfer any Customer Information to any third party, except as provided in this Agreement or as PFPC Trust may be directed in advance in writing by a Fund or as required in connection with the provision of services under this Agreement or as permitted or required by applicable law. PFPC Trust represents, covenants, and warrants that PFPC Trust will use Customer Information only in compliance with: (a) this Agreement; (b) any applicable Fund or Schwab privacy policies provided to PFPC Trust and accepted by PFPC Trust; and (c) all applicable laws, policies and regulations (including but not limited to applicable laws, policies and regulations related to spamming, privacy, and consumer protection). As soon as PFPC Trust no longer needs to retain such Customer Information in order to perform its duties under this Agreement, PFPC Trust will upon request promptly return or (if so instructed by a Fund in writing) destroy all originals and copies of such Customer Information, except to the extent PFPC Trust is prohibited by law from doing so. "Customer Information" -10- means all intentionally or unintentionally disclosed non-public personal information, however collected, including without limitation, through "cookies", Web bugs or non-electronic means, pertaining to or identifiable to a Customer (as defined below), including without limitation: (a) name, address, e-mail address, passwords, personal financial information, personal preferences, demographic data, marketing data, data about securities transactions, credit data, or any other identification data; (b) any information that reflects use of or interactions with a Schwab Service (as defined below), including but not limited to, information concerning computer search paths, any profiles created, or general usage data; or (c) any data otherwise submitted in the process of registering for, or during the course of using, a Schwab Service. "Customer" means any individual (a) customer, (b) prospect, or (c) subscriber or user of any Schwab Service. "Schwab Service" means any service that Charles Schwab & Co., Inc. and its affiliates make available to their Customers through Web sites, desktops, e-mail, wireless devices, or from any other communications channel or other medium developed, owned, licensed, operated, hosted, or otherwise controlled by or on behalf of Charles Schwab & Co., Inc. and its affiliates. 9. Cooperation with Accountants. PFPC Trust shall cooperate with each Fund's independent public accountants, and shall take all reasonable action in the performance of its obligations under this Agreement, to ensure that the necessary information is made -11- available to such accountants for the expression of their opinion with respect to the assets maintained hereunder, as required by a Fund. 10. Disaster Recovery. PFPC Trust shall enter into and shall maintain in effect with appropriate parties one or more agreements making reasonable provision for emergency use of electronic data processing equipment to the extent appropriate equipment is available. In the event of equipment failures, PFPC Trust shall, at no additional expense to a Fund, take steps to minimize service interruptions with respect to the accounts and the assets maintained hereunder with respect to such Fund. 11. Compensation. The fees for services rendered by PFPC Trust during the term of this Agreement with respect to a particular Fund are set forth in the fee letter between the Fund and PFPC Trust in effect on the date hereof, or as the same may be amended from time to time. 12. Indemnification. Each Fund agrees to indemnify and hold harmless PFPC Trust from all taxes, charges, expenses, assessments, claims and liabilities (including, without limitation, reasonable attorney's fees and disbursements) (collectively, "Losses") arising directly or indirectly from any action which PFPC Trust takes or does not take (i) at the request or on the direction of or in reliance on the advice of a Fund, (ii) upon Oral or Written Instructions or (iii) in connection with the provision of services to a Fund. Notwithstanding the above, PFPC Trust shall not be -12- indemnified and held harmless by a Fund against Losses to the extent (and only to the extent) that such Losses arise out of PFPC Trust's (i) breach of its duties and obligations with respect to such Fund under this Agreement; (ii) willful misfeasance with respect to such Fund under this Agreement; (iii) bad faith with respect to such Fund under this Agreement; or (iv) negligence with respect to such Fund under this Agreement. PFPC Trust will indemnify and hold harmless a Fund from all Losses incurred by such Fund to the extent (and only to the extent) that such Losses arise out of PFPC Trust's (i) breach of its duties and obligations with respect to such Fund under this Agreement; (ii) willful misfeasance with respect to such Fund under this Agreement; (iii) bad faith with respect to such Fund under this Agreement; or (iv) negligence with respect to such Fund under this Agreement. The provisions of this Section 12 shall survive termination of this Agreement with respect to any Fund. 13. Responsibility of PFPC Trust. PFPC Trust shall be under no duty to take any action on behalf of a Fund except as stated herein or as may be agreed to by PFPC Trust, in writing. PFPC Trust shall be obligated to exercise reasonable care and reasonable diligence in the performance of its duties and obligations hereunder and to act in good faith in performing services provided for under this Agreement. For purposes of indemnification under Section 12 of this Agreement, the standards set forth in the prior -13- sentence will be used as the measurement of whether PFPC Trust's performance is in breach of its duties and obligations with respect to a Fund under this Agreement. PFPC Trust, in connection with its duties under this Agreement, shall not be under any duty or obligation to inquire into and shall not be liable for the validity or invalidity or authority or lack thereof of any Oral or Written Instruction, notice or other instrument which conforms to the applicable requirements of this Agreement, and which PFPC Trust reasonably believes to be genuine. Notwithstanding anything in this Agreement to the contrary, PFPC Trust shall not be liable for any Losses, delays or errors or loss of data occurring by reason of circumstances beyond PFPC Trust's reasonable control, including without limitation acts of civil or military authority, national emergencies, labor difficulties, fire, flood or catastrophe, acts of God, acts of terrorism, insurrection, war, riots or failure of the mails, transportation, communication or power supply. For clarity, the immediately preceding sentence shall not obviate PFPC Trust's duties under Section 10 of this Agreement. Notwithstanding anything in this Agreement to the contrary, neither PFPC Trust nor its affiliates shall be liable to any Fund for any consequential, special or indirect losses or damages, whether or not the likelihood of such losses or damages was known by PFPC Trust or its affiliates. Notwithstanding anything in this Agreement to the contrary, no Fund nor any of its affiliates shall -14- be liable to PFPC Trust for any consequential, special or indirect losses or damages, whether or not the likelihood of such losses or damages was known by the Fund or its affiliates. Notwithstanding anything herein to the contrary (other than as specifically provided in Section 14(h)(ii)(B)(4) and Section 14(h)(iii)(A) of this Agreement), each Fund shall be responsible for all filings, tax returns and reports with respect to its Property or any transactions or collections undertaken pursuant to this Agreement with respect to such Fund, which may be requested by any relevant authority. In addition, each Fund shall be responsible for the payment of all taxes and similar items (including without limitation penalties and interest related thereto) relating to that Fund. 14. Description of Services. (a) Delivery of the Property. Each Fund will deliver or arrange for delivery to PFPC Trust, all the Property to be maintained with respect to its Portfolios hereunder, during the period that is set forth in this Agreement. PFPC Trust will not be responsible for any assets until actual receipt. (b) Receipt and Disbursement of Money. PFPC Trust, acting upon Written Instructions, shall (subject to the terms of this Agreement) open and maintain a separate custody account in the name of each Portfolio or, with respect to a Portfolio denoted with an "*" on Schedule A hereto, in the name of such separate sub-advised accounts of such Portfolio as the applicable Fund may -15- inform PFPC Trust from time to time by means of a Written Instruction (each such separate custody account is defined in this Agreement as an "Account"). PFPC Trust shall make cash payments from or for an Account only for: (i) purchases of securities in the name of such Account (or the name of the Portfolio to which such Account relates) or PFPC Trust or PFPC Trust's nominee or a sub-custodian or nominee thereof as provided in sub-paragraph j; (ii) purchase or redemption of shares of the Portfolio to which such Account relates which are delivered to PFPC Trust; (iii) payment of, subject to receipt of Written Instructions, interest, taxes (provided that tax which PFPC Trust considers is required to be deducted or withheld "at source" will be governed by Section 14(h)(iii)(B) of this Agreement), administration, accounting, distribution, advisory, management fees or similar expenses which are to be borne by such Account (or the Portfolio to which such Account relates); (iv) payment to, subject to receipt of Written Instructions, the transfer agent for the -16- Portfolio to which such Account relates, as agent for the shareholders, an amount equal to the amount of dividends and distributions stated in the Written Instructions to be distributed in cash by the transfer agent to shareholders, or, in lieu of paying the transfer agent, PFPC Trust may arrange for the direct payment of cash dividends and distributions to shareholders in accordance with procedures mutually agreed upon from time to time by and among the applicable Fund, PFPC Trust and the transfer agent; (v) payments, upon receipt of Written Instructions, in connection with the conversion, exchange or surrender of securities held by or delivered to PFPC Trust with respect to such Account hereunder (except that transactions of a mandatory or involuntary nature may be processed by PFPC Trust without Written Instructions); (vi) payments of the amounts of dividends received with respect to securities sold short; (vii) payments made to a sub-custodian pursuant to Section 14(c)of this Agreement; and (viii) payments, upon receipt of Written -17- Instructions, made for other purposes. PFPC Trust is hereby authorized to endorse and collect all checks, drafts or other orders for the payment of money received as custodian for a Portfolio. (c) Receipt of Securities. (i) Segregation. PFPC Trust shall segregate all securities received by it for a particular Account hereunder from securities of any other persons, firms or corporations. All such securities shall be held or disposed of only upon Written Instructions or otherwise pursuant to the terms of this Agreement. PFPC Trust shall have no power or authority to assign, hypothecate, pledge or otherwise dispose of any such securities or investment, except upon the express terms of this Agreement or upon Written Instructions, authorizing the transaction. In no case may any member of a Fund's Board of Trustees, or any officer, employee or agent of the Fund withdraw any securities maintained with respect to a Portfolio of that Fund. (ii) Domestic Sub-custodians. At PFPC Trust's -18- own expense, PFPC Trust may retain any bank (as defined in Section 2(a)(5) of the 1940 Act and which meets the requirements of a custodian under Section 17(f) of the 1940 Act and the rules and regulations thereunder) to act as sub-custodian with respect to domestic assets maintained hereunder. Any such sub-custodian shall have an aggregate capital, surplus and undivided profits, according to its last published report, of at least one million dollars ($1,000,000) if it is a subsidiary or affiliate of PFPC Trust, or at least twenty million dollars ($20,000,000) if such sub-custodian is not a subsidiary or affiliate of PFPC Trust. In addition, any such sub-custodian must agree to comply with the relevant provisions of the 1940 Act and other applicable laws, rules and regulations referenced in Section 4 hereof. (iii) Foreign Sub-Custodians. PFPC Trust may at any time and from time to time enter into arrangements with sub-custodians with respect to services regarding foreign assets maintained hereunder. Any such -19- arrangement will be entered into only with prior notice to the applicable Fund or as otherwise provided in the 1940 Act (e.g., pursuant to Rule 17f-5). In addition, any sub-custodian may engage another entity to act as sub-sub-custodian for purposes of holding the assets maintained hereunder. (iv) Responsibility for Domestic and Foreign Sub-Custodians. PFPC Trust's selection and use of a domestic or foreign sub-custodian or any sub-sub-custodian shall not relieve PFPC Trust of any of its duties under this Agreement, and PFPC Trust shall be fully responsible for the actions or inactions of any such domestic or foreign sub-custodian or sub-sub-custodian to the same extent that PFPC Trust would be liable to a particular Fund hereunder if such actions or inactions were its own hereunder(including for purposes of indemnification under Section 12 of this Agreement). Notwithstanding anything herein or otherwise to the contrary, (i) no depository, clearing agency or system, book-entry system, settlement system or -20- other similar entity, and no transfer agent or registrar for uncertificated securities, shall be considered a sub-custodian or sub-sub-custodian and (ii) PFPC Trust shall have no liability for any action or inaction of or for any event relating to any of the foregoing entities. (d) Transactions Requiring Instructions. Upon receipt of Oral or Written Instructions and not otherwise (unless such an event described in sub-clause (iii), (iv), (v) or (ix) of this sub-section (d) is of a mandatory or involuntary nature, in which case PFPC Trust may handle such event without Written Instructions), PFPC Trust shall: (i) deliver any assets maintained hereunder against the receipt of payment for the sale of such assets or otherwise in accordance with prevailing market practice; (ii) execute and deliver to such persons as may be designated in such Oral or Written Instructions, proxies, consents, authorizations, and any other instruments actually received by PFPC Trust hereunder whereby the authority of a particular Portfolio as owner of any securities maintained in a particular Account of such -21- Portfolio hereunder may be exercised; (iii) deliver any securities maintained hereunder to the issuer thereof, or its agent, when such securities are called, redeemed, retired or otherwise become payable; provided that, in any such case, the cash or other consideration is to be delivered to PFPC Trust; (iv) deliver any securities maintained hereunder against receipt of other securities or cash issued or paid in connection with the liquidation, reorganization, refinancing, tender offer, merger, consolidation or recapitalization of any corporation, or the exercise of any conversion privilege; (v) deliver any securities maintained hereunder to any protective committee, reorganization committee or other person in connection with the reorganization, refinancing, merger, consolidation, recapitalization or sale of assets of any corporation, and receive and hold under the terms of this Agreement such certificates of deposit, interim receipts or other instruments or documents as may be issued to it to evidence such delivery; -22- (vi) make such transfer or exchanges of the assets maintained with respect to a particular Portfolio hereunder and take such other steps as shall be stated in said Oral or Written Instructions to be for the purpose of effectuating a duly authorized plan of liquidation, reorganization, merger, consolidation or recapitalization of such Portfolio; (vii) release assets maintained in a particular Account hereunder to any bank or trust company for the purpose of a pledge or hypothecation to secure any loan incurred with respect to that Account; provided, however, that assets shall be released only upon payment to PFPC Trust of the monies borrowed, except that in cases where additional collateral is required to secure a borrowing already made subject to proper prior authorization, further assets may be released for that purpose; and repay such loan upon redelivery to PFPC Trust of the securities pledged or hypothecated therefor and upon surrender of the note or notes evidencing the loan; -23- (viii) release and deliver securities maintained in a particular Account hereunder in connection with any repurchase agreement entered into with respect to that Account, but only on receipt of payment therefor; and pay out monies maintained in a particular Account hereunder in connection with a repurchase agreement entered into with respect to that Account, but only upon the delivery of the securities; (ix) release and deliver or exchange assets maintained hereunder in connection with any conversion of such assets, pursuant to their terms, into other assets; (x) release and deliver assets to a broker in connection with the broker's custody of margin collateral relating to futures and options or other transactions; (xi) release and deliver assets maintained in a particular Account hereunder for the purpose of redeeming in kind Shares of the Portfolio to which such Account relates, upon delivery thereof to PFPC Trust; and (xii) release and deliver or exchange assets maintained hereunder for other purposes. -24- (e) Use of Book-Entry System. PFPC Trust is authorized and instructed, on a continuous and on-going basis with respect to each of the Funds, to deposit in the Book-Entry System all securities maintained hereunder eligible for deposit therein and to utilize the Book-Entry System to the extent possible in connection with settlements of purchases and sales of securities, and deliveries and returns of securities loaned, subject to repurchase agreements or used as collateral in connection with borrowings. PFPC Trust shall continue to perform such duties until it receives Written or Oral Instructions authorizing contrary actions(s). To administer the Book-Entry System properly, the following provisions shall apply: (i) With respect to securities which are maintained in the Book-Entry system, the records of PFPC Trust shall identify by book-entry or otherwise the Accounts to which such securities relate. PFPC Trust shall furnish each Fund a detailed statement of the Property held in each of the Fund's Accounts at least monthly and from time to time and upon written request. (ii) Securities and any cash of the Portfolios which are maintained hereunder and which are deposited in the Book-Entry System will at all times be segregated from any assets and cash -25- controlled by PFPC Trust in other than a fiduciary or custodian capacity but may be commingled with other assets held in such capacities. (iii) All books and records maintained by PFPC Trust which relate to the maintenance of a particular Fund's Property in the Book-Entry System will at all times during PFPC Trust's regular business hours be open to the inspection of such Fund's duly authorized employees or agents, and the Fund will be furnished with all information in respect of the services rendered to it hereunder as it may require. (iv) PFPC Trust will provide each Fund with copies of any report obtained by PFPC Trust on the system of internal accounting control of the Book-Entry System promptly after receipt of such a report by PFPC Trust. PFPC Trust will also provide a Fund with such reports on its own system of internal control as the Fund may reasonably request from time to time. (f) Registration of Securities. All securities maintained hereunder which are issued or issuable only in bearer form, except such securities held in the Book-Entry System or -26- another depository, shall be held by PFPC Trust in bearer form; all other securities maintained hereunder may be registered in the name of PFPC Trust; the Book-Entry System; a depository; a sub-custodian; or any duly appointed nominee(s) of PFPC Trust, Book-Entry system, depository or sub-custodian. Each Fund reserves the right to instruct PFPC Trust as to the method of registration and safekeeping of its securities maintained hereunder. Each Fund agrees to furnish to PFPC Trust appropriate instruments to enable PFPC Trust to hold or deliver in proper form for transfer, or to register in the name of PFPC Trust's nominee or in the name of the Book-Entry System or in the name of another appropriate entity, any securities of the Fund which PFPC Trust may maintain hereunder. (g) Voting and Other Action. Neither PFPC Trust nor its nominee shall vote any of the securities held pursuant to this Agreement, except in accordance with Written Instructions. PFPC Trust, directly or through the use of another entity, shall execute in blank and promptly deliver all notices, proxies, and proxy soliciting materials received by PFPC Trust as custodian hereunder with respect to a particular security maintained hereunder to the registered holder of such security. If the registered owner is not the particular Portfolio for which the security is maintained, then Written or Oral Instructions must designate the person to whom such notice, proxy or proxy soliciting material is to be sent. PFPC Trust will not be under a duty to respond to any class actions or similar matters. -27- (h) Transactions Not Requiring Instructions. In the absence of contrary Written Instructions, PFPC Trust is authorized to take the following actions: (i) Collection of Income and Other Payments. (A) collect and receive all income, dividends, distributions, coupons, option premiums, other payments and similar items, included or to be included in the Property maintained in a particular Account hereunder, and, in addition, promptly advise the Portfolio to which such Account relates of such receipt and credit such income to such Account; (B) endorse and deposit for collection, in the name of the applicable Portfolio, checks, drafts, or other orders for the payment of money; (C) receive and maintain in a particular Account hereunder all securities received as a distribution on the portfolio securities maintained in such Account as a result of a stock dividend, share split-up or reorganization, recapitalization, readjustment or other rearrangement or distribution of rights -28- or similar securities issued with respect to such portfolio securities; (D) present for payment and collect the amount payable upon all securities maintained in a particular Account hereunder which may mature or which may on a mandatory or involuntary basis be called, redeemed, retired or otherwise become payable on the date such securities become payable; and (E) take any action which may be necessary and proper in connection with the collection and receipt of such income and other payments and the endorsement for collection of checks, drafts, and other negotiable instruments. (ii) Miscellaneous Transactions. (A) PFPC Trust is authorized to deliver or cause to be delivered Property against payment or other consideration or written receipt therefor in the following cases: (1) for examination by a broker or dealer in accordance with street delivery custom; (2) for the exchange of interim receipts -29- or temporary securities for definitive securities; and (3) for transfer of securities into the name of a particular Fund or Portfolio or Account or PFPC Trust or a sub-custodian or a nominee of one of the foregoing, or for exchange of securities for a different number of bonds, certificates, or other evidence, representing the same aggregate face amount or number of units bearing the same interest rate, maturity date and call provisions, if any; provided that, in any such case, the new securities are to be delivered to PFPC Trust. (B) unless and until PFPC Trust receives Oral or Written Instructions to the contrary, PFPC Trust shall: (1) pay all income items held by it hereunder which call for payment upon presentation and hold the cash received by it upon such payment in the applicable Account hereunder; -30- (2) collect interest and cash dividends received with respect to the securities maintained hereunder, with notice to the applicable Fund; (3) hold in the applicable Account hereunder all stock dividends, rights and similar securities issued with respect to any securities held by PFPC Trust in such Account; and -31- (4) subject to receipt of such documentation and information as PFPC Trust may request, execute as agent on behalf of the applicable Fund all necessary ownership certificates required by a national governmental taxing authority, inserting the Fund's name on such certificate as the owner of the securities covered thereby, to the extent it may lawfully do so. (iii) Other Matters. (A) subject to receipt of such documentation and information as PFPC Trust may request, PFPC Trust will, in such jurisdictions in which PFPC Trust acts as Foreign Custody Manager for a particular Portfolio, seek to reclaim or obtain a reduction with respect to any withholdings or other taxes relating to assets of such Portfolio maintained -32- hereunder; and (B) PFPC Trust is authorized to deduct or withhold any sum in respect of tax which PFPC Trust considers is required to be deducted or withheld "at source" by any relevant law or practice. (i) Segregated Accounts. (i) PFPC Trust shall upon receipt of Written or Oral Instructions establish and maintain a segregated accounts(s) on its records which segregated accounts will relate to a particular Account. Such account(s) may be used to transfer cash and securities, including securities in the Book-Entry System: (A) for the purposes of compliance a Portfolio with the procedures required by a securities or option exchange; providing that, if the Portfolio is a series of a Fund that is an investment company registered under the 1940 Act, such procedures comply with the 1940 Act and any releases of the SEC relating to -33- the maintenance of segregated accounts by registered investment companies; or (B) upon receipt of Written Instructions, for other purposes. (ii) PFPC Trust may enter into separate custodial agreements with various futures commission merchants ("FCMs") that a particular Portfolio (or a particular Portfolio with respect to a particular Account) uses with respect to the assets maintained hereunder ("FCM Agreement"). Pursuant to an FCM Agreement, margin deposits with respect to any transactions involving futures contracts and options on futures contracts will be held by PFPC Trust in accounts ("FCM Account") subject to the disposition by the FCM involved in such contracts and in accordance with applicable SEC rules and the rules of the applicable commodities exchange. Such FCM Agreements shall only be entered into upon receipt of a request from the applicable Portfolio. Transfers of initial margin shall be made into a FCM Account only upon Written Instructions; transfers of premium and variation margin may be made into a FCM -34- Account pursuant to Oral Instructions. Transfers of funds from a FCM Account to the FCM with respect to which PFPC Trust holds such an account may only occur upon certification by the FCM to PFPC Trust that all conditions precedent to its right to give PFPC Trust such instructions have been satisfied. (j) Purchases of Securities. PFPC Trust shall settle purchased securities upon receipt of Written Instructions that specify: (i) the name of the issuer and the title of the securities, including CUSIP number if applicable; (ii) the number of shares or the principal amount purchased and accrued interest, if any; (iii) the date of purchase and settlement; (iv) the purchase price per unit; (v) the total amount payable upon such purchase; (vi) the name of the person from whom or the broker through whom the purchase was made; and (vii) the Account to which such purchase applies. PFPC Trust shall upon receipt of securities purchased or otherwise in accordance with prevailing market practice pay out of the -35- monies held in the Account to which the purchase applies the total amount payable to the person from whom or the broker through whom the purchase was made, provided that the same conforms to the total amount payable as set forth in such Written Instructions. Nothing in this Agreement shall require PFPC Trust to make any advance in order to settle purchased securities. (k) Sales of Securities. PFPC Trust shall settle sold securities upon receipt of Written Instructions that specify: (i) the name of the issuer and the title of the security, including CUSIP number if applicable; (ii) the number of shares or principal amount sold, and accrued interest, if any; (iii) the date of trade, settlement and sale; (iv) the sale price per unit; (v) the total amount payable upon such sale; (vi) the name of the broker through whom or the person to whom the sale was made; and (vii) the Account to which the sale applies and the location to which the security must be delivered and delivery deadline, if any. PFPC Trust shall deliver the securities upon -36- receipt of the total amount payable upon such sale or otherwise in accordance with prevailing market practice, provided that the total amount payable is the same as was set forth in the Written Instructions. Notwithstanding the other provisions hereof, PFPC Trust may accept payment in such form as shall be satisfactory to it, and may deliver securities and arrange for payment in accordance with the customs prevailing among dealers in securities. (l) Reports. (i) PFPC Trust shall furnish each Fund the following reports: (A) such periodic and special reports as the Fund may reasonably request; (B) a monthly statement summarizing all transactions and entries each of the Fund's Accounts, listing the portfolio securities maintained in such Accounts with the adjusted average cost of each issue and the market value at the end of such month, and stating the cash amount of such Accounts including disbursements; (C) the reports to be furnished to the Fund -37- pursuant to Rule 17f-4 (if the Fund is an investment company registered under the 1940 Act); and (D) such other information as may be agreed upon from time to time between the Fund and PFPC Trust. (ii) PFPC Trust shall transmit promptly to each Fund any proxy statement, proxy material, notice of a call or conversion or similar communication received by it as custodian of the Property maintained hereunder with respect to such Fund's Portfolios. PFPC Trust shall be under no other obligation to inform the Fund as to such actions or events. For clarification, upon termination of this Agreement with respect to such Fund PFPC Trust shall have no responsibility to transmit such information or to inform the Fund or any other person of such actions or events. (m) Crediting of Accounts. With respect to registered United States domestic securities (i.e., securities having an industry CUSIP number), security purchase and sale transactions will be posted to the applicable Account on settlement date and dividends, interest payments and final principal redemptions will -38- be credited to the applicable Account on payable date. With respect to foreign securities, security purchase and sale transactions will be posted to the applicable Account on settlement date to the extent that the foreign sub-custodian maintaining such securities hereunder so posts the transaction (and otherwise will be posted on the date such foreign sub-custodian posts the transaction) and dividends, interest payments and final principal redemptions will be credited to the applicable Account on payable date to the extent that the foreign sub-custodian maintaining such securities hereunder so credits such amounts (and otherwise will be credited on the date such foreign sub-custodian credits such amounts). With respect to transactions or payments not referenced in one of the two preceding sentences, such transactions or payments will be posted or credited to the applicable Account at the time determined by PFPC Trust in its reasonable discretion (but in no event later than the date on which such transaction or payment actually settles). No amount will be credited on payable date with respect to securities that are in default. If PFPC Trust credits an Account with respect to (a) income, dividends, distributions, coupons, option premiums, other payments or similar items on a contractual payment date or otherwise in advance of PFPC Trust's actual receipt of the amount due, (b) the proceeds of any sale or other disposition of assets on the contractual settlement date or otherwise in advance of PFPC Trust's actual receipt of the amount due or (c) provisional crediting of -39- any amounts due, and (i) PFPC Trust is subsequently unable to collect full and final payment for the amounts so credited within a reasonable time period using reasonable efforts or (ii) pursuant to standard industry practice, law or regulation PFPC Trust is required to repay to a third party such amounts so credited, PFPC Trust shall have the absolute right in its sole discretion upon notice to the applicable Fund to reverse any such credit or payment and to debit or deduct the amount of such credit or payment from the Account, and PFPC Trust shall also be entitled without the need for such notice to otherwise pursue recovery of any such amounts so credited from the applicable Fund. In addition, notwithstanding the foregoing sentence, if any Property has been incorrectly paid or credited, PFPC Trust shall have the absolute right in its sole discretion without demand or prior notice to reverse any such payment or credit, to debit or deduct the amount of any such payment or credit from the applicable Account, and to otherwise pursue recovery of any amounts so paid or credited from the applicable Fund; PFPC Trust will give prompt after-the-fact notice (i.e., such notice will be given within timeframes that comply with PFPC Trust's standard operating procedures) to the applicable Fund of any such reversal, debit or deduction. Each Fund, on behalf of each of its respective Portfolios, hereby grants a first priority contractual possessory security interest in and a right of setoff against the assets maintained in a particular Account hereunder in the amount necessary to secure the return and payment to PFPC Trust -40- of any advance or credit made by PFPC Trust (including charges related thereto) with respect to such Account. (n) Collections. Provided PFPC Trust has complied with its required standard of care with respect to a particular Portfolio under this Agreement, all collections of monies or other property, in respect, or which are to become part of the Property of such Portfolio (but not the safekeeping thereof upon receipt by PFPC Trust) shall be at the sole risk of such Portfolio. If payment is not received by PFPC Trust within a reasonable time after proper demands have been made, PFPC Trust shall notify the applicable Fund in writing, including copies of all demand letters, any written responses, and memoranda of all telephonic demands and oral responses, and shall await instructions from the Fund. PFPC Trust shall not be obliged to take legal action for collection unless and until reasonably indemnified to its satisfaction. PFPC Trust shall also notify the applicable Fund as soon as reasonably practicable whenever income due on securities is not collected in due course. (o) PFPC Trust and/or sub-custodians may enter into or arrange foreign exchange transactions (at such rates as they may consider appropriate) in order to facilitate transactions under this Agreement, and such entities and/or their affiliates may receive reasonable and customary compensation in connection with such foreign exchange transactions. 15. Duration and Termination. This Agreement shall continue in full force and effect with respect to a particular Fund (or -41- Portfolio thereof) unless terminated as hereinafter provided or amended at any time by mutual, written agreement of such Fund and PFPC Trust. With respect to a particular Fund (or Portfolio thereof) and PFPC Trust, this Agreement may be terminated by either of such Fund or PFPC Trust by an instrument in writing delivered, faxed or mailed, postage prepaid, to the other, such termination to take effect on the date stated therein, which date shall not be sooner than sixty (60) days after the date of such delivery or mailing. In the event this Agreement is terminated with respect to a particular Fund (or Portfolio thereof), pending appointment of a successor to PFPC Trust, PFPC Trust may deliver the assets of such Fund (or such Portfolio) that are maintained hereunder to a bank or trust company of PFPC Trust's choosing, having an aggregate capital, surplus and undivided profits, as shown by its last published report, of not less than twenty million dollars ($20,000,000), to be held under terms similar to those of this Agreement. PFPC Trust shall not be required to make any delivery or payment of the assets maintained hereunder with respect to a particular Fund (or Portfolio thereof) until full payment shall have been made by such Fund (or such Portfolio) to PFPC Trust of all of PFPC Trust's fees, compensation, costs and expenses relating to such Fund (or such Portfolio); PFPC Trust shall have a security interest in and shall have a right of setoff against such Fund's (or such Portfolio's) Property which is in PFPC Trust's possession as security for the payment of PFPC Trust's fees, compensation, -42- costs and expenses relating to such Fund (or such Portfolio). 16. Notices. Notice shall be addressed (a) if to PFPC Trust at PFPC Trust's address, 8800 Tinicum Boulevard, 3rd Floor, Philadelphia, Pennsylvania 19153, marked for the attention of the Mutual Fund Custody Department (or its successor); (b) if to a Fund, at the address of the Fund; or (c) if to neither a Fund or PFPC Trust, at such other address as shall have been notified to the sender of any such notice. If notice is sent by confirming facsimile sending device, it shall be deemed to have been given immediately. If notice is sent by first-class mail, it shall be deemed to have been given five days after it has been mailed. If notice is sent by messenger, it shall be deemed to have been given on the day it is delivered. 17. Amendments. This Agreement, or any term hereof, may be changed or waived only by a written amendment, signed by the party against whom enforcement of such change or waiver is sought. 18. Delegation. PFPC Trust may, with the prior written consent of a Fund, which consent may not be unreasonably withheld, assign its rights and delegate its duties with respect to such Fund hereunder to any wholly-owned direct or indirect subsidiary of PFPC Trust or of The PNC Financial Services Group, Inc., provided that (i) PFPC Trust provides the Fund a minimum of thirty (30) days in which to decide and to consent by written notice; (ii) if the Fund is an investment company registered under the 1940 Act, the delegate agrees with PFPC Trust to comply with all relevant -43- provisions of this Agreement and the 1940 Act; and (iii) PFPC Trust and such delegate promptly provide such information as the Fund may request, and respond to such questions as the Fund may ask, relative to the delegation, including (without limitation) the capabilities of the delegate. 19. Counterparts. This Agreement may be executed in two or more counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. 20. Further Actions. Each party agrees to perform such further acts and execute such further documents as are necessary to effectuate the purposes hereof. 21. Miscellaneous. As between each separate Fund and PFPC Trust, this Agreement embodies the entire agreement and understanding between such Fund and PFPC Trust and supersedes all prior agreements and understandings between such Fund and PFPC Trust relating to the subject matter hereof. The captions in this Agreement are included for convenience of reference only and in no way define or delimit any of the provisions hereof or otherwise affect their construction or effect. This Agreement shall be deemed to be a contract made in California and governed by California law. If any provision of this Agreement shall be held or made invalid by a court decision, statute, rule or otherwise, the remainder of this Agreement shall not be affected thereby. This Agreement shall be binding and shall inure to the benefit of the parties hereto and their respective -44- successors and permitted assigns. PFPC Trust shall retain title to and ownership of any and all data bases, computer programs, screen formats, report formats, interactive design techniques, derivative works, inventions, discoveries, patentable or copyrightable matters, concepts, expertise, patents, copyrights, trade secrets, and other related legal rights owned or licensed and utilized by PFPC Trust in connection with the services provided by PFPC Trust to any of the Funds. There are no oral or written representations, agreements or understandings between PFPC Trust and any Fund except as stated in this Agreement. PFPC Trust is entering into this Agreement with each of the Funds separately, and any duty, obligation or liability owed or incurred by PFPC Trust with respect to a particular Fund shall be owed or incurred solely with respect to that Fund, and shall not in any way create any duty, obligation or liability with respect to any other Fund. This Agreement shall be interpreted to carry out the intent of the parties hereto that PFPC Trust is entering into a separate arrangement with each separate Fund. -45- The respective names Schwab Capital Trust, Schwab Investments, The Charles Schwab Family of Funds and Schwab Annuity Portfolios refers to each of such respective Funds and its Trustees, as Trustees but not individually or personally, acting under their respective Declarations of Trust dated May 6, 1993, October 26, 1990, May 9, 1995 and January 21, 1994. The obligations of any one of the aforementioned Funds entered into in the name of or on behalf of a Portfolio of such Fund by any of the Trustees, representatives or agents of such Fund are made not individually, but in such capacities. Such obligations are not binding upon any of the Trustees, shareholders or representatives of such Fund personally, but bind only the assets of such Fund belonging to such Portfolio for the enforcement of any claims against such Fund. Transactions entered into by a particular Portfolio of a Fund are considered independent transactions and shall in no way effect transactions entered into by any other Portfolio of such Fund. Any amount owed by a Fund with respect to any obligation arising out of this Agreement, as amended, shall be paid only out of the assets and property of the particular Portfolio that entered into such transaction. -46- IN WITNESS WHEREOF, each of the respective parties hereto have caused this Agreement to be executed on the day and year first above written. PFPC TRUST COMPANY /s/ David E. Fritz ------------------------------------ By: David E. Fritz Title: Vice President SCHWAB CAPITAL TRUST /s/ Tai-Chin Tung ----------------------------------- By: Tai-Chin Tung Title: Treasurer and Principal Financial Officer SCHWAB INVESTMENTS /s/ Tai-Chin Tung ----------------------------------- By: Tai-Chin Tung Title: Treasurer and Principal Financial Officer THE CHARLES SCHWAB FAMILY OF FUNDS /s/ Tai-Chin Tung ----------------------------------- By: Tai-Chin Tung Title: Treasurer and Principal Financial Officer SCHWAB ANNUITY PORTFOLIOS /s/ Tai-Chin Tung ----------------------------------- By: Tai-Chin Tung Title: Treasurer and Principal Financial Officer -47- SCHEDULE A INVESTMENT PORTFOLIOS Schwab Capital Trust Schwab S&P 500 Fund Schwab Core Equity Fund Schwab Institutional Select S&P 500 Fund Schwab Institutional Select Large-Cap Value Index Fund Schwab Institutional Select Small-Cap Value Index Fund Schwab Total Stock Market Index Fund Schwab U.S. MarketMasters Fund * Schwab Balanced MarketMasters Fund * Schwab Small-Cap MarketMasters Fund * Schwab International MarketMasters Fund * Schwab Hedged Equity Fund Schwab Investments Schwab 1000 Schwab Short-Term Bond Market Fund Schwab Total Bond Market Fund Schwab California Short/Intermediate Tax-Free Bond Fund Schwab California Long-Term Tax-Free Bond Fund Schwab Short/Intermediate Tax-Free Bond Fund Schwab Long-Term Tax-Free Bond Fund Schwab YieldPlus Fund The Charles Schwab Family of Funds Schwab Money Market Fund Schwab Value Advantage Money Fund Schwab Institutional Advantage Money Fund Schwab Retirement Money Fund Schwab Government Money Fund Schwab U.S. Treasury Money Fund Schwab Municipal Money Fund Schwab California Municipal Money Fund Schwab New York Municipal Money Fund Schwab Florida Municipal Money Fund Schwab Government Cash Reserves Fund Schwab Pennsylvania Municipal Money Fund Schwab New Jersey Municipal Money Fund Schwab Annuity Portfolios Schwab Money Market Portfolio Schwab S&P 500 Portfolio SCHEDULE B AUTHORIZED PERSONS APPENDIX -48- Schwab Capital Trust - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- Schwab Investments - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- SCHEDULE B AUTHORIZED PERSONS APPENDIX The Charles Schwab Family of Funds - ------------------------- -49- - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- Schwab Annuity Portfolios - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- - ------------------------- SCHEDULE C David Fritz Kathryn Schaffer John Riley Catherine Lawless Heather Haggerty -50- EX-99.(G)(VI) 5 f84662exv99wxgyxviy.txt EXHIBIT 99.(G)(VI) Ex-(g)(vi) ACCOUNTING SERVICES AGREEMENT This Agreement is made, as of May 22, 2002, separately by and between each of Schwab Investments, The Charles Schwab Family of Funds, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Fund") and PFPC Inc.("PFPC"). Each Fund is registered as an open-end investment company under the Investment Company Act of 1940 (the "1940 Act"), as amended, unless otherwise set forth on the signature page hereof. Each Fund wishes to retain PFPC to provide accounting services to its investment portfolios listed on Schedule A, as attached hereto (each a "Portfolio"), and PFPC wishes to furnish such services as more fully described herein. In consideration of the promises and mutual covenants herein contained, each separate Fund and PFPC agree as follows: 1. Definitions. (a) "Authorized Person". The term "Authorized Person" shall mean any person authorized by a Fund to give Oral or Written Instructions with respect to such Fund. Such persons are listed in the Certificate attached hereto as the Authorized Persons Appendix (as the same may be revised by a particular Fund with respect to the Authorized Persons applicable to it upon reasonable prior notice to PFPC from time to time). If PFPC provides more than one service hereunder with respect to a particular Fund, that Fund's designation of Authorized Persons may vary by service. (b) "CFTC". The term "CFTC" shall mean the Commodities Futures Trading Commission. (c) "Governing Board". The term "Governing Board" shall mean a particular Fund's Board of Directors if the Fund is a corporation or a particular Fund's Board of Trustees if the Fund is a trust, or, where duly authorized, a competent committee thereof. If a Fund is a limited partnership, the term "Governing Board" shall mean such Fund's general partner. (d) "Oral Instructions". The term "Oral Instructions" shall mean oral or e-mail instructions received by PFPC from an Authorized Person (or from a person reasonably believed by PFPC to be an Authorized Person listed on the then current Authorized Persons Appendix.) For the benefit of PFPC, any e-mail communication sent to PFPC shall be sent to all of the persons listed on Schedule C hereto (as such Schedule C may be changed by PFPC upon notice to the Funds), and PFPC shall not be obligated to consider an e-mail instruction that is not sent to all of such persons to be an Oral Instruction under this Agreement. (e) "SEC". The term "SEC" shall mean the Securities and Exchange Commission. (f) "Securities and Commodities Laws". The terms the "1933 Act" shall mean the Securities Act of 1933, as amended, the "1934 Act" shall mean the Securities Exchange Act of 1934, as amended, the "1940 Act" shall mean the Investment Company Act of 1940, as amended, and the "CEA" shall mean the Commodities Exchange Act, as amended. The 1933 Act, the 1934 Act, the 1940 Act and the CEA - 2 - shall together be the "Securities and Commodities Laws." (g) "Shares". The term "Shares" shall mean the units of beneficial interest of any Portfolio or class of a Fund. (h) "Written Instructions". The term "Written Instructions" shall mean (i) written trade instructions signed by two Authorized Persons (or two persons reasonably believed by PFPC to be Authorized Persons listed on the then current Authorized Persons Appendix) and received by PFPC or (ii) electronic trade instructions transmitted by means of an electronic transaction reporting system which requires the use of a password or other authorized identifier in order to gain access or (iii) written instructions (other than trade instructions) signed by one Authorized Person (or a person reasonably believed by PFPC to be an Authorized Person listed on the then current Authorized Persons Appendix) and received by PFPC. The instructions may be delivered electronically (for clarity, e-mail instructions are governed by Section 1(d) of the Agreement) or by hand, mail or facsimile sending device. 2. Appointment. Each Fund hereby appoints PFPC to provide accounting services to each of its Portfolios listed in Schedule A hereto, pursuant to and in accordance with the terms set forth in this Agreement, and PFPC accepts such appointment and agrees to furnish such services. 3. Delivery of Documents. Each Fund has provided or, where applicable, will provide PFPC with the following: (a) if requested by PFPC, certified or authenticated - 3 - copies of the resolutions of the Fund's Governing Board, approving the appointment of PFPC or its affiliates to provide services; (b) a copy of the Fund's most recent effective registration statement; (c) a copy of the Fund's advisory agreement or agreements; (d) a copy of the Fund's distribution agreement or agreements; (e) copies of any shareholder servicing agreements made in respect of the Fund; and (f) certified or authenticated copies of any and all amendments or supplements to the foregoing. 4. Compliance with Government Rules and Regulations. With respect to each respective Fund, PFPC undertakes to comply with all applicable requirements of the Securities and Commodities Laws and with the requirements of such other laws that are applicable to the duties to be performed by PFPC with respect to such Fund hereunder as are reasonably requested of PFPC by such Fund and as are acceptable to PFPC (such acceptance by PFPC not to be unreasonably withheld). Except as stated herein, PFPC assumes no responsibility for compliance by a Fund or any other entity with respect to any requirements applicable to the Fund or any other entity. 5. Instructions. Unless otherwise provided in this Agreement, PFPC shall act only upon Oral or Written Instructions. PFPC shall be entitled to rely upon any Oral or Written - 4 - Instructions it receives from an Authorized Person (or from a person reasonably believed by PFPC to be an Authorized Person listed on the then current Authorized Persons Appendix). In the exercise of reasonable judgement, PFPC may assume that any Oral or Written Instructions received hereunder are not in any way inconsistent with the provisions of governing documents of a Fund or this Agreement or of any vote, resolution or proceeding relating to a Fund. Each Fund agrees to forward to PFPC Written Instructions confirming Oral Instructions so that PFPC receives the Written Instructions by the close of business on the same day that such Oral Instructions are received (provided that Oral Instructions transmitted by means of e-mail do not need to be so confirmed). The fact that such confirming Written Instructions are not received by PFPC or differ from the Oral Instructions shall in no way invalidate the transactions or enforceability of the transactions authorized by the Oral Instructions. PFPC shall promptly notify the Fund providing such confirming Written Instructions of any differences between the Oral Instructions and the confirming Written Instructions. Each Fund further agrees that PFPC shall incur no liability to the Fund for relying upon Oral or Written Instructions provided such instructions reasonably appear to have been received from an Authorized Person listed on the then current Authorized Persons Appendix. 6. Right to Receive Advice. (a) Advice of Counsel. If PFPC shall be in doubt as - 5 - to any questions of law pertaining to any action it should or should not take, PFPC may (but is not required to) request advice at its own cost from counsel of its own choosing (who may be counsel for any Fund, any Fund's advisor or PFPC, at the option of PFPC). If PFPC requests advice with respect to a Fund from counsel for such Fund, it will inform the Fund of that fact. (b) Protection of PFPC. Without limiting PFPC's other protections under this Agreement, PFPC shall be protected in any action it takes or does not take in good faith reliance upon directions, advice or Oral or Written Instructions it receives from a Fund or from counsel for a Fund and which is in compliance with those directions, advice or Oral or Written Instructions. Nothing in this Agreement shall be construed so as to impose an obligation upon PFPC to act in accordance with directions, advice or Oral or Written Instructions unless, under the terms of other provisions of this Agreement, the same is a condition of PFPC's properly taking or not taking such action. 7. Records. The books and records pertaining to a Fund, which are in the possession of PFPC, shall be the property of such Fund. Such books and records shall be prepared and maintained in a manner reasonably requested by the Fund and acceptable to PFPC; provided that if the Fund is an investment company registered under the 1940 Act, such books and records shall, in addition, be prepared and maintained as required by the 1940 Act and other applicable securities laws, rules and regulations. Each Fund, or the Fund's Authorized Persons, shall have access to the books and - 6 - records pertaining to the Fund (provided the same are in PFPC's possession) at all times during PFPC's normal business hours. Upon the reasonable request of a Fund, copies of any books and records pertaining to the Fund (provided the same are in PFPC's possession) shall be provided by PFPC to the Fund or to an Authorized Person of the Fund, at the Fund's expense; provided that upon termination of this Agreement with respect to any Fund or Portfolio, the original records of the Fund (or such Portfolio) shall be delivered to the successor fund accountant, at the Fund's reasonable expense. Following termination of this Agreement with respect to a Fund or Portfolio, PFPC may maintain a copy of the records of such Fund or Portfolio at its own expense. 8. Confidentiality. PFPC shall keep confidential information relating to a Fund which it obtains hereunder, and each Fund shall keep confidential information relating to PFPC which it obtains hereunder. Information to be kept confidential shall include: (a) any data or information that is competitively sensitive material, and not generally known to the public, including, but not limited to, information about product plans, marketing strategies, finances, operations, customer relationships, customer profiles, customer lists, sales estimates, business plans, and internal performance results relating to the past, present or future business activities of a Fund or PFPC; (b) any scientific or technical information, design, process, procedure, formula, or improvement that is commercially valuable and secret in the sense that its - 7 - confidentiality affords a Fund or PFPC a competitive advantage over its competitors; (c) all confidential or proprietary concepts, documentation, reports, data, specifications, computer software, source code, object code, flow charts, databases, inventions, know-how, and trade secrets, whether or not patentable or copyrightable; and (d) anything designated as confidential. Information shall not be subject to confidentiality obligations under this Agreement if: (a) it is already known to the receiving party at the time it is obtained; (b) it is or becomes publicly known or available through no wrongful act of the receiving party; (c) it is rightfully received from a third party who, to the best of the receiving party's knowledge, is not under a duty of confidentiality; (d) it is released by the protected party to a third party without restriction; (e) it is required to be disclosed by the receiving party pursuant to a requirement of a court order, subpoena, governmental or regulatory agency or law (provided the receiving party will provide the party to which the information relates (i.e., PFPC or a Fund, as applicable) with written notice of such requirement, to the extent such notice is permitted); (f) release of the information is required in connection with the provision of services under this Agreement; (g) it is relevant to the defense of any claim or cause of action asserted against the receiving party; or (h) it has been or is independently developed or obtained by the receiving party. PFPC will not gather, store, or use any Customer Information - 8 - (as defined below), and will not disclose, distribute, sell, share, rent or otherwise transfer any Customer Information to any third party, except as provided in this Agreement or as PFPC may be directed in advance in writing by a Fund or as required in connection with the provision of services under this Agreement or as permitted or required by applicable law. PFPC represents, covenants, and warrants that PFPC will use Customer Information only in compliance with: (a) this Agreement; (b) any applicable Fund or Schwab privacy policies provided to PFPC and accepted by PFPC; and (c) all applicable laws, policies and regulations (including but not limited to applicable laws, policies and regulations related to spamming, privacy, and consumer protection). As soon as PFPC no longer needs to retain such Customer Information in order to perform its duties under this Agreement, PFPC will upon request promptly return or (if so instructed by a Fund in writing) destroy all originals and copies of such Customer Information, except to the extent PFPC is prohibited by law from doing so. "Customer Information" means all intentionally or unintentionally disclosed non-public personal information, however collected, including without limitation, through "cookies", Web bugs or non-electronic means, pertaining to or identifiable to a Customer (as defined below), including without limitation: (a) name, address, e-mail address, passwords, personal financial information, personal preferences, demographic data, marketing data, data about securities transactions, credit data, or any other identification data; (b) any information that - 9 - reflects use of or interactions with a Schwab Service (as defined below), including but not limited to, information concerning computer search paths, any profiles created, or general usage data; or (c) any data otherwise submitted in the process of registering for, or during the course of using, a Schwab Service. "Customer" means any individual (a) customer, (b) prospect, or (c) subscriber or user of any Schwab Service. "Schwab Service" means any service that Charles Schwab & Co., Inc. and its affiliates make available to their Customers through Web sites, desktops, e-mail, wireless devices, or from any other communications channel or other medium developed, owned, licensed, operated, hosted, or otherwise controlled by or on behalf of Charles Schwab & Co., Inc. and its affiliates. 9. Liaison with Accountants. PFPC shall act as liaison with each Fund's independent public accountants, and shall provide account analyses, fiscal year summaries, and other audit-related schedules relating to a particular Fund to that Fund's independent public accountants. PFPC shall take all reasonable action in the performance of its obligations under this Agreement with respect to a particular Fund to assure that the necessary information is made available to such Fund's independent public accountants for the expression of their opinion with respect to such Fund, as such may be required by the Fund from time to time. 10. Disaster Recovery. PFPC shall enter into and shall maintain in effect with appropriate parties one or more agreements making reasonable provision for emergency use of electronic data - 10 - processing equipment to the extent appropriate equipment is available. In the event of equipment failures, PFPC shall, at no additional expense to a Fund, take steps to minimize service interruptions with respect to such Fund. 11. Compensation. The fees for services rendered by PFPC during the term of this Agreement with respect to a particular Fund are set forth in the fee letter between the Fund and PFPC in effect on the date hereof, or as the same may be amended from time to time. 12. Indemnification. Each Fund agrees to indemnify and hold harmless PFPC from all taxes, charges, expenses, assessments, claims and liabilities (including, without limitation, reasonable attorneys' fees and disbursements) (collectively, "Losses") arising directly or indirectly from any action which PFPC takes or does not take (i) at the request or on the direction of or in reliance on the advice of a Fund, (ii) upon Oral or Written Instructions or (iii) in connection with the provision of services to a Fund. Notwithstanding the above, PFPC shall not be indemnified and held harmless by a Fund against any Losses to the extent (and only to the extent) that such Losses arise out of PFPC's (i) breach of its duties and obligations with respect to such Fund under this Agreement; (ii) willful misfeasance with respect to such Fund under this Agreement; (iii) bad faith with respect to such Fund under this Agreement; or (iv) negligence with respect to such Fund under this Agreement. PFPC will indemnify and hold harmless a Fund from all Losses - 11 - incurred by such Fund to the extent (and only to the extent) that such Losses arise out of PFPC's (i) breach of its duties and obligations with respect to such Fund under this Agreement; (ii) willful misfeasance with respect to such Fund under this Agreement; (iii) bad faith with respect to such Fund under this Agreement; or (iv) negligence with respect to such Fund under this Agreement. The provisions of this Section 12 shall survive termination of this Agreement with respect to any Fund. 13. Responsibility of PFPC. PFPC shall be under no duty to take any action on behalf of a Fund except as stated herein or as may be agreed to by PFPC, in writing. PFPC shall be obligated to exercise reasonable care and reasonable diligence in the performance of its duties and obligations hereunder (including the services set forth in Schedule B to this Agreement) and to act in good faith in performing services provided for under this Agreement. For purposes of indemnification under Section 12 of this Agreement, the standards set forth in the prior sentence will be used as the measurement of whether PFPC's performance is in breach of its duties and obligations with respect to a Fund under this Agreement. PFPC, in connection with its duties under this Agreement, shall not be under any duty or obligation to inquire into and shall not be liable for the validity or invalidity or authority or lack thereof of any Oral or Written Instruction, notice or other instrument which conforms to the applicable requirements of this - 12 - Agreement, and which PFPC reasonably believes to be genuine. Notwithstanding anything in this Agreement to the contrary, PFPC shall not be liable for any Losses, delays or errors or loss of data occurring by reason of circumstances beyond PFPC's reasonable control, including without limitation acts of civil or military authority, national emergencies, labor difficulties, fire, flood or catastrophe, acts of God, acts of terrorism, insurrection, war, riots or failure of the mails, transportation, communication or power supply. For clarity, the immediately preceding sentence shall not obviate PFPC's duties under Section 10 of this Agreement. Notwithstanding anything in this Agreement to the contrary, neither PFPC nor its affiliates shall be liable to any Fund for any consequential, special or indirect losses or damages, whether or not the likelihood of such losses or damages was known by PFPC or its affiliates. Notwithstanding anything in this Agreement to the contrary, no Fund nor any of its affiliates shall be liable to PFPC for any consequential, special or indirect losses or damages, whether or not the likelihood of such losses or damages was known by the Fund or its affiliates. 14. PFPC shall, with respect to each separate Fund, perform the services set forth on Schedule B to this Agreement. 15. Duration and Termination. This Agreement shall continue in full force and effect with respect to a particular Fund (or Portfolio thereof) unless terminated as hereinafter provided or amended by mutual, written agreement of such Fund and PFPC. With - 13 - respect to a particular Fund (or Portfolio thereof) and PFPC, this Agreement may be terminated by either of such Fund or PFPC by an instrument in writing delivered, faxed or mailed, postage prepaid, to the other, such termination to take effect on the date stated therein, which date shall not be sooner than sixty (60) days after the date of such delivery or mailing. 16. Notices. If notice is sent by confirming facsimile sending device, it shall be deemed to have been given immediately. If notice is sent by first-class mail, it shall be deemed to have been given three days after it has been mailed. If notice is sent by messenger, it shall be deemed to have been given on the day it is delivered. Notices shall be addressed (a) if to PFPC at PFPC's address, 103 Bellevue Parkway, Wilmington, Delaware 19809; (b) if to a Fund, at the address of the Fund; or (c) if to neither a Fund or PFPC, at such other address as shall have been notified to the sender of any such notice. 17. Amendments. This Agreement, or any term hereof, may be changed or waived only by written amendment, signed by the party against whom enforcement of such change or waiver is sought. 18. Delegation. PFPC may, with the prior written consent of a Fund, which such consent may not be unreasonably withheld, assign its rights and delegate its duties with respect to such Fund hereunder to any wholly-owned direct or indirect subsidiary of PFPC or of The PNC Financial Services Group, Inc., provided that (i) PFPC gives the Fund a minimum of thirty (30) days in which to decide and consent by written notice; (ii) if the Fund is - 14 - an investment company registered under the 1940 Act, the delegate agrees with PFPC to comply with all relevant provisions of this Agreement and the 1940 Act; and (iii) PFPC and such delegate promptly provide such information as the Fund may request, and respond to such questions as the Fund may ask, relative to the delegation, including (without limitation) the capabilities of the delegate. 19. Counterparts. This Agreement may be executed in two or more counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. 20. Further Actions. Each party agrees to perform such further acts and execute such further documents as are necessary to effectuate the purposes hereof. 21. Miscellaneous. As between each separate Fund and PFPC, this Agreement embodies the entire agreement and understanding between such Fund and PFPC and supersedes all prior agreements and understandings between such Fund and PFPC relating to the subject matter hereof. The captions in this Agreement are included for convenience of reference only and in no way define or delimit any of the provisions hereof or otherwise affect their construction or effect. This Agreement shall be deemed to be a contract made in California and governed by California law. If any provision of this Agreement shall be held or made invalid by a court decision, statute, rule or otherwise, the remainder of this Agreement shall - 15 - not be affected thereby. This Agreement shall be binding and shall inure to the benefit of the parties hereto and their respective successors and permitted assigns. PFPC shall retain title to and ownership of any and all data bases, computer programs, screen formats, report formats, interactive design techniques, derivative works, inventions, discoveries, patentable or copyrightable matters, concepts, expertise, patents, copyrights, trade secrets, and other related legal rights owned or licensed and utilized by PFPC in connection with the services provided by PFPC to any of the Funds. There are no oral or written representations, agreements or understandings between PFPC and any Fund except as stated in this Agreement. PFPC is entering into this Agreement with each of the Funds separately, and any duty, obligation or liability owed or incurred by PFPC with respect to a particular Fund shall be owed or incurred solely with respect to that Fund, and shall not in any way create any duty, obligation or liability with respect to any other Fund. This Agreement shall be interpreted to carry out the intent of the parties hereto that PFPC is entering into a separate arrangement with each separate Fund. - 16 - The respective names Schwab Investments, The Charles Schwab Family of Funds, Schwab Capital Trust and Schwab Annuity Portfolios refers to each of such respective Funds and its Trustees, as Trustees but not individually or personally, acting under their respective Declarations of Trust dated October 26, 1990, May 9, 1995, May 6, 1993 and January 21, 1994. The obligations of any one of the aforementioned Funds entered into in the name of or on behalf of a Portfolio of such Fund by any of the Trustees, representatives or agents of such Fund are made not individually, but in such capacities. Such obligations are not binding upon any of the Trustees, shareholders or representatives of such Fund personally, but bind only the assets of such Fund belonging to such Portfolio for the enforcement of any claims against such Fund. Transactions entered into by a particular Portfolio of a Fund are considered independent transactions and shall in no way affect transactions entered into by any other Portfolio of such Fund. Any amount owed by a Fund with respect to any obligation arising out of this Agreement, as amended, shall be paid only out of the assets and property of the particular Portfolio that entered into such transaction. - 17 - IN WITNESS WHEREOF, each of the respective parties hereto have caused this Agreement to be executed on the day and year first above written. PFPC INC. By: Neal J. Andrews Name: /s/ Neal J. Andrews Title: SVP SCHWAB INVESTMENTS /s/ Tai-Chin Tung By: Tai-Chin Tung Title: Treasurer and Principal Financial Officer THE CHARLES SCHWAB FAMILY OF FUNDS /s/ Tai-Chin Tung By: Tai-Chin Tung Title: Treasurer and Principal Financial Officer SCHWAB CAPITAL TRUST /s/ Tai-Chin Tung By: Tai-Chin Tung Title: Treasurer and Principal Financial Officer SCHWAB ANNUITY PORTFOLIOS /s/ Tai-Chin Tung By: Tai-Chin Tung Title: Treasurer and Principal Financial Officer - 18 - SCHEDULE A Schwab Investments Schwab Total Bond Market Fund Schwab Short-Term Bond Market Fund Schwab California Short/Intermediate Tax-Free Bond Fund Schwab California Long-Term Tax-Free Bond Fund Schwab Short/Intermediate Tax-Free Bond Fund Schwab Long-Term Tax-Free Bond Fund Schwab YieldPlus Fund The Charles Schwab Family of Funds Schwab Money Market Fund Schwab Government Money Fund Schwab U.S. Treasury Money Fund Schwab Value Advantage Money Fund Schwab Institutional Advantage Money Fund Schwab Retirement Money Fund Schwab Municipal Money Fund Schwab California Municipal Money Fund Schwab New York Municipal Money Fund Schwab New Jersey Municipal Money Fund Schwab Pennsylvania Municipal Money Fund Schwab Florida Municipal Money Fund Schwab Government Cash Reserves Fund Schwab Capital Trust Schwab U.S. MarketMasters Fund * Schwab Balanced MarketMasters Fund * Schwab Small-Cap MarketMasters Fund * Schwab International MarketMasters Fund * Schwab Hedged Equity Fund Schwab Annuity Portfolios Schwab Money Market Portfolio - 19 - SCHEDULE B PFPC shall perform the following services for each separate Fund, and where referenced each separate Fund's Portfolios (each such separate Fund is referred to separately in this Schedule B as "the Fund"). With respect to the Portfolios of Schwab Capital Trust designated with an "*" on Schedule A of the Agreement, PFPC will create separate accounts for each sub-adviser of each such Portfolio and will perform items 1-6, 8-9, 14-15, 17 and 21 for each such sub-adviser account. 1. With respect to each particular Portfolio of the Fund, assist in keeping, maintaining and preserving (for such period of time as required under Rule 31a-2 of the 1940 Act) all accounts, records and other documents required under (a) Rule 31a-1(a) that relate to the services provided by PFPC with respect to such Portfolio under the Agreement; (b) Rule 31a-1(b)(1); (c) Rule 31a-1(b)(2)(i), (ii) and (iii); (d) Rule 31a-1(b)(3) and (e) Rule 31a-1(b)(8); 2. Calculate the value of each asset of each Portfolio of the Fund and the current net asset value of each such Portfolio and of each class of each such Portfolio; 3. Record and verify daily income, expense accruals and capital gains and losses with respect to each Portfolio of the Fund and provide notification of any proposed adjustments to the Fund; 4. Maintain historical tax lots for each asset of each Portfolio of the Fund; 5. Record the investment purchases and sales of each Portfolio of the Fund and transmit the same to the Fund's custodian for proper settlement; 6. Review transactions recorded by the Fund's custodian with respect to each Portfolio of the Fund in order to prepare the daily reconciliation of cash and investment positions with respect to each such Portfolio; 7. Record the capital share transactions of each Portfolio of the Fund and reconcile such transactions daily with the Fund's transfer agent; 8. Prepare the cash balances available for investment with respect to each Portfolio of the Fund for each of the - 20 - next five business days and update cash availability for each of such Portfolios throughout the day as requested; 9. Prepare such periodic financial statements and other reports as may be reasonably requested by the Fund from time to time; 10. Assist in the preparation of the Fund's Registration Statement; Pre-Effective and Post-Effective Amendments to the Registration Statement; Notices of Annual or Special Meeting of Shareholders; Proxy Statements; and such other notices, statements and filings as may be reasonably requested by the Fund from time to time; 11. Assist in the preparation and filing of the Fund's Annual and Semiannual Reports to shareholders; Form N-SAR; Form N-30D; Form 24f-2; and such other reports as may be reasonably requested by the Fund from time to time; 12. Assist in the preparation and filing of the Fund's federal and state tax returns; 13. Assist in the monitoring of compliance by each Portfolio of the Fund with Subchapters L and M of the Internal Revenue Code; 14. Assist (on a post-trade basis) with the monitoring of compliance by each Portfolio of the Fund with those requirements of the Investment Company Act of 1940 and the Fund's current Registration Statement as may be agreed to between PFPC and the Fund from time to time; 15. Assist in the monitoring of daily collateral asset segregation amounts by each Portfolio of the Fund for futures contracts and such other financial instruments as may be reasonably requested by the Fund from time to time; 16. Assist in the calculation of income, excise tax, and capital gain distributions with respect to each Portfolio of the Fund; 17. With respect to each Portfolio of the Fund, calculate the total return; yield; expense ratio; turnover rate; maturity (if applicable) and such other performance, financial and portfolio information as may be reasonably requested by the Fund from time to time; 18. Assist in the preparation of the annual budget, expense - 21 - accruals, expense allocations and waiver monitoring with respect to each Portfolio of the Fund; 19. Manage accounts payable with respect to each Portfolio of the Fund and authorize disbursements relating to such Portfolios upon Written Instructions; 20. Assist in the preparation of the Fund's quarterly Board materials; and 21. Provide such other services as may be agreed between PFPC and the Fund from time to time. - 22 - Authorized Persons Appendix Schwab Investments _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ The Charles Schwab Family of Funds _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ - 23 - Authorized Persons Appendix (continued) Schwab Capital Trust _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ Schwab Annuity Portfolios _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ _________________________ - 24 - SCHEDULE C Scott Hilton Greg Davis John Leszczynski Barbara Hill Valerie Sudler - 25 - EX-99.(G)(XII) 6 f84662exv99wxgyxxiiy.txt EXHIBIT 99.(G)(XII) EX-(g)(xii) RULE 17F-5 AND 17F-7 SERVICES AGREEMENT This Agreement is made, as of May 22, 2002, separately by and between each of Schwab Capital Trust, Schwab Investments, The Charles Schwab Family of Funds and Schwab Annuity Portfolios (each a "Fund") and PFPC Trust Company ("PFPC "). WHEREAS each Fund has retained PFPC to provide custody services to certain of its investment portfolios (each a "Portfolio") pursuant to a Custodian Services Agreement dated May 22, 2002. WHEREAS each Portfolio may from time to time determine to invest and maintain some of its assets outside of the United States. WHEREAS, subject to and in accordance with the provisions set forth in this Agreement, each Fund wishes to appoint PFPC to serve as Foreign Custody Manager under Securities and Exchange Commission Rule 17f-5 ("Rule 17f-5") under the Investment Company Act of 1940 ("1940 Act") and to provide risk analysis and monitoring required under sub-sections (a)(1)(i)(A) and (B) of Securities and Exchange Commission Rule 17f-7 ("Rule 17f-7") under the 1940 Act. WHEREAS, subject to and in accordance with the provisions set forth in this Agreement, PFPC wishes to serve as Foreign Custody Manager under Rule 17f-5 and provide risk analysis and monitoring required under sub-sections (a)(1)(i)(A) and (B) of Rule 17f-7. NOW THEREFORE, in consideration of the mutual covenants and agreements contained herein, each Fund and PFPC hereby agree as follows: A. Foreign Custody Manager. With respect to "Foreign Assets" (as defined below) in the jurisdictions listed on Schedule A hereto (as the same may be changed by PFPC from time to time), PFPC will perform the duties of a "Foreign Custody Manager" as set forth in Rule 17f-5, subject to and in accordance with the provisions set out in this Agreement. In consideration of PFPC's agreement to so perform, each Fund agrees to the provisions set forth in Paragraphs A and C-L of this Agreement. 1.PFPC shall select, place and maintain "Foreign Assets" (as that term is defined in Rule 17f-5(a)(2)) with an "Eligible Foreign Custodian" (as that term is defined in Rule 17f-5(a)(1)), provided that PFPC shall have determined that the Foreign Assets will be subject to reasonable care, based on the standards applicable to custodians in the relevant market, after having considered all factors relevant to the safekeeping of such Foreign Assets, including, without limitation, those factors set forth in Rule 17f-5(c)(1)(i)-(iv). 2. PFPC will assure that each foreign custody arrangement with an Eligible Foreign Custodian be governed by a written contract that PFPC has determined provides for the reasonable care of Foreign Assets based on the standards specified in Rule 17f-5(c)(1). Each such contract shall include, without limitation, all of the provisions specified in Rule 17f-5(c)(2)(i)(A)-(F). Alternatively, each such contract may contain, in lieu of any or all of the provisions specified in Rule 17f-5(c)(2)(i)(A)-(F), such other provisions that PFPC reasonably determines will provide, in their entirety, the same or a greater level of care and protection for a Fund's investments as the specified provisions, in their entirety. 3. PFPC will establish and maintain a system for the regular monitoring of the appropriateness of both maintaining the Foreign Assets with each Eligible Foreign Custodian and the custody contractual arrangements with such Eligible Foreign Custodians, it being understood, however, that in the event that PFPC shall have determined that the existing Eligible Foreign Custodian in a given country no longer affords reasonable care to Foreign Assets and that no other Eligible Foreign Custodian in that country would afford reasonable care, PFPC shall promptly so advise the applicable Fund and shall then act in accordance with authorized instructions with respect to the disposition of the affected Foreign Assets. 4. PFPC shall provide to each Fund's Board of Trustees written reports notifying the Board of the placement of the Fund's Foreign Assets with a particular Eligible Foreign Custodian and of any material change in the Fund's foreign custody arrangements, with the reports to be provided to the Board at such times as the Board may deem reasonable and appropriate based on the circumstances of the Fund's arrangements. Any report provided by PFPC pursuant to this Sub-Paragraph A.4 may be in electronic form. 5. For purposes of clarity, it is understood and agreed that PFPC shall not be responsible for any Foreign Custody Manager duties, including but not limited to those described in Sub-Paragraphs A.1-4 above, with respect to any securities depository. 6. In performing its duties under this Agreement, PFPC shall not supervise, recommend or advise a Fund relative to the investment, purchase, sale, retention or disposition of any Foreign Asset in any country, including with respect to prevailing country risks. PFPC agrees to provide such information in its possession as is specified in Schedule B hereto, as such Schedule B may be amended from time to time between PFPC and a particular Fund. In gathering such information, PFPC shall be subject to the standard of care set forth in Paragraph D hereof, but shall not be deemed to warrant the specific accuracy of such information. PFPC agrees to promptly notify a Fund at any time that PFPC becomes aware of a material change to the information provided pursuant to Schedule B, or if PFPC learns that any information previously provided is incomplete or inaccurate. Each Fund hereby acknowledges that such information is solely designed to inform the Fund of market conditions and procedures and is not intended as a recommendation to invest or not invest in particular markets. 7. Notwithstanding the provisions of any arrangements between any Fund and PFPC or otherwise, but subject to Sub-Paragraphs A.1-3 above, each Fund hereby agrees that its Foreign Assets may be maintained with any Eligible Foreign Custodian. B. Securities Depositories. PFPC will provide to the Funds the risk analysis and monitoring required under sub-sections (a)(1)(i)(A) and (B) of Rule 17f-7 subject to and in accordance with the provisions set out in this Agreement. In consideration of the provision of such risk analysis and monitoring each Fund agrees to the provisions set forth in Paragraphs B through L of this Agreement. 1. (a) As contemplated by Rule 17f-7, PFPC will provide a written analysis (which may be in electronic form) to each Fund and its investment adviser of the custody risks associated with maintaining the Fund's "Foreign Assets" (as that term is defined in Rule 17f-5(a)(2) under the 1940 Act) with each "Eligible Securities Depository" (as that term is defined in Rule 17f-7(b)(1)) listed on Schedule C hereto (as the same may be changed by PFPC from time to time) and at which any Foreign Assets of the Fund are held or are expected to be held. PFPC shall monitor the custody risks associated with maintaining each applicable Fund's Foreign Assets at each such Eligible Securities Depository on a continuing basis and shall promptly notify each applicable Fund or its investment adviser in writing (which may be in electronic form) of any material change in such risks. (b) Based on the information available to it in the exercise of diligence, PFPC shall determine the eligibility under Rule 17f-7(b)(1) of each depository listed on Schedule C hereto (as the same may be changed by PFPC from time to time) and shall promptly advise each Fund or its investment adviser in writing (which may be in electronic form) if any such depository ceases to meet the definition of an Eligible Securities Depository (as that term is defined in Rule 17f-7(b)(1)). 2. Each Fund acknowledges that it may maintain Foreign Assets only at the depositories listed on Schedule C hereto (as the same may be changed by PFPC from time to time). Each Fund agrees and acknowledges that its Foreign Assets may be held at any of the depositories listed on Schedule C hereto; provided that if any Fund provides written notice to PFPC specifically stating that a particular depository is not acceptable to it, then such Fund will not be deemed to have agreed and acknowledged that its Foreign Assets may be held by that particular depository. 3. Notwithstanding the provisions of any arrangements between any Fund and PFPC or otherwise, each Fund hereby agrees that its Foreign Assets may be maintained with any Eligible Securities Depository listed on Schedule C hereto (provided that if any Fund provides written notice to PFPC specifically stating that a particular depository is not acceptable to it, then such Fund will not be deemed to have agreed that its Foreign Assets may be maintained by that particular depository). PFPC will not be deemed to have chosen any such Eligible Securities Depositories. C. Third Parties. Each Fund acknowledges that PFPC (at its own expense) may utilize a third party to carry out PFPC's activities set forth herein, provided however, that the appointment or use of a third party will not relieve PFPC of its obligations and responsibilities to a Fund under this Agreement, and PFPC will be responsible and liable to a Fund for the acts or omissions of such third party to the same extent that PFPC would be responsible and liable to the Fund if such acts or omissions were PFPC's own in providing the services set forth in this Agreement to such Fund (provided that in no event will PFPC be liable to a Fund for any indirect, special or consequential losses or damages (regardless of whether PFPC or such third party was aware of the possibility thereof)). D. Responsibility and Indemnification. In providing services pursuant to this Agreement, PFPC shall exercise reasonable care, prudence and diligence (such as a person having responsibility for the safekeeping of Foreign Assets would exercise). PFPC will indemnify a Fund with respect to the services set forth in this Agreement for the losses, liabilities and expenses suffered by the Fund as a result of PFPC's (a) failure to exercise such reasonable care, prudence and diligence (such as a person having responsibility for the safekeeping of Foreign Assets would exercise), and (b) willful misfeasance, bad faith, negligence or reckless disregard in carrying out its duties and obligations under this Agreement, provided that in no event will PFPC be liable to a Fund for any indirect, special or consequential losses or damages (regardless of whether PFPC was aware of the possibility thereof). Each Fund will indemnify PFPC for losses, liabilities and expenses suffered by PFPC with respect to the matters set forth in this Agreement, except that a Fund will not indemnify PFPC for such losses, liabilities and expenses arising out of PFPC's (a) failure to exercise reasonable care, prudence and diligence (such as a person having responsibility for the safekeeping of Foreign Assets would exercise) in providing services to such Fund under this Agreement, or (b) willful misfeasance, bad faith, negligence or reckless disregard of its duties and obligations in providing services to such Fund under this Agreement, provided that in no event will the Fund be liable for any indirect, special or consequential losses or damages (regardless of whether the Fund was aware of the possibility thereof). E. Compensation. The fees for services rendered by PFPC under this Agreement with respect to a particular Fund are included in the separate custodian services fee letter between the Fund and PFPC in effect on the date hereof, or as the same may be amended from time to time. F. Integration. This Agreement shall supercede and replace each of the Amendments to the respective Custodian Services Agreements between PFPC and the Funds dated as of July 2, 2001 relating to PFPC's duties as Foreign Custody Manager under Rule 17f-5 and relating to PFPC's duties to provide risk analysis and monitoring required under sub-sections (a)(1)(i)(A) and (B) of Rule 17f-7. G. Choice of Law. This Agreement and the provisions hereof shall be construed in accordance with the laws of the State of New York, without regard to its conflict of laws principles. This Agreement may be executed in counterparts, all of which when taken together shall constitute one contract. Delivery of an executed counterpart of this Agreement by facsimile transmission shall be effective as delivery of a manually executed counterpart of this Agreement. Each party hereto represents that it has taken all requisite action (corporate or otherwise) to authorize the execution and delivery of this Agreement. The captions in this Agreement are included for convenience of reference only and in no way define or delimit any of the provisions hereof or otherwise affect their construction or effect. H. Declarations of Trust. The respective names Schwab Capital Trust, Schwab Investments, The Charles Schwab Family of Funds and Schwab Annuity Portfolios refers to each of such respective Funds and its Trustees, as Trustees but not individually or personally, acting under their respective Declarations of Trust dated May 6, 1993, October 26, 1990, May 9, 1995 and January 21, 1994. The obligations of any one of the aforementioned Funds entered into in the name of or on behalf of a Portfolio of such Fund by any of the Trustees, representatives or agents of such Fund are made not individually, but in such capacities. Such obligations are not binding upon any of the Trustees, shareholders or representatives of such Fund personally, but bind only the assets of such Fund belonging to such Portfolio for the enforcement of any claims against such Fund. I. Independent Transactions. Transactions entered into by one or more Portfolios of the Funds are considered independent transactions and shall in no way affect transactions entered into by any other Portfolio(s). Any amount owed by the Funds with respect to any obligation arising out of the Agreement, as amended, shall be paid only out of the assets and property of the particular Portfolio(s) that entered into such transaction. J. Each Fund represents that the Foreign Assets which are the subject matter of this Agreement are subject to the 1940 Act. PFPC represents that it is a U.S. Bank as defined in Rule 17f-5. K. This Agreement may be terminated with respect to a particular Fund by either such Fund or PFPC upon 60 days written notice to the other party. L. PFPC is entering into this Agreement with each of the Funds separately, and any duty, obligation or liability owed or incurred by PFPC with respect to a particular Fund shall be owed or incurred solely with respect to that Fund, and shall not in any way create any duty, obligation or liability with respect to any other Fund. This Agreement shall be interpreted to carry out the intent of the parties hereto that PFPC is entering into a separate arrangement with each separate Fund. IN WITNESS WHEREOF, each of the respective parties hereto have caused this Agreement to be executed on the day and year first above written. PFPC TRUST COMPANY /s/ David E. Fritz By: David E. Fritz Title: Vice President SCHWAB CAPITAL TRUST /s/ Tai-Chin Tung By: Tai-Chin Tung Title: Treasurer and Principal Financial Officer SCHWAB INVESTMENTS /s/ Tai-Chin Tung By: Tai-Chin Tung Title: Treasurer and Principal Financial Officer THE CHARLES SCHWAB FAMILY OF FUNDS /s/ Tai-Chin Tung By: Tai-Chin Tung Title: Treasurer and Principal Financial Officer SCHWAB ANNUITY PORTFOLIOS /s/ Tai-Chin Tung By: Tai-Chin Tung Title: Treasurer and Principal Financial Officer SCHEDULE A FOREIGN CUSTODY MANAGER JURISDICTIONS
COUNTRY SUB-CUSTODIAN CORRESPONDENT BANK - ------- ------------- ------------------ ARGENTINA JPMorgan Chase Bank JPMorgan Chase Bank Arenales 707, 5th Floor Buenos Aires 1061 Buenos Aires ARGENTINA AUSTRALIA JPMorgan Chase Bank Australia and New Zealand Banking Level 37 Group Ltd. AAP Center Melbourne 259, George Street Sydney NSW 2000 AUSTRALIA AUSTRIA Bank Austria AG J.P. Morgan AG Julius Tandler Platz - 3 Frankfurt A-1090 Vienna AUSTRIA BAHRAIN HSBC Bank Middle East National Bank of Bahrain PO Box 57 Manama Manama, 304 BAHRAIN BANGLADESH Standard Chartered Bank Standard Chartered Bank 18-20 Motijheel C.A. Dhaka Box 536, Dhaka-1000 BANGLADESH BELGIUM Fortis Bank N.V. J.P. Morgan AG 3 Montagne Du Parc Frankfurt 1000 Brussels BELGIUM
BERMUDA The Bank of Bermuda Limited The Bank of Bermuda Ltd 6 Front Street Hamilton Hamilton HMDX BERMUDA BOTSWANA Barclays Bank of Botswana Limited Barclays Bank of Botswana Ltd Barclays House, Khama Crescent Gaborone Gaborone BOTSWANA BRAZIL Citibank, N.A. Citibank, N.A. Avenida Paulista, 1111 Sao Paulo Sao Paulo, SP 01311-920 BRAZIL BankBoston, N.A. BankBoston, N.A. Rua Libero Badaro, 425-29 andar Sao Paulo Sao Paulo - SP 01009-000 BRAZIL BULGARIA ING Bank N.V. ING Bank N.V. Sofia Branch Sofia 12 Emil Bersinski Street Ivan Vazov Region 1408 Sofia BULGARIA CANADA Canadian Imperial Bank of Commerce Royal Bank of Canada Commerce Court West Toronto Security Level Toronto, Ontario M5L 1G9 CANADA Royal Bank of Canada Royal Bank of Canada 200 Bay Street, Suite 1500 Toronto 15th Floor Royal Bank Plaza, North Tower Toronto Ontario M5J 2J5 CANADA
7 CHILE Citibank, N.A. Citibank, N.A. Avda. Andres Bello 2687 Santiago 3rd and 5th Floors Santiago CHILE CHINA - SHANGHAI The Hongkong and Shanghai Banking Citibank, N.A. Corporation Limited New York 34/F, Shanghai Senmao International Building 101 Yin Cheng East Road Pudong Shanghai 200120 THE PEOPLE'S REPUBLIC OF CHINA CHINA - SHENZHEN The Hongkong and Shanghai Banking JPMorgan Chase Bank Corporation Limited Hong Kong 1st Floor Century Plaza Hotel No.1 Chun Feng Lu Shenzhen THE PEOPLE'S REPUBLIC OF CHINA COLOMBIA Cititrust Colombia S.A. Cititrust Colombia S.A. Sociedad Fiduciaria Sociedad Fiduciaria Santa Fe de Bogota Carrera 9a No 99-02 First Floor Santa Fe de Bogota, D.C. COLOMBIA CROATIA Privredna banka Zagreb d.d. Privredna banka Zagreb d.d. Savska c.28 Zagreb 10000 Zagreb CROATIA CYPRUS The Cyprus Popular Bank Ltd. Cyprus Popular Bank 154 Limassol Avenue Nicosia P.O. Box 22032 CY-1598 Nicosia, CYPRUS
8 CZECH REPUBLIC Ceskoslovenska obchodni banka, a.s. Ceskoslovenska obchodni banka, a.s. Na Prikope 14 Prague 115 20 Prague 1 CZECH REPUBLIC DENMARK Danske Bank A/S Nordea Bank Danmark A/S 2-12 Holmens Kanal Copenhagen DK 1092 Copenhagen K DENMARK ECUADOR Citibank, N.A. Citibank, N.A. Av. Republica de El Salvador y Quito Naciones Unidas (Esquina) Quito ECUADOR EGYPT Citibank, N.A. Citibank, N.A. 4 Ahmed Pasha Street Cairo Garden City Cairo EGYPT ESTONIA Hansabank Esti Uhispank Liivalaia 8 Tallinn EE0001 Tallinn ESTONIA FINLAND Nordea Bank Finland Plc J.P. Morgan AG 2598 Custody Services Frankfurt Aleksis Kiven Katu 3-5 FIN-00020 MERITA, Helsinki FINLAND FRANCE BNP Paribas Securities Services S.A. J.P. Morgan AG Ref 256 Frankfurt BP 141 3, Rue D'Antin 75078 Paris Cedex 02 FRANCE
9 Societe Generale J.P. Morgan AG 50 Boulevard Haussman Frankfurt 75009 Paris FRANCE Credit Agricole Indosuez J.P. Morgan AG 96 Blvd. Haussmann Frankfurt 75008 Paris FRANCE GERMANY Dresdner Bank AG J.P. Morgan AG Juergen-Ponto-Platz 1 Frankfurt 60284 Frankfurt/Main GERMANY GHANA Barclays Bank of Ghana Limited Barclays Bank of Ghana Ltd Barclays House, High Street Accra Accra GHANA GREECE HSBC Bank plc J.P. Morgan AG Messogion 109-111 Frankfurt 11526 Athens GREECE HONG KONG The Hongkong and Shanghai Banking JPMorgan Chase Bank Corporation Limited Hong Kong 36th Floor, Sun Hung Kai Centre 30 Harbour Road Wan Chai HONG KONG HUNGARY Citibank Rt. ING Bank Rt. Szabadsag ter 7-9 Budapest H-1051 Budapest V HUNGARY ICELAND Islandsbanki-FBA Islandsbanki-FBA Kirkjusandur 2 Reykjavik 155 Reykjavik ICELAND
10 INDIA The Hongkong and Shanghai Banking The Hongkong and Shanghai Banking Corporation Limited Corporation Limited Sudam Kalu Ahire Marg, Worli Mumbai Mumbai 400 025 INDIA Deutsche Bank AG Deutsche Bank AG Kodak House Mumbai 222 D.N. Road, Fort Mumbai 400 001 INDIA Standard Chartered Bank Standard Chartered Bank Phoenix Centre, Phoenix Mills Compound Mumbai Senapati Bapat Marg, Lower Parel Mumbai 400 013 INDIA INDONESIA The Hongkong and Shanghai Banking Standard Chartered Bank Corporation Limited Jakarta World Trade Center Jl. Jend Sudirman Kav. 29-31 Jakarta 10023 INDONESIA Standard Chartered Bank Standard Chartered Bank Jl. Jend Sudirman Kav. 33-A Jakarta Jakarta 10220 INDONESIA IRELAND Bank of Ireland J.P. Morgan AG International Financial Services Centre Frankfurt 1 Harbourmaster Place Dublin 1 IRELAND Allied Irish Banks, p.l.c. J.P. Morgan AG P.O. Box 518 Frankfurt International Financial Services Centre Dublin 1 IRELAND ISRAEL Bank Leumi le-Israel B.M. Bank Leumi Le-Israel B.M. 35, Yehuda Halevi Street Tel Aviv 61000 Tel Aviv ISRAEL
11 ITALY BNP Paribas Securities Services S.A. J.P. Morgan AG 2 Piazza San Fedele Frankfurt 20121 Milan ITALY IVORY COAST Societe Generale de Banques en Cote Societe Generale d'Ivoire Paris 5 et 7, Avenue J. Anoma - 01 B.P. 1355 Abidjan 01 IVORY COAST JAMAICA CIBC Trust and Merchant Bank CIBC Trust and Merchant Bank Jamaica Limited Jamaica Limited 23-27 Knutsford Blvd. Kingston Kingston 10 JAMAICA JAPAN The Fuji Bank, Limited JPMorgan Chase Bank 6-7 Nihonbashi-Kabutocho Tokyo Chuo-Ku Tokyo 103 JAPAN The Bank of Tokyo-Mitsubishi, Limited JPMorgan Chase Bank 3-2 Nihombashi Hongkucho 1-chome Tokyo Chuo-ku Tokyo 103 JAPAN JORDAN Arab Bank Plc Arab Bank Plc P O Box 950544-5 Amman Amman Shmeisani JORDAN KAZAKHSTAN ABN AMRO Bank Kazakhstan ABN AMRO Bank Kazakhstan 45, Khadzhi Mukana Street Almaty 480099 Almaty KAZAKHSTAN
12 KENYA Barclays Bank of Kenya Limited Barclays Bank of Kenya Ltd c/o Barclaytrust Investment Services Nairobi & Limited Mezzanine 3, Barclays Plaza, Loita Street Nairobi KENYA LATVIA Hansabanka Hansabanka Kalku iela 26 Riga Riga, LV 1050 LATVIA LEBANON HSBC Bank Middle East JPMorgan Chase Bank Ras-Beirut Branch New York P.O. Box 11-1380 Abdel Aziz Ras-Beirut LEBANON LITHUANIA Vilniaus Bankas AB Vilniaus Bankas AB 12 Gedimino pr. Vilnius LT 2600 Vilnius LITHUANIA LUXEMBOURG Banque Generale du Luxembourg S.A. J.P. Morgan AG 50 Avenue J.F. Kennedy Frankfurt L-2951 LUXEMBOURG MALAYSIA HSBC Bank Malaysia Berhad J.P. Morgan Chase Bank Berhad 2 Leboh Ampang Kuala Lumpur 50100 Kuala Lumpur MALAYSIA
13 MAURITIUS The Hongkong and Shanghai Banking The Hongkong and Shanghai Banking Corporation Limited Corporation Limited 5/F Les Cascades Building Port Louis Edith Cavell Street Port Louis MAURITIUS MEXICO Banco J.P. Morgan, S.A. Banco J.P. Morgan, S.A. Torre Optima Mexico, D.F Paseo de las Palmas #405 Piso 15 Lomas de Chapultepec 11000 Mexico, D. F. MEXICO Banco Nacional de Mexico, S.A. Banco Nacional de Mexico, S.A. Paseo de la Reforma 390 Mexico, D.F 06695 Mexico, D.F. MEXICO MOROCCO Banque Commerciale du Maroc S.A. Banque Commerciale du Maroc S.A. 2 Boulevard Moulay Youssef Casablanca Casablanca 20000 MOROCCO NAMIBIA Standard Bank Namibia Limited Standard Corporate & Merchant Bank Mutual Platz Johannesburg Cnr. Stroebel and Post Streets P.O.Box 3327 Windhoek NAMIBIA NETHERLANDS ABN AMRO Bank N.V. J.P. Morgan AG Kemelstede 2 Frankfurt P. O. Box 3200 4800 De Breda NETHERLANDS Fortis Bank (Nederland) N.V. J.P. Morgan AG 55 Rokin Frankfurt P.O. Box 243 1000 AE Amsterdam NETHERLANDS
14 NEW ZEALAND National Nominees Limited National Bank of New Zealand Level 2 BNZ Tower Wellington 125 Queen Street Auckland NEW ZEALAND *NIGERIA* Stanbic Merchant Bank Nigeria Limited Standard Bank of South Africa 188 Awolowo Road Johannesburg P.O. Box 54746 Falomo, Ikoyi Lagos NIGERIA
*RESTRICTED SERVICE ONLY. PLEASE CONTACT YOUR RELATIONSHIP MANAGER FOR FURTHER INFORMATION.* NORWAY Den norske Bank ASA Den norske Bank ASA Stranden 21 Oslo PO Box 1171 Sentrum N-0107 Oslo NORWAY OMAN HSBC Bank Middle East Oman Arab Bank Bait Al Falaj Main Office Muscat Ruwi, Muscat PC 112 OMAN PAKISTAN Citibank, N.A. Citibank, N.A. AWT Plaza Karachi I.I. Chundrigar Road Karachi 74200 PAKISTAN Deutsche Bank AG Deutsche Bank AG Unitowers Karachi I.I. Chundrigar Road Karachi 74200 PAKISTAN Standard Chartered Bank Standard Chartered Bank Box 4896 Karachi Ismail Ibrahim Chundrigar Road Karachi 74200 PAKISTAN
15 PERU Citibank, N.A. Banco de Credito del Peru Camino Real 457 Lima Torre Real - 5th Floor San Isidro, Lima 27 PERU PHILIPPINES The Hongkong and Shanghai Banking The Hongkong and Shanghai Banking Corporation Limited Corporation Limited 30/F Discovery Suites Manila 25 ADB Avenue Ortigas Center Pasig City, Manila PHILIPPINES POLAND Bank Handlowy w. Warszawie S.A. Bank Rozwoju Eksportu S.A. ul. Senatorska 16 Warsaw 00-082 Warsaw POLAND Bank Polska Kasa Opieki S.A. Bank Rozwoju Eksportu S.A. 11 Lucka street Warsaw 00-950 Warsaw POLAND PORTUGAL Banco Espirito Santo, S.A. J.P. Morgan AG 7th floor Frankfurt Rua Castilho, 26 1250-069 Lisbon PORTUGAL ROMANIA ING Bank N.V. ING Bank N.V. 13-15 Kiseleff Blvd Bucharest Bucharest 1 ROMANIA *RUSSIA* J.P. Morgan Bank International JPMorgan Chase Bank (Limited Liability Company) New York Building 2/1, 8th floor A/C JPMorgan Chase Bank Paveletskaya Square London (USD NOSTRO Account) 113054 Moscow RUSSIA
16 Credit Suisse First Boston AO JPMorgan Chase Bank Nikitsky Pereulok, 5 New York 103009 Moscow A/C JPMorgan Chase Bank RUSSIA London (USD NOSTRO Account)
*RESTRICTED SERVICE ONLY. PLEASE CONTACT YOUR RELATIONSHIP MANAGER FOR FURTHER INFORMATION.* SINGAPORE Standard Chartered Bank Oversea-Chinese Banking Corporation 3/F, 6 Battery Road Singapore 049909 SINGAPORE SLOVAK REPUBLIC Ceskoslovenska obchodni banka, a.s. Ceskoslovenska obchodni banka, a.s. pobocka zahranicnej banky v SR Bratislava Michalska 18 815 63 Bratislava SLOVAK REPUBLIC SLOVENIA Bank Austria Creditanstalt d.d. Ljubljana Bank Austria Creditanstalt d.d. Wolfova 1 Ljubljana SI-1000 Ljubljana Ljubljana SLOVENIA SOUTH AFRICA The Standard Bank of South Africa Limited Standard Corporate & Merchant Bank Standard Bank Centre Johannesburg 1st Floor 5 Simmonds Street Johannesburg 2001 SOUTH AFRICA SOUTH KOREA The Hongkong and Shanghai Banking The Hongkong and Shanghai Banking Corporation Limited Corporation Limited 5/F HSBC Building Seoul #25, Bongrae-dong 1-ga Seoul SOUTH KOREA Standard Chartered Bank Standard Chartered Bank 22/F, Seoul Finance Centre Building Seoul 63, Mukyo-dong, Chung-Ku Seoul SOUTH KOREA
17 SPAIN J.P. Morgan Bank, S.A. J.P. Morgan AG Paseo de la Castellana, 51 Frankfurt 28046 Madrid SPAIN SRI LANKA The Hongkong and Shanghai Banking The Hongkong and Shanghai Banking Corporation Limited Corporation Limited 24 Sir Baron Jayatillaka Mawatha Colombo Colombo 1 SRI LANKA SWEDEN Skandinaviska Enskilda Banken Svenska Handelsbanken Sergels Torg 2 Stockholm SE-106 40 Stockholm SWEDEN SWITZERLAND UBS AG UBS AG 45 Bahnhofstrasse Zurich 8021 Zurich SWITZERLAND TAIWAN JPMorgan Chase Bank JPMorgan Chase Bank 14th Floor Taipei 2, Tun Hwa S. Road Sec. 1 Taipei TAIWAN The Hongkong and Shanghai Banking The Hongkong and Shanghai Banking Corporation Limited Corporation Limited International Trade Building Taipei 16th Floor, Taipei World Trade Center 333 Keelung Road, Section 1 Taipei 110 TAIWAN THAILAND Standard Chartered Bank Standard Chartered Bank 14th Floor, Zone B Bangkok Sathorn Nakorn Tower 100 North Sathorn Road Bangrak, Bangkok 10500 THAILAND
18 TUNISIA Banque Internationale Arabe de Tunisie, Banque Internationale Arabe de S.A. Tunisie, S.A. 70-72 Avenue Habib Bourguiba Tunis P.O. Box 520 1080 Tunis Cedex TUNISIA TURKEY JPMorgan Chase Bank JPMorgan Chase Bank Emirhan Cad. No: 145 Istanbul Atakule, A Blok Kat:11 80700-Dikilitas/Besiktas Istanbul TURKEY *UKRAINE* ING Bank Ukraine ING Bank Ukraine 28 Kominterna Street Kiev 5th Floor Kiev, 252032 UKRAINE
*RESTRICTED SERVICE ONLY. PLEASE CONTACT YOUR RELATIONSHIP MANAGER FOR FURTHER INFORMATION.* U.A.E. HSBC Bank Middle East The National Bank of Abu Dhabi P.O. Box 66 Abu Dhabi Dubai UNITED ARAB EMIRATES U.K. JPMorgan Chase Bank National Westminster Bank Crosby Court London Ground Floor 38 Bishopsgate London EC2N 4AJ UNITED KINGDOM URUGUAY BankBoston, N.A. BankBoston, N.A. Zabala 1463 Montevideo Montevideo URUGUAY
19 VENEZUELA Citibank, N.A. Citibank, N.A. Carmelitas a Altagracia Caracas Edificio Citibank Caracas 1010 VENEZUELA VIETNAM The Hongkong and Shanghai Banking The Hongkong and Shanghai Banking Corporation Limited Corporation Limited 75 Pham Hong Thai, District 1 Ho Chi Minh City Ho Chi Minh City VIETNAM ZAMBIA Barclays Bank of Zambia Limited Barclays Bank of Zambia Ltd Kafue House, Cairo Road Lusaka Lusaka ZAMBIA ZIMBABWE Barclays Bank of Zimbabwe Limited Barclays Bank of Zimbabwe Ltd 2nd Floor, 3 Anchor House Harare Jason Mayo Avenue Harare ZIMBABWE
20 SCHEDULE B INFORMATION REGARDING COUNTRY RISK 1. To aid a Fund in its evaluations regarding country risk, PFPC shall furnish annually and upon the initial placing of Foreign Assets into a country by the Fund the following information: A. Opinions of local counsel concerning: i. Whether applicable foreign law would restrict the access afforded the Fund's independent public accountants to books and records kept by an Eligible Foreign Custodian located in that country. ii. Whether applicable foreign law would restrict the Fund's ability to recover its assets in the event of the bankruptcy of an Eligible Foreign Custodian located in that country. iii. Whether applicable foreign law would restrict the Fund's ability to recover assets that are lost while under the control of an Eligible Foreign Custodian located in the country. B. Written information concerning: i. The likelihood of expropriation, nationalization, freezes, or confiscation of the Fund's assets. ii. Whether difficulties in converting the Fund's cash and cash equivalents to U.S. dollars are reasonably foreseeable. C. A market report with respect to the following topics: (i) securities regulatory environment, (ii) foreign ownership restrictions, (iii) foreign exchange, (iv) securities settlement and registration, (v) taxation and (vi) securities depositories. 2. PFPC shall furnish the following additional information on an as needed basis: Market flashes, including with respect to changes in the information in market reports. 21 SCHEDULE C FOREIGN SECURITIES DEPOSITORIES
COUNTRY DEPOSITORY INSTRUMENTS ------- ---------- ----------- ARGENTINA CVSA Equity, Corporate Debt, Government Debt (Caja de Valores S.A.) ARGENTINA CRYL Government Debt (Central de Registration y Liquidacion de Instrumentos de Endeudamiento Publico) AUSTRALIA AUSTRACLEAR LIMITED Corporate Debt, Money Market, Semi-Government Debt AUSTRALIA CHESS Equity (Clearing House Electronic Sub-register System) AUSTRALIA RITS Government Debt (Reserve Bank of Australia/Reserve Bank Information and Transfer System) AUSTRIA OEKB Equity, Corporate Debt, Government Debt (OESTERREICHISCHE KONTROLLBANK AG) BELGIUM CIK Equity, Corporate Debt (Caisse Interprofessionnelle de Depots et de Virements de Titres S.A.) BELGIUM NBB Corporate Debt, Government Debt (National Bank of Belgium) BRAZIL CBLC Equity (Companhia Brasileira de Liquidacao e Custodia) BRAZIL CETIP Corporate Debt (Central de Custodia e Liquidacao Financiera de Titulos Privados) BRAZIL SELIC Government Debt (Sistema Especial de Liquidacao e Custodia) BULGARIA BNB Government Debt (Bulgaria National Bank) BULGARIA CDAD Equity, Corporate Debt (Central Depository A.D.) CANADA CDS Equity, Corporate, Government Debt (The Canadian Depository for Securities Limited) CHILE DCV Equity, Corporate Debt, Government Debt (Deposito Central de Valores S.A.) CHINA, SHANGHAI CSDCC, SHANGHAI BRANCH Equity (China Securities Depository and Clearing Corporation Limited, Shanghai Branch)
22
COUNTRY DEPOSITORY INSTRUMENTS ------- ---------- ----------- CHINA, SHENZHEN CSDCC, SHENZHEN BRANCH Equity (China Securities Depository and Clearing Corporation Limited, Shenzhen Branch) COLOMBIA DCV Government Debt (Deposito Central de Valores) COLOMBIA DECEVAL Equity, Corporate Debt, Government Debt (Deposito Centralizado de Valores de Colombia S.A.) CROATIA SDA Equity, Government Debt (Central Depository Agency Inc. - Stredisnja depozitarna agencija d.d.) CROATIA MINISTRY OF FINANCE OF THE REPUBLIC OF CROATIA Short-term debt issued by the Ministry of Finance. CROATIA CNB Short-term debt issued by the National Bank of (Croatian National Bank) Croatia. CZECH REPUBLIC SCP Equity, Corporate Debt, Government Debt (Stredisko cennych papiru) CZECH REPUBLIC CNB Government Debt (Czech National Bank) DENMARK VP Equity, Corporate Debt, Government Debt (Vaerdipapircentralen A/S) EGYPT MCSD Equity, Corporate Debt (Misr for Clearing, Settlement and Depository, S.A.E.) ESTONIA ECDS Equity, Corporate Debt, Government Debt (Estonian Central Depository for Securities Limited - Eesti Vaatpaberite Keskdepositoorium) EUROMARKET DCC Euro-CDs (The Depository and Clearing Centre) EUROMARKET CLEARSTREAM Euro-Debt (Clearstream Banking, S.A.) EUROMARKET EUROCLEAR Euro-Debt FINLAND APK Equity, Corporate Debt, Government Debt (Finnish Central Securities Depository Limited) FRANCE EUROCLEAR FRANCE Equity, Corporate Debt, Government Debt GERMANY CBF Equity, Corporate Debt, Government Debt (CLEARSTREAM BANKING AG) GREECE CSD Equity, Corporate Debt (Central Securities Depository S.A.) GREECE BOG Government Debt (BANK OF GREECE)
23
COUNTRY DEPOSITORY INSTRUMENTS ------- ---------- ----------- HONG KONG HKSCC Equity (Hong Kong Securities Clearing Company Limited) HONG KONG CMU Corporate Debt, Government Debt (Central Moneymarkets Unit) HUNGARY KELER Equity, Corporate Debt, Government Debt (Central Depository and Clearing House - Kosponti Elszamolohaz es Ertektar (Budapest) Rt.) INDIA NSDL Equity, Corporate Debt, Government Debt (National Securities Depository Limited) INDIA CDSL Equity (Central Depository Services (India) Limited) INDIA RBI Government Debt (Reserve Bank of India) INDONESIA KSEI Equity, Corporate Debt (PT Kustodian Sentral Efek Indonesia) IRELAND CREST Equity, Corporate Debt (CRESTCo Limited) ISRAEL TECH Equity, Corporate Debt, Government Debt (Tel Aviv Stock Exchange Clearing House Limited) ITALY MONTE TITOLI S.P.A. Equity, Corporate Debt, Government Debt ITALY BANCA D'ITALIA Government Debt IVORY COAST DC/BR Equity (Le Depositaire Central / Banque de Reglement) JAPAN JASDEC Equity, Convertible Debt (Japan Securities Depository Center) JAPAN BOJ Registered Government Debt (Bank of Japan) KAZAHKSTAN CSD Equity (CENTRAL SECURITIES DEPOSITORY CJSC) KENYA CBCD Government Debt (Central Bank Central Depository) LATVIA LCD Equity, Corporate Debt, Government Debt (Latvian Central Depository) LEBANON MIDCLEAR S.A.L. Equity (Custodian and Clearing Center of Financial Instruments for Lebanon and the Middle East S.A.L.) LITHUANIA CSDL Equity, Corporate Debt, Government Debt (Central Securities Depository of Lithuania) LUXEMBOURG CLEARSTREAM Equity
24
COUNTRY DEPOSITORY INSTRUMENTS ------- ---------- ----------- (Clearstream Banking S.A.) MALAYSIA MCD Equity, Corporate Debt, Government Debt (Malaysian Central Depository Sdn. Bhd.) MAURITIUS CDS Equity, Corporate Debt (Central Depository and Settlement Company Limited) MEXICO INDEVAL Equity, Corporate Debt, Government Debt (S.D. INDEVAL S.A. de C.V.) MOROCCO MAROCLEAR Equity, Corporate Debt, Government Debt NETHERLAND NECIGEF Equity, Corporate Debt, Government Debt (Nederlands Centraal Insituut voor Giraal Effectenverkeer B.V.) NEW ZEALAND NZCSD Equity, Corporate Debt, Government Debt (New Zealand Central Securities Depository) NIGERIA CSCS Equity, Corporate Debt, Government Debt (Central Securities Clearing System Limited) NORWAY VPS Equity, Corporate Debt, Government Debt (Verdipapirsentralen) OMAN MDSRC Equity, Corporate Debt (The Muscat Depository and Securities Registration Company, S.A.O.C.) PAKISTAN CDC Equity, Corporate Debt (Central Depository Company of Pakistan Limited) PAKISTAN SBP Government Debt (State Bank of Pakistan) PERU CAVALI Equity, Corporate Debt, Government Debt (CAVALI ICLV S.A.) PHILIPPINES PCD Equity (Philippine Central Depository Inc.) PHILIPPINES ROSS Government Debt (Bangko Sentral ng Pilipinas / Register of Scripless Securities) POLAND NDS Equity, Long-Term Government Debt (National Depository for Securities S.A.) POLAND CRT Short-Term Government Debt (Central Registry of Treasury-Bills) PORTUGAL INTERBOLSA Equity, Corporate Debt, Government Debt (Sociedade Gestora de Sistemas de Liquidacao e de Sistemas Centralizados de Valores Mobiliarios, S.A ROMANIA SNCDD Equity
25
COUNTRY DEPOSITORY INSTRUMENTS ------- ---------- ----------- (National Company for Clearing, Settlement and Depository for Securities) ROMANIA BSE Equity (Bucharest Stock Exchange Registry) RUSSIA VTB Equity, Corporate Debt, Government Debt (Ministry of (Vneshtorgbank) Finance Bonds) RUSSIA NDC Equity, Corporate Debt, Government Debt (Ministry of (National Depository Centre) Finance Bonds) SINGAPORE CDP Equity, Corporate Debt (The Central Depository (Pte) Limited) SINGAPORE SGS Government Debt (Monetary Authority of Singapore / Singapore Government Securities Book-Entry System) SLOVAK REPUBLIC SCP Equity, Corporate Debt, Government Debt (Stredisko cennych papierov SR Bratislava, a.s.) SLOVAK REPUBLIC NBS Government Debt (National Bank of Slovakia) SLOVENIA KDD Equity, Corporate Debt, Government Debt (Centralna klirinsko depotna druzba d.d.) SOUTH AFRICA CDL Corporate Debt, Government Debt (CENTRAL DEPOSITORY (PTY) LIMITED) SOUTH AFRICA STRATE Equity (Share Transactions Totally Electronic) SOUTH KOREA KSD Equity, Corporate Debt, Government Debt (Korea Securities Depository) SPAIN SCLV Equity, Corporate Debt (Servicio de Compensacion y Liquidacion de Valores, S.A.) SPAIN BANK OF SPAIN Government Debt SRI LANKA CDS Equity, Corporate Debt (Central Depository System (Private) Limited) SWEDEN VPC Equity, Corporate Debt, Government Debt (Vardepapperscentralen AB) SWITZERLAND SIS Equity, Corporate Debt, Government Debt (SIS SegaInterSettle AG) TAIWAN TSCD Equity, Government Debt (Taiwan Securities Central Depository Co., Ltd.) THAILAND TSD Equity, Corporate Debt, Government Debt (Thailand Securities Depository Company Limited)
26
COUNTRY DEPOSITORY INSTRUMENTS ------- ---------- ----------- TUNISIA STICODEVAM Equity, Corporate Debt, Government Debt (Societe Tunisienne Interprofessionnelle pour la Compensation et le Depot des Valeurs Mobilieres) TURKEY TAKASBANK Equity, Corporate Debt, Government Debt (IMKB Takas ve Saklama Bankasi A.S.) UNITED KINGDOM CREST Equity, Corporate Debt, Government Debt (CRESTCo Limited) UNITED KINGDOM CMO Sterling & Euro CDs, Commercial Paper (Central Moneymarkets Office) URUGUAY BCU Corporate Debt, Government Debt (Banco Central del Uruguay) VENEZUELA BCV Government Debt (Banco Central de Venezuela) ZAMBIA CSD Equity, Government Debt (LuSE Central Shares Depository Limited) ZAMBIA BOZ Government Debt (Bank of Zambia)
27 EX-99.(I) 7 f84662exv99wxiy.txt EXHIBIT 99.(I) Ex-(i) 1701 Market Street MORGAN, LEWIS Philadelphia, PA 19103 & BOCKIUS L.L.P. (215) 963-5000 COUNSELORS AT LAW Fax: (215) 963-5299 November 8, 2002 Schwab Investments 101 Montgomery Street San Francisco, CA 94104 Re: Opinion of Counsel regarding Post-Effective Amendment No. 44 to the Registration Statement filed on Form N-1A under the Securities Act of 1933 (File No. 33-37459). Ladies and Gentlemen: We have acted as counsel to Schwab Investments, a Massachusetts business trust (the "Trust"), in connection with the above-referenced Registration Statement on Form N-1A (as amended, the "Registration Statement") which relates to the Trust's shares of beneficial interest, par value $.00001 per share (collectively, the "Shares"). This opinion is being delivered to you in connection with the Trust's filing of Post-Effective Amendment No. 44 to the Registration Statement (the "Amendment") to be filed with the Securities and Exchange Commission pursuant to Rule 485(b) of the Securities Act of 1933 (the "1933 Act"). With your permission, all assumptions and statements of reliance herein have been made without any independent investigation or verification on our part except to the extent otherwise expressly stated, and we express no opinion with respect to the subject matter or accuracy of such assumptions or items relied upon. In connection with this opinion, we have reviewed, among other things, executed copies of the following documents: (a) a certificate of the Commonwealth of Massachusetts as to the existence and good standing of the Trust; (b) copies of the Trust's Agreement and Declaration of Trust and of all amendments and all supplements thereto (the "Declaration of Trust"); (c) a certificate executed by Koji Felton, the Secretary of the Trust, certifying as to, and attaching copies of, the Trust's Declaration of Trust and Amended and Restated By-Laws (the "By-Laws"), and certain resolutions adopted by the Board of Trustees of the Trust authorizing the issuance of the Shares; and (d) a printer's proof of the Amendment. In our capacity as counsel to the Trust, we have examined the originals, or certified, conformed or reproduced copies, of all records, agreements, instruments and documents as we have deemed relevant or necessary as the basis for the opinion hereinafter expressed. In all such examinations, we have assumed the legal capacity of all natural persons executing documents, the genuineness of all signatures, the authenticity of all original or certified copies, and the conformity to original or certified copies of all copies submitted to us as conformed or reproduced copies. As to various questions of fact relevant to such opinion, we have relied upon, and assume the accuracy of, certificates and oral or written statements of public officials and officers or representatives of the Fund. We have assumed that the Registration Statement, as filed with the Securities and Exchange Commission, will be in substantially the form of the printer's proof referred to in paragraph (d) above. Based upon, and subject to, the limitations set forth herein, we are of the opinion that the Shares, when issued and sold in accordance with the Trust's Declaration of Trust and By-Laws, and for the consideration described in the Registration Statement, will be legally issued, fully paid and nonassessable under the laws of the Commonwealth of Massachusetts. We hereby consent to the filing of this opinion as an exhibit to the Registration Statement. In giving this consent, we do not concede that we are in the category of persons whose consent is required under Section 7 of the 1933 Act. Very truly yours, /s/ Morgan, Lewis & Bockius LLP EX-99.(J) 8 f84662exv99wxjy.txt EXHIBIT 99.(J) Ex-(j) CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in this Registration Statement on Form N-1A of our reports dated October 11, 2002, relating to the financial statements and financial highlights which appears in the August 31, 2002 Annual Report to Shareholders of Schwab Short/Intermediate Tax-Free Bond Fund, Schwab Long-Term Tax-Free Bond Fund, Schwab California Short/Intermediate Tax-Free Bond Fund, Schwab Long-Term Tax-Free Bond Fund, Schwab Short-Term Bond Market Fund, Schwab Total Bond Market Fund and Schwab YieldPlus Fund(R), which are also incorporated by reference into the Registration Statement. We also consent to the references to us under the headings "Financial Highlights" and "Independent Accountants" in such Registration Statement. PricewaterhouseCoopers LLP San Francisco, California November 6, 2002 EX-99.(P)(I) 9 f84662exv99wxpyxiy.txt EXHIBIT 99.(P)(I) EX-(p)(i) THE CHARLES SCHWAB FAMILY OF FUNDS SCHWAB INVESTMENTS SCHWAB CAPITAL TRUST SCHWAB ANNUITY PORTFOLIOS POWER OF ATTORNEY I, the undersigned trustee and/or officer of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Trust" and collectively the "Trusts"), and each a Massachusetts business trust, do hereby constitute and appoint Koji Felton, Alice Schulman, Richard W. Grant and Tim Levin, and each of them singly, my true and lawful attorneys, with full power to them and each of them, to sign for me and in my name and the capacity listed below, any and all amendments to the Registration Statement on Form N1-A of each Trust, and to file the same with all exhibits thereto, and other documents in connection thereunder, with the Securities and Exchange Commission, granting unto my said attorneys, and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done in the premises, as fully as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue thereof. WITNESS my hand on the date set forth below. /s/Mariann Byerwalter Date: 09/04/02 - --------------------- -------- Mariann Byerwalter Trustee EX-99.(P)(II) 10 f84662exv99wxpyxiiy.txt EXHIBIT 99.(P)(II) EX-(p)(ii) THE CHARLES SCHWAB FAMILY OF FUNDS SCHWAB INVESTMENTS SCHWAB CAPITAL TRUST SCHWAB ANNUITY PORTFOLIOS POWER OF ATTORNEY I, the undersigned trustee and/or officer of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Trust" and collectively the "Trusts"), and each a Massachusetts business trust, do hereby constitute and appoint Koji Felton, Alice Schulman, Richard W. Grant and Tim Levin, and each of them singly, my true and lawful attorneys, with full power to them and each of them, to sign for me and in my name and the capacity listed below, any and all amendments to the Registration Statement on Form N1-A of each Trust, and to file the same with all exhibits thereto, and other documents in connection thereunder, with the Securities and Exchange Commission, granting unto my said attorneys, and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done in the premises, as fully as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue thereof. WITNESS my hand on the date set forth below. /s/William A. Hasler Date: 09/04/02 - -------------------- -------- William A. Hasler Trustee EX-99.(P)(III) 11 f84662exv99wxpyxiiiy.txt EXHIBIT 99.(P)(III) EX-(p)(iii) THE CHARLES SCHWAB FAMILY OF FUNDS SCHWAB INVESTMENTS SCHWAB CAPITAL TRUST SCHWAB ANNUITY PORTFOLIOS POWER OF ATTORNEY I, the undersigned trustee and/or officer of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Trust" and collectively the "Trusts"), and each a Massachusetts business trust, do hereby constitute and appoint Koji Felton, Alice Schulman, Richard W. Grant and Tim Levin, and each of them singly, my true and lawful attorneys, with full power to them and each of them, to sign for me and in my name and the capacity listed below, any and all amendments to the Registration Statement on Form N1-A of each Trust, and to file the same with all exhibits thereto, and other documents in connection thereunder, with the Securities and Exchange Commission, granting unto my said attorneys, and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done in the premises, as fully as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue thereof. WITNESS my hand on the date set forth below. /s/Gerald B. Smith Date: 09/04/02 - ------------------ -------- Gerald B. Smith Trustee EX-99.(P)(IV) 12 f84662exv99wxpyxivy.txt EXHIBIT 99.(P)(IV) EX-(p)(iv) THE CHARLES SCHWAB FAMILY OF FUNDS SCHWAB INVESTMENTS SCHWAB CAPITAL TRUST SCHWAB ANNUITY PORTFOLIOS POWER OF ATTORNEY I, the undersigned trustee and/or officer of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Trust" and collectively the "Trusts"), and each a Massachusetts business trust, do hereby constitute and appoint Koji Felton, Alice Schulman, Richard W. Grant and Tim Levin, and each of them singly, my true and lawful attorneys, with full power to them and each of them, to sign for me and in my name and the capacity listed below, any and all amendments to the Registration Statement on Form N1-A of each Trust, and to file the same with all exhibits thereto, and other documents in connection thereunder, with the Securities and Exchange Commission, granting unto my said attorneys, and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done in the premises, as fully as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue thereof. WITNESS my hand on the date set forth below. /s/Charles R. Schwab Date: 09/04/02 - -------------------- -------- Charles R. Schwab Chairman and Trustee EX-99.(P)(V) 13 f84662exv99wxpyxvy.txt EXHIBIT 99.(P)(V) EX-(p)(v) THE CHARLES SCHWAB FAMILY OF FUNDS SCHWAB INVESTMENTS SCHWAB CAPITAL TRUST SCHWAB ANNUITY PORTFOLIOS POWER OF ATTORNEY I, the undersigned trustee and/or officer of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Trust" and collectively the "Trusts"), and each a Massachusetts business trust, do hereby constitute and appoint Koji Felton, Alice Schulman, Richard W. Grant and Tim Levin, and each of them singly, my true and lawful attorneys, with full power to them and each of them, to sign for me and in my name and the capacity listed below, any and all amendments to the Registration Statement on Form N1-A of each Trust, and to file the same with all exhibits thereto, and other documents in connection thereunder, with the Securities and Exchange Commission, granting unto my said attorneys, and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done in the premises, as fully as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue thereof. WITNESS my hand on the date set forth below. /s/John Philip Coghlan Date: 09/04/02 - ---------------------- -------- John Philip Coghlan Trustee EX-99.(P)(VI) 14 f84662exv99wxpyxviy.txt EXHIBIT 99.(P)(VI) EX-(p)(vi) THE CHARLES SCHWAB FAMILY OF FUNDS SCHWAB INVESTMENTS SCHWAB CAPITAL TRUST SCHWAB ANNUITY PORTFOLIOS POWER OF ATTORNEY I, the undersigned trustee and/or officer of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Trust" and collectively the "Trusts"), and each a Massachusetts business trust, do hereby constitute and appoint Koji Felton, Alice Schulman, Richard W. Grant and Tim Levin, and each of them singly, my true and lawful attorneys, with full power to them and each of them, to sign for me and in my name and the capacity listed below, any and all amendments to the Registration Statement on Form N1-A of each Trust, and to file the same with all exhibits thereto, and other documents in connection thereunder, with the Securities and Exchange Commission, granting unto my said attorneys, and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done in the premises, as fully as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue thereof. WITNESS my hand on the date set forth below. /s/ Jeffrey M. Lyons Date: 09/04/02 - -------------------- -------- Jeffrey M. Lyons EX-99.(P)(VII) 15 f84662exv99wxpyxviiy.txt EXHIBIT 99.(P)(VII) EX-(p)(vii) THE CHARLES SCHWAB FAMILY OF FUNDS SCHWAB INVESTMENTS SCHWAB CAPITAL TRUST SCHWAB ANNUITY PORTFOLIOS POWER OF ATTORNEY I, the undersigned trustee and/or officer of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Trust" and collectively the "Trusts"), and each a Massachusetts business trust, do hereby constitute and appoint Koji Felton, Alice Schulman, Richard W. Grant and Tim Levin, and each of them singly, my true and lawful attorneys, with full power to them and each of them, to sign for me and in my name and the capacity listed below, any and all amendments to the Registration Statement on Form N1-A of each Trust, and to file the same with all exhibits thereto, and other documents in connection thereunder, with the Securities and Exchange Commission, granting unto my said attorneys, and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done in the premises, as fully as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue thereof. WITNESS my hand on the date set forth below. /s/Randall W. Merk Date: 09/04/02 - ------------------ ---------- Randall W. Merk President & Chief Executive Officer EX-99.(P)(VIII) 16 f84662exv99wxpyxviiiy.txt EXHIBIT 99.(P)(VIII) EX-(p)(viii) THE CHARLES SCHWAB FAMILY OF FUNDS SCHWAB INVESTMENTS SCHWAB CAPITAL TRUST SCHWAB ANNUITY PORTFOLIOS POWER OF ATTORNEY I, the undersigned trustee and/or officer of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Trust" and collectively the "Trusts"), and each a Massachusetts business trust, do hereby constitute and appoint Koji Felton, Alice Schulman, Richard W. Grant and Tim Levin, and each of them singly, my true and lawful attorneys, with full power to them and each of them, to sign for me and in my name and the capacity listed below, any and all amendments to the Registration Statement on Form N1-A of each Trust, and to file the same with all exhibits thereto, and other documents in connection thereunder, with the Securities and Exchange Commission, granting unto my said attorneys, and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done in the premises, as fully as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue thereof. WITNESS my hand on the date set forth below. /s/Donald F. Dorward Date: 09/04/02 - -------------------- -------- Donald F. Dorward Trustee EX-99.(P)(IX) 17 f84662exv99wxpyxixy.txt EXHIBIT 99.(P)(IX) EX-(p)(ix) THE CHARLES SCHWAB FAMILY OF FUNDS SCHWAB INVESTMENTS SCHWAB CAPITAL TRUST SCHWAB ANNUITY PORTFOLIOS POWER OF ATTORNEY I, the undersigned trustee and/or officer of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Trust" and collectively the "Trusts"), and each a Massachusetts business trust, do hereby constitute and appoint Koji Felton, Alice Schulman, Richard W. Grant and Tim Levin, and each of them singly, my true and lawful attorneys, with full power to them and each of them, to sign for me and in my name and the capacity listed below, any and all amendments to the Registration Statement on Form N1-A of each Trust, and to file the same with all exhibits thereto, and other documents in connection thereunder, with the Securities and Exchange Commission, granting unto my said attorneys, and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done in the premises, as fully as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue thereof. WITNESS my hand on the date set forth below. /s/Robert G. Holmes Date: 09/04/02 - ------------------- -------- Robert G. Holmes Trustee EX-99.(P)(X) 18 f84662exv99wxpyxxy.txt EXHIBIT 99.(P)(X) EX-(p)(x) THE CHARLES SCHWAB FAMILY OF FUNDS SCHWAB INVESTMENTS SCHWAB CAPITAL TRUST SCHWAB ANNUITY PORTFOLIOS POWER OF ATTORNEY I, the undersigned trustee and/or officer of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Trust" and collectively the "Trusts"), and each a Massachusetts business trust, do hereby constitute and appoint Koji Felton, Alice Schulman, Richard W. Grant and Tim Levin, and each of them singly, my true and lawful attorneys, with full power to them and each of them, to sign for me and in my name and the capacity listed below, any and all amendments to the Registration Statement on Form N1-A of each Trust, and to file the same with all exhibits thereto, and other documents in connection thereunder, with the Securities and Exchange Commission, granting unto my said attorneys, and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done in the premises, as fully as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue thereof. WITNESS my hand on the date set forth below. /s/Donald R. Stephens Date: 09/04/02 - --------------------- -------- Donald R. Stephens Trustee EX-99.(P)(XI) 19 f84662exv99wxpyxxiy.txt EXHIBIT 99.(P)(XI) EX-(p)(xi) THE CHARLES SCHWAB FAMILY OF FUNDS SCHWAB INVESTMENTS SCHWAB CAPITAL TRUST SCHWAB ANNUITY PORTFOLIOS POWER OF ATTORNEY I, the undersigned trustee and/or officer of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Trust" and collectively the "Trusts"), and each a Massachusetts business trust, do hereby constitute and appoint Koji Felton, Alice Schulman, Richard W. Grant and Tim Levin, and each of them singly, my true and lawful attorneys, with full power to them and each of them, to sign for me and in my name and the capacity listed below, any and all amendments to the Registration Statement on Form N1-A of each Trust, and to file the same with all exhibits thereto, and other documents in connection thereunder, with the Securities and Exchange Commission, granting unto my said attorneys, and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done in the premises, as fully as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue thereof. WITNESS my hand on the date set forth below. /s/Michael W. Wilsey Date: 09/04/02 - -------------------- -------- Michael W. Wilsey Trustee EX-99.(P)(XII) 20 f84662exv99wxpyxxiiy.txt EXHIBIT 99.(P)(XII) EX-(p)(xii) THE CHARLES SCHWAB FAMILY OF FUNDS SCHWAB INVESTMENTS SCHWAB CAPITAL TRUST SCHWAB ANNUITY PORTFOLIOS POWER OF ATTORNEY I, the undersigned trustee and/or officer of The Charles Schwab Family of Funds, Schwab Investments, Schwab Capital Trust and Schwab Annuity Portfolios (each a "Trust" and collectively the "Trusts"), and each a Massachusetts business trust, do hereby constitute and appoint Koji Felton, Alice Schulman, Richard W. Grant and Tim Levin, and each of them singly, my true and lawful attorneys, with full power to them and each of them, to sign for me and in my name and the capacity listed below, any and all amendments to the Registration Statement on Form N1-A of each Trust, and to file the same with all exhibits thereto, and other documents in connection thereunder, with the Securities and Exchange Commission, granting unto my said attorneys, and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done in the premises, as fully as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue thereof. WITNESS my hand on the date set forth below. /s/Tai-Chin Tung Date: 09/04/02 - ---------------- -------- Tai-Chin Tung Treasurer and Principal Financial Officer -----END PRIVACY-ENHANCED MESSAGE-----